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James Montier looks like a middle linebacker and does a brilliant job tackling the difficult question of what provides good tail risk protection in a declining market. Surprisingly he comes down on the side of cash.

Knowing how much cash to hold has always been one of the most difficult parts of managing money [at least for me]. I tend to feel guilty about high levels when markets are going up and then feel stupid for not having more when the markets are crashing.

Since June and the end of QEII, I have been selling some positions—both the overvalued and those that appear to have no potential to live up to my original expectations. Cash has also accumulated from additions. I have done almost no buying during the big run by the S&P to 1360 in May or at what appears to be an endless series of new market lows since August. Volatility has been massive.

During this downturn and in 2008-2009, I kept looking for that perfect investment that would protect my portfolio from these terrible market-wide drops. There are all kinds of tail risk insurance vehicles including ultrashort ETFs, buying the VIX, options/contingent claims, and maybe----cash?

What should an investor use?

Montier begins by trying to define what tail risk coverage should actually cover. Are you insuring against liquidity troubles? Inflation? Deflation?

I suspect most of us are concerned with liquidity. Remember how hard it was to find buyers at good prices for any stock during 2008 and early 2009? There was a distinct lack of liquidity during the height of the panic.

Montier shows us several portfolios and how they perform during a liquidity crisis. As it turns out his optimum portfolio is a 70% long S&P offset by a 30% VIX strategy. This will out-perform at the peak of the crisis. For a graphic look at the graphs exhibit 2 and 3 in the linked paper. Great-- this must be the answer. But things are not that simple for we mere mortals trying to time our way into the optimum time to buy volatility. Most of us can’t.

The time to consider buying insurance is when you are absolutely convinced you will never need it. How great did the market look last spring -— like it was never coming back down? When the good times are rolling, insurance is cheap, but it is at just that point you think you will never have any use for it.

We start wanting insurance when the market is imploding, and by that time, insurance is expensive and may not pay its way as a part of your port.

In recovery our timing has to be equally brilliant with a sell decision at the peak of the crisis, freeing up the cash we need to buy equities at the bottom. The tendency is to want to hang on the outperforming tail risk and wait too long to let go and get cash back in play.

A few key concepts in support of cash

There are three elements to consider that allow value investors to eschew tail risk protection and the difficulties in timing the buying and selling of insurance.

These are:

1. Valuation risk
2. Fundamental risk
3. Financial risk

Briefly:

Valuation risk is the avoidance of overpriced assets in favor of looking for the best values when opportunity presents. In order to take advantage of sales an investor must have cash in the account and not have to decide to sell assets into an illiquid market downturn to raise cash or have figure out the timing of selling the tail risk protection [for which you might have overpaid if you are only human]. When you need the cash, have it at hand and keep it ready.

As Seth Klarman notes, “Why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?”

Buying during maximum drawdown gives you such an immense margin of safety going forward, if you have chosen the equity carefully, your portfolio has every chance of full recovery and then some from the disaster.

Fundamental risk speaks to the permanent damage to intrinsic value events may inflict. This goes beyond valuation and includes thinking about what sort of tail risk specifically we need to cover. Is it deflation or inflation? If it is one or the other, how does it affect the value of the holdings in our portfolio and how do we minimize it? If we are certain of deflation, then bonds should be a part of the insurance. If it is inflation, cash may help.

From the paper:

As an aside, on inflation and deflation and protecting portfolios, cash once again has benefits. In order to generate optimal portfolios we would need a perfect macroeconomic crystal ball. That is to say, if we knew for certain that deflation was in the future, then bonds would make sense. Conversely, if we knew that inflation was a sure thing, then cash would make sense.

But optimal solutions often aren’t robust. They work under one scenario, which can only be known ex post. When constructing portfolios ex ante, the aim should be robustness, not optimality. Cash is a more robust asset than bonds, inasmuch as it responds better under a wider range of outcomes. Cash also has the pleasant feature that, when starting from a position of disequilibrium (i.e., a level away from fair value), it doesn’t impair your capital as it travels down the road of mean reversion to fair value (unlike most other assets).

Because of its zero duration, cash fares better than bonds in an inflationary environment. (This assumes that central banks seek to raise cash rates in response to inflation – an assumption, admittedly, that may be less valid at the current juncture than ever before.)

