Ethics – Page 6 – The Aleph Blog

Bandaging Wounds from Another Promoted Stock Scam

Posted on 11 July 2013 by David Merkel

Okay, time for the promoted stock scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 7/11/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.012	-99.5%	-64.6%
BONZ	10/22/2009	0.35	0.003	-99.3%	-73.2%
BONU	10/22/2009	0.89	0.003	-99.7%	-78.6%
UTOG	3/30/2011	1.55	0.005	-99.7%	-91.9%
OBJE	4/29/2011	116.00	0.305	-99.7%	-93.3%	1:40
LSTG	10/5/2011	1.12	0.031	-97.2%	-86.9%
AERN	10/5/2011	0.0770	0.0003	-99.6%	-95.7%
IRYS	3/15/2012	0.261	0.003	-98.9%	-96.7%
NVMN	3/22/2012	1.47	0.300	-79.6%	-70.5%
STVF	3/28/2012	3.24	0.330	-89.8%	-83.1%
CRCL	5/1/2012	2.22	0.031	-98.6%	-97.2%
ORYN	5/30/2012	0.93	0.154	-83.4%	-80.1%
BRFH	5/30/2012	1.16	0.458	-60.5%	-56.6%
LUXR	6/12/2012	1.59	0.017	-98.9%	-98.5%
IMSC	7/9/2012	1.5	1.260	-16.0%	-15.9%
DIDG	7/18/2012	0.65	0.058	-91.1%	-91.5%
GRPH	11/30/2012	0.8715	0.141	-83.8%	-94.9%
IMNG	12/4/2012	0.76	0.150	-80.3%	-93.3%
ECAU	1/24/2013	1.42	0.360	-74.6%	-94.9%
DPHS	6/3/2013	0.59	0.040	-93.2%	-100.0%
POLR	6/10/2013	5.75	0.600	-89.6%	-100.0%
NORX	6/11/2013	0.91	0.440	-51.6%	-100.0%

	7/11/2013		Median	-92.1%	-92.6%

They are predictably bad.? If anything, the last few promoted stocks have been exceptionally bad.? It makes me wonder whether players play the pump of the pump and dump are getting too numerous.? Maybe after a few more losses like POLR & NORX, there will be fewer players willing to speculate on companies with price momentum that are obviously bogus.

Tonight’s loss-to-be is Arch Therapeutics.? It was a distributor of auto parts that never made a dime of revenue called Almah, Inc., until four months ago.? It did the following:

On April 19, 2013, the Company entered into a Binding Letter of Intent (the ?LOI?) with Arch Therapeutics, Inc., a Massachusetts company (?Arch?), in connection with a proposed reverse acquisition transaction between the Company and Arch pursuant to which the Company would enter into a reverse triangular merger with Arch (the ?Merger?) and the Company would acquire all of the issued and outstanding capital stock and convertible notes and warrants of Arch in exchange for the issuance of 20,000,000 shares of the Company?s common stock to the shareholders of Arch. Arch operates as a life science company developing polymers containing peptides intended to form gel-like barriers over wounds to stop or control bleeding.

On April 19, 2013, subsequent to the Company?s fiscal quarter ended March 31, 2013, Mr. Powers resigned as the Company?s sole officer and director and Mr. Norchi was appointed as the Company?s director and sole officer, and Mr. Avtar Dhillon was appointed as a director.

On May 10, 2013, pursuant to the terms of the LOI, the Company entered into an Agreement and Plan of Merger (the ?Merger Agreement?) with Arch and Arch Acquisition Corporation, a Massachusetts corporation and the Company?s wholly-owned subsidiary (?Merger Sub?). In accordance with the Merger Agreement, Merger Sub will merge with and into Arch (the ?Merger?), with Arch surviving the Merger upon the terms and subject to the conditions set forth in the Merger Agreement.

As set forth in the Merger Agreement, the Company will acquire all of the issued and outstanding capital stock and convertible notes and warrants of Arch (through a reverse acquisition transaction) in exchange for the issuance to the holders thereof of 20,000,000 shares of the Company?s common stock. The stockholders of Arch will receive two and one-half shares of the Company?s common stock for each share of common stock of Arch held by them immediately prior to the effective time of the Merger.

Almah, no revenues, no earnings, negative net worth. Arch, a “promising” technology company that decides to buy a stock listing buying Almah in a reverse merger.? If the technology were so good, why not remain private and work with private equity, or enter into joint ventures with large medical technology companies that have incredible reach?

It beggars belief that one would merge with a virtually defunct company to build a strong medical technology company.? Leave aside all of the scam language in the promotion.? But here are some examples from the disclaimers:

Facts stated in this article were supplied to endorser from third-party sources.
XXX has been compensated $10,000 by YYY for endorsing this product, and ZZZ has been paid a $25,000 by YYY for sending out this advertisement.
YYY, the third party advertiser, has paid $390,000 USD and is expected to pay an additional $400,000 to WWW as of June 20, 2013 for this advertising effort in an effort to build investor awareness.
YYY. represents that it does not own any shares of Arch Therapeutics, Inc. (except for 2,500,000 shares of restricted stock) which YYY. will not sell, pledge or hypothecate or otherwise agree to dispose of for 90 days following the initial dissemination of this advertisement.

