David J. Merkel is a CFA, FSA. His forthcoming equity asset management shop is tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities.where he researched a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. From 2003-2007, he was a leading commentator at the investment website RealMoney.com.

These are his Eight Rules of Investing:

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My objective in guiding investors is to teach them how to tilt the odds of success in their favor. As a value investor that rotates sectors, I have eight methods that each tilt the odds a little in my favor. Individually, each tilt is worth a little. As a group, they have been very powerful for my past results. Unaudited, these methods have allowed me to beat the market since the strategy started in September of 2000.

  1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
  2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
  3. Stick with higher quality companies for a given industry.
  4. Purchase companies appropriately sized to serve their market niches.
  5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
  6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
  7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
  8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

Each of these rules enforces a discipline on the overall portfolio that most professionals and individual investors do not possess. It takes the emotion out of investing, and forces us to think like risk-sensitive, profit-seeking businessmen. I agree with Buffett when he said, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.” The two disciplines mutually reinforce each other, leading to better results.

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Part II is after the jump

The Portfolio Rules Work Together

Here are the eight rules with links to my recent pieces:

  1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
  2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
  3. Stick with higher quality companies for a given industry.
  4. Purchase companies appropriately sized to serve their market niches.
  5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
  6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
  7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
  8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

For the most part these are rules that would only serve a value investor. They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which rules 7 and 8 spell out. The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors. Value traps are companies that are cheap, but cheap for a reason. How do you avoid value traps?

  • Try to have industry factors working for you (Rule 1)
  • Look for companies that still have some room to grow (Rule 4)
  • Avoid companies that are aggressive in their reporting of income (Rule 5)
  • Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together. They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series. From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.

Category: Apprenticed Investor, Investing, Rules

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

17 Responses to “David Merkel: The Eight Rules of My Investing”

  1. VennData says:

    Doubt it.

    But more importantly, the effort this takes, the cost, and the risk of NOT outperforming means indexing is the way to go. Will all that time, effort and risk pay off in the next decade? Nobody knows.

    If you want to try to outperfrom the S&P500, tilt your index selections to small cap and value indices. The tacit tilt in a portfolio often explains someones self-percieved “out performance.” Since this tilting is more risky, than the explanation for a seeming outperformance is that there is more risk in the portfolio.

    By definition, I outperform every year since I use low cost index funds, and spend very little time, just a yearly rebalance to my target asset allocation, those low costs mean I am guaranteed to outperform, by the cost difference.

    So instead of 35% S&P500, 35% Non-US Equity and 30% TIPs. Use 25%S&P500, 25% Non-US Equity 20% VBR (Vanguard’s small cap value ETF) and 30% TIPs

  2. CANDollar says:

    If you used these rules in say, summer of 2007 you would still have lost considerable capital a year and a half later.
    If you used these rules in say, spring of 2009 you would have gained considerable capital a year and a half later.

    These kinds of rules can be useless, dangerous or wonderful depending on where you put your capital at risk.

    If you bought into a variety of index funds using a value approach to dollar cost and rebalance regularly, and use a simple risk management rule like the 40 week MA you would probably meet or even exceed the above strategy with far less cost and trouble.

  3. Sechel says:

    “#5 Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings” sound extremely difficult and often not done(by both individual investors and professionals). In my opinion the guys who do this right, to get an edge, are the true heroes of finance, whether its Jim Chanos figuring out Enron, or John Hempton at Bronte Capital or even someone like Jonathan Weil who today wrote about Apple’s accounting issue regarding the booking of future revenue. Not being able to figure this stuff out, I’ve short handed a rule that sounds like if a company routinely outperforms its piers on an earnings and profitability basis and does so consistently, something may be up. I call this my AIG rule

  4. peachin says:

    ” Numbered Rules” have a lot of religion in them. 12 Steps, 10 commandments, 7 rules of…., 3 ways of this and that….So, having said that… we can consider – Religion as a “broken form!” The 21st century is “fluid” the only conflict is “perception vs. Reality” which can be diminished by the mathematics of probability – Volitility – supply and demand – whatever… Focus is everything… Holding is destructive (Except for AAPL – which is an anomaly) I guess, agility and focus – yes that’s it.. yes THAT’S IT!

  5. call me ahab says:

    man, am I sleepy now . . .yawn

  6. peachin says:

    Henry vs. Jack -(rules to live by)

    On Writing
    Writing COMMANDMENTS
    1. Work on one thing at a time until finished.
    2.Start no more new books, add no more new material to “Black Spring.”
    3. Don’t be nervous. Work calmly, joyously, recklessly on whatever is in hand.
    4. Work according to Program and not according to mood. Stop at the appointed time!
    5. When you can’t create you can work.
    6.Cement a little every day, rather than add new fertilizers.
    7.Keep human! See people, go places, drink if you feel like it.
    8. Don’t be a draught-horse! Work with pleasure only.
    9.Discard the Program when you feel like it—but go back to it next day. Concentrate. Narrow down. Exclude.
    10.Forget the books you want to write. Think only of the book you are writing.
    11.Write first and always. Painting, music, friends, cinema, all these come afterwards.
    - Henry Miller on Writing (above)

    Jack Kerouac (below)

    Scribbled secret notebooks, and wild typewritten pages, for yr own joy
    Submissive to everything, open, listening
    Try never get drunk outside yr own house
    Be in love with yr life
    Something that you feel will find its own form
    Be crazy dumbsaint of the mind
    Blow as deep as you want to blow
    Write what you want bottomless from bottom of the mind
    The unspeakable visions of the individual
    No time for poetry but exactly what is
    Visionary tics shivering in the chest
    In tranced fixation dreaming upon object before you
    Remove literary, grammatical and syntactical inhibition
    Like Proust be an old teahead of time
    Telling the true story of the world in interior monolog
    The jewel center of interest is the eye within the eye
    Write in recollection and amazement for yourself
    Work from pithy middle eye out, swimming in language sea
    Accept loss forever
    Believe in the holy contour of life
    Struggle to sketch the flow that already exists intact in mind
    Don’t think of words when you stop but to see picture better
    Keep track of every day the date emblazoned in yr morning
    No fear or shame in the dignity of yr experience, language & knowledge
    Write for the world to read and see yr exact pictures of it
    Bookmovie is the movie in words, the visual American form
    In praise of Character in the Bleak inhuman Loneliness
    Composing wild, undisciplined, pure, coming in from under, crazier the better
    You’re a Genius all the time
    Writer-Director of Earthly movies Sponsored & Angeled in Heaven
    As ever,
    Jack

    Spend more time being “jack” and less being “Henry”
    sorry, not really, Sunday is a slow day before Presidents Day

  7. AlexM says:

    I didn’t see anywhere what his actual results were for 2000-2012. It is difficult to judge if there are no numbers to compare.

    Also, I totally agree with CANDollar, WHEN you invest has a great deal more bearing on your results than what methodology you use. Timing is everything – despite what the “buy and hold” experts tell you. Barry has shown us some excellent results due to entering and exiting the market during the right times.

    It is one of the secrets of analyzing investing track records where the typical performance for any given time frame are standardized. i.e., if the S&P went up about 53% for 2009, but who invests day one and sells day 365? And your results for 2009 would be very different if you were fully invested in 2008 and rode the crash down.

    Timing is everything in the markets.

  8. machinehead says:

    Wow, I’m shocked at some of the cynical, dismissive comments on an insightful essay. David Merkel’s point that ‘industries are underanalyzed,’ relative to companies and the broad market, has the ring of truth.

    Merkel’s strategy (especially point 2) bears some similarities to James O’Shaughnessy’s ‘What Works on Wall Street’ approach. O’Shaughnessy incorporates momentum explicitly, to find ‘value stocks that are rising in price.’

    What Merkel describes is classic security analysis, Graham and Dodd style. Few have the ability to do it well, so they tend to get compensated for their efforts. Now and then I plow through an annual report. But the volume of report-reading and monitoring of company managements required to implement Merkel’s system with ’30-40 names’ is way beyond what I could undertake.

