Progress Requires Innovation, Innovation Requires Freedom; No Freedom, No Progress, That’s Government

Joe Quirk on seasteading:

Benjamin Franklin participated in several major innovations in his day. He helped discover and control electricity, and he helped design the US Constitution. The control of electricity set off a cascade of innovations, driving almost every modern technology we can name. Yet the instrument of government he helped invent has not progressed.

Consider that Franklin’s many inventions have advanced beyond his wildest imagination: the Franklin stove, bifocal glasses, refrigeration, the flexible urinary catheter (my favorite). Yet, the methods of government he helped invent have not evolved. And why?

Because inventors and entrepreneurs had the freedom to experiment with Franklin’s technological ideas, but not his political ideas. More importantly, as Patri [Friedman] says, customers had power to choose amongst gadgets competing to please them, while citizens are captive to the political system they inherit.

One day, people will laugh at the idea of government (legitimized, institutional theft and murder) just as today people laugh at the idea of monarchy as a system of government.

Government is a technology– it is a means for achieving particular ends. What people don’t understand right now is that

  1. government is a means, not an end and
  2. government is an inappropriate and contradictory means for the end of “living in a harmonious, civilized and prosperous human society”

Government reduces human relationships to the Laws of the Jungle, the very thing we all claim to be striving so mightily to avoid.

As Allen Thornton wrote in the early 1980s,

And just what is this government? It’s a man-made invention. It’s not some natural phenomenon or a special creation of God. Government’s an invention, just like the light bulb or the radio.

The state was invented for me, to make me happier, but a funny thing has happened: If I don’t want this invention, people are outraged. No one calls me unpatriotic for refusing to buy a light bulb. If I don’t choose to spend my money on a radio, no one says that I’m immoral. Why should anarchy upset everyone?

Anarchists are ahead of their time, even though the truth they speak is itself timeless– conservatively, probably 200-300 years ahead of their time. The gradual evolution of the “human collective social consciousness” over time has been away from absolutism and toward individualism, with various depressing but ultimately temporary and regional setbacks along the way. Most visionaries DO look like kooks to their neighbors and countrymen before their vision is realized.

But it is the “market purists” who will have the last laugh, and ultimately deliver every one into the closest thing to a perfect society that one can get while still remaining firmly in the grips of reality in this universe.

They’ll be naysayed and boohooed and shouted at quite a bit along the way, though. Good thing most of us are of stout heart and strong mind.

Review – More Money Than God

More Money Than God: Hedge Funds And The Making Of A New Elite

by Sebastian Mallaby, published 2010

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information asymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational asymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B

Conclusion

I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – There’s Always Something To Do

There’s Always Something To Do: The Peter Cundill Investment Approach

by Christopher Risso-Gill, Peter Cundill, published 2011

The Peter Cundill approach to value investing

The following note outline was rescued from my personal document archive. The outline consists of a summary of Christopher Risso-Gills’ recent biographical investment profile of Canadian value investor Peter Cundill, There’s Always Something To Do. The notes are in summary form of the most critical aspects to Cundill’s value investment perspective and analytical process.

