Equity Prices And The Indexing of Everything

I was in graduate school when the Spooz were first approved for trading. The academic argument for the contract was based on the solid premiss of risk arbitrage like other commodities contracts.  The argument holds up today as well as it did then in that regard. At the time, however, academics joked that, if the entire market moved to trading nothing but indexed products, there would be no price signal at the individual  level of public companies to establish value. They joked because they thought this was implausible if not impossible.  Maybe they were right.  But I see the marginal effects of indexing starting to manifest themselves more robustly. That sends me down an intellectual rabbit hole.

As an active portfolio manager I see the effects every day. For example, the spot price of oil has a direct effect on energy ETFs. Thus, when oil is under pressure, most of the $XLE component prices come under pressure regardless of how the spot price of oil effects their operations. And the larger the exposure to an index of an individual name the more pronounced the sympathetic move in price. Thus, I my opinion, this reduces market efficiency in the context of asset values – at least in the short run.

Recently, I’ve seen many economists urge both institutions and individuals to forgo active management for indexing.  Yesterday, in the Wall Street Journal, Jason Zweig wrote:

The debate about whether you should hire an “active” fund manager who tries to beat the market by buying the best stocks and avoiding the worst—or a “passive” index fund that simply matches the market by holding all the stocks—is over.

Whether most know it or not, this is the strongest practical application of the Efficient Markets Hypothesis. And for all the ridicule he’s taken, Eugene Fama must be smiling. And Jack Bogle has a lot of “I told you so” ammo. Economist have a faith in efficient equilibrium. At the macro level they’re mostly right. But on the micro level they know that disequilibrium always exists.

Assuming this trend will continue – at least until active managers learn how to exploit the inefficiencies I mentioned above much better –  the average advisor will look for alpha in sector selection, “smart beta” (more a marketing term than a risk strategy IMO) or minimizing risk via Modern Portfolio Theory (which was pretty useless during the Global Financial Crises.) Financial advisors, in whom the 80/20 rule is obvious, will likely follow the crowd and go all index. Yes, “Dare to be average!” has always been the cri de coeur  of the retail money management business.

For the value manager, however, the inefficiencies created by indexing might be the biggest advantage to gaining long term alpha in many years.  Doing so, however, will not be for the faint of heart and if your clients are sensitive enough to count your performance tick-by-tick you might think of either getting different clients or different work. The focus on long term alpha often means significant periods of under-performance and every money manager knows that “what have you done for me lately” is ever-present. The need to clearly communicate your investment approach is more important than ever. What you have to deal with is this:

Asness and Liew argue that just a few anomalies are robust across time, countries, and asset markets, notably momentum and value. On value, they note that a trading strategy of high minus low, that is long a portfolio of cheap stocks (high book value to price) and short a portfolio of expensive stocks (low book value to price) has generated consistently high returns relative to (CAPM) risk over time, albeit not without occasional terrifying episodes.

[Emphasis mine.] Personally, I’m not changing my investment style. I have always underperfomed in raging bull markets and more than made up for it in other times. But long term alpha should always be the goal of a portfolio manager in my view. And being an index junkie reduces the number of great opportunities in the market that exist.

None of this is to say that long term alpha can not be gained in other approaches. It can. But I’m partial to value because it has a better track record in market draw downs. That’s just me.

On a related note, Twitter is abuzz with all this talk today. In the process I ran across this Cliff Asness piece on Fundamental Indexing. It’s very much worth reading.





Investing If Time Were No Object

A few years ago Tyler Cowen penned a little book, The Great Stagnation: How America Ate All The Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better (the eBook is on sale today for $3.79 and I recommend you buy it right now.) In usual Cowen style, the premise is highly controversial and has been pooh-poohed by both academics and innovators alike. It’s worthwhile, I think, to look closely to what Cowen sees.

In a nutshell Cowen is saying that our standard of living has not seen the big strides that came from things like the mass migration of people from farming to the industrial economy, the advent of truly life enhancing technology shifts like electrification and its derivatives such as refrigeration, washing machines, central heating, etc. And, I think most importantly, the mass education of the American population. As the book’s description reads:

Median wages have risen only slowly since the 1970s, and this multi-decade stagnation is not yet over. By contrast, the living standards of earlier generations would double every few decades.

