Reigning in the banks

Though this might mean lower bonuses for everyone but hopefully this will reduce the amount of work I am getting! Simplify the rules and regulations as well. Lower leverage, lower risks and please...lower the amount of new trades. Banking should be boring and I would like to have it that way.

Tiger Airways IPO

"Investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners."
-Warren Buffet

One of the worst industry ever to invest in, couple this with losses over the past few years and a negative net asset value. This may be the year of the tiger but with numerous global airlines dropping like flies, don't expect a spectacular flight for this one. Main sellers of the stocks, Ryanair. If the kings of LCCs can't turn this company around, I can't see how Temasek and SIA can.

Expectations of future profits due to the IRs is nothing but a hope at best. It might turn out well, it might not. On the otherhand, if this paper tiger were to roar, then it is sure indication that we are entering bubble territory. Caveat Emptor.

What a mess!

As much as I like the club, its finances are in a mess. Here's what I picked up from soccernet:

The bond will be used to repay the "senior secured notes". It was thought that the Glazers would be looking to finance the £175 million worth of payment-in-kind notes that are currently attracting 14.25% interest. However, this is considered personal debt and will not be refinanced through bonds.

"Manchester United today announced that it will be seeking to raise approximately £500 million aggregate principal amount from an offering of senior secured notes due 2017,'' said a United statement. "The notes, whose proceeds will be used to refinance existing debt secured against the club, will be issued by MU Finance plc.''

But the Glazers will not be selling the club and intend to use the money saved from restructuring the debt to ensure significant money is available to Sir Alex Ferguson to spend in the transfer market.

I have no idea what are in the books. However, from the surface, 14.25% worth of interest is just madness to me. No corporation can ever survive that kind of interest rates on loans. This is the kind of rate you pay for a junk bond, something with a high probability of blowing up within the next few years. Furthermore, isn't issuing new bonds to refinance existing debt a big red flag, a classic robbing Peter to pay Paul syndrome. The Glazers are destroying a great franchise from the inside.

A legend of the past

" I was taught to work as well as play, My life has been one long, happy holiday; Full of work and full of play- I dropped the worry on the way- And God was good to me everyday."
- John D. Rockefeller

Currently reading Ron Chernow's biography of John D.Rockefeller. This guy is an absolute legend. If Standard Oil were to remain as a company today. It would have consisted of ExxonMobil, Chevron and ConocoPhillips combined, which is 3 of the top 5 companies on the Fortune 500. As a percentage of United States GDP, no other American fortune amassed including those of Sam Walton and Bill Gates combined would even come close. This was probably the greatest amount of absolute wealth that any self-made person could amass by his own hands. A controversial character through and through, extremely philantrophic in terms personal life but ruthlessly efficient when it comes to business. It is not hard to imagine the critical role that he played in propelling America's ascension to supremacy as a world superpower.

Learn, unlearn and re-learn

The only function of economic forecasting is to make astrology look respectable.
-John Kenneth Galbraith

Here comes the end of 2010 and the start of a brand new decade. There were lessons learnt and re-learnt and for some unfortunately I still do not learn. Putting the past aside, its time to start anew. Going forward, what are the lessons we can learn from the past that can better guide us towards the future?

Here are my top 5 lists:

1. It ain't over till it's over

Never ever pass judgements too quickly. What might seem a wise choice then might not be so wise later. What might seem stupid then might not be stupid later. Whether you are right or wrong in terms of decisions is all time and outcome relative. You can make all the right moves and the most logical decisions but there is always the element of chance that things might not turn out as expected. There's nothing to rejoice when prices go up and nothing to panic when prices go down. If one does not need validation from the markets, then it does not matter what the market does most of the time.

2. Long-lasting competitive advantage is the driver of value

Statistics and past performances matters as much as how relevant they are as a guidepost to the future. In some cases they can be predictive, in others they are as good as a flip of coin. Value is only as good as how much you will get. If all those earnings and cashflows is going to find itself stuck in some machinery and assets, then unless the company is going to liquidate the assets, you are not going to see those cash. Understanding the economics of a business is a much better way of assessment than some esoteric calculations. Porter's 5 forces though not exhaustive is a good framework to start with.

3. The tendency of man is towards extremes.

Humans are like a pendulum that swings from one end to another. That is why we had cycles in the past, we will definitely have them in the future. However, the magnitude and duration is unknown and unforeseeable. A good business per se does not justify an astronomical price and a bad business per se might not mean it is totally worthless. (It neither works the other way round either.) Reality is not as simplistic as what many people think. Except for scientific laws of nature and history, there is no such thing as sure thing.

4. Psychological biases: Try looking into the mirror

People like to look at success stories and forget about the silent evidences of countless failures. Nothing is more inspirational than fighting and overcoming the odds to emerge victorious. However, one usually fails to notice is that to "overcome the odds", by definition means to be the exception. What makes people like to think "this time its different", for everyone else the rule applies, whereas for me, "it's the exception". Therein lies a paradox, without believing we are the exception, we wouldn't try, then there would be no success stories today. In order to be the true exception, one would have to ask himself and find out "What do you have that others don't? What are you doing that others are not?" Food for thought.

5. It's all a matter of perception

Our internal representations or experiences of any event is not precisely what happened but rather a personalized internal re-representations. People interpret things differently. The conscious mind is unable to process all the signals that are being sent to it. The brain filters and stores the information it needs and ignores the rest. The different filters in place are the reasons why two different people might view the same things differently. Those filters are made of beliefs, values, attitudes and metaprograms. Many of these filters are ingrained and stored within our emotional and cognitive system so much so that we are not aware of it. Since we do not know how things really are, but only how we represent them to ourselves, the best we can do is only to represent them in ways that helps us rather than harm us.

