Beating the Mogul Game — An Exercise in Applied Mathematics

I have often wondered about how to rank sports teams.  This goes way back to when I was 10 years old, when I ran across a magazine at summer camp that purported to do this for NFL football.  And so I wondered for many years, looking at similar problems and wondering how a ranking of teams could be generated from a win-loss history.  I finally came to a conclusion when I played the Mogul Game.

The Mogul Game has 148 rich people, and they vary from the super-rich (Gates, Buffett, Ellison) to the not-so-rich (I think they got a kick out of putting Donald Trump at/near the bottom of the list, much as he boasts to Forbes that he is much wealthier than they calculate).

After playing the game idly for a little while, I concluded that if I wanted to win, I would have to capture and analyze data from the game in order to win it.  And so I did, recording who was richer than whom.  I went through four phases:

• Doing qualitative comparisons when I wasn’t certain of who was richer.  Who had the two parties beaten and lost to?
• Comparing the trial ranks when the difference was greater than 10.
• Looking at the highest ranked persons that a given set of contestants had won against, and the lowest ranked that they had lost to.
• Looking at the average of the highest rank won against and the lowest rank lost to as the best proxy for a contestant’s own rank, unless it violated the results of an actual contest.  In hindsight, I should have adopted that rule much earlier.

It took three days of off-and-on playing to master the game.  Not all that important, but as I mentioned above, the method can be applied with some modifications for ranking sports teams in an unbiased way.  The same could be applied to any competitive activity where there is a win/loss result.  There are two changes for other activities, though.  Games are not necessarily transitive.  Rich person A is richer than B.  B is richer than C.  A will always be richer than C.  In competitions, Team A can beat team B one day, and lose the next.  Also, Team A can beat team B, which can beat Team C, but C can beat A.  So, if I were doing this for baseball teams, my ranks would drive probabilities of one team beating another.

Why would this be necessary when one can simply inspect the win-loss percentages?  Teams with good records may have weak schedules, and this takes account of the strength of the teams played in assessing the strength of a team.  I’m not sure what they do with ranking College Football or Basketball teams, but this would be a more bloodless way of making the comparison.  Granted, it takes a certain number of contests before there is enough density of information to create a ranking, but given a list of wins and losses from an entire season, this method should be capable of ranking an entire league.

I know this is an odd post for me, but I found it to be an interesting project, and it does have other applications.  Thoughts?

The Return of My Money, Not the Return on My Money

Before I begin, I want to thank longtime readers, and ask them to give me some feedback.  I have a category entitled Best Articles; what would you nominate to be in there.  Also, what would you take out?  I’ve tagged a few articles from the early days, but since then, have not done much with it.  If you have ideas, please let me know.  Thanks again.

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As bond investors go, I tend to focus on what can go wrong more than most, so when I looked at the cover of Barron’s today, I said, “Oh, no.  Pushing yield now?”

It’s no secret that most safe investment grade debt does not yield much now.  Many investors, hungry for yield, must look for other ways to earn income, even if it means greater hazard of capital loss.  That is another impact of the federal reserve flooding the debt markets with liquidity — the safe investments yield little, forcing those that want yield to take significant risks, whether those risks are lending long, high credit risk, operational risk (common stock and MLP dividends), or subordinated credit risk (preferred stocks).

The history of chasing yield is not promising.  In general, average retail investors reach for yield at the wrong time, and Wall Street is more than happy to facilitate that through structured notes and other high yielding investments where the risk is greater than the excess yield.

But wait — I can endorse some of the article.  I like utilities here.  I don’t own Verizon or AT&T, but I could imagine owning them.  MLPs in energy distribution?  Probably safe; consider their competitive positions and consider where things might go wrong.  I’m not jumping to buy them, though.

Where I can’t sign on is with preferred stocks and convertibles.  All of the preferred stocks that the article cites are financials with marginal investment grade ratings.  The convertibles are from a grab bag of low junk-rated securities.

