Philipsen, The Little Big Number

What we measure matters. As Dirk Philipsen writes in his forthcoming The Little Big Number: How GDP Came to Rule the World and What to Do about It (Princeton University Press), “Choices about what to count, and how to count it, define many of our core values.” (p. 5)

The strength of a national economy—and, by extension, the prosperity and progress that most people believe are byproducts of economic growth—is measured by a well-known but, Philipsen argues, fatally flawed metric, the gross domestic product.

GDP was born in crisis and forged in war. In 1933 Simon Kuznets and a small staff from the Commerce Department and the National Bureau of Economic Research got the job of providing estimates of total national income for the years 1929-1931. The team found that total national income paid out to individuals had declined by 40% between 1929 and 1932. Their report was something of a best seller: “within eight months of its printing, almost 4,500 copies were sold at $ .20 a copy.” (p. 103) Soon enough the concept of national income became part of everyday political culture. “As a 1936 New York Times editorial remarked, ‘Estimates of national income, once discussed only among a handful of economists and statisticians, are now cited glibly in conversations over cracker boxes and brass rails, and many campaign arguments are based upon them.’” (p. 105) By World War II Kuznets and his students “turned the statistics of the gross national income and product accounts into information essential for planning and wartime production.” (p. 115)

GDP began to take on a life of its own. “Growth of GDP promised to create employment and necessary demand; it allowed the United States to provide vital aid to Europe and Japan and to maintain a large military during times of rising tensions with Soviet communism and growing threats to global resources and foreign markets; it eventually helped the United States win the Cold War and a series of proxy ‘hot’ wars against communism; it helped ease domestic unrest and prevented possible ‘class wars’ by raising the standards of living (as defined by per capita GDP).” (p. 126) Eventually it became a global article of faith.

What does GDP measure? For the most part, only goods and services that have a price, that are bought and sold in the market. The author introduces us to Ms. Golden Arrow, our guide to how this all plays out. Here are a few examples. “If Ms. Arrow stays home with [her children], perhaps even schools them at home, none of her work is factored into GDP, and officially nothing grows. If she does any of the things increasing numbers of American parents do—send them to private schools, enroll them in after-school activities, drive them from music lesson to math tutoring to basketball practice, hire babysitters for the much-needed evening out with her spouse—her GDP contribution grows by leaps and bounds. … If Ms. Arrow manages to stay happily married throughout all this, her spousal bliss adds nothing to official accounts of national economic success. If she runs into marital problems, requiring doctors, pills, and therapists, or perhaps even law enforcement, her GDP meter starts ticking in earnest. It hits full stride if she ends up in divorce: lawyers, courts, domestic help, separate living quarters, eating out, membership fees for dating services.” GDP remains stagnant when she lives in a safe, stable neighborhood. “But introduce things like severe inequality, social strife, or economic distress, and the resulting need of extra security measures—added police, home security systems, locks, handguns, jails—will advance GDP growth. So does her decision to move to a distant suburb: more roads, more gasoline, more construction, more accidents, more residential services.” (pp. 155-56) You get the picture. GDP is quality-blind, people-blind, justice-blind, ecosystem-blind, complexity blind, accountability-blind, and purpose-blind.

Philipsen maintains that, as a measure, GDP is both primitive and dangerous and should be abandoned. It is a delusion that jobs, the good life, or progress itself depends on GDP growth. (p. 208) Sustaining and expanding human well-being, which should be our goals, are not the same as promoting growth or income.

We need new measures that speak to these goals. We need “a national dialogue about goals of an economic constitution based on the four essential sides of our goalpost: sustainability, equity, democratic accountability, and economic viability. Simultaneous to this dialogue, taking place nationally and internationally, we can have ‘experts’—legal scholars, economists, ecologists, climatologists, medical professionals, philosophers—begin the process of figuring out how best to measure the performance of the goals embedded in our new economic constitution, and thus establish structures and regulations that support and incentivize the pursuit of these goals.” (p. 271) Some efforts are already underway, most notably the “Beyond GDP” initiative by the European Commission, but much remains to be done. Philipsen’s book is a clarion call.

Seifert, Profiting from Weekly Options

If you like taking quizzes you’ll love Robert J. Seifert’s Profiting from Weekly Options: How to Earn Consistent Income Trading Weekly Option Serials (Wiley, 2015). About a third of the book is devoted to test questions and answers. The author also has a glossary that he presents in full as an appendix and in part in the early chapters.

