Category Archives: Getting financial advice

growth investing and “The Investment Answer”

March 4, 2014 By in Constructing a Portfolio, Getting financial advice, growth vs value, Portfolio management, securities markets, stock market Tags: , , , , , , , , Leave a comment

Yesterday I skimmed the short but valuable book The Investment Answer, by Goldie and Murray.  The late Mr. Murray was an institutional salesman for a number of brokerage firms;  Mr. Goldie is a fee-only investment adviser.

The book, which I think is well worth reading, contains lots of financial planning basics, laid out in clear, simple language.   The first chapter, which deals with the traditional registered representative, is particularly good.

The only real quarrel I have with The Investment Answer is the chart it contains which asserts that value investing generates higher returns than growth investing.  This is a common belief, reinforced by numerous academic studies which claim to “prove” this.

I think this claim is just wrong.

But I had a long, and relatively successful career as a growth stock investor, so of course I’m going to think this.

Worse than that, however, I suspect that demographic and technological change are undermining the fundamental pillars of the traditional value investing style.

About those studies–

–the typical procedure is for an academic to take a universe of stocks, say the S&P 500, and divide it into two parts.  The “value” part will consist of stocks with the lowest price-earnings ratios, lowest price-to-cash-flow ratios and lowest price-to-book-value ratios, all based either on historical data or on consensus Wall Street estimates (in the case future-oriented information is also used).  Put another way, these are the cheapest stocks, based on consensus beliefs.  The “growth” part will be everything else, meaning all the expensive stocks.

The studies then show that the cheap stocks perform better than the expensive ones.  What a surprise!?!

What’s wrong here?  It’s the definition of value vs. growth.  The studies assume the difference is between two mutually exclusive groups separated from one another using a single set of rules.

The reality is that growth and value are not mutually exclusive.  They’re two different ways of looking at the investment world.

The growth investor looks for stocks where he believes the consensus view is mistaken, either by underestimating how fast earnings will grow and/or how long this superior earnings performance will last.  A growth investor may hold many stocks that the academic classifies as “value” (think: the AAPL of a few years ago);  there are many that the academic classifies as “growth” that no self-respecting growth investor would touch with a ten-foot pole.

Why don’t growth investors kick up a fuss about this academic nonsense?  It’s not in their best interest.  Why show your trade secrets for everyone to see?  That would just make your job harder.

More tomorrow.

 

 

 

 

knowing vs. doing

February 6, 2014 By in Getting financial advice, Portfolio management Tags: , , 1 Comment

Sometimes (read: most of the time), I fall behind in reading the FT and the Wall Street Journal.  So I binge read to catch up.

During my last, snowstorm induced, round I came across last weekend’s WSJ article, “When a Giant Gain Causes Pain.”  It’s about a married pair of PhD economists from Harvard who both taught finance, while together running a consulting company that advised corporate clients on financial risk.

The husband taught a course on securities analysis, centered around the study of a single stock.  About eighteen months ago, the subject was Tesla (TSLA).

The professor had eschewed (a word my son Brendan favors) tasting his home cooking since having been wiped out buying naked options (as most people crazy enough to do this are).  He had never bought a student-analyzed stock.  But this time he backed up the truck and filled it to bursting with TSLA, at $38.  Not only that, he bought enough naked calls to make $30,000 in a week.  …all this apparently without his wife noticing.

Haunted by his previous options experience, he cashed the calls out, told his wife he was thinking of selling TSLA at $200   …and promptly died.

The wife had an immense amount of professional education and training–plus her husband’s notes and plan.  But she had no practical experience.  She’s quoted as saying she was “utterly unprepared for how difficult it would be emotionally.”  Unnerved by TSLA’s volatility, she sold the stock, apparently about as badly as one possibly could.

What I find instructive about the article is that it brings home the idea that investing is a craft skill.  It requires common sense and experience, which we only get by doing, not simply by book learning.  It’s kind of like the difference between reading sabermetrics and actually going to the plate to face a pitcher.

Everyone botches up his/her first trade–and usually much more than that.  If I have any fault to find in this situation it’s that the wife waited until she was 60 to take part in the game she studied, wrote about and taught for her entire professional life.

(A side note:  in this latest binge, I also read a sizable number of reflections on Mohamed El-Erian’s departure from Pimco.  It’s clear that Mr. El-erian is well-liked and well-respected.  He is a brilliant marketer, whose gimmick is that he’s an academic, not really a marketer.   Along the way, he has become fabulously wealthy as co-CEO of Pimco.

Everyone agrees he’s a very intelligent guy.  What’s striking to me, however, is that  in the extensive press reports I’ve read I can’t find a single comment to the effect that he is a competent investor.  Pimco seems to want to avoid the issue; anonymous grumblings come from Harvard.  Sad, although it’s hard to feel too sorry for the ultra-wealthy.)

 

 

high yield (junk) bonds (ii)

December 2, 2013 By in bond market, Getting financial advice, Industry Analysis, Investment firms, junk bonds, junk bonds, Portfolio management, securities markets Tags: , , , , , , , , Leave a comment

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.

accredited investors and the JOBS Act

November 19, 2013 By in accredited investors, Getting financial advice, Investment firms, Securities regulation, the SEC Tags: , , , , , , 1 Comment

“accredited” investors

When you open a brokerage account in the US, you fill out a form that requests information about your income, risk tolerances and investment knowledge.  From what I can see, it gets only superficial scrutiny.  But saying that you have some money and understand the risks of investing in various types of publicly traded securities does two things.  It gets you a seat at the table and it protects your broker from customer lawsuits claiming they lost money because they didn’t understand what they were getting into.  In a sense, passing this vetting process makes you accredited–but that’s not what the term “accredited” usually means.

