After my last book review, a reader asked how I was able to read so many books, given my other responsibilities.  My answer is this: I keep a book near me at all times.  When I get a break, I read a few pages.  Over a week, that means a book gets read.  That’s how I read so many books.

Onto tonight’s book: I had a number of friends that liked Nerds on Wall Street, and I liked it as well.  The book has a number of strengths.  The author explains complex financial instruments in relatively simple terms.  The same for complex trading techniques.

The author gives history and background as one that was sucked into computerized finance from a technical background that might have had him in a purer technological role.  As I read what he went through, I said to myself, “He was seven years ahead of me.”  I had my own share of innovative things that I did, but the things done in his era were bigger.

He gives reasonable explanations of how computerized trading works, and what factors they look for in designing trading systems.  He talks about the common factors that dominate trading systems, and a few that he knows of but has not published.  (He gives a taste, but does not serve up the full dish.)

Like me, he serves up a full plate of data mining disasters.  There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.  The few significant regularities make sense to seasoned observers, and are not consistent.  They pay off 70% of the time, and kill you 15% of the time.

On Wall Street, if you are really, really smart, they will hand over to you exceptionally advanced tools that you can use to destroy yourself in a unique and memorable way.  So it was for LTCM.


The book is badly edited.  Many elements appear multiple times with little modification.  It sometimes reads like a bunch of articles that was strung together into a book.  The editors should have tried to create something more cohesive.

The last several chapters feel like an afterthought, though many of the ideas presented there are ideas that I have suggested.  I have talked about splitting mortgages into smaller mortgages plus equity appreciation rights.  I have also suggested creating mutual banks, rather than what was done with the TARP.

All that said, the average reader will learn a lot here.  I recommend the book to those that want to dig into how the equity markets became more computerized.  For those that want to understand the same for the debt markets, that book remains to be written.

If you want to buy it, you can find it here: Nerds on Wall Street: Math, Machines and Wired Markets

Full disclosure: If you enter Amazon through my site and buy anything, I get a small commission.  Your price does not go up.  You benefit, I benefit, Amazon benefits.  How could it be better?

This is not a political blog.  That said, almost all writing on economics and business embeds a political point of view.  I recognize that my view is relatively libertarian with respect to economics/business, but conservative with respect to ethical issues.  There are a few things that I think would get wide agreement from many parties, aside from those entrenched in DC.  That is what tonight’s post is about.  I think that I will not post like this often.

1)  End gerrymandering — all congressional and state districts should follow the following rule: The ratio of the square of the circumference to the area of a district should not exceed 30. This would make representatives less partisan than is common today, because they would have to be elected by groups closer to a random sample of the people in a given area.  Exceptions would be granted for non-negotiable boundaries, like state and national boundaries.

2)  Make them read the bills publicly.  We have a health bill that is 1990 pages long.  Make them read it, and make the legislators listen.  Whip those that fall asleep.  Further, let the bills fully express the changes made in a plain english manner.  Amendments to existing laws must be written out in entire, rather than referencing a code, and saying that it has been deleted, amended, etc.

3)  Limit the length of bills.  The Law of God through Moses was far more comprehensive, and is far shorter than even most narrowly focused bills.

4)  Flesch-test all bills.  Make them simple enough to be understood by ninth-graders.  Hey, they force this on insurance companies!  Do you suppose that laws which should have universal application should be different?

5)  Publish an abstract of all major laws that affect citizens once every five years.  Give a copy to every adult citizen.  Let this be done in every state as well.

6)  Re-emphasize the ninth and tenth amendments to the Constitution.  Those amendments are supposed to maximize liberty for states and individuals.

7) Amend the Constitution to make Federal and State laws superior to treaties.  I know what mischief this would do, but I would rather be ruled by my local peers than by foreigners who have no understanding of what our American system is like.

Would that we would do this.  Our government is less and less understandable to the average citizen.  If we want our government to exist for a long time, we need to put into place reforms that will cause the government to be more responsive to its citizens.

Bond indexes are what they are.  They represent the average dollar invested in the bond markets.  Those that say that the indexes are flawed miss the point.  Indexes represent the average return of an asset class, with all of its warts and wrinkles.  That is the nature of an index; it earns what the asset class as a whole earns.

So what if big issuers dominate the index?  The average dollar in bonds reflects that.  Do you want to take a bet against the average?  You probably do, and I do as well.  But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

I appreciated the book The Fundamental Index – Arnott did us a favor by writing it.  The book shows how to do enhanced indexing off of fundamental factors.  (A pity that the book went public at the point where most of those factors were overpriced.)

The trouble with enhanced indexing is scalability.  Suppose Arnott’s fund and those like it grew large relative to the market as a whole.  The components of his strategy that are smallest relative to their total market size will get bid up disproportionately.  Eventually they will not be a favored investment of the strategy, and as they move to sell, they will find that they are large holders of something the market is not so ready to buy.  As the price goes down, perhaps it becomes attractive again. Perhaps an equilibrium will be reached.

One thing is certain, though.  The non-enhanced index can be held be everyone.  The enhanced index will run into size limits.

