Notes – The Great Deformation – Part I, The Blackberry Panic Of 2008

The Great Deformation: The Corruption of Capitalism in America

by David A. Stockman, published 2013

I received a copy of David Stockman’s 2013 analysis of the mechanics of the 2008 financial crisis and its aftermath as a gift from a friend and sat down to read the first 50 pages, Part I.

I think Stockman attempts to make several key points as a set up to the remainder of this lengthy tome:
-the mainstream/regime narrative of an incipient economic crisis catalyzed by a financial collapse originating in Wall Street credit markets controlled by major Wall Street institutions (such as Morgan Stanley and Goldman Sachs) is one part baseless lie and one part clueless ignorance of facts on the ground at the time
-there was a crisis, for these particular institutions, which was a result of years of non-value adding financial and accounting chicanery enabled by Fed Chairman Greenspan’s infamous “put” and the crisis would’ve resulted in the liquidation of these firms assets (and the termination of their managers) into abler hands which would’ve been a good thing for competitive financial markets and the capitalist economy as a whole
-this crisis was not only averted by the frantic lobbying of connected officials in Congress, the Treasury and other regulatory agencies by crony executives in the affected firms, but these same executives and officials worked in concert to turn the bailout moment into a massive payday/profit opportunity; most of the people making decisions about this in the government, particularly in the Treasury and the Fed, were inexperienced, miseducated or otherwise rank amateurs with little understanding of the context of their decisions or their consequences beyond the immediate moment
-the scale of the bailouts in terms of pure dollars was completely without precedent or connection to actual costs and risks present in the system at the time
-memoirs of officials and executives involves in the bailout discussions published extemporaneously do not make a substantial case for their decisions based off of data available about the period years later
-much of the decision-making at the time, by concerned executives as well as captured officials, seems to be dominated by the twin desire to avoid taking responsibility for mistakes made in the past (thereby looking foolish) and to continue the illusion of the viability of the system based on these mistakes going forward

“All the rest,” as it has been said, “is illustration.”

There were parts of the narrative I found confusing to follow at times. Its possible I didn’t read clearly, but in several instances it seemed like on one page or at the beginning of a chapter Stockman would be arguing that the potential capital losses of a particular company were small enough relative to their total balance sheet that they could easily sweat the loss from a survival standpoint and then on the next page or at the end of the chapter, he seemed to suggest the same loss was so sizable that it would threaten the viability of the enterprise itself.

I think there was a lot of question-begging in the narrative as well. Stockman builds a decent logical case for why there was no “contagion” that could spread from Wall Street (the financial markets) to Main Street (the rest of the economy) that would result in a general economic depression. But his argument always rests on the costs being shifted to various government backstop agencies and funding sources which could make things like commercial lending and payroll finance markets “money good”. It isn’t explained where these institutions would come by the required funds necessary to remain in operation without a bout of money printing (bailouts) and how this is different than the bailouts Wall Street received.

That leads to another concern I have with the overall thesis, which is that somehow, what happens on Wall Street is arbitrary and doesn’t affect greater economic outcomes. While I agree with the notion that purging the financial system of bad debts and bad business models during periods of crisis is a process of economic health rather than economic illness, I so far fail to see how the repricing and reorganization of economic capital taking place in these markets would not result in similar repricings and reorganizations of capital investment throughout the economy as a whole. Stockman details several multi billion dollar examples of ” predatory financial practices” in which members of Main Street America were able to finance lifestyles they couldn’t prudently afford the costs of and it seems like these are prime (or subprime, as it were) examples of assets that would need to be repriced and reorganized into abler hands. The gutters of both Streets would be filled with the purged excess, and it would eventually drain.

Annoyingly, Stockman repeatedly exalts “our political democracy” and even conflates its goodness and functioning with free market capitalism. For me, this is a fundamental flaw in reasoning and defining terms that throws his entire analysis into suspicion, at least from the standpoint of his analytical framework operant and his own agenda in terms of desired social outcomes. I don’t think Stockman and I are on the same page, in other words.

