Category: Investing

The next level of shareholder activism

…shareholder activism can be put to good use and bad. It challenges inefficient corporations that waste valuable assets, but it can also foster destructive and destabilizing short-term strategic decisions. The key issue in an activist campaign often boils down to who will do a better job running the company—a professional management team and board with little accountability, or a financial investor looking out for his or her own interests.

Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism

Elliott Management is a prominent hedge hedge fund with a succesful 4 decade track record, perhaps most infamous for seizing a  ship from Argentina’s Navy during a debt dispute back in 2012. Elliott has become a most widely known as an activist investor in recent years.  Its impact has also been important because it has shaken up large companies previously thought immune to activists. Furthermore, Elliott has been a successful activist in Europe and Asia, where conventional wisdom once held  that activism didn’t really work.

Elliott’s tactics are extreme, and controversial, but they work. Although sometimes there are unintended consequences- Elliott has indirectly affected regime change in two different sovereign nations.  Fortune’s latest issue has an in depth profile of Elliott Management that is well worth reading.

For more on the history of corporate activism, and its impact on  the history of capitalism,  Dear Chairman is a definitive guide.

Business history teaches us that the pursuit of profit brings out an extreme and obsessive side of people. When we harness it well, we get Wal-Mart, Les Schwab Tires, Southwest Airlines, and Apple. When we don’t, we get salad oil swindles, junk bond manipulations, and Steak ’n Shake funneling its cash to its CEO’s hedge fund. The publicly owned corporation has been a remarkable engine engine for progress and economic gowth because it can place large amounts of capital in the hands of the right people with the right ideas. Without proper oversight, however, public companies can squander unimaginable amounts o money and inflict great harm on everything around them. The emergence of the shareholder as the dominant force in corporate governance has bestowed a tremendous amount of power and responsibility on investors….

Dear Chairman

Riches Among the Ruins

No Economy is too small, no political crisis is too dire, and no country is too bankrupt for a solo operator like me to find riches among the ruins.

-Robert Smith

Riches Among the Ruins: Adventures in the Dark Corners of the Global Economy is an incredibly entertaining bottom up look at frontier market crises over the last 3 decades from the perspective of a travelling distressed debt trader.  Each chapter is dedicated to Robert Smith’s experience in a particular country: El Salvador, Turkey, Russia, Nigeria, Iraq, etc, etc. Each country is unique, but Smith’s weaves several key lessons throughout his memoir.

Anyone who seeks  profits in inefficient markets could benefit from Smith’s experience.

Information vacuums are key for middleman and arbitrageurs

In the mid 1980s no one had any idea what an El Salvador bond was worth- which is to say, they had no idea what value others might attach to it. The ignorance, this information vacuum, was my bliss. The seller’s price was simply a measure of how desperately he wanted to dispose of a paper promise of the government of El Salvador, and the buyer’s measure of how eager he was to convert his local currency into a glimmer of hope and seeing dollars down the road. The spread, my profit, was the difference between the two. In a fledgling market, with no reporting mechanisms and precious little information floating around, the spread can be enormous, and there was no regulatory or legal restrictions on how much you could make on a transaction.

Though my sellers and buyers, usually the representative of foreign companies doing business in El Salvador, often knew each other , played golf together, or broke bread together at American Chamber of Commerce breakfasts, I knew it would take some time before they eventually started to compare notes. At the beginning I doubt any of them even mentioned they were trying to sell or buy El Salvador bonds because the market didn’t exist yet. But until the market matured it was a gold rush, and I developed a monopoly on that most precious of all commodities in any market: information. I found out who wanted to sell, who wanted to buy and their price, and I held that information very tight to the vest.

In some cases buyers and sellers were on different floors in the same office building, or different divisions of the same global corporation.  The biggest challenges for foreign companies doing business in the developing world was converting local currency revenues back into dollars.  One way to get money out was to buy dollar bonds at fixed exchange rate and over time collect principal and interest in dollars.

Creativity and information edge: Struggles over bondholder lists

In almost every country, Smith, goes through difficulty to get the list of people holding the bonds in which he was seeking to make a market. Arbitrageurs and brokers who had access to the list guarded it aggressively, because it gave them an edge in acquiring positions at a discount, or profiting as a middleman. This was a key bit of information, available from connections at the Central Bank or other places.

His experience of trading nonperforming notes(NPNs) in Nigeria exemplifies the struggle over bondholder lists.

