Bye-bye 2014, hello 2015

Many things happened both economically and geo-politically in 2014. QE was wound down in the US, while Russia annexed Crimea, civil war raged in Syria, oil prices collapsed, the dollar strengthened, and ebola sent a shot across the bows. The US economy showed steady improvement throughout the year even as Abenomics stalled in Japan, Europe stumbled, and China slowed. Financial markets react to each and every event, and like a boxer, they absorb and go on, seemingly oblivious to that which was important before but now barely registers.

The markets are maddening because they never seem to compute the information in the same way as I. Markets have an intrinsic upward bias that is incessant, dogmatic and resilient. Until the vapor of strength disappears in a smoldering implosion of panic. We are five years into a strong up-cycle. The probabilities derived from history should lead one to caution. The odds are it is long in the tooth. But that was true at the end of last year and the year before that as well. I can't help but think we are in a nether world between the stimulant of recovery and the onset of correction. Markets have been kind and no one wants that to go away. That wishfulness that leads to self-delusion is what is most dangerous. Caveat emptor.

Many things will happen in 2015. We don't know what they will be, but we do know many events will transpire and the market will react. We don't know what will trigger the next major market decline. Faith in the central banks has kept a lid on any falter. Much of what happens is noise. In the broad sweep of history events that we thought momentous are but minor details. It may be that the biggest development of the last 15-20 years was the rise and fall of central banks. That chapter is still being written.

It is hard to frame the present in the context of history, only time will tell, but if we have confidence in man's ability to innovate, growth and expansion are likely to follow even as the markets, which may have got a little ahead of themselves, fail to reflect those secular drivers in perfect cause-effect.

My New Year's resolutions are as follows:

• Focus more on principles and the big picture.
• Make a conscious and concerted effort to get outside my comfort zone. 
• Work on developing new skills, especially in communication and relationships.
• Have a plan each and every day. 
• Be a nicer and better person.
• Don't think more highly of yourself than you ought. 
• Remind yourself that the world owes you nothing and you have to earn everything. 
• Be more positive (in life, in business, in outlook).

Building Wealth vs Protecting Wealth

Great quote from the Alpha Architect.

Wealth is often built by concentrated holdings, but wealth is protected by diversification.

Data, Tools, Technology, Accessibility...Not Always Good

More data, more access, more tools...that is the modern moniker.

But it has been devastating for investors.

The more data we have, the greater access to information and tools, only makes for more reactive decision making. The death sentence of good investment management. We think it is good for us, but it preys on our human nature, bleeding us of patience, discipline and conviction.

Investors must be disciplined enough to ignore the news, ignore their statements and to put their investment portfolios into Rumpelstiltskin deep sleep.

They would be much better off.

Active Management - Don't Just Stand There, Do Something...Not!

Active management is predicated on the odds of making a good directional call, the conditional magnitude of the expected change in the markets, the proper sizing of the change in the portfolio to take advantage of that information edge and the timing of entry and exit from the portfolio repositioning.

Anytime the odds are against you, you should not be making any portfolio changes. There are times when the odds are in your favor, but the magnitude of the expected market change is not great enough to warrant changing portfolio position.  And there are times when the odds are in your favor, and the expected market change is sufficiently great to warrant altering portfolio position to take advantage of the potential opportunity. When that is the case, it is critical to stick the entry and exit.

Three things must be got right to benefit:

1. You must have some idea of the odds wrt market directionality (because you are dealing with the future, odds are entirely subjective...now you may have all sorts of historic-based or fancy forecasting models, but you need to also allow that the odds you perceive are out of whack). Odds are focused on market directionality and magnitude of market move. If you bet and get directionality wrong you are toast.
2. Odds on market directionality is hard enough to get right. But gauging the second leg of good active management calls, ie. magnitude of market move (assuming you got directionality right) is another crapshoot. Once again active managers have all sorts of tools, charts, and fancy models to help, but it is all guesswork. If you get the second leg of a good active call wrong, ie. the proportions of the market move, then you risk having made a portfolio change for only marginal gain, ie. limited benefit, and have incurred unnecessary transaction costs.
3. Assuming you are right about the directionality and the magnitude of a market move, you then need to get three additional elements right. The timing of repositioning the portfolio, the sizing of the repositioning to take advantage of your insights, and the timing of your exit from that position (which requires a whole new set of odds related to directionality and magnitude). This may in fact be the hardest part of portfolio management.*

Active management is tough. There are a lot of moving pieces and a lot of unknowns. You've got to get a lot right to gain from your insight.

* A recent study reported on in the latest AAII magazine pointed out the ability of stock pickers to pick stocks is pretty good. But they stink at all the other elements of portfolio management.

China Is Melting Down

China is melting down but no one knows it or sees it.

The signs are all there. Falling growth (everywhere). Myriad government attempts to pump liquidity and capital into the system. The market still in make believe mode.

Panic has not set in. Commodities have been the canary in the coal mine, but no one seems too concerned. My bet is the property development sector will provide the trigger. Weakness in the Yen has set about the next leg of the global currency wars. Stresses and strains are showing everywhere (Europe, Japan, Latam, Australia).

We are in the calm before the storm. Batten down the hatches.

I'm Going To Mark This Spot For Active Management

With the release yesterday of Vanguard's funds performance relative to peers showing the pure dominance of passive over active management over whatever time frame you want to look at, I am going to put a marker in the ground, and as a good contrarian, say that marks the pinnacle of passive over active for this cycle.

I have no idea how long active vs passive relative performance cycles last, but if something can't go on forever, then it probably won't.

The irony of course is that I am launching a passive index based advisory practice just as active is likely to see a turnaround in its fortunes.

The other giveaway to the "peak passive" theory is the increasing crescendo of headlines touting the fact.

Oh well, back to basics. The principles of investing are simple. The act of investing is hard.

Investing - A contact sport?

Investing is not a contact sport.

Investing should be a spectator sport.

If you spend your time watching the proceedings, then you will invariably be drawn into the fray and that is where mistakes are made.

Jumping the Shark in Financial Advisordom

I am inundated with financial advisor magazines. I could have sworn there were only one or two a couple of years ago. Now there seem to 10 to 20 different magazines all trying to do the same thing - sell services to advisors.

It reminds me of the technology bubble and all those technology magazines I use to get back during that blow-out.

Getting Ahead in Traffic - An Analogy for Active and Passive Investing

Heather recently shared a great analogy between changing lanes in traffic and active and passive management.

In the same way that active management seeks to get ahead (beat the index), lane changers are trying to get ahead in traffic.

In the same way that studies have shown that those who stay in their lanes finish ahead of those who are always jostling for position, studies have also shown that those who stick to passive index funds typically do better than the average investor over the long term. 

Just as active management incurs lots of costs, so to trying to get ahead in traffic incurs lots of costs (psychological, emotional, physical).

The different speeds of the various lanes encourages drivers to jump from one lane to the next. Sounds familiar, as when investors use hindsight bias to jump into the latest investment craze. 

The Conceit of Value Investing

Value investors rightly argue that if you focus on acquiring undervalued assets, ie. assets trading below intrinic value (whatever that is...certainly no objective measure...a post for another day), then the market will eventually come around to recognizing the firm is worth more than what it is currently and start bidding up the price.

The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).

Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.

Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle. 

Keep It Simple - The Crux of Value Investing

I don't think you have to do fancy algorithms or deep quant or anything else to uncover deep value. You only have to be patient and be willing to pick-up a good company when the market has discarded it to the side of the road.

I call this value investing. In order to do it you have to have some gumption as to what you think the company is worth. The reason and the cause of the 'fall from grace' are important because you have to discern that it is a temporary setback.

The aforementioned is a company specific self-inflicted own goal or some sort.

The other major time when 'value' investing can work healthily is when the market itself has got itself in a panic and is casting everything out with the bathwater.

Contrarianism is ingrained deep within the process. 

Both instances call for a gauge of intrinsic value, conviction, courage and patience. Those are the most important elements to being and becoming a better investor.

Where Leverage Is Bubbling Up

I use to think the next debt crisis was going to be a sovereign debt crisis, but I think it may be much bigger and much worse - a combination sovereign, corporate, consumer debt crisis. Sovereign balance sheets have exploded in a countercyclical move to cover for reduced aggregate demand in the wake of the GFC. Now corporate balance sheets are exploding as the false veneer of higher profits and higher share prices allows companies to gorge themselves at the trough of low interest rates and an eager demand for higher yielding paper. This will come back to bite when the economy experiences its next cyclical downturn. The poor consumer, overstuffed as he is but hanging on, will simply be collateral damage as everything goes to hell in a handbasket.

The margin for error is diminishing.

Investing Requires Vision

Investing requires the vision and the imagination to see something the rest of the market doesn't and to envision a path by which it comes to fruition. Large doses of patience and conviction lend support to great investments.

Exploitable Anomalies

Small cap.
Value.
Information diffusion time lag. 
Momentum.
Mean reversion.
New fund.
Small AUM.
Quality companies.
Seasonals of all kinds. 

Got To Know What You're Good At

One way to know what you are good at is to identify those things you are bad at.

I'm bad at recognizing the dislocative disruption of new players and new trends. I see the trends but I don't extrapolate their likely diffusing effects very well. At the same time, I tend to give to much credit/strength to the incumbent(s), eg. Nokia.

Another area I am not particularly good at is identifying who the next big thing is going to be, ie. emerging leader. Part of the reason is that the market has already given the name a huge multiple and I can't bring myself to join in the party (late). Of course, if something is the next big thing, then its addressable market is a multiple larger than it is at the front end and it warrants the high multiple (that in hindsight now looks like a great price).

I'm a sucker for discounted relative value plays. Currently, CALL, ESI, ACI and OUTR are on my radar. But there is usually some good reason why they traded at an apparently steeped discount to their peers. If it is too good to be true, then it is probably too good to be true. I can't tell you the number of times I've been attracted to a name (sometimes bought it) only to find out there were shenanigans going on that I didn't know about (but the smart money did).

I am good at buying companies when the market has thrown the baby out with the bath water. This is an incredibly dangerous strategy, but it is in keeping with my own investing personality (DNA).

I don't have great vision for choosing the next great growth stock, but I have the courage to buy when/after the market has thrown something on the trash heap.

What Is Value?

Value is in the eye of the beholder...value is ethereal...value is a moving feast (non-stationary)...value is real...value is relative.

What is MSFT worth? What is INTC worth? What is GOOG worth? What is AAPL worth? What is ORCL worth? What is CSCO worth?

After years of multiple compression, things are looking up for the mega-cap techs. I don't know what level their multiples bottomed at but they are slowly seeing an expansion. Most are currently trading around 10x EBITDA. This seems crazy to me when they all exhibit a little growth, have monster margins, strong market positions and competent management. Still technological disruption threatens to undercut all of them and so some level of discount should be applied. But given their premium performance characteristics I would suggest the technological disruption discount should cancel the quality premium out and they should trade at a market average multiple. Given that they are essentially the market (given their size) this could of course be a tautology. Nevertheless, it is not difficult for me to see the market warm to these names and see their EV/EBITDA multiple move out to 12x or 13x. That is another 20%-30% upside tacked on to 10% earnings growth and a 3% yield. Not a bad return.

We have seen a massive move out of the smalls into the large and I don't see that changing anytime soon. The smalls got way out ahead of the game and are now mean reverting.

Buyer Beware

In my journeys around the asset management industry I sometimes come across fairly large ($2b in AUM or so), well respected asset managers with no marketing and no sales (or at least none that is in evidence).

These are firms that have found an audience for which there is no need to sell or market their services, ie. affinity marketing, and are not active in selling or marketing on a broader basis, ie. competing in the broader institutional marketplace.

The owners are fat and happy doing what they love doing - investing - and are not interested in growing or developing their business further. Their websites are atrocious, their resourcing levels low, and oftimes they have lots of family working in the business.

I can't imagine any (or many) of them are frauds. But they show the signs and have the capacity to carry out shenanigans if that is their predilection.

Contrary investing - the trapdoor and the panic

Two good strategies. Both require tremendous patience and discipline. One is a micro approach, the other a macro angle.

The first is the trapdoor spider strategy. You keep your powder dry waiting patiently for the market to throw you a prize. The prize is a great company that is overowned and has stumbled. Problems and concerns have arisen, but there is no fundamental rearranging of the deck chairs. Just a misstep. These things happen. Could be a 1 to 2 year workout. Don't buy too soon. The stock will bottom before the worst of the information comes out. When you see it holding fast or rallying on bad news. That is a good sign. But it can take some time for the stock to find its legs again.

The second is a general market panic. Could be a country. Could be an industry. Could be the whole market. Everything is marked down. Fear is rife. Buy the country or industry champion. These are too big to fail, too deeply entwined in the fabric. Again, another 1 to 2 year workout.

Behind The Numbers - Unsustainable Boosts To Earnings

Given the importance of choices among accounting treatments, look first for any accounting changes. Management can hide behind them to manipulate earnings quality.

Accounting treatment changes almost always change comparisons of apples to apples to comparisons of apples to kiwi fruit, obscuring reality and earnings quality.

Lengthening of depreciation period boosts EPS in the short term and hurts it in the long term. Track D&A as a percentage of fixed assets. If the percentage declines, the company may have extended the D&A period.

In mergers, the reporting entity changes. This offers management a way to consign all sorts of expenses and charges to the past. Acquisitions are tougher because the reporting entity doesn't change.

Manipulating the allowance for doubtful debts affects receivables, and it carries across the financial statements. If the percentage of allowance for doubtful accounts drops sharply relative to gross AR, it may indicate an artificial boost to revenues and therefore earnings.

Note: businesses just don't see their customers' payment quality increase faster than the rate of new receivables.

When a company makes an acquisition, it is allowed up to 12 mos to adjust the purchase price for the acquired company's carrying value of assets and liabilities. As a result of the purchase price reallocation within a year, expenses are kept off the income statement, artificially boosting earnings in the period of adjustment.

The most conservative treatment (of intangibles) is to immediately expense acquired in-process research and development, patents and licences, direct response marketing, and other R&D.

Software companies may capitalize software development (at their discretion) once technological feasibility is reached (whatever that means).

The frequence of capitalization, the items capitalized, and the relative size of those items tells investors whether capitalization is a serious concern or not.

Deferred revenue - revenue a company receives before it delivers the product or service.

Days in Deferred Revenues (DDR) = (91.25 x deferred revenue)/quarterly revenue.

Reducing reserves for warranties boosts EPS.

Know your company's debt intimately:

1. Avoid all companies whose business models depend on securitizations or consistent access to credit markets. 
2. Debt used to fund dividends and/or stock buybacks must pass the most stringent of tests - and usually fails. 
3. Carefully monitor the uses of debt to determine adequate returns on capital raised. 
4. Only buy companies with large debt to assets where you can model interest coverage, maturity dates and other terms. 

Tangible book value is least valuable when AR and/or inventory are manipulated.

Assuming too high returns on pension investments understates pension liabilities and overstates tangible book value.

Remember. It is normal for gross margins to vary. Be suspicious of any that were unchanging.

Price changes in cost of goods sold inputs are not sustainable as a source of earnings quality, but a dramatic increase in consumer demand and increased volume could make up for it.

To detect problems in input costs requires industry and company specific knowledge.

Recurring one time charges are a bright red flag wrt earnings quality. Serial one time charges may allow a company to establish reserves or bundle normal operating costs, making future results look better than they are.

The long investor should run from those companies with serial restructuring charges. They are not worth the effort to figure out.

Another way for management to manipulate earnings unsustainably is through taxes.  The value of net operating loss carryforwards (NOL - a deferred tax asset) depends on what profits and tax rates management estimate it will have in the future. Investors should compare the expected tax rate indicated by management and forecast by Wall St with what is actually reported in the quarter. An artificially low tax rate may indicate that the tax allowance was reversed, benefitting current EPS.

Behind The Numbers - Aggressive Inventory Management

Inventory is the second most important factor for earnings quality analysis.

The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.

Inventory affects profitability via gross margin on the income statement and shows demand for a company's products.

Days Sales in Inventory = (91.25 x Inventory/Quarterly Cost of Goods Sold).
Days Sales in Raw Materials = (91.25 x Raw Materials/Quarterly Cost of Goods Sold).
Days Sales in Work in Progress = (91.25 x Work in Progress/Quarterly Cost of Goods Sold).
Days Sales in Finished Goods = (91.25 x Finished Goods/Quarterly Cost of Goods Sold).

In addition to inventory on the balance sheet, the company also records deferred income to distributors, to whom it affords rights of return and price protection for products they don't sell. While deferred income represents some future revenue, in some company's cases it also represents inventory sitting in the sales channel that has yet to be sold and is at risk.

Tracking inventory component divergence gives the investor advance notice of good and bad performance. Focus on negative divergences wherever you find them and understand the business.

Positive divergence occurs when a company knows that business ahead is good, so its raw material inventory picks up while work in progress and finished goods either lag or do not increase at the same rate.

Investors want to avoid negative divergence when finished goods pile up in excess of sales while raw material inventories and work in progress are flat or declining absolutely or relative to sales.

Charlie Munger on technological advances bring products and favorable declining prices that benefit consumers and not shareholders of the producers.

Rising inventory by itself is no indicator of problems. What matters is inventory buildup relative to other factors.

If aging inventory is a greater percentage of total inventory, then mark-downs, write-downs, and obsolescence have a more servere impact. This is especially toubling with consumer products.

LIFO reserve changes - Changes from one method to another for any purpose, such as valuing reserves, are cause for concern. When a reserve is reversed, its a credit to the income statement. Essentially it is 100% margin, so the EPS boost is significant.

The retail method of inventory valuation recognizes markdowns as the products are sold, while the average cost measures markdowns when made. The change from average cost to retail method stretches out the period between markdown and actual reduction in inventory value.

Patience Is A Virtue - Sitting Tight

I have essentially been sitting tight on my positions (with the exception of being stopped out of my high momo shorts earlier this year) for the better part of a year. If I had held my high momo shorts I would have made a killing (30%-40% returns). I don't feel bad about that because you have to enact a limit loss discipline in the short realm. Fortunately, I didn't panic when the market took its little dive in February. The main reason was that I didn't think my holdings warranted being sold. I put a long mega-cap tech position on last year based on what I considered to be a significant undervaluation for the space (relative to the high growth momos and the rest of the market). That thesis has played out over the period and I expect it to continue to play out (which is likely to provide an upward bias to the indices). In fact, many of those names (INTC, QCOM, MSFT, ORCL, GOOG, AAPL, EMC, CSCO) still look very attractive on a valuation & yield basis relative to alternative investments. I have price targets set for each name and will begin reducing my exposure as those targets get hit. INTC = $36-$38, QCOM = $90-$100, MSFT = $45-$48, ORCL = $48-$52, GOOG = $620-$650, AAPL = $120-$130, EMC = $34-$36, CSCO = $34-$36. I also have a kind of net-net barbell on with KLIC, QLGC, GENC, TST & WSTL. I'm eyeing RELL but expect to pick it up when the market pulls back. I have a stodgy contrarian core with BP, RDSA, CHL, SYT, BEN and JPM, and two contrarian plays in BBRY and SGI and a speculator in ARO.

I think patience is the most important part of investing. At least it is for me. I feel that it is my weakness - my achilles heel. I cannot count the number of times I was in the right position, but failed to hold, either through lack of conviction or pulling the trigger too quick or reacting to macro events. With the market continuing to march higher, I am feeling pressure to take profits and put some money in the bank, even as my thesis hasn't played out. And when those names reach their target levels there is a good chance I'll re-evaluate and decide they are still the best option from a value, yield and alternative valuation perspective. In which case, I may trade around those positions. Right now, I am hitting my one year holding period and so the temptation to lock in long term gains is definitely there.

Behind The Numbers - Aggressive Revenue Recognition

Revenue is the top line of the income statement for a reason: it is the lifeblood of any company.

Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.

Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.

Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.

The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.

If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.

Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).

When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.

Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).

Watch out for nonmonetary transactions as a boost to reported revenue (barter).

Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.

Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.

Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).

Be wary when a company purchases a distributor - it can slip by some double counting.

Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.

Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems. 

Behind The Numbers - The Real Risk of Stock Investing

Most stocks lose money.

Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.

The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.

It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.

Beating inflation is likely an accident of birth.

Graham called "firmness of character"  - the ability to keep your own emotional counsel.

To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.

Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.

Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.

We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.

Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.

Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money.  The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.

Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.

Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.

It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.

Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.

When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.

The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall. 

When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.

Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.

Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.

If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.

Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.

Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.

Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.

The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.

What's Behind The Numbers - Intro

Every blow up avoided improves the performance of your portfolio.

Management faces crushing pressure to make things appear better than they are.

Management tortures the numbers to "beat by a penny" and to keep the Wall St analyst predators and their dreaded downgrades at bay.

Aggressive accounting may not be illegal, but its chicanery. Sooner or later, hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.

The job is to analyze earnings quality.

The book may place revenue recognition and inventory management next, but every part of the financials connects with another. "Earnings" is the financial picture as a whole.

Rising days sales outstanding or days sales in inventory may be the two great single indicators of trouble in the next quarter or several.

The Art of Short Selling - Six Pillars of Fundamental Short Selling

Short sellers get ideas from many sources. Some of the best ideas come from the most obvious of places - Barron's, WSJ, Forbes, etc. Short interest and stock float are important. A short seller should make sure the short interest is not so high that a short squeeze can increase the risk relative to return.

