February 25, 2008

How To Measure Risk: 3 Ways

Excerpt from Brick Financial's December 2007 Client Letter: 

There are several goals we have in running our [Core] portfolio and if met will demonstrate its risk relative to the market. They are:
          1. limit the frequency of negative return 3 to 5 year periods,
          2. limit the magnitude of the loses in those losing multi-year periods relative to the market,
          3. limit the magnitude of “peak-to-trough” drops in value to 25% or less and fewer than once in any 3 to 5 year period.

…we have had no negative return 3-year periods easily passing the first litmus test of reasonable risk. [Additionally] the Core Portfolio has never lost to the market in any three year period since inception. Finally, in the five-plus years of the Core Portfolio’s existence, we have had one “peak-to-trough” period of greater than 25% lasting a period of four months. Just as the best investment managers have all had periods of year-to-year underperformance, they have had peak-to-trough losses of 25% or greater at least once or twice every decade or so. Once again, we are in good company.

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January 11, 2008

Volatility Is Not Risk

Red DiceExcerpt from Brick Financial's June 2006 Client Letter:  

We believe that risk should be measured as the probability of permanent loss of capital. Too many professional and novice investors alike measure risk in terms of price fluctuations. An unfortunate byproduct of this view is that the more risk one takes on, the higher one’s potential returns. In other words, high beta stocks should garner high returns. As it turns out this is not really true. We pointed to Robert Haugen’s book, The New Finance, in our February Client Letter as providing evidence that low beta (low risk) stocks actually perform better in the long term than do high beta (high risk) stocks. Another side of this coin is labeling stocks risky or not risky by the beta or fluctuation compared to the market is foolhardy.

By way of example, let’s say we buy the stock of a company for $50 per share. In our analysis we have estimated the stock of this company should be selling for something close to double that price in the range of $90 to $110. In this example, we have very little risk as we wait for the market to recognize what we have and close the price to value gap by purchasing the stock at increasing prices. But if the stock suddenly falls in price to let’s say $30, the beta of the stock actually increases. The stock has become more volatile thus conventional wisdom says it has also become more risky. If the value of the company has remained unchanged, then the reality is the stock has become less risky as its price to value ratio has become more favorable – the proverbial margin-of-safety has increased. In this example an investor would have the opportunity to by an asset worth a $1 for just 30¢. Prior to the price decline that investor would have only been able to by that $1 for 50¢ although a fifty cent dollar is nothing to sneeze at.

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August 15, 2007

Actions in the Absence of Opportunity


Prices are increasing when underlying values seem not to warrant it. The private equity firms, flush with cash, are fueling this fire. For the moment, there are not too many companies we have much interest in based on valuation. Part of what we have done in the last quarter is move our money into a couple of the index ETFs.


This might seem counter intuitive as we just told you the markets are showing some value trends we don’t necessarily like. But we are simply following a line of reasoning practiced by many value investors. We have to place our money somewhere while we wait for individual investment opportunities. One of the places we can park our money is the market itself. We think investing directly in the market is a sound approach if, relative to individual positions that interest us, the market offers safety in principal with some potential return. (As of this writing we have increased the allocation of our client portfolios in cash and bond holdings.) For a more complete discussion of where to invest in the absence of an immediate individual opportunity, check out the December 2005 Client Letter.

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April 21, 2006

The "Zealots" Have It Wrong

The following commmentary is an excerpt from Brick Financial Management's February 2006 client letter:
"...The Zealot answer to the problem would be to create a portfolio set with some fixed percentage in stocks, some in bonds and some in cash without regard for valuation. This would be executed through some investment combination in index and actively managed mutual funds. The practice commonly referred to as asset allocation (or the Investment Policy decision), thought by the Zealots to be the most important decision an investor can make. The Zealot believes that the asset allocation decision, and not security selection, is the most important determinant of long term performance.

The Zealots and asset allocation As proof they reference one (that’s right, one) study. We’ll call the study BHB. The Zealots tell us that BHB says that of the determinants of performance - asset class selection, security selection and market timing – asset selection determines 93.6% of long term portfolio performance. [We find it odd that BHB did not consider management fees, transaction costs and taxes among the determinants.] They also went on to say that security selection determined less than 5% of portfolio performance. The Zealots love BHB as it seems to support EMH which states that security selection is pointless.