At one point Smith worked with a counterparty who was himself tasked with acquiring as many of the NPNs as possible. Smith was hired as a broker on this mission. The counterparty gave him a list that literally had physical holes. His counterparty had cut out names of big holders, limiting Smith to chasing down small holders(keeping larger investors to himself). Of course, in those small illiquid assets portfolio aggregation had value, so smaller the note better the price from buyer perspective. However, building up the portfolio was an arduous process. Smith was interested in maximizing profit, but his counterparty was tasked with acquiring as many NPNs as possible.

The Nigerian situation was interesting because the NPNs were spread out to investors around the world. The Nigerian bank held a meeting in the UK with countries trade creditors ostensibly to announce terms of payment. Prior to getting the list, a key bit of information Smith tried to get was simply who was in attendance at the meeting(unfortunately his lawyer failed to get it).

He ultimately tracked down the full list- it was actually quite easy once he learned where to ask. He called up a friend at the bank serving as the paying agent on the notes. It turned out that by law that only the Law Debenture Corporation, the official registrar could provide the list with one call to London. Ironically, Smith ultimately learned that each holder of an NPN was legally entitled to the whole list.

In the case of Iraq, it turned out information on holders of the debt instrument he was looking to acquire could be pieced together from information on the UN website. This highlights another a subtle change from Smith’s earlier glory years. Now information is theoretically less precious than it used to be. However, often few people know how to use it/find it/analyze it. Sometimes “publicly available” information is known by so few people, that it can lead to a significant edge.

Few who fancy themselves international mavens of finance want to do the grunt work.

Smith’s struggles parallel the adventures of investors in nanocap equities, real estate private partnerships, and other thinly traded securities, especially investors interested in activism or tender offers. Rules on getting the lists of asset holders vary between companies, and jurisdictions. Sometimes you buy one token share and demand it, but the company might make it difficult. In some jurisdictions , you can find shareholder lists online or from other public sources. A little creativity and extra knowledge of the rules can be a huge edge.

The role of misperception

At one point El Salvador had bonds that were objectively as low risk as Treasuries, but trading at 75-85 cents on the dollar because of political instability in the country. Smith was one of the few brokers making a market in these bonds, and he also cherry picked a few of the best bonds for his own account.

How was this possible? The answer was widely held misperception. Few people looked at a key detail:

I noticed something very interesting something other savvy buyers also noticed, no doubt. The principal and interest being paid to the bondholders was coming not from the central Bank of El Salvador but, but in the form of checks from the United States Treasury Department. To bolster the government of El Salvador, its client, and to protect its interest in the country, the US was going to ensure that El Salvador did not default. The real risk in these bonds was practically nil. The US was virtually guaranteeing they would be paid – and paid on time. On top of that, the bonds with the earliest maturities were often being called and paid in full before the due date. With the big boys at Citibank, Morgan Stanley, and the other major investment banks out of the game — too dangerous– stakes too small— I had the playing field to myself and what a field of dreams it proved to be.

Nigeria was another key example of how misperceptions influence markets:

Nigeria also taught me the value of circumspection. Even today when there is so much more financial information readily available in real time on computer screens throughout our world, circumspection is essential in a business such as ours. The Nigerian buyback succeeded in part, because everyone involved kept their own counsel about what was unfolding. There was nothing fraudulent or even unethical about, at least not by the commonly accepted standards of institutional finance. In our business, everyone is secretive because information is truly power in the zero-sum game of making money. Therefore those who know don’t say, and those who know don’t say.

…the larger point however, is that I was able to thrive precisely because there was not yet any real market in these instruments back then. Everyone was stumbling around in the dark with no information. Everyone, that is, but me. I had just enough to make a go of this business.

Origins of distressed debt exchanges

A distressed company or country can reduce its leverage by purchasing or otherwise acquiring its existing debt instruments at a discount to face value. The company may (discreetly) buy back its debt on an open market, or make a cash tender offer. Alternatively it may negotiate with lenders to exchange debt for equity. (See Distressed Debt Analysis: Strategies for Speculative Investors for more detail on the mechanics of distressed debt exchanges and other techniques distressed companies can use to reduce leverage)

These techniques are widespread in developed world distressed debt markets today, but according to Smith, the original development of these techniques came in response to blocked currency problems of companies doing business in countries where it was difficult to convert local profits into a hard currency such as dollars. Turkey was one of the first countries to use this technique to address foreign debt problem and attract new foreign investment. Many emerging market companies did this as a way of realizing value from non-performing loans.

The idea was to retire dollar debt by exchanging it with the Central Bank of the country for local currency that would then be invested in a company, factory ,or real estate in the country. Indeed some countries , to bolster certain segments of its economy, might, by the terms of the deal, restrict the equity investment to specific types of investments.

These methods can be applied to trade creditors as well as bank loans. For example, if Ford  sells  car parts to Turkey, and the buyer defaults on the dollar invoice due to currency restrictions, the trade claim can be swapped for equity ownership in real estate or an operating company. That ownership can be sold to other party for higher price than it would get for trade claim.

For more detail on the early use of debt for equity swaps by emerging markets, see The Global Bankers by Roy Smith.

Dynamics of negotiations impacted how the value got distributed, but in most cases, all parties ended up at least slightly better than they would have been otherwise. Seller of debt gets higher price than secondary market, and local currency investment might be more profitable in long run, but would still have difficult problem of converting currency out. The country would get debt swapped at a discount, and get new capital investment in. From a macroeconomic perspective in a small frontier economy, there is, however, risk of adding to inflation.

Nigeria was Smith’s exposure to the debt equity buyback as a technique for reducing indebtedness and improving a balance sheet. Now the technique was widely used. Sometimes the operations are initially kept secret so the debtor can buyback as much as possible at a low price.

More on the nuances of middleman

Smith operated as a middleman and is justifiably proud/cynical about the middleman’s ability to extract value from markets. When he spoke with buyers he would be optimistic about the country, when he spoke with sellers he would be pessimistic. He never introduced his buyer and seller. However, a middlemen often proved to be essential in the areas in which Smith operated.

Here are three scenarios in financial markets where middleman are genuinely very useful or essential:

  • Market doesn’t exist yet. Smith created markets where none had existed. Many times his sellers were stuck with seemingly useless paper without him. Sometimes the buyers and sellers knew each other, but without Smith had no idea it was possible to trade. Smith did millions USD in transactions from simply placing advertisements in newspapers such as WSJ and FT saying he wanted to buy assets, and  placing advertisements in local frontier market papers saying he was selling.
  • Buyer wants to be discrete.  In illiquid markets, its critical for a buyer to be discrete. This is where a middleman can be of significant value, because even after collecting their fee, the buyer still gets a better average cost. When Nigeria was buying back NPNs, it was essential to keep actions secret by spreading purchases around middleman, and spreading purchases out over time. Middleman asking to buy does not arouse suspicion.  However, an entity affiliated with Nigerian central bank buying would drive up prices.  Plus being able to chase down buyers/sellers was valuable since Smith was more willing and able to do grunt work than people affiliated with large financial institutions.

Once people understand what you’re doing, the price goes up. Why? DuPont might be happy with $300,000 for a million dollar claim, but if they realize it would still be a great deal for [the buyer] at twice that price, they might not part with their claim so readily. Having a middleman is essential. With a middleman, DuPont and the buyer would never meet.

  • Legal restrictions on foreigners. Some countries have restrictions on foreigners buying trade claims, so foreign need to find a foreign partner. Smith experienced this in Turkey.

What makes a market ripe for a lone operator

Smith operated mostly alone out of dilapidated hotel rooms in various countries around the globe. Even as he built up his business he still stayed independent from all of the major investment banks. Indeed he targeted markets that were ignored by the larger players.

Two factors make a market ideal for a small, lone operator:

  • Sums to be made relatively modest.

    “When the big boys saw me running around San Salvador trying to make a deal, they thought it was a joke. At first I thought they might be right. But I was happy to pick up the crumbs they wouldn’t touch. “

    The six figure/ low seven figure transactions he made were far too small for major financial institutions to bother with, but they were relatively large from the perspective of his one man operation.

  •  Extremely dangerous. Smith took the “go where others are afraid to go” to the extreme. At the time he visited Nigeria, it was in such disarray that many westerners had taxi cabs get hijacked in broad daylight. He traveled to El Salvador in the middle of a civil war and a deadly leftist insurgency brought violence close to his operations. It wouldn’t be the last time he traveled into a war zone to make investments.

 Lessons from struggles/failures.