Franchises have extensive potential for financial stumbles; and once one franchise is analyzed, a group of them can be easily perused. A short seller should look for types of business that eat money - financial services and real estate - or companies with complex financial statements and blind pools of investments - the financial sector is another solid choice in this category. Once a company is targeted it should be analyzed with skepticism and curiosity every time a new financial document is published.

(1) The Pessimist's Guide to Financial Statements
The financial statements are always the first step for any serious student of stocks. Short sellers attempt to discover what is behind the numbers, what drives the company, what the business prognosis is.
Quality control - The first look at the financials is with the intent of breaking teh company into tiny pieces and checking to see if all those pieces are real. The most useful part of the financials will be the footnotes. The other consistent keys are what is not there and what cannot be understood. Start by looking for bogus assets. Then test accounts receivable and inventories looking at growth versus previous years and comparing growth to growth in sales and CGS. If the receivables growth is substantially greater than the growth in revenue, problems with earnings are likely. Growth in inventory vs growth in CGS is the single most reliable indicator that a manufacturer or retailer will stumble. A frequent area of abuse is deferred charges. Examples of deferred charges are prepaid advertising and deferred commissions or sales charges. Another category worthy of jaundice is goodwill and other intangible costs. Capitalizing routine expenses is another clue that a company is manipulating earnings. Accumulated depreciation is a sleeper balance sheet line that nobody watches much. If accumulated depreciation drops when gross PPE rises, the company might have changed the average life assumption and run the reversal through the income statement or might have simply reduced the depreciation expense in subsequent quarters. Look for off balance sheet liabilities, debt guarantees or recourse factored receivables. Make a subjective decision on what percentage of the business is stable and repeatable. Give it the buzz word test. Watch for auditor turnover - it is the one signal that is truly indicative of trouble.

(2) In Search of Greed and Sleaze
Form 4 - insiders purchases or sales.
Proxies - one of the best data sources for inurement and greed.
WRT salaries - compare salaries + bonuses to net income. Look at cash compensation relative to company earnings. Does the company pay a % of pretax profits to the primary officers in the form of a bonus? Are they paid a % of revenues? Does the company pay a bonus for taxes on options? Terms of retirement contracts? Unusual severance pay contracts? Arms length transactions??? Is the board a bunch of rubber stamps?

(3) The Bigger Puzzle
The research segment starts in the library, whereas the store check segment ends up watching the marketplace.

(4) Who Owns It?
High institutional ownership and high Wall St coverage can make for a quick collapse if something unexpected happens.

(5) Check The Water Temperature
Accumulate brokerage reports to provide the company think and Wall St attitude. Use analysts for indications of Street-think and as conduits of management information.

(6) Pay Attention
Keep paying attention. The date of the earnings release is also statistically relevant. The later they are, the worse the numbers. Keep watching - once a potential target, always a potential target. Do not cover just because of price movements; wait until resolution of the scenario. Short selling can be much like a cat waiting outside a mouse hole - the level of persistence, patience, and attentiveness is not for everyone, especially over sustained periods of time.

Recap
Wall St ices the inefficient cake with compulsive conformity. Everyone gets on the bandwagon and stays until the evidence is too compelling, then they all fall off with a jolt.

Do not genuflect in front of a business, an executive or an analyst. Keep your distance and your objectivity. The stock market is about people disagreeing over stock prices.

A short seller is a skeptic with a constructive, optimistic bent.


The rule of thumb when you study a proxy is that if you have to read it three times, you have struck pay dirt.

The Art of Short Selling - Criticisms of Short Selling

Short sales established an inflated supply and cause price declines.

The laws of supply and demand cannot be contravened by laws artificially restricting marketing methods. Or, in the words of Bernard Baruch, "No law can protect a man from his own errors. The main reason why money is lost in stock speculations is not because Wall St is dishonest, but because so many people persist in thinking that you can make money without working for it and that the stock exchange is the place where this miracle can be performed."

The Art of Short Selling - Shortcomings

The short sellers post price run-up exercise is to determine where the clues failed, why the price levitated, and why a normally accurate trail sign was misleading.

Three Short Sins: Sloth, Pride, Timing

Sloth
The first and biggest reason for failure in stock selection on either the short side of the long side is too little work. Usually, sloth is prompted by shorting someone else's idea.

Pride
Hubris is manifest in two primary analytical errors: (1) the sudden use of rigid formulas, and (2) the short sale of good companies.

Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. A valuation short is no different than a market bet.

Timing
The timing problem is the single biggest argument against individuals short selling - it throws off the risk/return relationships and suggests that individuals should use the discipline for selling or not owning stocks rather than for short selling. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment bankers to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In some instances, the lag time between the discovery of a fatal flaw and the demise of the company results in a change in the macroenvironment that bails out the troubled short sale candidate. Shorts all too often fail to realize how long debt takes to sink a company when the business environment is good. Almost every short position lasts too long for sellers.

One way to tweak timing is to wait until a stock cracks to short initially, after the first drop when the earnings and price momentum have slowed.

Commodities
It is easier to find fundamental balance sheet flaws than to trade grain prices. Make sure any short bet is on the company and not the commodity.

Tech Stocks
Tech inventories rise when a new product is in the works. Insiders own volumes of stock and sell often and without apparent regard for company condition. Margins can contract and expand with product cycles and the pricing curve.

Squeezes
The float of a stock is of paramount importance for a short position. Short slamming tactics do not work well for a company with a large float and a heavy Wall St following.

Complexity
Many short sellers fall in love with their own analysis, particularly if it is clever or extremely complex.

Lastly
The mistake is always shorting the company that's not that bad. The analyst has to be convinced that the core business will be overwhelmed by the problem and not just a hiccup. You can hide disgusting accounting practices with growth for a very long time.

The Art of Short Selling - Crazy Eddie

The company caught the attention of shorts primarily because of valuation. The Street analysts were counting on growth. And that was when the prospectus began to fill in the blanks where the valuation exercise left off.

Crazy Eddie had all the trappings of a personal bank for the Antar family.

Quant Achilles Heel

Some quants systems no doubt focus on either one vector or one factor. Some are no doubt multi-factor. While the truly ambitious are no doubt seeking a unified theory of the markets, ie. try and incorporate all known anomalies.

Such a system would incorporate small cap bias, momentum bias, quality bias, value bias, broad diversification, red flags.

It is the red flags area where short sellers focus. Myriad changes reflected in a firm's accounts may point to warning signs. You can model those and you can model management quality (based on history), but identifying frauds or accounting shenanigans is an incredibly subjective endeavor when the data points you are working with are inconclusive (and they are always inconclusive).

I guess that is why "fundamental based", qualititative oriented investors are now getting caught with their hands in the cookie jar, ie. insider trading. Finding and getting an edge is extremely difficult.

On a side note. I am amazed when I look at so-called small and micro caps where the marketing material of managers in the space talk about inefficiencies due to lack of coverage, that the stocks are generally fairly valued. Now fairly valued is in the eye of the beholder, but there are few glaring mis-valuations from what I can see across the whole spectrum.