Variation in returns is not total returns But we (the Heretics), being skeptical by nature and being unable to ignore the success we’ve had with security selection, didn’t buy the interpretation of the BHB study. So we actually read the thing. What did we discover? At no point does the BHB study measure total long-term returns. What it measures is the total variation in quarterly (short-term) returns. In other words, BHB measured how much a portfolio went up and down over short periods and not how much money it made in the long term. BHB determined the successful portfolio as one that didn’t fluctuate a lot. Whether or not the portfolio actually made any money was not a determinant of investing success. Hmm…interesting.

Variation in returns means little We must keep in mind that the variation of quarterly returns alone tells us practically nothing about the prospects of investors achieving their financial objectives. Funding financial objectives comes from portfolio contributions and the compounding of returns over time. In other words, returns should not be ignored, even in the short-term. [Further, even if short term volatility is of utmost concern, we must realize that extreme diversification does not necessarily eliminate it. A more effective technique would be to choose investments that havesimilar returns but do not move in tandem. In other words, they should have a high negative correlation.]

Traditional asset allocation fails When using the material in the BHB study, and interpreting the results correctly, we find that the asset allocation decision determines only 15 percent of returns over a 10-year period. This little tidbit damages the credibility of the asset allocation process as practiced today, which is to say that long term investors should automatically be invested mostly in stocks and short term investors should automatically be invested in bonds and cash. This portfolio management by autopilot is nonsense. In our Client Education Brochure, we point out thatover 10-year periods, stocks perform better than bonds and cash over 80% of the time. But turned on its head, we see that bonds and cash perform better than stocks 20% of the time. If your time horizon is only 10-years long, wouldn’t you want to know which assets would perform best over the coming period? What you wouldn’t want to do is make an assumption that history will repeat itself. We think it important that we account for those times when stocks underperform.

Using, better yet, misusing the BHB study the Zealots set portfolios with rigidity (i.e., 20% large cap stocks, 10% foreign stocks, 15% small cap stocks, 10% short term bonds, etc). They wind up owning stocks from every corner of the market. Should any one piece of the portfolio advance or decline too significantly away from the original asset allocation, Zealots either buy or sell accordingly. This would seem to make sense if it were not for differing time horizons, valuation and costs.

As we just mentioned, there are occasions when both bonds and cash perform better than stocks, usually during extended bear markets. Thus the problem arises when arbitrarily selling (or buying) a portion of a portfolio that has advanced (or declined) significantly. The problem is exaggerated when valuations of the securities and the time horizon suggest just the opposite action should be taken. Extreme diversification, as traditional asset allocation requires, would always have the client in some asset that was underperforming. At best theportfolio would do about average with the market. As Heretics we can’t shake the belief that we should try and can do better than the market.

Value allocation succeeds Brick Financial believes that most investors should have some exposure to stocks, bought at low valuations, at all times. But when we create portfolios we will let the valuations of groups of stocks, bonds and cash, determine the asset allocation. This process is sometimes called “Tactical Asset Allocation”(TAA). A more fitting title would be “Value Allocation” (VA) which accounts for valuation of securities, investment time horizon, costs and fees..."

Read the entire commentary by clicking this link>>

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April 18, 2006

The Little Book That Makes You Rich!

The following commentary is taken directly from Brick Financial Management's November 2005 letter to clients.

The Little Book
Instead of getting into the details of our portfolios this month, we thought we’d change things up a bit with this letter. Recently, a neat little book hit bookstores. Written by hedge fund manager, Joel Greenblatt, The Little Book That Beats the Market explains value investing in (mostly) layman’s terms. The book touts a “magic formula” that Greenblatt says will help any investor beat the returns of the market. A review from the University of Western Michigan Library states:

“Using basic math skills and simple concepts, Greenblatt shows you how to achieve investment returns that beat the pants off even the best investment professionals and the top academics… Through entertaining anecdotes and practical pearls of wisdom, the book explores the basic principles of successful stock market investing and reveals the secrets to buying good companies at bargain prices automatic… The (magic) formula has been tested over hundreds of different periods and thousands of stock picks and has been proven extremely profitable for those who are willing to stick with it...”
Good companies at bargain prices The book is of particular interest to us and the clients of Brick Financial because it so clearly lays out basic value investing principles that we follow every day. Basically the book is about how to find superior companies at bargain prices. Greenblatt’s magic formula helps investors identify those companies.

