Recommended Reading


Beat the Crowd: How You Can Out-Invest the Herd by Thinking Differently

by Ken Fisher

Ken Fisher has said pretty much everything he wanted to say in his previous ten or so books, but as a well-known contrarian he thought it would be helpful to clear up the confusion about just what a contrarian is. A contrarian is not someone who just does the opposite of the crowd; that’s a curmudgeon. A contrarian goes a different way from the crowd (and probably from the curmudgeons as well), which may be the opposite but probably isn’t. Besides, it isn’t always easy to tell what the opposite is.

For example, if the crowd (most investors, analysts, pundits) believes the market (a/k/a The Great Humiliator) will go one way, it will most likely (but not always—it is never predictable) go another way. There are four ways it could go: up a little, down a little, up a lot, or down a lot. So if the crowd thinks it will go down a little, a curmudgeon will probably reflexively bet it will go up. Just to be contrarian. But a true contrarian will bet it probably will not go down a little. It might go up a little, up a lot, or down a lot. The trick is to know which, and you can get a good idea which if you master Fisher’s principles for beating the crowd. Many of these ideas come from his earlier books Debunkery and The Only Three Questions That Still Count. Here’s a summary of some of these big ideas that can help you out-invest the herd by thinking differently.

Keep your eye on the LEI. There is way too much information out there, and most of it is useless if not downright dangerous. Past information is already priced in, and the market does not care a whit about any information that will have an impact more than thirty months out. The usual P/E ratios, earnings, ROI, etc. are backward looking and irrelevant. But the LEI, or Leading Economic Index of ten leading indicators, has proven itself to be uncannily predictive of market movements. Fisher notes that “No recession in the last 55 years has occurred during a rising LEI trend—they all started after LEI had fallen for some time.” (p.64) The trick is to know how much time is “some time.” That’s why Ken is a billionaire and you’re not. Get the LEI of the land for free (updated monthly) at The Conference Board’s website.

Also look at the Gross Operating Profit Margin. This is a more forward looking measure of profitability than the more commonly watched Earnings Per Share. That makes sense, so add it to your list of screening criteria. The equivalent for banks is net interest margin.

Look for the elephant in the room. If everyone knows it’s there, it’s already priced and cannot be the elephant! For example, everyone knows that additive manufacturing or 3D printing is a disruptor, so it’s not an elephant, but a particular application such as printing of organs might be.

P/E ratios are overrated. Even the CAPE—ten years back is too much history and is not predictive of the future. Many bull markets begin when the P/E is already high (the normal situation as the market comes out of a recession, when earnings get bashed). Fisher also takes issue with the notion that stocks revert to the mean. I think a true contrarian might take a long term high P/E as evidence of a strong company likely to remain strong (as with some defensive stalwart companies), if supported by additional evidence. Food for thought.

Behavioral finance is a thing, but not the thing you think it is. By now most of us have rejected the academic notions that humans and markets are rational, as old school economists used to tell us. We have biases such as confirmation bias, anchoring, and recency bias, and many more. (You can learn a lot about this from Charlie Munger’s video on cognitive biases.) But these new-fangled funds that purport to tap in to this social science gold mine are really just value funds in disguise, with a higher price tag. BF is not a way to choose stocks; it is a way to check your own biases.

Beware fake news! Fisher didn’t actually say this, as this book pre-dates Trump’s elevation of the notion to mythical status, but the sentiment is there. The media is mostly negative and very myopic, and thus very misleading. (Fisher suspects this may help explain why recent market cycles have been drawn out more than previously. Make a note of this, it could be an elephant! At least until it becomes widely known and gets priced in.) Check the first page Google results of almost any topic and most of it will be negative and myopic, even if the reality is otherwise. But unfortunately too many people buy into fake news, which allows the savvy contrarian to know which way not to go. You won’t see any elephants on the first page of a Google search, so you can look somewhere else for potentially valuable and largely ignored information that might help you beat the crowd.

 

The Intelligent Investor

by Benjamin Graham


This is the Bible of value investing. Everybody talks about it, but few read it. I can understand that – it was written in 1949, in a style as dry as the Dustbowl. Many of the companies referenced no longer exist. And things have changed. The blue chips of the Dow are no longer the only game in town. Fewer companies pay dividends. Some laws have changed and new investment products have been introduced. Buying and selling stocks has become simpler, cheaper, and theoretically more proletarian. But the basic principles are sound as ever. Mostly.

