“Ready Player One” by Ernest Cline

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Years ago, I heard about a book called “Ready Player One“. I fully intended to check it out, but forgot about it and was sidetracked.

A short time ago, I read that Stephen Spielberg was working on a movie adaptation of the book and thought I had to check it out for myself.

Boy, was that a great decision! “Ready Player One” was one of the most fun books I’ve read in years.

The Book

“Ready Player One” is set in a dystopian 2044.  The world finally hit “peak oil” decades earlier and the world has been consumed by an energy crisis ever since.  The energy crisis triggered a worldwide depression and increases the occurrence of war, famine. The middle class has essentially disappeared and the poor live in trailers stacked high into the sky.

To escape from the world, users go to the OASIS. The OASIS is a virtual world. Users can put on a pair of virtual reality glasses and be transported to any place, limited only by their imaginations. Most fictional worlds are covered — there are authentic recreations of different universes: Star Trek, Star Wars, Firefly, Middle Earth, Blade Runner . . . just to name a few. Most of humanity spends all of their time in this virtual universe, mainly because the outside world is so horrific and the online world is so completely immersive.

At the beginning of the book, the creator of the OASIS (James Halliday) dies. With no living heirs, he leaves behind his entire fortune and controlling interest in the OASIS to whoever can find it in a series of puzzles embedded in the OASIS. Halliday creates a series of quests and puzzles in the OASIS for whomever can solve them. They are all rooted in his obsession with the 1980s and early video games.

The protagonist of the book (Wade Watts, known in the OASIS as Parzival) is one of millions of people looking for Halliday’s Easter Egg. He’s poor and growing up in a stack of trailer homes. As you might imagine, he’s up against significant competition, including a rival multi-billion dollar corporation intent on seizing the OASIS and Halliday’s fortune for themselves by any means necessary.

The Fun

The book is incredibly fun. Not only is it a great adventure with interesting characters and a compelling vision of the future, but it is a deep nostalgic trip into the 1980s. It includes references to everything imaginable from the decade. The protagonist’s virtual meeting room in the OASIS is modeled after the living room from “Family Ties“. One of the quests involves the movie “War Games”. Things covered include Rush, Pac-Man, obscure video games like “Dungeons of Daggorath“, pizza shop arcades . . . actually, it’s hard to think of what facets of pop culture from the ’80s aren’t covered. The protagonist even drives a Back to the Future inspired Delorean in the Oasis. Naturally, it is capable of space flight and light speed!

I grew up completely absorbed in the pop culture of the 1980s and the decade has a special place in my heart, so that’s probably a major reason why I loved this book. It was also nice to read a book written by fellow geek who loves the decade even more than I do. My video game experiences are mostly from the NES and SNES era, but I could still appreciate all of the Atari references.

Recommendation

If you’re looking to kick back and go on a rip roaring adventure, I can’t recommend this book enough. It’s the perfect summer read. Definitely check it out before the movie comes out next year.

Next on the agenda is Cline’s second book, Armada.  I’ll let you know what I think when I finish it!

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q2 2017 Performance Update

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The trends that were in place in Q1 are still raging on into Q2. Large cap tech stocks continue their ascendancy and value lags. In comparison, I am not doing well at all.

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Inside My Portfolio

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The laggards in the portfolio are the same from the first quarter. My retail stocks (CATO, AEO, GME, DDS) continue to get hammered. Dillard’s seems to be holding up as the best of the bunch. This makes sense because it is the least scary looking and highest quality of the retail names that I own.

Dillard’s is usually a mall anchor and focuses on higher end clothes. There are also stand-alone stores. American Eagle is actually in the mall (where fewer people are going these days) and targets teenagers. Teenagers, in sharp contrast to the teenage world I grew up in, don’t care about what clothes they wear. This is good for civilization but not for my portfolio! Cato is one of the few names I own that actually produced a quarterly loss in Q1, making that one a bit terrifying. It will be interesting to see how this plays out. I suspect the scarier looking names (AEO, CATO) will actually outperform the less scary DDS, but we’ll see.

Topbuild (BLD) continues its momentum. If it tops 50% in gains, I may pare back the position. Sanderson Farms (SAFM) is benefitting from rising chicken prices.

IDT is a very volatile stock. After their terrible quarter in March, it fell from $20.29 to $12.38. It then rebounded up to $17.58, falling again after another bad quarterly result down to $13.75. The loss occurred because of a $10 MM legal settlement with the FCC. The good news is that there was hardly any drop off in the core operating business of IDT and the settlement appears to be temporary (I hope!). IDT is also paying a healthy dividend.

The Market

The overall market continues its momentum, with most of the performance soaked up by big cap glamor companies. Amazon is up 29% year to date, Telsa is up 69%, Facebook is up 31%, Netflix is up 21%. This occurs against the backdrop of a strong economy with serious headwinds. There is significant political uncertainty around the Trump administration, and the Fed continues raising rates.

I don’t think the current environment will last. The present frenzy over sexy stocks like Facebook, Amazon, and Tesla has ‘late ’90s’ and ‘nifty 50’ written all over it. There is no telling when the momentum will stop, but I think it will end eventually. The question is when it will stop, which is a question that no one can answer. Is this 1997 or 2000? Is this 1967 or 1972? No one knows, but I’m not going to jump on the bandwagon and embrace the current mood.

Value strategies continue to lag. This has been going on for a decade. A strategy I like to compare myself to is Validea’s Benjamin Graham Portfolio. Year to date their 20-stock Ben Graham portfolio (based on their own interpretation of a Ben Graham stock screen) is down 9.2%. This gives me some comfort, as I know that I’m in good company. Since 2003, Validea’s version of the Ben Graham strategy delivered an annualized return of 8.6%, compared to the S&P 500’s average of 6.5%.

I see similar comparisons with AAII’s value stock screens. AAII’s best performing stock screens over the long run are their value screens. Most of these stock screens are also having a tough time year to date. Again, this gives me comfort. I know I’m in good company!

As they say: misery loves company!

The big question is how all of this plays out. Back in 2008, value stocks declined before the broader market. It was a canary in the coal mine, predicting the broad-based decline in stocks that year. In contrast, value stocks registered similar poor performance in 1998 and 1999. When the broader market was decimated in 2000-2003, value stocks actually had a bull market! Hopefully, the current situation is more like 1999 than 2008, but we’ll just have to wait and see.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ranking the Fed

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Writing about Alan Greenspan’s record made me wonder if there was a way to measure the performance of a Fed Chairman, systematically without biases.

The Misery Index

The Fed has a dual mandate: maintaining both price stability and maximum employment. Back in the ’70s, these factors of unemployment and inflation were added up into what was known at the time as “the misery index.” The job of the Federal Reserve is to keep both unemployment and inflation low (i.e., keep the misery index low). It hasn’t always succeeded:

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In the early 1960s, the US economy experienced both low inflation and low unemployment. Inflation steadily trended higher and peaked in the 1970s.

In the 1970s, the United States faced a phenomenon known as stagflation, simultaneously high unemploymentwhichand high inflation. It perplexed economists, as traditionally there was a trade-off between unemployment and inflation. The cure for inflation was unemployment, the cure for unemployment was some inflation. In the 1970s, this relationship broke down, and both soared to next heights.

This is why the misery index peaked in the late 1970s and early 1980s. Inflation has not crept back in a meaningful way since its defeat in the early 1980s. Most increases in the misery index since the beginning of the 1980s are due to increases in unemployment.

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Ranks

I decided to rank the chairmen by the net change experienced in the misery index during their tenure. By this measure, no chairman can match the record of Paul Volcker. His tough monetary medicine (double digit interest rates) caused a brutal recession in the early 1980s, but this was the medicine that the economy needed to finally break inflation.