Cash is also a pretty good deflation hedge. Obviously, as prices fall, cash gains in real terms. Of course, all else being equal, bonds with a higher duration do better. Take the Japanese example shown in Exhibit 7. Cash does well in the initial stages of the bubble bursting (as per the valuation risk analysis above). In 1995, Japan’s CPI enters deflation (albeit mild) and remains flat for the next decade and a half, give or take. Cash maintains purchasing power in real terms. Of course, bonds do better than cash over this period, but to know that ex ante would require perfect foresight regarding the path of Japanese inflation – something beyond our ken.


Finally we have financial risk. Four words encapsulate the concept –- avoid leverage/ be contrary.

Take-away

Cash is not all bad and being fully invested 100% all the time is not necessarily desirable.

The wrong time to think about insurance is when the house is burning down. As illogical creatures we are easily lulled and convinced by the here-and-now and crowd behavior. We think the good times will last forever.

Conversely when the markets appear to be dying an ugly death and investors are heading for safer havens and buying insurance, we start crowding into those same investments at any cost. Zero yield treasuries? High-priced ETFs and options?

While cash may under-perform tail risk protection at the apex of a crisis, it is more forgiving of the poor timing buying and selling the insurance is subject to. It also has the “pleasant” feature of giving you something to use to buy the portfolio-saving values when they come without having to make pressured decisions what to sell to raise cash in the heat of the moment.

Let’s hear it for cash
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Take-away

Cash is not all bad and being fully invested 100% all the time is not necessarily desirable.

The wrong time to think about insurance is when the house is burning down. As illogical creatures we are easily lulled and convinced by the here-and-now and crowd behavior. We think the good times will last forever.

Conversely when the markets appear to be dying an ugly death and investors are heading for safer havens and buying insurance, we start crowding into those same investments at any cost. Zero yield treasuries? High-priced ETFs and options?

While cash may under-perform tail risk protection at the apex of a crisis, it is more forgiving of the poor timing buying and selling the insurance is subject to. It also has the “pleasant” feature of giving you something to use to buy the portfolio-saving values when they come without having to make pressured decisions what to sell to raise cash in the heat of the moment.

Let’s hear it for cash


Excellent post and citations. I'm sorry that it was inferred on POD that it came from a subscription service. Otherwise, there may have been more input here. I'd especially like a response from Mungofitch on the Berkshire or Mechanical Investing board. But that won't stop me from providing my opinion.

1. I do believe in cash. It's a wonderful protection, but it doesn't do much for value investors who can get swept down with market changes. As others have said, being right isn't as profitable as being wrong, but having the market act as you believe. Over time being right is better, but we've all experienced the years it can sometimes take to be recognized right.

2. For my little value "sandbox" or about 20% of my total investments I was caught in that conundrum in April. My personal investment numbers showed an "irrational" market where I'd earned about 15% in 2010 (all during the last half) and another 9% in the first part of 2011. IMO that market didn't justify those returns, but my conviction in my value choices led me to seek "insurance."

Mungofitch educated me on the value of deep out-of-the-money puts on broad indexes, namely SPY. In April through June the volatility was light, the spread small, and thoughts that the S&P would drop 20% low. I was educated that these likely would expire worthless, but they allowed me to keep the stocks I wished at a cost to return of about .5%. I'll admit that I'm delighted that I've sold about half for 3 to 4 times what I've paid. But the reality is that I would have made more if the market had risen, so it reimburses some, not all of the loss. There is much more and Mungofitch is the professor.

3. Looking at my portfolio and consistent reading of dshort.com AND reviewing Mebane Faber's timing statistics also caused me to "hedge" half of my large cap US and international funds, as well as my Small cap and emerging market funds. However, depending on how you define cash, I think you also need to include ST Federal or Treasury funds. It's a little extra interest.

4. I'll pause here to point out that the flaw in this briefly described system is that it isn't an easily replicable system at all. It's not slavish to Faber signals, nor does Doug Short's data sing out to me when it is time to sell, or buy. However, for me:

a) I do think it is analytical;
b) I do think it is consistent with my reading of Benjamin Graham, especially Chapters 3 and 4 on Defensive Investors, as well as Chapter 8 "The Investor and Market Fluctuations";
c) It doesn't take a great deal of time, which for me is a precious commodity;
d) For me, because I measure my portfolio over time, it works.

