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Archive for May, 2012

Pennies from Hell

Thursday, May 31st, 2012

I had lunch with Eddy Elfenbein today, and we had a great time together.  After all of the time that we have e-mailed, linked, etc., it was great to make the acquaintance.

Before I start tonight’s post, that makes me want to say this: if you are a blogger that likes me, and you are traveling to the Baltimore/DC area, email me, and let’s get together.  Even if you are marginal on me, try me, and if I accept I will buy lunch.

Many of us as bloggers do a service for the investment community; I have sometimes said that we are the conscience of Wall Street.  Well, tonight’s post is another post to warn people away from a class of investments that almost always loses money: promoted stocks / penny stocks.

As I looked through my archives, I was surprised at how many promoted penny stock I have written about — there were eleven.  Not what I intended when I started this blog, but I go where I think I am needed.  So, what has the performance been of the promoted penny stocks since I wrote about them?

TickerDate of ArticlePrice @ ArticlePrice @ 5/30/12Decline
GTXO

5/27/2008

2.45

0.04

-98.4%

BONZ

10/22/2009

0.35

0.02

-94.3%

BONU

10/22/2009

0.89

0.10

-88.8%

UTOG

3/30/2011

1.55

0.05

-96.8%

OBJE

4/29/2011

2.90

0.05

-98.3%

LSTG

10/5/2011

1.12

0.15

-86.6%

AERN

10/5/2011

0.0770

0.0016

-97.9%

IRYS

3/15/2012

0.261

0.160

-38.7%

NVMN

3/22/2012

1.47

1.35

-8.2%

STVF

3/28/2012

3.24

0.53

-83.6%

CRCL

5/1/2012

2.22

1.34

-39.6%

Can I say “Ouch?!”  This is almost as bad as the dot-com bubble, except there are no successes to give the illusion that if you pick them right, you will do fine.

But today, after coming home from lunch, I went to the mailbox and found three (THREE!!) penny stock scams in my mail, two from the same promoter.  I could be wrong, but I think the frequency of penny stock scams is increasing, perhaps out of desperation for some people to make money.

One of the promotions was Circle Star, which I have mentioned before, though this was through a different promoter, and you can see the promotion here.  The writer received $75,000 for his efforts.  Enough said.

Then there was Oryon Technologies [ORYN], Inc.  This company that masquerades as a technology and apparel company, was a mining company three months ago.  It has never earned a dollar of revenue.  Enough said.

The last one was Barfresh Food Group, Inc. [BRFH]  Smoothies as a patentable investment idea is ridiculous.  But at least the disclaimer on this one is honest:

Do not invest in this company unless you can afford to possibly lose your entire investment. NBT Equities Research and/or its publisher, ChangeWave, Inc., dba NBT Communications has received thirty five thousand dollars and been pledged seventy-five thousand shares of rule 144 common shares in Barfresh Food Group Inc. to assist in the writing of this advertisement. Primo Strategies LLC paid one million three hundred thousand dollars to marketing vendors to pay for all the costs of creating and distributing this report, including printing and postage, in an effort to build investor awareness.

and

Primo Strategies LLC was paid by non-affiliate shareholders who fully intend to sell without notice their shares into this advertising/market awareness campaign, including selling into increased volume and share price that may result from this campaign. The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this campaign. A non-affiliate shareholder acted as advisor to Primo Strategies LLC in this market awareness campaign, including providing outside research, materials and information to outside writers to compile written materials as part of this campaign.

and

Third Party/Agency Disclaimer: Content of this message is published by NBT Equities Research, LLC and/or its publisher, ChangeWave, Inc. and sent to select email lists through various marketing agencies to provide readers with information on selected publicly traded companies. Winning Media is managing a total budget of $250,000 for this and other advertisements in an effort to build industry and investor awareness. The $250,000 budget was provided to Winning Media by MarketByte LLC, a shareholder of Barfresh Food Group, Inc. MarketByte LLC reserves the right to buy and/or sell shares of Barfresh Food Group, Inc. at any time. This should be viewed as a potential conflict of interest.

This company has received revenues, but has not earned profits, and has a negative net worth as well.  It was a company searching to buy movie scripts, and realized that smoothies were a better business.  Go figure.  In general, companies that make big shifts in industrial direction are usually horrible companies.

