Today I saw an article about a high school investing contest, and like most contests of that type, it does not teach investing, but speculation.

I’ve wanted to try this for about ten years or so.  I’d like to try running a stock picking contest, but only if I can offer decent prizes, and get enough participants.  I’ve written about this before, these would be the rules:

  1. No leverage and no shorting
  2. No trading — buy & hold
  3. No Exchange Traded Products, and only common stocks
  4. Minimum market capitalization of $100 million
  5. Only stocks traded on US exchanges
  6. Forced diversification — a portfolio of ten stocks equally weighted
  7. One stock from each of ten volatility buckets, to reduce speculation
  8. Highest geometric mean return wins — this gives a bonus to consistency, which also reduces speculation.  (Alternative rule: the best return on the seventh best stock in each portfolio wins.)
  9. Six month time frame.
  10. One entry per person.

The most critical rules are seven and eight.  The idea is to get people to think like investors, not speculators.  By forcing investors to buy a broad range of companies from conservative to aggressive will force them to evaluate individual companies, with an eye to avoiding big losers.  Rule number one, as many say, is don’t lose money.  This would honor the idea of avoiding losses while trying to make gains.  It would be a lot like what intelligent investing in a portfolio of stocks is really like.

The idea is to promote stock-picking.  Now lest you think I have taken all of the speculation out of this, let me tell you what my rules don’t stop:

  • Factor tilts — you can assemble a portfolio with price momentum
  • Industry and sector tilts
  • Foreign tilts
  • Size tilts
  • Valuation tilts
  • Investing in special situations
  • Copying famous investors

Now, Who Would Be Sponsors?

I can’t fund this on my own.  Also, I don’t think registration fees could fund such a contest.  Parties that could benefit from the branding and free advertising would include financial information companies and brokerages — they are some of the logical beneficiaries of promoting stock-picking.  So, would the following consider sponsoring such a contest?

  • Wall Street Journal, Yahoo Finance, Bloomberg, Marketwatch, Reuters, Money, Value Line, theStreet.com, etc.
  • Nasdaq OMX, Intercontinental Exchange
  • Schwab, E-Trade, Scottrade, Interactive Brokers, Ameritrade, Fidelity, ETrade, etc.

I don’t know, but I would want to have at least 1,000 entrants and $50,000 in prize money if were going to run a contest like this.  I’m sure it would be a lot of fun, and would teach investors a lot about investing, as opposed to speculation.

Thoughts?  Send them to me.  (Especially if you are interested in sponsoring the event.)

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.

Photo Credit: Matthias Ripp

Photo Credit: Matthias Ripp || Some bad ideas should be locked away…

Dan Primack of Fortune wrote in his daily email:

Saving unicorns from themselves? There was an interesting piece last week from Martin Peers in The Information (sub req), arguing that the private markets need some sort of shorting mechanism so that there is a check on unreasonable valuation inflation. It would make the market more efficient, Peers argues, even though implementation would require several structural changes (particularly to stock transfer rules). He writes:

“Private companies will probably resist the development of a short-selling market, given it would hurt valuations, which in turn can undermine the value of employee option programs, and give them less control over their shareholder group. But those risks are likely to be outweighed by the long term benefits of bringing more buyers into the market and ensuring the company’s valuation can be sustained outside of the constraints of the private market.”

Leaving out the technical difficulties — including the lack of ongoing price discovery — one big counter could be that shorts didn’t so much to stop the earlier dotcom bubble (which largely took place in the public markets).

Adam D’Augelli of True Ventures pointed me to a 2002 academic paper (Princeton/London Biz School) that found “hedge funds during the time of the technology bubble on the Nasdaq… were heavily tilted towards overpriced technology stocks.” They add that “arbitrageurs are concerned about attacking the bubble too early without support from their peers,” and that they’re more likely to ride the bubble until just a few months before the end.

That would seem to be too late to impose price discipline in private markets, but I’m curious in your thoughts. Does some sort of private shorting system make sense? And, if so, how would it be structured?

I’m going to take a stab at answering the final questions.  There is often a reason why the financial world is set up the way it is, and why truly helpful financial innovations are rare.  The answer is “no, we should not have any way of shorting private companies, and it is not a flaw in the system that we don’t have any easy way to do it.”