5. And then the next question, when DO you enter back in with that cash? As you point out, with cash THAT is a fun decision.

Again, KK, thank you for your valuable contribution!

Hockeypop
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5. And then the next question, when DO you enter back in with that cash? As you point out, with cash THAT is a fun decision.

Hockeypop


For me it was the week of August 8. I got 4 out of 5 right. But last week did scare me a bit.

My take is that there will be no double dip recession or market meltdown like in 2008. 2008 was a liquidity crunch cause by excess leverage. In other words, not enough cash. When you have covenants and reserve requirements coupled with mark-to-market accounting (whether you have plans for selling the securities or not) you set up a house of cards just like a bank without enough reserves. What we saw in 2008 was an economy wide bank run. When you are forced to sell when there are no buyers the bottom drops out of the market. Period! To use James Montier's expression, portfolios were not "robust."

How is that different now? Corporations are sitting on tons of cash. The government took the junk from the bankers (the Fed is probably bankrupt as we speak but they don't let themselves be audited). In other words corporations and banks are "robuster" than they were in 2008. Overseas, Germany and France cannot allow Greece to fail. Over there the banks have their taxpayers over a barrel just like the Wall Street banks have American taxpayers over a barrel. In other words, the financial world is safe even if taxpayers are unemployed.

There is a huge disconnect between wealth creation and employment in America. The world's greatest wealth creators are American companies. Just look at Apple. But the bulk of the jobs building the poducts are overseas. Apple is a bit of an exception because it has a large workforce manning the Apple Stores. But manufacturing is overseas. Cisco takes pride in saying that no Cisco employee ever touches a Cisco product. The highly paid engineers are in America but production, again, is overseas.

This disconnect between wealth and jobs is the current American dilemma but I don't think it can crash the economy or the market. In this split economy you can buy the high end like Lululemon or the low end like dollar stores but avoid the middle end like the plague.

Denny Schlesinger
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hey HP

Thanks for sharing your own tail risk strategy

5. And then the next question, when DO you enter back in with that cash? As you point out, with cash THAT is a fun decision.

What percentage of your port did you hedge percentage-wise and how did you decide when and how much to sell when you wanted the cash back?
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CC:
1. I agree about no recession;
2. In the recent great discussion on the BMW board and Mechanical Investing board between Kelbon and Mungofitch, I come down on Mungofitch's position that the overall market is very due for a further decline to more traditional valuations, and even under-valuations. Of course Mungofitch also states that value investors will due better than indexers.
3. I'm still bearish.

Hockeypop
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My situation/assumptions:

1. 1/2 of my portfolio is in TIAA-CREF for DW and me, so my non-equity options are small for MM, TIPS, bond-fund. Also, while I can and do make changes to DW's TIAA portfolio, I'm more cautious there. It's easiest to hedge in Vanguard accounts;

2. Vanguard only allows options in after-tax accounts. I have about 25% of my "sandbox" of individual stocks and ETFs, but since that's ALL in Vanguard, that makes up 50% of that Vanguard portfolio.

So:
3. So, for my sandbox, in April through June, rather than selling it, I bought SPY puts in the $110 area of various lengths. While they don't cost much, they do obligate you to buy 100 shares. If I had been forced to buy those shares that would have represented about 45% of my total 25% sandbox.

Mungofitch's advice for this "insurance", which I've followed, is to buy them when volatility is low and spreads are too, assume that you'll never use them (because overall markets do rise), and sell about half when/if they go "in the money" at the strike price.

The value/cost/profit of the puts is much smaller than the market value, but is nice in a falling market which is now 20% less than when I started. I've use it buy more Berkshire since I've sold half the puts when SPY got to $112 and then $110.

4. For the fund part of my portfolio, around May I sold all of MY TIAA-CREF Global Fund (about 45% US), which left an equal amount in DW's account. I didn't exactly go to cash, but split it about equally between MM and TIPS. That was a good decision as far as return. If I had been strictly following Faber, I would have now sold all the equities.