Regardless of one’s opinion on that thesis, I think it has important implications; not for the future of the developed world but for everywhere else.

More recently, Marc Andreessen has been tweet-storming the tectonic shift in global economics that will be caused by the advent of the inexpensive smart phone. This is a simple idea; this new technology puts in the hands of everyone access to the sum of human knowledge and the ability to trade goods and services with near frictionless ease. Which brings me back to Cowen.

To me the important part of The Great Stagnation is not in the current state here but in the story of prior to 1970. Productivity exploded in the developed world as time was freed from the labor of managing household chores (the biggest economic boon in history by the way), the procurement of food and clothing and the extension of productive hours that came from the light bulb. The developing world, though the advantage of trade (read Recardo re: comparative advantage), is about to increase both productivity and, hence, earnings as a consequence of this rapidly proliferating technology. The smart phone will have similar effects to our history by bringing education to the masses as well. These are like the conditions in place that resulting in the mind-blowing advance in living standards we experienced from the first industrial revolution.

There’s a rub (there’s always a rub.) In the west we have been blessed by (classical) liberal institutions. There is no dismissing that The Enlightenment philosophers had a durable effect on free trade and the capitalistic construct. The developing world has some way to go to change there anachronistic government structures that will allow the type of trade we take for granted in the west. But we can see it changing everywhere – from China’s state capitalism model to the enthusiasm for India’s liberal new reformist prime minister, Narendra Modi. I expect we’ll see it continue everywhere in one form or another as access to knowledge sweeps the world at an increasing rate. But it will take time.

As a portfolio manager I understand the benefits of investing in EMs for both growth and portfolio diversification. That, however, is so pedestrian that it’s not much worth the time to write about.

But, what if time was no object in one’s investing frame? How would you invest then?

I manage my kids IRA’s and help them with their 401(k)s. I also am building accounts for my grandkids. For my kids I’m allocating 50% of their portfolios to EM. For my grandkids it’s the same but half of that I’m putting in Africa – the area where I think there is more potential in both the spread of liberal society and gains from access to knowledge. There is where the growth will be in the next 50 years. Will it be a bumpy ride? Probably. What does that have to do with the long term?

I might wrong and my kids push back a bit (although they don’t pay that much attention.) But if I were starting out today that’s what I’d do with my own money.

I’ll write about what I would do with the other 50% in another post. But investing looks different if one can take the time constraints out of the calculus. It’s an exercise worth doing.



The Twitter Induced Drift

I saw this exchange this morning between Jon Boorman and Michael Shea.



I came to the conclusion a while back that too much Twitter, for all of its benefits, was really hurting my performance.  That’s not Twitter’s fault. It’s mine.

I am not a trend follower/RS trader though I know a few of them who do very well and I highly respect their craft. But I started my career as a financial analyst – a skill set that takes decades to learn – and that’s what I know best.  For me, investing is a pretty simple concept: Buy inexpensive assets and sell expensive ones. Not that I don’t make a lot of mistakes. But it has worked for me over the long term and I’m proud of the long term alpha I’ve generated.

Last year I loaded up my twitter stream with people who have significantly different styles than mine. On the one hand it’s good to learn how others approach the market. On the other, it can – and did to me – distract one from one’s core strengths. I found myself seriously over-trading and, as a consequence, ignoring the type of analysis that is bedrock to my investment discipline.

In February I began to cull my follow list and I got rid of about 100 traders whose ideas never resulted in any profit for me. Then, I went through a systematic process of winnowing down my list of technical analysts to a few who do work in sector analysis or whom frequently delivered ideas that conformed with my underlying value strategy.

I also threw out a lot of rather talented people who have a compunction to lecture the world on what makes a successful trader. With all due respect, I have boots older than many of you and the last thing I need is an endless stream stale market bromides that take up space and waste our most precious commodity – time.

I’m not a technician and I need good TA support.  Todd Harrison artfully says that the market is made up of technicals, fundamentals, structure and sentiment. I pay attention to all of these. That, however, doesn’t mean that I should practice my craft by setting my core strengths behind anyone else’s. And I’m glad I caught myself doing just that. Still, I have learned a great deal from the people I still have on my stream and I’m in awe of some of their trading chops. Without them I’d be worse. But finding the ones that really add value is the key.

