Ethics – Page 2 – The Aleph Blog

On Investment Charlatans

Posted on 12 February 201613 February 2016 by David Merkel

Photo Credit: Alex Proimos || A bunch of con men attempt to bilk an unsuspecting lady

There are many ways to try to cheat people in the investment world. ?You can promise them:

No risk (an appeal to fear)
High returns (greed)
Secret knowledge (can appeal to either or both fear and greed)
An easy life, free from the worries common to man.
And more…

For virtually every human weakness or sin, there is a road to cheating men. ?This is why it is difficult to cheat a truly honest man, because an honest man is:

Industrious — he knows most ways to improve his lot in life involve considerable work, whether physical or mental.
Skeptical — he knows not everyone is honest, and there are many that pursue ways that harm themselves or others.
Self-controlled — he doesn’t need to become wealthy, but if it comes bit-by-bit, he can handle it.
Unafraid — he doesn’t scare easily, and there are many purported scares out there. ?There are always people trying to make money off of apocalyptic scenarios. ?(Believe me, in a truly apocalyptic scenario, where the government breaks down, or you lose a war on your home soil — no one wins. ?And, there is no way to prepare.)
Studious, and has wise?friends — he doesn’t quickly buy novel reasoning, or unfamiliar concepts without testing them, and running them past his personal “brain trust.”
Patient — he can’t be rushed into something, and he can walk away.
Virtuous — when he does commit, he holds to it, and makes good on what he promised. ?He expects the same of others, and does not deal with those of bad reputation.

There’s more, and I don’t hold myself out to be perfect here, but that is a part of what I aim for. ?If you are like this, you will be very difficult to cheat.

With that wind-up, here is the pitch: I ran across a video while doing my usual work, when I saw a picture of Buffett. ?Now, everyone wants to invoke Buffett because he is a genuinely bright guy on all affairs affecting money and wealth. ?Many who do so twist what Buffett has done for their own ends. ?You can see the graphic used to the left.

So this guy posits that Buffett got rich off of “Guaranteed Income Certificates.” ?You can listen to the whole 39-minute video, and never learn what a?Guaranteed Income Certificate is. ?This is a tactic to make you think that the video-maker has hidden knowledge. ?He does not lie, per se, but dances around what it is and how Buffett has used them. ?I figured out what he was talking about in a about two?minutes, but only because the language was so discursive, with many rabbit-trails.

So what is the vaunted?Guaranteed Income Certificate?

Preferred stock.

Preferred stock?

Yes, preferred stock, that hoary creation that gets wiped out when most firms go into bankruptcy. ?There are few cases where the preferred stock is worth anything in a crisis. ?It is far from guaranteed. ?It has all of the disadvantages of a bond, with none of the countervailing advantages of common stock, which can provide strong returns.

Geek note: why is preferred stock called preferred? ?Three, maybe four reasons:

Its dividend payment can only be unpaid if the common dividend is unpaid first. ?It has a dividend payment priority.

If the dividend is eliminated, preferred stockholders as a group typically gain representation on the Board of Directors.

In bankruptcy, they receive preference over the common shareholders when the company is recapitalized or liquidated. ?That said, in bad scenarios, their claim is the second lowest of all claims — behind the secured creditors, the government, lawyers, general creditors, bank debt, and unsecured bonds. ?Believe me, that preference on common shareholders is not a big protection.

The preferred dividend is usually, but not always higher than the common dividend.

All preferred stock is is a promise to pay dividends if the company can do so without going broke, and ahead of the common shareholders. ?Like all risky investments, you can lose it all. ?Average recovery in bankruptcy for?preferred?stock is?around 5 cents on the dollar, versus 40 cents for most bonds,and 80 cents on bank debt.

Now, Buffett has done some clever things with preferred stock that is convertible into common stock, or alongside common stock or warrants. ?Occasionally he has bought some regular preferred stock as an income vehicle for his insurance companies. ?But Buffett almost never plays merely for income, he wants the gains that come from stocks.

Now, I didn’t listen to the whole video — after five minutes of the beautiful voice dancing around the issue, I stopped it, right clicked, downloaded it, and went?to the end. ?As is common with these sorts of videos, it makes it sound easy, as if infinite income could be yours if you just buy this service. ?They sell you on what your dream life will be like: you will have more than enough money for vacations, you’ll never have to work again, you can spend as much time visiting the faraway grandchildren…

The guy who put the video together, and sells his service, was big on hiding things behind new names that he concocted:

Preferred stock becomes Guaranteed Income Certificates
Venture Capital / Private Equity becomes Doriot Trusts
Master Limited Partnerships?become Secret Oil income Streams
Royalty Trusts are treated as a novel investment, rather than the backwater that it is.

The presentation is also expert in lying with true statistics, making the ordinary sound extraordinary. ?It also has the “but wait, there’s more!” pitch, where they throw in a bunch of old reports to make the deal seem sweeter. ?The cost of the newsletter if saved for the very end — beware of those that won’t tell you the cost up front. ?Good deals will always show you the price early. ?Charlatans hide the price.

There are no secrets. ?There is no easy road to an easy, wealthy life. ?I want to end this post ?the way I ended a similar post called “On the 770 Account,” which was a code name for permanent life insurance. [Sigh. ?Oddly, that post still gets a lot of hits, probably because no one has stepped forward to call that one out.]