At the book’s core are four basic weekly trades—long call or put, credit spread, risk reversal, and backspread (1 x 2). Seifert explains when to initiate them and how to manage them. For instance, higher-priced stocks don’t lend themselves to the outright purchase of a call or put or to a backspread. “Once you move to the higher-priced stocks, you must go to the synthetic in order to overcome the premium. Although the option model works the same for higher-priced and lower-priced stocks, the dollar risk comes into play, and since our goal is to minimize the dollar risk and maximize our leverage, you must use the risk reversal on high-priced stocks.” (p. 113)

He analyzes how the trader should deal with these four types of option positions in varying market conditions—in a congestion phase, a trending phase, and a blowoff phase. To take but a single example, you could sell a bullish credit spread in a congested market, especially at a double bottom. You’re looking for a reward/risk ratio of approximately 2/3. “If you are more aggressive, you could consider the 60/40 [delta] spread and see if you can do it ‘Vega neutral.’” (p. 140) If the market rallies after you put your trade on, you can do nothing and allow it to expire worthless or you can roll it up. To play defense, you can sell another credit spread on the other side of the market, turning your initial position into an iron condor.

Seifert’s vocabulary is sometimes idiosyncratic, so the reader has to pay close attention early on or risk having to go back for remedial education.

Profiting from Weekly Options is not the most obvious place to begin an options education even though it assumes no previous knowledge. But those seeking to capitalize on the growing weekly options market will find it a worthwhile addition to their trading library.

Sull & Eisenhardt, Simple Rules

In 1948 Warren Weaver, of the Rockefeller Foundation, wrote an article in which he described science “as progressing through successive eras, defined by the three types of problems—simple, uncertain, and complex—that they solved. Simple problems address a few variables that can be reduced to a deterministic formula.” Newton’s laws are examples. “By the late nineteenth century, scientists shifted their attention to problems of uncertainty, such as the motion of gas particles in a jar.” They used probability theory and statistical analysis to predict how large numbers behave in aggregate, “paving the way for advances in thermodynamics, genetics, and information theory.” That left us with the most difficult set of problems, those dealing with complexity. (pp. 9-11)

The financial markets are complex adaptive systems. They cannot be described by deterministic formulas. They don’t lend themselves to statistical prediction. What, then, is an investor or a trader to do?

MIT and Stanford professors Donald Sull and Kathleen M. Eisenhardt offer some suggestions in their forthcoming Simple Rules: How to Thrive in a Complex World (Houghton Mifflin Harcourt, 2015). Their book will inevitably be compared to Daniel Kahneman’s Thinking, Fast and Slow and Malcolm Gladwell’s Blink. But it is more practical than its predecessors, written for people (especially business people) who have to make tough decisions.

Simple rules often work best. “In contrast to complicated models, simple rules focus on only the most critical variables. By ignoring peripheral factors and tenuous correlations, rules of thumb eliminate a great deal of noise. The absence of noise results in decisions that work reasonably well across a wide range of scenarios, rather than being optimized for a single situation. … In very complex systems, like the stock market or the economy as a whole, where causal relations are poorly understood and shift over time, the risks of overfitting past data are particularly acute. Statisticians have found that complicated models consistently fail to outperform simple ones in forecasting economic trends, and the accuracy of their predictions has not improved over time. When it comes to modeling complex systems, sophisticated does not equal effective.” (pp. 34-35)

Simple rules “are particularly effective when the situation is in flux, flexibility trumps consistency, and the benefits of seizing opportunities exceed the cost of making mistakes. “ (p. 44)

Admittedly, there are situations in which complicated decision-models work better than simple rules. For instance, “decisions that can be made by computers, such as via automated trading programs, are better candidates for complicated models than those that rely on human willpower to implement.” (p. 37) In general, however, simplicity wins the day.

Effective simple rules can be sorted into six broad categories: boundary, prioritizing, stopping, how-to, coordination, and timing. The authors give examples of each type of rule, drawing on a range of behaviors (from which house to rob to when to sell a stock, from how to deal with out-of-control forest fires to how starlings flock).

The authors describe ways to develop simple rules in business, non-profit, and personal settings. These rules, of course, cannot be created in a vacuum. “Investing the time upfront to clarify what will move the needles dramatically increases the odds that simple rules will be applied where they can have the greatest impact.” (p. 144)

Investors and traders who want to simplify their overly complex systems or who want to create an efficient rule-based system or plan will be well served by this book. The task will remain difficult (or not, if they opt to follow the 1/N rule). In any event, the recommendations in Simple Rules should keep the investor or trader from straying too far off course.

Allman, Impact Investment

Impact investors believe in the power of private capital to solve intractable social problems and, at the same time, deliver a financial return. Impact investing is a burgeoning field. “As of 2014, over USD12.7 billion has been committed to impact investing, representing a growth of 19 percent from the prior year. Numerous investors are active ranging from lone high net worth individuals to a multitude of private equity funds. Even larger-scale financial institutions and investment services have dedicated funds and resources to impact investing.” (p. 1)

Keith A. Allman and Ximena Escobar de Nogales have written a how-to manual for the would-be investor. Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis (Wiley, 2015) takes the reader through the steps that an investor would normally follow: sourcing and screening, investment analysis and valuation, due diligence and investment structuring, term sheet and documentation, and building value to exit.

The process is arduous and more constrained than traditional private equity investing. Private equity funds have a single mission—to make money. Impact funds have a dual mission—to deliver both financial and social/environmental returns. This means that impact investors will have a smaller pool of potential investments from which to choose. It entails a more complicated set of metrics throughout the process. It also means that the compensation of the fund manager has to be pegged to both financial and social goals—a tricky calculation at best.

Impact Investment is an excellent guide for investors who want to venture into the field of idealistic capitalism. As this book amply demonstrates, they will need all the help they can get.

Lichtenfeld, Get Rich with Dividends, 2d ed.

In Get Rich with Dividends: A Proven System for Earning Double-Digit Returns (second edition, Wiley, 2015) Marc Lichtenfeld, chief income strategist of the Oxford Club, lays out a plan to consistently achieve above average returns. He calls it the 10-11-12 system because it is designed to achieve an 11% yield and a 10-year average total return of 12% in 10 years. To accomplish this, the investor needs a 4.7% starting yield, a 10% dividend growth, and a market that performs as it has historically.

Lichtenfeld provides a step-by-step guide to constructing a winning dividend portfolio. Since his guide doesn’t lend itself to brief summary, I’ll focus on two points: (1) the historical performance of stocks that raise their dividends and (2) buybacks versus dividends.

According to Ned Davis Research, assuming an initial investment of $100, between 1972 and 2010 dividend cutters were worth $82 (a compound annual growth rate of -0.52%), companies that didn’t pay a dividend were worth $194 (1.76%), companies that paid a dividend but kept it flat were worth $1,610 (7.59%), and dividend raisers were worth $3,545 (9.84%). The author’s system would turn the initial $100 investment into nearly $7,500 over the same period.

As for the performance of stocks versus high-yield bonds, historically, stocks have “a greater chance of suffering a loss, but only by 3%. To compensate for the risk, stocks generate 92% in extra return. …[I]n the past, you’ve had a 9% chance of losing 27% of your money over 10 years investing in stocks or a 6% chance of losing 40% of your money investing in high-yield bonds.” (p. 49) Dividend stocks, the author concludes, are a better investment than junk bonds.

When companies have excess cash, they can pay a dividend, buy back stock, make an acquisition, or simply horde the money. Which is better for the investor—a dividend or a stock buyback? Not surprisingly, Lichtenfeld comes down in favor of dividends.

A stock buyback does not require a company to repurchase the amount of stock it announces in its stock repurchase authorization. But when it does buy back its own shares, it decreases the share count and thereby increases the earnings per share. So when a company announces a stock buyback, it normally sees a pop in its stock price, even if its profits don’t move at all. “It’s simply an accounting trick that doesn’t reflect any change in the business.” (p. 60)

By contrast, “when a company pays a dividend, that’s real. It’s not part of an authorization plan that may or may not be executed. … A dividend declaration is like a vote of confidence by management not only affirming that there will be enough cash to pay the dividend and run the business but also stating that it has set an expectation for a certain level of earnings and cash flow.” As a 2007 study concluded, “share repurchases are associated with temporary components of earnings, whereas dividends are not.” Or, as another study found, “dividends are paid by firms with higher ‘permanent’ operating cash flows.” (pp. 60, 61)

Investing in dividend-paying stocks is a sound strategy for those who seek income or, if they have time on their side, who want to reap the wondrous rewards of compound interest. Long-term investors will find an abundance of valuable, actionable advice in Get Rich with Dividends. It’s definitely worth a read.

Moraif, Buy, Hold, and Sell!

The author of Buy, Hold, and Sell!: The Investment Strategy That Could Save You from the Next Market Crash (Wiley, 2015) heads the financial advisory firm Money Matters with Ken Moraif and hosts a weekly radio show with the same name. He is writing for investors, especially those over the age of 50, who want to protect their nest eggs from the ravages of a deep bear market.

For decades investors were told to buy and hold. They bought into myths that perpetuated this advice: the market always comes back, don’t miss the 20 best trading days, don’t be the fool who sells at the bottom, diversity your portfolio … that’s all you need to do, you won’t make any money if you sell and sit in cash, and you haven’t lost any money unless you….

Moraif debunks these myths and tackles what I consider to be the toughest part of investing—selling. When should you take profits or cut your losses? He offers a couple of simple alternatives. First, looking at the equity market as a whole, you can use the 200-day moving average, preferably with a band around it to prevent whipsaw. Second, when it comes to individual stocks, you can use a stop-loss or, if you have a profit, a trailing stop-loss tied to the stock’s volatility.

When shouldn’t you sell? Single event-driven market selloffs are a bad time to bail because the market usually rebounds quickly. If, however, there’s more than one reason, especially if there’s an accumulation of ugly economic data, the investor should pay close attention.

Moraif’s book offers those who worry about their financial futures, particularly those who don’t have time to recover if something goes badly awry, a few basic risk management principles. He tries to take some of the angst out of selling and aims to give the investor “peace of mind, … a feeling of security in a world of volatility, risk, and economic unrest, … the chance to enjoy your retirement as you should—as a second childhood without parental supervision.” (p. 179) Would that disciplined investing lent itself to such emotional calm.

Belmonte, Buffett and Beyond, 2d ed.

In Buffett and Beyond: Uncovering the Secret Ratio for Superior Stock Selection (Wiley, 2015) Joseph Belmonte offers investors a metric he believes is pretty close to the Holy Grail: return on equity (ROE) as configured by Clean Surplus Accounting.

The companies that investors choose for their portfolios should have a ROE that is high and consistent over time. The problem is that practically all investors calculate ROE in a way that is both inefficient and unreliable. Traditional ROE is not a useful ratio for comparing the operating efficiency of one company to that of another because, for most companies, it is inconsistent from year to year. Worse, there is almost no correlation between book value (equity) and stock returns.

Traditional ROE uses earnings to calculate the return portion of ROE. But earnings include both non-recurring items, which are not predictable, and future liabilities. As Belmonte argues, “[i]n no way do these events show how efficiently you’ve been running your operation. And we’re concerned with operating efficiency in our ROE ratio and not branches falling out of the sky because of a hurricane passing by.” (p. 59) So, for the return portion of the ROE ratio one should use net income, not earnings.

What about the equity portion of ROE? Owners’ equity (or book value) equals the common stock issuance plus all retained earnings, where these retained earnings can come only from net income minus dividends.

Based on his research, indicating that stocks with a history of high Clean Surplus ROEs outperformed the S&P 500, Belmonte came up with six simple rules for structuring a portfolio.

1. Choose stocks with Clean Surplus ROEs above 20%.

2. Choose stocks that have a good history of operation, either a solid ten years or a shorter history but with high and rising ROEs.

3. Choose stocks with low or no dividends.

4. Choose stocks with little debt.

5. Stocks with rising ROEs are attractive even if their ROEs are below 20%.

6. Sell a stock when the Clean Surplus ROE drops below 20%.

The top stocks in Belmonte’s 2014 screen were Gilead, Priceline, Lorillard, Apple, and BlackRock. Panera was a stock that came out of his portfolio when the forecasted ROE for 2014 fell below 20 percent. Monster Beverage, by contrast, held to a steady ROE around 23% over the last three years. “In the two years since we made that change, Panera has no gain, while the S&P 500 index has risen 35 percent and Monster Beverage has risen 70 percent.” (p. 128)

Belmonte ran numerous backtests, but they are not models of rigorous quantitative research. Investors might want to crunch their own numbers before committing hard-earned money to his system.