The only and last best exception I make are people who make me smile regardless of what their market approach is. Trading is an intense lifestyle and we all need a good dose of smiles to offset the constant flipping of the fear an greed switch.

I don’t remember who said it (but I think it was Howard Lindzon) that we don’t suffer from too much data. We suffer from poor filters. For me less has been more and my performance of the last several months is all the proof I need.

Yes, less often is more.


Stocktoberfest – Why I’m Going Again

I’m a regular user of Stocktwits but I’m certainly not actively engaged in the community. I find the site a great source – perhaps the best – for real-time data on names that I’m interested in.  I also find it extremely noisy and not particularly good at helping me with my portfolio management style that I practice in my client book. The ratio of traders to investors at the site is highly biased to trading. That’s not to say that traders can’t profit by it. I’m sure many can and do.  The short term mind-set just isn’t very helpful to me though.  Since I’ve been in the market for nearly 40 years and running OPM for 18, I have many other sources that I rely upon which are more helpful to me. But that’s me.

On October 27th and 28th the gang at Stocktwits will host its third annual Stocktoberfest. I’m going again for the second time after I was so impressed with last years program. That said, what I got from the event last year was not what I expected and, to a certain extent, had much less to do with trading than it did with getting a broader view of the state of the investing world. I figured it might be helpful to some who are considering going what I found least and most valuable. I’ll start with the least.

I’m a crusty old fossil in comparison to the bulk of the attendees.  I felt out of place much of the time in the company of the young quick-draw traders. But I can ignore that since my time in the business informs me that trading rock stars come and go.

There were multiple presentations on technical analysis which, as we all know, is the style du jour in investment analysis. Most of the TA presentations were pretty rudimentary and much less than what one can learn inside of books on the subject. Considering my bias is much more based on fundamental analysis, I learned very little from those presentations. For the young or inexperienced trader, to be sure, the speakers on TA are people who everyone is wise to follow. The value, then, was in who was talking rather than what they were saying.

There was also next to nothing on portfolio risk management and asset allocation. But I had no expectations of that given that the subject matter is extremely arcane and better suited to a professional money mangers venue. I do think there might be some place for more of it though. In my experience it’s risk management that really delivers long-term alpha and it’s been under-mentioned for the last few years.

On the plus side, there were many great presentations on the state of financial/market technology. I found the segments on those subject matters to be both interesting and exciting. They provided a glimpse over the horizon on the evolution of tools available to both individual and professional investors that are disrupting the foothold of sell-side Wall Street and the entrenched purveyors of financial data. This year’s roster looks like there will be more of the same and that alone is worth the price of admission. The investment world is changing rapidly and those who can find the new tools are the one’s that will succeed. Miss this at your own peril.

There was this other “thing” though that is the primary reason I’m going back – the “smart kids.”

Howard Lindzon, it appears, uses events like these to bring young entrepreneurs and money together. I met many people who were in early stage start-ups looking for financial backing or a niche in which to fit their efforts. Most of these people were so impressive I have a hard time articulating how blindingly bright they are. One after another were, as I said at the time, “wicked smart” (but maybe that says something about my dullness.) Their energy was contagious and there foresight unfamiliar. I hope to meet more of these people and I hope to develop relationships with some of them if luck allows.

I left last year with my batteries recharged with an optimistic view of the future.  That was the real serendipity. The energy carried me for a good six months and renewed my interest in paying a lot of attention to the innovator class in our economy.

If you’re considering going I’d advise you do. No matter who you are you’ll leave better for it.

I’m hoping for a repeat of last year. I’m also hoping my expectations aren’t too high. But if I come away with half of what I gained last year you can bet I’ll go again next year.

It was that good.



