Speculation – Page 5 – The Aleph Blog

Asset-Liability Mismatches and Bubbles

Posted on 9 July 2015 by David Merkel

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless. ?But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust. ?Half of the interview aired — the part on domestic matters. ?The part on Greece and China didn’t air, and what a pity. ?I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy. ?People had a hard time figuring out where to put their money. ?Savings and fixed income didn’t offer much. ?Real Estate was great if you could afford it. ?The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes. ?Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago. ?Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods. ?Short-termism and following momentum is most of what creates bubbles. ?Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt. ?Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down. ?When the amount of equity in the ?account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made. ?When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels. ?This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom. ?(Note: that article won a small award. Powerpoint presentation here.) ?The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly?fake, because all of the borrowing is temporarily pulling future prosperity into the present. ?When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not. ?Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers. ?In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling). ?They are trying to be more liberal about liquidating margin debt. ?They are limiting share sales by major holders. ?They are postponing IPOs. ?They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble. ?I think they are deluded. ?Yes, they are relatively more powerful in their own country than US regulators and policymakers. ?But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have?low forward-looking returns. ?If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more. ?For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here. ?It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself. ?Remember, margin of safety matters. ?More on that coming in a future post.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.

The Phases of an Investment Idea

Posted on 27 June 201528 June 2015 by David Merkel

Investing ideas come in many forms:

Factors like Valuation, Sentiment, Momentum, Size, Neglect…
New technologies
New financing methods and security types
Changes in government policies will have effects, cultural change, or other top-down macro ideas
New countries to invest in
Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
New asset classes or subclasses
Durable competitive advantage of marketing, technology, cultural, or other corporate practices

Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. ?When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.

For an example, think of Ben Graham in the early days. ?He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. ?As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.

As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. ?Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.

The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. ?Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. ?It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.

Value investing principles, rather than dying there, broadened out to consider?other ways that securities could be undervalued, and the analysis process began again.

My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.

Now think of the technologies that led to the dot-com bubble. ?The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. ?The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.

My second point is that often the price performance of an investment idea overshoots. ?Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. ?It might happen because of expected?demand that does not occur, or too much short-term leverage applied to long-term assets.

Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? ?A new investment factor is discovered:

it earns great returns on a small amount of assets applied to it.
More assets get applied, and more people use the factor.
The factor develops its own price momentum, but few?think about it that way
The factor exceeds the “carrying capacity”?that it should have in the market, overshoots, and burns out or crashes.
It may be downplayed, but it lives on to some degree as an aspect of investing.

On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. ?By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. ?On a dollar-weighted basis, the verdict on the factor might not be so hot.

So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? ?Not very useful. ?Dollar weighted? ?Better, but still of limited use, because the discovery era will likely never be repeated.

What should we do then to make decisions about any factor/idea for purposes of future decisions? ?We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. ?That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.

It leaves us with a mess, and few?firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”

That’s all for now. ?As always, be careful with your statistics, and use sound business judgment to analyze their validity in?the present situation.

There’s a Reason for Risk Premiums

Posted on 3 June 2015 by David Merkel

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. ?In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? ?I don’t have the article in front of me but I’ll toss out a few.

Many were Credit-oriented. ?Lend and make money.
Some were volatility-oriented. ?Sell options on high volatility assets and make money.
Some were currency-oriented. ?Buy government bonds where they yield more, and short those that yield less.
Some had you act like a bank. ?Borrow short, lend long.
Some were like value investors. ?Buy cheap assets and hold.
Some were akin to arbitrage. ?Take illiquidity risk or deal/credit risk.
Others were akin to momentum investing. ?Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

Someone will start a hedge fund off this.
Many of these are correlated; with enough leverage behind it, the hedge fund?could leave a very large hole when it blows up.
Yes, who wouldn’t want to be a bank without regulations?
What an exercise in data-mining and overfitting. ?The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. ?(Even those are not truly free; animals have to be fed and cared for.) ?They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that?pays all of its interest and principal. ?Usage: “Is it ‘money good?'” ?”Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. ?There are a few problems though:

Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. ?What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? ?What insurance company wouldn’t want to sell off its junk bonds at that time as well? ?And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. ?Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. ?Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

Possible Investment Contest

Posted on 13 May 201513 May 2015 by David Merkel

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

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

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

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

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

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

Now, Who Would Be Sponsors?

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

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

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

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

The SEC Pursues a Fool’s Errand

Posted on 6 May 2015 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

“It’s Baseball, Mom.”

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

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

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

We Don’t Need To Be Able To Short Private Companies

Posted on 29 April 2015 by David Merkel

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

Dan Primack of Fortune wrote in his daily email:

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

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

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

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

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

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

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

What is required to have an effective means of shorting assets

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

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

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

The Troubles Associated with Shorting Private Assets

I can think of four?troubles. ?Here they are:

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

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

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

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

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

What Might Be Better

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

What Might Be Better Still

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

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

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

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

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

Conclusion

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

Learning from the Past, Part 4

Posted on 28 April 2015 by David Merkel

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

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

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

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

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

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

Small Cap Value Forever!

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

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

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

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

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

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

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

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

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

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

What did I learn?

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

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

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

Two Warning Signs

Posted on 21 March 201522 March 2015 by David Merkel

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

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

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

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

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

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

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

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

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

On Bitcoin

Posted on 12 February 2015 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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