Two notes before I start: 1) I haven’t read the paper at The Information, because it is behind a paywall, but I don’t think I need to do so.  I think the answer is obvious.  2) I ran into this question answered at Quora.  The answers are pretty good in aggregate, but what exists here are my own thoughts to present the answer in what I hope is a simple manner.

What is required to have an effective means of shorting assets

  1. An asset must be capable of being easily transferred from one entity to another.
  2. Entities willing to lend the asset in exchange for some compensation over a given lending term.
  3. Entities willing to borrow the asset, put up collateral adequate to secure the asset, and then sell the asset to another entity.
  4. An entity or entities to oversee the transaction, provide custody of the collateral, transmit payments, assure return of the asset at the end of the lending term, and gauge the adequacy of collateral relative to the value of the asset.

Here’s the best diagram I saw on the internet to help describe it (credit to this Latvian website):

short selling

I’m leaving aside the concept of naked shorting, because there are a lot of bad implications to allowing a third party to create ownership interests in a firm, a power which is reserved for the firm itself.

The Troubles Associated with Shorting Private Assets

I can think of four troubles.  Here they are:

  1. The ability to sell, lend, or buy shares in a private company are limited by the private company.
  2. Lending over long terms with no continuous price mechanism to aid in the gradual adjustment of collateral could lead to losses for the lender if the borrower can’t put up additional capital.
  3. The asset lender can decide only to lend over lending terms that will likely be disadvantageous to the borrower.  Getting the asset returned at the end of the lending term could be problematic.
  4. It is difficult enough shorting relatively illiquid publicly traded assets.  Liquidity is required for any regular shorting to happen.

The first one is the killer.  There are no advantages to a private company to allow for the mechanisms needed to allow for shorting. That is one of the advantages of being private.  Information is not shared openly, and you can use the secrecy to aid your competitive edge.  Skeptical short-sellers would not be welcome.

The second problem is tough, because sometimes successive capital rounds are at considerably higher prices.  The borrower will likely not have enough slack assets to increase his collateral, and he will be forced to buy shares in the round to cover his short because of that.  The lender could find that the borrower cannot make good on the loan, and so the lender loses a portion of the value his ownership stake.

But imagining the first two problems away, problem three would still be significant.  If the term for lending were not all the way to the IPO, next capital round or dissolution/sale, at the end of the term, the borrower would have to look for someone to sell shares to him.  It is quite possible that no one would sell them at any reasonable price.  They know they have a forced buyer on their hands, and there could be informal collusion on the price of a sale.

Perhaps another way to put it is don’t play in a game where the other team has significant control over the rules of the game.  One of the reasons I say this is from my days of a bond manager.  There were a lot of games played in securities lending, and bonds are not the most liquid place to short assets.  I remember it being very difficult to get a bond back from an entity that borrowed it, and the custodian and trustee did not help much.  I also remember how we used to gauge the liquidity of bonds we lent out, and if one was particularly illiquid, we would always recall the bond before selling it, which would often make the price of the bond rise.  Games, games, games…

What Might Be Better

Perhaps using collateralized options or another type of derivative could allow bets to be taken, if the term extended all the way to the IPO, the next capital round, or dissolution/sale of the company.  The options would have to be limited to the posted collateral being the most the seller of the option could lose.  Some of the above four issues would still be in play at various points, but aside from issue one, this would minimize the troubles.

What Might Be Better Still

The value of the shorts is that they share information with the rest of the market that there is a bearish opinion on an asset.  Short-sellers are nice to have around, but not necessary for the asset pricing function.  It is not unreasonable to live with the problem that some assets will be overvalued in the intermediate-term, rather than set up a complex method to try to enable shorting.  As Ben Graham said:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

The weighing machine will do its job soon enough, showing that the overvalued asset will never produce free cash adequate to justify its current high price.  Is it a trouble to wait for that to happen?  If you don’t own it, you shouldn’t care much.

If you want to short it, I’m not sure that will hasten the price adjustment process that much, unless you can convince the existing owners of the asset that it isn’t worth even the current price.  Given that buyers have convinced themselves to own the asset, because they think it will be worth more in the future, intellectually, convincing them that it is worth less is a tough sell.