  • Smith tried to launch a remittance and check cashing business, but it didn’t work. He shares several things he learned from the experience:
    • The business didn’t have didn’t have enough locations on sending side. Most of the locations on the sending side were located in a main city, but customers were scattered throughout the countryside. The only way they could use the services was to make the long journey into town.
    • The failed remittance business also taught Smith not to be overly impressed by people with wealth and power. His partner was wealthy and powerful, but he was still unreliable, so the business didn’t work.
    • He wasn’t comfortable profiting from the poor. He was fine profiting from the blind large institutions as a trader in obscure debt instruments.
    • One thing he did right was cut his losses early. He passed on an opportunity to throw more money into the business because he saw it wasn’t going to work.
  • No permanent allies, only permanent interests He had falling out with people and did business with them again later when interests realigned.
  • Like many frontier and emerging market investors He made the mistake of investing in Russia right before it defaulted. His holdings dropped to almost zero on a mark to market basis. Although he ended up making his money back, its not clear that his IRR was anywhere close to what he would normally seek. His fateful decision to invest in Russia occurred after taking a bank sponsored trip to Russia, where in retrospect there were many red flags. Two quotes stand out as lessons from the problems he experienced in Russia:

If you’ve been in the market a long time and you see that nothing is clear that corporate governance isn’t transparent, that there isn’t a legitimate tax systems and no rules or regulations to protect investors you are not made to feel better by drinking lots of wine, eating good food, and flying in a private jet.

If Wall Street is saying this is the best thing since sliced bread, the juice is all runout.

Goodhart’s law and the fall of Nick Schorsch: The infamous mousepad

The House of Cards that Nick Schorsch built was destined to collapse for a variety of reasons. But what started the demise was  then-CFO of ARCP Brian Block just making up some numbers in a spreadsheet. This led to ARCP revealing a $23 million accounting misstatement. After that it became nearly impossible for the non-traded programs to raise new capital, and a whole slew bad behavior and examples of egregious mismanagement soon came to light(I’ve highlighted examples of their questionable corporate governance before). ARCP changed its name to Vereit, but the whole American Realty Capital complex of affiliated entities that depended on new fundraising would never recover.

ARCP’s culture was obsessively focused on achieving financial projections, especially for adjusted funds from operations(AFFO), a preferred Wall Street metric for REITs . According to Investment News:

In fact, the company gave employees computer mouse pads with 2014 AFFO guidance on them. “AFFO per share greater than $1.16,” the computer mousepad declared. “First believe it, then achieve it.”

I was able to independently verify the existence of this infamous mousepad. Here is a (deliberately obscured) photo:

Nick Schorsch designed this mousepad that specified the AFFO targt for the company.

This mousepad is a manifestation of “Goodhart’s Law” in action. Named after economist Charles Goodhart, this states that

When a measure becomes a target, it ceases to be reliable.

Goodhart’s law is very similar to “Campbell’s Law” named after social scientist Donald Campbell. Campbell’s law states:

The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.

When people are incentivized to achieve one metric above all else, there behavior will result in the number ceasing to be have its orignal meaning. Goodhart’s law was originally used to describe how monetary policy targets led to distortion. Recent examples of this phenomenon on include reclassification of crimes to reduce crime statistics, and abuse of academic citations. In Capital Returns: Investing Through the Capital Cycle , Edward Chancellor highlighted the Goodhart’s law as the reason conducting investment analysis based exclusively on the single metric of earnings per share growth. The ARCP incident certainly wasn’t the first time that Goodhart’s law led people to fudge the accounting numbers.

Goodhart’s law inevitably leads to waste of resources. One example from the Soviet Union nail factories illustrates this in a big way:

The goal of central planners was to measure performance of the factories, so factory operators were given targets around the number of nails produced. To meet and exceed the targets, factory operators produced millions of tiny, useless nails. When targets were switched to the total weight of nails produced, operators instead produced several enormous, heavy and useless nails.

Beyond just reclassifying or forging numbers, and producing useless nails, incentives distorted by the emphasis of single metrics can have even scarier effects:

During British colonial rule of India, the government began to worry about the number of venomous cobras in Delhi, and so instituted a reward for every dead snake brought to officials. Indian citizens dutifully complied and began breeding venomous snakes to kill and bring to the British. By the time the experiment was over, the snake problem was worse than when it began. The Raj government had gotten exactly what it asked for.

To avoid the trap of Goodhart’s law or Campbell’s law managers (and investment analysts) need to take think deeply about what is measured, and take multiple factors into consideration, never relying too much on any individual metric. Failing to consider Goodhart’s law can be fatal for investments.

