I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves.  There are several reasons for that:

  • It”s simple.
  • It’s fast.
  • And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues.  If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information.  That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It’s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in.  And even if they have carryout, the line could go around the block… a hardship for many even if you are getting the famous Ocean Broccoli Beef.  (Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets.  Imitation was a large part of the dot-com bubble and the housing bubble.  When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable.  It all ends when the cost of capital to finance the asset is considerably higher than the cash flow that the asset throws off.  And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow.  Could that ever be a bubble?  The odds are low but the answer is yes.  It is possible for any strategy to distort relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon.  (As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets.  The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis.  The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways.  The first way is not new — it is a way of saying “I want the average result, and very low fees.”  It’s a powerful idea and generally a good idea.  If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it.  This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone.  The effects could vary, though.

  • You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
  • You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt.  On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
  • You would see pressure on corporations with odd capital structures like multiple share classes to simplify, so that all of the equity would trade at high multiples.
  • Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital.  Or, buy up competitors.  If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
  • People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently.  I’m only saying it could be one day.  Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of.  At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt.  As for me, I will continue to pick stocks.  It has worked well for me.


Six years ago, I reviewed a book The Club No One Wanted To Join.  It was a poorly done book written by a bunch of people who were swindled by Bernie Madoff.  Now, I didn’t want to be unsympathetic — after all, they were cheated.  But they missed many signals that tipped off others, and could have tipped off them to the fraud.  Worse, they tried to argue that since many top-performing mutual funds had total returns similar to that of Madoff, there was no way anyone could have figured out that it was a scam.  They neglected to note that Madoff’s returns were ultra-smooth, while the returns of the mutual funds were not.  Big difference.

There’s one more thing: many of them gave in to the idea that they had found a hole in the system.  Far from it being “The Club No One Wanted To Join,” rather, it was their own secret private club that they were smart enough to join when fate smiled on them, and they got their opportunity.

Tonight, I am talking about a different sort of scam that sucked in a different class of people.  This scam was a corporation where the management took a firm into bankruptcy that could easily pay its debts, at least in the short-run.  The management likely conspired with the bondholders against its shareholders, seemingly in an effort to gain a greater reward from the bondholders who would own the firm post-bankruptcy than they could from operating the firm outside of bankruptcy.  The name of this firm is Horsehead Holdings [ZINCQ].

For background, you can read this article in the New York Times.  For the ultimate result of the bankruptcy, you can read this article in the Wall Street Journal: Zinc Producer Horsehead Cleared to Exit Bankruptcy.

I’m not writing about this to give a blow-by-blow description of how the bondholders and management cheated shareholders out of their ownership interests, though I will touch on that at points.  I am writing about this to respond to those who wrote to me in the midst of the bankruptcy trial to try to gain some coverage of what was going on.

Over 20 people wrote to me and almost 100 journalists/media in an attempt to create “viral” coverage of the trial, and if nothing else, bring public attention to the travesty that was the bankruptcy process.  As it is, I wrote one paragraph on the matter, but I didn’t see anything from any major publication until after the trial completed.  I did mention to a number of the writers that efforts to get coverage would not affect the outcome of the bankruptcy court; it is relatively insulated from public opinion, as it should be.

(As an aside: if you write such a letter to journalists, or me, try to stay on topic.  It is not relevant to call the bondholders “greedy,” that they are a hedge fund, or talk about their prior dealings with Collateralized Debt Obligations that failed during the recent financial crisis.)

Aleph Blog is mostly about risk control.  As I read the letters from the shareholders who were watching their ownership rights be destroyed, I noted a few things that might have enabled some of them to avoid much of the unfavorable outcome:

  • Buying a levered highly cyclical company.
  • Relying on the insights of bright investors who buy concentrated stakes  in a few companies.
  • Not diversifying enough.

Let me take these in order:

Buying a levered highly cyclical company

If you look at the risk of owning a single company, there are two ways where a company can affect the degree to which a change in sales can raise the profits of the company.  The first way is to choose a production method that has high fixed costs and low variable costs, which is typically true of cyclical companies.  The second way is to borrow money.  Both methods magnify returns, right or wrong.

Typically, you only do one at a time.  Supermarkets are stable, so they often borrow more to lever up returns.  Mining companies, among other industries that require heavy capital investment, are anything but stable booms and busts are common and follow product prices.

Horsehead Holdings had a high degree of leverage from both debt and being in a cyclical industry.  It ran into a scenario where the price of its main product, zinc, fell hard.  At the time before they filed for bankruptcy, management could legitimately say to themselves, “If the price of zinc remains this low we will shortly be insolvent, particularly if our new processing plant doesn’t work out.”

Now, the bankruptcy code is a rather flexible beastie.  It allows for a management team to file before things are at their worst so that they can try to preserve a better outcome for the company.  My suspicion is that management’s motives were mixed when they filed — they wanted the best deal they could get for themselves, but may have assumed that there wasn’t much life left to the equity anyway.  Who could have predicted that the price of zinc would rally back so much, such that the company could have survived in its pre-bankruptcy state?

Now, has this ever happened to me?  Not exactly, but there are other ways that managements can dispose of a company to the detriment of the stockholders.  I lost money on C. Brewer Homes when management did a leveraged buyout when the stock price was unduly depressed.  Enough stock was in the hands of arbs that the deal went through.  Oh, and if you want another one, there was the loss on National Atlantic Holdings which I described in ugly detail in this article.

The main point is this: don’t assume that management will act in the interests of stockholders, particularly in a stressed situation.  The leverage and cyclicality of Horsehead Holdings set up the possibility of that occurrence, and the fall in the price of zinc triggered it.

Relying on the insights of bright investors who buy concentrated stakes  in a few companies

I respect both Mohnish Pabrai and Guy Spier.  They are bright guys, and from what I can tell at a distance, ethical too.  They were big holders of Horsehead Holdings, and I’m sure they had good reasoning behind their decisions.  But, even excellent investment managers aren’t infallible. If you are just picking one of their ideas, that could be a rocket to the sky — or the ground, while their portfolio as a whole might do well.

Also, they will make their decisions with some lead time over you if the data shifts.  Any investment advisor you mimic is not required to tell you when they change their mind, aside from required filings with the SEC… which are delayed, and sometimes don’t cover everything.

Has this happened to me?  Yes it has.  I have sometimes invested partly  on who is invested in a company, though never to the point of not doing my “due diligence.”  But aside from some early failures 20+ years ago, it never hurt me much because I was never guilty of:

Not Diversifying Enough

A number of the people emailing me said they put more than half their savings into Horsehead Holdings.  If you are going to engage in such risky behavior, you need to know more than everyone else investing in the stock.  No exceptions.  I agree with investing in a concentrated way, but my view of that for average people is no positions larger than 5% of your capital.  That is plenty concentrated enough.

I have one holding that is 13% of my assets — a private company that I know exceptionally well.  My house is another 13%.  After that, my next largest holding is 3% of my assets.  I believe in the assets that I buy, but I concentrate enough by only owning individual stocks, and very little in the way of pooled investment vehicles.

With 75% of my assets in risk assets, I take enough risk.  I don’t have to amplify that by taking disproportionate security-specific risk.  (The stock portfolios that I provide for clients have 35 or so stocks in them… given that I tend to concentrate in a few industries, that takes reasonable rsk.)


Again, my sympathies to those who lost on Horsehead.  I can’t do anything about those losses.  At least you have the opportunity to sue the management of the company.  It certainly seems like the management team cheated the stockholders, though I can’t say for sure.

What I can help are future investors, and my counsel is this: Diversify!  You are your own best defender, so don’t merely mimic bright investors; do your own due diligence.  Be wary of investing in cyclical companies with high debt levels.  Don’t implicitly trust that management teams will act in your interest.  And finally, diversify, as it protects against failures in other areas.

PS — I looked through my notes of the past.  I did look at Horsehead Holdings, and I passed on it.  That said, I don’t know why… hopefully it was for a good reason, though I expect that I didn’t have room for another cyclical company, and not another one in base metals.

Photo Credit: Renegade98 || What was it that Buffett said 'bout swimmin' naked?

Photo Credit: Renegade98 || What was it that Buffett said ’bout swimmin’ naked?


It’s only when the tide goes out that you learn who has been swimming naked.

— Warren Buffett, credit Old School Value

When I was 29, nearly half a life ago, Donald Trump was a struggling real estate developer.  In 1990, I was still trying to develop my own views of the economy and finance.  But one day heading home from work at AIG, I was listening to the business report on the radio, and I heard the announcer say that Donald Trump had said that he would be “the king of cash.”  My tart comment was, “Yeah, right.”