The Unfortunate Goals in Investment Plans

I was blessed to take a  Money & Banking class from a brilliant man, Dr. Richard Smith, who had exceptional real world experience.  Dr. Smith was a lieutenant commander of a torpedo boat and WWII where he earned a Bronze Star, served as CFO for Potlatch Corp, held a J.D. from Iowa State (’42), a Harvard MBA (’47) and PhD from the University of Oregon (’68.) He was also my adviser and the professor in several other finance classes. But the most instructive thing he ever taught me was the in the title of Ch.3 of his Money & Banking textbook. It read:

The Unfortunate Fact That Balance Sheets Balance

Smith’s thesis was not that we shouldn’t care about accounting errors. In fact, his point was exactly the opposite; that a “balanced” balance sheet offers a sense of undue legitimacy. And that “legitimacy” often caused an analyst to forgo further due diligence that would be done if the balance sheet, in fact, did not balance.

This simple idea has guided my entire career to question every unchecked “legitimacy.”

Over the many years that I had P&L responsibility at First Chicago Corp we would go though the annual ritual of doing budgets – both baseline and zero based. They were a big deal as incentive bonuses were set on the ability for line mangers to meet the bottom line objectives. The obvious problem is the tendency for some managers to low-ball expectations. The not so obvious problem is what I call the “good enough” syndrome – where once an objective is achieved the willingness to press gains is diminished (my line managers used to dread my monthly budget variance reviews because “good enough” was never good.) I see the same thing with traders using price targets and portfolio managers with benchmarks.

Planning is a tricky business. Often the assumptions used are not tested rigorously enough. Recency bias tends reduce the variability parameters for sensitivity tests. And the one thing that I have seen managers do time and again is to forget that all plans will be wrong in the end. But…

The value of your plan is not in the product but the process of planning.

For investors I see this in just about every discipline except, perhaps, in some rigorous RS portfolios.  Traders use price targets without retesting multiple time frames. Value investors very often fail to check their value thesis against macro trends and keep under-performing assets regardless of backdrop indicators. Financial planners rarely retest their assumptions more than once a year (hint: you can do this without re-running plans for all your clients until something changes.) All of these things cause either chronic under-performance or have high opportunity costs. Have you ever been a “sold-out bull” when a stock hit your price target but continued to ramp another 10%?

There is no doubt that the overused cliche of Trade Your Plan is, at it’s heart, correct. But the fact always remains that the weakest part of investment plan is a plan that doesn’t include a perpetual dynamic review.

Don’t get fooled that yesterday’s plan is still good for today. It’s probably not. And even if it is it most likely can be better. How do I know? Because even with Dr. Smith’s great instruction I have and still do make the mistake of seeing “legitimacy” where little exists. And it’s often unfortunate.



Noise, Stocktwits and Running OPM

I’m a huge fan of Stocktwits and I’m convinced that the evidence on the impact of social media in making better investment decisions is building. That said, I find that the current focus in social is highly skewed to the “home-gamer” and lacks a serious venue for the exchange of ideas for independent investment advisors.

This, by no means, is a criticism of Stocktwits. After a few cursory conversations with them I’m simply convinced that we don’t fit into their business model well enough for them to devote significant resources to things that would make it a better platform for advisors. And, for the most part, Stocktwits is highly focused on trading with very little value to broad portfolio management.

LinkedIn does offer a few discussion groups for RIAs but, after following them for  some time, I find them to be better for ideas about business development and compliance. Additionally, LinkedIn group memberships produces a huge amount of spam and self-promotion that interferes with getting to what really might add value to our individual practices. So, at least from my perspective, there is an unfilled need in social for the small but growing community of independent advisors.

I’ve met some really smart and talented advisors on Twitter and Stocktwits. To name a few (and people you should follow) are Jefferson Bass, Raj Dhaliwal and Scott Krisiloff. There are others of course. It’s been interesting learning the different styles that other advisors employ and there’s much we can learn from each other. There are specific things that I would like to learn including but not limited to:

  • What trading platforms people are using and why.
  • What research, both free and paid, advisors find most valuable.
  • Who uses allocation software and who has developed their own.
  • Investment processes and discipline.
  • General opinions on macro environments.

And of course

  • War stories

Others will likely have different interests and understanding those should help us all discover the important things we’re not looking at.

Having said all of that, I would be more than willing to begin to develop a group blog if I can find one or two people who would contribute as time allows. I understand the demands on our time and certainly am not looking for an unrealistic level of participation – just a start.

