Have a look at this article.  He makes the case as to why leveraged ETFs should not be held over the long term, as I have argued before.

There is a problem with this.  Imagine for a moment that all users of leveraged ETFs extinguish their positions daily.  There would be no shares to be sold the next morning to those who want to take a position. Where would the shares come from to be bought or sold?

Leveraged ETFs rely on those that will not use them over one day only. They provide the supply/liquidity for everyone else.

Maybe there should be a tiny dividend accrued/paid to holders at the end of each day to equalize for the rebalancing losses.  I don’t know for certain, but I suspect that would ruin the economics of running a leveraged ETF.  It would add to the daily costs of hedging, which are already significant.  But maybe the overall costs would be borne more equitably with dividends corresponding to the hedging interval.  It would also deter paired shorting of leveraged ETFs.

But maybe losses for levered speculators is its own best reward.  The ability to take levered positions shouldn’t be free; someone trying to do it on his own would incur costs.

It’s paternalistic, but maybe these products should be barred on public policy grounds.  On net, they guarantee losses to holders.   If people want to construct these strategies themselves, and bear the costs explicitly, fine.  But to have the costs borne implicitly by fools is another matter.

We limit market leverage partly for systemic reasons, but also because it prevents people from harming themselves.  As for me, I would not object if the regulators eliminated leveraged ETFs.  They serve no long-term useful purpose.

Some friends of mine asked me if I could create an insurance-centric hedge fund.  I said that it was unlikely because I’m not good at shorting.  They pressed me on it, because they knew if I had good longs, with my quantitative skills, I could create a credible short position that might hedge the longs.

Ugh.  I don’t want to do it, but maybe I could make this work.  I certainly could use the revenue.  So what would I focus on in such a fund?

• Relative valuations
• Management quality
• Reserve releases/strengthening from prior year claims
• Momentum — yeh, momentum.
• Long-term underwriting profitability

My goal is to make money for average people, not the wealthy, but if that is the only way that my firm can survive, I will set up a hedge fund in the insurance space.  I love insurance; I know it intuitively, but I know that once I  begin to take big bets, I may fail badly.

If you know me well, you know that I only take prudent risks.  I’m not risk-averse, I like taking risks when the odds are in my favor.

So I am puzzled at this point.  I have done better in evaluating the broad markets than the narrow insurance markets, but if I have to be a narrow investor in order to survive, I can do that.

If you have advice for me here, I will receive it with thanks.

What is this graph?  I’ll give you a hint — it has something to do with technical analysis where investors look for signals near turning points.

Ideas?  Let me know in the comments.  I’ll have a post on this later.

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.  Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.  I usually put in a number of gaps close to the square root of the dominoes.  Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.  Any jolt to the system will topple most or all of them.  Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.  Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.  These thoughts are my own, though others have uttered them as well.   In order for there to be a panic that destroys a large portion of the financial system, there has to be:

• High levels of leverage.
• Leverage that is layered, where many parties are lending, and carry trades are common.  Parties borrow to lend more aggressively.
• Collateralized lending — financial entities lend far more when lending is collateralized.  Most of the time, the existence of collateral prevents defaults.  But when things get really bad there is no protection with most collateral.
• Problems with highly rated debt.  When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
• There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
• Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.  That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.  Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.  It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.  Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.  The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.  Maybe we’ll get there in another 2-3 years.

Why do we do time-weighted returns for analysis of portfolios?  Because we are lazy, and they are simple to calculate.  We don’t want to be bothered with the effects of cash flows.

Besides, mutual fund managers don’t make decisions to move money in and out of their funds.  They should not be held accountable for the actions of their shareholders.

Really?  I think that is only half correct.  The good fund manager takes account of his implicit liability structure.  When will people leave, when will they come?  For almost all funds, investors are trend followers.  And the the greater the degree of volatility, the worse the investors are at following the trend.  Thus a manager of a volatile fund should run with more of a cash buffer, particularly when markets are moving down hard, because he will have more of his clients cashing out.  The manager of a volatile fund should also avoid taking concentrated positions, because when he is doing well, his own buying may drive the stocks he owns up, only to see them fall harder when he is forced to liquidate positions when the market is doing poorly, and shareholders are leaving.  Wise managers concentrate near bottoms, and diversify near tops.

Now for my poster child, the Legg Mason Value Trust.  Bill Miller is a very intelligent guy, and has a very talented staff.  My main criticism of his management is that it neglects the core concept of value investing, which is “margin of safety.”  The core concept is not cheapness, or as Bill Miller was fond of saying “lowest average cost wins.”

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.  As Legg Mason Value Trust grew larger it concentrated its positions.  It also did not care much about margin of safety in financial companies.  It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.  I’m not sure the situation has stabilized, but it is probably close to doing being there.

But now to the point: what did Bill Miller earn for shareholders?  The earliest date that I could get data for was 3/31/1993, probably due to the creation of EDGAR in the mid-90s.

On a dollar-weighted basis, he earned 2.71%/year for investors through 10/31/2010.  But for those stout-hearted souls that bought and held, they earned 6%+ more, 8.78%.  But those that did that had to be patient, even Stoic, people who had no need for liquidity, and no propensity for panic.  (There is always enough time to panic. )

Legg Mason Value Trust was a volatile fund, and as such, it is no surprise that the difference between time-weighted and dollar-weighted returns are so large.  But what does this imply about Bill Miller? He beat the S&P 15 years in a row.  But as posts like this point out, did he go from first to worst?

His neglect of the core idea in value investing, margin of safety, allowed him to do well as the lending bubble expanded, and low quality companies prospered.  But when the tide went out, he was found to be swimming naked.  Far from following Buffett’s principles, or Graham’s, he was just a growth investor masquerading as value investor because “he bought them cheap.”  And they got a lot cheaper, and he had to sell them cheaper still.

So what are the lessons here?

• Focus on margin of safety in investing.  Analyze balance sheets.
• Avoid investing in popular funds, even excellent managers make mistakes when lots of money is coming in.
• Stick to your knitting.  Don’t engage in all manner of fancy logic once you achieve success.  Stay humble.
• Remember that your timing in investing makes a difference.  Don’t be quick to add to a winning fund.  Better to find a fund with good ideas that is temporarily underperforming.
• Buy-and-hold often beats the average investor over the long haul.  Some traders might do better, but have you developed that skill?
• Avoid managers that say a lot of clever things, but can’t deliver on returns.

So be wise, and realize, you are still responsible for your investment success or failure, even if you hand it off to others.

I received a question from a friend of mine and want to give an answer:

Background: I teach high school physics.  In my AP class, I have some cross-registration with the Micro-econ & Personal Finance classes.  In those classes, they play the “Stock Market Game” in which they’re given $25k and compete for the semester for the highest total.  Inevitably, discussion of economics, stocks, and that game finds its way into my class where I am incapable of _not_ getting involved.

Problem 1: The game only lasts for a semester (4 months).  Result: very short term thinking

Problem 2: The teacher pushes stock-chart reading, “200 day average vs 50 day average”, looking at price movements, etc.  There is little (if any) balance sheet reading, company growth investigation, or stock price evaluation going on.

Relevance for here: The kids immediately turn to penny stocks thinking to make a quick buck- “If I buy 50,000 shares of this company at $0.25, I can sell it for a huge profit when it goes up to $0.50.

Question: Do you have any recommendations for short quips / talking points to reveal their folly to them? 

(I had a kid last year almost not graduate when he became so enamored with playing the stock market that he thought he could “crack the code” and make a fortune off penny stocks.)

I have only experienced one good investment contest in my life.  It was in 1983-1984, when Value Line sponsored a contest offering significant prizes.  They did something unique: they divided the market into 10 groups sorted on volatility, and told investors that they had to pick one stock out of each of the ten groups.

Brilliant. this eliminated the ability of people to just pick risky stocks, and bet on getting lucky turning the whole thing into chance.

A portfolio of ten equally-weighted stocks demonstrates more ability than a single pick.  For any single stock, or concentrated portfolio that does well, the answer should be that they got lucky, as humans see it.

As it was, in the Value Line Contest, I finished just short of getting a prize.  My returns were less than a percent behind the lowest winner.

Now as to what you should do, dear friend, in the short run, momentum matters more than valuation, most of the time.  The teacher may be giving them the right advice for the contest.  Personally, I would go to the teacher, rather than the students, and tell him to do a contest more like Value Line did.  If he needs help with the volatility groups, I can provide the data.

But the two main things to point out on penny stocks is this: 1) Most people investing in penny stocks lose a lot of money, because the stocks seem cheap, but they have little in assets or earnings relative to their price.  2) There are penny stock promoters who tout penny stocks so that others will buy at a higher price, so they can sell to them, and the new buyer can experience the losses.

If the contest is structured properly, it should have a minimum capitalization limit, and a diversification requirement.  Tell the other teachers to consider this.

Yesterday, I received a pitch in the mail for a penny stock.  They should put a big red X over my address, but alas, they don’t.

Now for all of my prior penny stocks that I have been written about, all have done horribly.

• Bonanza Gold
• GTX Corp
• Bioneutral
• Uniontown Energy Inc.
• Obscene Jeans Corp

Now we have AER Energy Resources [AERN] which has done horribly, and does not file financial statements, having “gone dark.”  From a research note on the web, this is what they said:

Please be advised that VictoryStocks.com has been paid $1,300,000 by Sanaz Trading Inc. to perform promotional and advertising services for a one month profile of AER Energy Ressources Inc. which services include the issuance of this release and the other opinions that we release concerning AERN   VictoryStocks.com has not investigated the background of Sanaz Trading Inc. the hiring company. Anyone viewing this newsletter should assume the hiring party or , affiliates of the hiring party own shares of AERN of which they plan to liquidate, further understanding that the liquidation of those shares may or may not negatively impact the share price. VictoryStocks.com has received this amount as a production budget for advertising efforts and will retain amounts over and above the cost of production, copywriting services, mailing and other distribution expenses as a fee for our services. As such, our opinion is neither unbiased nor independent, and you should consider that when evaluating our statements regarding AERN. VictoryStocks.com is owned by: FreePennyAlerts, LLC, 40 East Main Street, Suite 572, Newark, Delaware 19711. Questions regarding this release may be sent to Editor @ VictoryStocks.com.

I only ran into that scam because I Googled Lone Star Gold [LSTG], and that popped up.  Lone Star Gold is a negative income negative net worth stock.  A promoter for Lone Star Gold snail mailed me, complete with handwriting and excess staples, but the horrid disclosure in teeny tiny type was this:

IMPORTANT NOTICE AND DISCLAIMER: This paid email advertisement by XXX (hereafter “XXX” does not purport to provide an analysis of any company’s financial position, operations, or prospects and this is not to be construed as a recommendation by XXX, or an offer to sell or solicitation to buy or sell any security. Lone Star Gold Corp. (hereafter “LSTG”), the company featured in this issue, appears as paid advertising. Mermaid Finance Ltd has paid $1,768,000 for the dissemination of this info to enhance public awareness for LSTG. Although the information contained in this advertisement is believed to be reliable, XXX makes no warranties as to the accuracy of any of the content herein and accepts no liability for how readers may choose to utilize it. The information contained herein is based exclusively on information generally available to the public and does not contain any material, non-public information. Readers should perform their own due-diligence before investing in any security including consulting with a qualified investment advisor or analyst. Readers should independently verify all statements made in this advertisement and perform extensive due-diligence on this or any other advertised company. YYY has received twenty thousand dollars for this and related marketing materials. YYY/XXX also expects to receive new subscriber revenue, the amount which is unknown at this time, as a result of this advertising effort. YYY and XXX nor any of their principals, officers, directors, partners, agents, or affiliates are not, nor do we represent ourselves to be, registered investment advisors, brokers, or dealers in securities. XXX is not offering securities for sale. An offer to buy or sell can be made only with accompanying disclosure documents and only in the states and provinces for which they are approved. Research and any due diligence was conducted by an outside researcher for this advertisement. More information can be received from LSTG’s website at www.lonestargold.com. Further, specific financial information, filings and disclosures as well as general investor information about publicly listed companies and other investor resources can be found at the Securities and Exchange Commission website at www.sec.gov and www.nasd.com. Any investment should be made only after consulting with a qualified investment advisor and only after reviewing the financial statements and other pertinent corporate information about the company. Many states have established rules requiring the approval of a security by a state security administrator. Check with www.nasaa.org or call your state security administrator to determine whether a particular security is licensed for sale in your state. This advertisement is not intended for readers in any jurisdiction where not permissible under local regulations and investors in those jurisdictions should disregard it. Investing in securities is highly speculative and carries a great deal of risk, which may result in investors losing all of their invested capital. Past performance does not guarantee future results. The information contained herein contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933 and Section 21 E of the Securities Exchange Act of 1934, including statements regarding expected continual growth of the featured company. Forward-looking statements are based upon expectations, estimates and projections at the time the statements are made and involve risks and uncertainties that could cause actual events to differ materially from those anticipated. Forward-looking statements may be identified through the use of words such as expects, will, anticipates, estimates, believes, or by statements indicating certain actions may, could, should, or might occur. Any statements that express or involve predictions, expectations, beliefs, plans, projections, objectives, goals or future events or performance may be forward-looking statements. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the publisher notes that statements contained herein that look forward in time, which include other than historical information, involve risks and uncertainties that may affect the company’s actual results of operations. Factors that could cause actual results to differ include, but are not limited to, the size and growth of the market for the company’s products and services, regulatory approvals, the company’s ability to fund its capital requirements in the near term and the long term, pricing pressures and other risks detailed in the company’s reports filed with the Securities and Exchange Commission. XXX is a trademark of YYY. All other trademarks used in this publication are the property of their respective trademark holders. XXX is not affiliated, connected, or associated with, and are not sponsored, approved, or originated by, the trademark holders unless otherwise stated. No claim is made by XXX to any rights in any third-party trademarks.

Each promoter paid more than a million bucks.  Given the light level of trading in the stocks, and the low share price, the promoters were trying to do a significant pump-and-dump.  Personally, I think it would be really tough to squeeze over $1 million off of these tiny horrible companies, but maybe I don’t know the revenue model so well.

As I frequently say, “Don’t buy what someone want to sell to you.  Buy what you have researched, and what you think has value.”  Ignore penny stocks, with all of the ads that are on the web.  Short them if you dare.  These are horrible companies; any stock that has someone paid to promote it is a sell.  Sell, sell, sell!

This could not be simpler, so ignore the touts that promote penny stocks.  Short them if you dare, “the market can remain insane longer than you can remain solvent,” as Keynes said.

Penny stocks are for losers who dream of great gains.  They get the losses that they deserve.

I am often a fan of neglected small cap stocks.  When I find a good one, I add it to my portfolio.  But I am generally not a fan of stocks that trade below $1.00.  Why?  Because there are many promoters of the stocks who deceive those who are illiterate regarding the markets, promising big gains, but end up delivering significant losses.

I see lots of penny stock ads.  Big deal. But one ad got under my skin.  This article was motivated by an ad that said, “Penny stocks made me rich.”  Now, there may be a handful of people for which that is true, but in general, those that invest in penny stocks lose money.

There is a constant in investing, that amateurs who invest in volatile asset classes tend to lose money, and more money as the asset classes get more volatile.  Penny stocks are volatile in the extreme.  Even leaving aside the promoters who pump-and-dump, it is a rare person who can approach these in a businesslike manner.

But now, if I can, I’d like to describe the penny stock universe to you.  Here is how penny stocks differ versus the market as a whole:

Because biotech companies tend to be small, and have a high failure rate, the healthcare sector is much larger for penny stocks.  With basic materials, the adage that a gold mine is a hole with a liar at its mouth holds true.  Thus there are more companies in those two sectors.

Services, Energy, Consumer Noncyclicals, and Utilities are all industries where there are increasing returns to scale, and where minimizing costs likely dominate over trying to offer specialized products that add value.

Now let’s look at penny stocks segmented by sector and size.  Same sectors, but the $21 billion of market capitalization that the 2,800+ penny stocks live in are divided into five roughly equal quintiles by market capitalization.

Here’s the breakdown:

The financials have Fannie, Freddie, and some other large failed banks in the first quintile.

Health Care has a lot of companies, regardless of size.  Services, Basic Materials, Energy and Technology are similarly consistent.  Many small companies pursuing advantage versus much larger competitors.

The smaller sectors are random as should be expected. There is no surprise there.  After all, they don’t have advantages from economies of scale.

Here is my final table:

In general, the smaller the market capitalization gets, the less liquid the stocks are.  This is not perfectly linear, because there are promoters pumping and dumping the stocks in the lowest quintile. (and in higher quintiles as well.)  The larger the market capitalization, the harder it is to pump-and-dump.

So be wary when buying stocks with small market capitalizations.  All the more, pay attention to balance sheets, revenue recognition policies, and other accounting quality measures.  Act like an intelligent value investor, if you dare, because you are playing on dangerous ground.  There are safer places to play, go elsewhere.  Don’t let the seeming cheapness delude you.  This is an area where accounting frauds are rife, and where ordinary investors lose a lot.

DON’T BUY PENNY STOCKS.

This will be a short post.  I am not worried about China selling its US Treasury bonds for several reasons:

1. As they sell, the Yuan will rise versus the Dollar, which the Chinese Government does not want. Eventually their exports will fall, as US exports rise.
2. After that, the Chinese Government faces a reinvestment problem.  What do they reinvest in?   The Euro is under threat, the Yen doesn’t want more investors, and the rest of the developed world’s currencies are in the stratosphere.