At that point in time, I knew that a lot of different entities were in need of financing.  Though the stock market had come back from the panic of 1987, many entities had overborrowed to buy commercial real estate.  The major insurance companies of that period were deeply at fault in this as well, largely driven by the need to issue 5-year Guaranteed Investment Contracts [GICs] to rapidly growing stable value funds of defined contribution plans.  Outside of some curmudgeons in commercial mortgage lending departments, few recognized that writing 5-year mortgages with low principal amortization rates against long-lived commercial properties was a recipe for disaster.  This was especially true as lending yield spreads grew tighter and tighter.

(Aside: the real estate area of Provident Mutual avoided most of the troubles, as they sold their building that they built seven years earlier for twice what they paid to a larger competitor.  They also focused their mortgage lending on small, ugly, economically necessary properties, and not large trophy properties.  They were unsung heroes of the company, and their reward was elimination eight years later as a “cost saving move.”  At a later point in time, I talked with the lending group at Stancorp, which had a similar philosophy, and expressed admiration for the commercial mortgage group at Provident Mutual… Stancorp saw the strength in the idea, and still follows it today as the subsidiary of a Japanese firm.  But I digress…)

Many of the insurance companies making the marginal commercial mortgage loans had come to AIG seeking emergency financing.  My boss at AIG got wind of the fact that I was looking elsewhere for work, and subtly regaled me of the tales of woe at many of the insurance companies with these lending issues, including one at which I had recently interviewed.    (That was too coincidental for me not to note, particularly as a colleague in another division asked me how the search was going.  All this from one stray comment to an actuary I met coming back from the interview…)

Back to the main topic: good investing and business rely on the concept of a margin of safety.  There will be problems in any business plan.  Who has enough wherewithal to overcome those challenges?  Plans where everything has to go right in order to succeed will most likely fail.

With Trump back in 1990, the goal was admirable — become liquid in order to purchase properties that were now at bargain prices.  As was said in the Wall Street Journal back in April of 1990, the article started:

In a two-hour interview, Mr. Trump explained that he is raising cash today so he can scoop up bargains in a year or two, after the real estate market shakes out. Such an approach worked for him a decade ago when he bet big that New York City’s economy would rebound, and developed the Trump Tower, Grand Hyatt and other projects.

“What I want to do is go and bargain hunt,” he said. “I want to be king of cash.”

That’s where Trump said it first.  After that he received many questions from reporters and creditors, because his businesses were heavily indebted, and property values were deflated, including the properties that he owned.  Who wouldn’t want to be the “king of cash” then?  But to be in that position would mean having sold something when times were good, then sitting on the cash.  Not only is that not in Trump’s nature, it is not in the nature of most to do that.  During good times, the extra cash that Buffett keeps on hand looks stupid.

Trump did not get out of the mess by raising cash, but by working out a deal with his creditors in bankruptcy.  Give Trump credit, he had convinced most of his creditors that they were better off continuing to finance him rather than foreclose, because the Trump name made the properties more valuable.  Had the creditors called his bluff, Trump would have lost a lot, possibly to the point where we wouldn’t be hearing much about him today.

Trump escaped, but most other debtors don’t get the same treatment Trump did.  The only way to survive in a credit crunch is plan ahead by getting adequate long-term financing (equity and long-term debt), and keep a “war kitty” of cash on the side.

During 2002, I had the chance to test this as a bond manager.  With the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, “The market is offered without bid.  We’ve never seen it this bad.  What do you want to do?”  I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.  By noon, I had used up all of my liquidity, but the market was turning.  On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

That’s tough to do, and my client pushed me on the “extra cash sitting around.”  After all, times are good, there is business to be done, and we could use the additional interest to make the estimates next quarter.

To give another example, we have the visionary businessman Elon Musk facing a cash crunch at Tesla and SolarCity.  Leave aside for a moment his efforts to merge the two firms when stockholders tend to prefer “pure play” firms to conglomerates — it’s interesting to look at how two “growth companies” are facing a challenge raising funds at a time when the stock market is near all time highs.