Final Note

THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT!

There is no secret club. ?There are no secret formulas. There are a lot of clever lawyers, accountants, and actuaries that the wealthy employ, but for average people, the high fixed costs won?t make it work.

If you want to be wealthy, you have to run your own firm, run it well, providing value to many. ?Don?t listen to those who say they have an easy way to wealth. ?They are lying, and are looking to make money off of you. ?Those who give you free advice are using you in some way. ?(Wait, what does that make me to be? Sigh.)

Signing off, your servant David, who does this for his own reasons?

Book Review: The Devil’s Financial Dictionary

Posted on 10 December 2015 by David Merkel

This book is not what I expected; it’s still very good. Let me explain, and it will give you a better flavor of the book.

The author, Jason Zweig, is one of the top columnists writing about the markets for The Wall Street Journal. ?He is very knowledgeable, properly cautious, and wise. ?The title of the book Ambrose Bierce’s book that is commonly called The Devil’s Dictionary.

There are three differences in style between Zweig and Bierce:

Bierce is more cynical and satiric.
Bierce is usually shorter in his definitions, but occasionally threw in whole poems.
Zweig spends more time explaining the history of concepts and practices, and how words evolved to mean what they do today in financial matters.

If you read this book, will you learn a lot about the markets? ?Yes. ?Will it be fun? ?Also yes. ?Is it enough to read this and be well-educated? ?No, and truly, you need some knowledge of the markets to appreciate the book. ?It’s not a book for novices, but someone of intermediate or higher levels of knowledge will get some chuckles out of it, and will nod as he agrees along with the author that the markets are a treacherous place disguised as an easy place to make money.

As one person once said, “Whoever called them securities had a wicked sense of humor.” ?Enjoy the book; it doesn’t take long to read, and it can be put down and picked up with no loss of continuity.

Quibbles

None

Summary / Who Would Benefit from this Book

If you have some knowledge of the markets, and you want to have a good time seeing the?wholesome image of the markets?skewered, you will enjoy this book. ?if you want to buy it, you can buy it here: The Devil’s Financial Dictionary.

Full disclosure:?The author sent a free copy?to me via his publisher.

If you enter Amazon through my site, and you buy anything, including books, 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.

Stocks That Can Double, Can Give You Trouble

Posted on 2 December 2015 by David Merkel

I haven’t written about promoted penny stocks in a long time. ?Tonight I am not writing about promoted stocks, only penny stocks as promoted by a newsletter writer. ?He profits from the newsletter. ?Ostensibly, he does not front-run his readers.

Before we go on, let me run the promoted stocks scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 12/1/15	Decline	Annualized	Dead?
GTXO	5/27/2008	2.45	0.011	-99.6%	-51.5%
BONZ	10/22/2009	0.35	0.000	-99.9%	-68.5%
BONU	10/22/2009	0.89	0.000	-100.0%	-100.0%
UTOG	3/30/2011	1.55	0.000	-100.0%	-100.0%	Dead
OBJE	4/29/2011	116.00	0.000	-100.0%	-100.0%	Dead
LSTG	10/5/2011	1.12	0.004	-99.6%	-74.2%
AERN	10/5/2011	0.0770	0.0001	-99.9%	-79.8%
IRYS	3/15/2012	0.261	0.000	-100.0%	-100.0%	Dead
RCGP	3/22/2012	1.47	0.180	-87.8%	-43.4%
STVF	3/28/2012	3.24	0.070	-97.8%	-64.7%
CRCL	5/1/2012	2.22	0.001	-99.9%	-87.2%
ORYN	5/30/2012	0.93	0.001	-99.9%	-85.4%
BRFH	5/30/2012	1.16	1.000	-13.8%	-4.1%
LUXR	6/12/2012	1.59	0.002	-99.9%	-86.3%
IMSC	7/9/2012	1.5	0.495	-67.0%	-27.9%
DIDG	7/18/2012	0.65	0.000	-100.0%	-100.0%
GRPH	11/30/2012	0.8715	0.013	-98.5%	-75.4%
IMNG	12/4/2012	0.76	0.012	-98.4%	-75.0%
ECAU	1/24/2013	1.42	0.000	-100.0%	-94.9%
DPHS	6/3/2013	0.59	0.005	-99.2%	-85.5%
POLR	6/10/2013	5.75	0.005	-99.9%	-94.2%
NORX	6/11/2013	0.91	0.000	-100.0%	-97.5%
ARTH	7/11/2013	1.24	0.245	-80.2%	-49.3%
NAMG	7/25/2013	0.85	0.000	-100.0%	-100.0%
MDDD	12/9/2013	0.79	0.003	-99.7%	-94.5%
TGRO	12/30/2013	1.2	0.012	-99.0%	-90.9%
VEND	2/4/2014	4.34	0.200	-95.4%	-81.6%
HTPG	3/18/2014	0.72	0.003	-99.6%	-95.9%
WSTI	6/27/2014	1.35	0.000	-100.0%	-99.9%
APPG	8/1/2014	1.52	0.000	-100.0%	-99.8%
CDNL	1/20/2015	0.35	0.035	-90.0%	-93.1%

	12/1/2015		Median	-99.9%	-87.2%

If you want to lose money, it is hard to do it more consistently than this. ?No winners out of 31, and only one company looks legit at all — Barfresh.