What then for bond ETFs?  Are they chained to inferior indexes?  No.  By their nature, bond indexes are almost impossible to replicate perfectly because of liquidity constraints. Many institutional bond investors buy and hold, particularly for unique issues.  That’s why indexes are constructed out of liquid issues which will have adequate tradability.  Who issues those bonds?  The big issuers.  It is not possible to create a scalable bond index in any other way, and even then, there will always be some bonds in the index that are impossible to find, and/or, because they are index bonds, they trade artificially rich to similar bonds that are not in the index.

Almost all bond indexers are enhanced indexers, because they don’t have enough liquidity to exactly replicate the index.  Instead, bond indexers try to replicate the factors that drive the index, with better performance if they can manage it.  That’s where choosing non-index bonds that are similar in characteristics, but have better yields comes in.  That is the value of active bond management; it does not mean that the indexes are flawed, but that there are ways for clever investors to systematically do better, that is, until there are too many clever investors.

Pricing Issues

Morningstar prepared this piece on pricing difficulties with bond ETFs and open-ended bond funds.  Yes, it is true that many bonds don’t trade regularly, and that matrix pricing gives estimates for prices on bonds that have not traded near the close, where an asset value must be calculated.

Remember the scandal over mutual fund front-running?  In that case, stale pricing off of last trades enabled clever connected “investors” to place late trades where the calculated NAV was far away from the theoretically correct NAV (if assets traded continuously).  In order to calculate the theoretically correct NAV (which the late traders did in order to make money), the mutual funds had to engage in a form of matrix pricing, adjusting the last trades to reflect changes in the market since each last trade until the close.  Far from being inaccurate, matrix pricing is far superior to using the last trade.

I will take the opposite side of the trade from the Morningstar piece.  Markets are not rational, especially bond ETF investors.  I trust the NAV more than the current price; matrix pricing is complex, but it is pretty accurate.  Yes, for some really illiquid, unique issues, it will get prices wrong, but that is a tiny fraction of the bond universe.  We can ignore that.

Rationality comes to bond ETFs when sophisticated investors do the arbitrage, and create new ETF units when there is a premium to the NAV, or melt ETF units into their constituent parts when there is a discount to NAV.  That pressure places bounds on how large premiums and discounts can become.

The more specific the bonds must be to create a new unit, the harder it is to do the arbitrage, and the higher the level of premium can become before an arbitrage can occur.  If a less specific group of bonds can be delivered to create a new unit, i.e., the bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option-adjusted spread/yield, etc., then arbitrage can proceed more rapidly, and premiums over NAV should be smaller.

So, when there are large premiums to NAV, it is better to sell.  Large discounts, better to buy.  Of course, take into account that short bond funds should never get large premiums or discounts.  If they do, something weird is going on.  Long bond funds can get larger premiums and discounts because their prices vary more.  It takes a wider price gap versus NAV before arbitrage can occur.

As for cash creations, those that run the ETF could publish a shadow ETF price, which would represent the price that they could create new units themselves, taking into account how they would like to change the ETF’s positions in order to better outperform while matching the underlying characteristics of the index.  That shadow ETF price could not be a fixed percentage of the existing NAV.  It would have to vary based on the cost of sourcing the needed bonds.  This would run in reverse for cash-based redemptions, which would only likely be asked for when the ETF was at a discount.  Better for the fund to do some modified “in-kind” distribution, agreed to in advance by the sophisticated unit liquidator.

Derivative Issues

Well, if there’s not enough liquidity in the bond market to accommodate our desired investment, why not create it synthetically through credit default swaps?  That might work, but if the bonds are illiquid, often the derivatives are as well, or, the derivatives trade rich to where an identical bond would trade in the cash market.  There is also credit risk from the party buying protection on the default swap; if he goes broke, your extra yield goes away, at least in part.

I don’t see derivatives as being a solution here, though they might be helpful in the short-run while waiting to source a bond that can’t be found.  Derivatives aren’t magic; liquidity comes at a cost, and some of those costs aren’t obvious until a market event hits.

Also, I would argue that the rating agencies are better judges of creditworthiness on average than the prices of credit default swaps.  Though rating agencies should be examined for their conduct in structured securities, their record with corporates is pretty good.  The rating agencies do fundamental research; yields do reflect riskiness, but markets sometimes wander away from their fundamental moorings.  Derivatives can trade rich or cheap to the cash market for their own unique reasons.  Same for bond spreads – just because one bond has a higher spread than another similar bond, it does not mean that that bond is necessarily more risky.

When I was a corporate bond manager, I would occasionally find bonds that yielded considerably more than others of a given class.  My job, and the job of my analyst was to find out why.  Often the bond was not well known, or was a better quality name in a bad industry.  On average, spreads reflect riskiness, but in individual situations, I would rather trust the judgments of fundamental analysts, including the rating agencies, though private analysts are better still.

So what should I do in the Current Environment?

I don’t think we are being paid to take credit risk at present, so stay conservative in bonds for now.  Specifically:

  • Underweight credit risk.
  • With equities, stress high-quality balance sheets, and stable industries.
  • Underweight financials, particularly banks and names that are related to commercial real estate.
  • GSE-related residential mortgages look okay.
  • TIPS don’t look good on the short end, but look okay on the long end.
  • Be wary of paying premiums on bond ETFs… and maybe look at some closed-end funds that trade at discounts.
  • The yield curve is steep, but that is ahead of a lot of long supply coming from the US Treasury.  Stick to short-to-intermediate debt, and wait for supply to be digested.  After that, maybe some long maturity positions can be taken as rentals, so long as inflation does not take off.
  • Diversify into foreign bonds, but don’t go crazy here.  The Dollar has run down hard, and opportunities are fewer.  (I will have a deeper piece on this in time, I hope.)

