Conference Illusions

Sunny Florida in the dead of winter. A generic hotel ballroom packed with indistinguishable vendor booths. Two hotel staffed open bars adorned with branding from the “Vendor Fair and Cocktail Hour” sponsor. Small circles of generally white middle aged men wearing mostly identical gray or navy suits having numerous variations of the same conversation.

It starts out with the usual greeting and discussion of how much they are enjoying the wonderful weather in Florida – even though they’ve spent the entire day in hotel ballrooms with no natural light. Then they move on to “comparing” how awful the winter weather has been where they live. It’s -10 in Chicago? We went 3 weeks straight below freezing in Toronto! In Boston the snow banks are as high as a 6 story building! This continues on for awhile until the conditions at each locale have been finally described as being only slightly more inhabitable to mankind than the dark side of Pluto.

Whoever “won” the weather description continues playing the role of alpha male and immediately changes the conversation to business. The all ask how each others company is doing, of course the only acceptable answer is some variation of “great”, “wonderful” or “best quarter ever”. Those that could potentially have a use for each others product profess that they are nearly sure their company is yearning to purchase just such a product.

Now it is time for the business card exchange. A ritual which temporarily transforms a piece of printed cardboard into a valuable gift to be bestowed and cherished. Each participant eagerly distributes his own card while thoughtfully reviewing the information printed on the ones he receives. In that single moment, the card is no longer just a piece of paper with the same information as everyone’s email signature and LinkedIn account. Instead it represents his professional hopes and dreams – the allure of a marque new account, a potential acquirer for his firm or his next employer. Still caught up in the moment, the new cards are safely tucked away in coat pockets less what they represent be lost or forgotten.

A final round of goodbyes commence with solemn vows to “follow up as soon as they get back to the office” or to “run this up the flag pole” and “make sure this gets in front of the right people”. As the group disperses, phones materialize from pockets not holding business cards and are used to send emails to colleagues and superiors about the importance of who they just met and how they had a “high level of interest” and are “very interested in our product”.  All these emails end with a variation of the standard self-congraluatory/self-justification line “this single interaction made the entire conference worth it” as the hopes and dreams are still very alive for now.

Snowy (Chicago, Toronto, Boston) the Monday after the conference. Alarm clock, morning coffee, taking dogs out, getting kids off to school, commute, traffic, coworkers, “how was your weekend?”, “how was the conference?”, status meetings, voicemails, emails, lunch meetings, conference calls, client meetings, commutes, traffic, takeout dinner, kids homework, TV, bed. Days pass with nary a thought of the treasured business cards or the conversations that spawned them until they’re rediscovered in the bottom of a bag while looking for a cellphone power cord. The slightly wrinkled pile of cards is spread out on the desk. Vague memories of the conference filter back but any conversation specifics are overshadowed by the late nights and alcohol. What exactly did this person do? Why did they say they were interested in the product? What was the followup supposed to be about?

A self-compromise is reached. It would obviously be unprofessional to contact them so long after the promised followup date and not even remember the conversation yet it would also be a waste to just throw away such a valuable contact. Instead, the cards are added to the already growing pile on the desk that is going to be entered into an address book and LinkedIn right after checking this email.

Hours later and the pile of cards remains unreviewed and unentered. They are now completely out of site, buried under an avalanche of flight, hotel and car itineraries. The email was in invitation to another conference. This one in Vegas.

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Too Easy

Bill Browder’s best investment made his fund more than 10,000% in only 5 years. Over $100,000 for every $1,000 invested initially invested.

Interested? Bill’s book (which I strongly encourage you to read in full) explains in detail exactly how he did it.

“Gazprom was eight times the size of ExxonMobil and twelve times bigger than BP, the largest oil companies in the world— yet it traded at a 99.7 percent discount to those companies per barrel of reserves.” – Bill Browder from Red Notice: A True Story of High Finance, Murder, and One Man’s Fight for Justice

How was this even possible in modern times? Aren’t the markets now so perfectly efficient that even Warren Buffet can no longer beat them.

“Why was it so cheap? The simple answer was that most investors thought that 99.7 percent of the company’s assets had been stolen.”

An oil and gas company in a country run by Vladimir Putin and the Russian Oligarchs.  A company where management was not only working against shareholders, but brazenly transferring out entire assets.

“Based on an extremely conservative estimate, we determined this subsidiary was worth about $ 530 million, yet a group of buyers was allowed to buy 53 percent of Sibneftegaz for a total of $ 1.3 million— a 99.5 percent discount to our calculation of its fair value! Who were these fortunate buyers? One was Gennady Vyakhirev, the brother of Gazprom’s CEO, Rem Vyakhirev.”

Against a macro backdrop of extreme inflation, a recent debt default and fleeing foreign capital.

Still interested?  It gets better.

After spending months investigating the extent of the Gazprom asset thefts by interviewing competitors, customers and ex-employees, he took all he had learned about the corruption in Gazprom and turned it over to the press.   Bill went public about the extreme corruption at Gazprom all the while living in Moscow and endangering the safety of himself, his firm and everyone he worked with in Russia.  Going public eventually led to the investment paying off but also to horrific costs which are detailed in the book.

I apologize if you were hoping that 100x returns could be achieved with no more effort and risk than entering a few EBITDA screens into a Bloomberg terminal and clicking a “buy” button.  But did you really think you were going to find tremendous opportunities in the same securities that any 10 year old with an iPhone can pull up the last 10 years of financials for in the time it takes for a red light to change?  That would just be too easy.

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House Expense Ratios


While U.S. stocks during those years enjoyed an average real rate of return of about 6% a year, the annual inflation-adjusted return on houses was a meager 0.18%. Factor in real estate’s heavy transaction costs and that number turns negative. – Michael Milken’s WSJ OpEd

The scariest part is that the above return for houses would be even worse if things like maintenance, property taxes, interest, insurance and other expenses were included. I estimate the all-in expense ratio of a fully paid off house to be at least 2% per year and one recently purchased with a mortgage to be initially over 5% per year (with current low interest rates).  On a $300,000 house with a new mortgage combined costs would be ~$15,000 per year.  Over 10 years (assuming no increase in value/expenses) the average expense ratio may fall to ~4% as the interest portion is reduced but would still be ~$120,000 in costs that have to be overcome before any net appreciation can occur.  When the house is sold at the end of the ten years it will likely incur another 6%+ transaction fee, bringing the total 10 year costs to $138,000 or an incredible 46% of the original purchase price.

This isn’t to say that people shouldn’t buy houses as there are many good reasons for owning them – stability, access to schools, etc. and of course you do need a place to live.  Where things go wrong is when the “investment” argument is pushed to justify excess home spending in lieu of other savings and investments.

Any extra dollars allocated to housing are nearly guaranteed to lose money on an inflation adjusted basis.  These extra dollars are also locked up in an extremely illiquid asset which you may be forced to sell if you no longer want to live/work in the same city.  All the while you have missed the opportunity to diversify your investments and generate additional wealth by investing in low cost ETFs and mutual funds.

You wouldn’t borrow money to invest in a mutual fund with a 3%+ expense ratio, a 6% back-end load and a long term track record of negative real post fee returns.  Don’t make the same mistake when buying a house.

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Mini Options, Maximum Fees

The new “mini” option contracts were billed as a way to make options more affordable to the average retail trader. By reducing the number of shares each contract represents from 100 to 10, retail traders would no longer need to own 100 shares of pricey stocks like Apple or Google in order to execute a covered call strategy or purchase puts for protection. While it is true that the amount of cash or underlying stock required to execute an option strategy on the mini’s is less, their relative cost dwarfs their standard 100 share siblings.

Leading online brokers have made no alterations to their standard commission structures to accommodate the lower prices of the mini options. In the case of TD Ameritrade, A single mini contract incurs the same fees as a standard size option – $9.99 + $0.75. This makes the commission on a mini size contract as a percentage of the transaction 10x that of a standard size option. In addition, current spreads on mini’s are higher, leading to a higher price when buying and lower price when selling.

As an example – here are a few different scenarios for an investor today executing a round trip buy and sell of a $435 June 22th Put on Apple using TD Ameritrade’s current commission schedule.


Option transaction costs for a retail trader on a single contract are already extremely high.  In the above example the combination of commissions and spread create a 4.5% headwind per trade, already almost insurmountable odds.  For reference, a Las Vegas casino’s edge on double zero roulette is only slightly higher at 5.3%.

If a trader purchases a single mini contract, the total cost in spread and commission surge to over a third of the initial investment virtually guaranteeing a substantial loss on the investment.  Buying multiple mini contracts does not help as for similar dollar amounts it is also a far worse deal than the standard contracts as the increased spread and commissions almost quadruples the percent of the investment lost fees.

With the odds already stacked against option traders with small accounts, the new mini options actually result in increased trading fees for retail clients.  In an industry that is looking for growth and to reassure a nervous investing public, new products should be focused on increasing a retail client’s odds of success, not reducing them.





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Hero of the Week – Andrew Mason

Thousands of high ranking corporate executives are fired every year, yet Andrew Mason may be the only one to ever actually admit it. Most executive turnover press releases are nothing but lies and propaganda that would make Stalin proud. They left to “spend more time with their family”, “pursue other opportunities” or are “taking an extended sabbatical” – from which they will never return.

Contrast Mason’s frankness

“From controversial metrics in our S1 to our material weakness to two quarters of missing our own expectations and a stock price that’s hovering around one quarter of our listing price, the events of the last year and a half speak for themselves. As CEO, I am accountable.”

to the very public pronouncements of another well known CEO, Ron Johnson of JC Penney. Upon informing Wall Street that JC Penney’s sales were down an astonishing 32%, he went into politician mode. “This is my third transformation,” he said. “I told you this would be a multiyear effort, and it will be, I told you transformations are unpredictable and can be bumpy, and this one has been.” he said. Unpredictable and bumpy? Those are rather vague terms to describe a strategy that reduced JC Penney’s sales by over $4 billion, or almost twice the size of Groupon.

Andrew Mason may not have been the most successful CEO we’ve ever seen, but he was definitely one of the most honest and for that he deserves credit.

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The Definition Of A Must Read

If you care about investing at all, I implore you to read the 2013 Credit Suisse Global Investment Returns Yearbook.

The section on “low-return world” deserve special attention and should be required reading for anyone who ever mentions “asset allocation”, “expected rate of return” or “retirement planning”.  I fear there are far too many firms/advisors/products still basing future estimates off US bond/equity returns from the past 70 years, an environment that is not only very different from where we are today, but was also one of best investing environments ever recorded.

Also make sure to read the section on “Mean reversion” and the results of their walk-forward testing on mean reversion of valuation ratios.  Their conclusions may change the way you react the next time you are presented with an extremely well written and researched piece discussing a market’s extreme over/under valuation.

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Tick Sizes Are Not The Problem

On the day that Dell announced it is becoming a private company, the SEC is holding a roundtable to discuss tick sizes in the securities markets. This discussion is mandated by the JOBS act passed last year and is based on the theory that the substantial reduction in the number of public companies and IPOs is due to SEC changes to the securities markets microstructure.

In 2011 the Treasury Department created an IPO “Task Force” to generate recommendations on how to generate more IPOs. There primary results were summarized as (quoting from the report):

According to the IPO Task Force Report, the impact of decimalization has been twofold.  First, market structure changes associated with decimalization favor short-term trading strategies over long-term fundamental strategies.  For smaller public company stocks with lower liquidity, the lack of fundamental strategies results in trading volume that is too low “to make money for the investment bank’s trading desk.”  The IPO Task Force Report argues that this lack of profitability undermines the incentive for underwriters to take smaller companies public.”

Translation – Investment banks are not making as much money trading small cap stocks due to lower spreads so they do not want to facilitate an IPO and collect 6% of the dollar amount raised.

If this were the case, why wouldn’t investment banks just raise their IPO fee to a level that made it worthwhile to facilitate an IPO?

“Second, the IPO Task Force Report states that “decimalization . . . put the economic sustainability of sell-side research departments under stress by reducing the spreads and trading commissions that formerly helped to fund research analyst coverage.”  The IPO Task Force Report also argues that analyst coverage has significantly shifted away from smaller capitalization stocks towards highly liquid, larger capitalization stocks, reflecting the change in financial institution focus.  In particular, the IPO Task Force Report suggests that analyst coverage of smaller public companies has become unprofitable both because of the Global Analyst Research Settlement in 2003, which prohibited the direct compensation of research analysts through investment banking revenue, and the advent of decimalization, which reduced spreads that formerly helped fund analyst coverage.
Thus, the IPO Task Force Report concludes, less analyst coverage of smaller capitalization companies means that less information on these stocks is generated, which, in turn, reduces market interest in these stocks.”

Translation – Investment banks are not making enough money trading small cap stocks to pay analyst to publish research on these companies.  No one outside of Wall Street analysts has any economic incentive to do any independent analysis on these now inefficently priced assets, so no one wants to trade the stocks.

It is difficult to imagine that the thousands of hedge funds, mutual funds and other buy-side institutions that collectively employe tens of thousands and analysts and quantitative researches striving to maximize performance are ignoring a large percentage of potential investments due to a lack of Wall Street provided research.

“Prior to the IPO Task Force Report, in a paper released in June 2010, Grant Thornton also concluded that decimalization has had a negative effect on the equity markets, and characterized decimalization as a “death star.”  The paper argues that decimalization almost eliminated the economic incentive to trade in small capitalization stocks, taking “96 percent of the economics from the trading spread of most small cap stocks – from $0.25 per share to $0.01 per share.” The paper also asserts that decimalization, combined with other innovations such as an increase in online brokerage, was significantly more damaging to the IPO market than oft-criticized provisions from the SarbanesOxley Act of 2002. As with the IPO Task Force Report, the Grant Thornton paper argues that increasing the tick size for smaller capitalization stocks will encourage financial institutions to spend more resources to analyze these stocks.”

Translation – the 96% reduction in the cost of trading small cap stocks has made them less attractive to investors.  Everyone would be better off if it cost 20x as much to purchase a small cap stock and that extra money was used to subsidize Wall Street “research” – without which no one will trade these stocks anyway.

I wonder if any of the subsidized “research” that there is no longer money for ever tried to make the argument that a company’s product would be less attractive to potential customers if it’s cost was reduced 96%?

The underlying theme of all these arguments is they are solely looking at the world from Wall Street’s perspective.  Every major argument centers around the lack of trading profits for Investment Banks and Market Makers on the secondary market and the lack of extra profits to subsidize research.  The report goes on to do an exhaustive analysis of other secondary market statistics such as effective spread, market vs limit orders, volatility and market maker participation / profitability.  Again, all things Wall Street cares about.

Nowhere in this report or in any of the agendas for the roundtable discussion does anyone look at this issue from the perspective of either a public company or a private company considering an IPO.  Everything is around increasing trading profits and subsidized research, to the benefit of Wall Street.  This model may have worked well when companies did not have other options, but since the late 90’s the rise of private equity, private secondary markets and other forms of private capital have given companies many alternatives to Wall Street.

For Wall Street to attract companies back to the public markets it needs to stop focusing on the minutiae of secondary market tick sizes and start asking the hard questions about what benefits the public markets provide a company versus the private finance alternatives.

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Balanced Portfolio Risks

Great post by Michael Stokes at MarketSci Blog on the impact that historically low treasury rates could have on Tactical Asset Allocation (TAA) models.  A large portion of historical gains from both backtested TAA models and balanced portfolios have been from the huge increase in treasury bond values over the past 30 years as yields have fallen from a peak of over 15% to less than 2% today.

If yields were to stay relatively stable, the lack of increase in the value of treasuries combined with the low yield would significantly reduce the returns contributed by the bonds portion of a balanced portfolio.  Barring any significant stock market out-peformance, this is likely to bring balanced portfolio returns down significantly from what investors have previously experienced.

A worse scenario is if yields rise rapidly and drive down the value of an investor’s existing bond portfolio.  The yield would be higher but it would take years for the extra yield just to restore the loss in principle value.  A large rise in treasury rates could also lead to a reduction in equity PE ratios to offset the increased rates of “risk free” returns.  Meaning that investors could see simultaneous losses in both the bonds and equites portions of their portfolio.

As the saying goes – “Whenever you figure out the key to Wall Street, they change the locks”.  Most investors and advisors believe the current key is to have a large bond position to provide steady and consistent income, a plan that has worked well for 30 years.  What will happen to these portfolios if the bond portions begin to earn minimal returns or become money losers?

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Can JC Penney double revenue?

I just finished watching Bill Ackman’s CNBC interview where he described the current state of JC Penney (JCP). Prior to watching the interview most of the comments about it were surprisingly negative. I felt he did a good job making the bullish case and I appreciated that he actually took the time to explain the situation in depth with real numbers instead of providing the usual CNBC sound bites.

The core of the thesis is that JCP is in the process of rolling out 100 “mini brand stores” inside each current store. They have currently rolled out 10 of the “mini brand stores” and those stores are seeing $270 in sales/sq-foot versus $135 for the rest of the store. The assumption is that as they roll out the other 90, the overall store will now be at ~$250 in sales/sq-foot.

What I wish was better explained is what the breakdown of merchandise currently is between the 10 “mini brand stores” and the rest of the store. If the most desirable JCP merchandise is in those new stores, then it makes perfect sense that they would show a huge increase in sales/sq-foot versus the rest of the stores. But as they roll out another 90 stores, they can’t all be premium in relation to the overall store so what will that do to the sales/sq-foot. Are the 10 current mini stores currently generating a disproportionate percentage of total revenue available to JCP?

The second issue is that if they do scale the sales/sq-foot linearly it becomes a very large number. Ackman mentioned taking it from 7 million sq/feet to 111 million sq/feet. Adding $115 per sq/foot across 104 million of space generates an additional $13 billion in revenue. That’s a huge number and to achieve it they have to add more revenue in the next 3 years than Bed Bath & Beyond currently generates.

Where will that revenue come from?  Unlike in Johnson’s previous experience in Apple where the iPod and iPhone were part of new categories, $13 billion in department store style retail sales does not just materialize. It will have to be composed primarily of lost sales from other retailers.  Which ones is still to be determined.  One last thing to consider as the JCP press continues to be negative is that the list of big names lined up in support for the turnaround continues to grow. Both Lee Ainslie of Maverick Capital and Ricky Sandler of Eminence capital bought a significant number of shares last quarter.

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Afraid to Try

Last night my daughter’s elementary school had parent’s night and announced a new technology program for grades 3-5. Students now have the option of bringing their iPad or iPhone with them to school. A mere 12 hours after this announcement the school’s Facebook group is being flooded with the usual complaints that the kids are too young for this level of responsibility, what if the device gets damaged stolen, etc. This of course is accompanied by the omnipresent modern protestation device, a plea to email a high placed executive asking them to “to reconsider this program or at least hold a community forum to get input from parents”.

The most frustrating part to me of these knee-jerk protests to any change is the overreaction. The school is not considering allowing students to carry concealed handguns or eliminating teachers completely. Instead they are trying a new program to take advantage of tools the majority of students already own. Will the program be a success? I have no idea. Will some devices be broken or stolen? Very possibly. If the program turns out to be a disaster will the school cancel it? Very likely. But I believe it would be far better for the school to try this and other new programs and have them fail miserably than not try at all.

We move to neighborhoods like ours for the quality of the schools. Everyone always says they want our public schools to be more innovative and take advantage of new technology. Yet here is a school trying to do exactly that and facing resistance from the very parents who’s children would be the primary beneficiary if the new program is a success. And why? Because a few devices might get broken or stolen while being used to try provide a better education to your child? Have we become so risk averse that we’re no longer willing to try to improve the world around us because of the risks to completely replaceable inanimate objects that are already halfway obsolete?

I understand how people have legitimate concerns about the frailty and costs of these devices and worry about entrusting them to an 8 year old. But there’s a flip side as well, the act of trusting what is obviously a very valued possession to an 8 year old provides an incredible opportunity for success and growth as well. Our children are not incompetent, our schools are not crazy, our iPads are not sacrosanct. Combining the three is extremely unlikely to have a severe negative impact on any of the involved parties and may even do some good. But we will never know unless we override our default reaction of risk aversion and give new things a try before pronouncing them to be without value.


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