In the end, only asset and liability cash flows count, regardless of what secondary buyers and sellers do.  Secondary trading does not affect the value of assets, though it may affect the perception of value in the short run.  Thus, you don’t need short sellers to aid in setting secondary market prices, but they are an aid there.  In the primary markets, where whole companies are bought and sold, the perceived cash return is all that matters.

Conclusion

Ergo, live with short run overvaluation in private markets.  It is a high quality problem.  Sell overvalued assets if you own them.  Watch if you don’t own them.  Shorting, even if possible, is not worth the bother.

Welcome back to this irregular series where I go through the large blunders that I have committed in my investments.  Let’s start with an unusual one: a telecommunications partnership.

In the late ’80s the US government allocated some telecom spectrum via a lottery process.  I had some friends that participated in the first lottery, and received a decent amount of valuable spectrum.  The only thing they had to do was have the engineering documents drawn up, which a third party consultant did.  I said to myself that if it ever came around again, I would try to participate.

In the early ’90s, lo and behold, a second lottery with the same rules.  I invested enough to gain a 30% interest in a partnership that would be going after the center of the US, ignoring the east and west coasts.  I had seven partners with 10% interests, and they elected me to be the lead partner.  So far, so good, right?

Well, seemingly.  The thing is, why should the government allocate spectrum by lottery?  Shouldn’t they sell it off to the highest bidder?  After all, that’s what most people did with the spectrum they received in the first lottery.  (I was planning on trying to create an operating company.)  Shouldn’t the US government cut out the middlemen, and receive more for a valuable and somewhat limited asset?

Prompted by the telecommunication firms, who preferred having fewer and larger auctions rather than buying from a bunch of disparate individuals, the US government acted in its own interests, and cancelled, even after all of the lottery participants plans had been approved.

In the end, we got back our fees from the government, but lost the money that we spent on engineering documents.  After writing off the losses, it was a loss of 50%.  That said, I also lost any profits from investing the money in stocks over the eight years that the money was tied up.  (The promoter that did the engineering documents went into hiding, having lost their shirts in the process, with a lot of annoyed people that bought their services.)

Small Cap Value Forever!

So what was I doing in equity investing in that era?  Small cap value — little companies trading at bargain prices.  Of all the managers that I interviewed when creating the multiple manager funds for my employer, I found the small cap value guys to be the most business-minded and interesting.  A few of us at my firm would research out lesser known companies and share the ideas.  We had some fun with it.  We would occasionally say to each other, “Small Cap Value Forever!”

Now, when the dot-com bubble came around, I was not tempted to play in that area of the market, but I fell into a lesser version of the same trap here.  I started doing this just as small cap value’s period of outperformance was ending, and growth was taking over.

So how did I do?  Not that bad… Small cap value lagged the S&P 500 by about 5%/year over the time I was focused on it, and I was able to beat the S&P 500 by a little bit.  Not the greatest, but not the worst, either.  In the process, I ran into a number of bizarre situations that taught me a lot, particularly with the smallest companies that I invested in.

In one case, I made the mistake of entering a market order to initiate a position.  (Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was.  The price promptly fell back to where it was prior to my purchase.  Adding insult to injury, management ruined the place, and the price fell by over 80%.  I looked at the situation, thought the assets were worth far more, and submitted a bid to an institutional investor to buy out his entire stake (and I would become a 5%+ holder of the company — I had to ask my compliance area if I could do that, and they were bemused at the odd request, and assented.)  The investor did not take my bid, but held on, and the management announced a buyout for the company at a level that would have given me a significant gain had I been able to buy the block of stock, but instead left me with a 80%+ loss on a small position, which wasn’t large enough to consider filing for appraisal rights.

Then there was one that went very well, but taught me the wrong lesson.  A few weeks after I bought a stake in a small electronic parts company, Corcom, another company bought it for cash.  At first I was happy with the quick and sizable win, but then I realized that I might have done better over time if the company hadn’t sold out.

That said, I noticed how wide the arbitrage spread was on the deal, and the annualized rate was 40%/year.  I bought more and more of it, and eventually even used leverage to goose returns (this doesn’t sound like the older me, right?  Right.)  I made a lot of money in the process when the deal completed.