This is a time to preserve capital, not reach for gains.  Don’t grasp for yields that cannot be maintained.

PS — Thanks to the guys at Index Universe and Morningstar for the articles; they stimulated my thinking.  I like both sites a lot, and recommend them to my readers.  The articles that I cited had many good things in them, I just wanted to take issue with some of their points.

1) Perhaps the US Treasury is getting a few things right.  Let’s start with lengthening the average maturity of Treasury debt.  I have backed this idea in the past.  It is worthy to note that zero coupon yields peak out around 20 years out, and then start declining.  It is quite possible that debt longer than 30 years might price at a discount to 30-year debt, if for no other reason than there is a demand for longer debt as an asset to fund longer liabilities with seeming certainty.

The US Treasury is finally getting some sense in this matter, and is looking to lengthen their maturity profile.  Good for them; let’s see if foreign investors are willing to take down longer-dated dollar-denominated debt.

2) I have also encouraged the concept of liquidating institutions that are “Too Big to Fail;”  I believe they deserve a special chapter in the bankruptcy code.  Well what do you know?  Congress is proposing much the same idea. (Ugh, Barney Frank agrees with me?  But, so does Sheila Bair.  Better company.)  Here are some of the details.  Far better to liquidate such institutions rather than bailing out the holding companies (what idiocy!).  That said, why would we give more money to GMAC?  It is not critical in a systemic sense.  Let it go under.

3) Most stimulus programs waste money.  Better to rebate taxes to everyone equally.  It is fairer than choosing favorite firms or markets.  With that I would argue that it is time for the first time buyer credit to end in residential real estate.  Most of those that bought would have bought anyway, and the credit benefited sellers more than buyers as it pushed prices up for now.

4) The efficient markets hypothesis did not mean that market prices are always right, as if we hit that evanescent neoclassical equilibrium.  No, prices are always wrong to some degree, but that does not mean it is easy to recognize the mistakes.  So I limitedly back Jeremy Siegel, who says that the efficient markets hypothesis was not to blame for this crisis.  That said, common misunderstandings of the EMH did affect the crisis, because markets do self-correct, but over years and decades, not months or days.

5) If you had the ability to ask one question to Tim Geithner, Secretary of the Treasury, what would it be?  I have my list, but maybe I am off base.  As I close for the morning, here are my questions:

  • Haven’t low interest rates boosted speculation and not the real economy?
  • We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?  What is your long-term plan for the solvency of the United States?
  • We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.  How can we have a strong dollar?
  • None of your policies has moved to reduce the culture of leverage.  How will you reduce total leverage in the US?
  • Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company well?  People now believe that in a crisis, the government takes from the prudent to reward the foolish.  Why should the prudent back such a government?
  • If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
  • We are discussing giving tools to regulators for the tighter management of the solvency of financials.  There were tools for managing solvency in the past that went unused.  Why should we believe the new “stronger” tools will be used when the older tools weren’t used to their full capacity?  (The banks push back hard.)

I doubt that I will get a chance to have those questions answered, but who knows?  From Quantcast, I know that some at the US Treasury and the Federal Reserve (I have my own set of questions there) read my blog regularly, so I leave it up to them ponder my questions, whether I ever get answers or not.

Most of us were kids once.  I think I was a kid once, but my memory is fuzzy.  I do remember playing the card game “War.” Nice game, but suppose if you were dealt a weak deck you had the option to look at the opponent’s deck, and stack yours to meet the challenge.  That would be a sharp example of how game theory could be used to defeat a stronger player.

This book is a little further afield than I usually go, because this is not an economics or finance book in the traditional sense.  The Predictioneer’s Game describes using game theory to solve complex problems, and possibly, affect the results in your favor, or, the favor of your client.

The author, Bruce Bueno de Mesquita is a professor of political science at NYU, and a senior fellow at the Hoover Institution.  Though he uses game theory in his academic work, on the side, he uses game theory in his own firm to analyze tough policy, business, and legal questions.

His methods are simple and complex.  Simple, because the math at first glance isn’t that difficult, but complex, because many different iterations of the simple model must be considered using a computer.  Often the answer that the computer spits out is a surprise that reveals that there is a clever strategy to achieve an unusual result.

There are many elements that go into building such a model.  It begins with designing the question in a way that facilitates sharp opinions from experts.  The experts name all of the parties that have an interest in the outcome, and:

  • What their desired outcome is.
  • How motivated they are to achieve their desired outcome.
  • How influential can they be with other parties in the dispute.
  • How much they want an agreement, even if it is not their favored outcome.

The experts rate all of the parties on those variables on a scale of 0 to 100.  Then the math starts, analyzing what sorts of coalitions can develop to come to an outcome that satisfies those with the most influence and motivation.

Now, I don’t buy in entire his view that everyone is strictly motivated by self-interest.  I have adopted five children, in addition to having three with my wife.  Yes, we wanted a large family, but we would have been happy with fewer.  We saw this as something good for society on the whole, as well as the church, which made us more willing to adopt.  If we are going to argue that a person having love for their culture or for their church is an expression of self-interest, then please tell me what would be self-disinterest.  To use an example from the book, I have mixed feelings about “Mother Teresa,” but I have little doubt that she did what she did out of devotion to the Catholic Church, and not out of self-interest.

That said, until proven otherwise, assuming any party is entirely self-interested is probably correct to a first approximation, which is why game theory is so applicable to complex problems.

Bruno de Mesquita has quite a track record according to the CIA:

Since the early 1980s, C.I.A. officials have hired him to perform more than a thousand predictions; a study by the C.I.A., now declassified, found that Bueno de Mesquita’s predictions “hit the bull’s-eye” twice as often as its own analysts did.

As a result, I tend to believe his claims as he goes through the book.  He has helped solve some tough political and business problems. Most of the examples in the book fall into legal or political categories, though there are a number of examples for the business world: CEO succession (funny), merger negotiations, and how to buy a new car.

The last will pay for the book on its own.  I have used the technique twice before, and it works.  That said, that I have used it twice before means it is not unique to the author.  (For those buying used cars, I have another approach.)

Now, the author offers the opinions of his models on:

  • What will happen in the global warming negotiations?
  • Will Iran develop a nuclear bomb?
  • Will Iraq and Iran develop an alliance?  (Note: there is no explicit mention of the Saudis in this discussion, which I think is a major miss.)
  • Will Pakistan continue to cooperate with the US in the “war on terror?”

Good questions all, but I would ask the following questions:

  • How will the various nations of the world fare through the coming demographic crises?
  • Will the US Government pay off its debts in real terms, or will they inflate the debts away?
  • Will the US Dollar remain the global reserve currency?  If not, then for how long?
  • When will the Communist Party lose control in China?

Perhaps the author could favor us with some answers, but regardless, I recommend the book to all that have interest in predicting the outcomes of complex situations.

Who will benefit from the book?  This is a book that many will benefit from, because the subject area is broad, and the ability to turn the windmills of the mind are considerable.  For those who want to buy it, they can buy it here: The Predictioneer’s Game: Using the Logic of Brazen Self-Interest to See and Shape the Future

Full disclosure: my goal is to have alignment of interests between me and my readers.  I don’t want any of my readers buying something only to benefit me.  But if you want to buy something at Amazon, please enter it through my site — you buy at the prices that you like, and I get a commission.  I like the fact that my readers get what they want at no additional cost as they aid me.  I look for win-win situations, and this is one of them.

This was a book that I did not ask for.  Wiley has been sending some books unsolicited.  I’m not glad on all of them, but I am glad they sent this one.

Much as I admire Jack Bogle, I am not a Boglehead.  Low fees?  Yeah.  Diversification without overdiversification?  Sure.  Asset allocation?  Top priority.  Passive investing?  Best for most of us, but not me.  Quantitative methods don’t work?  Sorry, they do, if done right.  And aside from all that, I think (unlike Jack) that unhedged foreign bonds are a core part of asset allocation, especially if used tactically.  (Buy them when little looks good in domestic fixed income, like now.)

But in skimming/reading this book, I came away impressed with the acumen of those that call themselves “Bogleheads.”  They are not just dittoheads, but people who have thought hard about the retirement planning process for average individuals.

There is a decent amount of advice on tax planning.  What sorts of vehicles will make sense for most people?  How much can be contributed?

There is a decent amount of data on the usefulness of insurance, and it tends to follow my understanding of matters:

  • Avoid combination products unless you have a specialized tax planning need.  Keep savings separate from protection.
  • Don’t forget disability and health insurance.
  • Immediate annuities can be a useful replacement for some of the bonds in a retiree’s portfolio.

A small amount of the book deals with investing proper, but what is there is good, if simple.  It posits fund investing and passive investing, which again, is best for most people.

Another part of the book deals with the neglected liquidation phase.  How to do it?  What to tap first?  When should one file for Social Security, and what games can be played there?

Finally, the book considers what can go wrong in life (divorce and other disasters), and how to bounce back; also, how to find a good professional to help you with your specific needs, which “one size fits all” does not cover.


The book really does not deal with the troubles that will come in Social Security, Medicare and federal/state/corporate pension plans.  Also, by its nature, tax law is ephemeral in the US — in an era of rising structural deficits due to entitlement programs, who can tell what the tax situation will be 20 years out?  23 years ago, after the passage of the Tax Reform Act of ’86, who would have thought that we would create something materially worse in complexity terms than what TRA ’86 replaced?  Rates are lower, though, but I don’t see it staying that way for long.  We can look at Roths, but will the government preserve the tax-free treatment if things really get tight?

Also remember that this is a single purpose book — retirement, though they have some good sections on insurance and investing.  For a good, short, all purpose book on personal finance, consider Easy Money: How to Simplify Your Finances and Get What You Want out of Life.


That said, I found it to be a useful guide for average people that might not be up on the nuances of strategy for retirement that an average person might use.  Wealthy people should retain specialized advisors, because they will be aware of strategies that would not make sense for average people.

This was a book that I skimmed half and read half, because I’m familiar with the material and would just check aspects of sections that I was familiar with to see if they got it right.  If you want to buy it, you can find it here: The Bogleheads’ Guide to Retirement Planning.

Full disclosure: If you enter Amazon through my site and buy anything, I get a small commission.  Your costs remain the same.

After the last article on this topic, you would think that they would take me off of the mailing list.  But no.  Wait!  How did GTX Corp do after I wrote my article?

In short, when I wrote, the price went down temporarily, and then rebounded as the flyer advertising GTX circulated among the uneducated masses.  Since that time, the price is down ~90%.

If the advertising group pushing GTX Corp had any self-awareness, you would think they would take me off of their mailing list.  Sad to say, I have a new microcap stock to share with you:  Bonanza Goldfields Corp. [BONZ]

In an era where many fear inflation, an appeal to gold has credibility, and could draw those who think they missed out on the move upward.  The flyer has many evocative images — gold coins, gold bars, etc.  The aura of wealth is palpable.  They appeal to the troubles at present, and suggest that gold is the solution, and that the price of gold will rise as a result.

Because I don’t want to be sued, I am not identifying the researchers — I call them ABC and XYZ.

They give the sense that there are very promising finds of gold to be made from Bonanza Goldfields.  These claims are made in big type, while in small type, the following is written (yes, no paragraphing):

IMPORTANT DISCLAIMER: This paid advertising issue of ABC Research (hereafter “ABC Research”) does not purport to provide an analysis of any company’s financial position and is not in any way to be construed as an offer or solicitation to buy or sell any security. ABC Research is a paid advertiser. OTCBB: BONZ is the featured company. XYZ Inc managed the publishing and distribution of this publication. XYZ Inc is a financial communications media company that disseminates information via paid advertisements. Although the information contained in this advertisement is believed to be reliable, XYZ Inc and its editors make no warranties as to the accuracy of the description of any of the content herein. The information contained herein is being republished from publicly disseminated information issued by third parties regarding BONZ and are presumed to be reliable, but neither XYZ Inc Inc or their editors accept any responsibility for the accuracy of such information. Neither XYZ Inc, nor any of their principals, officers, directors, partners, agents, or affiliates are not, nor do we represent ourselves to be, registered investment advisors, brokers, or dealers in securities. Readers should independently verify all statements made in this advertisement. XYZ Inc, as well as various affiliated companies and vendors have received and managed a total production budget of $1,300,000 for this advertising effort and will retain, over and above the cost of production and publication, any amounts that remain as additional compensation for production services relating to the advertising and publishing efforts. This advertisement was not paid for by BONZ or its management. Please make special note that XYZ Inc, their respective principals, officers, directors, shareholders, stakeholders, creditors, partners, agents, or affiliates own shares of BONZ and intend to sell all of their shares in any company profiled at any time, be that before the date of a profile, during the date of a profile, or at any time after the date of a profile, as has been the practice of XYZ Inc, and their related parties on many previous occasions. Past performance does not guarantee future results. The information contained herein contains forward looking information within the meaning of Section 27 A of the Securities Act of 1933 and Section 21 E of the Securities Exchange Act of 1934, including statements regarding expected continual growth of the featured company. The information contained herein includes forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Reference is made in particular to the description of BONZ’s plans and objectives for future operations, assumptions underlying such plans and objectives and other forward-looking statements included in the information provided. Such statements, which contain terms such as “expect”, “believe”, “anticipate”, “suggest”, “plan”, “indicate” and similar terms of uncertainty, are based on management’s current expectations and beliefs and are subject to a number of factors and uncertainties which could cause actual results to differ materially from those described in the forward-looking statements. All statements relating to operational results are hereby qualified in their entirety by the company’s filings, including its financial statement filings, under the Securities Exchange Act of 1934. Do not base investment decisions on this advertisement. We assume no responsibility for any use or misuse of this material. Consult your investment advisor and do your own due diligence before making any investment in this or any other securities. This report is for INFORMATIONAL PURPOSES ONLY· THIS IS NOT INVESTMENT ADVISE!!!

The grammatical and other errors in the statement are theirs.  But what do we learn from it?

  • This isn’t a security analysis, much as it would appear to be otherwise.
  • ABC Research paid $1.3 million to distribute this advertising.  BONZ did not pay.
  • XYZ owns shares of BONZ, and may sell them at any time.  They have done so with prior companies advertised in the past.

What we don’t learn is what relationship ABC has to XYZ.  I can find ABC on the web, but I can’t find XYZ.  My guess is that ABC and XYZ are affiliates, but I can’t prove that.  Otherwise, why would ABC pay so that XYZ could benefit from the $1.3 million payment, as well as sell into a rising market for their shares?

The “important disclaimer” was printed in teensy 5 1/2 point type in long lines, making it difficult to read.  They weren’t interested in giving clarity.  Where did they offer clarity?  In the big type, often with special coloration or highlighting:

  • OTCBB: BONZ  This GOLD stock is SET to SKYROCKET!!! BONZ could bring up to 600% to your portfolio in the next two weeks.  PULL UP STOCK QUOTE NOW
  • ABC’s latest stock profile featured OTCBB: BONU  The stock skyrocketed from $0.25 to $3.5 for two weeks in August 2009.  OTCBB: BONZ will be an even bigger winner.
  • GOLD IS AT ALL TIME HIGH We believe that gold will hit $2000 per ounce soon and we believe that OTCBB: BONZ will follow the Gold Trend an could hit $2 PER SHARE!!
  • BONZ means $$$$ for your portfolio and HUGE profits!!!