I also sold half of our Emerging Markets and Small Cap funds in Vanguard. In Vanguard I put those in ST Federal or Treasuries.

5. Right now I'm at about 43% in cash (20%), ST bonds, annuity, and Tips (23%) but with 15% in those bond-like investments I obsessively ask you about. About 5% of my total portfolio is still hedged with the puts. At September 30 the total portfolio was up about 3%, where I figure it would have been down at least 10% had I done nothing. I generally very good about setting up my yearly benchmarks and then measuring my portfolio at least quarterly.

Even though I'm going to retire in a year DW is at her peak earning years and probably won't retire for another 8 years, so we're not spending our investments for a while. I'm more aggressive than a "normal" 65 year old, i.e. I don't suggest this for ANYONE else.

More than you wanted to know, but I'll bookmark this now and see how smart I was a year from now.

Hockeypop
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Knowing how much cash to hold has always been one of the most difficult parts of managing money [at least for me]. I tend to feel guilty about high levels when markets are going up and then feel stupid for not having more when the markets are crashing.


Paging Benjamin Graham, he has the solution.

Kahuna, CFA posted a link on the BMW Method board recently to…

"A rediscovered GRAHAM MASTERPIECE. A1963 Speech by Benjamin Graham on the Right Way to Think About Investing."

Here is the original typewritten text of a speech Benjamin Graham gave in San Francisco one week before John F. Kennedy was assassinated. In this brilliant presentation, Graham explores how an investor should go about determining whether the market is overvalued, how to tell what asset allocation is right for you, and how to pick stocks wisely. This speech is a rare opportunity to see the workings of Graham's mind in the raw.

I am grateful to Mr. Richard A. Rigg of San Francisco, who was in the audience that day, for providing me with this copy of Graham's speech. Because I did not discover it until very recently, it is not included in the new book Benjamin Graham: Building a Profession, so I wanted to share the text online.


Jason Zweig

http://www.jasonzweig.com/documents/BG_speech_SF1963.pdf

Snip (from pages 9 and 10):

The first point is that the investor is required by the very insecurity ruling in the world of today to maintain at all times some division of his funds between bonds and stocks (cash and various types of interest-bearing deposits may be viewed as bond-equivalents.) My suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%. Consequently the maxim holding of bonds would be 75% and the minimum 25% — the figures being reversed. Any variations made in his portfolio mix should be held within these 25% and 75% figures. Any such variations should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high in relation to value.

Now while this is the classic language of investment authorities, it is amazing how many people think in exactly opposite terms. That was brought home to me shortly after the May 1962 break when a savings-and-loan company representative came to me with questions. The first question he asked me was "Don't you think that common stocks now are less safe than before because of the decline in the market?" That hit me between the eyes. Here were financial people who could seriously consider that stocks were less safe because they have declined in price than they were after they had advanced in price. The policy I propose to have more common stocks when the market seems to be low and less when it seems to be high by value standards is obviously opposed to the psychology of investors generally and to that of speculators always. It is particularly true now because of the great confusion between investment and speculation which I shall refer to later. I suppose the idea of having common stocks at low levels than at high levels is a ''counsel of perfection" for most investors. But it could be followed by many investors to the extent of an inflexible rule that they should not increase the percentage of common stocks in their portfolio as the market advances, except of through the rise of the market itself. However, a more sophisticated application, which would take the advantage of a rise in the market level for sales, could be something like this. Use as fixed 50-50 division between bonds and stocks. When the market level of the stocks rises to a point where they constitute 55% of the total or maybe 60%, you would then sell out enough to bring your proportions back to 50%. That was the famous Yale University system, which was one of the earliest formula methods known.

*Note that Graham states that, "cash and various types of interest-bearing deposits may be viewed as bond-equivalents."


The whole transcript of the speech is well worth a read. Thanks to kahunacfa for the link.

kelbon
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maintain at all times some division of his funds between bonds and stocks (cash and various types of interest-bearing deposits may be viewed as bond-equivalents.) My suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%. Consequently the maxim holding of bonds would be 75% and the minimum 25% — the figures being reversed. Any variations made in his portfolio mix should be held within these 25% and 75% figures. Any such variations should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high in relation to value.