Both Tesla and Solar City are needy companies when it comes to financing.  They need a lot of capital to grow their operations before the day comes when they are both profitable and cash flow from operations is positive.  But, so did a lot of dot-com companies in 1998-2000, of which a small number exist to this day.  Elon Musk is in a better position in that presently he can dilute issue shares of Tesla to finance matters, as well as buy 80% of the Solar City bond issue.  But it feels weird to have to finance something in less than a public way.

There are other calls on cash in the markets today — many companies are increasing dividends and buying back stock.  Some are using debt to facilitate this.  I look at the major oil companies and they all seem to be levering up, which is unusual given the recent trajectory of crude oil prices.

We are in the fourth phase of the credit cycle now — borrowing is growing, and profits aren’t.  There’s no rule that says we have to go through a bear market in credit before that happens, but that is the ordinary way that excesses get purged.

That is why I am telling you to pull back on risk, and review your portfolio for companies that need financing in the next three years or they will croak.  If they don’t self finance, be wary.  When things are bad only cash flow can validate an asset, not hopes of future growth.

With that, I close this article with a poem that I saw as a graduate student outside the door of the professor for whom I was a teaching assistant when I first came to UC-Davis.  I did not know that is was out on the web until today.  It deserves to be a classic:

Quoth The Banker, “Watch Cash Flow”

Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I’d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
“Cash flow,” the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, “No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom.  What matters is cash flow.”
He repeated, “Watch cash flow.”

Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, “Stop!  Enough!
Pay the interest, and don’t give me any guff!”

Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I’d held depreciation back,
And my banker said that I’d done something rash.
He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he’d insist on some security—
All my assets plus the scalp upon my pate.
Only this, a standard rate.

Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain—unremitting woe!
And I hear the banker utter an ominous low mutter,
“Watch cash flow.”

Herbert S. Bailey, Jr.

Source:  The January 13, 1975, issue of Publishers Weekly, Published by R. R. Bowker, a Xerox company.  Copyright 1975 by the Xerox Corporation.  Credit also to aridni.com.

Wiped Out

Before I start this evening, thanks to Dividend Growth Investor for telling me about this book.

This is an obscure little book published in 1966.  The title is direct, simple, and descriptive.  A more flowery title could have been, “Losing Money in the Stock Market as an Art Form.”  Why?  Because he made every mistake possible in an era that favored stock investment, and managed to lose a nice-sized lump sum that could have been a real support to his family.  Instead, he tried to recoup it by anonymously publishing  this short book which goes from tragedy to tragedy with just enough successes to keep him hooked.

Whom God Would Destroy

There is a saying, “”Whom the gods would destroy, they first make mad.”  My modification of it is, “Whom God would destroy, he first makes proud.”  In this book, the author knows little about investing, but wishing to make more money in the midst of a boom, he entrusts a sizable nest egg for a young middle-class family to a broker, and lo and behold, the broker makes money in a rising market with a series of short-term investments, with very few losses.

Rather than be grateful, the author got greedy.  Spurred by success, he became somewhat compulsive, and began reading everything he could on investing.  To brokers, he became “the impossible client,” (my words, not those of the book) because now he could never be satisfied.  Instead of being happy with a long-run impossible goal of 15%/year (double your money every five years), he wanted to double his money every 2-3 years. (26-41%/year)

As such, he moved his money from the broker that later he admitted he should have been satisfied with, and sought out brokers that would try to hit home runs.  The baseball analogy is useful here, because home run hitters tend to strike out a lot.  The analogy breaks down here: a home run hitter can be useful to a team even if he has a .250 average and strikes out three times for every home run.  Baseball is mostly a game of team compounding, where usually a number of batters have to do well in order to score.  Investment is a game of individual compounding, where strikeouts matter a great deal, because losses of capital are very difficult to make up.  Three 25% losses followed by a 100% gain is a 15% loss.

In the process of trying to win big, he ended up losing more and more.  He concentrated his holdings.  He bought speculative stocks, and not “blue chips.”  He borrowed money to buy more stock (used margin).  He bought “story stocks” that did not possess a margin of safety, which would maybe deliver high gains  if the story unfolded as illustrated.  He did not do homework, but listened to “hot tips” and invested off them.  He let his judgment be clouded by his slight relationships with corporate insiders at the end.  HE TRIED TO MAKE BIG MONEY QUICKLY, AND CUT EVERY CORNER TO DO SO.  His expectations were desperately unrealistic, and as a result, he lost it all.