Following the formula requires caution
Greenblatt goes to great lengths to explain to the reader that the magic formula is not a panacea. The formula is bound to lead to some years of underperformance. [Even proven investors have down years.] Those that don’t have the conviction or where-with-all to stick with it are bound to abandon the approach. Thus, following the formula requires faith in the underlying principles of value investing. It requires the ability to endure the long-term. And it requires, as Warren Buffett has stated, a “quality of temperament…not a high IQ”.

He is also adamant in saying that you should not be investing directly in stocks if you do not know the principles of accounting, forecasting, and basic financial principles. If you can not confidently work your way around a company’s financial statement then, according to Greenblatt,

“You have no business investing in individual stocks on your own!... Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

Highlights of The Little Book
Some of the main points of the book, and those that are most relevant to clients of Brick Financial, follow:v

  • There is a place where they sell businesses for half price all the time. And it doesn’t take a genius to figure out where to find them. The trick to finding these one dollar bills for 50 cents is that you as the investor must believe that these “dollars-on-discount” exist. Everyone should endeavor to save money. There are places an investor can put his money – under a mattress, in the bank, in government bonds or in corporate bonds. Some investments are better than others though.
  • Buying a stock means buying a percentage share in a business which entitles you to your proportional share of that company’s future earnings. Estimating the current value of the business requires guessing what the future earnings of the business will be. Your investment in any company should offer you more of a return than you might get in “safer” alternatives like the mattress, bank, or bonds.
  • Most stock investors are irrational and speculative which is one reason why the prices of stocks swing wildly in short periods of time. For instance, GM’s stock price can go from $30 to $60 in just a few months. It is improbable that the value of the GM would double in that time. Does this phenomenon make any sense? No! But all we as investors need to know is that it occurs and attempt to exploit it. We don’t need to know why it occurs. Even though it is difficult to value business, we must make our best guess. And when we do decide to invest, we are best served to wait for the moment when the stock price of the company is below our guess of the business’ intrinsic value. Benjamin Graham coined this action as buying with a margin of safety.
  • It is better to buy a company that earns more money relative to the amount you paid for it. In other words, if company A earns $2.40 per share per year and company B earns $1.20 per share per year, yet both companies cost you $12 to purchase, which is the better buy? Company A of course. You’re getting more earnings for your money. Company A’s earnings yield is 20%, while company B’s is only 10%.
  • An investor would also be keen if he bought only good business. How do you tell which are the good business? As an example, let’s say it cost both company A and B $400,000 to build each of their widget stores and get up and running. Let’s further say that company A earns $200,000 but company B only earns $10,000. Which is the better business? Company A once again. Company A’s return on invested capital (ROIC) is 50% while company B’s ROIC is a paltry 2.5%.
  • If an investor stuck to buying good business (high ROIC) at cheap prices (high earnings yields) he’d do well with his investments.
  • Buying good businesses at bargain prices works as an investment strategy. Not only has it worked in the past but because its principles are sound, it will work in the future. There will always be better business than others and there will always be better values than others. But the investor must have faith in the principles.
  • The “magic formula” as well as any well reasoned investment strategy will occasionally fail to do well in the short-term. The short-term can often mean years, not days or months. It is extremely hard to stick with a strategy that may not work for several years in a row. Which is a good thing. If the formula worked all the time, everyone would use it and it would eventually cease to work. The trick is to have a long-term mindset. Long-term in this case means three, four, or even five years or more!
  • Although you want an investment strategy that has worked in the past, a good track record will not ensure results in the future. A good track record will not keep you following if the results are not as good. You should follow an investment strategy if the principles are sound. Buying good businesses at bargain prices is a sound principle and is the definition of value investing.
  • If an investment strategy is sound, the longer the time horizon, the better the chances for success. Time horizons of 5, 10 or 20 years are ideal. Such a time horizon will give an investor a large advantage over most other investors.
  • As much as 95% of the trading that occurs in the stock market is completely unnecessary and meaningless.
  • The stock market offers the best possibility for high investment returns over time. However, most people that should invest should not invest on their own. So it is difficult to know where to start. Stockbrokers generally have NO idea how to help investors. They’re only trained to sell products at the investor’s expense. Mutual funds would be fine but the vast majority of mutual never beat the market. A hedge fund may be a viable option but their high fees are usually not justified by their performance.
  • Since there are so few good avenues for investors to participate in the stock market, the best choice is most often an index fund. Or he may use an easy to use “magic formula” like the one in the book.