Now back to the quants achilles heel. The rigidity of their systems (whether is a static set of criteria or pattern recognition algorithms) or the backward looking nature of the learning systems mean that quants will always miss the nuance of something and/or miss the change in environment because they lack cognitive awareness. And they will never catch the subjective dimensions of not trusting management that comes from a visceral gut feeling.

I'm Here Because of My Father

When I went to college I had no idea what I was going to do. I asked my father and he said go into business. So I went into the business school. When it came time to decide a major. I asked him again, and he said go into finance. Now remember this was the mid-80s, New Zealand was just embarking upon a significant liberalization of its economy and financial sectors, and the future looked very bright.

When I graduated at the end of '88 and went home New Zealand was caught in a massive deleveraging spiral triggered by the '87 crash. Somehow I got a job in the markets and all was well. I was learning so much about the markets (things they didn't teach you in school) and really enjoying a birds-eye view of that time.

The Art of Short Selling - Industry Obsolescence: Theme Stocks

Massive industry change can be triggered by macroeconomic events, by a specific product revolution, or by the death of a fad.

Wall St is much quicker to hype a new fad than to discard the old.

1980s Texas taught investors that when a region and its economy are built on growth, a slowing rate of change in the growth engine can pull the whole structure to the ground.

Banks are classic short candidates because the lending cycle is only as long as the credit experience of the current crop of bankers.

Betting on a real estate downturn means short the companies with big real estate exposure. Real estate always takes a while to work out because it is not marked to market every day.

How much damage can a wretched real estate environment do to a bank? The real estate pros knew that when it came, it lasted  - three to four year minimum to clear out the overhang, with banks trading as low as 40% of book.

They knew that buying a bank stock or an S&L stock was like buying a blind pool. Buyers never knew what they had, so the macroenvironment had better be right.

When no one cares anymore, it is usually time to buy long or at least cover shorts.

Banks with their arcane and specialized terminology, are boring, to analyze, much like insurance companies. As a group, banks are perceived as sacred, inviolate, protected by the govt and the many insurance programs. They are in fact highly leveraged corporations. When equity is only 5% of assets, it does not take much to nibble through the base. So banks can be profitable and predictable on both sides, particularly if shareholders or stock sellers count cranes in their own backyards to determine how frenetic the pace of real estate expansion really is relative to the perceived economic growth in town.

The Art of Short Selling - If You Can't Fix It, Sell It

Three categories of opportunity appear in a bull market (1) the restructured and heavily indebted company close to a stumble, (2) the "for sale" but not sold company, and (3) the company with deteriorating earnings that attempts to create the appearance of health with the sale of assets.

Assets are hard to value in a greater fool environment. Before a stock is shorted, the maximum buy-out value must be lower than the stock price.

Parkinson's Law of Short Selling: the stock price expands to fill the available short capacity and last iota of patience, particularly when it is a "no brainer."

From the Kay Jewelers example, the shorts concluded from the buy-out announcement frenzy that short speculation on "for sale" candidates was a less risky business than risk arbitrage - particularly if you could stand the news announcements and upward lurches.

The Art of Short Selling - Money Suckers: Coining Money To Live

Some companies require great gulps of capital to stay alive, even during periods of economic expansion. When operations fail to prime the pump of free cash flow, financial markets irrigate the basic business. To fund a company that goes to the markets routinely, the debt or equity buyer must assume one of two things: that the company will either eventually earn enough money to pay back the obligation or will make a reasonable return on equity or that the assets on the balance sheet will appreciate enough so that the sale will cover the outstanding obligation.

When the market appetite for new debt and equity disappears, so does the company.

When a fundamental change occurs in the business environment, there are two strategies to follow for the short seller: short the marginal company or short the institutional favorite. The institutional favorite is the quality company with good growth, pretty financials and a large number of institutional investors. Insto favorites crash more quickly than marginal companies because the instos all head to the exit at the same time. The marginal company has shaky financials, bad management, and a history of aggressive but often poorly executed business strategies. Problems develop more rapidly when no support exists. The stockholder base is less sophisticated. They are slower to sell, they pay less attention, or even worse they are comprised of friends and family.

Prepaid acquisition costs are costs that the company decided to defer expensing until later.

The most important lesson from Integrated, one that should have been obvious, was that banks and other short term lenders control the destiny of a company that has negative cash flow.

Short maxim: wait to short until reality can be proved, ie. wait until actual earnings come in less than expected.

When the bulls start talking about takeovers - always a good sign for the bears.

The most prevalent mistake of short sellers is that they are often shortsighted about the duration of hope for a new industry and for concomitant stock price decreases.

The Art of Short Selling - If You Can't Read It, Short It

Most companies write reports that are comprehensible to a person with a fair knowledge of accounting terminology. Some companies write reports that are impossible to follow, even for accounting experts. Experience suggests that if you cannot understand a report, officers are hiding something worse than you expect. It is almost an iceberg phenomena: If you find five or six serious questions in financial statements, you can be sure that there are many more that you cannot see. If a call to the company for explanation receives a garbled response that sounds suspiciously like the company official is speaking in tongues, you have got a live one.

The simplest form of financial obfuscation is detected by tracking the growth in receivables versus the growth in sales. Outsized growth leads the analyst to search out policies on booking revenues and collecting cash.

Any asset that does not have a ready market value is fair game for asset shuffling. The following are the most important points about insurance company financial statements:

1. All insurance companies are required to file annual financial statements with the state insurance department (filed in March).
2. These statements require different accounting practices ("statutory accounting") so they don't match GAAP. The driving force of statutory accounting is liquidity. The spirit of the rule is the determination of solvency or of claims paying ability. 
3. All this fits together in one number called surplus (similar to net income). 

The proper valuation of assets and liabilities is most important to the accuracy of the surplus total. Surplus provides the cushion for surprises and the funds for expansion. It is the heart of an insurance company. It also determines how much an owner can take out and whether the regulators take over.

Insurance companies have a lot of leeway on the carrying value of securities, particularly when the assets do not have a public market value. As a critical bystander, all you have to do is cast doubt on the quality of some of those assets to avoid owning the parent stock. If you question a significant number of assets relative to surplus, short the parent.

The Art of Short Selling - High Multiple Growth Stocks, Part 2: High Returns, Faltering Growth

The very backbone of a bull market is growth - new products, new sales, new technology.

There is almost always a bell ringing on the growth stocks that have one product. Shorts get killed trusting their intuition and common sense. Longs get killed with their belief that the company can always expand to one more market.

Two relevant concepts that define the shorts analytical task are pipeline fill and sustainable growth. Pipeline fill gives the revenue curve its shape. Sustainable growth rate sets the financing needs for that curve.

Cott Corp - going against Coke and Pepsi. Most corporate managers reproduce the errors of the past with remarkably regular frequency and inspire their corporate culture with the same consistence of mismanagement.

Pipeline fill refers to the process of filling the distribution channels' inventories - think drug companies getting out a new product. At some point the pipeline is full - every store has a shelf of product - and the growth rate is purely what the consumer consumes.

Cott paid sr employee salaries with stock and capitalized the expense as goodwill on the balance sheet. Watch when an analyst goes to work for a firm they covered. Top tick.

The Snapple story was a great lesson for growth stock players and short sellers alike. Store checks and valuation be damned, inventories are key in a one product company rolling out in a new era industry. If they build up, it is almost always because the product is not selling as planned.