As he lost more and more, he fell into the psychological trap of wanting to get back what he lost, and being willing to lose it all in order to do so.  I.e., if he lost so much already, it was worth losing what was left if there was a chance to prove he wasn’t a fool from his “investing.”  As such, he lost it all… but there are three good things to say about the author:

  1. He had the humility to write the book, baring it all, and he writes well.
  2. He didn’t leave himself in debt at the end, but that was good providence for him, because if he had waited one more day, the margin clerk would have sold him out at a decided loss, and he would have owed the brokerage money.
  3. In the end, he knew why he had gone wrong, and he tells his readers that they need to: a) invest in quality companies, b) diversify, and c) limit speculation to no more than 20% of the portfolio.

His advice could have been better, but at least he got the aforementioned ideas right.  Margin of safety is the key.  Doing significant due diligence if you are going to buy individual stocks is required.


This book will not teach you what to do; it teaches what not to do.  It is best as a type of macabre financial entertainment.

Also, though you can still buy used copies of the book, if enough of you try to buy the used books out there, the price will rise pretty quickly.  If you can, borrow it from interlibrary loan.  It is an interesting historical curiosity of a book, and a cautionary tale for those who are tempted to greed.  As the author closes the book:

“Cupidity is seldom circumspect.”

And thus, much as the greedy need to hear this advice, it is unlikely they will listen.  Greed is compulsive.

Summary / Who Would Benefit from this Book

A good book, subject to the above limitations.  It is best for entertainment, because it will teach you what not to do, rather than what to do.

Borrow it through interlibrary loan.  If you feel you have to buy it, you can buy it here: WIPED OUT. How I Lost a Fortune in the Stock Market While the Averages Were Making New Highs.

Full disclosure: I bought it with my own money for three bucks.

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.

Photo Credit: Gwydion M Williams

Photo Credit: Gwydion M Williams || They do the Hokey Pokey 😉


Investors need things to scare them, or they don’t have a normal life.  This is kind of like the bachelor uncle who tells little nieces and nephews about scary things that lurk under their beds, and only come out at night for mischief and mayhem.  (Then the parents pick up the pieces later, when they wonder why William or Elizabeth no longer sleep well at night.)

That’s the way I feel about US & international market reactions to the possibility of UK/Britain exiting the EU, otherwise called “Brexit.”  It’s overblown.  Quoting from an older article of mine:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom.  If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today.  Even with a subpar agreement, perfidious Albion is very effective at getting what they need completed.  This is especially true of their very effective and creative financial sector in the City of London without which most effective international secrecy, taxation avoidance and regulatory avoidance business could not be done.

There are other reasons not to worry as well if you live outside the UK.  The biggest reason is that the UK is only a small part of the global economy, and the economic effects on non-EU trade and finance are smaller still.  And unlike the idea was small but “contained,” in this case, large second order effects aren’t there.  Yes, someday other nations may wise up and decide to leave the EU, but no major countries are likely to do that over the next decade, absent some crisis.  (Crises in the EU? Those aren’t allowed to happen; ask any Eurocrat, they’ll tell ya.)

A second reason not to worry is that leaving the EU ends a second level of regulation of UK economic activity.  This will enable better growth in the longer term.  Are there things that the UK will lose?  Sure, they won’t have as good of a trade deal with the EU, but they will have the ability to try to craft better deals elsewhere, like a Transatlantic Free Trade Area.

The Economist had a decent summary of the good and bad for the UK over leaving the EU.  Here’s their summary table:

Looking over this, the UK already depends less on the EU than most member states, making the exit less of a big deal for the UK and the EU.

My view is this: leaving the EU won’t be a big thing in the long run for the UK.  In the short-run, there will be some uncertainty and volatility as things get worked out.  For the rest of the world, it will be a big fat zero, so ignore this, and focus on something with more meaning, like bizarre monetary policy, and the twisting effects it is having on our world, or the global entitlements crisis — too many people retiring, too few to support them, especially medically.

So, be willing to take some additional risk if people mindlessly panic if the UK/Britain exits the EU.


Let me mention four posts that I did recently on energy issues:

There were four main ideas that came out of those articles:

  • Saudi Arabia would allow the price of crude oil to fall to hurt competitors/rivals, particularly Iran.
  • The price of crude oil would stay near $50/barrel.
  • Lots of overlevered companies dependent on a high price for crude oil would go bankrupt.
  • But bankruptcy would happen to fewer, and more slowly, because of all the private equity wanting to buy distressed assets.