I also understand that IARs may have compliance issues if they have broker licensing and other such issues. I’m fine with anonymous blog handles to circumvent those concerns but I would obviously require that contributors be vetted appropriately for authenticity by members.

Perhaps I’m deluding myself thinking this idea has any legs. But, for people like me who spend their days in one-person offices without the benefit of a large organization providing resources I can’t believe I’m alone in seeing some value in doing this.

If you’re interested drop me a line at dave@davebudge.com. Who knows, maybe if we get this going Stocktwits will give us spot on their approved blog list.

Let’s do this thing.

Note: I have comments set so that I have to approve commenters once before they can freely post because of spam. I’ll keep an eye on it but don’t let that frustrate you. It may take me a day to get to it before it shows up.


“What philosophers say about actuality [Virkelighed] is often just as disappointing as it is when one reads on a sign in a secondhand shop: Pressing Done Here. If a person were to bring his clothes to be pressed, he would be duped, for the sign is merely for sale.”
― Søren Kierkegaard, Either/Or: A Fragment of Life

Andrew Kassen has penned a series of wonderful observations on what appear to be potential changes in market structure, what may be the catalyst and why it feels different this time. There’s profit in reading those post and you should make the time.

As Andrew points out, many traders have been nicked by the recent market action and, just as many, appear to be flummoxed that the signals that they had come to trust over the past year are not working as well now. On the one hand, this could simply be a rotation away from expensive growth stocks and dip buying continues but in different sectors. On the other hand, it may be something entirely different. Knowing, though, is well beyond my pay grade. I venture to say that it’s entirely beyond anyone’s pay grade.

We do know the confusion between being smart and being lucky in markets. My observation is that there are a lot of lucky people proudly selling some sort of “sauce” that they pour liberally on the same food everyone else is eating while giving it some supercilious affectation. The problem, of course, is not that they’re selling it. It’s that they actually believe it’s worth selling. That’s not to say that there aren’t some extremely talented traders running subscription services. There are. There are just a lot fewer of them than most people imagine.

But let’s say, for a moment, that we’re seeing something more than a simple growth/value rotation. What then? Can your $29.95 a month teach you how to right size your risk on the down side or is it just going to put you into naked shorts that can unexpectedly have you getting to know margin clerks?

As I said, I have no idea what is going to happen. I had a great week. Not because I’m so damned smart but because I’m a value investor and the tape paid for value. But it’s hard to change your trading perspective – going from growth to value or long to short. For most people this is very binary. Either you can or you can’t. Either/or. Do you really know? A lot of you will soon find out I think.




Information Democratization and Market Efficiency

I had a spirited debate this morning with a colleague who I highly respect about value investing.  His thesis is that finding “value” – defined as buying a company’s stock at a discount to intrinsic value – no longer exists (or exists much less than before) because of increased access to financial information. Information of which formerly was only readily available to big players. It’s an interesting question so I thought I’d put to pen some of my thoughts on it.

For you unfamiliar with theoretical finance, by “efficient” we mean that a stock sells at or near its intrinsic value given available public information so no premium or discount can be attributed to any asset. This, of course, is the heart of the Efficient Markets Hypothesis (EMH) authored by Nobel laureate Eugene Fama and argued against by Nobel laureate Robert Shiller. For the record, I’m on the side of Shiller. Still, in the economics of marginalism, the question is not whether information makes the market efficient but, rather, does it make markets more efficient?

Through the lens of a short term trader, the ability to see the immediate direction of momentum appears highly enhanced by the social networks such as Stocktwits.com.  What this seems to accomplish for some traders is an ability to get on a moving trolly with the hopes they can get off before it heads back. To the extent to which this is a successful long term trading approach the jury remains out until such time as it’s tested through a bear market. But, the ability to trade inside short term trends does not address the question at hand – unless one embraces the EMH. And if you do think there’s something to the EMH then trading is a waste of time since “everything is baked in the cake.”

I would suggest that, as far as value discovery is concerned, the efficiency of the market is not only not improved but, in fact, it is reduced.