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Regarding the average level of the misery index, the best chairman was William McChesney Martin. The data I used only covered a portion of his tenure in the 1960s. It would likely look even better if I included the 1950s. Martin presided over a period of simultaneously low unemployment and low inflation. The next best by this measure was Alan Greenspan.

By the metric of unemployment, Martin also experienced the lowest average unemployment rate. The lowest inflation rate was experienced by Janet Yellen. Inflation has been declining under her tenure, with inflation being virtually zero in 2015 due to the collapse of oil prices. The decline in inflation during this decade defied the expectations who expected the massive monetary easing of the Bernanke era to result in high levels of inflation.

Are the Rankings Fair?

Trying to empirically measure the performance of the Federal Reserve is a difficult task. My preferred measure is not the absolute level of misery, but the net change in the misery index during the tenure. By this metric, Paul Volcker is the winner.

Some might say that a chairman like Volcker is uniquely advantaged with this list because his starting point for unemployment and inflation was so staggeringly high. I would counter this and say that Volcker deserves the highest ranking for what he accomplished. In retrospect, it might seem like Volcker’s actions were obvious (tighten the money supply to restrain inflation), but this was a monumental challenge. He made the incredibly difficult decision of focusing solely on inflation. The medicine was tough for the economy: double digit unemployment and interest rates. Volcker’s policies caused an immense public backlash. Construction workers sent Volcker 2×4’s to protest his policies. The public was outraged, but Volcker’s tough medicine worked. He broke the back of inflation and unemployment soon followed.

Ronald Reagan also deserves credit for standing behind Volcker. It is quite tempting for a President to encourage the Fed to loosen monetary policy. Nixon did this in the 1970s, which helped create the stagflation problem in the first place. George H.W. Bush put similar pressure on Alan Greenspan, who didn’t give in. George H.W. Bush blamed his election loss on Greenspan. The temptation was massive for Ronald Reagan to try to twist Volcker’s arm in 1982. We remember Reagan as being popular, but at that point in the depths of the recession, Reagan had a 40% approval rating. He didn’t give in despite the public outcry, and neither did Volcker. They both deserve immense credit for that.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“The Map and the Territory” by Alan Greenspan

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I recently finished Alan Greenspan’s 2013 book, The Map and the TerritoryThe book is Greenspan’s attempt to explain what went wrong in 2008 and why it shocked most economists.

Greenspan Hate

Since 2008, it has become quite fashionable to hate on Alan Greenspan. Right wingers in the mold of gold bugs and Ludwig von Mises acolytes look at him as someone who fine-tuned the economy into oblivion. Left wingers look at him as a libertarian ideologue who was close friends with Ayn Rand and stripped the financial sector of regulation and let banks do whatever they want, leading the economy into oblivion.

In the current environment of bipartisan vitriol, it seems crazy that back around the year 2000, Greenspan was lauded as a genius and the greatest Fed chairman of all time. The title of Bob Woodward’s 2000 book about Greenspan reflects the popular sentiment: MaestroGreenspan was the Mozart of economics, solely responsible for the economic miracle of the late 1990s.

When someone’s reputation becomes that pumped up, it’s bound to mean revert.

Mean reversion can be quite nasty. The praise heaped on Greenspan in the late ’90s and early 2000s was more than he deserved. Similarly, the hatred heaped on him lately is also not deserved. What is amusing is that the recent criticism simultaneously paints him as both an interventionist and a libertarian ideologue. Greenspan hatred is bipartisan, but the reasons for the hatred are completely contradictory.

The Record

I think that Greenspan made some mistakes, but they have to be weighed against his triumphs. His record as Fed chairman was often exemplary, even considering the mistakes he made at the end. He wasn’t an ideologue. He was a pragmatist who tried to navigate the mess of our government to achieve the best possible result. My guess is that he started out as a gold-bug Ayn Rand libertarian, but realized that purist libertarian idealism wasn’t compatible with getting jobs in government where he could actually wield influence. He wanted to actually influence public policy, not just talk about it. To be effective, he had to be open to compromise.

That Greenspan era is referred to as “The Great Moderation“. The Great Moderation was an amazing economic achievement. The Greenspan era was one of infrequent shallow recessions, low inflation, low unemployment, climbing asset prices and resiliency in the face of multiple crises.

Resiliency is a key point. During his tenure, the United States faced the following crises: the crash of 1987, the Asian financial crisis, the demise of Long Term Capital Management, the collapse of the dot com bubble, the savings and loan crisis and 9/11. While the markets experienced some wild gyrations over these events, the real economy barely noticed. Even after the collapse of the dot com bubble and 9/11, unemployment peaked at only 6.3%. To put that in historical perspective, 6.3% was the unemployment rate in 1994 and 1987 during times of expansion.

The failures are the focus right now. The failures include: believing that banks wouldn’t take excessive risks with capital (a preposterous position in retrospect), fighting the regulation of derivatives (covered in this excellent Frontline documentary). He likely took interest rates too low for too long in the wake of 9/11 and the dot com bubble (as has been theorized by the economist John Taylor). Indeed, low rates in the early 2000s might be the very reason that the recession of that period was so shallow. The Great Recession might very well have been the bill coming due for having such a relatively easy recession earlier in the decade.  None of that can be proven, of course.

Although, imagine if Greenspan did not respond to the collapse of the dot com bubble and 9/11 and didn’t let interest rates plummet. He would have been blamed for making a recession worse than it needed to be at a time when we had low inflation and could have handled lower rates because inflation was so low. It all would have been to lessen the severity of a future recession which, in this alternate universe, might never have even happened. Hindsight is 20/20, which is an advantage of being a pundit and a cost to getting your hands dirty and taking positions in the public arena, as Greenspan did.

As for regulations, Greenspan should have pursued tougher regulation of banks and regulated derivatives. Although, it is important to keep in mind that this would have put him at odds with all the banks and the entire Washington establishment. The Clinton administration and the Republicans in Congress back in the ’90s loosened restrictions on banking and didn’t want to regulate derivatives. There was a bipartisan consensus on these issues back then, as demonstrated by the passage of Gramm-Leach-Biley. The deregulation combined with public policy that actually encouraged risky lending as a form of social justice was simply toxic. A good example of this is the Community Reinvestment Act and its intensification under the Clinton adminstration.

If Democrats are on board with deregulating, then who is going to stop it? When it comes to tearing down regulations, Republicans are the gas and Democrats are the brakes. In the ’90s, there were no brakes. It was all gas, with predictable long term results. Greenspan should have sounded the alarms, but I don’t think that one man (albeit, a very influential man) could stop an out of control Mack truck barreling down a highway.

Everyone deserves blame for the financial crisis. Certainly some more than others, but most people had a hand in it. The regulators failed, Washington failed, the banks failed. More importantly and less discussed is the fact that we failed. We failed as citizens to appropriately monitor our institutions. Growing up back in the ’90s, I was always amazed at the complete and total lack of interest that most adults had in current affairs. Civic engagement fell off a cliff. The voters were asleep at the wheel while our politicians made reckless decisions. A democracy is only as strong as its participants. We weren’t paying attention when Washington was engaging in reckless actions. We gladly borrowed the money without doing the arithmetic, but then blamed the banks when the bills came due. Nearly everyone had a hand in what happened. Greenspan failed, but one man is not singularly responsible for our collective failing as a society to appropriately monitor our institutions and act with financial prudence.

The Book

This is a book review, so I suppose I should actually review the book and stop talking about Greenspan!

The book itself is a real tour-de-force of ideas. Greenspan takes the reader through a tour of his thoughts and insights into the economy, which are too numerous to list them all. The book does contain a few very big ideas, which I’ll discuss here.