    Personally, I’ve abandoned judgement-based investing for a purely mechanical system which diversifies among asset classes rather than individual names. This achieves more stable, reproducible returns for me. But Merkel’s approach is sufficiently rules-based to avoid the erratic results of a pure seat-of-the-pants approach.

    Thanks for the insights, David.

  9. machinehead says:

    Thoughtful essay — thanks!

  10. GetReal1 says:

    Adding Rule #9, always have a fed chairman in your back pocket.

  11. call me ahab says:

    “Wow, I’m shocked at some of the cynical, dismissive comments on an insightful essay.”

    I guess insight, like beauty, is in the eye of the beholder

    next time I’ll try not to upset your delicate senses

  12. peachin says:

    Alex, Machinehead, Sechel, Mitt, VennData and Vin diesel: Real Big Money is in Tax Exempts and Illegal insider “taps” – Investing..? “Whew…………” Good Trading sees between the lines of Market Makers, Fast Trading, computer quants, and “Talking Heads” I guess If I had to follow anyone’s thoughts they would be Leonardo Pisano, a.k.a. Leonardo of Pisa, a.k.a. Fibonacci “of number sequences” Otherwise, traders are waiting for your (Investor’s) money to enter the markets so they can “take” it! (SO THEY CAN TAKE IT!!!) Most investors do lots of reading and hearing – to no end- you should start by knowing what “Support and Resistance” are and how Volume affects it (and how strong news can override it all) You have to have “stops” in place.. know how to use “Stops” and have your “finger” on the trigger, your foot resting near the power brakes – and if you are in the “arena” you better watch the “tape” – no stomach for that? Get a life! (in investing)…Oh, please, please, please – Barry – don’t ban me from the site!

  13. Joe Friday says:

    To quote the beer commercial, “HERE WE GO”:

    Iran halts oil sales to Britain & France

    (Reuters) – Iran ordered a halt to its oil sales to Britain and France on Sunday in a move seen as retaliation against tightening EU sanctions.

    “Exporting crude to British and French companies has been stopped … we will sell our oil to new customers,” spokesman Alireza Nikzad was quoted as saying on the ministry website.

  14. drewburn says:

    I followed David for a long time on Real Money. I always found him useful, though I think he did more fixed income back then. Still, I’m a guy who does mostly equities, but always listens to what smart people in fixed income have to say. I really like this part: “buy cheap companies in good industries, where the trends are not fully discounted.” I’m a big “trend not fully discounted guy.” I find the “find good companies with strong balance sheets in industries with lousy pricing power” much harder (and requiring of more patience/discipline.) But I always liked David’s writing.

    And I agree with machinehead on the “industries being under analyzed.” As a whole the sell side is always looking at companies, stocks they can promote, not the industry as a whole. The sector stuff gets much less precedence or analysis. I’ve been very under-diversified for 12 years, mostly staying in natural resources, and frankly I’ve beaten the crap out of the market.

    I even think that macro investors don’t do a very good job at long term macro trends. Demographics, social and political changes (accounting changes!!)…….they don’t repeat, but they rhyme……….

  15. theexpertisin says:

    Learning about other’s investment plan is always of interest to me.

    I attempt to implement a strategy contained in one sentence:

    A fool and his money are soon parted.

    After about forty years as an investor, I am getting the hang of it.

  16. Sunny129 says:

    I trust no Company’s balance sheet since I assumed it is rigged to it’s favor. So are the opinion of majority analysts.

    I invest in a few div paying blue chips+DRIP and res,t in low cost index ETFs. No need to learn the analytical skills to shift through their BS data sheet.

  17. David Merkel says:

    Well, thanks to all for commenting. If you’re curious about how well this has worked for me, you can drop me a line here. I prefer not talking about it publicly for legal reasons; I can simply say it has done well for me (though not in 2011); if you want, you can ask for the data, and you can be the judge.