Think about this Differently

Suppose for a moment you did have a great idea that could revolutionize a given business.  Would you:

  1. Try to grow the business using only your own capital, and that of friends and family, and a limited number of  angel investors, until you realize that institutional capital and knowledge is needed to take this to the next level, i.e., venture capitalists.  Advertise where needed, but don’t give potential competitors too much of an idea that you are out there.
  2. Take over a rotted shell of a public company, and use its broken balance sheet to attempt to grow.  Exchange unpayable loans for increased equity stakes for the lenders, diluting yourself.  When their stakes get big enough they engage some third parties to do a pump-and-dump.  Some bozo writes the copy, another bozo distributes it.

No credible idea would come public via method 2, they would work through venture capitalists.  So I would tell you without hesitation that there is never a reason to buy a promoted penny stock.  The large holders are the only ones with sufficient economic interest to promote a pump & dump, and they are likely the ones behind the bozos doing the promoting.

One Public Policy Recommendation

We need to codify something here, that if a brochure says in 12 point type: “Call your broker today to discuss how large a position in Circle Star Energy Corp [CRCL] you can comfortably own,”  (This was in the written brochure and not on the web, as far as I have seen.) then any disclaimer in a smaller, or less readable typeface is not valid in court.  This is an implicit form of fraud, and I believe that the writers and distributors of this drivel, as well as those that paid them should be able to be successfully prosecuted for fraud.

One last thing, to the guys who write these “analyses” that display incredible certainty and opportunity in large type, and then say that this is not really an investment analysis in tiny unreadable type — how can you look at yourselves in the mirror when you are such liars and cowards?

Book Review: The Billion Dollar Mistake

Tuesday, May 29th, 2012

Note to readers: I appreciate votes at Amazon.com if you like my reviews, and you can vote here.

We learn more from failures than successes.  With failures, it is easy to observe the cause in hindsight and realize that we neglected a key principle in investing.  With successes, the reasons vary, and it is much harder to generalize.

In the book, most of the failures stem from failing to consider implicit or explicit debt on investments.  I am a sympathetic critic here, because most of my own failures in investing stem from the same flaw.

The two exceptions are the Leon Cooperman and the Madoff investors, where the problem was fraud.  Fraud is tough, and there are ways to reduce the odds of being snared by it — I have written about that at my blog.  It is impossible to eliminate.

But there are some defenses, look for free cash flow, and check the normalized operating accruals.  Scams tend to increase accruals, and no have free cash flow.

High levels of debt are always dangerous; best for amateur and most professional investors to avoid the situations.  If you can do this, you will eliminate most large portfolio failures.

Strengths of the Book

The book considers a wide range of investors.  It has Wealthy Dudes, Hedge Fund Managers, Private Equity Managers, Mutual Fund Managers, Corporations, Individual Investors, and CEOs.  The book considers both passive and active investors, and that is a real strength.  The author aimed for generality in investing when he wrote this.  He could have focused on a single area, but he didn’t.

Quibbles

In dealing with Geoff Grant, the author shows that he does not understand asset-backed securities that well.  What happened there was that they did not understand portfolio margining, and that they could be forced to sell under tough conditions, which is a potential asset-liability mismatch.

With respect to Chris Davis and AIG, it is clear that Davis was relying on historical performance which would no longer prospectively be true.  Complexity in accounting is almost always punished.  Ask Mr. Buffett as to why he keeps his reserves conservative.

Who would benefit from this book:   With the above caveats, I recommend this book.  We learn more from failures than successes; and you could learn a lot from this book.  If you want to, you can buy the book here: The Billion Dollar Mistake: Learning the Art of Investing Through the Missteps of Legendary Investors.

Full disclosure: I asked the PR flack for the book when she asked me to review his latest book, which I am still reading.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

 

391 Auctions

Saturday, May 26th, 2012

Jason Zweig of the Wall Street Journal has an interesting piece up called Could Computers Protect the Market From Computers?  I appreciate Jason, he writes a lot of intelligent stuff, and had the guts to revise one of my favorite books, “The Intelligent Investor.”

We are talking about positive feedback loops, where computers amplify the actions of humans demanding action now.  Computers, for all of their strengths, are rules based, and we the humans feed them the rules, or the information that allows them to react to data as they emerge.  The rules may be very complex, but they are rules, and do not allow for humans to modify the computer’s reaction to the market on-the-fly.