Much of the book is devoted to retelling the story of the crisis and the mistakes made. Greenspan doesn’t come out and say: “I screwed up and I am sorry”, but I think it amounts to that. He discusses how we need stronger regulations. He laments the bailout and the actions of the banks. He also makes a strong argument that we need to address the risks posed by too big to fail institutions.

He even talks about better ways to deal with the environment and takes the reader through a seemingly crazy experiment of trying to determine the actual weight of GDP.

Animal Spirits

It’s clear that Alan Greenspan spent most of his career trying to reduce the economy to equations, to mathematical arrangements that can be measured. That’s why it is fascinating in the book to see him examine the importance of flesh and blood human beings to the economy. John Maynard Keynes referred to human emotions driving economic activity as animal spirits. Humans don’t always make sense. 2008 helped Greenspan wake up and realize that animal spirits are key even if they can’t be measured.

That’s why the first chapter is called “Animal Spirits”, as Greenspan catalogs all of the ways that human emotions affect our economic judgement, which isn’t a surprise to most of us, but is indeed a revelation to economics that have spent their careers trying to reduce human behavior to beautiful mathematical models.

Greenspan tries to quantify some of these emotional judgments. For instance, he observes that the yield curve (where longer maturities supply higher interest rates), has been firmly in place throughout the history of civilization.  The earnings yield of the US stock tends to stay around 5-6% over long stretches of time, implying that this is the human preference of return for the risk of owning equities. (Sidenote: This might explain why Jeremy Siegel observes that the long-term return of equities after inflation is around 6% for nearly 200 years in his book Stocks for the Long Run.)

Greenspan marvels throughout the book at the extent to which human emotions drive economic behavior. He observes that the cultural diversity of Europe is a major reason for the Euro’s struggles as a currency to unite the region. Culture plays a role in determining the savings rate of a country (does the country value consumption in the present over long term saving?) as well as the effectiveness of regulation (is the culture permissive towards corruption and cheating?).

The Entitlements-Savings Trade Off

The most interesting point that Greenspan makes in the book is that there is a trade-off between entitlement spending and savings. This makes intuitive sense because in societies with generous entitlement programs, there is less incentive for people to save money. If you know that the government will pay for your retirement, what is the point of foregoing consumption in your youth to save for retirement? Should a 30 year old pick a vacation or increased 401(k) contributions? Our tendency is definitely towards the vacation and a generous safety net only makes that choice more appealing.

In fact, Greenspan demonstrates that the sum of total savings and entitlement spending adds up to 28-32% of GDP. Over time, as entitlement programs expand and the population becomes older, increases in entitlement spending reduce the nation’s savings rate. Every dollar that we spend on entitlement programs like social security and Medicare is one less dollar that we save.

In 1965, for instance, about 5% of GDP was social benefits and 25% of GDP was saved. A total of 30%.  By 1992, about 10% of GDP was devoted to social benefits and 20% of GDP was saved. Again, a total of 30%, with the increased social spending crowding out private savings. In 2010, the amounts converged. 15% of our GDP went to social spending and 15% of our economy was devoted to savings.

Due to increased entitlement spending, national savings declined from 25% to 15%.

This is bad because savings is the raw fuel of investment. That’s less money for banks to lend, that’s less money available to issue corporate bonds, that’s less money that can be raised in the equity markets. The less capital that is available, the less investments are being made in the future productive capacity of our economy.

I think Greenspan argues pretty conclusively that there is very likely a trade off between the two. Does this mean we should tear down our entitlement programs completely to maximize our savings rate? Of course not. With that said, entitlement reform should be pursued to contain the growth of entitlement spending before it endangers the federal budget and crowds out private savings.

I think this shows a larger trade off at the core of all public policy, which we like to pretend doesn’t exist. What liberalism offers in its most extreme form is a society with maximum safety and public comfort (i.e., generous safety nets, government funded retirement, a universal basic income). What conservatism offers in its most extreme form is a society with maximum dynamism (i.e., high economic growth and creative destruction). It seems foolish to think that we can have it all: have government take care of everyone’s materials need in a dynamic and fast growing economy. This trade off is at the core of our public policy debate. We should stop pretending that the trade off doesn’t exist.

Conclusion

You should read this book! Even if you dislike Greenspan (I’m imagining Ron Swanson on the right and Lisa Simpson on the left), it doesn’t hurt to get his perspective. He was at the center of most economic policy for the last 50 years and has some useful insights. I also think it’s impressive that he took the time to write this book and take us down his own intellectual journey in the wake of 2008. Most people develop their opinions about the world around the age of 20 and barely budge after that. Greenspan is 91 years old and approaches everything with an open mind, ready to look at the data and reevaluate his opinions. The world would be a better place if we all took that approach.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Can a Small Investor Beat Wall Street?

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One of the common responses I hear when I tell people that I buy and sell stocks using my own analysis goes something like this:

“Why even bother? There are so many smart people researching these stocks with far more time to devote to it than you. They have better information and can do more homework. You might as well buy an index fund.”

Indeed, there are many people trying to beat the market and Wall Street spends a vast amount of money on research and analysis, which is likely superior to the analysis that I have the time to do.

The Data

I decided to step back and check the actual data about Wall Street recommendations. I wondered what would happen if you systematically bought baskets of each Wall Street recommendation (buy, sell, etc.), held on to them for a year and then re-balanced annually. The results from the Russell 3000 universe are below:

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If Wall Street analysis were on point, there would be a more linear result. Each basket should outperform the next.

Instead, the actual data produces this choppy result. Neutral ratings outperform buys and strong buys. Meanwhile, those rare “strong sell” ratings actually outperform the sell recommendations.

This analysis of Morningstar star ratings comes to a similar conclusion. Morningstar assigns star ratings to mutual funds (5 stars are the best, 1 star is the worst). The paper linked to analyzes the resulting returns after Morningstar issues the rating. The 5 star ratings outperform the 1 star ratings, but in the lower end it gets lumpy. The 1 star rated funds outperform the 2 and 3 star funds.

Also, consider this tidbit of stock market history which is quite shocking: in November of 2001, more than half of Wall Street analysts rated Enron as a buy or better.

Why This Result?

This leaves one to speculate: why do we get this result? I think there are three key reasons:

1. Human nature makes us extrapolate the present into the future. Analysts aren’t immune to this tendency.

Any analyst can look at Amazon, for instance, and tell me that they are doing a great job at growing their revenues. Any analyst can look at the retail sector and tell me that retail is hurting as more consumers shift their buying preferences online. In 2006, any analyst could tell you that the financial sector was enjoying a nice upswing and would also provide you with a very convincing explanation (i.e., the “financial supermarkets” created in the wake of Gramm-Leach-Biley were leading to higher returns on equity for banks) or that the energy sector was doing well thanks to advancing oil prices (they would probably say that oil would continue to increase due to growing demand from emerging market economies and peak oil). In 1999, any analyst could have looked at the growth in fiber-optics and told you that JDS Uniphase was doing very well and would continue to do so because the rapidly growing information economy would fuel greater demand for fiber optic cable. Analysts are frequently deceived because they underestimate the tendency of things to change. Some have expressed this sentiment with greater eloquence.

When you look at a Wall Street research recommendation, what you’re seeing is the conventional wisdom. The conventional wisdom is usually an extrapolation of what is going on right now into the future. The conventional wisdom usually becomes more ingrained when we listen to really smart people provide convincing explanations for why the trend will continue.

Things change and the conventional wisdom is frequently incorrect. It is human nature to take trends and extrapolate them into the future. This worked for our ancestors trying to evade a predator, but it doesn’t work when trying to predict changes in the modern world. The tendency of trends to reverse (for great businesses to falter, for bad businesses to turn around) defies the ingrained expectations of human nature.