There’s more, but that’s most of what they wrote in big type to attract the attention of people.  In medium sized-type, the analyst/advertiser spins a tale of how this company has promising land, mainly located in Arizona, where they have done some assays and found some gold, silver, lead, zinc, and copper.  They claim to have an experienced team of people to exploit the resource.


Before I deal with BONZ, what of the stock BONU that they predicted such gains on — gains that BONZ will exceed?  They included a graph that looked like this for readers:

The company’s name is BioNeutral Group, Inc. Their corporate decription reads as follows:  BioNeutral Group, Inc.manufactures specialty chemicals.  The Company produces chemicals that can neutralize environmental contaminants, toxins, bacteria, viruses, and spores.

But why show such a small graph?  How has BioNeutral Group, Inc. done over the last 12 months?

My, but that was selective.  If I may, it looks like ABC’s report led to a temporary bump in BONU, much as it did for GTXO.  My guess is that better informed people who know the promotion is going on profit at the expense of the rubes who believe their report.  I have not researched BioNeutral, but my guess would be that the stock price would continue to decline, like that of GTXO.

So what of Bonanza Goldfields?

I went and grabbed the 10-K, and the S-1 from their IPO in 2008.  That’s one of the first things anyone should do in a case like this.  What do we learn?

  • Their auditor is not a major auditor, but they still could not issue a “going concern” opinion for the last two years.
  • The firm has negative net worth and negative net working capital.
  • The firm has one asset valued at $99,000, their mining claim, and petty cash.
  • They have no revenues, and have lost money for the past two years.
  • They do not have the resources to explore/exploit their mining claim.
  • From the S-1:  We currently have no employees except the board of directors and officers. We have no employees other than our officer and director as of the date of this prospectus. Our board members currently devotes approximately 5 hours per week to company matters and after receiving funding, they plan to devote as much time as the Board of Directors determines is necessary to manage the affairs of the company. There are no formal employment agreements between the company and our current employees. We conduct our business largely through consultants.
  • From the 10-K: As of fiscal year end June 18, 2009 the Company had 1 employee.
  • From the S-1: During the period ended June 18, 2008, the Company granted to members of the Board of Directors, 6,997,900 shares of common stock valued in the aggregate at $69,979, for service rendered to the Company outside of their responsibilities as members of the Board of Directors and were valued concurrent with maximum price the common stock was sold in a private placement.

    During the period ended June 18, 2008, the Company issued 3,302,100 shares of its common stock for $85,000. The shares were issued to third parties in a private placement of the Company’s common stock.  The shares were sold throughout the period ended June 18, 2008, at a range between $.01 – .02 per share. (DM: giving them a small gain.)

  • The risk factors are voluminous, consistent with a company that doesn’t have much going on.
  • None of the Board of Directors have any experience in mining listed; the advertisement suggests extensive management experience (over 120 years), though it is silent about mining management experience.
  • Officers own 66% of the firm, as of the date of the 10-K.
  • There are three entities that have provided the financing: Gold Exploration LLC, who sold them the parcel, and gets some royalties.  Taylor Invest & Finance and Venture Capital International have provided financing, and were sellers of shares at the IPO (look at page 11 — also note that there are multiple entities selling stock controlled by the same people.  Odd.)
  • Bonanza Goldfields raised no proceeds in the IPO.
  • I’m not sure I am reading it right, but it looks like Taylor Invest & Finance and Venture Capital International would end up with a large amount of the company if they converted their financing to shares.  The wording is vague.
  • I also can’t explain why “In June 2008 a total of 3,302,100 common shares were sold to public non-U.S. investors, for an average price of $0.026 per share.”  These same shareholders sold it all for the same price in April of 2009.  The only possible benefit I can see is that it somehow cements relationships with Taylor Invest & Finance and Venture Capital International.
  • They entered into more financing arrangements with Taylor Invest & Finance, and Advantage Systems Enterprises Limited (another seller at the IPO).
  • They split the stock 7 for 1.
  • From the 10-K: At June 18, 2009, there were 72,100,000 shares of common stock of Bonanza outstanding and there were approximately 21 shareholders of record of the Company’s common stock. That is a small number for just having done an offering, particularly when the S-1 said there were just 19 shareholders then.

This filing may connect Mr. Vippach of Venture Capital International and a Mr. Soullier, who might be related to the 40% owner Rose Marie Soullier.  That’s just a curiosity, though; I have no idea if it means something.

The stock did not start trading until May 5th, 2009, long after the IPO in September 2008. It traded around 65 cents a share, a considerable amount above the IPO price.  The current price of 30-33 cents gives the firm a market cap of around $18 million.  Off of the recent financings, they are looking to explore their mining interests.  They have also bought two more interests.  They have enlisted Gold Exploration LLC to help them analyze the property.  (Why should Gold Exploration LLC sell property to them, and then help them analyze it?  Weird.)  Also odd is the cancellation of shares of the #2 shareholder, seemingly for no compensation.  Gold Exploration, LLC, or at least Steve Karolyi, a co-founder, has had dealings with three other microcap miners, Mariposa Resources, Firstar Exploration Corporation, and Zone Mining (now delisted).  I don’t have enough data to say whether it seems fishy or not.


There’s a lot of weird stuff here, and a lot of stuff that I don’t know:

  • How does a company with practically no assets, no revenues, and a negative net worth support a $18 million market cap?
  • How are ABC and XYZ related?  What does ABC Research get out of this?
  • Do they have any relationship with BONZ, or those with economic interests in BONZ?
  • How much of BONZ does XYZ own?
  • How are the various financiers related?
  • Is Gold Exploration LLC just a service provider?
  • The advertisement offers no justification for its target prices.
  • The advertisement uses gold as a hook, because it is hot now.

Note: here is a penny stock feed complete with twitter: they think it is going up.  I would, too, looking at the charts, and looking at the advertisement.  But I can’t speculate on stuff like this; it’s unethical.  Stay away — do not go long or short.

As I closed the prior piece — Buyer beware, and don’t listen to strangers giving you advice.  Cultivate networks of knowledgeable friends who are trustworthy, and avoid getting taken for a ride by slick-talking (writing) hucksters who pitch clever ideas to you.  Do your work, and buy cheap, boring ideas like I do.


One note in passing: shouldn’t the SEC have some interest in this sort of advertising?  I mean, at least have a rule that says that legal disclaimers must be in type larger than the largest font size otherwise in the document, and with no other alterations to affect readability.  Then perhaps it would be harder to fool people through advertising that pretends to be research.

Full disclosure:  No positions in any securities mentioned.  This is my opinion only, and not that of my employer.  I’m only interested in honesty in the markets.


When I write a piece, and entitle it “Toward…” it means that I don’t have all of the answers.  Typically I think I am getting somewhere, but the speed of progress is open to question.  That said, good questions and constructive criticism aid me on my way.

From Private Equity Beat at the WSJ: Toward a new theory of the cost of equity capital, on the Aleph Blog. We confess to not being entirely up on the benefits of Modern Portfolio Theory versus Modigliani-Miller irrelevance theorems, which is probably why we are journalists and not PE execs. But we nonetheless find this analysis of how to price equity interesting.

From Eddy Elfenbein at Crossing Wall Street: I like the logic, but my question is—what if a firm has little or no debt?

Good question.  The total volatility of a firm can be broken up into three pieces: financial leverage, operating leverage, and sales volatility.  Saturday’s piece dealt with financial leverage and its costs.  An unlevered firm in the financial sense still possesses operating leverage and volatility of sales.  Different unlevered firms have different costs of equity capital because they have different levels of sales volatility, and different degrees of operating leverage.

That will manifest itself in option implied volatility, which is a crude measure of what people would pay to gain and lose exposure to the equity of the company.  The cost of equity should be positively related to that.  More volatile companies should have a higher cost of equity.

Another way to look at it is to ask what is the effect on the firm if the company issues or buys back equity.  How much does the generation of free cash flow change relative to the price paid or received for equity?

Another question:

Doug Says:

October 19th, 20098:25 am

“As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.”

How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising “coupons” and get back value much greater than “par” at the end of his/her investment.

I realize that models such as gordon growth take this into account, but you don’t address it in your “debt plus a premium” calculation.

Doug, good point.  The FCF yield, unlike a dividend yield, as used by the Gordon and other DCF models, reflects the ability of the company to reinvest the FCF that is not paid out as dividends.  It reflects growth already in a crude way.  If the ability to grow via reinvestment is below the FCF yield, then the company may as well just sit around and buy back stock.  If the ability to grow earnings is higher (unusual), then the FCF yield will understate prospects.

That’s a crude way of phrasing it, but the FCF yield is a good place to start.

Finally, regarding my thoughts on M-M:  Take Falkenstein’s recent book — high yield tends to underperform with both debt and equity. Or consider that less levered companies tend to return better over the long haul (Megginson, Corporate Finance Theory, page 307.)

M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms.


The idea here is to try to view the cost of equity capital as a businessman would, rather than an academic who has little exposure to the world as it operates.  Look to the degree of certainty in obtaining cashflows; the yields on various assets should rise as certainty declines.

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

  • Beta is not a stable parameter; also, it does not measure risk well.
  • Company-specific risk is significant, and varies a great deal.  The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?  They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.  If less scientific, it was probably more accurate than MPT.  Science is often ill-applied to what may be an art.  Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems.  They are true in fair weather, but not in foul weather.  The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.  The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.  The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.  If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.  If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.  I will use a securitization of commercial mortgages [CMBS], to serve as my example here.  There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is – the party that gets the leftovers after all of the more senior capital interests get paid.  In many securitizations, that equity tranche is small, because the underlying assets are high quality.  The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.  That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton’s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.  But for average investors, what does that mean?  How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.  The driving rule should be that riskier instruments deserve higher yields.  Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.  As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.  Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody’s – the part that bought KMV).  If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.  This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.  The answer varies with the assets financed, and the degree of leverage already employed.  Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

I’ve wanted to write this for a while.  Though this is an outline of how to replace MPT in estimating the cost of capital, it has broader ramifications, and could become a much larger business, much like the rating agencies started with a simple business, and branched out from there.

Maybe someone is doing this already.  If you are aware of that, let me know in the comments.


PS — Sorry that I have been gone for the last few days.  Church business took me away. I’m back now, and will be posting on Monday.

Why don’t average investors use discounted cash flow analyses?  Typically, they don’t use them for several reasons.

  • Most people don’t want to use an algebraic formula to estimate anything.  As some legendary trader reputedly yelled at a quant, “No formulas!  You can make me add, subtract, multiply, and divide!…  And don’t make me to divide too often!”
  • It is not intuitive to most.  It takes a bond-like or actuarial approach to analyzing stocks — forecasting future free cash flows and discounting them at the firm’s cost of capital.
  • It is highly sensitive to assumptions one employs.  Small changes in growth rates or discount rates can make a big difference in the estimate of value.  It lends itself easily to garbage in, garbage out.  (I remember a Dilbert cartoon where an analyst told Dogbert that scientific decision analysis required forecasting future free cash flows and discounting them.  He added that the discount rate had to be right or the analysis would be garbage.  Dogbert’s comment was to the point: “Go away.”)
  • It takes a lot of work, and shortcuts are easier, providing most of the analysis with less effort.

Now, most professional investors don’t use DCF either, for many of the above reasons.  But there are a number that do, among them Buffett.  Morningstar uses DCF for its stock recommendations.  It’s not a bad system after one makes the effort as an organization to standardize your free cash flow estimates and discount rates.  Most professionals invert the process, and rather than trying estimate what a stock is worth, they estimate what they think the company will return at the current market price.

Expectations Investing is one way to formalize DCF, and a rather comprehensive one.  It would be a good way for an investment organization to formalize its investment process, but is way too complex for one person implement, unless one is following some type of simplifying system like Morningstar, ValuEngine or any of the other purveyors of DCF analyses out there.

In the process of formalizing DCF, the book explains the problems with traditional P/E analysis, and how a focus on free cash flow can remedy the problems.  A weak spot in the book is their discussion of cost of capital.  Their cost of equity capital analysis relies on beta, which is not a stable parameter, nor does it really capture what risk is.  That said, inverted DCF can work without discount rates.  The book takes the approach that the discount rates are the less critical factor, because when they change for one firm, they typically change for all firms.  The book’s solution is to use current prices to drive DCF backwards and determine market free cash flow expectations for a stock.

The analyst can then look at those expectations, and try to determine whether they are too high or too low.  The analyst can also look at whether there might be changes due to unit growth, product price changes, operating leverage, economies of scale, cost efficiencies, and changes in the marginal efficiency of capital.  After the analysis, usually one or two factors will stand out capturing a large portion of the variability.  The analyst then focuses on those, and what drives them.  Unexpected changes lead to revisions to the analyst’s model, and the game continues.

Beyond that, the analyst needs to understand how the company in question fits into its industry.  The book discusses Michael Porter’s five forces, the value chain, disruptive technologies, and the economics of information.  Beyond that, the book touches on:

  • Real Options — the ability of a company to pursue value enhancing projects or not.
  • Buybacks — do them when the company has no better opportunity, and the shares are undervalued.
  • Mergers and Acquisitions — how to tell when are they good or bad ideas.
  • Reflexivity — Are there situations where a higher or lower stock price affects the business?  High/low valuation makes financing easy/difficult.
  • Understanding management incentives — how will they affect financial results and management behavior over the short and long runs.

At 195 pages in the body of the book, Expectations Investing is not a long book for what it covers.  The flip side of that is that is breezes over much of the complexity inherent in what they propose.  One other shortcoming is that little time is spent on financials, which are a large part of the market, and for which it is intensely difficult to calculate free cash flow.  After reading the book, I would have no idea on how to apply their DCF model to valuing a bank or an insurance company.

Aside from financials, if someone were to ask me, “Is this how valuation should be done?” I would say, yes, ideally so.  But it brings up one more critique: though I hinted at it above, most of the shortcuts that investors use are special adaptations and first approximations of the DCF model.  That is why shortcuts have validity — if you know the critical factors that drive profitability for a given company or industry, why waste your time on a big model with many inputs?  Cut to the chase, and use simpler models industry by industry.

Who would benefit from this book: someone who either wants a detailed means of calculating a DCF model, or a taste of the issues that an analyst/investor has to consider as he evaluates the worth of a company’s stock.

This is a neutral review from me.  I neither encourage or discourage the purchase of the book.  It has its good and bad points.  But if you want to purchase it, you can find it here: Expectations Investing: Reading Stock Prices for Better Returns.  I have a copy of Damodaran’s The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd Edition), weighing in at 575 pages, as well as his book Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Second Edition (similar size, with a quarter inch of dust on my shelf.  Guess I don’t use it that much).

I could do a review of one or both of those, but if Expectations Investing is overkill for the average investor, and light for the professional, then either of Damodaran’s books are for the professional only.  At best I think it would only produce a review on the weaknesses of DCF analysis.

Full disclosure: If you enter Amazon through my site, if you buy something there, I get a small commission.  Your price does not change.  I review old and new books, and I don’t like them all; my goal is to direct readers to the books that can best help them.