The Future of Finance

It seems clearer and clearer to me that the financial industry is headed for an age of rocket science. An age whereby quantitative and computational finance governed by greeks, complex alogorithms and black boxes would account for an overwhelming majority of trades on exchanges. What would be the future effects of this? Would the traditional investor be disadvantaged? Is it time that all of us should have black boxes of our own?

In this post I would attempt to share my thoughts on this:

What would the future effects of this?
It means that the market will become more and more efficient in such techniques and the profit margin in relation to risks will continue to shrink. The investor will have to on an increasingly frequent basis develop new techniques and ideas, backtest it and roll it out before some hedge fund or large bank comes into the scene. The impact of this on security prices to me is unknown but I guess that prices would become much more volatile as trades become much faster than ever before. Slight changes in economic indicators can have large impact on security prices. More and more people will have to depend on leverage. Then this means there will be counter-techniques whereby institutions with large enough capital to influence prices can front-run or harvest smaller black box players by busting their stop losses or force margin calls. Volume of stocks traded would explode and this would spell well for exchanges.

Would the traditional investor be disadvantaged?
It depends, very much on the whether the investor or trader relies on similar quantitative indicators to make his trades. If he does, then he will surely be outdone by these black boxes and it would be about time he revises his investment framework. Retail investors should keep away from techniques that would pit themselves in direct competition with the big boys out there.

Is it time that we should all have black boxes of our own?
I would say no as a matter of fact. These black boxes will almost wipe out the the arbitrage business of financial securities. It requires strong foundation of financial and programming skills which is not oftenly found in any normal person. However, there is one thing that black box users do not have, that is to have a long time horizon. The quant community by and large do not like to leave themselves exposed to price fluctuations for too long. The buy and hold technique might seem outmoded and dead, but I would say it would depend very much on what you buy and at what price you bought. Blindly buying the indexes, will just allow you to do average. These quant traders would come under increasing stress and pressure to find new techniques and ideas. Whilst true buy and hold investors who have perfected the art would have no such stress.

Debunking the Efficient Market Myth II

For several decades, there would come a time when the prevailing view that the world is so chaotic and so much beyond our control that even the most prudent of stock investments seemed foolhardy. Yet on hindsight these periods were all of opportunities that seemed almost incredible with the advantages of hindsight.

There were several times in these decades whereby some stocks will become darlings of the market. These were later to prove to be the most dangerous kind of trap for those who blindly followed the crowd than those who really knew what they were doing.

All these periods resembled the others in that they create opportunities whenever the financial community significantly misjudge the situation. The great waves of optimism and pessimism reflects the unfortuante tendency for humans to go towards extremes. Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same). The idea that we have finally come into an era of prosperity or "Goldilocks" economy (remember Larry Kudlow), whereby severe booms and recessions are a relic of the past should be shelved in the memory as a "new era story".

Now I deem it to be appropriate to touch on the subject of Beta. This is a traditional academic measure of price fluctuations of common stocks against the market index. What bothers me is how the academic authorities equate Beta or price fluctuations whatsoever with the concept of risk. Price variation yes, risk no. Real investment risk is measured not by how much price will decline but the danger from the loss of quality and earning power through economic changes or deterioration in management. The idea of measuring investments via price fluctuations confuses the stock market's opinion and what actually happens to the owner's stake in the business. In the desperate search to quantify risk into a single statistical measure, academics have forgotten to evaluate the conceptual arguments of the theory. As Einstein said, "Make everything as simple as simple as possible but no simpler." This is one such oversimplification.

Beta in its purest form ignores all the qualitative characteristics of the company, what it produces, what is the nature of the business, what kind of people do they have for management. He might not even care what the company is called. What he treasures is the price history of the stock. Then if that is the case, then the concept of beta is of no difference to those who use technical analysis as both derive their validation from price fluctuations.

The true investor welcomes volatility for it means that there will be periods of time whereby irrationally low prices will be attached to outstanding businesses. He would be free to exploit its folly to his liking. What the price history of the company maybe is of no importance to him, he would prefer to further his understanding of the business. He does not seek validation from the markets and would not be disturbed even if nobody traded the stock for a year or two.

Real risk though cannot be judged or calculated with numbers, it can in some cases be judged with a level of accuracy that would be useful. A good framework would be to use Porter's Five forces in the evaluation and understand the nature of the business. Thereafter, would be judging the extent of accuracy these factors allow themselves to be predicted as well as the characteristics of management. Lastly, would be the price that the investor would pay for the business.

All these characteristics might strike an analyst as unbearably ambiguous since they do not come in some form of database by itself. In the parlance of law, this would be called the "reasonable man's test". If you were to unable to apply it with a degree of confidence that would be reassuring. Then, this would be a clear indication you are out of your circle of competence or the subject matter at hand does not render itself to such evaluations.

Obviously, every investor will make mistakes. But by confining oneself to a relatively few easy-to-understand cases, a reasonably intelligent, informed and dilligent person will be able to judge investment risks to a useful degree of accuracy.

Academics built arcane investment and capital allocation theories around price histories with correlations to create optimal portfolios. Laudable attempts but not very useful when the underlying concept is fundamentally flawed. Most of the greatest investors who have earned the highest compounded rate of returns all do not use any "optimal portoflio" of any kind. If a business is worth a dollar and one pays 40 cents for it something good may happen to him.