If I had a new way of treating wounds that was really effective, I would do it myself privately, or work with private equity.? As it is, this stock promotion is garbage, and not worthy of investment.

The only thing I can’t find is any connection between the promotion and the company.? The promotion doesn’t mention the past, and the company is seemingly not involved in the promotion.? Maybe an owner could be pushing it; they are the only ones that could profit from the promotion.

Improve Your Skills

Posted on 1 July 20131 July 2013 by David Merkel

We live in a world where we no longer have to grow our own food, spin our own cloth, drive away predators, and much more.? There was a time, 100+ years ago where most people had to do the same thing, and? there were a few specialists.? Today, we are all specialists, aside from some who live in desperately poor countries.

But specialists have a problem.? What if their specialty is being changed because of technology?? Or, what if their specialty is being eliminated by the internet?? It’s not as if you can go back to being a farmer; now you have to compete by updating your skills if your skills are in less demand than previously.

It is incumbent on specialists that they fend for themselves, and be aware whether their skills are decreasing in value.? Because improving skills is not generic, I can’t tell you what to do, aside from the idea of improving your knowledge of how the company makes profits, or even better, finding a new area, usually adjacent to existing businesses, where the firm can make money.

If your specialty is dying, you might have to look to areas near yours, and show competence, or get retrained.? If you sell something, you can sell something like it.? If you operate or service something, you can do it for something similar.? For those the manage cash flow or the whole of the company, you can find similar j0bs in companies like yours, though you might have to take a step down.

As I see it, taking a step down is getting your foot in the door.? It is far better to be working at a lesser job than to be idle.? The longer you are idle, the less employable you are seen to be.? Once you have a job there are abilities to advance inside and outside the firm.? If you are employed, it is a signal to other employers that you are valuable.

But beyond that, you have to be vigilant.? Is there a way for technology or cheap labor to eliminate your position?

That’s the problem and glory of the division of labor.? The division of labor makes us all better off as a whole, but not necessarily each one.? There are often those that lose, and I would argue, it is their fault because they did not adapt.? No one is entitled to their living.? If family farms can’t earn their keep, it is better that they should sell.

That is why I say clever workers need to understand their core skills intensely, but need to know the adjacent skills to a decent degree.? Beyond that, do you understand:

how the business makes money?
the strategy of the company within the industry?
how suppliers view the industry?
how consumers view the industry?
how to manage subordinates well?
non-economic problems that are holding the company back?? (I.e., a squabbling management team.)
the effects that changing economic policy have on the industry and company.

You are your own best guardian, in human terms.? No one else has as concentrated an interest in your career as you do.? Therefore, take the opportunity to improve your skills.? It will likely pay off.

Book Review: The AIG Story

Posted on 19 June 2013 by David Merkel

I am biased on AIG.? It was never as good as proponents of its past have said.? But it was not as bad as current detractors allege.

AIG went through several eras, some of which are barely covered by this book.? There was the secular growth era, which existed from the beginning until the late 1980s.? It was easy to continue to grow in P&C businesses in the US until then.? After that growth would have to come from other ideas:

Life insurance in the US and abroad.
Foreign P&C insurance
Aircraft leasing
Asset management

And so, AIG moved from being primarily a US P&C insurance company to being a behemoth, big in life and P&C everywhere, as well as aircraft leasing and asset management.

Other Books on AIG

If you are reading this book, you ought to also read Fallen Giant. and Fatal Risk.? Excellent books both, but they cover different aspects of AIG.? Fallen Giant focuses more on the development of AIG by the founder Cornelius Vander Starr.? It spends relatively little time on the fast growth era which was the start of Greenberg tenure as CEO.

Fatal Risk focuses on the diversification era under Greenberg’s era, when AIG was so big in US P&C insurance that they began diversifying into risks that had more capital markets exposure — Life, annuities, derivatives, airline leasing, commodities, and asset management.

All three of the books spend disproportionate time on the failure of AIG, which is kind of a shame, because the failure was the simplest part of the story.

No risk controls because Greenberg was ousted.? That said, risk control should be institutionalized, not personalized.? That was Greenberg’s fault.? No one man should be in charge of risk for a whole company.
Too much subprime and other mortgage risk spread through the whole organization. (Investments in the life companies, securities lending, derivatives, direct lending, mortgage insurance, etc.)
True leverage was understated on the GAAP financials.

Notable Information

One aspect of AIG that The AIG Story tells is how AIG became a single company.? There were many minority interests, and when Greenberg was a new CEO he bought all of them in.? That decision allowed the company to focus, and not be concerned with minority interests.