I think the general principle is very sensible, but I would quibble with the particular numbers that are suggested here. If I understand Graham's idea properly, it is to have a default position of 50% bonds (and bond-like things like cash) and 50% equity, when the market is fairly valued, going up to 75% bonds when equity markets are overvalued and as low as 25% bonds when equity markets are undervalued.

Since it is fairly well established that you will generally do better with equity than with bonds (the 'equity premium'), this formula would seem to condemn you to having on average half of your investments in an underperforming asset class. To be fair, Graham acknowledges that there are countless variations on this theme of a 'formula plan', and that the important thing is for the investor to have some rule to 'keep him out of mischief'. His formula is also not very clear on what constitutes a market that is 'high' or 'low' or 'fair'.

So put another way, Graham recommends being 50% invested when markets are 'fair', and as low as 25% invested when they are high, with 75% invested when they are low. My rule, to keep me out of mischief, is similar, except that it is centred differently, has a different range, and has a definition for 'fair', 'high' and 'low'. My current practice is to be 90% invested if the market (the S&P being my index) is 'fair', meaning that it is about 13 or 14 times trend S&P earnings, i.e. about 1000 today (makes for round numbers). I would go to 100% invested if the market were to drop 10% below fair value (say 900), 110% at 20% less (800) and up to 120% invested if it was 30% under (700), but no more. Maybe I am influenced by the 2009 nadir of 666, although being almost 3 years ago, that was probably still a touch above fair value.

Conversely, if the market were 10% overvalued (1100), I would go to 80%, with 70% invested at 20% over (1200, or about today's level), and 60% invested at 30% over (1300, as in right now), and so forth. I would be out of the market only at 90% over (1900); out of the market meaning all cash or something cash-like. Graham says to keep 25%, to ward off regret, and I suppose he may be right, but I'll cross that bridge when we get there.

Regards, DTM
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When I used to hold stocks and bonds, my bond holding oscillated between 20 and 30% of the portfolio. I didn't buy bonds based on the value of the market but based on the available interest rate. When rates were high I would buy bonds with maturity of three to five years, enough of them to get to the 30%. When a bond expired I would buy another if rates were high enough. If not, I would wait until rates rose again.

Denny Schlesinger
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Since it is fairly well established that you will generally do better with equity than with bonds (the 'equity premium'), this formula would seem to condemn you to having on average half of your investments in an underperforming asset class. To be fair, Graham acknowledges that there are countless variations on this theme of a 'formula plan', and that the important thing is for the investor to have some rule to 'keep him out of mischief'. His formula is also not very clear on what constitutes a market that is 'high' or 'low' or 'fair'.

1. To be fair this was an article from his much more evolved and famous book. His concepts of value perhaps aren't too far off from yours.

2. However, the concept of allocation interplay in investments is still a good one. Perhaps for a different thread and not here on Value Hounds where I enjoy the individual stock discussion, the traditional Callan Periodic Tables show that a) there are different leaders in a year to year basis, and b) it's difficult to say proactively which ones those will be.

2010 and before:
http://www.callan.com/research/download/?file=periodic%2ffre...
All tables:
http://www.callan.com/research/periodic/

Hockeypop
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DTM,

So put another way, Graham recommends being 50% invested when markets are 'fair', and as low as 25% invested when they are high, with 75% invested when they are low.

I disagree with this interpretation. The way I read Graham is that he is saying manage your portfolio by following value. It also recognizes that frequently bonds and stocks move out of sync with each other if not counter-cyclical. The underlying assumption is that if stocks are high then bonds are likely to be low and vice-versa. As a stock value investor I did not grasp this concept until relatively recently. I was still stuck in the realm of X% stocks, Y% bonds based on a personal risk profile and anticipated need for capital preservation. After that split was created I would apply value principles to each portion of the portfolio.

If we followed value out of the dot.bomb and through the decade of sideways we would A)be sitting pretty and B) not be "bonds have outperformed stocks over the last decade therefore bonds are better. I was over weight bonds 97 - 00 (over 40%) and as fidgety as a cat on a hot tin roof because I thought that was 'bad' investing. As soon as the stock market got more reasonable, but actually not in value range, I started pairing down my bond positions and picking up stocks. If I bother to learn from my past and the actions of the markets in the past, Graham was right. I would have been siting on a gold mine if I had pared down to the very best 25% stocks and bought more bonds while picking bonds was stupid easy and cheap. I should have been far more value disciplined and patient coming out of 00. I would have lost a heck of a lot less, had a steady stream of investable income and enjoyed the bond ride up. This would have set me up to cherry pick the best value stock ideas.