2. Wall Street doesn’t care about valuation as much as it should.

Valuation plays another role. Stocks with “strong buy” recommendations are frequently overvalued. Of the 32 analysts covering Amazon, for instance, 23 of them have a strong buy recommendation. Clearly, valuation isn’t even considered the analysis, as Amazon currently has a P/E ratio of 179.84. Amazon might continue it’s ascendancy, but history shows that stocks with such lofty valuations frequently under-perform. Amazon’s business may continue to succeed, but that doesn’t mean that the stock is a good investment when the lofty valuation is taken into consideration.

3. Wall Street prizes access to management.

Wall Street values good relationships with companies. Sell ratings or critical analysis hurts the relationship that banks have with companies. As this Bloomberg article explains, relationships are the reason that only 6% of the 11,000 Wall Street recommendations are sell ratings.

Relationships are critical to Wall Street. A good relationship with a company means that the Wall Street banks are more likely to underwrite deals for those companies, such as mergers and acquisitions, which generate high fees for the banks. Good relationships can also improve their odds in being selected to underwrite new loans for that company, another important source of income.

Another reason is that they want access to management to get better information about the companies. They feel that access to management is a critical component of gathering information about potential investments.

My unconventional view is that talking to management can be counterproductive. Management is always going to say things that are positive about the company no matter what, so what’s the point of even entertaining them? CEOs typically get their jobs not because of any technical expertise, but because they are masters at dealing with people. They are typically wildly charismatic people.

Charisma is usually not matched off with any real expertise or insight. When Wall Street analysts talk to management, they are simply being charmed by a charismatic person into believing a more optimistic portrayal of the company than is actually deserved. I think an investor is better off going to sec.gov and reading through the financial data published in quarterly and annual reports rather than allowing themselves to be manipulated by a charismatic management team.

The great Walter Schloss had this to say about meeting with management: “When I buy a stock, I never visit or talk to management because I think that a company’s financial figures are good enough to tell the story. Besides, management always says something good about the company, which may affect my judgment.”

Conclusion

My conclusion is simple: small time investors can win at this game even though we are at an informational disadvantage. This is because much of the Wall Street “analysis” is clouded by behavioral biases, an under-appreciation for value and a tendency to be manipulated by management.

A small investor can also operate in corners of the market where Wall Street banks fail to look, as their focus is usually on extremely large companies that can generate fee income.

Moreover, as has been discussed previously on this blog, Wall Street is increasingly short term oriented. In a world where investors obsess over their returns on shorter and shorter time periods, an investor with a long term outlook and willingness to under-perform in the short run is at a significant behavioral advantage.

I’ll end this with a quote on this subject from the master himself, Benjamin Graham:

“The typical investor has a great advantage over the large institutions . . . Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Coming Apart” by Charles Murray

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In Coming Apart, Charles Murray tackles the widening inequality and distrust between the classes in our society. Murray argues that the growth in inequality is driven by higher wages assigned to high intelligence and the focus of his book is on the growing cultural chasm between what he calls the “cognitive elite” and the new lower class.

Murray refers to two fictional communities to describe the widening divide, “Fishtown” (where the new lower class live) and “Belmont” (where the upper middle class live). The book also focuses exclusively on white Americans. Murray focuses on this to focus the analysis exclusively on class and not on race.

The World of 1960

The book begins with a trip back in time to 1960. In 1960, there were rich people, but the their lives weren’t very different from other classes. Their houses were bigger, but a slightly higher square footage didn’t make them mansions. Their cars were nicer, but were largely similar to the sedans that everyone else drove and everyone owned American cars. Aside from occasionally going out to a fancy dinner, the meals that they ate were largely the same as everyone else. Americans all watched the same tv shows, read the same newspapers and lived roughly the same lifestyle.

There was a cohesive American culture. There wasn’t much disconnect between the views of elites and everyone else. This kept the elites largely in touch with the nation as a whole.

Today

Today the residents of Belmont live a life that would be foreign to the lower classes in the country. They watch different tv shows, their news comes from different sources, they eat healthier, they exercise more, they don’t smoke, they go to expensive schools, they spend radically more money on childcare, they marry more, they divorce less, etc.

Murray attributes this divide to the country becoming a cognitive meritocracy. The popularization of standardized testing (like the SAT) in the 1950s and 1960s was designed to identify and propel smart kids to dramatic heights. To reward intelligence and ability instead of class. This effort succeeded succeeded and kids that would have probably stayed in their home towns their entire lives were now able to go to elite universities and earn six figure incomes. It also occurred at a moment when the economy changed in a way where cognitive abilities were rewarded more richly than ever before. They then married other smart people. Intelligence is hereditary, so their kids were usually smart as well. They then had the income to prepare these kids for standardized tests and elite universities. The cycle then repeats.

Meanwhile, the cultural and material dispersion that occured since the 1960s creates more choices than ever before for those with high incomes. This allows those high earners to create an entirely different life than those afforded to other classes. While a high earner in the 1960s lived in a large house, they lived in a house that would be familiar to most Americans and they shared most of the same cultural tastes. This is no longer the case.

Murray claims that the elites and the upper middle class are living in a “bubble”. In fact, he created a test to determine if you indeed live in a bubble. You can take the test here.

Culture

Murray believes that the differences in culture are accelerating the gap between the classes. The upper middle class is still defined by “traditional” marriage that rarely ends in divorce. They marry, they stay married, children are typically born during marriage and the parents stay together. They highly value education and push their children to focus on this area. This helps keep their wealth intact and sets their children up for similar success.

In 1960, social institutions were strong in Fishtown. There were community institutions that held neighborhoods together (churches, men’s organizations, etc.). Marriages remained intact. When marriages were unable to discipline and help children, neighbors and members of the community frequently stepped in. As these institutions collapsed since the 1960s, there has been a corresponding increase in various problems.

Marriage and two-parent child rearing are on the decline in Fishtown. Marriage is down, divorce is up.

Noteworthy is the decline of men in Fishtown. They are no longer the primary breadwinners. Without marriage and without work, many of these men men are rudderless and losing their sense of purpose. Women in Fishtown are thus more likely to be employed and taking the primary head-of-household role.

Men in Fishtown show steadily increasing rates of unemployment and lower incomes. Many would attribute this to globalization and a decline in working class jobs, but Murray points out that the decline was occurring when the economy was booming in the 1990s. With this decline in work, there has been a sharp rise in disability benefits in recent decades, despite less manual labor intensive jobs and advancing medical technology. The decline appears to be largely cultural.

Herein we get into a chicken or the egg argument. Are men in decline because of a lack of economic opportunity, or has the character of the men in Fishtown fundamentally changed? Murray addresses this issue by talking about the economic climate of the 1990s, in which jobs were plentiful, but were frequently difficult to fill. He also takes word of mouth anecdotes from business owners who talk about the difficulty they have in finding diligent workers.

Meanwhile, all of these trends are widening the cultural and economic divide between Fishtown and Belmont.

Conclusions

The book was written in 2012, but I think that it foreshadows the 2016 election. The Bernie Sanders insurgency on the Left and the rise of Donald Trump on the right took those living in the “bubble” completely by surprise. There was a deep dissatisfaction with the “elites” that drove the election. After reading this book, I think much of it is fueled by this wide class divide that Murray describes. Murray’s description of the bubble also explains why it took everyone living in the bubble completely by surprise.

Murray offers prescriptions for the shrinking the divide and all of them are difficult because they involve a fundamental change in culture. The government can certainly pursue programs to alleviate the economic causes of inequality, but I don’t really understand how we can collectively change the course of a culture.

I actually think the re-integration of the culture may happen on its own and hopefully with a more 21st century style. I certainly wouldn’t want to return to the social mores of 1950s America. The 1950s wasn’t all malt shakes, Marilyn Monroe, Elvis and hula-hoops. There was severe racial segregation, marriage was a prison for many women and equal rights were certainly not enjoyed by all.