So far, Stockman’s book expects a lot of prior knowledge on behalf of the reader. He doesn’t begin the book outlining his economic or financial theories, nor his concept of the purpose of government. We intuit bits and pieces of it as he proclaims this bad, that person good, this event horrid, etc. But he never really says “I’m from the School of X” or gives a summary of the key principles necessary to follow his analysis. Therefore, it comes off as strenuously assertive rather than rigorously logical. And I think part of Stockman’s goal is to spread blame in a bipartisan fashion, while building bridges and giving accolades in an “independent” manner. So far, though, it seems arbitrary due to this lack of explanation about his framework.

Review – Professional Investor Rules

Professional Investor Rules: Top Investors Reveal The Secrets of Their Success

by various, introduction by Jonathan Davis, published 2013

The many faces of money management

A 1948 Academy Award-winning film popularized the slogan “There are eight million stories in the Naked City”, and after reading the eclectic “Professional Investor Rules”, I’m beginning to think there are almost as many stories about how to manage money properly.

Value and growth, momentum and macro-geography, market-timing and voodoo superstition; all these major investment strategies and themes are on display, and many more to boot, and all come bearing their own often-tortured metaphors to convey their point.

What’s more, it seems the pacing and style of the book change along with the advice-giver: while some of the entries follow the books eponymous “rule” format for organizing their thoughts, others involve myths, lengthy prose paragraph-laden essays and headings with sub-headings. Some have charts, and some do not.

One things consistent, at least– all the advisors profiled contradict one another at some point or other, and some even manage to contradict themselves in their own sections.

But it’s got this going for it, which is nice

Those are some of the glaring cons to the book. It’s not entirely without it’s pros, however.

One of the things I liked about the book is, ironically, also one of its flaws– the great variety of personas. They run the gamut from the known to the unknown, the mainstream to the contrarian, the sell-side to the buy-side. This book is published by a UK outfit (Harriman House), which means many of the professional soothsayers will be unfamiliar to US audiences, but it also means you get a selection of icons from the Commonwealth and former British territories (such as Hong Kong and other Asia-based managers) that you’d likely never hear about on CNBC or other American publishing sources.

Following this contrarian inversion theme, I liked that all the phony  fuzzy thinkers were right there next to the sharper pencils because it made their baloney that much more rotten. I think this is a great service for an uninformed investor picking up this book. If they had come across some of the more foppish money dandies on their own, elsewhere, they’d be liable to get taken in and swindled like the thousands of others who sustain such frauds. But at least in this case you’ve got a go-go glamour guy saying no price is too high for a growing company right next to a value guy warning that that way lies the path to certain, eventual doom.

And maybe this isn’t a big deal to others but I like the packaging on this hardcover edition I’ve got– it’s truly a HANDy size, the fonts and color scheme are modern and eye-catching and the anecdotal organization of the book makes it easy to pick up and put down without feeling too upset over whether or not you’ve got the time to commit to a serious read right then.

Fave five

Here are five of my favorite ideas from the book, along with the person(s) who said it:

  1. At any one time, a few parts of your portfolio will be doing terribly… focus on the performance of the portfolio as a whole (William Bernstein, Efficient Frontier Advisors)
  2. Far more companies have failed than succeeded (Marc Faber, The Gloom, Boom and Doom Report)
  3. Fight the consensus, not the fundamentals (Max King, Investec Asset Management)
  4. When someone says ‘it’s not about the money,’ it’s about the money (H.L. Mencken… consequently not actually a money manager and not alive, but it was quoted in one of the in-betweens spacing out the chapters)
  5. Academics never rescind papers and never get fired (Robin Pabrook and Lee King Fuei, Schroeders Fund, Asia)

Conclusion

Who is this book for? Accomplished, well-read pro-am investors will find nothing new here and much they disagree with, so I’d recommend such readers stay away. Someone completely new to investing and the money management industry might find the book valuable as a current snapshot of the gamut of strategic strains present in the money management industry.

Overall, while “Professional Investor Rules” has its moments, overall I came away less enthused than I did with Harriman House’s earlier offering, Free Capital. For anyone looking to learn investing techniques from accomplished, self-made millionaires, that’s the book I’d point them to– the advice therein is worth multiples of that being given by the mass of asset gathering managers of OPM contained in this one.

