Review – Quantitative Value (#valueinvesting, #quant, @greenbackd, @turnkeyanalyst)

Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors website

by Wesley R. Gray and Tobias E. Carlisle, published 2012

The root of all investors’ problems

In 2005, renowned value investing guru Joel Greenblatt published a book that explained his Magic Formula stock investing program– rank the universe of stocks by price and quality, then buy a basket of companies that performed best according to the equally-weighted measures. The Magic Formula promised big profits with minimal effort and even less brain damage.

But few individual investors were able to replicate Greenblatt’s success when applying the formula themselves. Why?

By now it’s an old story to anyone in the value community, but the lesson learned is that the formula provided a ceiling to potential performance and attempts by individual investors to improve upon the model’s picks actually ended up detracting from that performance, not adding to it. There was nothing wrong with the model, but there was a lot wrong with the people using it because they were humans prone to behavioral errors caused by their individual psychological profiles.

Or so Greenblatt said.

Building from a strong foundation, but writing another chapter

On its face, “Quantitative Value” by Gray and Carlisle is simply building off the work of Greenblatt. But Greenblatt was building off of Buffett, and Buffett and Greenblatt were building off of Graham. Along with integral concepts like margin of safety, intrinsic value and the Mr. Market-metaphor, the reigning thesis of Graham’s classic handbook, The Intelligent Investor, was that at the end of the day, every investor is their own worst enemy and it is only by focusing on our habit to err on a psychological level that we have any hope of beating the market (and not losing our capital along the way), for the market is nothing more than the aggregate total of all psychological failings of the public.

It is in this sense that the authors describe their use of “quantitative” as,

the antidote to behavioral error

That is, rather than being a term that symbolizes mathematical discipline and technical rigor and computer circuits churning through financial probabilities,

It’s active value investing performed systematically.

The reason the authors are beholden to a quantitative, model-based approach is because they see it as a reliable way to overcome the foibles of individual psychology and fully capture the value premium available in the market. Success in value investing is process-driven, so the two necessary components of a successful investment program based on value investing principles are 1) choosing a sound process for identifying investment opportunities and 2) consistently investing in those opportunities when they present themselves. Investors cost themselves precious basis points every year when they systematically avoid profitable opportunities due to behavioral errors.

But the authors are being modest because that’s only 50% of the story. The other half of the story is their search for a rigorous, empirically back-tested improvement to the Greenblattian Magic Formula approach. The book shines in a lot of ways but this search for the Holy Grail of Value particularly stands out, not just because they seem to have found it, but because all of the things they (and the reader) learn along the way are so damn interesting.

A sampling of biases

Leaning heavily on the research of Kahneman and Tversky, Quantitative Value offers a smorgasbord of delectable cognitive biases to choose from:

  • overconfidence, placing more trust in our judgment than is due given the facts
  • self-attribution bias, tendency to credit success to skill, and failure to luck
  • hindsight bias, belief in ability to predict an event that has already occurred (leads to assumption that if we accurately predicted the past, we can accurately predict the future)
  • neglect of the base case and the representativeness heuristic, ignoring the dependent probability of an event by focusing on the extent to which one possible event represents another
  • availability bias, heavier weighting on information that is easier to recall
  • anchoring and adjustment biases, relying too heavily on one piece of information against all others; allowing the starting point to strongly influence a decision at the expense of information gained later on

The authors stress, with numerous examples, the idea that value investors suffer from these biases much like anyone else. Following a quantitative value model is akin to playing a game like poker systematically and probabilistically,

The power of quantitative investing is in its relentless exploitation of edges

Good poker players make their money by refusing to make expensive mistakes by playing pots where the odds are against them, and shoving their chips in gleefully when they have the best of it. QV offers the same opportunity to value investors, a way to resist the temptation to make costly mistakes and ensure your chips are in the pot when you have winning percentages on your side.

A model development

Gray and Carlisle declare that Greenblatt’s Magic Formula was a starting point for their journey to find the best quantitative value approach. However,

Even with a great deal of data torture, we have not been able to replicate Greenblatt’s extraordinary results

Given the thoroughness of their data collection and back-testing elaborated upon in future chapters, this finding is surprising and perhaps distressing for advocates of the MF approach. Nonetheless, the authors don’t let that frustrate them too much and push on ahead to find a superior alternative.