First, let’s look at market structure and the influences that have changed. Regardless of how engaged individual investors are in trading stocks, the majority volume (outside of HFT “market making”) is still in the hands of institutions. We see the impact of this all the time in a lot of areas. And if you’ve ever been in a trade where a single large position holder rushes to get in or out at the end of the day and you get “VWAPed” you know exactly what I’m talking about. Over the recent run-up back to the highs, BAML has reported that institutions and hedge funds have been actually selling equities while individual retail investors have been the only group buying. Whether or not this proves an example of “sold to you” (aka The Greater Fools Theory) remains to be seen. But the fact remains that “big money” has always been a better indicator of value than the individual investor.

However, since the advent of HFT there is a question of what structurally is actually moving price. There are all sorts of algorithms pushing and pulling prices around which have no relation to fundamental value of the underlying assets. While this has made markets much more liquid it has nothing to do with value. In fact, I believe it distorts value discovery (reduces efficiency) because they are trading on everything but value. Algorithms trading against social media are particularly distorting since they trade purely against sentiment. Now, HFT makes up a whopping 70% of all trades – none of it attached to fundamentals.

My good friend makes the point that even outside of the market structure value is more imputed in price because access to high quality financial reporting is available to nearly anyone. This is true to an extent. However, institutions and hedge funds have seen no discernible improvement in information flow (with the possible exception of getting flags from Twitter) in at least a decade.  Further, even though financial information is easier to access by individuals, how prepared is the investing public to understand what they’re getting? Has the financial sophistication of the general public improved. Call me an elitist but I think the investing public is less sophisticated today that the investing public 30 years ago as a simple matter of the statistics of the denominator.

All of this, of course, has not a thing to do with anyone’s ability to make money. But it has a lot to do with how well the average investor performs. While it’s fashionable to say only price matters at any given point in time – true enough – it’s also true that the market has a real and tangible relationship to the underlying economics of various sectors. The market passes above and below the performance of the “real” economy and that’s also true with individual names.

The market never has been efficient and, as I’ve said, appears less efficient to me today than usual. I could be wrong but, at the end of the day, there is nothing new under the sun. Let the volatility begin.






A Beginners’ Guide For Finding Value Stocks

The market has been rewarding growth, both real and imaginary, in spades. That may or may not continue for a while. Everybody is happy. There will be a time, however, where most of the growth premium in the market will either stop expanding or, parish the thought, come in. When it does it might be useful for you new to stock picking how to look at value stocks. This is a cursory look at value investing and by no means complete. Let me preface all of this with the fact that “value” as I define it is scarce right now. As scarce as I’ve seen it in years. But that will change and there will be a time when big fat pitch value stocks increase in numbers. Better to lean how to look for them know then after the juice is gone.

Positioning at least a part of your portfolio in value stocks is fundamental to anyone’s diversification design. First, in a market correction, value stocks usually have significantly less downside. Secondly, finding value in out-of-favor sectors can mean significant upside if that sector ever comes back into favor. Third, value stocks are often targets of acquisition during periods of industry consolidation and premiums get paid.

There are several ways to look at what is termed “value” in the market. People use it differently and so it makes sense to for everyone to have a good sense of what it means in what context. There’s a great article in the FT today talking about exactly that (behind the paywall, sorry.)

In the current vernacular, “value” is usually referred to stocks that are selling at a discount to their competition. While that’s generally correct I think it sometimes leads to missing many fat pitches as it tends to ignore sectors that are out of favor. When I think of value I think of stocks with good prospects that are selling near or below tangible book value. The problem with that, however, is it can be misleading given accounting issues in the value of intangibles. We’ll leave that for another discussion.

Back in the “old days” – you know, sometime before Jesus lost his sandals – the bible for understanding value investing was a book published in 1934 – Security Analysis by Benjamin Graham and David Dodd. Math, the time value of money, balance sheet and earnings health metrics and other measures have not changed since equities started trading publicly. Nor will they ever. You want to be Warren Buffett? Read that book.

I use a simple checklist when assessing a value stock.

Industry:  What industry is the company in?  Is it expanding, contracting or stable? Is it dominated by one or a few large players or does it have disbursed competition? What are the barriers to entry that hold back disruption? What regulatory changes could impact growth? None of these issues are determinative but all should be considered as you build a case for any value stock. For example, even if an industry is contracting that doesn’t mean that the strong players won’t grow. In fact, contracting industries can be positioned to shake out weak players and eventually leave both sales growth and margin expansion to those left standing. But it’s important to take all of this into account.

Business: Simply put, what does the company do? This is more important than the obvious. Most companies have more than one profit center and it’s important to know what lines of business and industries the company is engaged. How are the respective business line positioned within their industries? Is the business in multiple industries and, if so, are the product lines complementary to each other and leverage core competencies? It’s useful to think of $AAPL as both a hardware and software company. (Note: I usually stay away from businesses that cross too many industries since I think it detracts from management’s focus. That’s not always true but true more often than not.)

Management: Who runs the company? How long have they been in the position and what kind of track record do they have. What is their compensation and incentive packages? How deep is the bench? Are there any issues, such as health or litigation, that can take the management team’s eye off the ball. Don’t go overboard with this but you should have at least a cursory familiarity with management. Yahoo finance has compensation numbers as do the 10Ks. You should also do a review of the company’s 8K filings for disclosures of material changes in management.

Macro: Make sure you never buy  stocks without looking out the window to make sure the weather is stable or better. Rolling into value stocks at the beginning of a 20% correction will still usually cause losses. They may be less than the major indexes but they’ll be losses nonetheless. I’m not arguing to time the market but just use some common sense.

Financial: The meat of the matter. It’s rather circuitous but I start with a financial screen to narrow the list and then, after seeing things that meet the superficial criteria I take the make and start back at the top of the checklist.

Every trading day I run a simple screen to see if new names pop up under what I consider “value.” It involves these measurements:

  • Market cap > $300 million
  • Dividend Yield > 3% (this changes with time but nearest round number to the 10 year treasury.)
  • P/E ratio <15
  • PEG ration < 1
  • Debt/Equity < .8
  • Current Ratio > 1.5

Market Cap: I use $300M and over simply because micro caps have too much accounting risk and lack of liquidity for my taste . That’s me. Some value investors do great in that space. My luck has been spotty. If you’re new it’s a good exercise to paper trade micro caps to see how you do.

Dividend Yeild: A company with a consistent (better yet, a consistently growing) dividend indicates it likely has a consistent level of free cash flow. This isn’t always true so it’s important that the dividend payout ratio is < 1. Liquidating dividends can be, but not necessarily are, a sign of trouble but you need to know. The additional benefit to a dividend is that holds up value in a down market.  But be careful, a dividend that is far too high can also be a red flag.

P/E Ratio: I use a multiple of 15X because it’s roughly the market’s historical average. But in down markets I’ll lower that. After all, if the market is trading at 15X then 15X isn’t value looked at in isolation.

PEG Ratio: The PEG ratio is the P/E divided by the expected growth rate. I find this a good metric but it’s important to understand the limitations of the forecasted growth. The forecasts in most screens are the average of analysts projections. Still, these are as good as it gets and has proven pretty reliable for me.

Debt/Equity: I adjust this number if I’m looking for ideas in highly capital intensive sectors where leverage is supported by cash flow such as utilities. But for a broad screen I like to see companies that aren’t highly leveraged. In fact, I tend to add point to a company as their debt ratio decreases. Remember, though, don’t take this in isolation. Sometimes zero debt is bad insofar as better ROI/ROE can be achieved by employing leverage.

Current Ratio: For those of you who are unfamiliar, the current ratio is current assets/current liabilities. This shows a companies ability to pay it’s current obligations including the current portion of long term debt.  I also look at the “Quick Ratio” which is (current assets – account receivable)/current liabilities. More than anything these metrics show managements talent at managing working capital. If the numbers are too low it can mean too much short term debt among other things.

OK, that should be enough to get you started. There’s a great free screening tool at Finviz.com where you play and test various measures. Obviously it works for other fundamental and technical measures as well but I find it most useful for fundamentals and use other software for technical analysis. I also look at any stock that makes my value list through a technical lens just so I have an idea of support and overhead.

But value investing is much more time intensive than simply reading a chart. It takes me about an hour to drill down through a final analysis of any one value stock. And just like technical analysis it can be wrong. But if you hit one on the sweet spot it can pay big especially against market risk.

Over time I’ll try to expand on some of these concepts. If you’re a member of the technical analysis religion I assume beforehand that you think this is all nonsense. But first hand I’ve bought value stocks several times where the charts looked terrible and I got 400% + gains over three or four years (I’ve also had several where I lost 15% or so – buy and hold is dead.)  My bias toward value notwithstanding, I think it’s important to understand value investing as mush as understanding growth. As the environment changes it’s simply another arrow in your quiver.

Thoughts from a Macro Trader

Those of us who invest on big global macro themes have always been in the minority and, now, are as out of favor as anytime I can recall with the exception of the late 1990s. We’re the guys that waste our time looking at economic statistics in search for hints of dislocations that may impact markets over long term trends. Most of us, while being profitable, have underperformed the market in the recent past. That is nothing new since our larger objectives are more focused on risk management and gaining average long term alpha than on single year returns. It’s in times like now when we’re subject to the greatest opprobrium – which, by the way, is a signal worth paying attention to. Jimmy Rogers is subjected to some level of ridicule to which, it’s noteworthy,  those who do don’t have as much money has he. Keep that in mind.

That’s not to say that I don’t trade. I do (although I’m not great at short time frame ideas) but it’s interesting to see the perspective of younger traders where three days is a swing trade. Frankly, the way I see it, any position exited within a year is a swing trade. But I’m old and crusty and my perception clock runs faster because a year relative to my life continues to get shorter at an increasing rate.

The shortness of time frame I’m seeing (and I admit that it’s only the anecdotal vibe I get from the traders I follow on Stocktwits and Twitter) rather reflects the social zeitgeist of “you only live once” (YOLO). Certainly the whole YOLO thing is so obviously true that it demands ignoring. The risk, however, is that you live longer than you think you will. Just sayin’.

Regardless of my personal style, I have great respect for great traders (because I’m not one.) The obvious problem is that there are a lot of young traders who have done very well over the past few years that might start to think they’re actually great traders instead of passengers on a bull run. It’s only a matter of time until hubris becomes their enemy and I’m convinced we’ll see the majority of them looking for other gainful employment at some point. I think it’s also  important to note how difficult it can be to start looking down when all you’ve done is look up for the last five years. Short traders like Bill Fleckenstein are a special breed and very few people have any clue the psychology it takes to really press a down market. I’m certainly not one.

Which gets me back to why I started writing this missive.

I’m starting to see some rather outsized dislocations in all sorts of places; from the valuation of $RUT and high yield bonds, Chinese CDS spreads, the potential for the unwinding of the Yen carry trade and the mismatch of economic optimism to the price of copper – just to name a few.  That’s not to say that the market won’t digest and correct any and all of these. It’s also not to say that it will.

But the mere mention of these things has subjected me (and a few people I highly respect) to some ridicule and bombed me with the (just as ignorable as the YOLO thing) “only price matters” bromide. I ask all of you this: who is it exactly that thinks price doesn’t matter? Do me a favor and drown that in the bathtub. I’ve been accused of being a ZeroHedge-esque scare monger (I don’t read ZH) and a perma-bear even though I’m 70% invested long stocks. I’ll admit, I have hedges. But I almost always have hedges because I’ve seen in my nearly four decades in finance that the risks that knock your schmuck into your watch pocket come from places few people are looking.

The reason I don’t read ZeroHedge is that it does me a disservice to get involved in doom and gloom thinking. At the same time, though, it does me an equal disservice to read a lot of Pollyannas. Risk never disappears – on the upside or down. And for those who correctly admonish ZH for keeping people out of the market I think they should check their own shit because, just maybe, they might keep people in the market longer than they should sooner of later. If you want to be a good mentor to new traders you just might include a word of caution. Otherwise I have little use for your opinion (not that you care.)

It’s not my job to encourage anyone to be in or out of the market even though I think it’s one of the best ways to build real wealth. But it is my responsibility to point out things that could have big implications to the financial health of people. You can live with your biases all you want. That’s not my concern. But I’ve lived – and traded – though both bull and bear markets and I’m still standing.

Criticize me all you want.

p.s. – My attempts at blogging more often have been a complete failure. But if/when things get dicey in the markets I’ll probably do more. Those are the markets that interest me most.