I’m skeptical that we can stop unusual things from happening resulting from computers trading rapidly by having other computers monitor it.  First, stocks are volatile, and news can break that leads to significant rallies/declines.  Second, part of the difficulty from the “flash crash” was computers getting out of sync with one another.  We can’t guarantee that the regulatory computers might not fall behind the trading computers, and what might happen if the “right” action to slow trading emerges slowly.

Third, one has to recognize that you should only have regulations that are understood easily by participants, and accepted, or else the rules will face a lot of lobbying pushback.

I think that there is little to no gain to the market as a whole from sub-second trading speeds.  I think we could slow down the market, and force a more rational market than what we currently have, by limiting the ability to cancel orders — all orders must be good for at least one second.

Markets need good rules and structure to work well.  Rather than having shadowy computer overlords, which only academics could like, craft a rule that says, “One auction per second.”  Or create a central order book and eliminate alternative venues for execution.  The cost listed in the article is cheap.  I’m agnostic on what the best solution is, but to me, the best solution involves slowing things down, so that information does not cause cascades off of short-term signals.

Even simple rules like, “Stop trading for any company that has dropped/risen by more than 5% on the day for 30 minutes,” would be preferable to any guidance from computers that is less clear.

Rather than using computers and complex reasoning, we need simple rules to slow things down, or…who cares, let errors happen.  I made money on the day of the “flash crash” by buying shares of a company that was solid but temporarily depressed.  Teach people not to use market orders or they could get harmed.

This is the market, after all, and if you are “bellying up to the bar,” you should be ready for the fact that you are outgunned.  You are likely not smarter than all of the resources being deployed against you by hedge funds, high frequency traders, etc.  Secondary markets in equities exist to provide flexibility to holders of the equities, most of whom hold their stocks every day, with only a small fraction trading.  Trading is a sideshow to value creation, which happens in the companies, not the exchanges.

Which makes me take step back and mention that Buffett wouldn’t care if the exchanges were closed for a year, because he buys solid companies.  Suppose for a moment, I had written an article called 391 Auctions, where I would suggest that the markets have one auction each minute, and that all orders must last until the end of the minute, with no cancellations.  (After I wrote, this I changed the article title, so I did do it.)

With 391 auctions per day, who couldn’t think that we were providing enough opportunity for price discovery each day?  Slow things down, and ignore those arguing for technical efficiency versus those arguing for rational markets that allow people to make reasonable decisions in real time.  One auction per minute?  Could work well — watch the bids and asks line up, once per minute.

Markets need structure to work well.  This could be one way of doing it; I am open to other ideas, but letting the computers attempt to do it opaquely seems like a loser to me.  Slowing things down seems like a winner, because secondary trading is a sideshow to the real value creation that happens inside the companies.

Sorted Weekly Tweets

Saturday, May 26th, 2012

Market Dynamics

 

  • Go Your Own Way: Correlation Breakdown in the Market http://t.co/3Zwpx3kB @japhychron hints at deterioration in US stocks as USD strengthens May 26, 2012
  • RE: To me it implies that conservative HY investors are running out of places to put money.  Yellow flag. http://t.co/eUSRq8dY May 25, 2012
  • Vanguard Closes High-Yield Fund — ETF Alternatives http://t.co/bMmYUMTC Note: ETFs proposed take more credit risk than Vanguard fund does $$ May 24, 2012
  • Vanguard’s high yield fund was fairly conservative; they may feel strain in the size of their positions relative to t… http://t.co/lLJFeiYc May 24, 2012
  • RE: They were called the Americus Trusts, sponsored by the Americus Shareowner Service Corp., and they had Scores and… http://t.co/TPNPkL8T May 23, 2012
  • Wealthy Americans Turn to Trusts to Shield Assets http://t.co/2rKGuNWb Reasons: taxes, liability, avoid probate. Covetous world $$ May 23, 2012
  • You can say that again, momentum is addictive $$ RT @credittrader: lol – never learn – especially when momentum feels so good haha May 23, 2012
  • @credittrader I’m well. Fascinating that $JPM didn’t learn from the correlation crisis in 2005; tranche px/corr relationships shift $$ May 23, 2012
  • IG CDX diverges from S&P500; JPMorgan advocates mean reversion trade http://t.co/FIsOqhBN Long IG spreads vs HY spreads and equities $$ May 23, 2012
  • Kroll Sees Supplanting S&P in Rating Commercial Mortgage Bonds http://t.co/IrzfQ6cH Gratuitous trash talk on competitor S&P from Kroll $$ May 22, 2012
  • Treasuries in Longest Winning Streak Since ’98 on Europe http://t.co/EWJkiN5u Everyone knows that Treasury yields can only fall, right? $$ May 20, 2012