They begin their search with an “academic” approach to quantitative value, “Quality and Price”, defined as:

Quality, Gross Profitability to Total Assets = (Revenue – Cost of Goods Sold) / Total Assets

Price, Book Value-to-Market Capitalization = Book Value / Market Price

The reasons for choosing GPA as a quality measure are:

  • gross profit measures economic profitability independently of direct management decisions
  • gross profit is capital structure neutral
  • total assets are capital structure neutral (consistent w/ the numerator)
  • gross profit better predicts future stock returns and long-run growth in earnings and FCF

Book value-to-market is chosen because:

  • it more closely resembles the MF convention of EBIT/TEV
  • book value is more stable over time than earnings or cash flow

The results of the backtested horserace between the Magic Formula and the academic Quality and Price from 1964 to 2011 was that Quality and Price beat the Magic Formula with CAGR of 15.31% versus 12.79%, respectively.

But Quality and Price is crude. Could there be a better way, still?

Marginal improvements: avoiding permanent loss of capital

To construct a reliable quantitative model, one of the first steps is “cleaning” the data of the universe being examined by removing companies which pose a significant risk of permanent loss of capital because of signs of financial statement manipulation, fraud or a high probability of financial distress or bankruptcy.

The authors suggest that one tool for signaling earnings manipulation is scaled total accruals (STA):

STA = (Net Income – Cash Flow from Operations) / Total Assets

Another measure the authors recommend using is scaled net operating assets (SNOA):

SNOA = (Operating Assets – Operating Liabilities) / Total Assets

Where,

OA = total assets – cash and equivalents

OL = total assets – ST debt – LT debt – minority interest – preferred stock – book common equity

They stress,

STA and SNOA are not measures of quality… [they] act as gatekeepers. They keep us from investing in stocks that appear to be high quality

They also delve into a number of other metrics for measuring or anticipating risk of financial distress or bankruptcy, including a metric called “PROBMs” and the Altman Z-Score, which the authors have modified to create an improved version of in their minds.

Quest for quality

With the risk of permanent loss of capital due to business failure or fraud out of the way, the next step in the Quantitative Value model is finding ways to measure business quality.

The authors spend a good amount of time exploring various measures of business quality, including Warren Buffett’s favorites, Greenblatt’s favorites and those used in the Magic Formula and a number of other alternatives including proprietary measurements such as the FS_SCORE. But I won’t bother going on about that because buried within this section is a caveat that foreshadows a startling conclusion to be reached later on in the book:

Any sample of high-return stocks will contain a few stocks with genuine franchises but consist mostly of stocks at the peak of their business cycle… mean reversion is faster when it is further from its mean

More on that in a moment, but first, every value investor’s favorite subject– low, low prices!

Multiple bargains

Gray and Carlisle pit several popular price measurements against each other and then run backtests to determine the winner:

  • Earnings Yield = Earnings / Market Cap
  • Enterprise Yield(1) = EBITDA / TEV
  • Enterprise Yield(2) = EBIT / TEV
  • Free Cash Flow Yield = FCF / TEV
  • Gross Profits Yield = GP / TEV
  • Book-to-Market = Common + Preferred BV / Market Cap
  • Forward Earnings Estimate = FE / Market Cap

The result:

the simplest form of the enterprise multiple (the EBIT variation) is superior to alternative price ratios

with a CAGR of 14.55%/yr from 1964-2011, with the Forward Earnings Estimate performing worst at an 8.63%/yr CAGR.

Significant additional backtesting and measurement using Sharpe and Sortino ratios lead to another conclusion, that being,

the enterprise multiple (EBIT variation) metric offers the best risk/reward ratio

It also captures the largest value premium spread between glamour and value stocks. And even in a series of tests using normalized earnings figures and composite ratios,

we found the EBIT enterprise multiple comes out on top, particularly after we adjust for complexity and implementation difficulties… a better compound annual growth rate, higher risk-adjusted values for Sharpe and Sortino, and the lowest drawdown of all measures analyzed

meaning that a simple enterprise multiple based on nothing more than the last twelve months of data shines compared to numerous and complex price multiple alternatives.

But wait, there’s more!

The QV authors also test insider and short seller signals and find that,

trading on opportunistic insider buys and sells generates around 8 percent market-beating return per year. Trading on routine insider buys and sells generates no additional return

and,

short money is smart money… short sellers are able to identify overvalued stocks to sell and also seem adept at avoiding undervalued stocks, which is useful information for the investor seeking to take a long position… value investors will find it worthwhile to examine short interest when analyzing potential long investments

This book is filled with interesting micro-study nuggets like this. This is just one of many I chose to mention because I found it particularly relevant and interesting to me. More await for the patient reader of the whole book.

Big and simple

In the spirit of Pareto’s principle (or the 80/20 principle), the author’s of QV exhort their readers to avoid the temptation to collect excess information when focusing on only the most important data can capture a substantial part of the total available return:

Collecting more and more information about a stock will not improve the accuracy of our decision to buy or not as much as it will increase our confidence about the decision… keep the strategy austere

In illustrating their point, they recount a funny experiment conducted by Paul Watzlawick in which two subjects oblivious of one another are asked to make rules for distinguishing between certain conditions of an object under study. What the participants don’t realize is that one individual (A) is given accurate feedback on the accuracy of his rule-making while the other (B) is fed feedback based on the decisions of the hidden other, invariably leading to confusion and distress. B comes up with a complex, twisted rationalization for his  decision-making rules (which are highly inaccurate) whereas A, who was in touch with reality, provides a simple, concrete explanation of his process. However, it is A who is ultimately impressed and influenced by the apparent sophistication of B’s thought process and he ultimately adopts it only to see his own accuracy plummet.

The lesson is that we do better with simple rules which are better suited to navigating reality, but we prefer complexity. As an advocate of Austrian economics (author Carlisle is also a fan), I saw it as a wink and a nod toward why it is that Keynesianism has come to dominate the intellectual climate of the academic and political worlds despite it’s poor predictive ability and ferociously arbitrary complexity compared to the “simplistic” Austrian alternative theory.

But I digress.

Focusing on the simple and most effective rules is not just a big idea, it’s a big bombshell. The reason this is so is because the author’s found that,

the Magic Formula underperformed its price metric, the EBIT enterprise multiple… ROC actually detracts from the Magic Formula’s performance [emphasis added]

Have I got your attention now?

The trouble is that the Magic Formula equally weights price and quality, when the reality is that a simple price metric like buying at high enterprise value yields (that is, at low enterprise value multiples) is much more responsible for subsequent outperformance than the quality of the enterprise being purchased. Or, as the authors put it,

the quality measures don’t warrant as much weight as the price ratio because they are ephemeral. Why pay up for something that’s just about to evaporate back to the mean? […] the Magic Formula systematically overpays for high-quality firms… an EBIT/TEV yield of 10 percent or lower [is considered to be the event horizon for “glamour”]… glamour inexorably leads to poor performance

All else being equal, quality is a desirable thing to have… but not at the expense of a low price.

The Joe the Plumbers of the value world

The Quantitative Value strategy is impressive. According to the authors, it is good for between 6-8% a year in alpha, or market outperformance, over a long period of time. Unfortunately, it is also, despite the emphasis on simplistic models versus unwarranted complexity, a highly technical approach which is best suited for the big guys in fancy suits with pricey data sources as far as wholesale implementation is concerned.

So yes, they’ve built a better mousetrap (compared to the Magic Formula, at least), but what are the masses of more modest mice to do?

I think a cheap, simplified Everyday Quantitative Value approach process might look something like this:

  1. Screen for ease of liquidity (say, $1B market cap minimum)
  2. Rank the universe of stocks by price according to the powerful EBIT/TEV yield (could screen for a minimum hurdle rate, 15%+)
  3. Run quantitative measurements and qualitative evaluations on the resulting list to root out obvious signals to protect against risk of permanent loss by eliminating earnings manipulators, fraud and financial distress
  4. Buy a basket of the top 25-30 results for diversification purposes
  5. Sell and reload annually

I wouldn’t even bother trying to qualitatively assess the results of such a model because I think that runs the immediate and dangerous risk which the authors strongly warn against of our propensity to systematically detract from the performance ceiling of the model by injecting our own bias and behavioral errors into the decision-making process.