Non-Traded REITs and Thanksgiving Turkey

Non-traded REITs are like thanksgiving turkey:

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. “On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”
-Nassim Nicholas Taleb The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: “On Robustness and Fragility” (Incerto)

 

AR Global Non-Traded REITs

That chart could easily be replaced with “4 years in the life of AR Global REIT investors. ARC Hospitality(Now Hospitality Investors Trust) was offered at $25.00 a share from 2013-2015, and would never have been marked below $22.00 on a client statement until this summer. It was recently revalued at $13.20 . Likewise ARC Healthcare Trust III was offered at $25.00, and recently marked down to $17.64. Both programs were sold as conservative stable investments that wouldn’t have the volatility one experiences in the stock market.

Of course, the revision of value wasn’t really unexpected, so the thanksgiving turkey/black swan analogy isn’t really right. . ARC Hospitality was egregiously over leveraged, all the ARC REITs, egregiously mismanaged by a kleptocratic external adviser. However, for customers who based their belief exclusively on the account statement, rather than actual analysis of the portfolio, the experience has been like that of the thanksgiving turkey. Investors in other non-traded REITs have had even worse experiences. Account statement stability is an illusion. Snapping out of that illusion can be painful.

In the case of ARC Hospitality, Brookfield Asset Management has mostly taken over, and will likely drive some recovery of value. Brookfield provided some rescue equity financing on dilutive returns- the alternative would have been a potential “going concern issue”. They have convertible preferred with a strike price about 11% above the current NAV. In the case ARC Healthcare Trust III, management is doing convoluted affiliated merger with another AR Global managed REIT. Strangely when an affiliate is buying it, they believe its worth less than the value they were selling it at before. More on these shenanigans later.

Grinding It Out

In Grinding It Out: The Making of McDonald’s Ray Kroc tells the story of how he built McDonalds into a behemoth. The key themes that run through it are his persistence and obsessive attention to detail. There are also some interesting strategic insights on how he views store operators differently than the typical franchise business, and how he selected real estate locations. If the book is too long, there is also a movie, and a country music song telling the same general story. The book is unique, however, since it provies a direct view into Ray Kroc’s thought process.

On Partnership:

One of the basic decisions I made in this period affected the ehart of my franchise system and how it would develop. That was that the corporation was not going to get involved in being a supplier for its operators. My belef was that I had to help the individual operator succeed in every way I could. His success would insure my success. But I couldn’t do that and, at the same time, treat him a a customer.

There is a basic conflict in trying to treat a man as a partner on the one hand while selling him something at a profit on the other. Once you get into the supply business, you become more concerned about what you are making on sales to your franchisee than with how his sales are doing. The temptation coud become very strong to dilute the quality of what you are selling him in order to increase your profit. This would have a negative effect on your franchiesees business, and ultimately, of course, on yours. Many franchise systems came along after us and tried to be suppliers, and they got into severe business and financial difficulty. Our method enabled us to build a sophisticated system of purchasing that allows the operator to get his suplies at rock-bottom prices. As it turned out, my instinct helped us avoid some antitrust problems some other franchise operators got into.

On selecting locations for new stores:

Back in the days when we first got a company airplane, we used to spot good locations for McDonald’s stores by flying over a community and looking for schools and church steeples. After we got a general picture from the air, we’d follow up wit h a site survery. Now we use a helicopter, and its ideal. Scarceley a month goes by that I don’t get reports from whatever districts happen to be using our five copters on some new locations that we would never have discovered otherwise. We have a computer in Oak Brook tat is designed to make real estate surveys. But those printouts are of no use to me. After we find a promising location, I drive around it in a car, go to the corner saloon and into the neighborhood supermarket. I mingle with the people and observe their comings and goings. That twlls me what I need to know about how a McDonald’s store would do there.

 

Freedom Corridor vs. Belt and Road

India’s opposition to One Belt One Road makes sense given the whole Kashmir issue, and general geopolitical competition.  Indian think tanks have therefore been warning about risk to both China and target countries(ie this article makes some good points but is a bit cliched and hyperbolic)

Making things more interesting,  India and Japan this month launched their own similar(albeit geographically narrower)  initiative: The Asia Africa Growth Corridor(AAGC), aka the Freedom Corridor.   Right now its still in the  development bank and think tank press release phase,   but India and Japan have strong incentive to follow up with real money pretty quickly.  India and Africa have a deep history of mercantile and maritime connections.  India’s Exim bank has already funded $8 billion in credit in Africa, according to Modi’s speech during an African Development Bank meeting, which was held in India last week.  Port infrastructure in East Africa and the Indian Ocean are likely to be the first priorities, along with agriculture and electricity.  Incidentally,  India and Japan are also  building a LNG terminal in Sri Lanka, a country that is heavily in debt to China as a result of controversial infrastructure projects.