Did you know that Graham believed you should always have a minimum of 25% and a maximum of 75% of your portfolio in high-grade bonds? And the rest in blue chips? In fact, when the last edition of this book came out in 1973, Graham was considering recommending an all-bond portfolio! Many market-beating investors today have closer to zero percent bonds. Ken Fisher (see Debunkery) shows that stocks have way better returns than bonds and are safer over time. If you are convinced you only have a few years left on this earth and want to preserve all your capital then go ahead and load up on bonds, but most people will have little use for them.

Graham introduces a lot of the fundamental value investing principles popularized by Warren Buffett and others. There is the idea of buying a sound company at a fair or bargain price. If you can do better than that, you enjoy the famous “margin of safety.” It’s easy to be wrong, and having that extra wiggle room can make all the difference. You want to buy and hold rather than jump in and out. You want to build wealth over time, not look for the quick score. Frankly, these ideas have been so widely discussed in Buffett’s writings, as well as the writings of those who follow Buffett, that there is little reason for most casual investors to go to the source. But if you are an academic by nature, or just want a more solid foundation for your investing education, then read this book.

The 2003 edition (Graham’s 1973 edition updated with comments by financial journalist Jason Zweig) is the one to get. Zweig’s commentaries are easier to read than Graham’s old-time prose, and he also expounds on and updates some of the topics using modern day cases and companies. The 2003 edition also has a few goodies at the back, like Buffett’s brilliant article, “The Superinvestors of Graham-and-Doddsville.” This alone is worth the price of the book.

 

Debunkery

by Ken Fisher

While he is the son of the legendary Philip Fisher – who Warren Buffett says was a 15% influence on him (the other 85% coming from Benjamin Graham) – Ken Fisher is a self-made billionaire and a phenomenally successful investor and money manager. He has written several books and academic articles, in addition to his long running gig as the “Portfolio Strategy” columnist for Forbes magazine. His writing is informal, humorous, and easy to read, given the heft of the subject matter.

Fisher is a fascinating character. He is a tree hugger, an expert on California redwoods and logging history. Does that make him a liberal? I doubt it, because he unabashedly worships at the altar of capitalism. He irreverently shows his political hand when he shares his definition of politics: from the Greek poli (many) and ticks (small blood-sucking insects). He sounds like my kind of guy. And to top it all off, he’s a contrarian.

Debunkery belongs on your bookshelf because you will refer to it often. It is an extremely easy read – each chapter is only 3-4 pages and is devoted to a specific load of bunk. There are lots of charts and tables, many of which show Fisher’s own research. Combining the wonders of modern technology and the mountains of historical data, Fisher tests fifty bits of conventional investing wisdom to determine their veracity. Most fail the test, but pass or fail, it’s good to know the truth. Here are a few of his gems:

The US national debt is not all that big, nor is it bad. Historically, the UK has had higher levels of debt than the US, even during the most glorious days of the British Empire. When the cost of debt is low, you borrow more to fuel growth.

The trade deficit is similarly not a bad thing. It just means that prosperous countries like the US can afford to by more from other countries than they export. Where the money comes from and where it goes doesn’t matter as much as the fact that the money is moving.

Most calendar cycles are rubbish. The year does not go as January goes, and you shouldn’t sell in May and go away. However, there is some consistency to US presidential cycles. The information is there, but few people do the math.

Which category of stock fund should you buy? It doesn’t really matter, they all do about the same over time. Just buy one (low cost) and hold it. The problem comes in when you’re constantly selling low to buy the latest hot sector, just in time for it to drop, sell, repeat….

 

The Wolf of Wall Street

and

Catching the Wolf of Wall Street

by Jordan Belfort

The Wolf of Wall Street tells of the decadent rise and fall of Off Wall Street whiz kid Jason Belfort.

As with most sequels, the primary purpose of Catching the Wolf of Wall Street is to make money from the market of ready buyers of the original. And Belfort certainly needs the money, with a $110 million restitution order for his misdeeds – what the hell, let’s just say crimes.

Belfort isn’t doing it for the money alone. He spends a lot of pages trying to rehabilitate his image. He was a bright boy if not a model student, no doubt too bright to be engaged by a mediocre public school system. His middle-class upbringing left him hungry for fast riches, just like plenty of other middle class kids who wanted for, well, nothing. He ended up in a business where lots of people cut corners, and he just learned to do it better. He got caught up in drugs and the high life, an addict – a victim. Just a good kid gone astray. In the end he cooperated with the feds and ratted out his friends, who would have done the same to him so it’s all good.