When it comes to divorce, it is a tricky issue. Murray contends that divorce hurts children and this is true when you look at the numbers. What’s difficult to measure statistically is how harmful parents staying in bad and unhappy marriages is to children. A major reason divorce skyrocketed in the 1960s and 1970s is because women finally had the freedom to get out of bad marriages, when in previous eras they remained trapped with emotionally abusive (or even physically abusive) men. Would we be better off returning to the era of the 1950s, when people married when they were 18-21 and barely knew each other and stayed in marriages that made them unhappy? I don’t think so. Bottom line, whatever new institutions we develop to address these issues, I certainly hope we don’t return to the marriage culture of the 1950s.

One of the worst ways to predict our cultural future is to take present trends and extrapolate them into the future. The U.S. has been through cultural divides in the past and overcome them. The Civil War was certainly more serious than today’s Budweiser/Dom-Perignon class divide. The post-World War II and pre-JFK assassination era of American history was an unparalleled era of social cohesiveness. Despite the divisions of the Civil War, Gilded Age and roaring 1920s, the pendulum eventually swung to social cohesiveness and I think the same will happen again naturally. The irony is that when it happens, I suspect we will find it soul-deadening just like the youth of the 1950s and 1960s did!

Investing

This is an investing blog, so I have to tie this back into that critical question that touches our souls: how do we make money off of this? 🙂

When reading about the bubble, I constantly thought that most people on Wall Street are living in a bubble and the bubble affects their judgment. If upper middle class people in suburbia are in a bubble, then wealthy financial professionals in Manhattan certainly are. Living in the bubble likely affects the values that they assign to stocks.

Two companies come to mind when I think of the bubble. One is Tesla. People with money are flocking to Tesla. However, at $83k per car, Tesla is so far out of reach for most Americans that they might as well be sold on Venus. Among the rich, Tesla is the epitome of cool. Elon Musk is cool. Electric cars, space tourism and hyperloops are cool. The problem is that cool is kryptonite to investors. A notable exception is Google’s 2004 IPO. Google was cool and it worked out. That doesn’t usually happen. You can ask anyone who bought a dot com stock in 1999, or even a legitimate tech company like Cisco back then. Tesla is barely making a profit and their market cap now exceeds General Motors! Interestingly, at the height of the tech mania, Cisco’s market cap exceeded General Electric’s. GM has 22 times the annual revenues of Tesla. The valuation makes no sense. It looks to me like the Murray’s cultural bubble is creating financial bubbles.

Another example is Shake Shack. Shake Shack is all the rage in Manhattan. They introduced one by me (I live in suburbia) and I tried it out. The meal was basically a double cheeseburger from Wendy’s and a frosty, but double the cost in a cool looking building. Except I thought Wendy’s was better. This is the cultural divide at work. In Manhattan, a Wendy’s burger and a frosty is a foreign concept. For the rest of the country, we drive by it every day. Shake Shack currently trades at 67 times earnings and 2.84 times revenue.

If you’re removed from the bubble, it’s probably easier to spot absurdities in the market than it is for your typical Wall Streeter. In that sense, stepping outside of the bubble can likely help you recognize opportunities in today’s markets.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“The Big Secret for the Small Investor”, by Joel Greenblatt

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I recently completed The Big Secret for the Small Investor by Joel Greenblatt. I’ve read all of Joel Greenblatt’s books and this is his easiest strategy to implement for the average investor. What’s the big secret and who is Joel Greenblatt?

Who is Joel Greenblatt?

Joel Greenblatt, as I’ve discussed before on this blog, is one of the greatest investors of all time. In terms of investing prowess, Joel delivered 50% returns from 1985 to 1995, at which point he returned all outside capital to his investors and focused on managing his own money with his parter, Robert Goldstein. What do 50% returns look like?  $1 was turned into $51.97 over the 10 year period.performancejoel

Source: You Can be a Stock Market Genius, by Joel Greenblatt

Joel Greenblatt’s Previous Books

In addition to achieving stellar returns, Joel has done small investors numerous favors by outlining the strategies that he uses to make money in his books. Most investors like Joel are highly secretive with their strategies, but Joel has been generous enough to share the strategies that he uses, at least on a very high level. His first two books briefly summarized below:

  1. You Can Be a Stock Market Genius – Written in 1997, this book provides a nice road-map to places in the market that the average investor can investigate to find bargains. They are areas where the large professionals won’t tread due to size, complexity and opportunity cost. This is the approach that Greenblatt used to achieve the 50% returns from 1985 to 1995 described above. Joel encourages readers to look into these areas of the market where the professionals fear to tread. He encourages finding things that are off the beaten path and doing your homework. Areas covered include: spin-offs, recapitalizations, rights offerings, risk arbitrage, merger securities, bankruptcies, restructurings, LEAPs, warrants and options. This is by far the most informative of Joel’s books, but it is also the most difficult to implement. It is geared towards investors who already have a familiarity with the markets and want a road-map to the roads less traveled. At some point, I will review this book in depth on this blog.
  2. The Little Book That Beats the Market – This was written in 2005. Realizing that his original book was at too high of a difficulty level for the average investor, Joel formulated a more simple approach in this book. The little book outlines the magic formula strategy of investing. The magic formula ranks all companies in the market by cheapness (defined as EBIT/Enterprise Value) and then ranks all the companies by quality, or return on invested capital. The rankings are then combined into a list of companies that are both cheap and have high returns on capital. Joel recommends that readers buy 20-30 magic formula stocks annually and then sell after a year unless the stock is still on the list. The book was written so he could explain investing to his kids. As a result, it distills the concepts of value investing in a manner that is very readable. I find it incredible that Joel shared this research with the public. He even generously maintains a free screener at https://www.magicformulainvesting.com/

Why Write the Big Secret?

The Little Book was a best seller and the magic formula was sensational. The magic formula continued to beat the market after the book was written. If Joel outlined a winning strategy that could be easily implemented by small investors and provided them with the tools for doing so, what was the point of another book? The problem wasn’t the magic formula. The problem was human investors.

While the magic formula continued to work after Joel wrote the book, investors implementing the formula failed to achieve the results. During the two-year period studied by Greenblatt, the S&P 500 was up 62%. The magic formula beat the market during this period, earning 84%. However, actual investors choosing from the list of magic formula stocks only earned 59.4%.

In other words, investors took a winning strategy and systematically ruined it. This is likely because they avoided the scariest stocks on the list and went with the ones that had the best story.

If most investors can’t successfully implement the magic formula, should they simply passively index?

Indexing

Index investing works over long periods of time because over the decades the economy will grow, inflation will increase and the combination of economic growth and inflation will translate into higher corporate profits, which will translate into higher stock prices. Index funds are also extremely low cost.

Warren Buffett is in the final stages of a high profile bet with Ted Seides about indexing. In 2008, Buffett bet Ted $1 million (with the proceeds going to charity) that index funds would beat a group of hedge fund investment vehicles (fund-of-funds) hand picked by Ted. It looks like Buffett will handily win the bet. In Berkshire’s most recent letter, Buffett explains why he won. To sum it up: a lot of managers try to beat the market, and mathematically some will beat it and most won’t. The indexes reflect average performance, and mathematically a majority of managers can’t do better than average. Because hedge funds charge such high fees (typically 2% of assets under management and 20% of the profits), it will be nearly impossible for a group of them to beat the market.

Ted Seides tried to explain the reasons for his loss in this Bloomberg article. Reasons cited include: most investors didn’t stick with the index, there are many nuances to the returns of hedge funds, they provide protection during bear markets, etc. To save you the time from reading through the litany of excuses, I’ll leave you with this Upton Sinclair quote:

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

What is The Big Secret?