There is a Chinese aphorism,  “When the sandpiper and the clam grapple, it is the fisherman who profits” (鹬蚌相争渔翁得利).  If China and India really end up competing by spending money around East Africa, companies involved in building or benefiting from improved infrastructure could reap a decent reward.    Will the benefits accrue to any outside minority investors in publicly listed companies?  Too soon to tell, but it will be interesting to watch. The usual caveats about EM corruption and waste apply to AAGC as much as they do to OBOR, but the financial media is likely to oversimplify.  India and Japan’s now official strategy could impact select companies listed in India and Japan, in addition to companies in the less developed capital markets of East Africa and Sri Lanka. 

Quick Thoughts on The Signal and the Noise

Learning to think probabilistically is one of the most critical skills one can master. Nate Silver’s The Signal and the Noise: Why So Many Predictions Fail–but Some Don’t is a valuable book on thinking probabilistically and forecasting in an uncertain environment. It compares and contrasts examples across multiple disciplines, including weather forecasting, seismology, finance, and more.

This book pairs well with Against the Gods, Fortune’s Formula and Superforecasting.   Against the Gods is in my opinion, the most important book on the development of probabilistic thinking. Early civilizations were good with geometry and logic, but helpless with uncertainty. Ironically it was gamblers and heretics who moved mankind forward by  developing the science of  probability, statistics, and ultimately risk management.   Fortune’s Formula shows the connection between information theory, gambling, and correct position sizing for investors. It helps the answer the question: when you have a slight edge, how much should you bet? Nate Silver draws heavily on Superforecasting.  Particularly important is the idea of “foxes and hedgehogs”. Foxes are multidisciplinary, adaptable, self critical , tolerant of complexity, cautious and empirical. In contrast, Hedgehogs are specialized, stalwart, stubborn, order-seeking, confident, and ideological. As you might expect, foxes make far better forecasters than hedgehogs, even though hedgehogs make for better television.

Anyways, here are a few key insights from my notes on The Signal and the Noise

1) Data is useless without context.

There are always patterns to find in data, but its critical to understand the theory behind the system you are studying to avoid being fooled by noise. This is true in forecasting the weather, investing, betting on sports, or any other probabilistic endeavor. The ability to understand context is also a critical advantage humans have over computer programs.

“Statistical inferences are much stronger when backed up by theory or at least some deeper thinking about their root causes. “

The importance of understanding context comes to the forefront when you compare human’s success with weather forecasting, vs relative failure with earthquake forecasting.

“Chaos theory is a demon that can be tamed- weather forecasts did so, at least in part. But weather forecasters have a much better theoretical understanding of th earth’s atmosphere than seismologists do of the earth’s crust. They know more or less, how weather works, right down to the molecular level. Seismologists don’t have that advantage. “

The ability to understand context is what separates success from failure in all pursuits dealing with uncertainty. The profile of professional sports gambler Bob Voulgaris, is highly instructive. Voulgaris focuses on NBA basketball. A key insight is that Voulgaris has powerful tools for analyzing data, and he makes good use of the data, but he also has deep understanding of the qualitative subletities of how NBA basketball works. Obvious statistical patterns are quickly incorporated into betting lines, whether they are signal or noise. Voulgaris looks deeper, and finds places where the line misprices true probabilities.

“Finding patterns is easy in any data rich environment; thats what mediocre gamblers do. The key is in determining whether the patterns represent noise or signal. “

2) Beware of overconfidence

“… the amount of confidence someone expresses in a prediction is not good indication of its  accuracy, to the contrary, these qualities are often inversely correlated. “

3) Think big, and think small. Mix the macro and the micro.

“Good innovators typically think very big, and they think very small. New ideas are sometimes found in the most granular of details where few others bother to look. And they are sometimes found when you are doing your most abstract and philosophical thinking, considering why the world is the way that it is and whether there might be an alternative to the dominant paradigm.”

This is reminiscent of the “global micro” approach used by several manager’s profiled in Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets

4) Recognize the Value of Bayesian Thinking

The work of Thomas Bayes forms the framework underlying how good gamblers think.