The first trick is defining value and creating guidelines that help us follow value. (very much still a work in progress) The second trick is leaving behind the idea that asset allocation is +70% of returns.

jack
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So put another way, Graham recommends being 50% invested when markets are 'fair', and as low as 25% invested when they are high, with 75% invested when they are low.

•••••••••••

I disagree with this interpretation. The way I read Graham is that he is saying manage your portfolio by following value. It also recognizes that frequently bonds and stocks move out of sync with each other if not counter-cyclical. The underlying assumption is that if stocks are high then bonds are likely to be low and vice-versa.




Jack,

I don't think your interpretation is really what Graham had in mind. Remember, he includes cash and cash equivalents in his definition of bonds. I don't think he was making the assumption, or implying, that "bonds" are necessarily going to produce a more desirable return when stocks seem high. I think his emphasis was on safety, and the preservation of capital, because stock prices can be, and often are, more volatile and unpredictable than other investments.

Take today's situation. Interest rates are uncharacteristically depressed and are not likely to move significantly whether stock prices rise, or fall, in the short-term.

kelbon
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I don't think your interpretation is really what Graham had in mind. Remember, he includes cash and cash equivalents in his definition of bonds. I don't think he was making the assumption, or implying, that "bonds" are necessarily going to produce a more desirable return when stocks seem high. I think his emphasis was on safety, and the preservation of capital, because stock prices can be, and often are, more volatile and unpredictable than other investments.


I agree with kelbon's interpretation, although I will read the Graham thing more carefully to be sure, as soon as I have a moment. I think it would have been clearer, if my interpretation is right, to just say how much in equity, and how much in cash, forget about bonds. I can't think that having bonds right now is a good idea, cash seems much the better idea for X% of the portfolio, say 30% right now. There may of course be times, as for example in the Volcker years, when fixed income makes more sense than cash, but that was then and this is now.

Regards, DTM
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I will read the Graham thing more carefully to be sure, as soon as I have a moment. I think it would have been clearer, if my interpretation is right, to just say how much in equity, and how much in cash, forget about bonds. I can't think that having bonds right now is a good idea

I suggest everyone read, or re-read, Graham's "The Intelligent Investor." I read it for the first time over 25 years ago, and honestly didn't understand it. It was like a revelation on the re-read. That probably means I have more context to understand it now. That is the major reason I joined and listened to the Berkshire board (although I've known Berkshire since about its beginning -- while I was in Lincoln, Nebraska).

Chapter's 3 and 4 on the Defensive Investor are wonderful IMO. I also have Chapter 7 on the "Investor and Market Fluctuations" heavily underlined. When I read something good by Mungofitch, Kelbon, KitKatt, Jackcrow or others I often see if Graham talks about it too. Also read the Appendices.

Hockeypop
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kelbon,

From Chapter I, section "Results to be expected by the aggressive investor"

The field of undervalued securities may well include corporate bonds and preferred securities as well as common stocks. In fact, our reasoning leads us to the rather extreme conclusion that the only kinds of corporate bonds and preferreds suitable for the investor under present conditions are those which are depressed in price to the point of being definitely undervalued.

Chapter IV also has a long discussion about the merits of stocks vs high quality bonds, the major point being stocks bought at the right prices outperform bonds while stocks bought at just any old price do not.

Chapter V,
Let him avoid ordinary corporate bonds as long as the best grade issues yield little more than his<sic> United States Savings Bonds
(At the time the classic was first written he was a big fan of savings bonds because bond prices and yields were no better or possibly worse than what could be had from buying savings bonds.)
. . .

"Second-Grade Bonds and Preferreds"
Hence a second-grade 4.5% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense -- and if you are patient you will probably be able to buy at that level.

Second-grade bonds and preferred stocks possess two contradictory attributes which the intelligent investor must bear clearly in mind. Nearly all of them suffer severe sinking spells in bad markets. On the other hand, a large proportion of them recover their positions when favorable conditions return, and the ultimately "work out all right".