The Big Secret that Joel unveils in this book is simple: index investing works, but it is flawed and there are better passive strategies that can help investors do even better than indexing.

Indexing will deliver returns over the long run and will beat most active managers. I index myself in my 401(k). The portfolio I track here is my IRA that I have specifically dedicated to a concentrated hand picked value strategy.

However, Joel argues in The Big Secret that even though indexes deliver decent returns over long (i.e., 10-40 year) stretches of time, they are fundamentally flawed. The flaw as Greenblatt sees it is the fact that they are market cap weighted. The allocation of a stock in an index fund corresponds to the total market cap of the stock in relation to other companies in the index. In other words, stocks in an index fund are all weighted to the current relative valuations of the companies that make up an index. In other words, when a stock goes up in an index, the index buys more of it. If a stock goes down, it is weighted less heavily in the index. From a value perspective, this is the wrong approach.

This also explains the momentum that we see in the late stages of a bull market. As the indexes have a nice run, money pours into index funds. Money then flows to the largest components of the index, inflating their valuations even more. You see this happening today and you saw the same thing in the late 1990s. The irony is that the more we embrace indexing to capture average performance, then the less efficient the markets become. This isn’t a bad thing. It is an opportunity.

The opposite of this occurred in 2008. All stocks declined regardless of the prospects for the company. This was because money was pulled from stock funds with no rhyme or reason, causing all stocks to decline.

These trends go on until they can’t. Eventually the market recognizes the true value of companies. In the short run, massive money flows into and out of index funds can cause inefficiencies. As Benjamin Graham taught us, in the short run the market is a voting machine. In the long run, it is a weighing machine.

Seth Klarman discussed this phenomenon in his recent investor letter:

“One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities.

When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).

Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”

Passive Alternatives to Indexing

If the Stock Market Genius approach is too hard for most, if most investors struggle with the Magic Formula approach due to behavioral errors and passive indexing systematically does the wrong thing — then what can the small investor do?

Due to these issues, in The Big Secret Joel recommends a few passive choices that investors can implement. The passive aspect is key, as all of these approaches avoid buying and selling individual stocks and don’t require any homework.

The passive choices Joel recommends as alternatives to indexing are:

  1. Equally weighted index funds. While most index funds are market-cap weighted, equally weighted funds are exactly as they sound. They buy every stock in the index, but equally weight them. This prevents the fund for systematically buying more of a “hot” stock that is likely overvalued. An example of this kind of fund is the Guggenheim Equal Weight ETF (RSP). In the last 10 years, the S&P 500 returned 58.75%. Over the same period, the Guggenheim equal weight S&P 500 ETF is up 77.11%.
  2. Fundamentally weighted index funds. A fundamental index weights stocks not on market capitalization, but on the size of their business. This can be measured by revenues or earnings. This makes sense, because the size of an enterprise is a better determinant of its true value than simple market cap. It also helps investors avoid the hot stocks of the moment with high market caps while simultaneously having low sales or earnings (like Tesla, for instance). An example of this kind of fund is the Revenue Shares Large Cap ETF (RWL), which weights stocks in the fund based on their revenues instead of market cap. This fund returned 85.12% over the last 10 years, compared to 58.75% for the S&P 500.
  3. Value weighted index funds. Value funds are exactly as they sound: they concentrate the fund’s holdings into the cheapest stocks in the market based on metrics like price-to-book and price-to-earnings. While over the long run these strategies have been proven to work, in the last 10 years they’ve had a tough time. The Vanguard Value ETF (VTV) is up on 30.63% in the last 10 years compared to 58.75% for the S&P 500. Much of the underperformance is attributable to concentration in bank stocks during the financial crisis (they appeared to have low price to book values, but the book value turned out to be fiction) along with lagging the momentum of the market in the last few years. This isn’t the first time that value lagged the S&P. The last time that value strategies experienced this kind of under-performance was in the 1990s. Value went on to perform extremely well in the 2000s, while the indexes lagged due to the high market cap weightings in the technology sector early in the decade. I think history will likely repeat. Another great example of a value oriented ETF is the quantitative value ETF. QVAL implements the strategy outlined by Tobias Carisle and Wesley Grey in their book Quantitative Value. They use quantitative approaches to find value bargains (using the enterprise multiple as the value metric) and then further trim down the list to eliminate potential financial fraud, avoiding stocks with excessive short selling, for instance, and use a variety of quantitative criteria to find quality bargain stocks. QVAL launched in 2014, so it doesn’t have a long enough track record to compare it with the S&P 500, but it is worth your consideration. I would check out the book if you want to learn more.

Conclusions

Joel did small investors a great service by writing this book. I suspect that the passive strategies outlined will outperform indexes over the long run. They are much easier to implement than the magic formula or the homework intensive You Can Be a Stock Market Genius style of investing. Simply buy the funds and leave it alone.

I prefer my own strategy of individual stock selection, but I realize that this is not implementable for most investors. While I think it’s fun, it is a lot of work and most people don’t find it to be all that enjoyable.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q1 2017 Performance Update

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My Q1 2017 Performance: Down .11%

S&P 500 Q1 2017 Performance: Up 5.53%

My portfolio is regularly tracked here.

The S&P 500 had an amazing quarter and I had a lackluster one in relative terms. Overall I’m down 2% since I started tracking the portfolio in mid December 2016. At one point I was down 5% earlier this quarter.

Anti-Amazon Trade (GME, CATO, DDS, AEO)

Much of my under-performance is attributable to my anti-Amazon trade. As mentioned in the earlier post, the conventional wisdom is that Amazon is going to destroy conventional retail. I remain unconvinced that retail is going to die. People will always shop in physical stores. While retail may be in decline, it will not go away. For clothing in particular, people will always want to see the item and try it on. There is also the instant gratification aspect of conventional retail that will allow it to endure. Moreover, no matter how technologically sophisticated we become, people will always want to leave the house and occasionally go shopping. They are not going to hang out at home all day and never shop in a physical location again. Even Amazon realizes this truth, which is why I find it amusing that they are thinking about expanding into physical retail!

My unsophisticated thesis is simple: the retail stocks are all priced like retail is going to die soon and I don’t think it is going to happen. Simultaneously, the price of Amazon has been bid up to an extreme P/E ratio (180.98) and the momentum continues.

While I may be early to the anti-Amazon trade, I don’t think I am wrong. Predicting when the market will accurately value a stock is not possible. You can only buy when there is a mismatch between price and intrinsic value and wait.

IDT

IDT is my worst performer. During the week of March 6th after reporting disappointing earnings, the stock collapsed from $19.50 to $13.11, a decline of 33%. The stock plummeted further to $12.03. I was certainly wrong on this one, but I do not want to sell. $5.66 of that $12 price is cash. IDT has no debt. They also aren’t cutting their dividend and while the core business is struggling, it’s not dying. I’m sticking with it.

MN

Manning and Napier is also not doing well. Active management continues to be punished after the amazing track record of the indexes since 2009. Investors don’t want to pay high fees to asset managers when they can buy a low-cost index fund that will outperform them. Assets under management are declining, which is hurting the business. I don’t think this trend will last forever and in the meantime I am at least being paid a nice dividend yield to own Manning and Napier. The company currently has a negative enterprise value, with the current price less than the cash on hand, which currently stands at $9.19 per share. It’s a ridiculously cheap stock and the slightest glimmer of hope should allow me to take at least one free puff from this cigar butt.

Bubble Basket

David Einhorn refers to a “bubble basket” that he’s short on, which includes Amazon and Netflix. Q1 2017 was a good time for bubble basket. Tesla, a company with no earnings trading at 6.48 times revenue, is up 30% year to date. Amazon is up 18.23% and trades at 180 times earnings. Netflix, trading at 347 times earnings, is up 19.39%. Facebook, trading at 40 times earnings, is up 23.47% year to date. These are simply crazy valuations and I suspect they eventually they will go down in history with the Nifty Fifty.

