Archive for March, 2010
Shanking Your Way to Success: Tiger Woods & Roger McNamee
Spring has sprung and that means golf is back in full swing with the Masters golf tournament kicking off next week in Augusta, Georgia. Next week also marks the return of Tiger Woods in his first competition since news of Tiger’s sex scandal and car crash originally broke. As an avid golf fan (and occasional frustrated player), I must admit I do find a devilish sense of guilty pleasure every time I see a pro golfer shank a ball into the thick of the woods or plop one in the middle of the drink. I mean, how many hundreds of balls have I donated to golf courses across this great nation? Let’s face it, no matter how small, people derive some satisfaction from seeing others commit similar mistakes…misery loves company. Even the world’s elite, including Tiger Woods, slip up periodically.
For quite possibly the worst, nightmarish, meltdown classic of all-time, you may recall Frenchman John van de Velde’s 18th hole collapse at the 1999 British Open in Carnoustie, Scotland.
Investment Pros Shank Too
Investment legend Peter Lynch (see Investment Caffeine profile on Lynch), who trounced the market with a +29% annual return average from 1977-1990, correctly identified the extreme competitiveness of the stock-picking world when he stated, “If you’re terrific in this business you’re right six times out of ten.” Even with his indelible record, Lynch had many disastrous stocks, including American International Airways, which went from $11 per share down to $0.07 per share. Famous early 20th Century trader Jesse Livermore puts investment blundering into context by adding, “If a man didn’t make mistakes he’d own the world in a month.”
Mistakes, plain and simply, are a price of playing the investment game. Or as the father of growth investing Phil Fisher noted (see Investment Caffeine profile on Fisher), “Making mistakes is an inherent cost of investing just like bad loans are for the finest lending institutions.”
McNamee’s Marvelous Misfortune
Since the investment greats operate under the spotlight, many of their poor decisions cannot be swept under the rug. Take Roger McNamee, successful technology investor and co-founder of Elevation Partners (venture capital) and Silver Lake Partners (private equity). His personal purchase of 2.3 million shares ($37 million) in smartphone and handheld computer manufacturer Palm Inc. (PALM) has declined by more than a whopping -75% since his personal purchase just six months ago at $16.25 share price (see also The Reformed Broker). McNamee is doing his best to recoup some of his mojo with his hippy-esque band Moonalice – keep an eye out for tour dates and locations.
Lessons Learned
More important than making repeated mistakes is what you do with those mistakes. “Insanity is doing the same thing over and over again, and expecting different results,” observed Albert Einstein. Learning from your mistakes is the most important lesson in hopes of mitigating the same mistakes in the future. Phil Fisher adds, “I have always believed that the chief difference between a fool and a wise man is that the wise man learns from his mistakes, while the fool never does.” As part of my investment process, I always review my errors. By explicitly shaming myself and documenting my bad trades, I expect to further reduce the number of poor investment decisions I make in the future.
With the Masters just around the corner, I must admit I eagerly wait to see how Tiger Woods will perform under extreme pressure at one of the grandest golf events of the year. I will definitely be rooting for Tiger, although you may see a smirk on my face if he shanks one into the trees.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in PALM or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Simmons Wants to Kiss Life Insurance Worries Away
The Makeup Master
Gene Simmons, lead singer of rock group Kiss, was born as Chaim Witz in Israel 60 years ago. After 40 years of rocking & rolling, the band is still alive and well and touring this spring in the U.K. I am no stranger to Gene Simmons – as a matter of fact, Kiss was the first concert I attended as a kid at the San Francisco Cow Palace in the 1970s. Despite his early professional career success, all the limelight and money was not enough for Gene Simmons, so he put his entrepreneurial skills to the test and aggressively added a broad Kiss merchandising line (over 3,000 licensed/merchandise items), including everything from Kiss baby clothing and Kiss wine to Kiss dart boards and Kiss caskets. Yep, soup to nuts, from the cradle to the grave, and you can even purchase the merchandise with your Kiss Visa credit card!
All Aboard the Premium Financing Train
Now, Mr. Simmons has expanded his business interests to a broader set of financial services. Specifically, Simmons has co-founded a company (Cool Springs Life) that sells premium finance life insurance targeted at high net worth individuals. Simmons and CEO Samuel Watson stopped off at Bloomberg to spread the premium finance gospel:
Premium financing arrangements set up for life insurance are primarily designed for wealthy individuals with large, multi-million dollar estates. This explains a little about whom are the prime targets for life insurance premium financing, but why would wealthy individuals potentially want this financing tool?