(second tier roughly = junk at the time of the original writing)

Chapter VI "Purchase of Bargain Issues"
We define a bargain issue as on which, on the basis of facts established by analysis, appears to worth considerably more than it is selling for. The genus includes bonds and preferred stocks selling well under par, as well as common stocks.

Not only does he argue that corporate bonds should be bought on a valuation basis he suggest, for some, that value can be found in junk if priced properly.

What needs to be kept in mind is the split between the defensive and enterprising investor. The defensive investor seeks average returns with as little effort as required. They are encouraged to use simple tools and seek fair prices. The enterprising investor is encouraged to buy intelligently across all asset classes and by this he means an eye toward value.

jack
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What needs to be kept in mind is the split between the defensive and enterprising investor. The defensive investor seeks average returns with as little effort as required. They are encouraged to use simple tools and seek fair prices. The enterprising investor is encouraged to buy intelligently across all asset classes and by this he means an eye toward value.

jack


You had me until that last statement. While I mistakenly cited Graham Chapters, the major discussion of the defensive investor is in Chapters 4 and 5. In fact he says that the defensive investor most probably won't buy growth stocks and will buy the greatest value that he/she can, shading on the side of large cap, higher dividends with the understanding that may be difficult.

In Chapter 8 he says that loss of price is not the same as loss of value. The defensive investor has the capability of equities that may be risky in price because of a general market downturn, but safe in value if measured by intrinsic value standards. Sounds like a mantra for Value Hounds for either the defensive or enterprising investor.

Speaking personally, my 3% YTD return would have seemed horrible in April, but looks good now. I think we both agree that a value approach, when measured over some period of time (usually not so short) has the capability of success. However, as many have said, the market has the capability of not recognizing/adeqquately pricing value long enough for anyone to question their own good conclusions.

And, having said THAT I admonish myself that six month drastic changes in a portfolio, may be lucky (although being successful I'll not yet admit that) and not totally appropriate widely in a retirement portfolio. Having lived through the early 1970's, mid-1980's, 2000 and 2007, we are cursed to live in interesting times. I DO appreciate all of your differing opinions.

Hockeypop
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Jack,

Graham wrote a lot over a period of decades, and inevitably over time, his emphasis and opinions became modified and sometimes even seemingly contradictory.

By 1963 it looks like Graham had changed his mind on preferred stocks.

With respect to preferred stocks the import[ant] point is that they do not belong in the individual investor's portfolio. The reason is they have a great tax advantage for corporate owners which they don't have for individual owners.

[…]it should be obvious that preferred should be bought only by corporate investors just as tax-free bonds should be bought only by people who pay income tax.


kelbon
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Kelbon,

Graham wrote a lot over a period of decades, and inevitably over time, his emphasis and opinions became modified and sometimes even seemingly contradictory.

Absolutely. In 48 he was advocating savings bonds because they could be had for a 2.5% - 2.9% yield while long dated high quality corporates were yielding the same or less. He almost always adds a proviso couched in language like "at this time" or "at current prices". The constants through all the revisions are: investing intelligently and manage the investor as much or more so than manage the portfolio.

The enterprising investor can pursue most any asset class as long as it was thoughtfully considered. The enterprising investor can invest in growth stocks but they should not chase growth stocks. The enterprising investor can buy junk but they should not chase yield. He often says that at the right price there is often opportunity in higher risk assets. The key is not being a contrarian or a follower but a thoughtful, intelligent investor.

When it comes to Graham I find the most value in how he encourages people to think about investing over what he thinks, at that time, are better or worse securities.

jack
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jack,

When it comes to Graham I find the most value in how he encourages people to think about investing over what he thinks, at that time, are better or worse securities.

I completely agree. As investors mining Graham's writing for his mindset, general principles, and intelligent and prudent thoughts about human nature and the consequential fluctuations in asset prices should be our focus. On the other hand, if you happen to be an historian, Graham's specific take on what's a more prudent and intelligent investment choice, for example, during November 1948, is pertinent; otherwise, it's only of anecdotal interest.

kelbon
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"Second-Grade Bonds and Preferreds"
Hence a second-grade 4.5% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense -- and if you are patient you will probably be able to buy at that level.