In two breezy pages (122-123) we get Greenberg’s take on how he built his life insurance business, buying SunAmerica (1998) and American General (2001).? An aggressive company buys two more aggressive companies, overpaying in the process.? There should be no surprise why AIG’s stock price was basically flat from 1999 to 2007.? Greenberg overpaid for life insurance companies he did not understand.? He was a P&C guy, and did not get how life insurance companies worked.? He saw two aggressive companies willing to sell at exorbitant prices, and paid up.? Culturally, they fit, but buying overpriced assets always takes its toll.

Not mentioned is the debacle that was the attempt to take over The Equitable in 1991.? AIG assumed that a New York company would have a distinct advantage versus AXA, a French company that was the eventual buyer.? AIG made the following errors:

Scared Equitable’s management team into the arms of AXA, who would treat them well.? Yes, Equitable’s management team was incompetent, and needed to be shown the door, but you didn’t have to tell them that directly.
Assumed that the Real Estate portfolio would not rebound.
AIG offered to buy The Equitable for very little, while AXA offered $1 billion of funny money, surplus notes and convertible debt.? Strange, but the funny money was worth more than almost nothing.

Unlike the purchases of SunAmerica and American General, the purchase of The Equitable would have been cheap.? Very cheap.? And AIG missed it, and also under-rated the abilities of AXA.? I was there; I know.

This brings me to a significant point over what was included, and what was excluded… this is the story as Greenberg wants it to be told.? He excludes his errors, and focuses on his achievements.? He was not as good of a CEO as often credited in the 1990s.

On page 127, Greenberg talks about leaving markets where AIG could not earn an underwriting profit, but by the 1990s, AIG was so big that that flexibility was gone.

Closed Culture

AIG’s culture bound employee? fortunes to the stock price of AIG.? Options, participation in C.V. Starr, and a number of other programs created significant incentives for people to stay, and trust in the continual increase in the price of AIG shares.? That created a culture of “lifers” if if survived long enough.

Also, in the 1980s and 1990s the board of AIG had more insiders than most, but when corporate governance rules changed, by 2005, the AIG board was populated by enough incompetent businesspeople, that there was no way that they could control the risks inside AIG.? They tossed out Greenberg at the behest of Spitzer, and then could not supply the moxie that Greenberg had.

The Financial Crisis

The post-2008 Greenberg understands the financial crisis.? Let me quote:

A financial crisis was brewing due to a combination a including: (1) U.S. policy overstimulated appetites for home ownership and kept interest rates low for too long, (2) regulation of institutions was poor, as commercial banks fed the appetite for home ownership with generous mortgages while investment banks demand with complex financial products and increasing leverage; (3) rating agencies failed to analyze many financial products adequately, and the lack of trading in such products on organized markets made them difficult to value; and (4) regulators at the SEC failed to monitor the leverage of many financial institutions, whose debt levels rose to as much as 30 to 40 times capital and, in AIG’s case, regulators at the? Office of Thrift Supervision, which had authority because AIG owned a savings and loan association, simply ignored any signs of trouble.

Hindsight is 20/20… there were many mortgages insured by AIG before Greenberg left, and many mortgage bonds purchased by his life subsidiaries as well.

Greenberg tries to make out the problems of AIG as a liquidity crisis, and not a solvency crisis.? I’m sorry, but in a panic, there is no difference.? If you can’t produce cash when needed, you are insolvent.? It’s that simple.? AIG had enough incremental demands for cash in the crisis, that it should have gone into chapter 11.? Maybe the Fed should have rescued the derivatives counterparty, and charged it back to AIG, but beyond that, it should not have acted.? Much as Greenberg complains, AIG was insolvent, and should have been reorganized.? He would have gotten far less as a result.

He also takes umbrage against Ed Liddy, a good man who attempted to do what the stupid government wanted — liquidate in a hurry, but Greenberg does not recognize that he set much of this process (though not all of it) in motion himself.

Greenberg won the suits against himself.? He personally did nothing materially wrong.? But the mismanagement of AIG in the Greenberg era and the time thereafter did deserve to be punished with chapter 11, not coddled with a bailout and tax incentives.

Quibbles

The book is worth reading, but what you are getting here is court history — the history as approved by the King.? It has elements of history in it, and it is mostly true, but you have to consider the source.? A lot of true history was purposely omitted.

Who would benefit from this book: If you are an AIG buff, you can’t get the full picture without knowing what Greenberg purports.? If you want to, you can buy it here: The AIG Story.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

Polar Petroleum, Frozen

Posted on 10 June 2013 by David Merkel

I’m not going to run the promoted stock scoreboard again so soon, but let it be known that Dephasium has fallen ~75% in the 5 days since I wrote about it.? Put on your peril-sensitive sunglasses, here is the chart:

Yes, my article was written at the peak.? In this case the “dump” was rather violent.

But why I am I writing about promoted stocks this evening?? This morning in my e-mail, I received this [note: after a little time, this link won’t work].