Premium Financing Benefits:
- Pay for Estate Taxes: The primary advantage of life insurance for the wealthy is to provide liquidity to beneficiaries (in the form of a death benefit) at the death of the “insured” to fund future estate taxes. Estate tax legislation is still up in the air, but in my view will likely increase to a hefty 45% to 55% rate over the next year. The tax-free liquidity (see a knowledgeable CPA to confirm tax status) provided to the surviving beneficiary by the insurance policy can be especially important if the deceased person’s assets are tied up in illiquid assets like real estate. The government is impatient in regards to tax collections, so gaining immediate access to the death benefit proceeds is a more attractive alternative than forced sales of illiquid assets (potentially at fire-sale prices).
- Other People’s Money: Some people prefer to purchase things with other people’s money. The cost of the financing can be another benefit to the strategy. The interest rate owed on a premium financing deal may be lower than the return a client can earn on alternative investments. If the investment strategy proves successful, the borrower will earn a positive spread on the loan (borrow low, invest high).
- Lower Estate Value: By gifting life insurance assets to a trust (e.g., an Irrevocable Life Insurance Trust – ILIT), there are ways for a wealthy donor to lower his estate value by employing gifting strategies and other estate planning structures. These estate planning tactics often preserve asset values for designated beneficiaries, rather than forking over unnecessarily high taxes to the IRS (Internal Revenue Service). In some cases a knowledgeable attorney can structure premium payments in such a fashion that exemption allowances alleviate any potential gift tax consequence.
Normally nothing in life comes risk-free and the same principle applies to life insurance premium financing.
Premium Financing Risks:
- Interest Rate Risk: Many of these contracts are constructed based on a floating interest rate structure like LIBOR (London Interbank Offered Rate) , therefore if interest rates rise, the borrowers could expose themselves to higher interest payments.
- Credit Risk of Lender: Heaven forbid we go through another financial crisis of the same scale as 2008-2009, but insurance players such as AIG were large players in the premium financing market during this period and caused significant disruption to all relevant participants in the premium financing food chain. Failure of a lender could compromise the integrity of the life insurance and estate planning strategy.
- Risk of Deteriorating Borrower Assets: Depending on the circumstances and facts surrounding the premium financing structure, the lender may require different forms of borrower collateral (i.e., stocks, bonds, real estate, letter of credit, etc.) on top of the cash value/surrender value of the life insurance policy. If the borrower’s collateral value decreases below a certain threshold, the borrower may be forced to supply additional collateral.
For those people who want to rock and roll all night and party every day, perhaps life insurance premium financing is not for you. However, if you got a lot of dough and want to preserve the value of your estate, maybe you should give Gene Simmons a call. With a signed contract, he might even include a Kiss casket for your future funeral plans.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and a derivative security of an AIG insurance subsidiary, but at time of publishing had no direct positions in AIG. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Markowitz’s Five Dimensions of Risk
Eighty-two year old Harry Markowitz, 1990 Nobel Prize winner, is best known for his creation of Modern Portfolio Theory (MPT) in the 1950s. MPT elegantly combines mathematical variables such that investors can theoretically maximize returns while minimizing risk with the aid of diversification. Markowitz’s Efficient Frontier research eventually led to the future breakthrough of the Capital Asset Pricing Model (CAPM).
The Different Faces of Risk
Before we dive further into Markowitz’s dimensions of risk, let’s explore the definitions of the word “risk.” Just like the word “love” is interpreted differently by different people, so too does risk. To some, risk is defined as the probability of loss. To mathematicians, risk often means the historical volatility in returns as measured by standard deviation or Beta. For many individual investors, risk is frequently mischaracterized by emotions – risk is believed to be high after market collapse and low after extended market rallies (see also Wobbling Risk Tolerances article).
The Five Dimensions of Risk
With the procedural definitions of risk behind us, we can take a deeper look at risk from the eyes of Markowitz. Beyond the complex mathematical equations, Markowitz also understands risk from the practical investor’s standpoint. In a recent Financial Advisor magazine article Markowitz reviews the five dimensions of risk exposure:
1) Time Horizon
2) Liquidity Needs
3) Net Income
4) Net Worth
5) Investing Knowledge/Attitudes on Risk
Rather than pay attention to these practical dimensions of individual risk tolerance, countless investors adjust their risk exposure (equity allocation) by speculating on the direction of the stock market, which usually means buying high and selling low at inopportune times. Although it can be entertaining to guess the direction of the market, we all know market timing is a loser’s game in the long-run (see also Market Timing Treadmill article). Markowitz’s first four risk exposures are fairly straightforward, measurable factors, however the fifth exposure (“knowledge and attitude”) is much more difficult to measure. Determining risk attitude can be an arduous process if risk tolerance constantly wavers through the winds of market volatility.