There’s Always Something to Do: The Peter Cundill Investment Approach

  • “I think that intelligent forecasting should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls and so assist management to tailor events and to bend them in a desired direction.”
  • He made a habit of visiting whichever country had the worst performing stock market in the past 11 months.
  • “In a macro sense, it may be more useful to spend time analyzing industries instead of national or international economies.”
  • “It must be essential to develop and specify a precise investment policy that investors can understand and rely on the portfolio manager to implement.”
  • A few investment principles:
    • never use inside information, “All you get from inside information is a whiff of bad breath.”
    • economic facts and company values always win out in the end
    • don’t try to be too clever about the purchase price
    • isolate what the real assets are
    • never forget to examine the franchise to do business
  • Insider buying is not always well-informed– Peter once scooped up shares of J. Walter Thompson (JWT) at a perceived discount and faced a hostile and confused president who was selling stock from the companies pension fund and couldn’t figure out why Cundill was buying (pg. 29), which demonstrates that there are informational disadvantages and ambiguities that keen analysts can take advantage of, even over company insiders; insider buy/sell ratios and actions should be considered thoughtfully and fully “discounted”, not taken as authoritative proof of anything by themselves
  • “Very few people really do their homework properly, so now I always check for myself.”
  • Look for hidden gems on the balance sheet
  • Investing globally:
    • if you find one foreign stock that is trading at a significant discount, snoop around because there may be other bargains in the foreign industry or market
    • There was nothing “ad hoc” about the way Peter addressed the process of international value investment. In every instance it had to be firmly based on a clear understanding of local accounting practices and how those might differ from accepted standards in North America. The fact that it was different, less transparent, or deliberately opaque was never a reason for ignoring or excluding a market or security. Peter’s attitude was “vive la difference”; if a balance sheet was hard to penetrate it was not just a challenge but an opportunity because the difficulties actually represented a “barrier to entry” even for the experienced professional investor and undoubtedly excluded all but the most sophisticated private investors.
    • The other aspect, which Peter considered to be a vital component of a successful international strategy, was building carefully constructed networks of locally based professionals who had a thorough understanding of value investment principles and would instinctively recognize a security that would potentially fit the Cundill Value Fund’s investment criteria.
  • “THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE AND MORE PATIENCE. THE MAJORITY OF VALUE INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
  • “It is also dangerous to rely on a single strategy in a doctrinaire fashion. Strategies and disciplines ought always to be tempered by intelligence and intuition.”
  • Personal margin note: Peter did not succeed in isolation but cultivated and utilized networks of knowledgeable and influential people (investors, political activists and politicians, business people); he also had several mentors
  • Peter was impressed by a group of corporate socialites he had dinner with, “They maintain that having a hangover is a waste of a day.”; personal margin note: respect the value of time, the ultimate scarce resource, always
  • Peter organized a prestigious investment conference, the Cundill Conference, where he both talked and exchanged ideas on investing with other friends and gurus, as well as heard from invited guest expert speakers who spoke on a range of topics totally unrelated to investing, to promote cross-disciplinary rigor and creative spark
  • “The boards of charitable foundations are convenient meeting places for influential people. Their ostensible purpose is intimately bound up with the social and commercial ones.”
  • Peter relocated to London from Toronto to better pursue his global value investment approach, seeing London as the center of capital and the business crossroads of the world at the time; personal margin note: where is today’s London, or tomorrow’s?
  • On flying across the Atlantic routinely on the Concorde:
    • “It is a remarkable sounding board, especially in my world of matters financial.”
    • “One becomes even more keenly aware that there is never just one factor determining events, there are many of them interwoven and acting simultaneously.”
    • “I always need to discipline myself to be aware of the world generally, rather than trying to be specific. I only need to be specific about the numbers.”
  • Selling stocks which near or surpass their intrinsic value often acts as an “inbuilt safety valve” for the value investor in markets which are in a bubble or overpriced generally
  • Peter channels Horace’s Ars Poetica via Graham in a journal entry prior to the 1987 Crash: “Many shall be restored that now are fallen, and many shall fall that are now held in honor.”
  • “Sooner or later the market will do what it has to do to prove the majority wrong.”
  • Cundill, via Oscar Wilde, on an approach to stocks: “Saints always have a past and sinners always have a future.”
  • “Being out on a limb, alone and appearing to be wrong is just part of the territory of value investment.”
  • Cundill on overvalued markets: “it can tempt one to compromise standards on the buy side and it may lure one into selling things far too early.”
  • Cundill’s value approach gently evolves: “Discounts to asst value are not enough, in the long run you need earnings to be able to sustain and nurture these corporate values. We now, as a matter of course, ask ourselves hard questions as to where we expect each business to be in the future and, as well, make a judgment on the quality of management.”
  • Cundill defines shorting based off of his ‘antithesis of value’: “identifying a market where values are so stretched and extreme that they are clearly unsustainable. They have passed far beyond the realms of any measure of statistical common sense.”
  • “The great records are the product of individuals, perhaps working together, but always within a clearly defined framework.”
  • “In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.”
  • On avoiding the temptation to sell an eventual winner: “What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”
  • Cundill on his shock related to 1968 sentiment toward the shoddy accounting of the conglomeration movement: “Nobody cared; accounting is a bear market phenomenon!”
  • “Every company ought to have an escape valve: inventory that can readily be reduced, a division that can be sold, a marketable investment portfolio, an ability to shed staff quickly.”
  • “We always look for the margin of safety in the balance sheet and then worry about the business.”
  • “If there’s no natural skeptic on an investment maybe it would be wise to appoint one of the team to play Devil’s Advocate.”
  • More on investing overseas in developing markets: What was required was an asset-based margin of safety significantly greater than would be considered adequate in the more developed markets. It was also fairly obvious that in these less developed markets tangible fixed assets were superior to cash, which had a nasty habit of evaporating.
  • Cundill on retirement: “Retirement is a death warrant.”
  • Poetic Cundill: “No fortunes are made in prosperity, Ours is a marathon without end: Enjoy the passing moments.”
  • Cundill’s wit and wisdom on what makes for a great investor:
    • “Curiosity is the engine of civilization”, he advises to have serious conversations with people that result in an exchange of thoughts and to keep one’s reading broad.
    • “Patience, patience and more patience.”
    • “Always read the notes to a set of accounts very carefully… seeing the patterns will develop your investment insights, your instincts — your sense of smell. Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in crisis.”
    • “Holding on to a heavily discounted stock that the market dislikes for a period of five or ten years is not risk free. As each year passes the required end reward to justify the investment becomes higher, irrespective of the original margin of safety.”
    • “An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.”
    • Routines: “They are the roadmap that guides the pursuit of excellence for its own sake.”
    • Via Peter Robertson, “always change a winning game.”
    • “An investment framework ought to include a liberal dose of skepticism both in terms of markets and of company accounts.”
    • Personal responsibility: “If you lose money it isn’t the market’s fault… it is in fact the direct result of your own decisions. This reality sets you free to learn from your mistakes.”
    • Suggested reading list:
      • Extraordinary Popular Delusions and the Madness of Crowds
      • The Crowd: A Study of the Popular Mind
      • Buffett: The Making of an American Capitalist
      • The Money Masters
      • The Templeton Touch
      • The Alchemy of Finance
    • Cundill’s Corrolary to Murphy’s Law: “When things get so bad that you’re really scared, that’s the time to buy.”
    • Global investing: “Given the dearth of bargains today, it pays to search for them everywhere.”
    • On independence, via Ross Southam, “You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.”
    • “If it is cheap enough, we don’t care what it is.”
    • “I would say that the problem with big businesses that have moats around them is they tend to over-expand.”
    • “IPOs for the most part are dreams engendered by the hope that pro forma estimates will be met. We deal to a certain extent in nightmares that everyone knows about.”
  • Three parts to Cundill’s investment strategy:
    • NAV
    • sum of the parts analysis
    • future NAV estimation
  • “Sometimes nothing is more misleading than personal experience.”
  • Investments held by Peter Cundill, managed by others, a potential place to search for ideas or gain more insight, pgs. 223 and 224

Wall Street Mesmerized, Perplexed By “400% Man”, But Why?