Be sure to get the book Finally, we encourage you to read this book. You can click this link to pick up a copy. You can also view a review by The Wall Street Journal here.

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February 07, 2006

Misgivings About BofA

Excerpt from Brick Financial's January 2006 Client Letter:


...The BofA sell was a little different. It too faced the daunting condition of a nearly flat yield curve. It, like most other large banks, is likely to see its net interest margins get worse before they get better. The recent earnings miss is a symptom of this. Although the company’s management expects their acquisition of credit card issuer MBNA to begin adding to earnings as soon as 2007, we’re skeptical.


Not that we think MBNA is a questionable business. Just the opposite. We think it’s a fine business. It is more that we think the management of BofA, especially its CEO Ken Lewis, has an uncomfortably optimistic outlook (euphemism for “misleading”) no matter the conditions of the economic climate. An example of what we mean is when management consistently reports pro forma figures rather than the more conservative GAAP figures. Pro forma figures have many assumptions or hypothetical conditions built in which allows for an alternative view of the financial statements. But that’s just semantics. Usually companies use pro forma figures to hide all the bad stuff.


On a recent conference call Ken Lewis stated that the company was able to grow earnings by 31% over a two year period. The GAAP figures revealed something not quite in line with what Lewis’s statement. Hedge fund manager Thom Brown ( pointed out this discrepancy and recounted an email exchange he had with the company.
“This is what we refer to around here as ‘Charlotte math. By the lights of my Bloomberg, BofA earned $3.57 per share in 2003, $3.86 in 2004, and $4.15 in the year just ended. So over the past two years, earnings have risen by 16%, half the 31% growth that Lewis alleges. In response to my inquiry, a company spokesman emailed to say that the 2003 EPS Lewis was referring to are the pro forma numbers the company filed at the time of the Fleet deal in 2004. Which is to say, Lewis’s statement is nonsense. [emphasis ours] The fact is that investors don’t have a claim on retrospective pro forma numbers, nor do those numbers help build economic value over time. What matters are actual, here-and-now GAAP numbers. Lewis knows that, of course, but he threw out those phony numbers to make his performance look better than it really is. That’s our Ken!”

Evaluating the management of companies is essential to our investment process. We look for capable management. We look for management groups that treat their shareholders (and customers) with high regard. We need to feel like management is speaking with us candidly and honestly. We do not want management painting a rosy picture, were there really is none. We want management to “give it to us straight”. We just don’t get that feeling from the management of BofA...

Read the rest of the January 2006 Client Letter by clicking here.

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January 06, 2006

December 2005 Client Letter

Our long-term performance

Last month marked the moment that our oldest portfolio, the Relative Value, hit three years old. We are just now entering into a time where our performance becomes more meaningful in determining our skill as stock pickers. Of course, even three years is still a short amount of time. One would need five years or more to make a decent assessment of a stock picker’s skill, 10 years would be better. The longer out you go, the less random chance is responsible for investment results. That said the 3-year mark may still be helpful in comparing our performance to date against our stated goals, which are to:

  • Increase your (and our) invested capital, consistent with reasonable risk, and

  • Outperform the market indices over long periods of time.