Here’s the wrong conclusion I drew: small deal arbitrage was lucrative and easy.  I started doing that exclusively for two years during 1998-2000.  During that time I learned:

  • It’s not easy.  Small deal arbitrage investing is like investing in high yield bonds where the management teams have disproportionate opportunity to act against the interests of owners.
  • It’s not as lucrative as it looks, either.  One deal gone wrong will eat the profits of ten that go right.
  • It takes a lot of time to find, analyze and compare new deals.  I spent much more time on that than when I was doing value investing.  I felt my time with my family was suffering.

More deals went bad than should have.  My credit analysis on the deals was subpar.  I particularly remember one where the buyer used an obscure clause to get out of the deal, and the company, Advanced Technical Products, took the acquirer to court and lost.

After the loss in court, I sold for a 70%+ loss, and then insult added to injury happened again… after 9/11, the products that they made for structural purposes came into high demand, and the stock shot up more than fifteen times.  Had I held on, I would have quadrupled my original investment.  (I smile and laugh a little as I write this.)

What did I learn?

This was the worst two years of all my investing, so I learned quite a bit:

  • Often your worst errors come trying to repeat a single abnormally large success.
  • Stick to what you know best, which for me was value investing.
  • Don’t chase fads.
  • Analyze management teams of small companies very carefully.  They can potentially get away with a lot more if there are no significant controlling investors.
  • Analyze your own investing to figure out what you are best at.  I did such an analysis afterward, and saw value investing and industry analysis as key strengths.
  • Focus on risk control.  Focus on risk control.  Focus on risk control……
  • Do more analysis of unusual ways of investing before committing money.

On the bright side, this period set me for my best period of investing, which would be 2000-2010.  The lessons and discipline learned would prove invaluable to me, and the companies that I served.

Photo Credit: Kevin Trotman

Photo Credit: Kevin Trotman

Before I write this evening, I have updated the blog’s theme so that it is more readable on mobile devices.  I’ve tried to preserve most of the best of the former design.  Let me know what you think.  Also, I have tried to get commenting to work using Jetpack.  For those that want to comment, if you can’t, drop me an email, and I will try to work it out.  I prefer more interaction than less, even if I can’t always get around to responding.

On to the two warning signs: the first article is The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies.  This is about the terms that some private equity investors are getting that help to support current valuations of companies.  Here are a few examples:

  • Guarantees that they’ll get their money back first if the company goes public or sells.
  • They can also negotiate to receive additional free shares if a subsequent round’s valuation is less favorable
  • Warrants to allow the purchase of shares at a cheap price if valuations fall.

Here’s my take.  When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails.  It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity.  Things may not look so good after the cash is used, and expectations give way to reality.

In the late ’90s and early 2000s a number of companies tried doing similar machinations because they had a hard time borrowing at reasonable rates, or, they wanted to avoid clear public disclosure of their debt terms.  In the bear market of 2000-2002, most of these schemes blew up, some catastrophically, like Enron, and some doing minor damage, like Dominion Power with their fiber ventures subsidiary.

When you hear about a guarantee, think about how large it is relative to the total size of the company, and what would happen if the guarantee were ever tapped by everyone who could.  If the guarantee is fueled by some type of dilution (issuing stock now or contingently in the future), maybe the total shares to issue would be so large that the price per share would collapse further.

There’s no magic here — there is no good way in the long run to guarantee a certain market cap or creditworthiness.  That said, I agree with the article, this sort of behavior comes near the end of a cycle, as does the behavior in this article: Why Bankers Are Leaving Finance for No-Salary Tech Jobs.

We saw this behavior in the late ’90s — people jumping to work at startups.  As I often say, the lure of free money brings out the worst in people.  In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts.  This also tends to happen later in a speculative cycle.

So be wary with private equity focused on tech, and any collateral damage that may come from deflation of speculative valuations in technology and other hot sectors.

Photo Credit: Zach Copley

Photo Credit: Zach Copley

I’ve generally been quiet about Bitcoin.  Most of that is because it is a “cult” item.  It tends to have defenders and detractors, and not a lot of people with a strong opinion who are in-between.  There’s no reward for taking on something that has significance bordering on religious for some… even if it proves to be a bit of a “false god.”

