My Amazon Review of Andrew Lo's and Stephen Foerster's "In Pursuit of the Perfect Portfolio:........."

 

Thinking About Retirement Portfolios

 

Finance professors Andrew Lo and Stephen Foerster have given us a tour or modern finance theory through the lives and ideas of its leading academics and practitioners with the goal of coming with a “perfect” retirement portfolio. He starts his intellectual history with the mean-variance work of Harry Markowitz and then goes on to discuss the “betas” of Bill Sharpe, the efficient market hypothesis of Eugene Fama and the options pricing world Black-Scholes/Merton. We also have Jeremy Siegel who’s “Stocks for the Long Run” became the bible of the 1990’s bull market, yet Siegel did call the top in the NASDAQ in early 2000.

 

His practitioners are index fund founder John Bogle, pension consultant Charles Ellis and bond guru Martin Leibowitz. We also have the behavioral economist Bob Shiller of irrational exuberance fame. In the interests of full disclosure Marty Leibowitz was my boss for a time at Salomon Brothers and I worked with Myron Scholes there as well. I also first met with Bob Shiller at the infamous Fed meeting on the stock market in 1996 where I was a participant.

 

What all of them had in common is that they were math “nerds” as kids. Further something must have been in the water at the University of Chicago and M.I.T. in the late 1960s. It was at those two places along with Sharpe’s UCLA that modern portfolio theory exploded on to the scene. For my perspective I received an MBA from UCLA in January 1966 in finance where modern finance was barely discussed and four years later when I returned for a Ph.D. in finance it was all that was discussed.

 

So, what is an investor contemplating retirement to do? The general consensus is that there is no generic retirement portfolio. It depends on the individual investor’s tolerance for risk and consumption patterns. Within that framework nearly all of them would recommend low-cost index funds and TIPs. There is some support for the traditional 60/40 stock bond portfolio, but Siegel and Ellis are skeptical of bonds when interest rates are extraordinarily low as they have been for the past several years. However, this presents a quandary, if bonds can be over-priced why can’t stocks be and vice versa. This is where Shiller’s cyclically adjusted price earnings ratio might be a tool to be used qualitatively.

 

Several of them recommend adding international stocks through a low-cost index fund, small cap stocks and value stocks to the mix. Although this was certainly theoretically sound around the turn of the century, over the past two decades those substitutions within an equity portfolio would have severely detracted from investing the S&P 500 alone.

 

My criticism of the book is that it gives to great a weight to the concept of efficient markets. While the markets are efficient most of the time, that is always not the case. Witness the recent collapse of high value-money losing companies as an example. The authors mention the term “black swan,” in passing, but they do not mention Nicholas Nassim Taleb who popularized the term a decade ago. This omission is unfortunate because Taleb is one of the keenest critics of modern finance theory. Simply put the tails of return distributions are much fatter than in a normal distribution and the probability distributions are not stable over time. Moreover, we know our lives are path dependent, why shouldn’t markets be path dependent, at least, in some cases and especially when the economic regime changes.

 

Although cited, the 1900 dissertation by Louis Bachelier in Paris, should have been given more emphasis. As mentioned, Bachelier anticipated Einstein by five years on the idea of Brownian Motion, he also had a well-developed idea on the pricing of stock options that pre-dated Black-Scholes by 70 years. Specifically, he defined the notion of put-call parity which is essential for modern options theory to work.

 

Nevertheless, Lo and Foerster have written a very helpful book for investors seeking sensible guidelines for retirement planning and who also would benefit from modern finance theory.

For the full amazon URL see: Thinking About Retirement Portfolios (amazon.com)

My Amazon Review of Bruce Greenwald's et.al. "Value Investing: From Graham to Buffett and Beyond" 2nd. Ed.

 

In Search of Value

 

As a value investor, I have the highest respect for Bruce Greenwald and his colleagues. Unfortunately, in recent years value investing has failed to live up to its billing. Indeed, over the past two decades Warren Buffett’s Berkshire Hathaway has performed roughly inline with the S&P 500. (I am a shareholder.) My history with value investing goes back to reading Graham & Dodd in 1964 while attending Baruch College. Further I own the classic 1940 edition of that book and Greenwald’s first edition of this book. Nevertheless, I did find my way to owning Microsoft, Apple, and Alphabet.

 

Nevertheless, Greenwald’s new book is worth a careful read. He is very wise in dismissing modern portfolio theory’s Beta as a measure of risk. Why? The beta measure of risk is independent of stock price. He is also very cautious about using discounted cash flow over long periods of time because the results are extremely sensitive to small changes in the discount and growth rates.