But who sent it to me?? The Washington Times.? After receiving it, I sent someone in their web area this letter:

YYY,

I don?t know if you handle this aspect of Washington Times advertising, but today I received a promoted stock ad for a fraudulent company from the Washington Times via e-mail.

The company?s name is Polar Petroleum [OTCBB: POLR], a company which:

Has never earned a penny of revenue.

Was a ?technology company? until last year, ?Post Data.? From its last 10K: ?The Company intends to market a service of decommissioning electronic data storage devices, making them inoperable and thereby making the electronic data contained therein or on permanently un-recoverable.?

Is likely being used by the promoters to do a ?pump and dump,? where affiliates do a series of transactions that inflate the price of the thinly traded stock, and use this promotion to dupe people into buying out their shares at inflated prices, leaving them holding stock of a worthless company.? The net worth of the company is $0.005/share ? It trades near $5 thanks to the pump.

It?s dishonest for the Washington Times to participate in crud like this.? Why is the Times selling its reputation for a bunch of promoted stock scammers?

Sincerely,

David

PS ? I have written about this extensively.? Here is a sample:

http://alephblog.com/2013/06/03/another-lousy-promoted-stock/

To have a reputable newspaper convey the garbage that the promoters put forth is new, and worrisome.

But about the same time that I hit the “Send” button, the SEC took action.? They suspended trading in POLR.? They justified it here.? Good work, SEC!? (Can’t remember the last time I said that.)? And if you want to see the reactions of those that follow promoted stocks regarding POLR, you can see it here.

Though the loser promoting this garbage said it would go to $27, I’ll give you a different prediction: it will go to less than fifty cents within a year.? Given the actions of the SEC, it could easily go there on June 24th, when trading reopens.

Here is my advice to the SEC: maybe you could create a unit that follows promoted stock fraud, and do exactly what you have done with POLR to every promoted stock scam.? It would eliminate a significant area of fraud in our equity markets.

At the Towson University Investment Group?s International Market Summit, Part 5

Posted on 21 April 2013 by David Merkel

I left one small question for last; I gave a partial answer to this one at the conference.? I think I was the only one that said much on it.? Here it is:

Where does academic theory fail in finance and in economics?

Little questions, big answers.? How do you eat an elephant?? One bite at a time.? Let’s start with math in economics:

1) We have to reduce the complex math in economics — I think we are trying to apply math where it is not valid.? As such, the true strength of ability to explain what is going on decreases, while economic becomes an odd “inside game” for a funny group of mathematicians trying to make sense of an idealized world that bears little resemblance to our own world.

2) The next piece is on maximizing utility or profits.? Maximizing takes work, assuming one can even do it.? Work is a negative, so people conserve on that.? Most of us know this: we look for a solution that is “good enough,” and do it.? That means we don’t maximize utility, and the pretty equations don’t represent reality.

What’s worse is that men care more about relative results than absolute results.? We would rather be kings over an impoverished realm rather than middle class in a wealthy country.? We are worse than greedy; we are envious.

It’s even worse for firms.? There you have agency problems where the management often has its own goals that do not maximize profits, or their net present value, but maximize the benefits they receive.? Boards are frequently a cover for management, rather than advocates for the shareholders.

Regardless, since firms don’t maximize, the elegant math does not work. Putting it simply, if you want to understand economics better, don’t listen to economists — become a businessman.? An ordinary businessman knows more about how the world works than a neoclassical economist.

3) One of the beauties of a capitalist economy is its dynamism.? It adapts to changing needs and desires.? The variation is considerable; as an example, go through your supermarket and try to count the total number of different tomato products.? Or? look at the amazing degree of variety in a major tools catalog.? Or go to Costco, Walmart, Home Depot, Ikea, and look at the incredible variety that exists under one roof.

But that level of variety cannot be mathematically accommodated by economics.? They have to aggregate the complexity into categories, and a lot of the reality is lost in the process.? That is why I distrust? many economic aggregates, such as inflation, GDP, etc.? Politicians find “economists” to suit their political ends, and they come up with complex reasoning for why measured inflation is higher than it should be, inequality is rising, etc.? You can find an economic advocate for almost anything.

Macroeconomics

4) Because of the aggregation problem, the link between microeconomics and macroeconomics is made weak, especially since utility cannot be compared across any two people, and yet the economists mumble, and implicitly do it anyway.

5) At least with microeconomics, we can agree that demand falls as prices rise, and supply rises as prices rise.? But with macroeconomics, there is little agreement as to whether a given policy aids real growth or not.? Modern neoclassical economics is to me a bunch of sorcerer’s apprentices playing around with very large and crude tools that they think can affect the economy, only to find the results are not what they expect.? Somewhere, economists got the naive idea that they could eliminate the boom-bust cycle, only to find that by eliminating minor busts, they set up the conditions for growth in indebtedness, leading to a huge bust.? Far better to be McChesney Martin, or Volcker, who let recessions do their work, than slaves of the government who did not — Burns, Miller, Greenspan or Bernanke.