 

Eurozone

 

  • Merkel May Be Persuaded on Euro Debt-Sharing Compromise http://t.co/P3yQaN1K H/L misrepresents Merkel; does not seem likely politically May 25, 2012
  • Indeed, why not? RT @TimABRussell: “http://t.co/831diM1O Why not just pick the best person for each position regardless of sex, race, etc? May 25, 2012
  • If a man will not respect his “wife” by marrying & staying with her, why should you expect him to respect women in mo… http://t.co/83lvXtu1 May 25, 2012
  • Stock Market Performance Versus Dollar http://t.co/mfrXyqvp Difficult for the US stock market to do well when the $$ is strengthening v Euro May 25, 2012
  • Slim Family Sees European Crisis as Good Time to Invest http://t.co/XZOgx3xX Buy when there is blood running in the streets $$ #slimchance May 25, 2012
  • Europe Girds for Greek Exit http://t.co/HMfsVt86 Two problems: Can’t kick Greece out & Greece can only leave Eurozone by leaving EU $$ May 24, 2012
  • Euro-Zone Economic Contraction Deepens http://t.co/b49VctDj Overindebted Eurozone muddles as politics/bureaucracy strangle growth $$ May 24, 2012
  • EU Chiefs Clash on Euro Bonds as Crisis Summit Bogs Down http://t.co/S1YnHrbM Fiscal Union requires political union; elephant in room $$ May 24, 2012
  • The Seeds of the EU’s Crisis Were Sown 60 Years Ago http://t.co/SsWQUvGa Overly ambitious EU goal of “ever closer union” leads 2 crisis $$ May 24, 2012
  • War-Gaming Greek Euro Exit Shows Hazards in 46-Hour Weekend http://t.co/WD7HSbMI Assumes Greek competence & they care about global mkts $$ May 23, 2012
  • A Greek Exit Could Make the Euro Area Stronger http://t.co/C7v2mDmM Concludes that a Greek exit would lead the rest 2 pull together $$ May 23, 2012
  • Campaign for Joint Euro Bonds Builds http://t.co/xXAvSU73 Will the core Eurozone countries give up resources to bail out the fringe? $$ May 23, 2012
  • Europe’s Prisoner’s Dilemma – LTRO Needs to Continue for Years http://t.co/NldAsVL2 Until govt debt is gone from finl sector’s bal sht $$ May 23, 2012
  • Germany to Sell Interest-Free Bonds http://t.co/q7ewNqd2 It is good to be king. People give you their money, & they pay for the honor $$ May 22, 2012

 

US Politics / Economics

 

  • Even with a High Court win, Obamacare won’t work http://t.co/NKhyAe56 Failed ideas @ the states will not add up to a successful Federal plan May 26, 2012
  • USDA Is a Tough Collector When Mortgages Go Bad http://t.co/ZX24InYJ Definitely has different goals than most of the govt re mortgages May 26, 2012
  • Report: Negative Equity More Widespread Than Previously Thought http://t.co/UkQBpbGY Adds in value of second liens, 31%+ inverted $$ May 24, 2012
  • Let Mr. Reid look to his own spending extremism.  As for me, let the tax cuts expire, and automatic cuts happen.  Bet… http://t.co/cabthITQ May 22, 2012
  • Shale Glut Means $1-a-Gallon Savings at the Pump http://t.co/RHlFbT3L Liquefied Natgas would shave $1/gal over diesel for trucking $$ May 22, 2012

 

China

 

  • New Signs of Global Slowdown http://t.co/2o4kFRkD Weak Reports in U.S., Europe and China Suggest Economies Are Slipping in Sync $$ May 26, 2012
  • @researchpuzzler Pettis is among the best on China. @ritholtz and John Mauldin are good friends. Trends in China r very negative… $$ May 25, 2012
  • EM investing: check out the grid http://t.co/dIEGJeJC 3Qs How much electricity do they have? Future development? Probability of success? May 24, 2012
  • China flash PMIs point to contraction, again http://t.co/DZGf3ZZS The number for May is 48.7, compared to 49.3 in April. 7th decline. $$ May 24, 2012
  • China, North Korea ties hit rough weather http://t.co/r7TlDbux Kim Jong Un needs lessons showing honor2the Suzerain: Chinese Communist Party May 24, 2012
  • RE: @SoberLook I’ve heard that Chinese electricity consumption has flatlined.  Another straw in the wind. http://t.co/IqAHJCgo May 21, 2012

 

Companies

 

  • Facebook Investor Spending Month’s Salary Exposes Hype http://t.co/eGhCiHXq Please. Stox r risky. High expectation stox r veryrisky $$ $FB May 24, 2012
  • General Mills Unveils Restructuring, Job Cuts http://t.co/IUHltbai $GIS Budget-conscious US consumers push back against price increases May 23, 2012
  • Benihana Agrees to $296 Million Buyout http://t.co/YxJtfun3 Agreed 2b acquired by investment firm Angelo Gordon & Co. for about $296M $$ May 23, 2012
  • The Miracle on Wellington Street http://t.co/DUbSY81d Fairfax Financial Holdings’ tricky transaction for 6.6% of Odyssey Re -> legal trouble May 21, 2012
  • Barclays to Sell Entire $6.1 Billion BlackRock Investment http://t.co/notUgeFk Basel III rules make it uneconomic to hold as capital $$ May 21, 2012
  • Houghton Mifflin Harcourt Publishing Files for Bankruptcy http://t.co/heUuF3gj Bank debt -> New Equity, old Equity -> warrants for 5% $$ May 21, 2012

 

Financial Sector

 

  • JPMorgan Gave Risk Oversight to Museum Head Who Sat on AIG Board http://t.co/INr9ebI5 No banking experts on $JPM ‘s risk ctrl committee May 25, 2012
  • Goldman to JPMorgan Swap Trades Soar on Risks http://t.co/fvSPysAp A cheap-ish option on systemic risk rising. And not in the eurozone! $$ May 25, 2012
  • JPMorgan Copper ETF Plan Seen Creating Havoc by Merchant Groups http://t.co/zoJ0BfeM They oppose retail hoarding b/c it hurts them $$ May 24, 2012

 

Advice Regarding Life

 

  • I Wish I Had Known: Don’t Underestimate Compounding In EVERYTHING http://t.co/mIdFf5Dx People overrate their ability to change habits $$ May 26, 2012
  • Compound Experience, Not Just Interest http://t.co/n6CaWLN0 Early behavior influences later behavior, and the options that will be open 2u May 26, 2012

 

Berkshire Hathaway

 

  • Buffett Says Free News Unsustainable, May Add More Papers http://t.co/medRWMWm Strategy: Buy papers, end free distribution on Internet $$ May 25, 2012
  • Buffett’s Idiot Challenge Seized by Jain in Premium Hunt http://t.co/89qcKilo Misses how Jain blew it reinsuring life & LTC from Swiss Re May 23, 2012
  • Don’t get me wrong, Ajit Jain knows more about insurance than me; I’m saying he is not perfect; he does not know all insurance equally $$ May 23, 2012

 

High Frequency Trading

 

  • +1 That would work too RT @merrillmatter: @AlephBlog how about for all orders, one second minimum life May 24, 2012
  • Mutual Funds Promised Haven From Speedsters http://t.co/iCFFZXsU I proposed this HFT solution @ BaltimoreCFA 2 1 of those interviewed $$ May 24, 2012

 

Miscellaneous

 