The Double Whammy
Rather than becoming a nervous Nelly, constantly chomping on your finger nails, your investment focus should be on action, and the things you can control. The number one goal is simple….SAVE. How does one save? All one needs to do is spend less than they take in. Like dieting, saving is easy to understand, but difficult to execute. You can either make more money, spend less, or better yet… do both.
The Baby Boomers are not completely out of the woods, but the next generations (X, Y, Z, etc.) is even worse off because they face the “Double Whammy.” Not only are life expectancies continually increasing but the Social Security safety net is becoming bankrupt. Consider the average life expectancy was roughly 30 years old in 1900 and in developed countries today we stand at about 78 years. Some actuarial tables are peaking out at 120 years now (see also Brutal Reality to Aging Demographics). So when considering Markowitz’s risk exposure #1 (time horizon), it behooves you to calibrate your risk tolerance to match a realistic life expectancy (with some built-in cushion if modern medicine does a better job).
Taming the Wild Beast
Every investor’s risk profile is multi-dimensional and constantly evolving due to changes in Markowitz’s five risk exposures (time horizon, liquidity needs, net income, net worth, and knowledge/attitude). Risk can be a wild animal difficult to tame, but if you can create a disciplined, systematic investment plan, you too can reach your financial goals without getting bitten by the numerous retirement hazards.
Read the complete Financial Advisor article on Harry Markowitz
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Mozilo and Healthcare Tan Tax to the Rescue?
Ideological trains came crashing together as the battle for comprehensive healthcare reform resulted in the whole enchilada approach of the Democrats winning over the baby-step approach advocated by the Republicans. Thank goodness there is a savior to remedy the hefty $940 billion costs of the national healthcare plan…Angelo Mozilo. Not only will this mortgage tycoon (former CEO of Countrywide – the largest U.S. mortgage lender at one time) have his fat-cat wallet to fund multiple new healthcare taxes on the wealthy, but the government will also be collecting a new 10% tanning tax on all Mr. Mozilo’s bronzing sessions. Perhaps the CBO (Congressional Budget Office) healthcare reform cost saving estimates ($138 billion in the first decade) may come in even better than anticipated?
20,000,000 Tanning Sessions to Health
The public shouldn’t shed a tear for the real estate pain Mr. Mozilo endured – he still managed to stash a nice pile of dough before the mortgage walls came tumbling down on him. Given Mr. Mozilo’s timely sale of about $300 million in Countrywide stock before the share price cratered, coupled with the $23.8 million retirement fund and roughly $21 million in deferred compensation (Minyanville.com), Mr. Mozilo should have enough money to cover about 20,000,000 tanning sessions by my calculation. That sounds like a rather large number, but I expect Mr. Mozilo will shrewdly negotiate a bulk discount for the sessions, even if the government disapproves of the asssociated lost tax revenues.
However, one major potential hurdle for Mozilo may be finding the adequate time for tanning. If the SEC (Securities and Exchange Commission) is successful in prosecuting him on the alleged securities fraud and insider trading charges, then he may need to petition for a tanning bed in the prison gym.
Unintended Beach-going Consequences
Although we all condemn the harmful side effects of skin cancer from sunbathing, let’s not completely dismiss some of the advantages, including the benefits of Vitamin D production. Other cited ailments benefitting from sunlight exposure include, eczema, arthritis, psoriasis, acne, season affective disorder, and depression. One of the worse afflictions suffered by beach-goers (male and female alike) is the tragic “pastiness” condition. One of the severe unintended consequences of President Obama’s tanning tax may indeed be the extreme ridicule unleashed on light skinned beach bums that are unable to afford the tanning tax (see photo below).
Toss the Drumstick
On a more serious note, I get the fact that the government wants to raise a substantial amount of money to cover an extensive healthcare bill like this one – either through taxes and/or cost cuts. However, I think there are other areas in the healthcare food chain that need to climb higher in the national debate. Although, I’m OK with the tanning tax, I strongly believe there is more fertile ground in attacking obesity (see article on the Economics and Consequences of Obesity) and other costlier areas of treatment. The amount of money spent on managing obesity, and associated ailments, trounces the expenditures directed towards cancer by more than $50 billion by some estimates. Dated data shows we are spending more than $100 billion dollars on obesity-related healthcare costs. One study estimates obesity costs in the United States will reach $344 billion by 2018.
Bolstering the severity of the condition, the CDC (Center of Disease Control) noted the following:
“More than one third of U.S. adults—more than 72 million people—and 16% of U.S. children are obese. Since 1980, obesity rates for adults have doubled and rates for children have tripled. Obesity rates among all groups in society—irrespective of age, sex, race, ethnicity, socioeconomic status, education level, or geographic region—have increased markedly.”