How quickly we forget the ugliness of 2008.  If we have a second dip in the financial economy for whatever reason, the preferred and convertible securities will do the worst.  In order to get significant yields one must take credit risks in excess of average loss costs — it is safe to say at times like this, the purchase of risky securities is not rewarded.  Be wary with all purchases of risky debt at present.

Book Review: The Ten Roads to Riches

Many dream of riches.  Few achieve them.  Why?  It usually involves self-denial and hard work.  It’s not that anyone can’t achieve riches, if they start young enough, but they won’t make the sacrifices to do so.  A strong education helps, but is not absolutely required.  As my old boss Eric Hovde said to his staff repeatedly, the biggest difference in success comes from the degree of effort put forth.  I would only add that working smart amplifies the effort of working hard.

Ken Fisher the billionaire asset manager, identifies the ten ways he has seen to become wealthy.  They are:

3) Be the right hand man of a wealthy person.

4) Be a star athlete, entertainer, or one who significantly facilitates star athletes and entertainers.

5) Marry a wealthy person.

6) Be a lawyer that helps clients sue for major amounts of money on a contingency fee basis.

7) Manage a lot of Other People’s Money.

8 ) Be an inventor of something popular, a popular writer, a prominent politician, or invent an organization that a lot of people want to give money to.

9) Borrow a lot of money and speculate on property appreciation.

10) Work hard, save a lot, and invest wisely.

I think he has nailed it.  My way of summarizing it is that you have to do something that makes a lot of people happy, or at least has the potential to make a lot of people happy.  Or, make one wealthy person very happy or unhappy. Three groups — how do they work out?

A) Those who do something that makes a lot of people happy can earn a lot:

• Successful business founders, CEOs, right hand men, inventors
• Stars and their significant enablers
• Good asset managers
• Good writers
• Successful real estate developers

B) But even those that promise to do something to make people happy and fail at it can earn a lot:

• Any CEO of a big enterprise can earn a lot — at one investment firm, we used to joke that you got paid \$50 million to destroy a company — it is what they had to pay to get rid of you.  Their right hand men will still prosper too, just not as much.  In the current financial crisis, that is what gores many about the large surviving firms that were bailed out.  The executives are still prospering after previous dumb decisions.  Easy to complain about it, but it is nice work if you can get it.  (Note: this is why they should not have been bailed out, especially not at the holding company level.  Government officials lie when they say they could not have done it differently.  I for one suggested alternatives ahead of time.)
• The same applies to CEOs that tweak the company’s earnings while they are there, but leave their successor in the hole.
• Many still follow stars as their stars fade; they may not make as much, but it is still a lot.  Same for writers that lose their knack.
• Many asset managers have an early period where they don’t have much in the way of assets, and their track record is great; their ideas for excess return are executable with the current assets under management [AUM].  That leads to growth in assets, until they are too big for the asset class in which they have expertise.  They become index-like, or they venture outside their circle of competence, and their track record suffers.  But AUM is high, and the fees can provide a nice income.  Assets are sticky if you don’t do too badly, and are a good salesman/storyteller.
• Politicians can make a lot of money off of contacts or giving speeches once out of office, even if they were on net harmful to the nation while in office.
• Some charities (or nonprofits like mutual insurers or credit unions) can be less than scrupulous about what managers get paid.
• The real estate speculator, the CEO, and certain investment managers can have a “Heads-I-win, Tails-you-lose” attitude.  America gives people a lot of second chances before you are permanently branded as a fraud.  It only takes one big win to make a lot for yourself, even if you destroy the well-being of others in the process.

C) Then there are those that only have to serve a few:

• The spouse of a wealthy person.
• The right hand man of a wealthy person, and
• The Trial Lawyer going after a big tort
• Serve yourself, as an ordinary person working at a job.

No one begrudges the wealth of those in group A — they have served society well.  Many begrudge the wealth of those in group B — they have not served society well.  Group C?  It depends on motives.  More later on this.