Instead, it refers to the same kind of vetting process, but for private placements–purchases of securities not registered with the SEC and not sold through the traditional (expensive and time-consuming) IPO process carried out by the big brokerage houses.

For individuals, “accredited” means you have $1 million in assets, not including your principal residence, or you earn at least $200,000 a year.  (There’s a different criterion for institutional investors who want to trade in non-registered–usually foreign–securities.  To be accredited in that sense means having $100 million in investable funds under management.)

The bottom line:  “accredited” means either you’re in the top 1% or pretty close.

not good enough for the 21st century

In the pre-internet, pre-JOBS Act, pre-Mary Jo White world, that was ok.  Private placements were restricted to a very small number of individuals, whose main characteristic is that they can afford losses they might incur in buying risky securities.  The wealth criterion also effectively preserved the near-monopoly on public issuance of securities of the big brokerage houses on Wall Street.

That’s all changing.

the new order

There are already special rules to allow crowdfunding sales of securities.

For the JOBS Act (which allows smaller, early stage companies to raise funds with only limited disclosure) to be truly effective as a  capital raising vehicle for business startups, the pool of investors has got to be larger than just the usual “accredited” suspects.

Interestingly, at the same time as the newly active SEC is saying it sees some merit in things like bitcoin, the agency is also preparing to overhaul the definition of what an accredited investor is.

The new emphasis appears to be on accrediting people who have knowledge, training or experience that gives them insight into the risks and rewards of investing in a startup rather than just being able to take their lumps if an investment goes south.

I don’t know whether this is a good thing or not.

But Washington passed the JOBS Act last year to make it much easier for startups to raise money.  And, contrary to Mary Shapiro’s foot dragging, Mary Jo White is certainly going to set rules of procedure to allow the Act to function.  And that means opening this class of investments to more potential buyers.

I do think, however, that this will turn out to be another instance of a new internet-based business model undermining an older higher-cost pre-internet one.  It will be interesting to see how–and if traditional brokerage/investment banking firms will adapt.  I suspect that this change will have far greater ripple effects than anyone now expects–maybe even momentous ones.

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Ray Dirks, Kevin Chang and other stuff

October 7, 2013 By in Getting financial advice, hedge funds, How your broker gets paid, insider trading, sell-side analysts, Trading Tags: , , , , , , 1 Comment

a $30 million fine

According to the Wall Street Journal, Citi technology analyst Kevin Chang was fired last month.  Citi was fined $30 million by state regulators in Massachusetts for his leaking the contents of a research report to influential clients the day before it was published.  Other investigations are ongoing.

What happened?

The Journal, whose account appears to be taken from the Massachusetts consent order, says Mr. Chang found out from an Apple component supplier, Hon Hai Precision, that Apple had cut back orders–meaning, presumably, that sales of iPhones were running considerably below expectations. Chang wrote up his findings in a report that he submitted to Citi’s compliance/legal departments for review.

While his report was being processed, Chang was contacted by at least one hedge fund, SAC, which was looking for corroboration of similar conclusions drawn in an already released research report by Australian broker Macquarie.  Chang promptly emailed the guts of his report to four clients, SAC, T Rowe Price, Citadel and GLG.

The legal issue?   …selective disclosure of the research conclusions.

not the first time:  the Ray Dirks/Equity Funding case

Mr. Dirks was a famous sell-side insurance analyst back in the early 1970s.  In researching Equity Funding, a then-high flying stock, he discovered that the company’s apparently stellar growth was a fiction.  The firm had a bunch of employees whose job was to churn out phony insurance applications for made-up people, which EF then processed and showed “profits” for, just as if they were real.

When he found the fraud out, Dirks immediately called all his important clients and told them.  They sold.  Only then did Dirks inform the SEC.

Rather than being grateful for his news, the SEC found Dirks guilty of trading on inside information and barred him from the securities industry–a verdict that was reversed years later by the Supreme Court.

two observations

1.  Why put important clients first, even at the risk of career-ending regulatory action?  After all, many sell-side analysts take home multi-million dollar paychecks.

Their actions show who the analysts perceive their real employers are.  Ultimately, they collect the big bucks because powerful clients continue to send large amounts of trading commissions to pay for access to their research.  If that commission flow begins to shrink, so too does the size of the analyst’s pay.

Also, an analyst’s ability to move to another firm rests in large measure on whether these same clients will vouch for him–and will increase their commission business with the new employer.

2.  What happens to people like Dirks and Chang?

Dirks was eventually exonerated.  While he was appealing the SEC judgment, his thoughts on insurance companies continued to be circulated in the investment community.  Only they appeared under the byline of a rookie apprentice to Dirks–Jim Chanos.

Dirks eventually established his own research firm.  Interestingly, when I Googled him this morning, I found that the top search results were all basically rehashes of the favorable information put out by Ray Dirks Research itself.  No one remembers the real story.

Chang?  I don’t know.  He lives in Taiwan, where I suspect he will catch on with a local brokerage firm or investment manager.  As far as Americans are concerned, disgraced analysts or portfolio managers tend to end up in the media.  For example, Henry Blodget, who wrote all those laudatory “research” reports for Merrill touting internet stocks he actually believed were clunkers, now works for Yahoo Finance.  You can watch similar characters every day on finance TV.  Crooked, maybe.  But they’re articulate and look presentable.  And that’s all that matters.