Second-grade bonds and preferred stocks possess two contradictory attributes which the intelligent investor must bear clearly in mind. Nearly all of them suffer severe sinking spells in bad markets. On the other hand, a large proportion of them recover their positions when favorable conditions return, and the ultimately "work out all right".
(second tier roughly = junk at the time of the original writing)

Chapter VI "Purchase of Bargain Issues"
We define a bargain issue as on which, on the basis of facts established by analysis, appears to worth considerably more than it is selling for. The genus includes bonds and preferred stocks selling well under par, as well as common stocks.

Not only does he argue that corporate bonds should be bought on a valuation basis he suggest, for some, that value can be found in junk if priced properly.

What needs to be kept in mind is the split between the defensive and enterprising investor. The defensive investor seeks average returns with as little effort as required. They are encouraged to use simple tools and seek fair prices. The enterprising investor is encouraged to buy intelligently across all asset classes and by this he means an eye toward value.

jack


Couple of minor points:

Significant discounts to par (on the order of 50%) were available in the lower tiers of investment grade debt/preferred stocks during the crisis. The junk issues exhibited somewhat greater discounts than their investment grade neighbors but were far tougher to evaluate and "feel" good about a potential buy. Some of them were truly junk heading to zero like the GM issues I bought (for $3 or $4 on a $25 par) and sold at a small profit just in the nick of time.

So, attractive values can be found in investment grade issues, at times, too. And, one need not venture into junk land and I doubt I ever will again.

I also don't think that it was a coincidence that these issues fell off in price at the same time that the stock market was tanking. So, while it may not happen the same way next time, I do think these types of securities offer risk profiles more akin to equity than that of conventional bonds and if there is a high probability that they will be correlated with stocks during "hard times" then they should be regarded as such from the standpoint of captial allocation. If you own them, consider them as stocks, not the presumably "safer" bonds and certainly not as cash.

If it walks like a duck . . . .

Rich
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K,

I think that tax-disadvantage for the lay investor has since expired with the many changes in the tax code since '63.

For preferred stock, the divis are taxed the same as stocks - 15%.

Capital gains are the same.

Corporate rates would be 35%.

Rich
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K,

I think that tax-disadvantage for the lay investor has since expired with the many changes in the tax code since '63.

For preferred stock, the divis are taxed the same as stocks - 15%.

Capital gains are the same.

Corporate rates would be 35%.

Rich




Yes, yes, this issue has already been previously addressed.

Your comments are anecdotal, unless you are an historian :)

"As investors mining Graham's writing for his mindset, general principles, and intelligent and prudent thoughts about human nature and the consequential fluctuations in asset prices should be our focus. On the other hand, if you happen to be an historian, Graham's specific take on what's a more prudent and intelligent investment choice, for example, during November 1948, is pertinent; otherwise, it's only of anecdotal interest."

kelbon
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Just to be clear, my minor comments were in reference to exchange traded debt and preferred stock. Not conventional bonds.

Because of the long or open ended maturities of these issues, they do not offer the important quality of simply waiting for maturity to get your principal back in its entirety.

Rich
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When Graham first became a "Security Analyst" bonds were investments and stocks were speculation. Then in 1928 Edgar Lawrence Smith published the results of research that changed Wall Street for ever. Smith set out to show that bonds were better investments than common stocks but his research showed the exact opposite! Common Stocks as Long Term Investments so upset Graham that he blamed Smith for the 1929 stock market bubble.

A careful reading of Graham shows how he changed his mind as time went by. While Graham never gave a formula for calculating intrinsic value, in the beginning the value of a business was thought to be its book value. Later on he switched to "going concern" value. Investing is a fast evolving field and one should not take Graham literally because a lot of it is dated. But there are also rock solid foundations in Graham, truths that never change. Cigar butt investing is one of them: "Anything can be a good investment if it is cheap enough."

Denny Schlesinger


Common Stocks as Long Term Investments
http://www.amazon.com/Common-Stocks-Long-Term-Investments/dp...

My Amazon book review:
http://www.amazon.com/review/R28GDOIRZ69JMQ/ref=cm_cr_pr_per...
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