One thing is certain, though.  There aren’t many seats in each of the “roads to riches,” except for the last ordinary one, #10.  Few are founders of massive enterprises, or CEOs, or stars, or investors of must-have products or processes.  Few can serve in high office, or write best-sellers, or be able to source a lot of assets to manage.  Few can get the capital markets or banks to loan them millions, even billions.  Few get to try a lawsuit where a huge award is won.  Few get to marry rich.  Also, most succeeding have to hit their right path while young, to allow enough time for compounding their success.

It takes a lot of effort and good breaks in order to be at the top of any economic situation where there is a lot of wealth.  Even road #10, doing well at your job, saving a lot and investing wisely is tough.  Few get to become “The Millionaire Next Door,” but more achieve reasonable wealth that way than all of the rest combined.

Ken Fisher writes about all of these areas in an entertaining way, and gives practical advice on how to follow each road, including additional books to read, and techniques for getting started.  It is an ambitious and compact book weighing in at around 230 pages of text including the preface.  It is an easy, breezy read. As a bonus, in road 10, Ken Fisher shares basic investment advice for the retail investor.

More than Quibbles:

I owe a lot to Ken Fisher for advice that he gave me in Winter 2000, and though I enjoyed the book, I can’t endorse it wholeheartedly.  He is out to tell you how to do it, even in cases where there might be significant moral compromise.  He acknowledges that, but says it is a part of the game.

To me, the key question is what your motives are.  It’s one thing to enter into a risky business, offer full disclosure to all stakeholders in advance, make a best effort, and fail.  It is quite another to trick/cajole people into backing you without full knowledge, and fail.

It is one thing to try a legal case where the damages are proportionate to the harm caused, and another thing to help create disproportionate judgments. It is one thing to serve a wealthy person who asks you to do things that are ethical, and another thing to serve in things that are unethical.  Once you have fans, a privileged job, or “sticky assets,” do you start giving less than your best?  I write this as one that is himself prone to laziness when things go well.  It is a common sin that one has to fight.

Are you looking out for the best interests of those you serve, and society more broadly?  A tough question for any of us, but society itself does not do well when a dominant proportion of it does not serve for good motives.  If it gets bad enough, the society will lose legitimacy and vitality.

Finally, it is one thing to marry because you love the person, and want to give your all to your future spouse.  It is quite another thing to enter in with crossed fingers, and say, “Maybe this will work, maybe it won’t.  I will be careful to protect myself, because the odds of failure are significant.  But economically, it will work out for me either way.  I’m wealthy if we marry, whether it works or not, because the prenup will leave me well off.”

Here’s the common vow: I, (Bride/Groom), take you (Groom/Bride), to be my (wife/husband), to have and to hold from this day forward, for better or for worse, for richer, for poorer, in sickness and in health, to love and to cherish; from this day forward until death do us part. Maybe promises don’t mean much any more, but I can’t see how one marrying for money can say that with a clear conscience.

Before my wife and I married, but after we were engaged, we were at a bookstore together, and we were looking over some marriage books to find one our pastor recommended.  She found a book entitled, “Marry Rich.”  She said to me, “This is a joke book, right?”  I said, “Uh, you would be surprised at the motives some have in marriage.”  She began leafing through it, amazed at the level of greed involved.  She married her poor graduate student boyfriend anyway.  23 years later things are still working out well for her (and me).

One final note, not from the book: greed wears people out.  It is one thing to do what you love so long as money is not the sole purpose.  But those that are greedy for gain at all costs destroy themselves, and those around them.  It is not a good trade.

With those caveats, if you want to buy the book, you can buy it here: The Ten Roads to Riches: The Ways the Wealthy Got There (And How You Can Too!) (Fisher Investments Press).

Full Disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

Book Review: Warren Buffett on Business

In the Fall of 2005, I was at the Annual Meeting of the Casualty Actuarial Society in exotic Baltimore, Maryland.  The Keynote address was by Roger Lowenstein who did a talk on two topics.  Warren Buffett the great investor, and the looming problems from the demographic crisis.