Media Vision and Creative Technology - operate in an industry/sector that is characterized by short product life cycles and rapid change.

The bigger point on cash appetite in a growth company is a concept called sustainable growth rate. Sustainable growth rate says that a company can grow at the rate of return on equity times the retention rate without going to the capital markets. Growth companies with low ROE have to go to the market early and often and, if the prospects for eager buyers decline due to market conditions or failing financials, they have big trouble.

Growth is a good stock to own and a great stock to short if you can time both sides of the pyramid.

The Art of Short Selling - High Multiple Growth Stocks, Part 1: High Risk, Low Return

Bubble stocks are the purest and easiest form of short selling.

The simplest form comes from a company with a fad product that is perceived to have a long life. The next level of financial complexity is a concept or theme stock, from companies that sell a product or service to fill a newly perceived need.

Wall St awards preliminary kudos to companies just for trying or just for hiring the right investment banker or public relations agent. And that is what makes shorting concept stocks chilling, palm sweating, white knuckle hard work.

Questions to ask about concept stocks: does it work? how soon will it run out of money?

Shorts almost always judge correctly if the business is dying. On the timing of the demise, they are seldom right. Someone is usually available to buy stock, loan money, offer short term bank debt long after the company's financials are in nearly terminal condition.

Add two years to a short's best projection, and you might only have a couple more years to wait.

Grizzled analyst wisdom says sell the stock of a company building a new headquarters that is owned, not leased. It is a top of the earnings cycle clue.

Cute tickers for fad/concept companies is another tell.

The patience required to track the trail of failure is a critical skill for short sellers avoiding the wrong stock or the wrong time in a growth company's price trajectory. 
Cockroach theory: there is no usually just one bad quarter. Expect more to follow.

Concept stocks: cabbage patch kids, Coleco (home computers), Scoreboard (baseball cards), J. Bildner (yuppie/upscale grocery stores), Jiffy Lube (quick oil change franchises).

I've Got A Feeling

I don't think the market is ready to give up its gains. I think we have an upward bias at least until September. October is setting up to be a time when a greater ask is made.

Existential Angst

You can really begin to doubt yourself and your understanding of things when you sit here day after day reading ZeroHedge, Rick Ferri, Ben Carlson, Mebane Faber, The Reformed Broker and Barry Ritholz wondering what do I know and why would I want to compromise my integrity in such an industry.

When I reflect upon the last five-six years with all the things that have transpired (Greek/Southern Europe crisis, Sandy, Abenomics, anemic growth, Iraq/Afghanistan, Ukraine, Syria, China slowdown) and then I match it against the market (which has gone vertical in the last 18 months) I am flabbergasted.I know nothing. I understand nothing.

Where Does The Biggest Risk(s) Lie?

In reflecting upon the many doomsayers prognostications regarding systemic risk in the system and their attempts to make the case that it is worse now than in 2008, I see their points but struggle to see the timing. Sure, we are likely to see a cyclical decline or recession. The markets no doubt will be hamstrung by that, but I don't get the sense of a systemic risk event predicated upon a Minskian leverage moment. To be true, corporate balance sheets are not as strong as the aggregate numbers may propose. Much of the cash outstanding is concentrated among a small number of mega sized firms, and that is quickly being netted off against debt issuance to fund stock buybacks. A troubling development in my book and one for caution. There are many who point to the "too big to fail" banks having grown even bigger. There are many who point to the economic recovery being anemic. There are many who point to ZIRP and QE as creating an artifice for asset prices. There are many who point to China. Many who point to the potential for hyperinflation. Many who point to the obesity of the Fed's balance sheet. The global financial system is connected and interconnected. It is a tightly coupled complex system prone to collapse. But I think it takes significant time to build imbalances via increasing leverage brought about by growing confidence leading to complacency and hubris. I don't think we are there yet. The greatest accumulation of debt/leverage has taken place on central bank balance sheets and country debt. I think that is where the next crisis will arise from. But until confidence is punctured, central banks and countries can continue to issue bonds and increase their liabilities. The puncture is likely to be an "emperor has no clothes" moment and will forever re-shape the global financial system as central banks become ground zero for fear and contagion.

Incredibly Good Piece

This was an incredibly good piece highlighting the bull and the bear arguments.

http://pensionpartners.com/blog/?p=253 

The Odds

The odds are that we are getting toward the end of the current upcycle. The market and the economy bottomed in 2009 and have been on an upward or a recovering trajectory ever since.

My prior thesis of a compressed market cycle because the market was not allowed to clear has proven false.

That having been said, a regular (or average) market cycle is about 5 years or so. On that basis we are therefore closer the end of the cycle than the beginning.

I don't see too many people calling for a recession or even of a decline in the economy. It seems to me that the consensus is that growth has been disappointing but that the economy will continue to heal/recover even if it is at a less than stellar rate.

The bond market is confusing the consensus because the consensus is not looking for or fearful of a recession. However, it may well be the canary in the coal mine pointing to the end of the cycle.

My heart is not fearful of an upcoming recession but my head is mulling the probabilities and cautious.

A Little Early On That Call - Now Might Be A Better Time To Brush It Off

I wrote a commentary for the SMID cap strategy at the end of 2009 talking about the likely battle to take place over the next 2-5 years between cyclical forces of recovery coming up against secular headwinds. Here is an excerpt:

"Don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward."

In hindsight it looks as though I was a little early. But I stick by that general view of the forces and factors in play.

If I might be so repetitive. Now is probably a good time to brush that thesis off and deliver it again.

They say a clock is always right at least twice a day. Perhaps I'll be closer to the truth this time around.

Take The Money and Run - Close out CRAY Short

I didn't issue a report or anything like that because there are only two people (three actually) who have seen my Cray report (and I doubt they even read it).

But just for the record, I looked to close the position at $25.50. 

Time will tell how propitious that was, but I figured I'd take the money and run.

The report came out when the stock was trading around $35, but I would have looked to short it when it was trading above $40 on the gap from its 4Q earnings.

Timing is incredibly hard in the research game because it takes time to build the case and construct the report.

The Art of Short Selling - Bubble Stocks

A perfect short sell candidate is a stock with a large float to allow ease of borrowing and no buy-ins (forced buyback), a high stock price for maximum return, and no business or assets to keep the risk nominal and the investment horizon short term. A perfect short can cause terrible losses.

The single most important section in a prospectus is the risk factor section called "Investment Considerations." The company always tells you why it will fail.

The Art of Short Selling - Short Sellers

Robert Wilson (profiled by John Train in The Money Masters) is the acknowledged grandfather of the short selling hedge fund managers.

Julian Robertson used a fundamental approach based on prodigious research and a long term horizon. Valuation bets on price alone make bad short sales. There must be either a fundamental change in the outlook or a major misconception by the stock buying public.

Alex Porter (Porter, Felleman) - the trick is to be short the stocks you can stay short without pain or expense. He likes shorts where mgmt doesn't own much stock, management is not realistic or forthright, and where the company has a fatal balance sheet flaw.

Joe DiMenna (Zweig Funds) - Short frauds, earnings disappointments, hyped stocks, industry themes where macro forces are negative and deteriorating balance sheets. Try to determine a catalyst. Don't short stocks with strong relative strength and earnings momentum.

Short sellers tend to be odd people. Most are ambitious, driven, antisocial and singleminded. They are contrarian by nature and like to win against the odds. They often have a chip on their shoulder.

The Feshbachs looked for terminal shorts: (1) stock price overvalued at least by 2x's reasonable valuation, (2) A fundamental problem at the company, (3) A weak financial condition, (4) Weak or crooked management. They perceived themselves as hype detectors. To sell short you have to be certain that you see an important factor that other people do not see. You look for something that is obviously misperceived, obviously important, and obviously detrimental. The most important charater trait of a short seller is the ability to remain analytical when other people panic.

For McBear management is rarely the target, unless there is fraud. It is generally Wall St that has engineered the ascent of the stock.

Chanos' specialty is solving complex financial puzzles. He likes to short stocks with secular problems where he can make a "reasonably strong argument, based on the valuaton of the business, that the equity value of the enterprise is $0." Chanos does not visit companies. Likes to focus on return on invested capital as a key financial indicator. When the accounting gets murky people tend to shy away from rigorous analysis and rely on management and just take earnings per share at face value. Therein lies the opportunity.

Talk About the Pot Calling the Kettle Black

From the Financial Times:

Activist investor Jeff Ubben urges ‘fix’ for Silicon Valley

Talk about the pot calling the kettle black.

Corporate compensation and inurement is out of whack. I agree.

But it is ironic, to say the least, that a guy who comes out of an industry in which the top 10 managers each earn more than $1b a year - doing nothing but taking levered bets on other peoples money - has the gall to criticize the $100m salary of the guy who managed to build a globally ubiquitious business increasing its shareholder wealth from $36b to $367b company in less than ten years.


I say pox on both their homes. 


Addendum:
Institutional Investors Top 25 Earning Hedge Fund Managers in 2013.

The Insurance Scam

All insurance companies do this.

"bait and switch"

They hook you with attractive first year (or six month) rates and then they start cranking up the renewal each year (generally between 10%-30%).

The scam is based on the assumption that customers are either too lazy to change or can't remember last year's rate. 

To sink their teeth into you are far as they can, they try to get you signed-up for auto-renewal at the front-end.

The practice is probably worst with house insurance. I don't really know, because I pay for my home owners each year outside the mortgage escrow account.

Note: And it is not just Insurance that is the scam. Cable, internet, phone. They're all scams predicated on "bait and switch" and lazy consumers. The basic assumption is that if they make it so hard to switch, then they'll keep their annuity stream. And they are right. 

Lots of Sturm und Drang but Not Much To Show For It

Naturally I'm kicking myself for not hanging tough on my high beta shorts. Actually I'm not really. I wish I had them. They would have been killing it. But I had to cover because you just don't know how high a market can go.

What it does is confirm how close I am to making the big score.  If I keep it up, one day I am going to nail it and make the mullah.

It feels as though the market has been going nuts, but the averages are only off a little bit (actually the S&P is still up over a 1% for the year, Naz off 2.2%). Let's hope it doesn't implode upon itself because although there has been plenty of noise thusfar the damage hasn't been all the bad (unless you own the momo guys).

Season's Change

Here's hoping.

The Art of Short Selling - Wealth With Risk

Short sellers unearth facts from financial statements and from observation to ascertain that a stock is overpriced. Short sellers are information-based traders. Before 1983, no solely short funds existed. Stocks can only go to zero on the way down, but can go to infinity on the way up (reply: I've seen a lot more stocks go to zero than to infinity). Short sellers take greater risk than other investors - they must have strong evidence to support cases for price declines. Becauses reverses are sudden and terrifying, the burden of evidence rests on a solid, careful analysis completed before the stock is shorted.

Short selling is a niche. It is very small relative to the stock market as a whole. The long bias of and in the market creates exploitable inefficiencies for shorters, ie. there are more overpriced stocks than underpriced stocks (Asquith and Meulbroek). Negative earnings surprises affect stock prices to a greater degree than positive earnings surprises, and that effect persists over time. The common wisdom that there is no such thing as one bad quarter has a statistical basis. Stocks become torpedo candidates when very high expectations give way to earnings disappointments.

Short sale candidates cluster in three broad categories:

1. Companies in which management lies to investors and obscures events that affect earnings.
2. Companies that have tremendously inflated stock prices - speculative bubble.
3. Companies that will be affected in a significant way by changing external events. 

The trail signs to look for:

1. Accounting gimmickry: clues that the financial statements 
2. Insider sleaze: inurement, insider sellling.
3. Fad or bubble stock pricing: large price rise over short period.
4. A gluttonous corporate appetite for cash.
5. Overvalued assets or an ugly balance sheet.

The main precept of short selling analysis is bulk. Volumes of disparate facts and observations.

Accounting-based analysis is not difficult to do, but it takes time, patience and a suspension of belief.

The lack of attention by other professional investors to financial details provides the inefficiency in information dissemination that is so central to the short sellers art.

The goal is to identify the tragic flaw in a business long before the company's demise (the death rattle of a company in decline). The art of short selling trains analysts to avoid torpedo stocks or to profit from them.

The main weakness of short sellers is the inability/difficulty in judging the timing of collapse. Short sellers are consistently years too early when they sell stocks. Short sellers fear most a sustained rally in a stock.

How to make money in short selling and how not to lose money by selling are different sides of the same coin.

Short selling is a game of wits with the odds in favor of the analysts who do hard work and think for themselves, who turn jaundiced eyes on what passes for Wall St wisdom.

The Art of Short Selling - Preface

The analytical methods of great short sellers are characterized by prodigious analysis attentive to (1) the quality of earnings, (2) quality of assets, (3) and, quality of management.

You are looking for a bad business run by incompetent managers.

The years 1991 to 1993 decimated the population of short sellers. Those years saw the ascendancy of mutual funds, of momentum investing, and of the short squeeze.
(sounds eerily like 2012-2014 with ETFs, momentum investing, and short squeezes)

The simplest techniques work year in and year out - rising inventories, and insider selling.

Bernard Baruch on Bears

Bears can make money only if the bulls push up stocks to where they are overpriced and unsound.

Bulls always have been more popular than bears in this country because optimism is so strong a part of our heritage. Still, over-optimism is capably of doing more damage than pessimism since caution tends to be thrown aside.

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.

Quote at the beginning of "The Art of Short Selling."

Short term gain for long term pain

Mr. Putin appears to have come out on top with the West in his annexation of Crimea.

I don't think so.

Russia is heading for recession. Pent-up social discontent is likely to manifest when the good times pass. He has garnered tremendous short term gain at the expense of long term relationships.

Irrespective of whether Putin is around, this one will come back to bite Russia. 

Perhaps the most important ingredient to being/becoming a good investor...

...patience.

When I look back over the myriad names that I have owned and the reasons I owned them, and then look at when and why I sold them, and look at them now. I would have in virtually 90% of the cases have been much better off holding them than selling them.

The key ingredient that was missing from my investing DNA was patience.

Patience allows the compounding effect of time, the market (generally upward skewed) and your thesis to play out.

It's a set-up

Not an intentional set-up. Not a malelovent set-up. But a set-up all the same.