Snapchat also debuted on the markets this quarter, as a symbolic representation of the frothy mood. The IPO felt like a flashback to the late ’90s, when an IPO and a dot com at the end of a name was a key to instant riches. SNAP has no earnings, $404 million in revenue. $27.11 billion market cap. This isn’t Pets.com crazy, but it’s still pretty crazy.

Einhorn is losing money shorting these stocks, but I still think he’s right. Therein lies the problem with shorting: there is no way to predict how long the market will be crazy and ignore reality. It will eventually happen, but there is no telling how long it will take.

If you’re short and the stock goes up 100%: you lost all of your money. This is why shorting technology stocks in the ’90s was a risky move even though there was a bubble and the shorts were vindicated. If you were early to the short (in, say, 1998), then you would have lost a tremendous amount of money even though the thesis was vindicated in the early 2000s. Take a look at the percentage returns for the NASDAQ 100 from 1998 through 2002:

1998: Up 85.30%

1999: Up 101.95%

2000: Down 36.84%

2001: Down 32.65%

2002: Down 37.58%

“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes

That is why I don’t short stocks or use leverage. Timing is hard, even if you’re a pro like Einhorn. If Einhorn can’t do it, then I certainly can’t do it!

Portfolio Value

On an EBITDA/Enterprise Value basis, many of the worst performing stocks in my portfolio are some of the most attractively valued. Why sell now?

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The frequent under-performance of value strategies is a key reason that they outperform over the long run.

If a fund manager delivered the kind of relative under performance that I delivered this quarter, they would probably be yelled at by their boss or at the very least forced to endure a healthy dose of corporate passive aggressiveness.

It’s moments like this (which can last years) during which there is a strong incentive to simply buy stocks that look like the S&P 500 or had some recent momentum. This strategy is a recipe for long term under-performance.

Behaviorally, it is easier to go with the crowd. If you’re right and the crowd is right, then you’re doing great! If you’re wrong and the crowd is wrong, then at least everybody else was wrong too!

If, however, you take a contrarian opinion and the crowd is right and you’re wrong (as I am with the anti-Amazon trade for now) then you lose your job. Contrarian opinions are eminently risky. Things are even more behaviorally difficult when you look at the companies in a value portfolio. Why am I even investing in this garbage? Everybody knows that retail is dead, Gamestop will be replaced by streaming video games, etc. This makes it all the easier to click that tempting “sell” button and end the pain.

This is why having one investor (me!) and no boss is advantageous and makes for better investing.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

What is the best measure of quality?

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In an earlier post, I examined the performance of different value metrics. My conclusion was simple: cheap stocks beat expensive stocks.

Most value investors don’t simply look for cheap alone. They try to find companies that are both cheap and good. Good is typically defined as companies that can earn high returns on their capital.

Finding these companies is a worthwhile pursuit but it is difficult to pull off systematically because companies earning high returns on capital are going to attract significant competition. I think it is far more difficult to do this than most value investors appreciate. Mean reversion, fueled by competition, inevitably pulls these returns down. Finding the rare birds that don’t succumb to this is hard.  These companies usually have a “moat“, which is hard to identify. Needless to say, this kind of investing requires a touch of genius that I don’t have. When investing, I operate under the assumption that every company succumbs to mean reversion.

With that said, finding these rare opportunities certainly pays off over the long run. You can park money in a company like Coca-Cola or Nike and earn high returns over long stretches of time, while reducing taxes and transaction costs.

The Magic Formula 

Joel Greenblatt sought out a systematic quantitative method to find companies that are simultaneously cheap and earn high returns on capital. The result was The Little Book that Beats the Market. In the book, Greenblatt demonstrated that simultaneously buying cheap companies that earn high returns on invested capital will outperform. He calls this the magic formula and generously maintains a free screener here.

Tobias Carlisle took this a step further in Deep Value and discovered that the quality metric of high returns on invested capital actually reduces returns from the magic formula. He explains in Deep Value how mean reversion tends to bring these returns down. Cheap alone is better than cheap plus good. In other words, it takes qualitative insight to determine which companies have a moat that will allow them to sustain high returns on capital. Tobias maintains a free large cap screen for this here.

I would recommend reading both The Little Book That Beats the Market and Deep Value.

Backtesting Quality Metrics

I decided to test the returns for myself and try to see which “quality” metric works best when combined with a value factor. The test I ran is limited to Russell 3000 components. My definitions of cheapness were:

  • EBITDA/Enterprise Value is higher than 20%
  • Price to free cash flow is less than 15
  • Price to sales is less than 1
  • Earnings Yield is over 10% (i.e., P/E is less than 10)
  • Price to book less than 1
  • Price to tangible book less than 1

In addition to examining metrics that define high returns on capital, I also included metrics for financial quality, such as the debt to equity ratio and the Piotroski F-Score. Below is a summary of all of the quality metrics that I tested.

Return on Equity – This is the oldest and most simple method of corporate quality. It is simply the company’s net income divided by equity (assets – liabilities). For the purposes of the test, I define high ROE as over 20%.

Return on Invested Capital – Joel Greenblatt’s preferred measure of quality. This is earnings before interest and taxes divided by invested capital. Invested capital is defined as working capital plus net fixed assets. For the purposes of the test, I define high ROIC as over 15%.

Gross Profits/Assets – Robert Novy-Marx created a very simplistic measure of quality, gross profits/assets. He found that this  method works extremely well, because it uses profits further up of the income statement where it is more difficult for a firm to manipulate the numbers. You can read his paper on the subject here. For the purposes of the test, I define good gross profitability as over 30%.

Debt/Equity – This is another simplistic measure of financial quality. It is simply total debt divided by equity (assets-liabilities). For the purposes of the test, I define a good debt/equity ratio as under 50%.

F-Score – This is a more complex measure of financial quality designed by Joseph Piotroski, who is currently a professor at Stanford. Piotroski designed a 9 point scale of financial quality in a paper written back in 2000. Piotroski backtested combining this measure of financial quality with price to book and found that the results greatly exceeded the market. Each component adds to the score. A perfect F-Score would be a 9. It’s too bad F-Scores don’t go up to eleven. The components of the F-Score are defined below.

  • A net decline in long-term debt for the current year.
  • A net increase in the current ratio in the current year. The current ratio is current assets/current liabilities. It measures the liquidity of the company’s balance sheet to meet short-term obligations.
  • A positive increase in gross margins in the current year.
  • Faster asset turnover in the current year.
  • The total number of shares outstanding is flat or decreasing. In other words, the company isn’t issuing new equity and diluting the current pool of shares.
  • Return on assets is positive.
  • Operating cash flow is positive.
  • Return on assets for the current year is higher than the previous year.
  • Operating Cash Flow/Total Assets is higher than return on assets.

The results of the backtest are below. The results are in the Russell 3000 universe with annual rebalancing beginning in 1999.

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The High Return Metrics – ROE, ROIC, GP/Assets

Measures for returns on capital – ROE, ROIC and GP/Assets – actually detract from the performance of EBITDA/Enterprise Value. They add performance to the other valuation metrics slightly, with Gross Profits/Assets being the best.

The middling performance of high return quality metrics is due to mean reversion, or the propensity for high return businesses to eventually succumb to the pressures of competition.

With that said, if you are trying to identify high return businesses, the best metric to use appears to be Gross Profits/Assets.

Financial Quality (The Debt/Equity Ratio and the F-Score)

In contrast, measures of financial quality, such as the debt/equity ratio and the F-Score, supercharge all of the valuation metrics that are examined here. Why is this?