Belfort’s roller coaster life makes for an interesting read. After all, how many of us made big bucks at a young age, dated supermodels, and became the focus of a federal investigation? Fun stuff. Everyone in his life has a colorful nickname, just like in the mafia. Belfort even adds a few sex scenes, which are more funny (for the poor writing) than titillating. This book is a guilty pleasure, though, so don’t expect to learn much about investing.

End of book review. I now add some personal comments. In the nineties I spent a few weeks working at a brokerage with the respectable-sounding name of Biltmore Securities. I was hoping to use my MBA and law degrees in the compliance side, but I soon learned that compliance was the last thing they were interested in. One of the guys in the glassed-in office at the back was Belfort’s boyhood friend and business partner Elliot Loewenstern (Belfort’s nickname for him: the Penguin). Everyone spoke of Stratton (Belfort’s firm) with reverence, like it was the best house no one had heard of, on par with Goldman Sachs. Turns out, Belfort financed the operation at Biltmore.

I was told to take a desk and start slamming phones, just like dozens of others in that big room. I decided to give it a go. We were provided leads and used the straight line script just like Belfort describes it. After a couple of weeks it became apparent that they did not teach anything about stocks or investing, they were just selling crap to whoever they could talk into buying it. Intelligence and judgment were hindrances, the only things that mattered were greed, a glib tongue, and cockiness. I didn’t like the idea of trying to talk someone I didn’t know into sending me money for a stock I didn’t understand, just because the firm wanted me to. Sounded like the old pump and dump. Anyway, I left after a couple of weeks. You can google the ending: the place was shut down, a few principals were fined six figures each, and I think one did some time. Better yet, go to Youtube and check out a clip from the Ben Affleck movie Boilerroom. That’s pretty much the way it was.

 

Why I Left Goldman Sachs

by Greg Smith

If you’re expecting a sordid tale of excess like Jordan Belfort’s, you might be disappointed with this expose. Smith was a brilliant student in South Africa, got a scholarship to Stanford, and made it through the gauntlet of interviews, internships, and trials by fire to attain the pinnacle in the world of finance: a job at Goldman Sachs.

Smith worked hard and rose through the ranks in the New York office, ending up in London to kickstart their US equities derivatives business in Europe. His unique background – he speaks Zulu and was an accomplished ping pong player – helped ease his climb.

Goldman Sachs is colorful not for rampant drug use (there was none apparent), but for its tradition. Mentors were called rabbis (regardless of their actual religion), and the mantra in London was “dress British, think Yiddish.” You wouldn’t hear that at JP Morgan. The New York and London settings also add color. Smith and his newbie cohort were walking into the Series 7 exam when the planes hit the Twin Towers, but Goldman had them sit for the next exam a month later. Time is money, and they don’t waste any. And that distasteful business about brokers referring to their clients as “muppets”? That seems to have been confined to the London office.

So why did the golden boy leave Goldman? The firm was not a bunch of hungry street kids talking smack like at Stratton Oakmont or Biltmore. These were the smartest people on The Street, and they had solid business principles and even ethics. But in the wake of the financial meltdown of 2007 they lost their way. With little business coming in, they drifted from their core values. They began creating products so complicated (and toxic) their clients (large institutions, sophisticated or otherwise) didn’t know what they were, but bought them because they trusted Goldman. They got burned. Goldman could play both sides of a trade and go against their clients’ interests. The firm needed money, and those who could bring it in got promoted – even if they did not otherwise deserve to be. The hallowed Goldman culture had deteriorated.

Smith did not write this story to trash Goldman Sachs, but to get them and the rest of the industry to reflect on where they are heading. My guess is the industry will always head for the money.

 

The Game: How the World of Finance Really Works

by Alex Buchanan

Here’s another look at the finance industry, but from a different perspective. Buchanan describes the roles and players of the London financial district, the “City” or the “Square Mile.”

There are five players in the game of finance:

Stock brokers – these guys (and only a few girls) are salesmen. They schmooze with clients and try to get them to buy through their firm. Their clients get calls from them and their competitors all the time, so building a good relationship is vital. They come to work early to get up to speed on the market and plan their approach, then start contacting clients by phone, email, and Bloomberg messages trying to earn their keep. On the bright side, they can go home shortly after the markets close for the day.

Traders – they either execute trades for clients or trade with the firm’s own money. Remember, these clients are large institutions playing with big money, not individuals buying a hundred shares here and there. How, when, and how much are important questions. Traders walk at the bell and spend many a late night entertaining clients.