At the end of what was arguably a good talk, he asked for questions.  No one raised their hands.  After a pause, he asked for questions again, and I raised my hand.  I commented that he should have given his talk to the Life actuaries — they are the ones concerned about longevity and health costs, and if he really wanted to do a favor for casualty actuaries, don’t talk about Buffett the investor — talk about Buffett the P&C insurance CEO.

He commented that he was asked to speak about the topic by the CAS.  I like Lowenstein, so if you are reading this Roger, my apologies for making the comment.

Warren Buffett on Business is one step closer to the book I would like to see — I would like to see a book on Buffett as an insurance CEO.  Buffett is a great insurance CEO, and deserves a lot of credit in that capacity.  (Warren, I doubt you are reading this, but if you would like me to write that book, please e-mail me.)

But Berkshire Hathaway is an insurance/industrial hybrid, unique among companies.  Warren Buffett on Business ignores Buffett the investor to take up issues that are just as significant: Buffett the business owner and manager.

The words in the book are Buffett’s.  The man who organized the book took Buffett’s words over the last 25-30 years, and organized them into categories regarding management issues.  The topics include:

• Berky acts like a partnership even though it is a corporation.
• Corporate Culture and Governance
• Competent Managers and Honest Communication
• GEICO and Gen Re acquisitions (personally I think Buffett got hosed moving to terminate financial contracts  at Gen Re rapidly.  There is a rule of thumb that says negotiations on illiquid contracts should be undertaken slowly, unless the other side is panicking.)
• Assessing and Managing Risk
• Compensating Management
• Time Management
• Crisis Management
• Acquisitions — Buffett gets to own a wide number of unique corporations, because the one selling out wants the culture preserved, and if the price is right Buffett will do that.
• And more…

Both in the chapters and in the appendices, the words of Buffett shine forth as a way to manage corporations for the best long term results, even if things don’t work so well in the short run.

Quibbles

Much as I like the words of Buffett, I prefer a second voice adding analysis.  Let the words of Buffett star, but let someone else add color and history, because Buffett’s own words are not complete enough.

Also, an analysis of how Buffett managed the insurance lines of his enterprise would be welcome.  Even for those looking exclusively at investment issues, the insurance enterprises offered Buffett the balance sheet he needed to buy assets that could take a while to work out.

Who would benefit from this book: Any manager of any company would benefit from this book.  Buffett lovers, if you have read the last 25-30 years of annual reports from Buffett, and notable things he has said outside of that, you likely do not need this, unless you have specific questions on management that you want answered by Buffett, and you can’t remember what he said in the past.

For most of the rest of us, this will still be a valuable book.  If you want to buy this book, you can buy it here: Warren Buffett on Business: Principles from the Sage of Omaha

Full Disclosure:  I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

On Sovereign and Quasi-Sovereign Risks

I like investing internationally, because of the diversification it offers, both in stocks and bonds.  Or, think of it as a hedge.  Will the American Experiment continue to prosper?  We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.  I have two requirements.

• Contract law must be close to that in the US, or better.
• Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.  There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.  My acid test is watching over a long period and seeing how they treat foreign shareholders.  That is a good measure of the morality of management.  If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

• Russia
• China
• Most of the Middle East.
• Venezuela
• And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.  It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.  Don’t buy pigs in pokes.

This has application today with Dubai.  The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.  This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.  Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.  This incident will prove instructive on how these bonds keep or lose value in a reorganization.  What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.  Personally, I never found them compelling, and probably won’t in the future.  There is something compelling about straight senior unsecured debt that pays interest.  I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.  Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.  Even if you personally have the fortitude to do so, there may be others that influence you that don’t.  (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.  Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.  When I was younger, I thought the great risk of the Euro was that it would be too weak.  Bite my tongue.  The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed  skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.  That bias is largely gone today, after a period of few sovereign losses.  Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.  Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.  If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.  On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.  With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.  Not a strong bargaining position in my opinion.  The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.  What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.  Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.  Character is important in any credit decision, and the government of Dubai does not have good character in my book.