Take inflation as an example.? Does printing more money, or creating more credit boost asset prices, product & services prices, both, or neither?? The answer to this is not clear.? The Fed has taken many actions over the past 30 years, using a model that assumes tight relationships between short interest rates and inflation/ labor unemployment.? The evidence for these relationships are not evident, except at the extremes.

6) The idea that running deficits to “stimulate” the economy is questionable.? Debts have to be paid back, repudiated or inflated away, any one of which would make business and consumers less confident.? Further, the way the the money is spent makes a great deal of difference.? Much government spending inhibits or does not help economic growth; think of the complexity of the tax code — a recipe for wasted time, and unneeded social enginerring.? Some government spending does aid economic growth, where it lowers the costs of consumption or production — critical infrastructure projects, etc.? But those are rare.? If it were really needed, lower level governments or private industry would do it.

The thing is, most of the deficit spending has not been useful; there’s no economic reason to run such large deficits.? If we were rebuilding all of our aging infrastructure, that would be one thing, but the crazy quilt of tax breaks and subsidies affects behavior, but does not compound and aid growth.

7) We need to admit that culture is not a neutral matter.? Some cultures will have faster economic growth, and others will be slower.? There is no universal culture, no generic economic man.? Some cultures are more enterprising than others.? That has a big impact on growth quite apart from resources, population, education, etc.

8 ) Whether the money is tied to gold or fiat, banking must be tightly regulated.? Solvency of all financial institutions should be tightly regulated.? With financials risks arise when the is too much leverage, and too much leverage that is layered.? Things should be structured such that there is no possibility of dominoes knocking over other dominoes.

Limit leverage
Increase liquidity of assets vs liabilities
Forbid lending to/investing in other financials
Derivatives should be regulated as insurance, insurable interest must exist, which means that bona fide hedgers must initiate all transactions.

On Finance

9) The first thing to realize is that a mean-variance model for investments is loopy.? First, we can’t estimate the mean or the variance, much less the covariance terms.? There is also good evidence that variances are infinite, or close to it.? Thus the concept of an efficient frontier is bogus.? Far better to try to estimate crudely the likely forward returns on a cash flow basis, the way a businessman would, and weakly factor in the uncertainty of the forecasts.

10) Thus, beta is not risk, and volatility is not risk.? At least at present, until the low volatility funds get too big, there seems to be an anomaly where low volatility equity investing beats high volatility equity investing.? This is consistent with my theory that the relationship of risk and return is non-linear.? Taking no risk brings no return; taking moderate risk brings decent return; taking high risks brings low returns.? There is a sweet spot of prudent risk-taking that brings the best returns on average.

11) Multiple-player game theory indicates that to win, you assemble a coalition with more than 50% of all of the power, and you get disproportionate benefits.? Think about the poor buyer of a home in 2006, going into the closing with the deck staked against him.? Or think about forced arbitration of disputes on Wall Street, where the investors rarely win.

Complexity is not the friend of most ordinary economic actors.? Avoid it where you can.

12) Capital structure does matter; it is not irrelevant like Modigliani and Miller said.? Companies with low leverage tend to return more than companies with high leverage.? There are real costs to being in distress or near distress.

13) Markets can have non-linear feedback loops, like in October 1987, or the “Flash Crash.”? Markets are not inherently stable, and that is a good thing.? Instability shakes out weak players that are relying on a shaky funding base, leaving behind stronger players who understand risk.? It is not wise to try to eliminate the possibility of disasters occurring.? When you do that, pressures build up, and something worse occurs.? Better to let the market be free, and let stupid speculators get burned, so long as they aren’t regulated financial companies.

Ethics matters

14) Economics would be more valuable if it focused what is right, rather than what is “efficient.”? I know there will be differences of opinion here, but a discipline that focused on explicit and implicit fraud could be far more valuable than men who don’t have good models for:

Inflation
Asset Allocation
GDP
Unemployment
and more

Imagine applying all of that intelligence to fair dealing in economic relationships, rather than vainly trying to stimulate the economy, and accomplishing nothing good.? It would be like the CFA Institute applied to the economy as a whole.

The Education of an Investment Risk Manager, Part V

Posted on 3 April 2013 by David Merkel

One thing that came out of our “employee empowerment project” was a need to improve our equity and bond fund offerings.? At the same time, a fund manager manager [FMM] came out of the woodwork and suggested to us that we could do multiple manager funds.? They had analyzed many managers and had found some that they thought were great.

The more we thought about it, the more we thought it would be a great idea. Here’s why:

Our own abilities to find superior managers were limited.
A few members? of our team (including me) possessed ability to analyze what FMM would bring us.? We thought we could add value.
We came up with a clever name, “The All Pro Funds.”
We also thought we could add value? in changing weightings every now and then, and firing managers that we felt had become uncompetitive because they were now running too much money, had critical staff losses, or were underperforming style-specific indexes by a wide margin.
We could increase our fee a little to pay FMM and us for the additional work entailed.

And whaddaya know?? It worked.? The portfolios in aggregate? outperformed? their indexes even after fees, and fund flows increased dramatically.? The representatives had a story to tell.? Morale improved everywhere.? We were rolling, until…

A day came where we heard from one of the underlying managers that FMM had recommended their termination because they wouldn’t rebate more of their fees back to FMM.? I would not say that we went ballistic when we heard this — instead, we went cold on FMM.? Act fast?? No, act deliberately.? The senior officers tasked me and the #2 guy in marketing to deal with the problem.

We had a rule in our division — we will pay disclosed compensation, or we will pay undisclosed compensation, but we will never pay disclosed and undisclosed compensation.? Why?? We wanted our clients to know that if compensation was disclosed, that’s all there was.? If there is no “sticker price” but you are happy with the services provided, and don’t need to know what any agent is making that’s fin with us.? But we will not pass more money quietly to those that have said, “This is the sticker price.”

FMM had violated our sense of ethics to the core.? The two of us decided to put out an RFP, asking them to bid to help manage the now $1 Billion of assets. We excluded FMM.? We chose 10 well known manager consultants. Most responded to the RFP and we invited 5 to come present to us on a given day in spring.

-=-==–=-==-=-=-=-

I need to mention one other thing.? When we first started dealing with FMM, we appreciated their qualitative research, which seemed to have some punch.? After a year, they discovered returns-based style analysis.? This allowed them to analyze many more managers just by looking at their returns, and correlating them to a variety of equity and other indexes.? They stopped the qualitative research.

The first time I saw it, I thought it was hooey, even as I think MPT is hooey.? When you have a lot of highly correlated indexes, any attempt to intuit the style of a given manager is problematic; the error bands get too wide.? It is too difficult to determine what the correct answer is.? The optimal answer mostly represents happenstance, and not fact.? Tiny tweaks to the data produce big changes in the answer.? Not a good system.

There was one incident where I met with their new quantitative analyst, a woman 10 years younger than me.? She ask if we understood how the method worked.? I replied with some mathematical jargon regarding the method, leading her to say, “Oh, so you *really* understand this.”

Also, when I analyze a manager, I like looking at what they own.? I like looking at their trades.? I want to see consistency with what they claim is their strategy.? I also like to hear why they do what they do, and what sustainable competitive advantage they think they have.? There is value in that style of analysis.? There is little value in analyzing returns.

=-=-=-===–==-==–

To our surprise, one well-known consultant [call them STAR] that had no for-profit clients was one of the five.? The leader said it was a one-time experiment, so they were evaluating us, as much as we evaluated them.

On the day when they came to present, the presentations were all over the map, from highly professional to “did not prepare.”? Some big names could not answer basic questions about what sustainable competitive advantages they brought to the process, or were fuzzy about how they earned their money.

STAR had the best presentation, services, model, ethics, etc.? It was almost “no competition,” and they liked us as well.? We hired them, much to the chagrin of FMM, who begged us to keep them.? It had the following positive results:

Management fees down by 60%
Fund manager fees down by 50%
Far better marketing cachet
Better models for investment analysis.

We reduced client fees, but had better margins, and still greater growth.? Our division was transformed thorough the two projects.? Before we started our ROE was around 8%, and we were growing AUM at a 5-10% rate.? By the time all these changes occurred, our ROE was 25%, and our growth rate was not far from that.? We were now the stars of the firm, even though the firm culturally could not acknowledge that, because the life division was so big.

I learned several things from this five-year escapade:

Creating a desirable investment product takes work.? If you do something different that seems to add value, it will attract clients. (“We manage the managers for you, so you don’t have to”)
Focus on ethics in those you work with.
Reduce fees where possible, both your own, and that of suppliers.
Name recognition helps.
Be careful what you accept as analysis.? Just because there is clever math does not mean it represents how reality works.
If you don’t take chances, you won’t achieve anything great.? We didn’t have to burn our old strategy, and move to multiple manager funds, but we did it, and it made clients a lot happier.? The added work was work that that we liked to do.
Even if you have a supplier that did something good for you, do not tolerate breaches in ethics.? Find someone else to help you even if it costs more.? That it cost us less was merely a plus.

The Education of an Investment Risk Manager, Part II

Posted on 30 March 20131 April 2013 by David Merkel

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.? Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.?? I chose the spot with AIG, because they led me to believe I would work on the international side.? When I arrived, lo, I had a job on the domestic side.? As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.? They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.? As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.? AIG parent wanted growth in GAAP earnings.? They wanted to see a 15% ROE, which few in the life industry were attaining.? In order to do that, they entered into reinsurance treaties (before I arrived).? These would lever up the balance sheets of the subsidiary companies, without incurring debt.? Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”? I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”? He said, “What do you mean?”? I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.? I just shrugged.? I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).? In one sense, the treaties were structured like the trading requirements in CDOs.? If you must trade:

Get more income
Don’t give up rating
Don’t extend maturity
And a few more smaller things.