Two separate friends sent me links to an investor profile in SmartMoney magazine entitled “The 400% Man“, about a college dropout in Salt Lake City who appears to have made a killing over the last ten years following the principles of value investing.

Allan Mecham, had been posting mind-bogglingly high returns for a decade at a tiny private-investment fund called Arlington Value Management, and the Wall Streeters were considering jumping on board. For nearly two hours, they peppered him with questions. Where did he get his business background? I read a lot, he replied. Did he have an MBA? No. I dropped out of college. Did he have a clever computer model or algorithm? No, he replied. I don’t use spreadsheets much. Could the group look at some of his investment analyses? I don’t have any of those either, he said. It’s all in my head. The investors were baffled. Well, could he at least tell them where he thought the stock market was headed? “I don’t know,” Mecham replied.

When the meeting broke up, “most people left the room mystified,” says Brendan O’Brien, a New York City money manager who was there. “They were expecting to see this very sharp-dressed, fast-talking guy. They were saying, I don’t get it, I don’t understand why he wouldn’t have a view on the market, because money managers get paid to have a view on the market.” Mecham has faced this kind of befuddlement before — which is one reason he meets only rarely with potential investors. It’s tough to sell his product to an industry that’s used to something very different. After all, according to their rules, he shouldn’t even be in the business to begin with.

The fact that people were mystified by this young man’s performance should be embarrassing to Wall Street. And, not to rain on Mecham’s parade, but it really doesn’t speak to the greatness of Mecham so much as it speaks to the “mysticism” of Wall Street.

Benjamin Graham’s lessons on value investing have been available to the general public for over 70 years. Graham’s greatest disciple, Warren Buffett, is also the greatest investor of all time and one of the wealthiest individuals in the world. The story of his success has been told in countless biographies (of which little old me has managed to read two), all of which make it abundantly clear that Buffett’s time at an Ivy League graduate program likely had little to do with his destiny in the financial world. In fact, the man has railed against the Wall Street paradigm for decades himself and has explained to anyone who will listen — and they are legion! — why you can’t make money playing Wall Street’s game.

So, why is this all such a big surprise to these people?

It’s a big surprise because Wall Street isn’t broken. Wall Street is a mystical financial priesthood, just as the Federal Reserve and other central banks infesting the globe are mystical monetary priesthoods.

Wall Street doesn’t “get” value investing and is “surprised” to learn of its existence, and successful practitioners, because if Wall Street ever acknowledged that such a school of thinking existed, they’d be admitting their own inefficacy and the whole jig would be up. This is just the same as how the members of the Fed remain ignorant of the teachings of Austrian economics– to acknowledge and seek to understand them would be the beginning of the end of their nefarious charade.

The Wall Street business model is a volume-based, sales operation. It isn’t any different from television sales, automobile sales, pharmaceutical sales or insurance sales in terms of mechanics and objectives. All that’s different is the sales people are better “educated”, wear fancier clothes and work out of taller, shinier buildings. It’s a fee-based business, and the fees are generated by controlling assets and repeatedly churning them– the more you manage and the more often you turn it over, the more fees you generate and the richer you get.

Because Wall Street lives off of hyperactivity, the philosophy of patient inactivity (Buffet’s “waiting for a fat pitch”) and concentrated portfolios is, literally, blasphemous. Under such a model, your only chance at earning a return for your services is… to generate real returns for your clients! With the Wall Street model, you can get rich even as you lose your clients money. In fact, if you’re a brokerage or investment bank, you might even be able to accelerate the pace at which you enrich yourself as your client loses simply by trading more losing positions more often!

This is not an indictment of capitalism, free markets or financial exchanges, all of which are socio-economic goods with real value. This is an indictment of the Wall Street money management paradigm in relation to the tenets of value investing, a paradigm which doesn’t “work” at generating real returns for investors because it can’t– it wasn’t designed to do that!

Again, to draw comparisons to the Federal Reserve and the nature of central banking, the Fed can’t “fight inflation” and “lower unemployment” because that is not what the Fed was designed to do. The Federal Reserve CREATES inflation by issuing new fiduciary media into the economy and, with the assistance of the fractional reserve banking system, expanding the monetary base. It does this because the purpose of the Federal Reserve is to provide an alternative, “silent” tax system for the political class while easing the built-in, we-all-fall-down tensions within the fractional reserve banking system, which is the whole reason such a system requires a “lender of last resort.”

Wall Street, as a moniker for the fee-based, AUM-central “financial services” industry, delivers precisely what it was designed to deliver– lucrative pay plans and an unearned sense of superiority compared to everyone else in the economy for the specially-entitled club members and graduates of the connected institutions who populate it. It, like the banking industry and the global central bank system, operates via the herd mentality simply because those who thieve together, hang together. If you want to avoid hanging together, you must be committed to thieving together.

Defining risk as volatility, as Wall Street does, practically ensures that you’ll repeatedly expose your clients to real risk (that is, the risk of permanent capital loss) while naively trying to juggle the impossible task of managing ex post facto-determined volatility risk. Operating off of an asset accumulation/inventory churn model guarantees that your incentive structure will never be aligned with your clients, no matter how well-intentioned you might be. Government coercion in the form of mutual fund industry regulation and others provides the necessary legal muscle to prevent anyone who can think for themselves from attempting to do so.

Mecham’s closing comment is prescient:

Where does Arlington head next? Mecham says he won’t compromise his strategy to play the Wall Street game. That leaves Ben Raybould battling to market a fund, and a manager, that many other money managers can’t even understand. Mecham is bemused that so many people expect him to hold a broad basket of stocks and follow a benchmark, such as the S&P 500. “It’s laughable to think that in this competitive world, you’re going to find brilliant ideas every day,” he says. “The world’s just not set up that way.”

Exactly. And Wall Street will never manage to successfully manage risk and generate real returns for its clients– it’s just not set up that way.

Lessons in Short Selling: Why Jim Chanos Targeted Enron

I saw this testimony, delivered to Congress February 6, 2002, by Jim Chanos on his decision to short Enron before it collapsed, posted over at John Chew’s Case Study Investing. I enjoyed reading it and thought it was worth commenting on as a kind of basic guide to short-selling– why and how. This testimony is a Warren Buffett-style (and quality) lesson on short-selling fundamentals.

How To Identify A Short-Sell Opportunity

Kynikos Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on securities issued by companies that appear to have (1) materially overstated earnings (Enron), (2) been victims of a flawed business plan (most internet companies), or (3) been engaged in outright fraud.

Three key factors to look for in a short-sell:

  1. Overstated earnings
  2. Flawed business model (uneconomic activity)
  3. Fraud

As with the Enron fiasco, Chanos first became interested when he read a WSJ article that discussed Enron’s aggressive accounting practices. Aggressive, confusing, archaic or overly technical accounting practices are often a potential red-flag that could identify a company which is not actually as profitable as it appears to be to other market participants. When this profitability if revealed to be illusory later on, a catalyst is in place to galvanize investors into mass selling.

Another factor which can create an opportunity for a short is when the company has a flawed business model which essentially means the company is engaged in uneconomic activity. Short of government subsidies and other protective regulations, the market place tends to punish uneconomic (wasteful, that is, unproductive) activity with the tool of repeated and mounting economic losses until the offending individual or firm’s resources are exhausted and they must declare bankruptcy and liquidate their assets into the hands of more able owners. Chanos gives the example of tech bubble companies which never managed to achieve operating profitability– their business models were nothing more than exciting ideas, unable to overcome the reality check of achieving business profit.

The last type of short Chanos describes is general fraud– a company claims to own assets it does not own, or it is subject to liabilities and debts it has not disclosed, or there is an act of corruption or embezzlement amongst employees or managers of the business. Recent examples could be found in the growing “China short” sub-culture of financial research and hedge fund activity, such as the Sino Forest company which did not have thousands of acres of productive timberland it claimed to own.

The Enron “Case Study”

Returning to the Enron example, Chanos discloses three suspicious facts he and his firm uncovered through perusal of public financial disclosures that got them thinking about shorting Enron:

The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the U.S. Securities and Exchange Commission. What immediately struck us was that despite using the “gain-on-sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7% before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm a 7% return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7% and probably closer to 9%, which meant, from an economic cost point-of-view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000.

Chanos essentially did a competitive analysis on Enron and concluded that Enron was underperforming its competitors in the energy trading arena, despite large size and market dominance. He also concluded that its returns appeared uneconomic because they did not cover costs (capital), implying the company was  consuming capital rather than generating it.

We were also troubled by Enron’s cryptic disclosure regarding various “related party transactions” described in its 1999 Form 10-K as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for its March, June and September quarters. We read the footnotes in Enron’s financial statements about these transactions over and over again but could not decipher what impact they had on Enron’s overall financial condition. It did seem strange to us, however, that Enron had organized these entities for the apparent purpose of trading with their parent company, and that they were run by an Enron executive. Another disturbing factor in our review of Enron’s situation was what we perceived to be the large amount of insider selling of Enron stock by Enron’s senior executives. While not damning by itself, such selling in conjunction with our other financial concerns added to our conviction.

Importantly, Chanos notes that it was not the insider selling alone, but within the context of other suspicious activity, that concerned him. Often executives and insiders sell for personal liquidity reasons (buying a new home, sending kids to college, buying a boat, etc.) and some observers necessarily conclude this means foul play or that the insider knows the Titanic is about to hit an iceberg.

More common with smaller companies where management and ownership are often synonymous, related-party dealings are always something to be skeptical about and almost never are harmless in the context of multi-billion dollar public corporations.

Finally, we were puzzled by Enron’s and its supporters boasts in late 2000 regarding the company’s initiatives in the telecommunications field, particularly in the trading of broadband capacity. Enron waxed eloquent about a huge, untapped market in such capacity and told analysts that the present value of Enron’s opportunity in that market could be $20 to $30 per share of Enron stock. These statements were troubling to us because our portfolio already contained a number of short ideas in the telecommunications and broadband area based on the snowballing glut of capacity that was developing in that industry. By late 2000, the stocks of companies in this industry had fallen precipitously, yet Enron and its executives seemed oblivious to this! Despite the obvious bear market in telecommunications capacity, Enron still saw a bull market in terms of its own valuation of the same business — an ominous portent.

Again, Chanos and his firm were able to see the Enron picture more clearly by comparing it to the competitive landscape as a whole. How much validity does a firm’s claims possess when looked at in the context of the wider industry (or economy), rather than just its own dreams and/or delusions?

Throughout the rest of the testimony, we learn a few other interesting details about the development of his short thesis concerning Enron: the use of Wall Street analysts for sentiment feedback, the analysis of additional qualitative data for confirming target company statements and the use of conferences and investor communications networks to spread an idea and generate critical investor momentum.

Chanos also shares this helpful Wall Street axiom:

It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets.

An important reminder for considering all business strategies which require positive momentum (ie, Ponzi schemes) to work.

More telling than insider selling, in Chanos’ mind, is management departures, change ups and board reshufflings:

In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what “official” reason is given.

In the case of Enron, the executive to depart was Enron CEO Jeff Skilling who was considered to be the “chief architect” of the company’s controversial trading program. His absence meant not only that Enron was potentially a ship without a rudder, but that the captain had found a leak and was jumping overboard with the rats before everyone else figured it out.

In Summary

To summarize the lessons of the Enron case, good shorts usually involve at least one or more of the following: questionable earnings, uneconomic business models and/or fraud.

Accomplished short-sellers look for clues suggesting the presence of the above factors by reading between the lines in public financial disclosures and major news stories. They use social signaling clues like surveying Wall Street analysts and other market participants to gauge sentiment, which is a contrarian tool for discovering whether controversial information they are aware of is likely priced into the market or not. They engage in competitive analysis to judge whether the target firm’s claims are credible and reasonable. They watch the activity of insiders, specifically unanticipated departures of key staff, for confirmation of their thesis. They anticipate stressors to a firm’s business model which might serve as catalysts for revealing the precarious state of a firm’s business to other market participants.

Finally, and perhaps most importantly, they never take the price of the shorted security going against them as evidence that they are wrong and they add to their position as their conviction rises with new evidence of weakness or trouble for the target firm.

As Ben Graham would observe, in the short term the market is a voting machine and it’s common for those who are responsible for a fraud or dying business to cheerlead the market out of desperation. And as Chanos himself observed,

While short sellers probably will never be popular on Wall Street, they often are the ones wearing the white hats when it comes to looking for and identifying the bad guys!

Abodeely: Discounting The Value Of Experience

JJ Abodeely, author of the Value Restoration Project blog, writes about a theme that deserves more attention– that experience isn’t always an advantage and may even be a disadvantage, particularly at times like today where there appears to be a paradigm shift underway:

Consider how many firms espouse the experience of their managers as a key selling trait. The idea that experience might actually be detrimental to returns is not one that the investment management industry is willing to promote. However, an intellectually honest assessment of the role of experience in driving investment decision-making and results is in the best interest of advisors, managers and clients alike.

Perhaps even more importantly, relying on experience often means relying on a cloudy, biased recollection where our “memory is not as much a factual recording of events as it is a perception of the physical and emotional experience,” as behavioral finance professor John Nofsinger teaches us. Focusing on exposure, on the other hand, frees us to think beyond what our experience allows for. Perhaps ironically, forsaking experience for exposure may allow for a greater respect for the rhythm of history with a more objective and long-term analysis.

In practical terms, most investors today are impaired by their experiences in the 1980s and 1990s. They lack a historical understanding of secular market cycles and valuation, the closest thing we have to a law of gravity in finance. Similarly, most economists, with their data-heavy analysis, lean almost exclusively on the post-war period when modeling how the economy should behave. Most economists, strategists, analysts and investors have not experienced debt-induced financial crises, de-leveraging global economies or the demographic headwinds we face today. Nor does anybody’s experience include the ways in which today’s world is unique from any other point in history and the ways in which tomorrow’s history is completely unwritten.

More Thoughts On Lone Ranger Investing, Informational Asymmetries And “Going Private”

A few days ago I linked to a post from Hedge Fund News in which the author expressed some deep skepticism and reservations about common stock investments in the present era. The primary concerns were that the market is “rigged” to a large extent via Fed front-running and black-box trading algorithms. Stock market investing is largely about an informational edge. Without friends in high places, an army of analysts and a mainframe computer, how is the little guy supposed to have an edge anymore?

First, a contrarian take on the contrarian take.

Front-running the Fed works, until it doesn’t. Many try to front-run the Fed without any real, personal insight into what’s going on there (aka, having a whisper network that’s tapped in to the Fed) and those people get steamrolled in periods like the one we just witnessed in August 2011, when many market participants hit the “Eject” button all at once and the Fed isn’t there with a trampoline to catch everyone. Some do have those networks and their front-running is largely successful (though you have to wonder what the hell happened at PIMCO over the last two months with Alan Greenspan on retainer) and to that I have no response besides to observe that “Life isn’t fair, deal with it.” Some people are born with a Golden FRN lodged between their butt cheeks and some aren’t. It’s obviously not the majority of the market because if it were that’d defeat the whole purpose of having that kind of informational advantage.

For the average, little guy investor, all the Fed does is introduce extreme volatility into the picture. And volatility isn’t risk. In fact, volatility provides true opportunities for the value investor that he otherwise might never have gotten as the inevitable panics that ensue tend to drag down the good companies with the bad. Then, you buy good companies cheaply.

I look at the black-box trading the same way. So what if there are black-boxes? They add volatility to markets. Volatility is opportunity, not risk. Use limit orders if you’re worried about getting manipulated by these robots putting out false bids.

The concern about informational asymmetries caused by institutionalism and hedge fund analyst armies is more substantive. But it still doesn’t mean doom for the little investor (or maybe better to call him the “lone ranger investor”, because he might have a few thousand or he might have a few million). I am going to paraphrase a few points from Jason Zweig’s commentary from chapter 8 of The Intelligent Investor:

  • Institutions (and hedge funds) have billions of dollars under management; this massive AUM forces them to gravitate towards the same large-cap stocks
  • Investors tend to pour money into institutional vehicles as markets rise, and pull it out as it falls; this forces these players to buy high and sell low
  • Many institutions are obsessed with relative benchmarks, the performance and composition of which shape their trading patterns and selections; their creativity and independence is stifled as a result
  • Many institutions box themselves in with an arbitrary mandate or theme which forces them to make their investment decisions within a confined space, often without regard to absolute value found elsewhere in the market place

Now, let’s flip each of these points around to see how the lone ranger investor is advantaged by each:

  • The lone ranger has comparatively little AUM so he has the flexibility to allocate his portfolio into nearly any stock he wants, from nano-cap to mega-cap
  • The lone ranger is in sole control of his buying and selling as he doesn’t face redemption requests or sudden influxes of hot money like institutions do
  • The lone ranger doesn’t have to compete with any benchmark if he doesn’t want to, instead he can just chase absolute returns and not worry about how he measures against a given index or benchmark over a given period of time
  • The lone ranger is free to choose any style, theme and type of investment strategy he likes and never has to worry about a regulation or outside investors having a problem with it

A video of Ray Dalio over at Credit Bubble Stocks features Dalio riffing on the high degree to which average hedge fund returns are correlated with the broader markets. The implication is that hedge funds aren’t being creative and independent in their strategies and trades. What good is an army of analysts, in other words, if you’ve got them looking at the same exact companies (AAPL, NFLX, BAC, etc.) that everyone else is looking at? What good is it to be a hedge fund when all this really means is you can hold more than 5% of your portfolio in something like AAPL and then lever the hell out of it and cross your fingers hoping Ben Bernanke’s got your back?

Informational advantages come in three flavors:

  1. Investments no one else is interested in, ensuring you have little to no competition for information (for example, a micro-cap with no institutional sponsorship and no analyst coverage)
  2. Investments in which you have a special relationship with insiders or other connected people, ensuring you have better quality information
  3. Investments in which you have a unique perspective or framework for understanding, ensuring that even if information is fairly distributed amongst all participants, only you will know what to do with it

Number two is damn near impossible (and extremely legally risky) to get in the current era of financial market regulation for most people. But there is nothing to stop the lone ranger investor from focusing on numbers one and three. In fact, this is where he should be focused.

The real risk, and this was suggested in the Hedge Fund News piece, is that number two might be so pervasive in particular situations that it overwhelms number one and number three. But for the most part, those situations are fairly obvious and can be avoided. For example, don’t buy AAPL if that’s what everyone is trading.

So, that’s some of the advantages the lone ranger has, in spite of it all. But the HFN piece wasn’t total fluff and he’s right to still be skeptical. I was particularly struck by his suggestions about corporate governance. This is a big problem as I see it.

Yesterday I spent some time listening to Albert Meyer talk about his experience with uncovering numerous well-publicized frauds and accounting shenanigans of the last decade ($KO, $TYC, Enron and the New Era Philanthropy Ponzi). The way Albert made it sound, corporate governance in this country is in shambles and a true embarrassment to the idea of free and honest markets.

Albert talked about the problem with option issuance overhang. Even though these items are now expensed following a FASB rules change, Meyer insists that the true costs of executive compensation for many (most?) companies listed on US exchanges is severely understated. He called into question the practice of huge stock buybacks by most companies, which he said is really just the way in which companies cover up the inevitable dilution that would otherwise occur from executive stock option exercising– and it all comes at the expense of shareholders and mutual fund investors whose mutual funds buy the new shares of recently exercised options. One example he gave was $EBAY, which he said reported income of $800M in a particular period but should’ve reported an $800M loss (a swing of $1.6B) once you had factored in the option issuance and subsequent buybacks to prevent dilution.

Albert said there were only 7 companies in the US that do not compensate executives with stock options. He cited numerous examples of Congressional and regulatory (SEC) corruption with regards to the protective relationship these cretins have with American corporate boards and C-level management teams and the stock option issuance scam. He said there is a lot less of it going on outside of the US which is yet another reason why he finds himself seeking out investment opportunities there.

I’m getting into a digression here when I don’t mean to be, but I assure you this is all related. The point is this: the predominating corporate structure for business in this country, specifically amongst publicly-listed companies with career professional management teams who are not also owner-operators of the company, creates a uniquely perverse set of incentives that truly pits the interests of shareholders (the actual owners of the company, its assets and cash flows) against management and even their own boards! The reality in many cases is that executives and obedient, captured boards work together the milk the wealth of the company for themselves with outsized compensation packages based primarily on stock option issuance, leaving shareholders with all the risks and none of the rewards.

And as the HFN piece points out, the entrepreneurial spirit is particularly absent in these kinds of arrangements because it must be. There is no real connection between the performance of the business (good or bad) and the compensation of the board and management. In the event that the company does well, the gains are secretly dissipated through executive stock option exercising and subsequent colossal buybacks. In the event that the company does poorly, management and the board issue themselves numerous stock options at rock-bottom prices with long duration expirations, virtually guaranteeing that should the business ever turn around they’ll be there to siphon off all the gains for themselves and leave shareholders with nothing.

In effect, it’s a game, and a dirty one that the lone ranger investor doesn’t have many tools besides selectivity that he can use to win. It’s such a widespread practice that you really have to either get in at the absolute bottom or find a company where the corporate governance is much more shareholder aligned (high percentage of insider ownership, predominance of cash compensation for executives without major options issuance, share buybacks that occur at market lows not at market highs when management is cashing in their chips and exercising options, low percentage of institutional sponsorship and a truly independent board where ideally executive management doesn’t have many or any seats) if you ever hope to win it.

That is why I’ve been thinking a lot about “going private.” By going private, I don’t mean taking companies that are public, private, though that might be a good start as I honestly think that in many ways having access to public financing is simply an excuse for poorly managed companies to engage in Ponzi finance without it looking like such.

Instead, what I am talking about is being an enterprising, entrepreneurial investor primarily within the private investment space. This means not only starting your own businesses, but making contacts and seeking out investment opportunities that are not party to the public capital markets. In many cases, it means investing locally and investing in what you know about. It also potentially means outsize returns via informational asymmetries and reduced competition (amongst yourself and other potential investors).

In that vein, I was struck by this comment from Mark Cuban that I saw quoted on Tim Ferriss’s 4 Hour Blog in a post about rethinking investing:

YM: Do you have any general saving and investing advice for young people?

CUBAN: Put it in the bank. The idiots that tell you to put your money in the market because eventually it will go up need to tell you that because they are trying to sell you something. The stock market is probably the worst investment vehicle out there. If you won’t put your money in the bank, NEVER put your money in something where you don’t have an information advantage. Why invest your money in something because a broker told you to? If the broker had a clue, he/she wouldn’t be a broker, they would be on a beach somewhere.

Cuban’s sentiment echoes my own here and I find myself sharing this perspective with friends and family members who ask me for investment advice or what to do with their 401k.

The first thing I tell people is, don’t put your money in your 401k if you don’t know what you want to do with it once it’s there. People get taken in by the idea of pre-tax investing and employer matching, but ultimately those advantages are wasted if you are just going to make clueless, doomed-to-fail investments with that money. What good is having 6% matching or investing with 35% more money because you don’t pay taxes on the principal when you put it in, if you’re just going to lose 100% of it anyway?

The second thing I ask them is, what kind of options do you have and what kind of informational advantages do you have when you put your money into your 401k or the stock market in general? Most don’t have a clue. That’s a warning sign! If you don’t know what your informational advantage is, you don’t have one and you’re basically investing blind. Meanwhile, your opponents not only aren’t blind, they’ve got Lasik. They will take your money and run the first chance they get.

The final recommendation I make is, instead of investing in the stock market or a 401k (which the person admittedly knows nothing about), I suggest they save up to start their own business or invest in the business of a friend or family member who they know, trust and have tangible proof of their success. It would be much better to make private arrangements to invest equity or loan money privately in a situation like that than it would be to dump their hard-earned wealth into a Wall Street rucksack and then wake up 20 years later wondering where it ran off to.

When I make those suggestions to others I start to wonder if we would all be better off if we did the same.

Review – The 4-Hour Work Week

by Timothy Ferriss; published 2009

A few important takeaway quotes from Chapter 1, “Rules That Change The Rules”:

  1. Retirement is an unsustainable notion: implies you do what you dislike during the most physically capable years of your life; the math doesn’t work; you’ll probably opt to look for a new job or start another company as soon as you retire, out of boredom
  2. Alternating periods of activity and rest is necessary to survival, as well as “thrival”; work only when you are most effective to be more productive and happier overall
  3. “Someday” is a disease that will take your dreams to the grave with you; if it’s important to you and you want to do it “eventually”, just do it and course correct along the way
  4. Ask for forgiveness, not permission; if the potential damage is moderate or in any way reversible, don’t give people the chance to say no
  5. It’s better to emphasize strengths than repair weaknesses; identify your best weapons and focus on wielding them more wisely
  6. The positive use of free time implies doing what you want as opposed to what you feel obligated to do
  7. Relative income uses two variables: money and time
  8. Eustress: role models who push us to exceed our limits, physical training, risks that expand our sphere of comfortable action; people who avoid all criticism fail

The value of money spent is determined by:

  • what you do
  • when you do it
  • where you do it
  • with whom you do it

In other words, quality, not quantity, is the major consideration in “psychic yield” from money spent.

In Chapter 2, Ferriss proposes some “rules that change the rules”. To start with, the concept of saving and sacrificing for an old-age retirement is a broken one because:

  • it assumes up to that point you spend a majority of your time doing something you dislike during the most physically capable years of your life
  • the math doesn’t work and you end up reliving your low-income lifestyle in old-age
  • you’ll likely get bored and look for a job or start a company just to keep yourself busy, negating the whole point

Instead, Ferriss proposes taking periodic “mini-retirements” throughout your life. This concept is consistently applied even down to the weekly and daily level, as he suggests that,

Alternating periods of activity and rest is necessary to survive, let alone thrive… By working only when you are most effective, life is both more productive and more enjoyable.

Many people push their dreams into the future and thereby let “someday” become “never.” Instead of waiting for the perfect time to take a break, Ferriss recommends following a passion as soon as you are aware of it and course correcting along the way.

To use your time wisely in life, focus on the things you are best at, rather than wasting time shoring up your weaknesses. This is an economic concept known as “competitive advantage” and it works for individuals just as well as companies or countries (obviously). Using free time efficiently implies doing what you want to do with your free time, not what you feel obligated to do. Finally, it’s important to seek out eustress, which is healthy stress that results in testing our limits and then pushing them out a little further afterward. In other words,

People who avoid all criticism fail.

Chapter 3 is about overcoming the fear of realizing your dreams. Ferriss opens with the quote,

Many a false step was made by standing still.

To overcome fear, we must define it. Often, we realize that what we fear going wrong is an unlikely, temporary 3 or 4 (on a scale of ten) disaster, in return for a probable and permanent 9 or 10 success. If you don’t like what you’re doing now, and you stick with it, how likely is your situation to be improved one year from now?

Instead of seeing how much definite pain you can tolerate now, Ferriss advises you to pull the cord, take a leap and try something different while you still have a chance. You must develop a habit of doing things you fear on a daily basis because “what we fear doing most is usually what we most need to do.” You should ask yourself,

If I don’t pursue those things that excite me, where will I be in one year, five years and ten years?

If you’re bored and dissatisfied with your life and not following your passions, and you define risk as “the likelihood of an irreversible negative outcome”, then it follows that “inaction is the greatest risk of all.”

You’ve decided to face your fears and challenge yourself by demanding more. What should you do? As Chapter 4 recommends, aim as high as you can, and never let admonitions that what you are attempting is “unreasonable” stop you.

The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.

The bigger the goal, the less competition you will face. The less competition, the better your chances of bagging the big one– “the fishing is best where the fewest go.”

When choosing goals and objectives, ask yourself, “What would excite me?” and then do that thing.