Analysts – they do the research that provides the ammo for the brokers and traders. Analysts usually specialize in a particular sector and cover a number of companies therein. Though not generally respected by brokers and traders, analysts have to stay on their toes and be prepared to explain the latest twist in a stock’s price. With all the variables playing out, research is very subjective, and often follows rather than leads a firm’s desires. For example, across the industry you will see far more “buy” than “sell” recommendations.

Fund managers – wherever there’s a pool of cash, there is someone to manage it. Mutual funds, pension funds, governments, university endowments, charitable foundations, banks, and insurance companies all have piles of money that need to be invested. The fund manager’s job is to do that, while minimizing risk, and hopefully beat the market. Then there are the hedge fund managers, who take on more risk while trying to wallop the market. This is the ideal job in finance – using your wits and OPM to get extremely rich. No wonder there are so many funds out there.

Investment bankers – this is the top of the financial world. These guys don’t trade stocks, they do deals. Big deals, like mergers and acquisitions, leveraged buyouts, taking companies public, and arranging massive amounts of financing. Smarts are necessary but not sufficient. You also need experience and intuition, because every deal is different, the stakes are high, and the fees are huge. This is where financial, legal, and tax advice, and even politics, all come together.

Buchanan shares a few vignettes about players getting caught with their pants down. However, The Game does not take the reader on a rollicking ride like The Wolf of Wall Street, nor does it have the story arc of Why I Left Goldman Sachs. It is a straightforward description of how finance works in London, though it applies to most other financial capitals as well. If you are a finance major and you are not sure what you would like to do when you graduate, this book can help. It is also good for anyone else who wants a better understanding of how the world of finance works.

 

How a Second Grader Beats Wall Street

by Allan S. Roth

This is an easy to read book with a simple premise: all you need to beat the S&P 500 are a few index funds, and the math skills of an eight-year-old. The power of passive investing will do the rest.

Let’s start with the math skills. The critical equation is 10 – 2 = 8. Ten is the percent return the market yields on average, and two percent is about what you pay in costs and fees for an actively managed fund or portfolio (it could be more). Eight percent is what you get, less inflation. Lesson 1: don’t pay fees. If you use a low cost index fund (about .2 percent) you earn an extra 1.8% a year – in good years and bad – which can double the value of your portfolio in forty years.

So, should you just get an S&P 500 index fund? That wouldn’t be too bad, but you could do better. After all, the S&P only represents 500 of the largest US companies. It does not include many of the smaller ones that can juice up your returns, and it doesn’t include the rest of the world. Roth suggests the following allocation:

60% in a low cost total US market stock index fund
30% in a low cost total international stock index fund
10% in a low cost total bond market (US) index fund, as a buffer against bad times

This should beat the S&P 500 over the long term. If you want a little more excitement you can add a total REIT index fund (6% of your portfolio, taken from your US market allocation) and a precious metals fund (3%, taken from your international component). Your portfolio would look like this:

54% total US market stock index fund
6% total REIT index fund
27% total international stock index fund
3% precious metals stock fund
10% total bond market

As you get older and more risk averse (remember, this was originally designed for a second grader with a very long time horizon) you can add more to the bond fund and pare down the other components.

Human nature being what it is, what about those of us (pretty much everyone) who just know we can beat the market and are determined to try? You can have a separate fund for gambling on individual stocks you might like, but do not play with more than you can afford to lose. Never dip in to your passive portfolio to finance these adventures.

Roth offers another suggestion for investors. You should not use the S&P as your benchmark. Instead, you should compare your return to the average dollar invested in the market (which would be lower than the S&P). This is a more realistic way of thinking. It makes the indexing approach more palatable to all of those investors who are so sure they are among the few who can beat the market consistently.

 

Warren Buffett and the Interpretation of Financial Statements

by Mary Buffett and David Clark

Despite the prominence of the name Warren Buffett in the title and a smattering of his quotes in the text, there is no preface, introduction, or testimonial by the master himself. One of the authors was Warren’s daughter-in-law for twelve years, and the other is described on the cover flap as “an internationally recognized authority on the subject of Buffettology.” Hmmm, a recognized authority in an unrecognized field. You don’t need the acumen and insight of Warren Buffett to read into this – there is not much on offer here. This is a very simplistic, repetitive, and lightweight introduction to the basics of the balance sheet, income statement, and cash flow statement, with a few insights into Warren Buffett’s investment philosophy. To sum it all up, only buy businesses that have a durable competitive advantage.

Who should read this book? Someone with almost zero knowledge about financial statements, and who is not familiar with Warren Buffett’s investment philosophy. If you are truly such a novice you might learn a little bit from this book, but it won’t make you a value investor extraordinaire.