I think the threat of the Chinese Government to sell US Treasuries is empty.  They can’t do it without hurting themselves significantly.

Options:

• Buy storable commodities, gold? Done that.  Hoard more?  At these prices?
• Switch to other types of debt than government debt? After the brouhaha with Agency debt, I suspect they would be less than willing to wander off the beaten path.  Besides, they are pretty big, and they are dealing with thinner asset classes.  If they have driven up the prices of Treasuries, imagine what they could do to corporates?
• Start buying companies around the globe?  If governments would let them, maybe, but there would be a political stink.
• For a weird idea, China could buy surplus US housing and restore liquidity and collateral levels to a market in oversupply.  After a decade they get out at a profit, probably.

Also, the lower level of liquidity could be an issue if actions need to be taken to recapitalize their banks when the next crop of bad loans has to be reconciled in the next few years.

China’s options for holding the proceeds from its trade surplus are limited.  For all of their deficiencies, US Treasuries are a liquid and deep market.  Chinese exporters benefit from keeping the Yuan weak versus the US Dollar.  I don’t see things changing soon, absent a bolt from the blue.

This book review is different.  It was written back in 1963, and has not been reprinted.  If you want to buy it, you will have to buy it used.  My copy used to be a part of the Newport, Rhode Island Public Library.  It is a short recounting of the economic history of the Pilgrims.  The total pages allocated to the main text are less than 60 pages.

But a good 60 pages they are.  Michael Milken once self-servingly said, “America was built on Junk Bonds.”  If we were talking about the Pilgrims some might say their effort was financed by loan sharks, but really, it would be fairer to say that they were financed by venture capitalists, which occasionally worked on an equity basis, and also on a debt basis.

The author does not dwell on the religious views of the Pilgrims, aside from the effects it had on the financing of the colony.  Given that this was written in 1963 that is not a weakness, because writers in that era had better historical knowledge than most in the present era, in my opinion.

Though the book has only two chapters, it breaks down into 5 phases:

1. The decision to emigrate from Leyden (in Holland) to the New World, obtaining an initial patent, gaining financial backers who were less than reliable, to the formation of a Joint Stock company.
2. Leaving England and arriving at Plymouth, Massachusetts which was not their intended destination.   Disaster happens with their Winter arrival, with many dying.  The initial ability to service the debt is poor, which leads to squabbles among the financiers.  The joint-stock company breaks up, and the Pilgrims agree to buy out the financiers at a price that gives the financiers a profit, but leaves the leaders of the colony in debt to a new set of financiers.
3. Socialistic policies lead to disaster, until residents get their own land to till, leading to relative local prosperity.  In order to pay down debts the Pilgrims enter the fur trade, though with difficulties.
4. They get a new patent, and find that their agent, Isaac Allerton, was not fully trustworthy.  Disputes over accounting embroil the Pilgrims and their financiers, probably to the detriment of the Pilgrims.
5. Their financiers quarrel among themselves, after which an agreement is struck, where the amounts of goods that the Pilgrims delivered are adequate to pay off the debt.

The book doesn’t deal with the aftermath.  Anyone that has read Bradford’s writings on Plymouth Plantation would recognize that at the end, Bradford was dispirited, because almost all of those who came and survived, had moved further west to get more and better lands.  The religious motives of the colony were sufficient for its founding, but proved inadequate for its continuation.  After 25 years, the debts were paid, but for the most part, the colony had evaporated.

The collective financiers earned a handsome return, between 20-40%/year, maybe.  We don’t have enough details to be certain.  All I know is that the heavenly reward of the Pilgrims was far greater than their earthly toils to pay back their financiers.

Quibbles

The book could have dealt a little more closely with the motivations of the pilgrims, and their willingness to take deals that were against their interests.  Yes, the pilgrims were not as financially savvy as those that financed them, but they weren’t stupid either.  They were desperate to get out of the Netherlands and Britain.  That desperation drove some of the bad deals they took, and made them look like a bad risk, which narrowed down who would deal with them.  Leaving that aside, financing for most colonial ventures was stiff.

Who would benefit from this book: If you want to understand the economic struggles that the Pilgrims undertook, you will like this book.  If you want to, you can try to buy it here: Debts Hopeful and Desperate: Financing the Plymouth Colony.

Full disclosure: I bought the book with my own money.

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