I view Bitcoin as a method of payment, a collectible item, a commodity that is not fully fungible, and not a store of value.  It is not a currency, and never will be, unless a government takes it over and adopts it.

In order for a tradable item to be a store of value, the amount of variation in value in the short- to intermediate-term versus other items that has to be limited.  If there are other tradable items with greater stability toward the other items, those tradable items would be better stores of value.  Thus Bitcoin is inferior as a store of value versus the US Dollar, the Euro, the Yen, etc.  It is far more volatile versus goods and assets that one might want to buy, and goods and liabilities that one might want to fund.

Now as an aside, the same thing happens in hyperinflationary economies.  Merchants have to change their prices frequently, because the currency is weak.  Often another currency will begin to replace the weak local currency, like the US Dollar or the Euro, even if that is not legal.

Fungibility implies that any Bitcoin is as good as any other Bitcoin.  But with failures like Mt. Gox, a Bitcoin exchange that had Bitcoins under its care stolen from it, a Bitcoin under the care of Mt. Gox was not as valuable as one elsewhere.  (Another aside: that happened in a minor way with the Euro when Euros in Cypriot banks were forced to have a “haircut,” while Euros elsewhere were unaffected.)

Bitcoin is a means of payment, a way of transferring value from one place/person to another.  It seems Bitcoins move well, but they are less good at being safely stored.

The theft of Bitcoins points out the need for there to be a legal system to protect property rights.  Licit participants in Bitcoins as a group have not been adequate to assure that the rightful owners might not lose them as the result of computer hacking.  Contrast that with the protections that credit card holders have when false transactions are applied against credit card accounts.  The credit card companies eat the losses, funded by profits from interest charged an interchange fees.

The libertarian vision of a currency that does not require a court, a government to protect it is misguided.  Where there are thieves, there is a need for courts to try cases of theft, and deal with questions of equity if theft leads to an insolvency.

Now, governments can be less than fair with their own judicial systems.  I think of Dennis Kozlowski, formerly CEO of Tyco, who was barred from using his own money in self-defense when the US Government brought him to trial.  Much as you might like to have value protected from the clutches of the government, that is easier said than done, and there are thieves that will pick away at those who get value away from governments, because ultimately in an interconnected world, you have to trust other people at some points, and trust can be violated as much as the rights of a citizen can be violated.  Repeat after me: THERE IS NO PERFECTLY SAFE PLACE ON EARTH TO STORE VALUE!  That said, though, there are safer places than others, and so you have to live with the risks that you understand, and are prepared to take.

If you think that Bitcoin fits that bill, well, knock your socks off.  Have at it.  I will stick with US Dollars in banks, money market funds, bonds, and public and private stocks.  Maybe I will even buy some gold that does nothing, just for the sake of diversification.  But ultimately my store of value is in the bank of Heaven, as it says in Matthew 6:19-21:

“Do not lay up for yourselves treasures on earth, where moth and rust destroy and where thieves break in and steal; but lay up for yourselves treasures in heaven, where neither moth nor rust destroys and where thieves do not break in and steal. For where your treasure is, there your heart will be also.”

There is no perfect security on Earth, try as hard as you like.  Bitcoins may keep value away from the government under some conditions, but who will protect your property rights in Bitcoins in the event of theft?  You can’t have it both ways, so Bitcoins as property would either be taxed and regulated by governments, or be totally underground, which would diminish utility considerably.

One final note: Bitcoins can’t be used of themselves to produce something else.  They are a fiat currency, and only has value to the degree that users place on it.  I liken it to penny stocks, where traders can bounce the price around, because there is nothing to tether the price to.  At least with gold, you have jewelers demanding it to turn it into jewelry, and a broader pool of people who are somewhat less jumpy about what the proper exchange rate between gold and dollars should be.

But, gold can be stolen… again, no Earthly store of value is perfect.  All for now.