I realize the importance of a copper tone tan can have on the lives of millions of Americans, and I also recognize the tanning tax is just a small blip in the growing 2,200 healthcare bill signed into law. Nonetheless, the spotlight of the healthcare debate needs to focus on the highest cost silos (i.e., obesity). Otherwise, I’m not completely sure whether all of Angelo’s taxed tanning sessions will be enough to cover our country’s immense healthcare costs?
Related Article: Bill Maher Chearleads No Profit Healthcare
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in BAC or any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Jumping on the Globalization Train
What happens when you mix a group of Saudi Arabians, Germans, Chinese, French, and South Koreans with billions of dollars? This is not the lead-in question to a politically incorrect joke, but rather a teaser related to a multi-billion infrastructure project currently under a bidding process in Saudi Arabia.
The proposed $7 billion, 450 kilometer high speed Saudi Arabian railway connecting Islam’s two holiest cities (Mecca and Medina) is expected to ease congestion of the 2.5 million Muslims making the annual journey to Mecca as part of the Hajj pilgrimage.
Amidst the fallout from the recent global financial crisis, the benefits of capitalism, globalization, and free trade have come under attack. There obviously were some horrible decisions made and the collapse of financial institutions around the world underscored the necessity to shore up our regulatory system. Nonetheless, this microcosm of a project is proof positive that globalization is alive and well (see also Friedman Flat World article). How else can you explain China Railway Construction Corp./Beijing Railway Administration (China), Siemens (Germany), Hyundai/Samsung (South Korea), Alstom (France), and Saudi Binladin Group (Saudi Arabia) coming together on a multi-billion project bidding process?
Oil Rich Countries Think Strategically
Saudi Arabia is not the only oil-rich country that has used the dramatic increase in oil revenues to fund investments in the future. Beyond Saudi Arabia, other oil rich areas like Qatar, Russia, and the UAE (United Arab Emirates) federation are examples of regions wanting to join the 21st Century global party rather than sitting around idly. The billions of black gold being pumped from the oil reservoirs is getting poured into infrastructure, such as technology, roads, bridges, hospitals, and yes…railways. These countries realize the importance of diversifying their economies away from the dependence on any one sector. Leadership from these regions understand the damaging economic impact of boom-bust energy price cycles, therefore they are doing their best by diversifying into other economic areas – including infrastructure. How serious is Saudi Arabia when it comes to investments? Well, the United States stimulus program was a drop in the bucket (single digit percentage of GDP) relative to Saudi Arabia, which according to BusinessWeek had the largest stimulus package among the Group of 20 (69% of GDP).
The Case for Free Trade
As protectionists and trade union organizers scratch and scream in response to expansion of globalization, competing countries around the world have their economic foot on the pedal when it comes to extending trade borders.
Tariffs, quotas and various other taxes only serve to drag down the competitiveness of our country’s most treasured industries.
These economic trade concepts are not new. Adam Smith, considered by some as the “father of economics” wrote about the “invisible hand” in his famous book Wealth of Nations (1776) and economist David Ricardo explained “comparative advantage” in his book On the Principles of Political Economy and Taxation (1817). Without getting into the nitty-gritty, suffice it to say the advantages to free trade have been well documented over the centuries.
As the standards of living climbs for hundreds of millions of people in developing countries, these populations are becoming fertile ground for the sale of U.S. technology, pharmaceuticals, appliances, automobiles, and other goods and services.
Rather than pouring sand into the gears of innovation, incentives need to be established to motivate product excellence. Otherwise, capital and jobs will migrate to other countries. Intel CEO (INTC) Paul Otellini, who was recently quoted in a New York Times article, is urging Congress to improve business, tax, and education incentives. Thanks to China’s tax policy and availability of a skilled labor pool, Intel is able to save $1 billion on a $4.5 billion plant being constructed this year – not exactly chump change.
Certainly, rules need to be created that promote fairness and credible enforcement of penalties, otherwise the benefits of trade become diluted.
Overall, the recent financial crisis caused economists, politicians, and various pundits to question the validity and benefits of capitalism, globalization, and free trade. In the vast spanning web of global commerce, the recent high speed Saudi railway may only represent a very tiny thread in the whole world’s infrastructure spend. Nonetheless, this multi-billion project integrating international heavyweights from all over world proves that despite the shortcomings of globalization, capitalism, and free trade, the benefits remain substantial and there is still time to jump back on the train.
Read The Financial Times article on the Saudi Arabia railway project.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in Intel (INTC), China Railway Construction Corp., Beijing Railway Administration, Siemens, Hyundai/Samsung, Alstom, and Saudi Binladin Group or any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Bankruptcy: Where are You on the Capital Structure Totem Pole?
The media likes to focus in on the microscopic universe of 30 stocks we like to call the Dow Jones Industrial Average, or the “market.” The reality is the Dow is like a drop in the ocean if you consider the global opportunity set across the capital structure. What is the capital structure? Well, you can think of the capital structure like a totem pole. The actual universe of investment opportunities spans everything from Blue Chip dividend paying stocks to illiquid international convertible preferred securities. The selection of the security type will determine where you sit on the capital structure (totem pole), and the location is especially important when the topic shifts to the dreaded word…B-A-N-K-R-U-P-T-C-Y.
Opening the Chapter Book on Bankruptcy
From a security or safety standpoint, the preferred investor location is at the top of the totem pole (capital structure). Why? Because once an entity declares Chapter 7 and begins asset liquidation, the bondholders/creditors at the top of the structure get paid first – whereas the equity holders at the bottom of the pole get paid last (if there are any asset proceeds remaining to be distributed). Here is a general ranking, from top to bottom, of the major security categories along the capital structure (more specialized hybrid security versions can fit in between the listed items):
1) Secured Bonds
2) Unsecured Bonds
3) Convertible Bonds
4) Preferred Stocks
5) Common Stock/Equity
Bankruptcy is a legal process that provides relief to many individuals who can no longer pay all of their debts. A potential outcome in the bankruptcy process is “debtor discharge,” which wipes away some or all of an individual’s debt. Here is a brief synopsis of the bankruptcy flavors:
Chapter 11: Designed primarily for businesses, Chapter 11 bankruptcy law allows financially distressed businesses to remain in business as debt payments are reorganized under the supervision of the courts. Technically, individuals can also choose to file for Chapter 11 bankruptcy, however practically speaking, individuals generally choose other paths. High profile examples of Chapter 11 bankruptcies include Lehman Brothers, Enron Corp., WorldCom Inc., General Motors Co., and Chrysler Group.
Chapter 7 & 13: These segments of the bankruptcy code are principally constructed for individuals. A means test reviewing an individual’s financial situation will determine which plan is most feasible. Here are brief descriptions:
- Chapter 7 is often referred to as the liquidating bankruptcy. This bankruptcy strategy is often used by individuals to save assets like a home and/or car. Although non-exempt assets will be liquidated by the owner to pay off creditors, many of a debtors assets are categorized as exempt – meaning the owner will not be forced to sell assets and creditors are held at bay.
- Chapter 13 allows individuals to retain assets by following a court sanctioned payment plan. Typically debt payments are made by the individual over years, and as long as payments remain current, the owner can retain assets.
More to Gain, More to Lose at the Bottom
Being at the bottom of the capital structure totem pole (owning stocks) involves relatively more price volatility. If you combine the wild swings with the fact that about 50% of households own stock in some shape or form (Edward N. Wolff at New York University – 2009), then you create a recipe of intrigue. Theoretically, stocks have unlimited profit potential (not the case for most bonds). The media loves to report on the daily fortunes won and lost on the global stock exchanges, in addition to following the bigwig billionaires.
More Boredom, Less to Lose at the Top
Being at the top of the capital structure totem pole (owning bonds) comes with more security (less volatility), but also more boredom (less profit potential). That’s not to say healthy returns cannot be achieved in the bond market. We saw firsthand, during the financial crisis, how bankruptcy fears rocked certain areas of the bond market (e.g., high yield bonds), creating extraordinary investment opportunities. With liquidity returning to the market, and signs of economic stability coming back, investors will need to climb much higher up the tree to grab the hanging fruit.
Although there is plenty of room for optimism given certain macroeconomic and corporate indicators, the global economy is certainly not out of the woods. Business bankruptcies remain elevated, just as investors are piling into the perceived safe arms of corporate bonds. Interest rates, along with industry and company-specific factors will obviously impact the price performance of corporate bonds. If the economy hits choppy waters again, it behooves investors in higher yielding bonds to get a better understanding of where they sit on the capital structure totem pole. If not, those bond investors will slide down the capital structure, left commiserating about losses with their neighboring risk-loving stockholders.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in Lehman Brothers, Enron Corp., WorldCom Inc., General Motors Co., and Chrysler Group or any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Dealing with Wobbling Risk Tolerances
The words “risk tolerance” are often used loosely, but unfortunately many investors and advisors look at these terms as an objectively definable statistic, like your blood pressure or cholesterol level. Not only is risk tolerance not a definable statistic, but for most people it is also constantly changing.
Given that investment advisors themselves have a great deal of difficulty maintaining an even emotional keel, it should come as no surprise that most invidual investors have even more volatile risk appetites. Because of the nature surrounding the markets – 24/7 news coverage and non-stop tick by tick price scorekeeping –emotions continually tug at investors’ risk tolerances.
Average Investor NOT on Best Behavior
Certainly in my practice, I’ve seen the direct psychological (and physical) impacts volatile financial markets can have on people’s investment decisions. What makes deciphering risk tolerance even more difficult is the absence of any substantive profile definitions (except for vague categories like conservative, moderate, and aggressive). The foggy risk categorizations are compounded by the aforementioned fluctuating risk tolerances, which usually switch in the wrong direction, at the wrong time. Case in point: the technology bubble bursting. In the late 1990s, risk aversion completely disappeared – everyone and their mother wanted to invest in technology stocks. If you fast-forward to the mid-2000s, you will also recall Bessie the hair salonist and Jimmy the cab-driver taking excessive risk at the peak of the housing bubble.
In a recent Simoleon Sense post, an astute guest contributor (Tim Richards) points to research developed by Carrie Pan and Meir Statman (Santa Clara University – Department of Finance) showing the shortcomings implicit in investor behavior:
“… investors’ risk tolerance varies by circumstances and associated emotions. High past stock returns endow stocks with positive affect and inflate investors’ exuberance, misleading them into the belief that the future holds high stock returns coupled with low risk. Risk tolerance questions asked after periods of high stock returns are likely to elicit answers exaggerating investors’ risk tolerance. Conversely, low past stock returns burden stocks with negative affect and inflate investors’ fear, misleading them into the belief that the future holds low stock returns coupled with high risk. Risk tolerance questions asked following periods of low stock returns are likely to elicit answers underestimating investors’ risk tolerance.”
In addition to ill-advised investor timing, Richards correctly highlights the lack of comparability across various investor types, even if you apply acceptable definitions or numeric levels of risk. Simple allocation to various stock/bond exposure does not adequately capture a client’s risk tolerance. A portfolio with 60% invested in Blue Chip dividend paying companies is a tad different than a portfolio invested 60% in Russian stocks. What an 82-year old retiree in Florida thinks is “aggressive” may differ 180 degrees from what a 32-year old trader on Wall Street may think is “aggressive.”
The Failure of Risk Equations
Academics have attempted to boil the market into elegant mathematical equations, but with the acknowledgement that investing mixes science with behavior, it becomes apparent that the mathematical equations must also incorporate art. However, it can become quite difficult to create an ever changing artistic equation. A perfect example of an equation gone awry is the debacle that unfolded at Long Term Capital Management. Robert Merton and Myron Scholes were world renowned Nobel Prize winners who single handedly brought the global financial markets to its knees in 1998 when it lost $500 million in one day and required a $3.6 billion bailout from a consortium of banks (see also why investors get hurt and Butter in Bangladesh articles).
Even if you are a smart economist who can artistically mix quantitative numbers with investing, the problem becomes people’s preferences and decisions change as the infinite number of variables adjust in the marketplace over time. There certainly are some rules of thumb investors tend to gravitate towards (such as cheap companies with sustainable growth in profits and cash flows), but even for those companies successful at generating income, nobody can unequivocally predict exactly how and when investors will react by pushing prices higher.
Here is what Tim Richardshad to add on the subjects of mathematical models and market efficiency in his Simoleon Sense post:
“So, in recent decades the industry’s approach has been to develop mathematical models which can relegate human behaviour to a set of probability equations, thus allowing profitability and risk to be actuarially managed: fraud is no longer unacceptable – it’s now just a number to be factored into earnings forecasts. This is simply the latest in a long line of industry fads, using the ideas of efficient market theories to design approaches which are right quite a lot of the time and then very, very wrong all at once.”
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“[Markets] are not remotely efficient and it’s just a shame the world had to be brought to the edge of financial meltdown before anyone started listening.”
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“When everyone thinks that markets can’t fail is the time to be very risk adverse, when no-one wants to invest is the time to be greedy. Yet what’s an advisor to do when the know-your-customer questionnaire tells them to do exactly the opposite of what’s in the customer’s best interests?”
Equations can produce detrimental results, so a healthy dosage of skepticism is prescribed.
The Solution: Education, Liquidity, and Income Can Allow More Beauty Sleep
Education about logic pitfalls and the integration of liquidity-based needs into clients’ investment plans is key. Controlling and understanding one’s personal biases can reduce or eliminate common repeated investment mistakes. Covering the investors’ income needs is another essential and practical aspect to investing, especially when it can prevent forced position sales at inopportune times. Extending oneself along the riskier end of the spectrum may have felt comfortable in the mid 2000s, but losses and sleepless nights overwhelmed many investors in 2008 and early 2009. In a bull market, adding too much equity and other risky assets to a portfolio is like pimping heroine to a drug addict – it behooves the advisor to point out the potential dangers of positioning a portfolio too aggressively. Rebalancing your investment portfolio can also act as a natural hedge to prevent exposures from exploding in size or evapaporating away. On the other hand, pitching Armageddon and piling into overpriced risk-free assets during the tail end of a bear market can be just as negligent.
Risk tolerance is an amorphous concept that can lead to suboptimal, knee-jerk investment actions. If you want to earn higher returns, I strongly urge you to pick up a behavioral finance book to sharpen your investment decision-making skills and firm up your wobbling risk tolerance foundation.
Read the whole Simoleon Sense article.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Fishy Fuld Finances – Repo 105
The truth may set you free, or it may just send you to jail. Right now, Anton Valukas’s high profile 2,200 page report has unearthed a reeking stench surrounding a $50 billion fund shuffling scheme. Our legal system will ultimately determine the fate of Dick Fuld, former CEO of Lehman Brothers, and any potential co-conspirators. Anton Valukas, appointed by the U.S. bankruptcy court to get to the root causes of the largest bankruptcy in history (a 158 year old investment banking institution), spearheaded the year-long investigation.
While most observers have not shed a tear over the grilling of Fuld in the media, onlookers shouldn’t feel sorry for Valukas either. His firm, Jenner & Blocker, was paid $38 million for its troubles in researching the report through January of this year.
Completing the report was a Herculean task. Finishing the report involved narrowing down 350 billion pages of documents (spread across 2,600 systems) down to about 40 million pages, which were supplemented by interviews with more than 250 individuals, according to The Financial Times.
Repo 105 Crash Course
At the heart of the Valukas’s report is a unique accounting gimmick used by Lehman Brothers to conveniently shed billions in assets off its books at opportune times. The scheme distorted the firm’s financial position so Lehman Brothers could appear financially leaner than reality. This controversial practice is called Repo 105 (“repo” is short for “repurchase”). Here’s how it works:
a) The Right Way: In a typical legitimate repurchase transaction, widely used in the banking industry, a financial institution transfers assets (collateral) to a counterparty in exchange for cash. As part of the transaction, the institution that transferred the assets for cash agrees to repurchase the collateral from the counterparty in the future for the original value plus interest. These repurchase agreements are completely valid and function as an excellent short-term liquidity tool for the financial markets. What’s more, the transactions are completely transparent with the associated assets and liabilities in clear view on the publicly distributed financial statements.
b) The Crooked 105 Way: With toxic real estate values plummeting, and Lehman Brothers’ leverage (debt) ratios rising, Lehman executives became more desperate in hunting out more creative methods of hiding unwanted assets off the balance sheet. To satisfy this need, Lehman travelled across the Atlantic Ocean to court the legal opinion of a preeminent law firm, Linklaters, in order to have them sign off on the imaginative Repo 105 practice. Under Repo 105, Lehman pledged assets equaling 105% of the cash received from a counterparty. Based on the Repo 105 design, the transaction was considered a “sale” and therefore wiped Lehman’s balance sheet clean of the assets. Cash temporarily received by Lehman could then be used to pay down debt. Lehman conveniently used this strategy to pretty up the books (“window dressing”) around critical periods when financial results were shared with the public and investors. Shortly thereafter, Lehman would take back the discarded assets for a cash and interest payment (similar to the previously described repurchase agreement).
In a way, this Repo 105 transaction is like a teenage boy selling a Playboy magazine to his friend for cash right before his mom comes home, then agrees to repurchase the magazine from his friend as soon as the boy’s mom goes back to work. Sneaky, but effective…until you get caught.
Where are the Cops?
With the fresh corporate scandal wounds from the likes of Enron, WorldCom, and Tyco (TYC) still healing, a neutral observer might expect the auditors to more responsibly monitor the behavior of questionable client behavior. The death of accounting giant Arthur Andersen (former Enron auditor) was supposed to serve as a poster-child example of what can happen if irresponsible corporate behavior goes unchecked. Apparently Lehman Brothers’ “Big Four” auditor Ernst & Young didn’t learn a lesson from the carnage left behind by its deceased competitor. Not only did Ernst & Young sign-off on these transactions, but their neglect of whistle-blower allegations also serves to land E&Y in very hot water.
Frustratingly, this outcome wouldn’t be the first time a whistle-blower was ignored – Harry Markopolos the Bernie Madoff sleuth was rebuffed multiple times by the SEC (Securities and Exchange Commission) before Madoff confessed his illegal Ponzi scheme crimes. Although the SEC may feel some more heat relating to Lehman’s Repo 105 accounting fallout, the agency may catch a little break since Lehman surreptitiously neglected to disclose any of this controversial accounting trickery.The SEC and multiple state Attorney Generals may investigate Valukas’ findings further to see if civil or criminal charges against Fuld and other Lehman executives are appropriate.
The Ignorance Defense
Will ignorance be an adequate defense for Lehman executives? So far, this tactic appears to be the leading approach of 40-year Lehman Brothers veteran, Dick Fuld. Fuld’s lawyer claims the CEO had no knowledge of Repo 105 “nor did Lehman’s senior finance officers, legal counsel or Ernst & Young raise any concerns about the use of Repo 105 with Mr. Fuld.” The Lehman chief’s supposed unawareness becomes less credible in the midst of smoking emails such as the following one from a senior trader:
“We have a desperate situation and I need another $2 bn [balance sheet reduction] from you either through Repo 105 or outright sales.”
Other executives referred to Repo 105 as a “drug” that they needed to “wean themselves off.” When Bart McDade, a senior Lehman Brothers exec was asked about Fuld’s knowledge regarding the accounting gimmick, McDade had no qualms in explaining Fuld “knew about the accounting of Repo 105.”
The sheer size of these multi-billion dollar off-balance sheet transactions won’t make Fuld’s innocence campaign any easier. I believe when courts discuss values exceeding $50 billion in size, ignorance will not qualify as an excuse you can hide under – even in the context of a company holding net assets of $328 billion in June 2008.
Valukas doesn’t mince any of his words in the report when the conversation moves to Lehman’s objectives:
“The examiner has investigated Lehman’s use of the Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive purposes.”
Time will tell how the ultimate judgment will fall upon Dick Fuld and his partnering Lehman Brothers executives, but one need not be a bloodhound to smell the stale fishy odor of Repo 105. Fuld better find some potent breath mints, to quickly fight off the horrible seafood scent, or he might end up as fish bait himself.
Read Financial Times Article on Fuld & Lehman
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in TYC on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Google: The Quiet Steamroller
As Google Inc. (GOOG) has proceeded to steamroll most of its competition on the global advertising roads, they are learning to tread a little more lightly in hopes of avoiding unneeded scrutiny. There are very few places to hide, when your company is on track to achieve more than $20 billion in annual sales and is valued at more than $175 billion in the marketplace.
As Google revenues continue to rise and they look to take over the world (including their position in China), they are enlisting others to assist them in Washington as well. Through three quarters of 2009, the company increased their lobbyist budget by 41% to approximately $3 million, according to the Associated Press (AP).
Google Eating Bite Sized Acquisitions
Ever since the controversy caused by Google’s $3.1 billion takeover of web advertising network company DoubleClick (2007 announcement), and the failed joint search agreement with Yahoo! (YHOO) in 2008 due to government and advertiser concerns, Google has decided to consume smaller bite-sized companies as part of its acquisition strategy. Over the last five months alone, Google has acquired eight different small companies (generally less than $50 million acquisition price), including the following: 1) Picknik (photo editing website); 2) reMail (mobile search applications); 3) Aardvark (social networking focus); and 4) AdMob ($750 million mobile advertising network deal). Eric Schmidt, Google CEO, has stated he would like to do one smaller-sized acquisition per month. Google management also believes they have lowered the inherent risk in these smaller deals because of legacy ties to target companies – all these sought after companies house former Google employees, says Bloomberg. In addition to remaining below the radar, the string of small deals act as a supplement to Google’s hiring practices, which can become challenging in a scarce qualified engineering hiring environment.
Microsoft Pot Calling Kettle Black
Microsoft (MSFT), the behemoth software giant with monopoly-like market share in the PC operating system market, is now fighting back against growing giant Google. This effectively amounts to the pot calling the kettle black, given Microsoft has already paid about $2.44 billion in fines to EU (European Union) relating to antitrust actions in the past 10 years, according to TechCrunch. Nonetheless, Microsoft CEO Steve Ballmer is not shy about throwing Google under the bus, stating Google is not playing fair in the search market. Furthermore, Microsoft has filed an antitrust complaint against Google in Europe as it relates to Ciao, an online shopping service powered by Microsoft, and cried foul over an agreement Google made with book publishers and authors on a separate project.
Google is not stupid. They have witnessed massive monopolistic companies like Microsoft and Intel (INTC) butt heads with regulators and pay billions in fines. Needless to say, Google will do everything in its power to avoid additional, unwanted oversight, while quietly driving their steamroller over the competition.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at time of publishing had no direct position in MSFT, INTC, YHOO, or any other security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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