Ferriss’s preferred method for envisioning your future, exciting lifestyle is called “dreamlining”. You are to come up with a number of “having, being and doing” items, and then try to convert the “beings” into “doings” by coming up with specific actionable steps you could take (lessons, events, workshops, etc.) that will transform you into that kind of person. Then, you estimate the cost of these different items and divide each amount by 12 (or however many months you’re giving yourself to realize these dreams, though the shorter the better to avoid “someday”-fatigue) to get your monthly cost for each.

Adding the monthly costs of your dreamline to your current monthly expenses (multiplied by 1.3 to give yourself a savings buffer for something going wrong) gives you your Target Monthly Income (TMI) and gives you a real goal to shoot for in helping you understand how much more you need to make on a monthly basis to start realizing your dreamlines. This is the part where you get creative– sell stuff you don’t need and aren’t using anymore, reduce your expenses by not getting that latte every morning, and think up new sources of income by starting a side business or other passive income stream. You’ll often be amazed how close you are to your dreams when you look at them as a monthly figure and consider ways in which your current spending doesn’t really satisfy your dream desires.

Living your dream is about doing, and making bold decisions for yourself. This is why Ferriss ends the chapter by stating:

To have an uncommon lifestyle, you need to develop the uncommon habit of making decisions, both for yourself and others.

The next time someone asks you for a decision on something (where to go for lunch, what to do about that client, etc.), MAKE ONE and course correct if necessary. Almost everything is reversible.

Chapter 5 develops the theme of time management. The focus is on the 80/20 principle of Italian economist Vilfredo Pareto, namely, focus on eliminating the 20% of sources causing 80% of your problems while spending that freed up time on the 20% of sources responsible for 80% of your desired outcomes and happiness. Productive efficiency is about doing more by doing less ineffective stuff via selectivity.

The most important lesson: lack of time is actually lack of priorities.

Give yourself short, clear deadlines to work out critical tasks that contribute the most to your work or quality of life. Ignore or eliminate the rest. A few other tips:

  • Ask yourself, “If this is the only thing I accomplish today, will I be satisfied with my day?”
  • Never arrive at the office, your computer or anywhere else without a clear list of priorities– otherwise you’ll make up distractions to fill your time
  • Compile your to-do list for tomorrow no later than this evening
  • You should never have more than two mission-critical items to complete each day
  • Do not multitask

Chapter 6, The Low Information Diet, takes these principles and applies them further. Stop wasting time reading the news; start using, “Tell me, what’s new in the world?” as a conversation starter and let others read the news and summarize headlines for you.

If you need to learn how to do something, read the autobiography of someone who has done it. If you’re suffering from information overload, ask yourself, “Will I definitely use this information for something immediate and important?” And practice the art of nonfinishing– if something is boring or not useful, stop reading it/listening to it/watching it, etc.

Stop asking people “How are you?” and instead ask them, “How can I help you?” The former invites interruptions, the latter invites action.

Living The New Rich Lifestyle Starts With Mini-Retirement Jet-setting Practice

Paraphrasing (in Ferriss’s words) the first few paragraphs of the chapter about doing a life-reset by traveling abroad:

Some jobs are simply beyond repair. Improvements would be like adding a set of designer curtains to a jail cell. Most people aren’t lucky enough to get fired and die a slow spiritual death over 30-40 years of tolerating the mediocre. Being able to quit things that don’t work is integral to being a winner. The person who has more options has more power. Don’t wait until you need options to search for them. Take a sneak peek at the future now and it will make both action and being assertive easier.

Begin your new lifestyle of mini-retirements and following your life’s passion by relocating to one place for one to six months before going home or moving to another locale. This will give you time to relax and enjoy the new experiences without having to worry about catching your flight home, and without shortchanging yourself by assuming you won’t be around long enough to really submerse yourself in the local culture and language.

Chose a location where your money will go further than back home (such as Argentina, Thailand or Eastern Europe). To get there, use credit card miles or buy your tickets either far in advance or at the last minute, comparison shopping with Orbitz.com or Kayak.com and the airlines’ own websites and then bidding on Priceline.com for 50% off, moving up in increments of $50 at a time. Consider using major airlines to get to travel hubs in foreign countries and then buying a local airline ticket to make the final leg(s) of the trip from there.

When you arrive, stay in a hostel or cheap hotel and query fellow travelers and hostel/hotel owners for the lay of the land. Tour around local neighborhoods with hop on/hop off bus tours or public transit, or rent a bike. Go look for an apartment (fully furnished and full of amenities) and set up your base for a few months.

If you’re relocating to a country where you can use dollar-arbitrage to your advantage, you can likely live much better than you do back home, enjoying a nice apartment, eating out at fancy restaurants and enjoying entertainment and nightlife you couldn’t dream of back home.

You should also look into local, private language instruction (several hours per week), as well as other local activities such as cultural dance, music, athleticism and exercise, that will allow you to learn from experts, mix with locals, learn the language and do it all for less money than you’d spend back home for equivalent experiences.

Practice taking less with you: take one week of clothes, no toiletries and allocate $100-300 to buy the rest of what you need when you get there. When you come home, leave the excess behind. You should be able to travel internationally with a carry-on and a backpack.

Final Remarks About Living Life Well

If you can’t define it or act upon it, forget about it.

Have at least one 2-to-3 hour dinner and/or drinks per week with those who make you smile and feel good.

Eat a high-protein breakfast within 30 minutes of waking and go for a 10-to-20 minute walk outside afterward, ideally bouncing a handball or tennis ball.

A good question to revisit whenever overwhelmed: Are you having a breakdown, or a breakthrough?

Rehearse poverty regularly. (You’ll fear it less when you know what it’s like and that you can handle it.)