But what of the newsletter writer? ?He seems to have a couple of stylized facts that are misapplied.

Every day, around 45 stocks double or more in price.
Some wealthy investors have bought stocks like these.
Wall Street firms own these stocks but never recommend them to ordinary individuals
The media censors price information about these stocks so you never hear about them

Every day, around 45 stocks double or more in price.

That may be true, but most of those that do double or more in price don’t do so for fundamental reasons; they are often manipulated. ?Second, the stocks that do double in price can’t be found in advance — i.e., picking the day that the price will explode. ?Third, the prices more often fall hard for these tiny?stocks. ?Of the 30 stocks mentioned above that were not dead at the time of the last article, 10 fell more than 90% over the 10+ month period. ?13 fell less than 90%, 1 broke even, and 7 rose in price. ?The median stock fell 61%. ?This was during a bull market.

Now you might say, “Wait, these are promoted stocks, of course they fell.” ?Only the last one was being actively promoted, so that’s not the answer.

My fourth point is for the few that rise a lot, you can’t invest in them. ?The stocks that double or more in a day tend to be the smallest of the stocks. ?Two of the 30 stocks listed in the scoreboard?rose 900% and 7100% in the 10+ month period since my last article. ?How much could you have invested in those stocks? ?You could have bought both companies for a?little more than?$10,000 each. ?Anyone waving even a couple hundred bucks could make either stock fly.

So, no, these stocks aren’t a road to riches. ?Now the ad has stories as to how much money people made at some point buying the penny stocks. ?The odds of stringing several of these successful purchases in succession, parlaying the money into bigger and bigger stocks that double is remote at best, and your odds of losing a lot of it is high.

This idea is a less classy version of the idea promoted in the book?100 to 1 in the Stock Market. ?If it is difficult to find the 100-baggers 30 years in advance, it is more difficult to find a stock that is going to double or more tomorrow, much less a bunch of them in succession. ?You may as well go to Vegas and bet it all on Double Zero on the roulette wheel four times in a row. ?The odds are about that bad, as trying to get rich buying penny stocks.

The ad also lists three stock that at some point fit his paradigm — MeetMe [MEET],?PlasmaTech Biopharmaceuticals, Inc. (PTBI) which is now called?Abeona Therapeutics Inc. (ABEO), and?Organovo (ONVO). ?All of these are money-losing companies (MeetMe may be breaking into profitability?now) that have survived by selling shares to raise cash. ?The stocks have generally been poor. ?Have they had volatile days where the price doubled? ?At some point, probably, but who could have picked the date in advance, and found liquidity to do a quick in-and-out trade?

The author lists five future situations as a “come on” to get people to subscribe. ?I find them dubious.

As for wealthy investors, he mentions two: Icahn pulling of a short squeeze on Voltari (difficult to generalize from), and Soros with?PlasmaTech Biopharmaceuticals, Inc. ?It should be noted that Soros has a big portfolio with many stocks, and that position was far less than 1% of his assets. ?In general, the wealthy do not buy penny?stocks.

As for brokers and the media not mentioning penny stocks, that is being responsible. ?The brokers could get in hot water for recommending or buying penny stocks even under a weak suitability standard. ?The media also does not want to be blamed for inciting destructive speculation. ?Retail investors lose enough money through uninformed trading, why encourage them to do it where fundamentals are typically quite poor.

I’ve written two other pieces on less liquid stocks to try to explain the market better:?On Penny Stocks and?Good Over-the-Counter ?Pink? Stocks. ?It’s not as if there isn’t value in some of the stocks that “fly under the radar.” ?That said, you have to be extra careful.

Near the end of the ad, the writer describes how he is being extra careful also. ?Many of his rules make a lot of sense. ?That said, following those rules will get you boring companies that won’t double or more in a day. ?And that’s not a bad thing. ?Most significant money is made slowly — it doesn’t come in a year, much less in a day.

That said, I recommend against the newsletter because of the way that it tries to attract people. ?The rhetoric is over the top, and appeals to those who sense conspiracies keeping them from riches, so join my club where I hand out my secret knowledge so you can benefit.

In summary, as a first approximation, don’t invest in penny stocks. ?The odds are against you. ?Fools rush in where angels fear to tread. ?Don’t let greed get the better of you — after all, what is being illustrated is?an illusion that ?retail investors can’t generally achieve.

On Partnership Investing

Posted on 7 May 2015 by David Merkel

Tonight’s topic comes from a note sent to me by a friend. Here it is:

David, I have heard you say that you have entered into partnerships in the past.? What are your rules for partnerships, who will you enter with?? I have a neighbor who is interested in starting a business, the start up cash is small $5000.? I think there might be good opportunity, but I am concerned for good reason about my time availability, as well as Not being “unequally yoked”.? What business relations do Paul’s words govern.? do you have different rules for minority, majority, or controlling shares?

I appreciate your thoughts.

I have two “partnership” investments. ?One is very successful and is an S Corporation. ?The other is a limited partnership, and I wonder whether it will ever amount to anything. ?Both were done with friends.

There are a few?things that you have to think about with partnerships:

Is your liability limited to the amount of money you invested, or could you be on the hook for more if there are losses/lawsuits?
Are there likely to be future periods where capital might need to be raised? ?Under what conditions will that be done?
What non-capital obligations are you?taking on as a result of this? ?Labor, counsel, facilities, tools, etc?
How will profits and losses be allocated? ?Voting interests??How will it be managed??When will the partnership end? ?How can terms be modified? How can partnership interests be transferred, if at all? ?Etc.
Do you like the people that you will be partners with? ?You may be partners for a long time.
Be ready for the additional tax complexity of filling out schedule C, or a K-1, or some other tax form.

Go into a partnership with your eyes wide open, and check everything. ?If your partnership interests have limited liability, and the economics are structured similar to that of a corporation, then things are clearer, and you don’t have to worry as much.

Take note of any obligations that you might have that don’t fit into the “passive provider of limited capital with proportionate ownership” framework. ?Those obligations are the ones that need greater scrutiny. ?Include in that how those working on the partnership get compensated for their labor. ?Parties to the partnership may have multiple roles, and there can be conflicts of interest — imagine a partnership where one partner works in the business and receives a large salary, thus depressing profits for the non-working partners. ?How does that conflict of interest get settled? ?(Note that the same problems that exist in being an outside, passive, minority public stock investor reappear here.)

Also be aware of how ownership interests can change, and whether you may be forced to add more capital to maintain your proportionate interest in the business.

Try to have a good sense of the skill of the partner or employee managing the business. ?That makes all the difference in whether a business succeeds.

Most of what I say here assumes that you will not be a controlling majority partner, and that you will have limited influence over the business. ?If you do have control, the?problems of getting cheated by someone else go away, but get replaced with the problem of making sure the business is run adequately for the interests of all partners. ?Your ethical obligations also expand.

You mention the “unequally yoked” passage from Second Corinthians 6, verses 14 and following. ?In one sense, that doesn’t have much?more application here than it does in all investing if one is a Christian. ?Don’t involve yourself in businesses that of necessity involve you in things that you would not do yourself as a Christian. ?Don’t invest in enterprises where it is obvious that management does not care about ethics — you can see it in their behavior. ?This will be a little clearer and close to home in a partnership with a friend — you will know a lot more about what is going on.

With a non-limited partnership, there is an?additional way the “unequally yoked” passage applies. ?You expose your entire economic well-being to risk when you are a general partner. ?It is like a marriage — it is very difficult to negotiate your way out of the unlimited guarantee that you make there. ?It is like being a co-signer, which the Bible says to avoid.

Of itself, that doesn’t expose you to the unequal yoke, but when you are in an economic agreement that binding, if your partner takes the business in an ethical direction you find dubious, you will be in a weak position to do something about this. ?There is where the unequal yoke appears amid unlimited liability.

That’s all for now. ?There’s a lot more to consider here, but this is meant to be an introduction to the issues involved in partnerships. ?Hope it works well for you.

The SEC Pursues a Fool’s Errand

Posted on 6 May 2015 by David Merkel

I imagine the SEC (or the Fed, IRS, or the FSOC) saying: “If we only have enough data, we can answer the policy questions that we are interested in, create better policy, prosecute bad guys, and regulate markets well.”

If they deigned to listen to an obscure quantitative analyst like me, I would tell them that it is much harder than that. ?Data is useless without context and interpretation. ?First, you have to have the right models of behavior, and understand the linkages between disparate markets. ?Neoclassical economics will not be helpful here, because we aren’t rational in the ways that the economists posit.

Second, in markets you often find that causation is a squirrelly concept, and difficult to prove statistically. ?Third, the question of right and wrong is a genuinely difficult one — what is acceptable behavior in markets? ?Do we run a market for “big boys” who understand that this is all “at your own risk,” or a market that protects the interests of smaller players at a cost to the larger players? ?Do we run a market that encourages volume, speed and efficiency, or one that avoids large movements in prices?

This article is an attempt to comment on the Wall Street Journal article on the SEC’s effort to create the?Consolidated Audit Trail [CAT], in an effort to prevent future “flash crashes,” like the one we had five years ago. ?I don’t think the efforts of the SEC will work, and I don’t think the goal they are pursuing is a desirable one.

People take actions in the markets for a wide number of reasons. ?Some are hedging; some are investing; others are speculating. ?Some invest for long periods, and others for seconds, and every period in-between. ?Some are intermediaries, while others are direct investors. ?Some are in one market, while others are operating in many markets at once. ?Some react rapidly, and others trade little, if at all. ?Just seeing that one party bought or sold a given security tells you little about what is going on and why.

Following price momentum works as an investment strategy, until the volume of trading following momentum strategies gets too high. ?Then things go nuts. ?Actions that by themselves are innocent may add up to an event that is unexpected. ?After all, that is what dynamic hedging led to in 1987. ?There was no sinister cabal looking to drive the market down. ?And, because the event did not reflect any fundamental change to?where valuations should be, price came back over time.

My contention is even with the huge amount of data, there will still be alternative theories, information that might be material excluded, and fuzziness over whether a given investment action was wrong or not.

After that, we can ask whether the proposed actions of the government provide any significant value to the market. ?Some are offended when markets move rapidly for seemingly no reason, because they?lose money on orders placed in the market at that time. ?There is a much simpler, money saving solution to that close to home for each investor: DON’T USE MARKET ORDERS! ?Set the?price levels for your orders carefully, knowing that you could get lifted/filled at the level.

This is basic stuff that many investors counsel regarding investing. ?If you use a market order you could get a price very different than what you anticipate, as I accidentally experienced in this tale. ?I could complain, but is the government supposed to protect us from our own neglect and stupidity? ?If we wanted that, there is no guarantee that we would end up with a better system. ?After all, when the government sets rules, it does not always do them intelligently.

One of the beauties of capitalism is that it enables intelligent responses as a society to gluts and shortages without having a lot of rules to insure that. ?Volatility is not a problem in the long run for a capitalist society.

If you lose money in the short run due to market volatility, no one told you that you had to trade that day. ?Illogical market behavior, as in 1987 or the “flash crash” could be waited out with few ill effects. ?Most of the difficulties inherent in a flash crash could be solved by people taking a longer view of the markets, and thinking like businessmen.

“It’s Baseball, Mom.”

I often spend time watching two of my younger children play basketball,?baseball and softball. ?They are often in situations where they might get hurt. ?In those situations, after an accident, my wife gets antsy, while I watch to see if a rare?severe injury has happened. ?My wife asked one of my sons, “Don’t you worry about getting hurt?” ?His response was,?”It’s Baseball, Mom. ?If you don’t get hurt every now and then, you aren’t playing hard enough.” ?That didn’t put her at ease, but she understood, and accepted it.

In that same sense, I can tell you now that regardless of what the SEC does, there will be accidents, market events, and violent movements. ?There will be people that complain that they lost money due to unfair behavior. ?This is all a part of the broader “game” of the markets, which no one is required to play. ?You can take the markets on your own terms and trade rarely, and guess what — you will likely do better than most, and avoid short-term volatility.

The SEC can decide what it wants to do with its scarce resources. ?Is this the best use for the good of small investors? ?I can think of many other lower cost ways to improve things… even just hiring more attorneys to prosecute cases, because most of the true problems the SEC faces are not problems of knowledge, but problems of the will to act and bear the political fallout for doing so. ?And that — is a different game of baseball.

It’s Their Money

Posted on 22 November 201417 April 2023 by David Merkel

Recently, I had a client leave me. I’m not sure why he did — I didn’t ask, because that’s his business. It *is* his money, after all, not mine. After deducting the accrued fee, I thanked him for his business, and wished him well.

I try to be low pressure in my work. I also try to discourage the idea that if someone uses my services, they will do better than the average, much less phenomenally. I remind potential clients of what happened to stocks in the Great Depression (down almost 90% during a period in 1929-1932). I ask potential clients to stick with me through a full cycle of the market, but I don’t require it because:

It’s their money.

One thing I do promise them is that my money is on the line in the exact same proportion as their money. Over 90% of my liquid wealth is invested in my stock portfolio. I don’t make any decisions for clients that I would not make for myself, mostly for ethical reasons. But I make sure of it, because I am still my largest client, and I am always on the same side of the table as my clients, aside from my one and only source of revenue, my fee.

It’s their money, but, when it is under my care, it gets the close treatment that my own money receives — no more and no less.

Many wealth/asset managers want as much of a client’s assets as possible. Me I get uncomfortable when more than 50% of their assets are riding on me, but if that’s what the client wants, I will do it if they ask, because:

It’s their money.

Jesus, inverting Hillel, said “Do unto others, as you would have them do unto you.” That guides my marketing, because I know that many people feel pestered by those who market to them, including those who once they have their foot in the door, now want the whole relationship. Thus I avoid as much pressure as possible in marketing, and leave it to the good judgment of my clients as to how much they want to entrust to my care, and for how long.

It’s their money.

I don’t pretend to have all of the answers, or even all of the questions. If one of my clients asks me an unrelated question, and I have the time and expertise to aid them as a friend (i.e., you can’t sue me), I will take some time to help. They may ask me about what other managers are doing for them, asset allocation, insurance policies, and other things also. I will give them friendly advice, without any other expectation. I thank them that they are a client of mine — I try to end all of my client letters with that. In the end, I want them to be happy that they chose me to aid them, and to be happy when they leave as well.

That’s the way I would like to be treated as well — low pressure, transparency of services and fees, and alignment of interests with an ethical adviser who is a fiduciary.

Back to the beginning, aside from the client leaving me, the other reason I write this is all of the pitches I have been getting via e-mail, web, radio, etc., where I say to myself “How can they promise that?” “Doesn’t that break the ‘No Testimonials’ rule?” “Great to be selling advice and seminars — why not start an investment business and prove your theories?”

The investment business has more than its share of those who don’t deliver value, and I labor to be on the positive side of that ledger, as do many others. Choose those who will treat you as you deserve to be treated, and enjoy the benefits, because:

It’s your money.

Book Review: Berkshire Beyond Buffett

Posted on 29 October 2014 by David Merkel

It’s time to change what Warren Buffett supposedly said about his mentors:

“I’m 85% Ben Graham, and 15% Phil Fisher.”

For those who don’t know, Ben Graham is regarded to be the father of value investing, and Phil Fisher the father of growth investing. ?Trouble is, Warren Buffett changed in his career such that this is no longer accurate. ?Most of Buffett’s economic activity does not stem from buying and selling?portions of public companies, but by buying and managing whole companies. ?Buffett is the manager of a conglomerate that uses insurance reserves as a funding vehicle.