Other notes and unanswered questions

“Quantitative Value” is filled with shocking stuff. In clarifying that the performance of their backtests is dependent upon particular market conditions and political history unique to the United States from 1964-2011, the authors make reference to

how lucky the amazing performance of the U.S. equity markets has truly been… the performance of the U.S. stock market has been the exception, not the rule

They attach a chart which shows the U.S. equity markets leading a cohort of long-lived, high-return equity markets including Sweden, Switzerland, Canada, Norway and Chile. Japan, a long-lived equity market in its own right, has offered a negative annual return over its lifetime. And the PIIGS and BRICs are consistent as a group in being some of the shortest-lifespan, lowest-performing (many net negative real returns since inception) equity markets measured in the study. It’s also fascinating to see that the US, Canada, the UK, Germany, the Netherlands, France, Belgium, Japan and Spain all had exchanges established approximately at the same time– how and why did this uniform development occur in these particular countries?

Another fascinating item was Table 12.6, displaying “Selected Quantitative Value Portfolio Holdings” of the top 5 ranked QV holdings for each year from 1974 through 2011. The trend in EBIT/TEV yields over time was noticeably downward, market capitalization rates trended upward and numerous names were also Warren Buffett/Berkshire Hathaway picks or were connected to other well-known value investors of the era.

The authors themselves emphasized that,

the strategy favors large, well-known stocks primed for market-beating performance… [including] well-known, household names, selected at bargain basement prices

Additionally, in a comparison dated 1991-2011, the QV strategy compared favorably in a number of important metrics and was superior in terms of CAGR with vaunted value funds such as Sequoia, Legg Mason and Third Avenue.

After finishing the book, I also had a number of questions that I didn’t see addressed specifically in the text, but which hopefully the authors will elaborate upon on their blogs or in future editions, such as:

  1. Are there any reasons why QV would not work in other countries besides the US?
  2. What could make QV stop working in the US?
  3. How would QV be impacted if using lower market cap/TEV hurdles?
  4. Is there a market cap/TEV “sweet spot” for the QV strategy according to backtests? (the authors probably avoided addressing this because they emphasize their desire to not massage the data or engage in selection bias, but it’s still an interesting question for me)
  5. What is the maximum AUM you could put into this strategy?
  6. Would more/less rebalancing hurt/improve the model’s results?
  7. What is the minimum diversification (number of portfolio positions) needed to implement QV effectively?
  8. Is QV “businesslike” in the Benjamin Graham-sense?
  9. How is margin of safety defined and calculated according to the QV approach?
  10. What is the best way for an individual retail investor to approximate the QV strategy?

There’s also a companion website for the book available at: www.wiley.com/go/quantvalue

Conclusion

I like this book. A lot. As a “value guy”, you always like being able to put something like this down and make a witty quip about how it qualifies as a value investment, or it’s intrinsic value is being significantly discounted by the market, or what have you. I’ve only scratched the surface here in my review, there’s a ton to chew on for anyone who delves in and I didn’t bother covering the numerous charts, tables, graphs, etc., strewn throughout the book which serve to illustrate various concepts and claims explored.

I do think this is heady reading for a value neophyte. And I am not sure, as a small individual investor, how suitable all of the information, suggestions and processes contained herein are for putting into practice for myself. Part of that is because it’s obvious that to really do the QV strategy “right”, you need a powerful and pricey datamine and probably a few codemonkeys and PhDs to help you go through it efficiently. The other part of it is because it’s clear that the authors were really aiming this book at academic and professional/institutional audiences (people managing fairly sizable portfolios).

As much as I like it, though, I don’t think I can give it a perfect score. It’s not that it needs to be perfect, or that I found something wrong with it. I just reserve that kind of score for those once-in-a-lifetime classics that come along, that are infinitely deep and give you something new each time you re-read them and which you want to re-read, over and over again.

Quantitative Value is good, it’s worth reading, and I may even pick it up, dust it off and page through it now and then for reference. But I don’t think it has the same replay value as Security Analysis or The Intelligent Investor, for example.

4/5

         

Review – The Age of Cryptocurrency (#Bitcoin, #BTC, #blockchain, #economics)

I should’ve known better than to buy a book touting “the age of” something that came into existence only a few years ago and is currently playing out. Living history? Only if it leaves a meaningful legacy behind. But after reading this breathless book about bitcoins and blockchains, I have my doubts.

According to the authors, the primary usefulness of the blockchain, what makes it revolutionary, is that it will allow for low cost financial transactions. Not improved privacy, accuracy or honesty in exchanges. Not an end to the menace known as government. A few basis points in savings on transactions requiring a financial intermediary.

And even then, that is doubtful. The blockchain does nothing of and by itself. Despite being the heralded horseman of the middleman apocalypse, it requires a bunch of middleman applications and services (still being developed!!) to be practically useful to anyone, and of course no one is building and operating those mechanisms for free. Hello, economic scarcity, nice to see you again!

That’s kind of the theme of this entire, horrible book. “Wouldn’t it be so cool if…” and “Things are going to be totally different when…” but we’re not there yet, and we might never be.

This book was prematurely written, poorly researched (hyperventilated hype and name-dropping is not journalism, it’s puff piece paid marketing) and offers little to anyone seeking to understand how the blockchain operates in layman’s terms, nor does it put the extremely short lifespan of this technology into a meaningful chronological context so one can follow where it came from and where it might be going.

Challenging the global economic order? Considering the amount of fraud the community has already witnessed as disclosed in the book, it appears to be more part and parcel and less revolution in the streets.

The blockchain may offer some interesting applications in due time that don’t involve stupid self-owning companies pursuing their robotic amoral self-interest, but in the meantime I’m bearish to indifferent about it all and will continue to keep a bemused distance from the phenomenon, including schtick introductions like this work.

2/5

On Conspiracy (#conspiracy, @Snowden, #NSA)

I’ve spoken to a lot of people who deny the existence of various conspiracies behind well-known human events because they believe it’d be too hard to keep a secret with the assumedly large number of people who would have to be in on it to pull off the original act.

I want to ignore the possibility, which I’ve raised, that secrecy isn’t even necessary because many times people will ignore or not recognize criminality right in front of their face (ie, the ongoing, millenia-long fraud of the State).

Instead, I want to reflect on the following current events. Nearly every week for the past several months, new information about global national “security” apparatus spying has come to light thanks to the efforts of Edward Snowden and his allies. Each one of these stories are billed as surprising revelations not previously known.

I don’t think there has been any specific disclosure of how many people at the various agencies fingered are involved in each of these various schemes but it seems safe to say they are “numerous.” I don’t know what kind of upper bounds a person would put on the number of members of a conspiracy required to keep a secret but I’d have to believe, given that these agencies occupy fairly large office buildings and other campuses around the country and the world, that the number of operatives exceed those thresholds.

How, then, did these programs manage to remain a secret?

To take this further, how do “intelligence communities” manage to operate at all given that they, too, are “numerous” and their entire model operates on the assumption that secrets can be kept despite their numerosity?

If I were to venture a guess, I’d say the answer lies with recognition of the fact that people have strong incentives to keep secrets concerning criminal or otherwise socially-reprehensible activity they’re engaged in. Especially when such activity constitutes their “job” which provides food for their families, or, even more powerfully, when such activities line up with their ideological beliefs, whose faithful following gives their lives purpose and meaning.

I think it unwise to overly discount the economic likelihood of conspiracy.

The Student Loan Scam (#education, #fraud, @KidDynamiteBlog)

I saw this story on “What Student Loans Are Really Spent On” at ZeroHedge:

Robert Thomas Price Jr. borrowed about $105,000 for his tuition at Harrisburg Area Community College from 2005 and 2007, federal authorities say. It doesn’t cost anywhere near that much to study at HACC, though.
So Price, 45, of Newport, is facing federal student loan fraud and mail fraud charges.

A U.S. Middle District Court indictment alleges that Price spent much of the loan money on crack cocaine, cars, motorcycles, jewelry, tattoos and video games.

U.S. Attorney Peter J. Smith said today that Price secured about $92,000 in private student loans and around $13,000 in federal PELL grants and Stafford loans. Price was aided in the alleged scam by his ex-wife, a former HACC employee who is not charged or named in the case, Smith said.

Granted, this is anecdotal– one hapless fraud a pattern does not make.

But the fact that it even happened highlights a couple things of import in my mind:

  1. This guy was in his late 30s when he committed this fraud; I bet the average person would be surprised to know what the demographic profile is of the average student loanee, my guess is it is not a starry-eyed, hard-working, bright-but-unresourced 18yo kid just looking to make it in this cold, harsh world
  2. If it happened once, it’s possible it’s happened more than once; how much of the $1T+ in outstanding student loan debt is being spent in frivolous or fraudulent ways? Reminds me of David Einhorn’s book on a SBA loan-backed fraud he shorted and exposed. Fraudsters flock to government handout programs like flies to dung because the government has less of an incentive to catch and punish them given it doesn’t cost them anything but bad press if it takes place, there are always more taxpayers to steal from if fraudsters take a piece of the pie
  3. Student loans are leverage, and they are leverage used to engage in consumption; these kids with student debt don’t suddenly become ascetic monks while they scrupulously work toward their degree and eventually paying off their debt… they continue to live and spend like the college kids they are, just with someone else’s money

To the last point, I chuckled at this response from a friend to whom I sent the ZeroHedge article:

Oh yeah, big time. One of my really good friends that I’ve known since senior year HS, who has never really been a big spender or a big earner, is now a third (or fourth?) year medical student, and he is really living the life of the young adult…through loans. He has a loft in downtown [city withheld], has a HUGE flat-screen tv, bought a new car a couple years ago, and adopted a dog (granted, [name withheld] the dog is super sweet). I seriously doubt he 1) had all that money laying around before, and 2) would spend his own money like that. I’m 99.9% sure it’s all loans because he’s never spent money like this, even when he had a serious gf in college whom he loved and wanted to marry.

I think this article really connects with the last one you sent about vomitus whores. Student loans are essentially enabling all that behavior. Here’s some money, go to “school,” attend some BS classes and write some BS essays, then go drink with this free money. Or perhaps you can go buy a new fancy, shiny thing to show off so that girls will want to sleep with you. *sarcastic thumbs up

I certainly think there is some causation-via-correlation here, though how much exactly is uncertain. Young people are pretty stupid, levered or not. I mean, look at how they vote! What dopes! It’s like they get off on being debt slaves or something.

Anyway, that link in the quote is worth checking out. It’s a riotously funny post from today by Kid Dynamite on the shocking idiocy of the modern American collegiate zeitgeist. Brings new meaning to the term “idiot savant.”

Review – Fooling Some Of The People All Of The Time (#investing, #shortselling, #fraud)

Fooling Some Of The People All Of The Time, A Long Short (And Now Complete) Story, Updated with New Epilogue

by David Einhorn, published 2010

So much could be said about Einhorn’s “Fooling Some Of The People All Of The Time” that I’ll necessarily have to ignore much of it to keep this review to the point. And let me say up front that I believe the main point of Einhorn’s book is that frauds may not be transparent, but the people perpetrating and enabling them often are and on that note I believe it’s clear that Einhorn is the hero and the Allied Capital crowd are the villains. If the opposite be true, Einhorn certainly has me “fooled.”

For what amounts to a legal caper (not a crime caper, a legal caper) involving all kinds of humorless characters, including the liars at Allied Capital attempting to perpetrate a fraud, the duplicitous analysts and journalists seemingly working on their behalf to help cover it up and a menagerie of lawyers, government officials and SEC investigators — can you get any more humorless than that group? — “Fooling” is darned entertaining. Funny, too. I found myself chuckling at the outrageous prevarications of the guilty parties on more than one occasion.

It’s not just a good story, though, it’s something of an instructive modern parable, political, financial and even economic in nature.

Einhorn’s sojourn into the bowels of the Allied Capital fraud began before the current financial crisis but carried into it. Knowing this, it’s both fascinating to see the struggles of someone who had come upon the margins of the crisis before it had become a crisis as well as frustrating to see that the Allied Capital saga is yet another facet of that crisis and one which, despite Einhorn’s having published a whole book about it, has yet to see much coverage in the mainstream press. Three years into what is becoming a growing pile of frauds and wasted resources, many politicians and interest groups are unabashedly calling for the expansion of the Small Business Administration and its various loan programs, rather than the shutting down of a completely compromised institution.

Financially, “Fooling” tells two tales: one is of a bold, dedicated individual (Einhorn) and his small band of loyal followers (Greenlight Capital staff) and friends (private citizens like Jim Brickman) who, despite the odds and the constant doubting of the hoi polloi nevertheless persevered in their struggle for truth and were ultimately vindicated by the facts and their profitable short position; the other is the story of that same man and his merry band who put an ungodly amount of time and resources into investigating a fraud that ultimately represented only about 8% of their portfolio, begging the question, “How much of this was about ego-gratification versus responsibly representing the interests of Greenlight’s partners?”

Knowing that Einhorn and Greenlight continued to make other successful investments along the way, more than once you find yourself wondering if Allied Capital would prove to be some kind of a Pyrrhic Victory. Certainly it’s reasonable to question whether Greenlight wouldn’t have fallen victim to another fraud they had invested in at Tyco if they had spread their attention and energies more equally amongst their various positions.

In the end, it is the economic parable which reigns supreme, however. The Allied Capital case is one of those seeming empirical confirmations of free market economic tenets. One by one, the various watchdogs and regulators prove either useless, incompetent, disinterested or entirely corrupted, from the federal SBA, SEC and even FBI, to the ratings agencies, to the Wall Street establishment analysts to the sacred Fourth Estate itself. It is only Greenlight Capital, and finally the market place at large, motivated by the profit principle, which has any incentive to actually root out and expose the fraudulent financial activities at Allied.

Einhorn’s triumph demonstrates that it isn’t about people but processes, the fundamental and natural incentives of the two competing and mutually exclusive principles of profit versus welfare.

This book is not perfect but it’s enlightening in more ways than one. “Fooling” does an excellent job of revealing the way modern capital markets work and while Einhorn mostly manages to stay above the vulgarity of his opponents, the Allied feud proves that to win a confidence game it’s helpful to have both the truth, and some talented lawyers and public opinion-setters, on your side.

4/5

Lessons in Short Selling: Why Jim Chanos Targeted Enron

I saw this testimony, delivered to Congress February 6, 2002, by Jim Chanos on his decision to short Enron before it collapsed, posted over at John Chew’s Case Study Investing. I enjoyed reading it and thought it was worth commenting on as a kind of basic guide to short-selling– why and how. This testimony is a Warren Buffett-style (and quality) lesson on short-selling fundamentals.

How To Identify A Short-Sell Opportunity

Kynikos Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on securities issued by companies that appear to have (1) materially overstated earnings (Enron), (2) been victims of a flawed business plan (most internet companies), or (3) been engaged in outright fraud.

Three key factors to look for in a short-sell:

  1. Overstated earnings
  2. Flawed business model (uneconomic activity)
  3. Fraud

As with the Enron fiasco, Chanos first became interested when he read a WSJ article that discussed Enron’s aggressive accounting practices. Aggressive, confusing, archaic or overly technical accounting practices are often a potential red-flag that could identify a company which is not actually as profitable as it appears to be to other market participants. When this profitability if revealed to be illusory later on, a catalyst is in place to galvanize investors into mass selling.

Another factor which can create an opportunity for a short is when the company has a flawed business model which essentially means the company is engaged in uneconomic activity. Short of government subsidies and other protective regulations, the market place tends to punish uneconomic (wasteful, that is, unproductive) activity with the tool of repeated and mounting economic losses until the offending individual or firm’s resources are exhausted and they must declare bankruptcy and liquidate their assets into the hands of more able owners. Chanos gives the example of tech bubble companies which never managed to achieve operating profitability– their business models were nothing more than exciting ideas, unable to overcome the reality check of achieving business profit.

The last type of short Chanos describes is general fraud– a company claims to own assets it does not own, or it is subject to liabilities and debts it has not disclosed, or there is an act of corruption or embezzlement amongst employees or managers of the business. Recent examples could be found in the growing “China short” sub-culture of financial research and hedge fund activity, such as the Sino Forest company which did not have thousands of acres of productive timberland it claimed to own.

The Enron “Case Study”

Returning to the Enron example, Chanos discloses three suspicious facts he and his firm uncovered through perusal of public financial disclosures that got them thinking about shorting Enron:

The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the U.S. Securities and Exchange Commission. What immediately struck us was that despite using the “gain-on-sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7% before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm a 7% return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7% and probably closer to 9%, which meant, from an economic cost point-of-view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000.