Photo Credit: Jen Goellnitz

Photo Credit: Jen Goellnitz

Okay, let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 1/20/15DeclineAnnualizedDead?
GTXO5/27/20082.450.011-99.6%-55.6%
BONZ10/22/20090.350.000-99.9%-72.5%
BONU10/22/20090.890.000-100.0%-82.3%
UTOG3/30/20111.550.000-100.0%-92.0%Dead
OBJE4/29/2011116.000.069-99.9%-86.3%Dead
LSTG10/5/20111.120.004-99.7%-82.5%
AERN10/5/20110.07700.0000-100.0%-93.4%Dead
IRYS3/15/20120.2610.000-100.0%-100.0%Dead
RCGP3/22/20121.470.003-99.8%-89.5%
STVF3/28/20123.240.360-88.9%-54.2%
CRCL5/1/20122.220.004-99.8%-90.2%
ORYN5/30/20120.930.013-98.6%-80.1%
BRFH5/30/20121.160.466-59.8%-29.2%
LUXR6/12/20121.590.002-99.9%-92.3%
IMSC7/9/20121.50.910-39.3%-17.9%
DIDG7/18/20120.650.003-99.6%-89.1%
GRPH11/30/20120.87150.021-97.6%-82.5%
IMNG12/4/20120.760.010-98.7%-86.9%
ECAU1/24/20131.420.000-100.0%-98.4%
DPHS6/3/20130.590.003-99.5%-96.0%
POLR6/10/20135.750.001-100.0%-99.5%
NORX6/11/20130.910.008-99.1%-94.7%
ARTH7/11/20131.240.200-83.9%-69.7%
NAMG7/25/20130.850.013-98.5%-94.1%
MDDD12/9/20130.790.022-97.2%-95.9%
TGRO12/30/20131.20.056-95.3%-94.5%
VEND2/4/20144.340.655-84.9%-86.1%
HTPG3/18/20140.720.008-98.9%-99.5%
WSTI6/27/20141.350.150-88.9%-97.9%
APPG8/1/20141.520.035-97.7%-100.0%
1/20/2015Median-99.3%-89.8%

It is truly amazing how predictable the losses are from promoted stocks, and that is why you should never buy them. Today’s loser-in-waiting is Cardinal Resources [CDNL].  The promoters purport that this company will provide cheap clean fresh water to the world, and will make a fortune off of that.  Now let’s look at some facts:

What commends this stock to you?  Is it:

  • That it has never earned any money?
  • That the firm has had a negative net worth for the last four years?
  • That their auditors doubted on the last 10-K that this company would be a “going concern?”
  • That the company 12 months ago was known as JH Designs, which was in the “home staging and interior design services business?”
  • That the writers of the promotion got paid $30,000 to write the speculative fiction of the promotion?
  • That affiliated shareholders of CDNL paid another $670,000 to publish speculative fiction about the company to unwitting people in an effort to raise the stock price, so that they can sell their shares?

Here, have a look at part of the disclaimer written in five-point type on the glossy ad they sent me in the mail:

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

Thus, we know who is sponsoring and profiting from this scam.  It is existing shareholders who want to sell.  I can tell you with certainty that you should not buy this, and that if you own it, you should sell it.  There is one significant party that implicitly agrees with that assessment — the company itself, which issued shares at a price of ten cents per share in 2014, according to the recent 10-Q, if you look at the balance sheet and cash flow statements.

Avoid this company, and avoid all situations where stocks are promoted.  They are bad news for all investors.  Good investments never need promotion.

Photo Credit: International Monetary Fund

Photo Credit: International Monetary Fund

October 2014December 2014Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace.Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace.No change. This is another overestimate by the FOMC.
Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.Shades their view of labor use up a little.  More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No change.

 

Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable.Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.Shades their forward view of inflation down.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.07%, down 0.28% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate.They are no longer certain that inflation will rise to the levels that they want.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.CPI is at 1.3% now, yoy.  They shade up their view down on inflation’s amount and persistence.
The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.Sentence removed.
Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.Sentence removed.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.Moves this sentence lower in the document.
This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Moves this sentence lower in the document.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.Highly accommodative monetary policy is gone – but a super-low Fed funds rate remains.  Policy normalizes, sort of, but no real change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.In other words, we’re on hold until something goes “Boo!”
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No real change.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.Tells us what we already knew.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Sentences moved from higher in the document.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

 

Voting against the action wasVoting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate;Fisher thinks the economy is healthy enough to take some rate hikes.
Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target;

 

 

Kocherlakota wants to create another bubble, along with the rest of the doves.
and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements.Plosser wants to say that a shift has happened, when no shift really has happened in policy.  He also thinks they should avoid the idea that the Fed is waiting to do something, suggesting that tightening could come sooner.