As a result, this would be more accurate about the modern Buffett:

Buffett is?70% Henry Singleton,?15% Ben Graham, and 15% Phil Fisher.

Henry Singleton was the CEO of Teledyne, a very successful conglomerate, and one of the few to do well over a long period of time. ?It is very difficult to manage a conglomerate, but Teledyne survived for around 40 years, and was very profitable. ?Buffett thought highly of Singleton as a allocator?of capital, though the conglomerate that Buffett created is very different than Teledyne.

Tonight, I am reviewing a book that describes Buffett as a manager of a special conglomerate called Berkshire Hathaway [BRK] — Berkshire Beyond Buffett. ?This Buffett book is different, because it deals with the guts of how Buffett created BRK the company, and not the typical and misleading Buffett as a value investor.

Before I go on, here are three articles that could prove useful for background:

Buffett?s Career in Less Than 1000 Words, and
The Forever Fund?– deals with the Burlington Northern Acquisition, and Buffett’s efforts to create a firm that will thrive long after he is gone.
On the Structure of Berkshire Hathaway?– describes how the insurance enterprises, particularly National Indemnity, own and fund many of the industrial subsidiaries.

The main point of Berkshire Beyond Buffett is that Buffett has created a company that operates without his detailed oversight. ?As a result, when Buffett dies, BRK should be able to continue on without him and do well. ?The author attributes that to the ethical values that Buffett has?selected for when acquiring companies. ?He manages to cram those values into an acronym BERKSHIRE.

I won’t spoil the acronym, but it boils down to a few key ideas:

Do you have subsidiary managers who are competent, ethical, and love nothing better than running the business? ?Do they act as if they are the sole proprietors?of the business, and act only to maximize its long-term value consistent with its corporate culture? ?These are the ideal managers of BRK subsidiaries.
Acquiring such companies often comes about because a founder or significant builder of the company is getting old, and there are family, succession, taxation, funding or other issues that being a part of BRK would solve, allowing the management team to focus on running the business.
Do the businesses have sustainable competitive advantages in markets that are likely to be relevant several generations from now?

The beauty of a company coming under the Berkshire umbrella is that Buffett leaves the culture alone, and so long as the company is producing its profits well, he continues to leave them alone. ?Thus, the one selling a company to Buffett gets the benefit of knowing that the people and culture of the company will not change. ?In exchange, Buffett does not pay top dollar, but gets deals done faster than almost anyone else.

This is a very good book, and its greatest strength is that it talks about Berkshire Hathaway the company as built by Buffett to endure. ?If you want to understand?Buffett’s corporate strategy, it is described ably here.

Quibbles

Now, my three ideas above?*might* have been a better way to organize the book, rather than the hokey BERKSHIRE. ?Also, a lot more could have been done with the insurance enterprises of BRK, which are a critical aspect of how the company owns and finances many of the other subsidiaries.

But will BRK do so well without Buffett? ?Yes, his loyal son Howard will guard the culture. ?The Board is loyal to the ethos that Buffett has created. ?Ted Weschler and Todd Combs will continue to invest the public money. ?The all-star subsidiary managers will soldier on, at least in the short-run.

But will the new CEO be the person that “you don’t want to disappoint,” as some subsidiary managers think of Buffett? ?As a result, how will BRK deal with underperformers? ?What new structures will they set up? ?Tracy Britt Cool is smart, but will BRK need many like her, and how will they be organized?

Will he be a great capital allocator? ?Will he maintain the “hands off” policy toward the culture of subsidiaries, or will the day come when some centralization takes place to save money?

Will Buffett’s replacement be equally intuitive with respect to acquisition prices, and sustainable competitive advantage?

Buffett’s not perfect — he has had his share of errors with textiles, shoe companies, airlines, Energy Future, and a variety of other investments, but his record will be tough to match, even if replaced by a team of clever people. ?Say what you will, but teams are not as decisive as a single manager, and that may be a future liability of BRK.

Summary / Who Would Benefit from this Book

Most people will not benefit from this book if they are looking for a way to make more money in their life. ?There are no magic ways to apply the insights of the book for quick gains. ?Also, readers are unlikely to use Buffett’s “hands off” methods in building their own conglomerate. ?But readers will benefit because they will get to consider the building of the BRK enterprise from the basic principles involved. ?There will be?indirect benefits as they analyze other business situations, perhaps using BRK as a counterexample — a different way to acquire and run a large enterprise.

But as for getting any direct benefit from the book? There’s probably not much, but you will understand business better at the end. ?If you still want to buy it, you can buy it here:?Berkshire Beyond Buffett: The Enduring Value of Values.

Full disclosure:?I?received a?copy from the author?s PR flack.

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.

Full Disclosure: long BRK/B for clients and myself

The Future Will Be Like The Past, Only More So

Posted on 9 October 2014 by David Merkel

Photo Credit -- Javier || Buffett believes in America — Photo Credit — Javier || Buffett believes in America

Yesterday there was an article where Buffett was quoted on getting mortgages to buy houses. Let me quote the most relevant portion:

?You would think that people would be lining up now to get mortgages to buy a home,? Buffett said today at a conference hosted by Fortune magazine in Laguna Niguel,California. ?It?s a good way to go short the dollar, short interest rates. It is a no-brainer. But so far home construction pickup has been slower than I had anticipated.?