3-year Total Returns

Annualized 3-year Returns

Annualized Since Inception Returns†

3-year Sharpe Ratio

Relative Value










Portfolio Average





Wilshire 5000





S&P 50049.69%14.39%11.76%1.05

Avg. Domestic Equity Mutual Fund






†Relative Value model portfolio and the Portfolio Average since inception returns are from 12/6/2002. Index and mutual fund since inception returns are from 12/1/2002.

*Choice model portfolio since inception return is from 4/4/2003.


See the rest of Brick Financial Management's December 2005 client letter by clicking here


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May 13, 2005

Our Ports vs. Concentrated Mutual Funds

From Brick Financial's April 2005 Client Letter: 

...Although we just told you that the short term doesn’t matter much, it is interesting to see how other highly concentrated (less than 40 positions) value-oriented portfolios are performing.  These types are portfolios are extremely rare in the mutual fund world (they are little more popular among hedge funds).  The list below represents nearly all the mutual funds that fit that description. All of these funds and their managers have been able to beat the stock market over any period greater than 5 years. But let’s take look at the one year returns of these funds compared to our portfolios:



Capitalization Focus

Number of Holdings

1 year return as of 4/30/2005

Relative Value





iShares Russell Midcap Index



Index ETF


Oakmark Select





Mairs & Power Growth





Ariel Appreciation





Legg Mason Special Interest





iShares S&P 500 Index


Large Cap

Index ETF




Large Cap



Legg Mason Value Trust


Large Cap



Longleaf Partners


Large Cap



Legg Mason Growth Trust


Large Cap





Large Cap








White Oak Growth


Large Cap



source: Foliofn

Take note of a couple of things.  First, the range in returns from port to port is very wide (from our port Relative Value at 14.84% to White Oak Growth’s -12.93%).  The second thing you should take note of is that none of these outstanding managers are beating their respective indexes (represented by the iShares ETF funds).  Does this serve as evidence that each manager has lost his/her investment muster? Doubtful.  It is just the economic climate we find ourselves in.

For more of the April 2005 Client Letter click here.

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January 31, 2005

Year End/December 2004 Client Letter

Fun with percentages: A fun, if only slightly useful, exercise is to calculate how a particular percentage return will grow money. The effects of compounding are magical over long periods of time. One way of completing this exercise is to measure how long it would take to turn a one-time $10,000 investment into a $1,000,000 nestegg. For instance, if we were able to invest our money in the Relative Value portfolio, and continue to receive a 35.8% annualized return indefinitely (highly unlikely mind you), a one-time $10,000 investment would become a million dollars in about 15 years.

Anyone over the age of 30 knows that 15 years goes by impressively fast. Comparatively, an investment in the S&P 500 at the annualized rate of return the index has provided the last two years, 19.45%, would turn that $10,000 into one million in 26 years. An investment in real estate (NCREIF Apartment Index), which had a two year annualized return of 11.04%, would accomplish that money increasing feat in a measly 44 years. And an investment in bonds (4.22% annualized over the last two years), as measured by the Lehman Brothers Aggregate Bond index, would do it in short 111 years.

Looked at another way, we can see how slight differences in return will result in extreme differences in the amount of money that is accumulated at the end of an investment period. For example, that 35.8% annualized return we received by investing in the Relative Value portfolio, would turn our $10,000 investment into $213,000 in 10 years, $4.5 million in 20 years and $44 billion in 50 years. An 11% annualized return, like the one you’d have gotten in real estate investing over the last two years, would turn $10,000 into $28,000 in 10 years, $81,000 in 20 years and $1.8 million in 50 years. Now, $1.8 million is a lot of dough, but I’ll take the $44 billion please…to go.

Click here for more of this client letter.

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About Brick Financial Management, LLC

Blogged by Brick Financial

51 JFK Pkwy, 1st Fl. West
Short Hills, NJ 07078
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Brick Financial Management, LLC is a Registered Investment Advisor specializing in providing investment management services to individuals, families, organizations and institutions. We implement highly focused stock, bond, and balanced portfolios using an investment approach commonly referred to as value investing. Disclosure


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