 

Comments

  • Pretty much a nothing-burger. Few significant changes, if any.  The only interesting thing is that they have given up on inflation getting anywhere near 2% for now.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities flat and long bonds rise. Commodity prices are flat.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC chops some “dead wood” out of its statement. Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Photo Credit: brett jordan

Photo Credit: brett jordan

Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man!  We have retirements to fund, and precious little time to do it!”

Those that have read me for a while will know that I am an advocate for simplicity, and against debt.  Why?  The two are related because some of us tend toward overconfidence.  We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances.  We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.

The topic of the evening is margin loans, and is prompted by Josh Brown’s article here.  Margin loans are a means of borrowing against securities in a brokerage account.  Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods, or services.  Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.

Margin loans seem less burdensome than other types of borrowing because:

  • Interest rates are sometimes low.
  • They are easy to get, if you have liquid securities.
  • They are a quick way of getting cash.
  • There is almost never any scheduled principal repayment or maturity date for the loan.
  • Interest either quietly accrues, or is paid periodically.
  • You don’t have to liquidate securities to get the cash you think you need.
  • There is no taxable event, at least not immediately.
  • Better than second-lien or unsecured debt in most ways.

But, what does a margin loan say about the borrower?

  • He needs money now
  • He doesn’t want to liquidate assets
  • He wants lending terms that are easy in the short run
  • He doesn’t have a lot of liquidity at present.

So what’s the risk? If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:

  • Pay back some of the loan, or
  • Liquidate some of the assets in the portfolio.

And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.

Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis.  But when there is a lot of margin debt, that’s a problem.  As I like to say, markets abhor free riders.  When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come.  And come it will, like a heat seeking missile.

Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action.  But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.

A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.

I would again encourage you to read Josh’s excellent piece, which includes gems like:

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process.  It’s another reason not to take out those loans.

Remember, Wall Street wants easy profits from margin lending.  They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.

The Free Advice that Embraces Humility

Just say no to margin debt.  Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.

If you have margin loans out now, start planning to reduce them (before you have to).  You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your assets to their rightful owners.

Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so.  If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.

And after all that… enjoy your sleep, even amid crises.

Photo Credit: Penn State

Photo Credit: Penn State

Like my friend Josh Brown does, I often don’t know where I will end when I start writing… I know I have something to say, given my own time writing for RealMoney.com, and now having publicly written on financial matters for over eleven years, with thanks to Jim Cramer, who gave me my start.

Recently, a 9% holder of TheStreet sent a letter to Jim, asking him to either sell off TheStreet in an auction or leave CNBC and rebuild the value of TheStreet.  The Stock rose roughly 7% on the news.  Personally, I don’t think it should have budged.  Here’s why:

1) What is a perpetual money-loser worth?  TheStreet hasn’t earned significant money since 2007.

2) What is TheStreet worth in an auction?  The complainant says:

Despite these improvements TST trades at an enterprise value to 2015 estimated revenues of 1.3. This compares to BC Partners Limited’s acquisition of Mergermarket Group at three times revenue. Morningstar Inc. (“MORN” – $65.97) trades at 3.4 times 2015 consensus revenue estimate. Allegedly, BoardEx competitor Relationship Science recently raised capital at a $300 million valuation compared with its purported $5 million revenue for 2013.

TheStreet is not comparable to these in my opinion.  I’ll use Morningstar as my example: it is a comprehensive site offering a wide amount of data about investments, and relatively light on opinions.  Where it speaks, it is authoritative, and it has a relatively sticky following, making their revenues more valuable than that of TheStreet.  Let’s be real… would you buy TheStreet at the same enterprise value to sales ratio as Morningstar?

3) Selling investment opinions is a very competitive business, with low barriers to entry.  If a party is any good at marketing it, and wants to sell a newsletter, there are a lot of people who will buy, as noted later by the complainant:

We estimate that 41,500 customers pay roughly $350 per annum ($14.5 million in totum) for your newsletters. This is nothing to scoff at but a fraction of the 400,000 to 500,000 subscribers enjoyed, by (we believe) The Motley Fool Stock Advisor and Stansberry & Associates Investment Research – two wildly more profitable competitors which charge similar prices. (We estimate that each of these competitors yield $25 to $45 million of pre-tax earnings for their private owners.) Given the strength of your brand, it both amazes and frustrates that subscriptions to your products are so paltry. Were you to de-couple from CNBC (where you are understandably prohibited from promoting PLUS) I would hope, nay expect, that subscriptions of PLUS would treble.

I don’t like market newsletters generally, but I know there are a lot of people who would rather pay for opinions than money management services.  I often get requests to start a newsletter, but I don’t respect the concept.  My detailed ideas are for my clients; that’s the business that I am in.

Jim’s newsletter has been out for a long time.  Of those that buy newsletters, most would be familiar with Cramer, and know that the newsletter exists.  Even if Cramer came back to TheStreet full-time, I doubt it would get that much more in subscriptions.

4) Also, auctioning off a Cramer-less TheStreet would likely flop.  There would be few if any buyers for a such a company that had lost its main writer.

5) Then there is the complainant’s appeal to Cramer as to his legacy:

You are 59. When you lie upon your deathbed, how will you reflect upon on your legacy? Once a $70 stock, TST is now $2.20. You have done well, but how has the common shareholder done?

I have a little insight here.  A little less than twelve years ago, I was invited by my Merrill coverage to come to an institutional investor conference where Cramer would be the unscripted keynote speaker.  It was a great talk, and at the end of it, as Cramer left, I figured out where I likely needed to be if I wanted a word with him.  Sure enough, he came my way, and I identified myself to him as the guy who had been writing to him on bonds for the past four years.  He remembered me and greeted me warmly.  I told him that I was going to work at a hedge fund.  He congratulated me, and said that it was where all the smart guys were going.  And then he said something to the effect of:

I wish I were still running a hedge fund.  I really loved that.

And at that point, the crowd caught up, and that was the end of my time with him.  But when I got home that night, I sent him an e-mail telling him that life is too short, do what you love.  Go back to the hedge fund and write more occasionally for the rest of us.  His reply was brief as usual, and if my memory is any good it was something like:

Can’t do that.  Gotta get the price of theStreet.com over the IPO price.

Even at the time, that made me blink.  Make the stock rise by more than a factor of 10?  That would be Herculean at minimum.

But, that gives you an insight into Cramer’s mind at one point.  He’s already thought along those lines.  He’s no dummy.  He knows how difficult it would be — and he has pursued that effort for a number of years.  My sense is that he has given up, or maybe something close to that.  The price of TheStreet has been remarkably stable for the past five years, despite all efforts made…

6) But does Cramer have no legacy from TheStreet?  I would argue he does.  He enriched the investment writing world in two ways: he created a bunch of young savvy journalists that occupy many places in the broader investment journalism world, and he encouraged a lot of clever investors to write for him.

We are all better off as a result of both of these, even if the benefits never went to shareholders.  It’s a tough business, and even the best enterprises have a hard time making money at it.

7) Perhaps the complainant needs to be reminded of one of Marty Whitman’s principles on value investing: “Something off the top.”  Control of a company is a valuable thing, and one of the reasons is that a closely-held company does not merely pay the controlling owner dividends, they often receive something off the top.  That is true of Cramer here, with a salary of $3.5 million/year.  Why should he relinquish that?  In his mind, he may think that he has tried to turn it around for years to no avail.  If the company is not likely to ever get back to a significantly higher price, why should he knock himself out on a hopeless mission that he has already tried?

8 ) So, with that, let the complainant contact his fellow shareholders and ask for help.  I’m not sure they will agree with the prescription, though they might like to see some actions taken.  Personally, I can’t get excited about it; I would be inclined to pass, and quietly sell my shares into the current strength generated by the complainant.

Full disclosure: no positions in any companies mentioned here, and as they used to say at TheStreet, I am writing about a microcap stock, so they would typically not allow articles on it without a big warning, if at all.  To make it plain: don’t buy any TST shares as a result of what I wrote here.  Thanks.