Now, when I read the comment stream on the article, I was not surprised at the level of disagreement, but the vitriolic nature of the the disagreement. ?Buffett is certainly not made of Teflon anymore, and fame has led to its share of detractors.

Now, I don’t think that Buffett is giving the right advice to everyone here, but I also don’t think that he is talking his book because has has investments in?firms that sell:

Real estate
Manufactured housing
Building materials
Mortgages
Etc.

Indeed, Buffett has enough investments that almost anything he says could be talking his book. ?I think his character is such that he does not talk his book — his firm is one that is built on “low hype” attitudes, at least, low hype for a company of its size and complexity.

Should everyone run out and get a mortgage because it is a cheap time to be borrowing money? ?That is an individual question, hinging on how secure and high your income is versus the likely payment on the mortgage, and other housing-related expenses.

The interest rate may indeed be low relative to history, but how well will the economy do in the future? ?Maybe residential?housing is too expensive in some areas to get a lot of people excited about buying.

Buffett also said:

?Household formation falls off dramatically in a recession, at least initially,? he said. ?But that doesn?t last long. Hormones kick in and in-laws get tiresome, too.?

Unless something changes in US culture, there have been changes to the demand for homes, driven by the following factors:

People are marrying later and less frequently
They are having fewer kids
Urban areas are more attractive for many people to live in, reducing commute time and costs. ?Even car-buying is affected.
There are fewer move-up buyers because of the financial crisis.
The ability of lower middle class people to afford homes has been reduced, particularly in high cost of living areas.
The financial crisis has ruined the illusion that residential real estate is an investment that can’t lose money.

There may be more reasons, but even though the 30-year mortgage is the cheapest long-term financing that an average person can get, there are more people than before who are not interested in buying a home. ?Renting suits their goals fine.

As such, I think Buffett is wrong here, and that borrowing to buy residential housing will not be as prominent as it was in the past. ?But I don’t think he has any bad intentions in what he said — he believes in America, and thinks that we will return to the consumption patterns of the past, which relied on too much debt in my opinion.

Final note: I’m getting tired of reading comment streams. ?The people there are often too cynical, and too loose with the truth. ?Their expectations for what they deserve in this life are also inflated beyond what is reasonable. ?Some turn to conspiracy theories to keep themselves from blaming their bad fortune on their own actions.

Buffett is generally a good guy, and a good example as far as businessmen go — he does not deserve the abuse. ?I don’t agree with Buffett’s politics, but I don’t think that he is not sincere.

Full disclosure: long BRK/B and WFC

Inevitable Ineffective Banking Regulation

Posted on 1 October 20141 October 2014 by David Merkel

I am mystified at why people might be outraged or surprised that the Federal Reserve does a poor job of overseeing banks. ?The Fed is an overstaffed bureaucracy. ?Overstaffed bureaucracies always tend toward consensus and non-confrontation.

I know this from my days of working as an actuary inside an overstaffed life insurance company, and applying for work in other such companies. ?I did not fit the paradigm, because I had strong views of right and wrong, and strong views on how to run a business well, which was more aggressive than the company that I worked for was generally willing to do. ?Note that only one such company was willing to hire me, and I nearly got fired a couple of times for proposing ideas that were non-consensus.

This shouldn’t be too surprising, given the past behavior of the Fed. ?In 2006, the Fed made a few theoretical noises about residential real estate loan quality, but took no action that would make the lesser regulators do anything. ?It’s not as if they didn’t have the power to do it. ?One of the great canards of financial reform is that regulators did not have enough power to stop the bad lending. ?They most certainly did have enough power; they just didn’t use it because it is political suicide to oppose a boom. ?(Slide deck here.)

As a result, I would not have enacted Dodd-Frank, because I like my laws simple. ?Instead, I would have fired enough?of the regulators to make a point that they did not do their jobs. ?How many financial regulators were fired in 2008-2009? ?Do you hear the crickets? ?This is the #1 reason why you should assume that it is business as usual in banking regulation.

You won’t get assiduous regulation unless regulators are dismissed for undue leniency. ?I have heard many say in this recent episode with Goldman Sachs, the New York Fed, and?Carmen Segarra that those working for the Fed are bright and hard-working. ?I’ll give them the benefit of the doubt; my own dealings with those that work for the Fed is that most of them, aside from bosses,?are quiet, so you can’t tell.

Being quiet, and favoring the powerful, whether it is bosses, politicians, or big companies that you regulate is the optimal strategy for advancement at the Fed over the last 30 years. ?It doesn’t matter much how bright you are, or how hard you work, if it doesn’t have much impact on the organization’s actions.

I try to be an optimistic kind of guy, but I don’t see how this situation can be changed without firing a lot of people, including most of the most powerful people at the Fed, lesser banking regulators, and US Treasury.

And if we did change things, would we like it? ?Credit would be less available. ?I think that would be an exceptionally good thing, but most of our politicians are wedded to the idea that increasing the availability of credit is an unmitigated good. ?They think that because they don’t get tagged for the errors. ?They take credit for the bull market in credit, and blame everyone except themselves and voters for the inevitable bear market.