  • The sex slavery stuff makes me sad/angry. I have daughters. $$ RT @moiracathleen: Brothels on Wheels http://t.co/COBuwJbS @leafjohnson May 25, 2012
  • How a bizarre legal case involving a mysterious billionaire could force 1.2M Canadians 2b married, against their will http://t.co/zv7QJBCz May 24, 2012
  • Veterans Face Ruin Awaiting Benefits as Wounded Swamp VA http://t.co/W0Ydcu3x Long sad tale: wounded vets not getting enuf disability pay May 24, 2012
  • Gold Boom Spreading Mercury as 15 Mln Miners Exposed http://t.co/f7oBSo26 Long fascinating article about mercury poisoning in Colombia $$ May 24, 2012
  • Rust-Belt Babushkas Live Alone as Fewer Remain to Marry http://t.co/ASbsIAMg % of US single person households up ~250% since 1940, 8%->27% May 23, 2012
  • Private Spacecraft Lifts Off Toward Space Station http://t.co/JlGRR2m0 The sustainable space age has begun, w/private $$ flying rockets May 23, 2012
  • Fitch Downgrades Japan http://t.co/rITu0126 Blasts the govt 4 taking a “leisurely” approach2solving country’s spiraling debt problems $$ May 23, 2012
  • Is the College Cave Age About to End? http://t.co/ispDBLTX Thinner slices of “deeper” knowledge produce less relevant research & teaching May 21, 2012
  • Getting America on a Diet That Works http://t.co/vooh1iNN What’s funny2me is how little agreement there is today on what works in diets $$ May 21, 2012
  • +1 Fatal Risk RT @ToddSullivan: AMAZING book…one of my favorites RT @alephblog: Please follow my friend @BoydRoddy, who is new to Twitter May 21, 2012
  • Please follow my friend @BoydRoddy, who is new to Twitter. $$ May 21, 2012
  • Read my review: ‘The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds’ by Maneet Ahuja via @alephblog http://t.co/kJf89aVT May 21, 2012

The Rules, Part XXXII

Friday, May 25th, 2012

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.  The process cannot work in reverse, except by accident.

The recent case of JP Morgan’s hedging activities bring to light an observation that should be clear to all but isn’t.  Hedging only works when you are small relative to the markets in which you hedge.

Let’s consider tranched credit index default swaps.  We can create models where the prices of each tranche can be calculated given default frequency and severity.  But default is not a constant beast.  Defaults come in waves, and when incidence is high, so is severity of loss.  Vice-versa when incidence is low, leaving aside fraud.

We might have a good idea of where credit default should trade for a basket of corporate debtors “credits” so long as we look at the thing as a whole,  and don’t carve it up.  In general, a basket of borrowers is easier to predict than individual borrowers.

But the basket gets difficult when we split it up into first loss, second loss, third loss, etc. claims where different parties lose their capital at differing levels of total loss.  Yes, in theory, we can come up with prices.  We can even come up with hedge ratios  that show the theoretical tradeoff between tranches as losses increase or decrease, which might work, might, if you are a small player in that market.

Woe betide you, if you do anything too fancy, and you are big relative to the market.  Because you are big, you have affected the prices of the market.  Price relationships that were normal before you arrived have shifted and reflect your interests, which in the short-run makes your accounting look better.  As the bubble grows, those investing in the bubble look better.  But as the bubble expands, those that have invested in it find a wave of cash fighting against them, but it doesn’t matter, because momentum investors are still buying.

At the end, the large investor amid the bubble finds himself stranded.  The market knows his positions, and he can’t make trades to extricate himself, because the terms are onerous.

Look, I used to trade small-issue lesser-known bonds.  I only bought stuff that I knew would be money-good, i.e. pay off.  In that case, you have the option of speculating when spreads are wide, and selling when they get tight.  But if you do that with bonds that you don’t know whether they will likely pay in full, the ability to hedge is meaningless, because your hedge could break in a default.

And so it was for JP Morgan.  When you get too big relative to the market, it had better be when you are the buyer or seller of last resort, and you are catching the turn.  But in normal markets, bigs are pigs, and are likely to be slaughtered.

It doesn’t matter what your model says is the right tradeoff if you are too big relative to the market.  Your own actions have poisoned the signals that your models receive.

Amaranth fell into this same bucket, with a talented energy trader who understood how the market generally worked.  As his success grew, so did his size, and he didn’t realize that the size of the fund was distorting market prices.  At the end there was one unlikely scenario that was unhedged, and that was the scenario that occurred, and the results led to the collapse of the fund.

If Amaranth had been smaller they could have traded out of it.  At their size, they were “elephants in an elevator.”

Size matters, and for investment purposes, smaller is better.  And for the most part, less complex is better too.  Don’t demand liquidity from markets, or you will lose.  If liquidity comes to your door, and it seems to be a good deal, wave it in.

23,401 Auctions

Wednesday, May 23rd, 2012

I’m fascinated at the degree of hatred for high frequency trading [HFT] among my fellow portfolio managers, particularly those that live in the Baltimore area.  I have my own techniques for dealing with them: discretionary reserve orders, and not trading much.  If you are a longer-term investor, the games that exist in buying and selling in the short-run don’t matter much.  In my opinion, HFT milks short-term traders the most.