 

Greenwald plows over old ground in his discussion using net reproducible assets and earning power as a method for determining value. He then goes one step further by introducing franchise value into his valuation paradigm. Simply put franchise value is created by the ability of a firm to earn significantly higher returns over its cost of capital over a sustained period. Those returns arise from the existence of a protective “moat” around its businesses. Greenwald also recognizes that over time a firm’s franchise value can decline, and he thus introduces a decay factor to account for this factor.

 

The question arises is why hasn’t value investing been successful in recent years. There are at least two explanations. First is that the economy has shifted from tangible asset based to intangible asset based. That means GAAP accounting does not put on the balance sheet such intangibles as trademarks, patents organizational efficiency and research and development platforms. Greenwald adjusts for these factors, but there is higher error term surrounding the valuation of intangibles than tangibles. Second the Fed’s zero interest rate policy coupled with quantitative easing has likely distorted many of the historical metrics defining value.

 

The book was written before Berkshire Hathaway made its $735 million investment in Snowflake, a cloud computing software company. At Berkshire’s price, the company was valued at $34 billion and had trailing twelve months revenue of just under $500 million. Whatever one can say it is hard to make a valuation case for this company. Nevertheless, the stock more than doubled after Berkshire’s IPO purchase.

 

Greenwald has a very long discussion about Intel, the semiconductor giant, which at times in its history represented true value. He blames Intel’s recent problems on value destroying acquisitions. That is true in part, but Intel’s real problems run deeper. Its franchise value has deteriorated as it vaunted R&D operation failed to keep up with advances made by Applied Micro Devices, Nvidia and Apple. Moreover, its edge in manufacturing disappeared as Samsung and Taiwan Semiconductor surpassed it in the production of the latest generation of chips. In other words, Intel’s “moat” was paved over by competition despite its spending 19% and 22% of revenue on R&D and capital spending in 2019, respectively.

 

An added attraction of the book is that it includes vignettes from star value investors as Warren Buffett, Mario Gabelli, and Seth Klarman, among others. I read the book in the Kindle version; given the number of tables, it would have been an easier read in the hardback version.

 

Lastly, I recently started a position in a stock that currently trades at 10 times earnings and is trading at or below in my estimate, the reproduction costs of its assets. So, hope springs eternal and I will close with the opening quote that Graham & Dodd used in their classic text “Security Analysis: Principles and Technique,” from Horace’s Ars Poetica, “Many shall be restored that now are fallen and many Shall fall that now are in honor.”

For the full Amazon URL see: In Search of Value (amazon.com)

 

My Amazon Review of Seth Klarman's "Margin of Safety: Risk -Averse Value Investing"

A Primer on Value Investing

Seth Klarman through his Baupost Fund is one of the greatest investors of the current generation, perhaps of all-time. This 1991 book is an investing classic, so much so that it sells for $780 on the secondary market. The key insight for most value investors is the all investments must have an inherent margin of safety. That means looking at the downside before looking at the upside. The notion of risk is asymmetric, not the standard deviation of returns as modern portfolio theory suggests. For example for any given stock under modern portfolio risk is independent of price; for a value investor risk is extraordinarily dependent upon price.

Klarman is focused on absolute performance, not relative performance. Thus unlike the bubbleheads on CNBC he doesn’t have to be invested all of the time. He is rightly skeptical of Wall Street research and the exotic products their investment bankers come up with.

The key earnings metric for Klarman is rightly free cash flow. It is not earnings per share and it is not EBITDA. Depreciation is real and so too are capital expenditures which do not enter the income statement.

The reader has to remember that this book was written in 1991 against the backdrop of the 1987 crash, the junk bond collapse and the 1990 bear market. He is critical of newly issued junk bonds (high yield in today’s terminology). Little did he realize that 27 years later high yield would dominate the new issues. He is also critical of the index funds that now dominate today’s stock market. For the average investor index funds make a great deal of sense.

Why? Simply put the average investor doesn’t have the talent or the time to be a value investor like Klarman. To be another Seth Klarman takes more than a few brains and much hard work.

“Margin of Safety” is written in clear and concise language. My two criticisms are that there are far too few examples of value investing in action and it is obviously dated. Nevertheless the lessons to be learned from reading the book are timeless.

The full Amazon URL appears at: https://www.amazon.com/review/RLBRF216819WU/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv