23 Questions With David Merkel of Aleph Investments

'For a smaller manager like me, some less liquid stocks can make a lot of sense'

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PJ Pahygiannis
Dec 08, 2016
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1. How and why did you get started investing? What is your background?

I learned investing from my mother and business from my father. Both were good influences in my life. Both took prudent risks to take care of the economic life of our family.

I almost entitled my blog The Investment Omnivore because of my life. I have done something with almost every class of investment.

As an actuary, I was a pioneer with investment risk issues within life insurers. I was also forced to do financial reporting for over 12 years my least favorite area of practice. This made me more cognizant of investment risk issues, and why we should be skeptical of the figures that we get fed by corporate management teams. What the lower level prepares is not always what gets reported.

Most of my adult life, I have done some sort of value investing margin of safety concept because its neglect leads to all manner of colorful ways to lose money. More people would stay in investing if they properly sized their risks.

2. Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas from?

Here are my investing rules:

  1. Industries are underanalyzed, 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 industrieswhere 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 acceptedaccounting 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 to 40 names for diversification purposes.
  8. Make changes to the portfolio three to four 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.

I get investment ideas from all kinds of sources news articles, 13Fs, screens, etc. I try to let them sit for a while so that I forget where I got the idea, which forces me to evaluate them independently.

3. What drew you to that specific strategy? If you only had 3 valuation metrics what would they be?

It took a long time to come up with the rules. They came from an analysis of where I went right and wrong in my past investing.

Absolute valuation metrics are overdone. The tradeoff of stocks for cash is difficult to evaluate. I have a good model for that in aggregate, but it is much easier to compare stocks against each other. That is why I compare companies to those that I do own often a stock will strike me as being more attractive than the median stock in my portfolio and then I find a home for it by kicking out a less desirable stock that I currently own.

As an aside, P/B works better with financials while P/S works better with industrials and utilities. P/E is useful but you have to consider where you are in the pricing cycle of an industry. When things are horrible, the quality companies are typically a good buy, whether they have earnings or not.

4. What books or other investors changed the way you think, inspired you, or mentored you? What is the most important lesson learned from them? What investors do you follow today?

You can start here: Ten Investing Books to Consider.

General books on value investing:

Books that will help you understand markets better:

Books on managing risk:

I chose some good books here, some of which are less well known. They will help understand the markets and investing, and make you a bigger-picture thinker. Which makes me think, I forgot the second level thinking of "The Most Important Thing"by

Howard Marks (Trades, Portfolio).

5. How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?

I would like to hold a stock forever, but usually it is three to five years. That said, my rule is that I sell stocks when I find a stock to buy materially better than the stock I am selling. Always incrementally improve the portfolio.

It is easy to learn when you are wrong from your initial entry when you knowing if you are wrong from the current lower-circuiting price. That sell decision to no longer ask, Is this something? Is there something better to own at current prices? We make much better absolute decisions on stocks it is a major reason that I do not settle on my holdings.

6. How has your investing approach changed over the years?

Seventeen years ago, I did an analysis to try to understand where I did well and poorly in investing. I learned that I did best when I understood where the industry pricing cycles were and positioned in industries that were either underrated or given up for dead. Thus, I refocused on think-through industries first.

Aside from that, it is just value investing.

7. Name some of the things that you do or believe that other investors do not.

  • Looking at relative rather than absolute desirability of any stock or bond.
  • Starting with industries rather than being bottom-up or top-down.
  • Putting margin of safety first instead of opportunity or cheapness.
  • Thinking through virtually all investing and economic issues through an asset-liability management framework. Misfinancing is one of the most common errors in business and countries.
  • Adapting bond market concepts so they can be applied to the stock market.

8. What are some of your favorite companies, brands or even CEOs? What do you think are some of the most well-run companies? How do you judge the quality of the management?

Quality of management boils down to use of free cash flow, proper financing and skill at managing the operating business. I wrote extensively about it in the following series:

Talking to Management.

Favorite companies would include: Reinsurance Group of America (

RGA, Financial), Assurant (AIZ, Financial), Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), Industrias Bachoco (IBA, Financial) and Valero (VLO, Financial).

9. Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?

I tend not to use screens. After I find an industry that looks promising, I will look through a wide number of the companies in the industry to see who seems to be running their business intelligently and is undervalued.

I also collect ideas and then compare them to my existing portfolio as a group I will often get as many as four promising ideas that way. Look at my eighth rule for more.

10. Name some of the traits that a company must have for you to invest in, such as dividends. What does a high-quality company look like to you and what does a bad investment look like? Talk about what the ideal company to invest in would look like, even if it does not exist.

I like companies that use free cash intelligently. That means do mergers to achieve scale or buy back stock indiscriminately.

I like companies that become dominant in their niches and grow organically by finding adjacent opportunities new markets, products that use the existing business well.

I like companies that are neglected.

I like companies that treat outside passive minority shareholders like me fairly. I like my companies to be fair to all related parties: customers, workers, suppliers, regulators.

Companies that cheat others are not as profitable usually.

I like companies where the accounting is straightforward and companies with significant structural complexity. That is rarely rewarded in investing.

11. What kind of checklist or homework do you utilize when investing? Do you have a specific approach, structure, process that you use? Or do you have any hard cut rules?

My rules were listed in question two.

12. Before making an investment, what kind of research do you do and where do you go for the information? Do you talk to management?

Occasionally I will talk to management if something is unclear. Usually, I read documents at the SEC website and sometimes the company website. You want to be as unbiased as possible in investing, avoid doing things because a friend is doing it, popular among many or just because a company presentation or article makes it look promising.

In some industries like insurance, I will review regulatory documents because few look at them. Companies will bend GAAP reporting a lot more than they will the disclosures that they give to the regulators.

13. How do you go about valuing a stock and how do you decide how you are going to value a specific stock? When is cheap not cheap?

I do not value stocks per seI look at relative cheapness, which is easier to discern. That said, it is mostly a qualitative decision when I buy one stock and sell another I have to conclude that the new stock is more likely to perform better than the one being replaced.

Cheap is not cheap when:

  • Assets are overstated.
  • Earnings stem from questionable accrual entries.
  • The business has no sustainable competitive advantage, and is getting beaten by stronger competitors.
  • It looks technically cheap, but the company is overlevered or has a lot of debt coming due in the short run.
  • Earnings are not validated by cash flow.
  • Managements do not use free cash flow wisely.

14. What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?

Most of the stuff I am buying now is one-off. I am finding niche companies attractive, but relatively few broad themes.

I usually know of a few insurers that are cheap. Refiners look attractive. Emerging markets look attractive, aside from China. Most places outside the U.S. look better than the U.S. at present, though some of that is due to bad macroeconomics make sure the companies you own are well financed.

15. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?

The market is moderately overvalued. The light is flashing yellow for caution, not red for stop.

The thing that concerns me the most is that governments of the world are almost all getting highly indebted both directly and indirectly (through unfunded promises of future payments to their citizens). At some point, there will be national defaults and it will be difficult to see all of the second order effects in advance, such as dissolution of the European Union, wars, trade wars, government debt monetization, etc.

16. What are some books that you are reading now? What is the most important lesson learned from your favorite one?

I read a ton of books. None are that outstanding right now. I would encourage readers to read books on economic history because they can broaden your mind away from the news cycle blather that makes mountains out of molehills. I try to understand the big picture rather than absorb a simplistic view of the present from others.

17. Any advice to a new value investor? What should they know and what habits should they develop before they start?

A long time ago,

Ken Fisher (Trades, Portfolio) personally told me to develop away the CFA syllabus (which would be most commonly held ideas). I develop my own edge away from what the crowds view as value. Thats not a bad idea but be careful just because you are different does not mean you have common knowledge. It became common knowledge for a reason it works, even if it will not give you much of an edge against those who use it.

Develop the following habits: hard work, hard thought, patience, calmness, skepticism but not cynicism. Learn to evaluate investments both qualitatively and quantitatively. They are more powerful together. Be willing to read a lot.

18. What are your some of your favorite value investing resources or tools? Are there any investors that you piggyback or coattail?

Valuewalk is a great compendium website, as is Abnormal Returns. I use a lot of different things, including 13F filings that look good. Here are some ofthe factors I look at.

19. Describe some of the biggest mistakes you have made value investing. What are your three worst investments that burned you? What did you learn and how do you avoid those mistakes today?

Here is a set of nine stories of how I lost a lot of money and, occasionally, how I limited the losses. The set of stories includes all of my worst losses.

The main things that I learned from all of it was:

  1. To be more choosy about investments, particularly on how financially strong they are.
  2. Do not indiscriminately be average, judicious, check down your reasoning and, if valid, add a little, not a lot. You were wrong before, the odds of being wrong are high.
  3. Pass the idea by colleagues or friends if no one can find an error, go out to Wall Street and read the other side. If it sounds dumb, buy aggressively. (We did that with Tyco International (TYC, Financial)).

20. How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?

Much of that just takes time and a few losses to develop a good attitude. The losses are market tuition. Until you are disciplined mentally, you might want to be like me and create a variety of trading rules (see rules 7 and 8 and question 2) to limit your activity and dont break the rules.

If you focus on a margin of safety, the temptation to panic undo chances.

21. How does one avoid blowups in value investing?

Seek a margin of safety, which means a strong balance sheet for the industry in question. Seek talented management teams that use free cash flow well. Avoid complexity most good business and investing is not complex. Spend some time analyzing the accounting in industries where accrual items are relatively large compared to cash flow.

22. If you are willing to share, what companies do you currently own and why? How have the last five to ten years been for you investing wise compared to the indexes?

I am behind the S&P 500 over the last five years. Value investing has been tough over that period. I am ahead over the last 10 and way ahead over the last 20 years.

Here are the last five companies that I have purchased: MetLife Inc. (

MLG, Financial), J. C. Penney (JCP, Financial), Korea Electric Power Corp. (KEP, Financial), Express Scripts Holding Company (ESRX, Financial) and Aegean Marine Petroleum Network Inc. (ANW).

23. Here's a fun one - What stock would

Warren Buffett (Trades, Portfolio) or Benjamin Graham buy today if he were you?

Both would have bought Assurant at the IPO, but it is said that Buffett said that is was too tough. There are a lot of things that I own that Buffett might put to work examples might be Industrias Bachoco, National Western Life Insurance (NWLI) or Kansas City Life (KCLI). All of those stocks are illiquid, so you money to work in them. For a smaller manager like me, some less liquid stocks can make a lot of sense.

Full disclosure: Long AIZ, ANW, BRK.B, ESRX, IBA, JCP, KCLI, KEP, MET, NWLI and VLO.

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