Also, if we did fire so many people, where would we find our next crop of regulators? ?Personally, I would hand banking regulation back to the states, and end interstate branching, breaking up the banks in the process.

Remember, the insurance industry, regulated by the states, is much better regulated than the banking industry. ?State regulators are much less willing to be innovative, and far more willing to say no. ?State regulation is simple/dumb regulation, which is typically good regulation.

But whether you agree with my policy prescription or not, you should be aware that things are unlikely to change in banking regulation, because it is not a failure of laws and regulations, but a failure of will, and we have the same sorts of people in place as were there prior to the financial crisis.

Postscript

I would commend the articles cited by Matt Levine of Bloomberg regarding this whole brouhaha:

A bit more on Carmen Segarra.

Apparently the place to discuss regulatory capture is on Medium. Here is Dan Davies:

Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors.
So banks never need to listen to their line-level regulators because they can always get those regulators’ bosses’ bosses’ bosses to overrule them. Here is Felix Salmon, mostly agreeing. And here is Alexis Goldstein with a litany of Fed enabling of banks. Elsewhere, Martien Lubberink explains the transaction that got so much attention in the Fed tapes, in which Goldman agreed to hang on to some Santander Brasil stock for a year before delivering it to Qatar. He thinks it was pretty vanilla. And Adam Ozimek has a good point:

This American Life ep should lower avg est corruption belief. Goldman and NY Fed secretly taped & all u get is in non-confrontational nerds?

End the “Code of Silence”

Posted on 12 September 2014 by David Merkel

8407717744_fa2d32cc4d_z — Photo Credit: Jemma D

I was asked to contribute to a survey recently, and one question made me think. ?It was a question about why don’t more people consult investment professionals, and What keeps them from doing so. ?I gave a fairly standard answer for me:

There are two reasons: first, most people don’t have enough income or assets for investment professionals to have value to them. Second, people don’t understand what investment professionals can do for them, which is:

They can keep you from panicking or getting greedy
They can find ways to reduce your tax burdens
They can diversify your assets so that you are less subject to large drawdowns in the value of your assets

After I wrote it, I submitted it for publication, but I wasn’t really happy with my answer. ?The thing that left me less than happy are the various tales that I hear where investment advice is subpar, communicated poorly, etc. ?Personally, I expect the real reason many people don’t consult investment professionals is fear of a bad experience, which may often stem from a a bad experience that they have had or a friend my have had.

I sympathize with the goals of the CFA Institute’s Future of Finance Initiative. ?That said, I think it is a nice-sounding idea that won’t get far. ?I have four?main reasons why:

We don’t have a financial system where all financial professionals have to be under a common ethics code, with additional ethics code sections for areas of specialization.
We don’t have a culture among investment professionals that really wants to clean up the system, and talk about abusive practices, such that they become well-known and go away.
We don’t have enough of a culture among investment professionals that wants to genuinely educate the investors that want it, and in ways that don’t directly benefit us.
Because we don’t have one unified theory of investing, there will be enough gray areas where people will still get hurt by professionals.

On the first point, I would note a recent article of mine on self-regulation financial markets, where I said:

The guy from the National Futures Association emphasized the idea that mandatory membership in the association as a requirement to do business was paramount for an SRO and I can see that. ?The SRO then has the ?death penalty? hanging over the heads of those they regulate. ?That said, consider this: the CFA Institute may dream of the day when all involved in investing *must* hold a?CFA Charter.

I have no doubt that this would be a good thing. ?Ethics codes are good for the industry, and to kick out bad apples would be a good thing.

On the second point, it would be worthwhile for financial writers and some larger firms to take on common practices that are?abusive. ?This will be controversial, because not everyone will agree on every item, but even getting a stoplight list where red is bad practices, green is good practices, and yellow means be careful would be a good start.

On the third point, we need to advocate for the best practices even where it doesn’t exactly fit where our businesses make profits. ?Think of it this way: it often helps in home repair when someone who comes to fix one thing gives me some free advice on another matter that he doesn’t do, but sees it and tells me. ?That builds goodwill for a later date, because I know that person cares about me, and not just what I pay him.

On the last point, my earlier article went over many of the disagreements:

Ethics aren?t neutral; people disagree about what is right and wrong to a high degree.? Even in finance, there are considerable disagreements in what is the correct behavior:

Active vs Passive mangement

Value vs Growth

Does Technical Analysis work?? (Is there truly a single discipline there?? I don?t think so.)

That?s a considerable reason why it would be difficult to enforce the views of the CFA Institute over the markets.? There is no commonly agreed-upon view of how the markets work.? The views of the academics are ridiculous, and do not reflect market realities. But many asset allocators trust them, even though their results are poor.

But even if this results in some squabbles, at least people can be aware that there are differences of opinion, and maybe that can inform the way we talk to clients. ?Long only managers should tell their clients to buckle in, because they do not time the markets. ?Traders should tell clients that they won’t do well in choppy markets, and that methods to limit losses and let gains run have their limitations. ?Time horizons for investment decisions should be clearly identified, so that investors can set their expectations reasonably.

And that could be the best part of this: if investors have a good idea up front of how an investment will likely perform in a variety of scenarios, there will be fewer negative surprises, and hopefully, happy clients.

Anyway, that’s what I think the goals should be. ?Now, who else wants to make them practical, and be willing to speak up about this?