But I have my own solution to high frequency trading: revamp all markets such that there is one auction per second in the trading day.  Auctions happen at the top of each second: 9:30:00.000000… 9:30:01.000000… … 16:00:00.000000.  Additionally, orders still standing at the start of any second may not be cancelled for the next second.

Auctions once per second.  Click, click, click, click…  23,401 auctions per day offers more than enough flexibility to buyers and sellers.  No truly economic commerce would be hindered by such an arrangement.

Why would anyone argue with this?  It splits the difference, and brings order to markets where many are presently skeptical of the validity of the markets.

I’m open to other ideas here.  I toss this out as a way of making markets more transparent.  Transparency aids validity, which aids legitimacy, eventually.

High Profits

Wednesday, May 23rd, 2012

Dr. Jeff Miller wrote an interesting question the other day:

Why does a Shiller disciple care about profit margins?

Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.  When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.  Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.

And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.  Consider this piece.

There are a couple ways to answer the question:

  1. Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.  The difference between P/E and P/S is profit margin — E/S.
  2. Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
  3. My answer: we should care about it a little, for the above reasons.  But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.

My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.  Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.

As I wrote earlier:

A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.  It also has a similarity to Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).  It’s a Price-to-Adjusted Book value ratio as I see it.

The CAPE has value as a proxy.  It mirrors overall market value pretty well, like other fundamental ratios.

But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.  Getting there could be a long time.  Profit margins could remain high for a long time as a result, leaving  markets in a limbo zone, where it treads water as underlying value builds.

So profit margins should remain high for now.  Once labor is scarce globally,  and companies must pay more to get more or better quality labor, then will profit margins come under stress.

 

Little Things are Important

Tuesday, May 22nd, 2012

One of the problems with many politicians, journalists, financial analysts, economists, etc., is that they don’t think systematically.  Go back to late 2006, when I wrote my piece Wrecking Ball Looms for Big Housing Spec, which was regarding the coming subprime crisis.  (Note: my editor often retitled my pieces; my original title was more circumspect.)  Or read my piece in mid-2005 regarding the impending unwind of leverage and prices in residential real estate, Real Estate’s Top Looms.  Both of those are inside the wall at RealMoney.  Apologies if you can’t read them.

At the beginning of the crisis, most economists, including the present Fed Chairman, said that problems ere limited, because they only affected limited areas of the residential real estate market.  Now, part of that response reveals that the Fed and other regulators beneath them had not been doing their jobs, because it is well-known now that underwriting quality of all residential mortgage lending had deteriorated.

When an economic system is overleveraged, with leverage that is layered, such that a domino effect can occur, small failures can have disproportionate results.  It is almost like the economic system during the bull phase self-organizes for the largest possible failure.  (Note: self-organizing systems do not always optimize for the long term.  Think: what other ideas could that invalidate?)

An overlevered residential real estate system had the possibility of a self-reinforcing decline in prices, once prices started declining nationally.  Now we face a still-overlevered residential real estate sector with a lot of the market inverted, where people owe more than the house is worth, though pockets on the low end of prices show recovery in some areas of the US.

Little things are important.  Some people say, “How can Greece pose so much risk to the rest of Europe?  It’s economy is so small relative to the rest of Europe.  Well, that’s where the leverage comes in again.

Core Eurozone banks have lent to Greek entities, and those banks are not well-capitalized.  If Greece left the Eurozone, and repaid loans in depreciated New Drachma, it would lead to a crisis in confidence regarding loans made to Spain, Portugal, and Italy.  The exposure of core Eurozone banks is significant, to the point where it could cause a broader crisis.

Little things are important where the system has been optimized; where something near perfection is needed to insure the proper performance of the over-evolved system where many entities are playing for a slice of the cash flow, and most have over-borrowed, and overpaid.

The optimized scenario is akin to the dominoes being set up, and they are beautiful, but woe betide the one who knocks over a domino.  (Note: as a kid, I would build domino structures, but would leave out every tenth domino, in order to create something where if I made a mistake, only a little would fall down.  The last dominoes were added with the greatest care.)

There are some worries in the US over European exposure.  I don’t think that is likely, except with some of the biggest banks.  Maybe that could spill over, but I doubt it.  If it does spill over, it will prove that the biggest banks should be broken up.  My favored way is to regulate banks like insurers.  You can do business across state lines, but you are tightly regulated by your state.  Much better than what we have currently.

Survivable systems exist when adequate returns are earned without high leverage.  That may sound vague, but vague is often the best we can do in economics.

When debts are complex, aim for simplicity.  Complex systems tend to die.  Simple systems survive.  This is a rule of value investing, measure simplicity versus reward.  Complexity has a price; avoid it unless well compensated for it.

 

 

Book Review: The Alpha Masters

Monday, May 21st, 2012

 

This book has just been released.  I got an early copy.  The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?  This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.   Have you been through anything similar to that?  If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.  Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.  They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.  What are they like?

Among their many attributes, they are:

  • Driven/competitive — though I have known my share of failures in investing that have that attribute.
  • Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
  • Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
  • Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
  • Patient — if opportunities are not promising, don’t do much.  It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.  Study what could go wrong, and see if there is a way to take advantage of the situation.
  • Team-builders — They develop talented teams/cultures and motivate them to excellence.
  • Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

  1. Ray Dalio — Bridgewater
  2. Pierre LaGrange & Tim Wong — MAN Group / AHL
  3. John Paulson — Paulson & Co.
  4. Marc Lasry and Sonia Gardner — Avenue Capital Group
  5. David Tepper — Appaloosa Management
  6. William A. Ackman — Pershing Square Capital Management
  7. Daniel Loeb — Third Point
  8. James Chanos — Kynikos Associates LP
  9. Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.  That’s how she gained the contacts in order to write the book.  Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”  That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).  The former is an accomplished investor, but is not an expert on hedge funds.  Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.  If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Post 1800

Saturday, May 19th, 2012

So, what do I write about at the Aleph Blog?  I write about a lot of things.  That’s a strength, and a weakness.  A weakness, because not everyone cares about a lot of things and if I shift to cover an area that is unusual, readers may not care.

It’s a strength, in the same sense that most of the best athletes could do well at a wide number of games.  I follow a wide number of themes in the financial markets and economics.  I like to think that I bring more perspective to a wide umber of issues because:

  • I have been trained in neoclassical economic theory, and I reject it.
  • I have been trained in modern portfolio theory, and I reject it.
  • I’ve worked in most areas of the financial markets, and have seen similar events happen in different markets.
  • I have quantitative skills, but I have spent a lot of time of economic history.
  • Having practiced as an actuary, I have additional skills analyzing liability structures, which are underanalyzed.

My perspective is different.  I don’t expect you to agree with me, because some of my views are “out there,” and I know that when I write it.  I sometimes write things knowing that there is no way that these will be adopted, absent major changes to society.  I write those, knowing that radical change is not impossible, and when change happens, they will need sensible guidelines.

So what have I written about?  From my categories:

Macroeconomics (898)
Stocks (814)
Bonds (770)
Portfolio Management (685)
Value Investing (463)
public policy (384)
Fed Policy (374)
Insurance (356)
Real Estate and Mortgages (354)
Structured Products and Derivatives (340)
Speculation (292)
Quantitative Methods (285)
Personal Finance (218)
Asset Allocation (172)
Book reviews (169)
Currencies (158)
Industry Rotation (133)
Blog News (123)
Ethics (117)
Accounting (113)
Pensions (109)
Banks (103)
General (100)
Academic Finance (82)
Best Articles (44)
Christianity (19)
The Rules (17)
Home Schooling (14)
Tweets (14)

I write about economics, stocks and bonds. That’s me.  I want to describe what is going on and how it affects those holding fixed claims (bonds), and variable claims (stocks).

After that, I write about portfolio management and value investing — how do we manage the assets that we own?

The next group is the guts of the market: how does government and Fed policy affect things?  How do insurance, real estate, and derivatives affect our lives?

Beyond those, I write about many things, and I appreciate that you read me.  Your time is valuable; thanks for reading me.

My Performance

My greatest fear when starting up my firm was that after having a great 10-year run with my own assets (and for an employer), that I would go cold when I started managing assets for others.  That is what has happened, with underperformance of 9%+ versus the S&P 500 over the last 16 months.  This is my worst sustained performance over the last 20 years.

I don’t think my methods are poor, nor am I planning on changing.  Every investment method goes through dry times; I have to live through this.

So what will I do?  I will persist in the strategies that have done so well for me  over the last 20 years.  I will continue to do value investing.

I don’t know that it will work, but I think it will.  Value investing is the reliable weak signal amid a lot of investment noise.

And so I act and invest.  My time is coming, and thanks for reading me.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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