I was not there when the treaties were created.? Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.? As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.? After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.? I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.? Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.? What was worse, the liabilities underlying the treaty were structured settlements.? (Structured settlements result from a court case where someone is injured.? The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.? Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.? That’s where most of the bad estimates com in.)? In those days, structured settlements were a “winner’s curse.”? If you won, it was because you mis-bid.? AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).? LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.? LR decided to sue.? After I had gone on to Provident Mutual, AIG settled with LR.? Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.? That should have been enough to jolt AIG’s earnings for a quarter, but it did not.? Funny that, and it always left me a little suspicious of AIG.? (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.? I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.? It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

On the CFA Institute’s “Future of Finance”

Posted on 19 March 2013 by David Merkel

All hail the CFA Institute.? They are trying to inject more ethics into the market through their “Future of Finance” initiative.? I largely agree, but think they are overly optimistic in some areas.

Here are their basic ideas: http://www.cfainstitute.org/learning/future/about/Pages/statement_of_investor_rights.aspx

Here are their dreams: http://www.cfainstitute.org/about/vision/serve/Documents/integrity_list.pdf

My main problems are with the dreams.? Yes, I eventually want every investor to work with someone who has a fiduciary interest in his well-being.? But many people don’t want to take the time to find the people who have their best interests at heart.? There are many things we can overcome, but we cannot overcome the laziness of investors, both retail and professional.? This laziness is part of the nature of man; a few cure it through consistent effort, but most don’t.

To that end, some blame belongs to the unintelligent investors who barge into a market without sufficient knowledge.? That’s how it should be, because in many areas of business those that try to compete with insufficient knowledge lose vitality because they don’t know the basics of the business.

You can’t protect people from stupidity.?? Fraud is another matter.? Deception is different from dumb agreement.

But here is my main challenge to the CFA Institute: where do your ethics come from? Why are they right?? Are they God-given, or merely an agreement among men?

This matters a great deal, because if it is merely an agreement among men, many men will say, “So what! Why should I listen to you?”? If they are God-given, even if men argue with them, the answer comes back from God, “You are a sinner in many ways, including this.? When will you humble yourself to me, and trust in the sacrifice of my Son, which was the largest event in history?”

Ethics aren’t neutral; people disagree about what is right and wrong to a high degree.? Even in finance, there are considerable disagreements in what is the correct behavior:

Active vs Passive mangement
Value vs Growth
Does Technical Analysis work?? (Is there truly a single discipline there?? I don’t think so.)

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

Don’t get me wrong, I largely favor what the CFA Institute is proposing.? I just think it will be hard to turn it into public policy because of the large disagreements over how finance actually works.? Also, the degree to which neglectful parties buy into the markets through the persuasion of sellers, because they won’t look out for their own best interests directly.

So, look at what the CFA Institute is up to.? They are part of the “White Hats” in the market, like me, who argue for the good of investors.? My only difference with them is that their model of the market is not fully accurate.? Nor do they understand how men can err, even with detailed ethics codes.

Should Brokers Be Fiduciaries?

Posted on 13 March 2013 by David Merkel

From a reader:

As a reader of yours, I find your views always interesting and well thought-out, even when I disagree. Thank you for sharing your thoughts, wisdom, and experience, as I truly believe you raise up the areas of thought you touch.

I have a question that I hope you will address on your blog, though the urgency is low. As a CFA and CFP working in a small RIA, I have been paying close attention to the debate about imposing a uniform fiduciary standard onto RIAs and brokers. I would loved to hear your thoughts about this topic, maybe addressing the following:

Should brokers giving advice be held to the high fiduciary standard of advisers?

Could a two-tier fiduciary standard work (i.e. codification of the Merrill rule)?

The primary broker argument against the fiduciary standard, as I hear it, is that it would make services to retirement accounts unprofitable. Do you agree?

I hope to hear your thoughts on this published on your blog because I know that quite a few people with second or third degree connections (maybe first, but I don’t know) to the policy makers and lobbyists read your blog.

First, thanks — I know my reader base stretches into some lofty places, not that I deserve it.

There should be informed choice when choosing those that advise investors.? I don’t think that brokers should be held to a fiduciary standard, but I do think they should have to state to clients that they have a potential “conflict of interests.”? Clients don’t make money when trades occur, but brokers do.

The trouble is, retail investors are the dumb money.? There is a tension between allowing freedom and letting people get shorn by those that are more skilled.? Some financial products are sold not bought, and it is largely because people will not plan in advance for themselves.? We see that in life insurance all the time.

Here’s the other side of it: we can’t make retail investors smart.? In most transactions of life, the foolish get hosed.? We can’t protect people from being dumb.? If we did that consistently, our economy would probably fail.

The idea of “just prices” does not work.? It’s not flexible enough.? In the end, things work best when we let let markets work, but require extensive disclosure that most will understand, and some won’t.