Bayes was an English minister who argued in his theological work that admitting our own imperfections is a necessary step on the way to redemption. His most famous work, however, was “An Essay toward Solving a Problem in the Doctrine of Chances,” which was not published until after his death. One interpretation of the essay concerns a person who emerges into the world( ie Adam, or someone from Plato’s cave), and rises to see the sun for the first time:

“At first the does not know whether this is typical of some sort of freak occurrence. However each day that he survives and the sun rises again, his confidence increases that it is a permanent feature of nature. Gradually, through this purely statistical form of inference, the probability that he assigns to his prediction that the sun will rise again tomorrow approaches(although never exactly reaches) 100 percent.”

In essence, beliefs on probability are updated as new information comes in.

Ironically Bayes philosophical work was extended by the mathematician and astronomer Pierre Simon-Laplace, who was likely an atheist. Although Laplace believed in scientific determinism, he was frustrated with the disconnect between (what he believed to be the perfection of nature, and human imperfections in understanding it, in particular with regards to astronomical observations. Consequently, he developed some measuring techniques that relied on probabilistic inferences, rather than exact measurements. “Laplace came to view probability as a waypoint between ignorance and knowledge.” The combined work of Laplace and Bayes led to simple expression that is concerned with conditional probability. In essence Bayesian math can be used to tell us the probability that a theory or hypothesis if some event has happened.

5) The road to wisdom is to be less and less wrong.

forecasting, or at least operating in an uncertain environment, is an iterative process.

Nate Silver titles one of the chapters “Less and Less Wrong, as a homage to the Danish mathematician, scientist, inventor, and poet Piet Hein, author of Grooks:

The road to wisdom? — Well, it’s plain
and simple to express:
Err
and err
and err again
but less
and less
and less.

 

Disequilibrium Analysis

George Soros treats developments in financial markets as a historical process. In The Alchemy of Finance, he outlines his theory of reflexivity, discusses historical developments in markets, and describes a real time “experiment” he undertook while running the Quantum fund in the 1980s.

Markets are an ideal laboratory for testing theories: changes are expressed in quantitative terms, and the data are easily accessible.

Three of the key interrelated concepts in his framework, are anti-equilibrium, Imperfect Knowledge, and Reflexivity.

Disequilibrium

In markets, equilibrium is a very rare special case. Further, adjustments rarely lead to new equilibrium. The economy is always in adjustment.

According to George Soros:

If we want to understand the real world we must divert our gaze from a hypothetical final outcome , and concentrate our attention on the process of change that we observe all around us.

In trying to deal with macroeconomic developments, equilibrium analysis is totally inappropriate. Nothing could be further removed from reality than the assumptions that the participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations, and constantly changing outcomes. The process is reflexive.

The stock market, is of course a perfect example:

The concept of an equilibrium seems irrelevant at best and misleading at worst. The evidence shows persistent fluctuations, whatever length of time is chosen as the period of observation. Admittedly, the underlying conditions that are supposed to be reflected in stock prices are also constantly changing, but it is difficult to establish any firm relationship between changes in stock prices and changes in underlying conditions. Whatever relationship can be established has to be imputed rather than observed.

So its better to focus on nature and direction of ongoing adjustments, rather than trying to identify an equilibrium.

Imperfect Knowledge

Perhaps more problematic with an exclusive focus on rarely occurring equilibrium conditions is the assumption of perfect knowledge. Perfect knowledge is impossible. Everything is a provisional hypothesis, subject to improvement. Soros makes the bias of market participants the center part of his analysis.

Reflexivity

In natural sciences, usually the thinking of participants and the events themselves can be separated. However, when people are involved, there is interplay between thoughts and actions. There is a partial link to Heisenberg’s uncertainty principle. The basic deductive nomological approach of science is inadequate. Use of probabilistic generalization, or some other novel scientific method is preferable.

Thinking plays a dual role. On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of decisions which influence the course of the events. The two roles interfere with each other.

The influence of this idea is inseparable from the theory of imperfect knowledge.

The participants’ perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two.

This two way connection is what Soros called “reflexivity.”

The thinking of participants, exactly because it is not governed by reality, is easily influenced by theories. In the field of natural phenomena, scientific method is effective only then its theories are valid, but in social political , and economic matters, theories can be effective without being valid.

Effective here, means having an impact. For example, in a bubble, the cost of capital for some companies drops to be absurdly low, relative to the risk of their respective enterprises. Consequently, some businesses that would have otherwise died, may go on to survive. (Example from two decades after the Alchemy of Finance was written: Peter Thiel mentions when being interviewed in Inside the House of Money, that Paypal did a massive capital raise right a the height of the tech bubble, even though it didn’t need the money at the time) On the flip side, a depression can be self fulfilling, if businesses are unable to refinance.

This seems to be especially true in the credit markets:

Loans are based on the lender’s estimation of the borrowers ability to service his debt. The valuation of the collateral is supposed to be independent of the act of lending; but in actual fact the act of lending can affect the value of the collateral. This is true of the individual case and of the economy as a whole. Credit expansion stimulates the economy and enhances the collateral values; the repayment or contraction of credit has a depressing influence both on the economy and on the valuation of collateral. The connection between credit and economy activity is anything but constant- for instance , credit for building a new factory has quite a different effect from credit for a leveraged buyout. This makes it difficult to quantify the connection between credit and economic activity. Yet it is a mistake to ignore it.

This is reminiscent of Hyman Minsky’s Financial Instability Hypothesis

In terms of the stock market, Soros asserts (1)Markets are always biased in one direction or another. (2) Markets can influence the events that they anticipate.

Why are receivables up more than sales?

 

“Always take a company seriously, even if its financials are knee-slapping, hoot-promoting drivel”

Kathryn Staley

I’m about halfway through The Art of Short Selling. It has some incredible short selling case studies. One accounting issue that comes up is where accounts receivables spikes without a proportionate increase in actual cash sales. Tracking the ratio between accounts receivable and sales is a way to track a pretty simple trick that company accountants can pull. The example used is that of the a corporate/government training company with a famous politician on the board. It ended badly for shareholders. This happens a lot in questionable companies getting “out over their skis.”

Anyways…

“Receivables can be up by more than sales for several reasons:
1. The company acquired a company, and the acquisition is not yet under control-collections do not have the same billing cycle or terms for sales, for example. If the acquisition was a large one relative to sales, the relationship of year versus year in receivables is not comparable.

2. The company is booking revenues too aggressively-for example, a three-year contract recognized at the front end, so that receivables stay high because the rate of payment is slow.

3. The company changed its credit policy to easier terms or is giving incentives for sales, thereby jeopardizing future sales.

4. The company is having trouble collecting from customers. Building accounts receivables is a cost to the company because investing in business already booked hurts cash flow. Timely collections are sensible in a growing business because growth eats money by definition.”

How companies book revenues is a particularly quarrelsome issue for analysts: There are many ways to fool around, and technology and training companies are two categories of regular abusers. Revenues booked should have a consistent relationship with collection-if a company ships now and collects in 60 days, the accounts receivable schedule should consistently mirror that policy. So rising receivables versus sales or a lengthening number of days in receivables should always trigger a question: Something has changed, it says.

 

If your screener sets of an alarm due to a spike in receivables relative to sales, running through this list might help you find the answer. Understanding this question gets back to the basic question: how does this company make(or fail to make) money?

One more quote to top it off:

“For the last week I’ve been carrying “The Art of Short Selling” around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn’t matter if I’ve already read it. I just read it again.”

Michael Burry(1999)

15 Signs of a Great Growth Stock


I recently reread Common Stocks and Uncommon Profits by Phil Fisher, while I was flaneuring in Morocco. Fisher held stocks for years and even decades, and focused on situations where he could get a several hundred percent gain over his holding period. His process focused on “Fifteen Points” to look for in a common stock. Not every investment was positive on every point, but good long term investments would need to exhibit many of them.

Here are my notes on the Fifteen Points.

  1. Does the company have products or services with sufficient market potential to make a possible sizable increase in sales for at least several years?

Fisher didn’t spend time on “cigar butts”- he wasn’t interested in squeezing cash out of a dying business, even though it could be lucrative for certain investors. Likewise, he acknowledges that its possible to make a quick profit from one time cost cuts in an inefficient business, although that wasn’t his niche. Notably Buffett described himself as 85% Graham and 15% Fisher, and the Fisher component arguably made him more money over the long term.

It’s important to consider what the limits of growth might be- once every potential customer has purchased once, then what? During Fisher’s time he focused on a lot of high-tech product companies. In modern times, there are a lot more service focused companies which can potentially generate recurring revenue streams.

A company with massive long term growth potential may have lumpy sales growth. Annual comparisons generally don’t mean that much, instead investors should compare multiple years.

If management is decent and lucky they might find themselves with a long run growth opportunity. If their truly good and lucky, they’ll find a way to creat it.

If a Company’s management is outstanding and the industry is subject to technological change and development research, the shrewd investor should stay alert to the possibility that management might handle company affairs to produce in the future exactly the type of sales curve that is the first step to consider in choosing an outstanding investment.

One of the key examples is Motorola.

Continue reading