Cheap stocks are only cheap because they are in some kind of trouble. There is an “ick” factor. Any time you run a value screen, you will scratch your head and think “Do I really want to invest in this garbage?”

This is why financial quality metrics are more useful than business quality metrics. If a company has a good balance sheet and is financially healthy then it has time to resolve its problems. Managers have time to implement a new strategy that can turn things around. Even without a new strategy, time will help the financially healthy company. For instance, if the company is in a crowded, competitive industry, the financially healthy company can weather the storm while the highly leveraged firms will go out of business first. Less firms means less competition. Less competition means that future returns in the industry will improve.

This is the essence of the simple Graham method that I follow with my own portfolio. I am looking for cheap companies that have the financial ability to weather the storm that they’re in.

This is also why the high return metrics add a little to the other valuation metrics but detract from the EBITDA yield. Unlike the other valuation metrics tested here, the EBITDA yield is the only one here that uses Enterprise Value in the calculation. Enterprise Value brings balance sheet health into the valuation ratio. For EBITDA/Enterprise Value to result in a high yield, the company must have little debt and a lot of cash on hand. In other words, valuation metrics that use Enterprise Value will identify companies that are both cheap and have safe balance sheets.

RadioShack vs. Best Buy

This reminds me of an article I read over at the Motley Fool. The author explains why Radio Shack fell apart and Best Buy was able to turn around.

Radio Shack had numerous problems, including asking for your phone number when you buy batteries.

Best Buy’s problem is that it basically became a showroom for Amazon. The referenced article explain how Best Buy successfully turned things around by cutting costs, emulating the Apple Store, expanding the Geek Squad and improving their website.

I have a more simplistic explanation for why Best Buy was able to recover and Radio Shack fell apart. Radio Shack had a lot of debt and Best Buy didn’t. Radio Shack’s debt to equity ratio was over 670%. Best Buy’s debt to equity ratio was 41% a few years ago and is 29% today.

Best Buy’s balance sheet gave them an edge: time. They had time to work through their problems and try to find a solution. If Best Buy had Radio Shack’s debt levels, the CEO would have never been able to pursue the turnaround strategy. All troubled companies are trying to turn things around, but only those with financial strength will have the time to do so.

Screening for High F-Scores and EBITDA Yield

One of the most robust combinations tested was the F Score and the EBITDA Yield, with a 17.69% rate of return since 1999. I ran a screen for companies with an EBITDA yield over 20% and an F-Score of 8 or higher. This combination of criteria is very stringent. It only returned 5 results out of the entire Russell 3000. Best Buy actually comes up in this screen, implying that it is still a financially healthy bargain. Output from the screen is below.

Companies

I am not going to buy positions in these companies, but wanted to share the results of what I found. Hopefully this will give you some useful leads that are worthy of further research.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Shoe Dog” by Phil Knight

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I recently finished Shoe Dog by Phil Knight. I love memoirs and biographies. When they are combined with business insights, I am particularly interested.

Shoe Dog focuses on the early years of Nike and focuses almost exclusively on the experience of Nike in the 1960s and 1970s before the company went public. The structure of the book is a part of its appeal. Most memoirs take you on long boring slogs through the author’s childhood, teen years and later life. This book focuses almost exclusively on the most exciting time in Phil Knight’s life: when Nike struggled in the 1960s and 1970s to make its mark. He is also remarkably honest about the experience. He discusses all of the problems he faced and the doubts and stress that went along with it.  With most business memoirs, you get the sense that the writer had it all figured out from day #1. Phil’s story is different. He is also an amazing writer.

I was born in 1982, so throughout my life Nike has always been one of those brands that was as iconically American as a can of Coca-Cola or a Big Mac from McDonalds. Whether it was Marty McFly’s power laces, or Forrest Gump’s trek across America in the Nike Cortez, Nike has been sewn into the fabric of our culture. I never realized how new Nike was until I read the book. Nike had only gone public two years before I was born and the company wasn’t even called Nike until the 1970s.

The Story

Phil Knight’s story begins in college where he ran track for the legendary Bill Bowerman, who would later become the co-founder of Nike. Phil went on to graduate school at Stanford, where he wrote a paper about how Japanese sneakers could take down German brands, just as the Japanese did the same thing to German camera manufacturers.

Phil took the idea with him as he toured the world after college. During his travel throughout the world, he went to Japan. He met with the executives of a shoe company called Onitsuka. He told them that he represented the Blue Ribbon company and wanted to sell their sneakers (called Tigers) in the United States. He bought $50 worth of sneakers and began selling them out of the back of his Plymouth Valiant.

He continued to sell sneakers but needed a full time job, so he earned his CPA and began working for Price Waterhouse. He also spends some time as a professor of accounting after leaving Price Waterhouse. As the ’60s wore on and the shoe business expanded, he ultimately quits and runs the company full time.

The book takes you through the ups and downs (mostly downs) of running the company. The downs are gut wrenching. The book is as much an inspiration for would be entrepreneurs as it is a cautionary tale about the perils that await those who want to go into business for themselves. Nike had multiple near death experiences, including:

  • An early brush with death when Onitsuka threatens to end the relationship with Phil Knight when it was just beginning.
  • Conflicts with an east coast seller of Tigers, a former Marlboro Man living in New York.
  • Constant conflicts with Onitsuka, including a threatened hostile takeover and threats to use other sellers. Phil fought against this (which was the impetus for creating the Nike line and finding alternative suppliers), but this resulted in a court showdown that could have also potentially destroyed Nike.
  • Dancing the razor’s edge of leverage throughout the 1970s. Unwilling to take the company public and use equity financing (he was afraid that it would ruin the company culture), Nike’s early growth was fueled almost entirely with debt, leading to terrible cash flow problems. At one point, payroll checks bounce and Nike’s bank threatens to call the FBI because they suspect fraud.
  • A showdown with US customs. Influenced by lobbying efforts by Nike’s competitors, customs fines Nike $25 million (its annual sales at the time) over customs technicalities. Nike would then have to wage a lobbying war of their own to defeat the injustice.

Through the struggles, Nike and Phil grow. The story of Nike’s growth and the problems it encounters make the book exciting. The story ends with Nike’s public offering in 1980. The following decades are covered at the end, but the focus of the story is almost entirely on Nike’s early development.

Life Lessons

If there is anything to be learned from Phil’s story it is: don’t give into negativity. Things may look dark at times, but it will get you nowhere if you give into negativity and stop trying. There were many times when Phil could have thrown in the towel, but he never gives up no matter how bad his problems are. I suspect a lot of this comes from Phil being a runner. When you are running, you constantly want to stop. Running is about resisting that. Mind over body. Phil takes the same attitude towards business.

Another great lesson of this book: cultivate relationships. You never know where a relationship might lead in the future. One of the most important relationships that Phil developed was with Bill Bowerman. Who could have imagined that his college track coach would help him found one of the greatest American companies of all time? Relationships must be cultivated, because you never know what dividends they might pay in the future.

The Stock

Nike is one of the best performing stocks of all time. Nike is one of those franchise stocks that are extremely hard to identify early on. It’s a Buffett/Munger kind of stock. (Although, Buffett owns Brooks, a Nike competitor, so he would probably disagree with the characterization!)

Nike is one of those firms with an amazing enduring brand and a high return on equity that won’t quit and is seemingly immune to the kind of mean reversion that brings down most high flying businesses (Nike’s return on equity was 27.58% in Q4 2016).

$1,000 invested in Nike stock back in 1981 at the IPO price would be worth $336,046.15 today.  Shockingly, that’s even better than Apple. A $1,000 investment in Apple at the IPO price would be worth $274,490 today.

Indeed, there is something magical about that swoosh.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.