Perfection is not possible in law or regulation.? If we get “pretty good” we have hit the top.? Enjoy pretty good where it exists, though I would encourage investors to use those that have to put your interests ahead of all else.

PS — there has to be a way to service retirement accounts — as with insurance contracts, some sort of AUM fee or trailer commission would do it, but not something based off of transactions…

Comments on the Berkshire Hathaway Annual Letter

Posted on 2 March 2013 by David Merkel

I’ll let Buffett speak, and I will add a few comments.

When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar, in terms of the comparison we present on the facing page.

But subpar it was. For the ninth time in 48 years, Berkshire?s percentage increase in book value was less than the S&P?s percentage gain (a calculation that includes dividends as well as price appreciation). In eight of those nine years, it should be noted, the S&P had a gain of 15% or more. We do better when the wind is in our face.

To date, we?ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.

One thing of which you can be certain: Whatever Berkshire?s results, my partner Charlie Munger, the company?s Vice Chairman, and I will not change yardsticks. It?s our job to increase intrinsic business value ? for which we use book value as a significantly understated proxy ? at a faster rate than the market gains of the S&P. If we do so, Berkshire?s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.

I appreciate Buffett & Munger not changing their metric.? They could have said that the market return beat the S&P in 2012, but they didn’t.? Buffett is a compounder.? He figures that if he compounds net worth at an above average rate, he will beat the market returns of the S&P 500 over the intermediate term.? I agree; building intrinsic value will almost always lead to outperformance, unless the stock was significantly overvalued at the beginning.

On Searching for Acquisitions

Our luck, however, changed early this year. In February, we agreed to buy 50% of a holding company that will own all of H. J. Heinz. The other half will be owned by a small group of investors led by Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.

We couldn?t be in better company. Jorge Paulo is a long-time friend of mine and an extraordinary manager. His group and Berkshire will each contribute about $4 billion for common equity in the holding company. Berkshire will also invest $8 billion in preferred shares that pay a 9% dividend. The preferred has two other features that materially increase its value: at some point it will be redeemed at a significant premium price and the preferred also comes with warrants permitting us to buy 5% of the holding company?s common stock for a nominal sum.

Once again, we don’t know all of the details, but it really looks like Buffett got the better part of the deal, and by a decent margin.? He continues:

Our total investment of about $12 billion soaks up much of what Berkshire earned last year. But we still have plenty of cash and are generating more at a good clip. So it?s back to work; Charlie and I have again donned our safari outfits and resumed our search for elephants.

As many expected, Buffett has more than enough cash to deploy if he sees the right deal.? With valuations being high, I don’t see how they fire the elephant gun, unless a company with protected boundaries wants to sell.

Though I failed to land a major acquisition in 2012, the managers of our subsidiaries did far better. We had a record year for ?bolt-on? purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares.

Charlie and I love these acquisitions: Usually they are low-risk, burden headquarters not at all, and expand the scope of our proven managers.

The tuck-in acquisitions of BRK are particularly valuable.? Done out of the spotlight, they get done at reasonable terms, and grow BRK organically.

The new investment managers, Combs and Weschler, did well in 2012, and Buffett is giving them more assets to manage.

As noted in the first section of this report, we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money.

Now interest rates are low, and underwriting standards are far tougher across the industry than if we were in a high interest rate environment.

Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: There is very little ?Berkshire-quality? float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry?s premiums have been inadequate to cover claims plus expenses. Consequently, the industry?s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue.

What Buffett is saying is that his float is unique because:

His company underwrites carefully.
There is a decent amount of long-tailed business.
The short-tailed business (GEICO) is growing, which makes short-dated float feel long — in essence Buffett can borrow short and invest long, for now.

A further unpleasant reality adds to the industry?s dim prospects: Insurance earnings are now benefitting [sic] from ?legacy? bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years ? and perhaps for many years beyond that. Today?s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.

He is overstating the case here.? Most P&C insurers run short asset portfolios and have already adjusted to the low interest rate environment.

Now regarding the non-insurance operating businesses of BRK, they almost all had good years in 2012.? I’m not going to say more, though I will say that Buffett spent too much ink on newspapers; it is a teensy part of BRK.

Finally. Buffett talks about dividends.? There are two major ideas here:

Dividends are tax-disadvantaged versus buybacks.
If you can compound earnings at an above-average rate, there is no reason to ever pay a dividend.

What this might mean is that when a future CEO of BRK concludes that “there are no more worlds left to conquer” a la Alexander the Great, it would be reasonable to pay a dividend.? That said, he could also:

Centralize HR, legal and other functions.
Streamline subsidiaries, and make fewer managers manage more of BRK.
E.g., turn BRK into a real company.

There would be many ways to reshape BRK post-Buffett.? There are benefits and costs to doing that, but I think the benefits would be significant, unless the new CEO could keep the “hands off” way that Buffett does private equity.

Full Disclosure: Long BRK/B