Fees, Firepower & Funds: The Incentives Faced By Private Equity

I know very little about the private equity world, mindset, incentive structure and investment strategy, but I am eager to understand it better. I found a recent post, “Too Much Is Never Enough” at the Epicurean Dealmaker blog, to be informative reading, assuming the author knows what he is talking about. Plus, it came chock full of Seven Samurai quotes, which is pretty awesome:

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

This Is How Analyst Earnings Calls Look To Me, Too

I’m glad to know I’m not crazy and Jeff Matthews has a similar experience to my own. This is hilarious and represents satire at its best, satire that is essentially just reality with the names changed:

CFO Cathie Lesjack: “The following discussion is subject to all sorts of risk factors, and since most of your clients have already lost a lot of money in HP stock by listening to me in the past talk about how great we were doing and taking it at face value, I figure you should already know enough not to pay much attention to what we’re going to say.”
CEO Meg Whitman: “Thanks Cathie. We’re going to dispense with reading the press release and the boo-ya stuff, since most of you know how to read—at least you can read everything but a balance sheet. (Giggles) Operator?”
Operator: “Thank you.” (Reads instructions) “Our first question is from the line of Glen Obvious. Mr. Obvious?
Glen Obvious: (Confused) “Hey, thanks. That was quick. Umm…”
Whitman: “Operator, Glen, is trying to figure out what to congratulate us for, because he always starts out saying ‘congratulations’ on something so his poor clients who own our stock feel better no matter how bad the actual news is. Why don’t you move on to the next question while Glen gets his brain going.”
Operator: “Yes ma’am. Next is Janet Literal.”
Janet Literal: “Thank you for taking my question—”
Whitman: “Why wouldn’t we? This is a conference call.”
Literal: “Well, I always say that…so you’ll think well of me.”
Whitman: “Well cut it out. We’re all grown-ups here. You don’t have to thank us for foisting dopey acquisitions, massive write-offs, a negative tangible book value, a highly leveraged balance sheet and non-GAAP earnings on America’s small investors. Just get on with it.”
Literal: “Okay—well, that’s my question: you don’t have any non-GAAP numbers in the press release.”
Whitman: “Yeah, we figured since those aren’t actually based on ‘Generally Accepted Accounted Principles,’ we should probably start going with just plain old GAAP. It’s a lot closer to the truth that way.”
Literal: “But these GAAP numbers are terrible. You didn’t make any money.”
Whitman: “Bingo.”
Literal: “So how come your non-GAAP guidance was so much better than this?”
Whitman: “D’oh!”
Literal: “I’ll get back in the queue.”
Whitman: “We won’t hold our breath, honey. Next!”
Operator: “Your next question is from Fred Forehead. Mr. Forehead, your line is open.”
Fred Forehead: “Thank you for—oh, sorry, never mind that. Meg, how should we think about the revenue decline?”
Whitman: “You want me to tell you how to think about something?! Didn’t God give you a brain?”

Kleptocracy Via Inflation Is The Global Model, Not Just Chinese

Australian hedge fund manager John Hempton is out with a new piece on his blog about “The Macroeconomics of Chinese kleptocracy“, the main takeaway of which is:

But ultimately the Chinese establishment like inflation – it is what enables their thievery to be financed.

The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate – well that is a completely different story.

[…]

The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don’t all hell will break loose.

Unless the Chinese can get the inflation rate up expect a revolution.

I know John (who appears to be a well-intentioned but generally naive political conservative) would likely strongly disagree with the following characterization but…

This is the kleptocratic model prevalent in all major developed and developing world economies– inflation is the keystone piece of these systems and it is why CB presidents from Bernanke to Draghi to Shirakawa are all intent on creating and maintaining it.

If the inflationary engine fails to turn over, the loot-truck stops making its rounds. If the loot-truck stops making its rounds, the elite and their scumbag offspring don’t get paid and all the world’s peasants (you don’t have to work a farm to be an economic peasant) suddenly wake up to just how desperately poor they are after being continually ripped off for decade upon decade.

But, I’m a cynic, so of course I’d see the world that way. More reasonable men, like Mr. Hempton, are more prevalent in the world than I, so everyone is spared my dark view of things and can instead bask in the glory of knowing that, while our systems may not be perfect, at least they’re not as bad and out in the open as China’s.

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 – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Intelligent Investor (1949 Edition)
    • Hidden Champions of the Twenty-First Century
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes