Tag Archives: david-merkel

Volume Is Usually Low At Turning Points

A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients. It was relatively inexpensive, and had fallen out of favor. Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2,000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65. I then shifted away from my trading application, and went to do other work. After an hour, I went back to my trading screen, and saw that 1,200 shares had executed between $25.50 and $25.57, but now the price was much higher, and by the end of the day, higher still. It is even higher now. At the time, I took a look, and lo and behold: I got the bottom tick – the lowest price on that stock ever (for now). I also noted that I had almost all of the volume when it went down to the low price. But 1,200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money. I concluded that it was a happy accident that I got the bottom tick. I’ve had the same experience working at a hedge fund. I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone – it was us that day. That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much. To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions. That happens sometimes, but in experience, not that often. Near a peak, you would need a buyer anxious to buy a lot more NOW. Near a trough, a seller wanting to sell it all NOW. Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices – being too aggressive will likely give them a worse result than being patient. The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW. That doesn’t happen often. Practically, that means to not be so picky about levels in buying and selling. If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up. Better to focus on ideas that you think have long-term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule. Disclosure: None

Pick A Valid Strategy, Stick With It

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance. Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the strategy. Here are three simple bits of advice that I hand out to average people regarding asset allocation: Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote. If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. You’d be surprised how little you give up in performance from doing so. The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again. Use additional money slated for investing to rebalance the portfolio. Feed your losers. The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. That is the number one cause of underperformance for average investors. The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy. Now, about momentum strategies – if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point. That brings me back to rule #1 above – even for a momentum strategy, maybe it would be nice to have some safe assets on the side to turn down the total level of risk. It would also give you some money to toss into the strategy after the bad times. If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. No strategy is magic; none work all the time. But if you “harvest” your strategy when it is mature, that would be the time to do it. It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk. But if you do things like that, be disciplined in how you do it. I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. Greed got the better of them. Markets are perverse. They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. Similarly, when people swear off investing in risky assets, markets tend to perform really well. It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. The markets aren’t rigged. If you are a soldier heading off for war, you have to mentally prepare for it. The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy. We can make investing easier by restricting the choices that you have to make to a few key ones. Index funds. Allocation funds that use index funds that give people a single fund to buy that are continually rebalanced. But you would still have to exercise discipline to avoid fear and greed – and thus my three example rules above. If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns . Most trading that average people do loses money versus buying and holding. As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance. That’s easy to say, but hard to do. I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain. Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. Pursue that, whether you invest like me or not. Disclosure: None

Learning From The Past

I wish I could tell you that it was easy for me to stop making macroeconomic forecasts, once I set out to become a value investor. It’s difficult to get rid of convictions, especially if they are simple ones, such as which way will interest rates go? In the early-to-mid ’90s, many were convinced that interest rates had no way to go but up. A few mortgage REITs designed themselves around that idea. Fortunately, I arrived at the party late, after their investments that implicitly required interest rates to rise soon, fell dramatically in price. I bought a basket of them for less than book value, excluding the value of taxes that could be sheltered in a reverse merger. For some time, the stocks continued to fall, though not rapidly. I became familiar with what it was like to go through coercive rights offerings from cash-hungry companies in trouble. Bankruptcy was not impossible… and I burned a lot of mental bandwidth on these. The rights offerings weren’t really good things in themselves, but they led me to buy in at a good time. Fortunately I had slack capital to deploy. That may have taught me the wrong lesson on averaging down, as we will see later. As it was, I ended up making money on these, though less than the market, and with a lot of Sturm und Drang. That leads me to my main topic of the era: Caldor. Caldor was a discount retailer that was active in the Northeast, but nationally was a poor third to Wal-Mart (NYSE: WMT ) and KMart. It came up with the bright idea of expanding the number of stores it had in the mid-90s without raising capital. It even turned down an opportunity to float junk bonds. I remember noting that the leverage seemed high. What I didn’t recognize that the cost of avoiding issuing equity or longer-term debt was greater reliance on short-term debt from factors – short-term lenders that had a priority claim on inventory. It would eventually prove to be a fatal error, and one that an asset-liability manager should have known well – never finance a long-term asset with short-term debt. It seems like a cost savings, but it raises the likelihood of insolvency significantly. Still, it seemed very cheap, and one of my favorite value investors, Michael Price, owned a little less than 10% of the common stock. So I bought some, and averaged down three times before the bankruptcy, and one time afterwards, until I learned Michael Price was selling his stake, and when he did so, he did it without any thought of what it would do to the stock price. Now for two counterfactuals: Caldor could have perhaps merged with Bradlee’s, closed their worst stores, refinanced their debt, issued equity, and tried to be a northeast regional retail player. It didn’t do that. The investor relations guy could have given a more understanding answer when he was asked whether Caldor was having any difficulties with credit lines from their factors. Instead, he was rude and dismissive to the questioning analyst. What was the result? The factors blinked and pulled their lines, and Caldor went into bankruptcy. What were my lessons from this episode? Don’t average down more than once, and only do so limitedly, without a significant analysis. This is where my portfolio rule seven came from. Don’t engage in hero worship, and have initial distrust for single large investors until they prove to be fair to all outside passive minority investors. Avoid overly indebted companies. Avoid asset liability mismatches. Portfolio rule three would have helped me here. Analyze whether management has a decent strategy, particularly when they are up against stronger competition. The broader understanding of portfolio rule six would have steered me clear. Impose a diversification limit. Even though I concentrate positions and industries in my investing, I still have limits. That’s another part of rule seven, which limits me from getting too certain. The result was my largest loss, and I would not lose more on any single investment again until 2008 – I’ll get to that one later. It was my largest loss as a fraction of my net worth ever – after taxes, it was about 4%. As a fraction of my liquid net worth at the time, more like 10%. Ouch. So, what did I do to memorialize this? Big losses should always be memorialized. I taught my (then small) kids to say “Caldor” to me when I talked too much about investing. They thought it was kind of fun, and I would thank them for it, while grimacing. But that helped. Remember, value investing is first about safety, and second about cheapness. Cheapness rarely makes something safe enough on its own, so analyze balance sheets, strategy, use of cash flow, etc. This is not to say that I did not make any more errors, but this one reduced the size and frequency. That said, there will be more “fun” chapters to share in this series, because we always learn more from errors than successes. Disclosure: None.