Chanos essentially did a competitive analysis on Enron and concluded that Enron was underperforming its competitors in the energy trading arena, despite large size and market dominance. He also concluded that its returns appeared uneconomic because they did not cover costs (capital), implying the company was  consuming capital rather than generating it.

We were also troubled by Enron’s cryptic disclosure regarding various “related party transactions” described in its 1999 Form 10-K as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for its March, June and September quarters. We read the footnotes in Enron’s financial statements about these transactions over and over again but could not decipher what impact they had on Enron’s overall financial condition. It did seem strange to us, however, that Enron had organized these entities for the apparent purpose of trading with their parent company, and that they were run by an Enron executive. Another disturbing factor in our review of Enron’s situation was what we perceived to be the large amount of insider selling of Enron stock by Enron’s senior executives. While not damning by itself, such selling in conjunction with our other financial concerns added to our conviction.

Importantly, Chanos notes that it was not the insider selling alone, but within the context of other suspicious activity, that concerned him. Often executives and insiders sell for personal liquidity reasons (buying a new home, sending kids to college, buying a boat, etc.) and some observers necessarily conclude this means foul play or that the insider knows the Titanic is about to hit an iceberg.

More common with smaller companies where management and ownership are often synonymous, related-party dealings are always something to be skeptical about and almost never are harmless in the context of multi-billion dollar public corporations.

Finally, we were puzzled by Enron’s and its supporters boasts in late 2000 regarding the company’s initiatives in the telecommunications field, particularly in the trading of broadband capacity. Enron waxed eloquent about a huge, untapped market in such capacity and told analysts that the present value of Enron’s opportunity in that market could be $20 to $30 per share of Enron stock. These statements were troubling to us because our portfolio already contained a number of short ideas in the telecommunications and broadband area based on the snowballing glut of capacity that was developing in that industry. By late 2000, the stocks of companies in this industry had fallen precipitously, yet Enron and its executives seemed oblivious to this! Despite the obvious bear market in telecommunications capacity, Enron still saw a bull market in terms of its own valuation of the same business — an ominous portent.

Again, Chanos and his firm were able to see the Enron picture more clearly by comparing it to the competitive landscape as a whole. How much validity does a firm’s claims possess when looked at in the context of the wider industry (or economy), rather than just its own dreams and/or delusions?

Throughout the rest of the testimony, we learn a few other interesting details about the development of his short thesis concerning Enron: the use of Wall Street analysts for sentiment feedback, the analysis of additional qualitative data for confirming target company statements and the use of conferences and investor communications networks to spread an idea and generate critical investor momentum.

Chanos also shares this helpful Wall Street axiom:

It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets.

An important reminder for considering all business strategies which require positive momentum (ie, Ponzi schemes) to work.

More telling than insider selling, in Chanos’ mind, is management departures, change ups and board reshufflings:

In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what “official” reason is given.

In the case of Enron, the executive to depart was Enron CEO Jeff Skilling who was considered to be the “chief architect” of the company’s controversial trading program. His absence meant not only that Enron was potentially a ship without a rudder, but that the captain had found a leak and was jumping overboard with the rats before everyone else figured it out.

In Summary

To summarize the lessons of the Enron case, good shorts usually involve at least one or more of the following: questionable earnings, uneconomic business models and/or fraud.

Accomplished short-sellers look for clues suggesting the presence of the above factors by reading between the lines in public financial disclosures and major news stories. They use social signaling clues like surveying Wall Street analysts and other market participants to gauge sentiment, which is a contrarian tool for discovering whether controversial information they are aware of is likely priced into the market or not. They engage in competitive analysis to judge whether the target firm’s claims are credible and reasonable. They watch the activity of insiders, specifically unanticipated departures of key staff, for confirmation of their thesis. They anticipate stressors to a firm’s business model which might serve as catalysts for revealing the precarious state of a firm’s business to other market participants.

Finally, and perhaps most importantly, they never take the price of the shorted security going against them as evidence that they are wrong and they add to their position as their conviction rises with new evidence of weakness or trouble for the target firm.

As Ben Graham would observe, in the short term the market is a voting machine and it’s common for those who are responsible for a fraud or dying business to cheerlead the market out of desperation. And as Chanos himself observed,

While short sellers probably will never be popular on Wall Street, they often are the ones wearing the white hats when it comes to looking for and identifying the bad guys!