The set-up is this. The market is extended. But we already knew that. We have been conditioned to buy the dip (Bernanke put and everything). Everyone is happy. Stocks have gone up. There are no signs of disaster around. The economy is healing. However, there are signs of momentum sapping and sentiment changing. The coup de gras is a combination of respected commentators talking caution (Marks, Montier, Dalio, Gundlach), Fed tapering, meme that new Fed governor will be tested, geopolitical conflict & China cracking.

This is how the worm turns. And this is how it takes time for the market to digest the turn and then in turn justify the takedown. All of these things and more have been around a long time. Fear and risk are always there. But there are times when the market sits up and takes notice. I think now is one of those times. I am trying to lighten up going into mid-14, but it is hard to sell names that I think are good long term plays (even when I know they WILL take a 20%+ haircut in any takedown).

China! China! China!

How long, oh China, will you defer reality?

How long, oh China, will you defy gravity?

How long, oh China, will you run roughshod over the laws of economics?

How long, oh China, will you continue to mock us who doubt?

How long?





Maybe not all that much longer.
http://www.macrobusiness.com.au/2014/03/morgan-stanley-chinas-minksy-moment-is-here/

Why and how the market can keep going up as breadth disintegrates

The S&P 500 is at 1878. It is up 1.61% YTD, 23.7% 1 yr, 31% since January 2013, 62.5% since October 2011.

The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.

Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.

Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.

Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).

That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.

A "bubble" in growth

The market has experienced a massive run over the past year and a half. Much of that is due to the economic/political clouds clearing, confidence repairing, earnings coming through and ZIRP (and all its manifestations, eg. Bernanke Put, etc.) supporting a one-way trade.

But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.

We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.

There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.

Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.

Process = Recovery ==> Transition ==> Normal

The present path to normalization is, and has been, a long one compared to past recovery cycles.

Fundamentally it looks as though we are exiting recovery and on our way to normalization. Confidence is the key to continuation. I suspect the economy (along with the market which seems to have got ahead of things a bit) will go through a choppy transition period before it comes out the other side to normalization.

How long the transition period lasts is anyone's guess. Given that it has taken extraordinary stimulus (both monetary and fiscal) to get us to this point, it is not unreasonable to assume that the transition will be more painful and volatile than normal.

The trajectory of the market has been significantly different from the trajectory of the economy. The likely tightening of fiscal and monetary policy will throw a spanner in the works for both market and economy.

WhatsApp and Facebook = Jump the Shark

The smart money is using the fleeting money (high stock valuations) to hit the exits.

Whether it is Facebook using its funny money (stock) to buy WhatsApp for $19b, or the raft of other mega-valuation names (LNKD, TWTR, CSOD, NOW, P, AMZN, WDAY, CNQR, SPLK, DDD, SSYS, etc.) who are hitting the market market with secondaries and/or convertibles or debt of some sort, I think the smart guys are taking money off the table.

We are moving into the 2Q doldrums so I think this is probably a good time to shorten up as well. The market hasn't broken yet, but when it does there will be lots of regret. The writing was on the wall.

What is a bubble? aka A Con Game

The global financial crisis of 2007-09 is often described as a bubble bursting. A bubble implies highly inflated prices.

There were highly inflated asset prices, eg. a variety of housing related leveraged debt instruments, but the general equity markets were not overly inflated on either a trailing twelve month or a forward earnings basis. The bursting of the housing bubble (and I would suggest it was also a localized/regional event) was predicated upon a mountain of easy money which in turn led to a run on the financial system and a consequent financial market panic. The real world came to a stop, earnings consequently collapsed and equity valuations in hindsight looked grotesque. What it really highlighted was that the financial system (and the economy) are based substantially upon confidence. The confidence of bankers to lend, investors to invest and business men to make investment decisions. When that confidence disappears in a tightly coupled, complex system all bets are off. That is what we call systematic risk, where one action begets another and feeds upon itself.  

There was no one singular cause to the global financial crisis. There were myriad factors and contributors. However, when confidence in the whole system evaporated, it led to panic and an exit from all asset positions.

The 180 Rule

Interesting blog post talking about the 180 rule:

Essentially he advocates taking a serious look at shorting a stock that you own but want to sell, and going long a stock you were short but now want to cover.

He makes some good points like the value in re-evaluating the reasons why you are buying/selling and how the 180 rule can force that discipline upon you.

A Phenomena

There is a phenomena I have seen over and over again. It usually manifests itself as follows:

Company appears to be doing well via the numbers. Sales are growing, margins are expanding and the multiple is huge (too expensive for me). BUT...

I can't work out why the company is doing as well as it is. THEN...

It disappoints the street and the multiple shrinks enormously even as profits are substantial and it seems to the company is doing a lot more things right.

Case in point today is Coach (COH) which reported another disappointing quarter and is in Wall Street's doghouse.

The same could also be said for Apple.

Inequality and Political Change

Research Affiliates posted an interesting article today titled, "The Profits Bubble. "

The gist was that outsized profits are controlled (or allowed) by government and when they get too big (there is a trade-off between profits and income), the resulting growing inequality leads to social unrest and political change. The article correctly argues that profits cannot grow at a faster rate than the economy for too long and established that they have been growing at a faster pace than the economy for the last 20-30 years.

I think this idea/notion is correct. The problem is one of timing. It is very hard to know when or what the last straw will be that has been added to the camel's back. Changing societal/cultural norms and rising living standards around the world (rising economic tide in developing world, falling cost of living in developed world) are likely to make this process alot longer than prior history examples (maybe).

Societies are just like markets inasmuch as they are tightly coupled complex systems prone to periodic crisis and unravelings.

I'm not bearish...I just don't trust it

I'm not bearish.

I really think the US economy is coming out of its slumber. Most of the signs are pretty good.

The problem is I don't trust the market.

After such a big run over the last year, I can see the market continuing higher. With a little bit of earnings growth (9% projected this year...which could be a stretch, but maybe it isn't) and a little more multiple expansion (say from 15.5x to 18x) the market could easily deliver another 26% return - and even then would not be overly valued. I find myself making these rationalizations. It is easy to do.

The problem is the higher it goes, the less margin for error there is and the more I don't trust it.

When you know you are playing a con(fidence) game, you are always looking to be the first to exit the party (which can make for some bad - kneejerk - decisions). 

Time Perception

From Brain Pickings.

As disorienting as the concept might seem — after all, we’ve been nursed on the belief that time is one of those few utterly reliable and objective things in life — it is also strangely empowering to think that the very phenomenon depicted as the unforgiving dictator of life is something we might be able to shape and benefit from. Hammond writes:

"Time perception matters because it is the experience of time that roots us in our mental reality. Time is not only at the heart of the way we organize life, but the way we experience it."

Obvious Beforehand

It is obvious to me that the market will shortly (before July) have a 10%+ pullback in response to concerns about declining profit growth and mean reverting profit margins.

This conversation has been had over the last year but has yet to have effect.

Just saying!

P.S. I say this because I have a decent sized short position and it is getting hammered and I expect I'll be stopped out shortly - not long before the market loses its courage. It is also equally unlikely that I will reinitiate a short position in time to take advantage of the pullback - just the way things seem to work out.

P.P.S. This post points to the importance of behavioral issues, patience, courage, conviction and downside risk management/limitation.