All that said, my view has changed a little recently.  I could be wrong, but I think that the ceiling price for crude oil may be $70/barrel for a few years, with the average remaining at $50.  I believe this because I think the Saudis are more desperate for cash than most believe.

Here’s my reasoning:

  • First, you have them selling off a 5% interest in Saudi Aramco.  When you need money, there is a tendency to sell high quality easily saleable assets, because they will sell for a high price, and with little fuss.  Admittedly, they aren’t rushing to do it, which weakens my point.  My view is that you would sell off lesser things that aren’t core, rather than complicate life by selling off a portion of a top quality asset.
  • Second, they are seeking loans, and considering selling bonds.
  • Third, they are considering decreasing the subsidies that they give to their people.  I think this will be very difficult to achieve politically.
  • Fourth, when the amount of Saudi holdings of US Treasury bonds was announced, it was lower than many expected, at $120+ billion, which only covers a little more than a year of their budget deficits, which was $98 billion last year.
  • Fifth, and most speculatively, I wonder if many of the US Treasury holdings have been pledged to cover other debts.  No proof here, but it’s not uncommon to use highly liquid assets as collateral for privately contracted debts.  That may explain the musing by some that there had to be more US Treasuries  there… but where are they?

What this implies to me is that Saudi Arabia is now little different than most of their associates in OPEC.  Their financial situation is tight enough that they must pump crude oil without respect to the strategy of holding crude oil off the markets to get better prices.  It’s not just punishing US shale oil production and Iranian crude production — the Saudis need the money.

If the Saudis need the money, and must pump, then OPEC lacks any significant coalition to raise prices.  Prices will rise with growth in demand, and cheap resource depletion… but as for right now, there are enough barrels to come out of the ground below $70.

The Saudi need for money is a much simpler explanation than trying to knock out US shale oil, or gouge the Iranians, because it has the Saudis acting directly in their own interests, and it fits the price series for crude oil better.

PS — One more note: this is mildly bearish for the US Dollar as the US does not have the same dedicated buyer of US Dollar assets as it once did.  I say mildly bearish, because most of the damage is already past.

I’m thinking of starting a limited series called “dirty secrets” of finance and investing.  If anyone wants to toss me some ideas you can contact me here.  I know that since starting this blog, I have used the phrase “dirty secret” at least ten times.

Tonight’s dirty secret is a simple one, and it derives mostly from investor behavior.  You don’t always get more return on average if you take more risk.  The amount of added return declines with each unit of additional risk, and eventually turns negative at high levels of risk.  The graph above is a vague approximate representation of how this process works.

Why is this so?  Two related reasons:

  1. People are not very good at estimating the probability of success for ventures, and it gets worse as the probability of success gets lower.  People overpay for chancy lottery ticket-like investments, because they would like to strike it rich.  This malady affect men more than women, on average.
  2. People get to investment ideas late.  They buy closer to tops than bottoms, and they sell closer to bottoms than tops.  As a result, the more volatile the investment, the more money they lose in their buying and selling.  This malady also affects men more than women, on average.

Put another way, this is choosing your investments based on your circle of competence, such that your probability of choosing a good investment goes up, and second, having the fortitude to hold a good investment through good and bad times.  From my series on dollar-weighted returns you know that the more volatile the investment is, the more average people lose in their buying and selling of the investment, versus being a buy-and-hold investor.

Since stocks are a long duration investment, don’t buy them unless you are going to hold them long enough for your thesis to work out.  Things don’t always go right in the short run, even with good ideas.  (And occasionally, things go right in the short run with bad ideas.)

For more on this topic, you can look at my creative piece, Volatility Analogy.  It explains the intuition behind how volatility affects the results that investors receive as they get greedy, panic, and hold on for dear life.

In closing, the dirty secret is this: size your risk level to what you can live with without getting greedy or panicking.  You will do better than other investors who get tempted to make rash moves, and act on that temptation.  On average, the world belongs to moderate risk-takers.

A: How are you doing? Are you here for more enlightening banter?

Q: Not so well.  Have you heard of the Third Avenue Focused Credit Fund [TFCIX]?

A: Uh, the one that is in the news?

Q: Come on.

A: Yes, I know about it, but not much more than I have recently read.  Of all of Third Avenue’s Funds I know it least well.

Q: Weren’t you a bond manager who liked to take concentrated positions though?  You should be able to say something about this mess.

A: I dealt mainly with investment grade credit.  What’s more, I had a real balance sheet behind me at the life insurance company.  An ordinary open-end mutual fund has investors that can leave whenever they want — often at the worst possible time for them, or in this case, those that could not get out.

The main difference was that I could never be forced to sell, under most conditions.  I could buy and hold, and if the eventual credit of the borrower was good, my client would receive all that he expected.  TFCIX faced significant redemptions, and increasingly had mostly bonds that could not be quickly sold, and thus, were difficult to value.  That’s why they cut off redemptions — they couldn’t liquidate assets to give cash to customers on a favorable basis.  Personally, I think setting up the liquidation trust was the best that could be done.  That will allow Third Avenue to negotiate with interested buyers of the bonds without being rushed by redemptions.  The remaining fundholders should be grateful for them doing this now, though it would have been better to act sooner.

Q: But I own shares in TFCIX and need the money now.  What can I do?

A: Oh, my.  My sympathies.  You can’t do much.  There might be some off the beaten track lenders out there that might take it off your hands, but they wear “panky rangs,” as a mortgage borrower once said to me.

Q: Panky Rangs?

A: Pinky rings.  He was from the deep South.  I.e., no one is going to give you a decent bid for your shares, even if you could find someone willing to do so.  First, the value of the bonds is questionable, and the timing of the sales are uncertain.

In some ways, this reminds me a little of The London Whale incident.

Q: How is that relevant?

A: JP Morgan became too great of a part of the indexed credit derivatives market, and as a result, they lost the ability to value their positions, because they were too big relative to the market in which they traded.  Their very buying and selling had a huge impact on the pricing.  Though a value was placed on the positions, the entire situation was impossible to value accurately;  you couldn’t assemble a group to buy it all.

Some clever hedge funds took note of it, and began taking the opposite positions, thinking that they were overvalued, and fed JP Morgan more of what it was already bloated with.  Now maybe, if there hadn’t been so much press furor over it, together with the accounting questions that affected the financials of JP Morgan, they could have found a way out.  JP Morgan’s balance sheet was big enough, and if you left them alone, they would have all self -liquidated.  They might not have made the money they wanted that way, but it could have been done.  As it was, they were forced to liquidate more rapidly, and if I recall, they even called upon one of the opposing hedge funds to help them.

In any case, the forced liquidation led to losses.  Most forced liquidations do.

Q: So, what do think my shares are worth?

A: They are worth the liquidating distributions that you will receive.

Q: That’s no help.

A: Is the Federal Reserve willing to step up and buy the assets as they did with the Maiden Lane Trusts?  No one has a bigger balance sheet than they do, oh, oops.  Maybe they can’t do that anymore… who know where those emergency lending rules go…

Look, I’m sorry that you are stuck.  The Madoff “investors” were stuck also.  They had to wait quite a while.  In the end, they got paid more than most imagined they ever would.  Subject to credit conditions, I would suspect that the more time Third Avenue takes to liquidate, the more you will get.

Q: But that’s dribs and drabs over time, and I need it now.

A: Patience is a virtue.  Make other adjustments; sell something else; scale back plans… it’s no different than most people have to do when they have a loss.  It happens.

Q: I guess… but it would help to know what it was worth, so that I could estimate tradeoffs.

A: yes, it would, but the timing and amount of liquidations are uncertain, and the “market prices” don’t really exist for the underlying — they are too influenced by Third Avenue’s holdings.

Maybe they could have converted it into a closed-end fund,  but that would have cost money, and there still would have been the valuation issue.  People could have gotten paid now if that had happened, but I bet they would have blanched at the size of the unrealized losses.  I would just accept the payments as they come, that will probably give the best return, subject to future credit conditions.

Q: Do we have to modify your statement was true when we first started this discussion:

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

After all, if it is worth the liquidating distributions if I wait, maybe you should add, “or the cash flows you receive over time.”

A: I will do that, and that is part of what I have been arguing for here, but the price here and now is not that.  Just because you can’t sell it now doesn’t mean it doesn’t have value… we just don’t know what that value is.

Anyway, lunch is on me today, because there is another thing that you can’t sell that has value.

Q: What’s that?

A: Me.  A friend.

Q: Let’s go…


Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…


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.



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.

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