Danny DeVito Explains Tangible Book Value

This is a funny clip from the movie Other People’s Money.  The movie is about dying New England company trading below tangible book value and a corporate raider who targets it.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q1 2017 Performance Update

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My Q1 2017 Performance: Down .11%

S&P 500 Q1 2017 Performance: Up 5.53%

My portfolio is regularly tracked here.

The S&P 500 had an amazing quarter and I had a lackluster one in relative terms. Overall I’m down 2% since I started tracking the portfolio in mid December 2016. At one point I was down 5% earlier this quarter.

Anti-Amazon Trade (GME, CATO, DDS, AEO)

Much of my under-performance is attributable to my anti-Amazon trade. As mentioned in the earlier post, the conventional wisdom is that Amazon is going to destroy conventional retail. I remain unconvinced that retail is going to die. People will always shop in physical stores. While retail may be in decline, it will not go away. For clothing in particular, people will always want to see the item and try it on. There is also the instant gratification aspect of conventional retail that will allow it to endure. Moreover, no matter how technologically sophisticated we become, people will always want to leave the house and occasionally go shopping. They are not going to hang out at home all day and never shop in a physical location again. Even Amazon realizes this truth, which is why I find it amusing that they are thinking about expanding into physical retail!

My unsophisticated thesis is simple: the retail stocks are all priced like retail is going to die soon and I don’t think it is going to happen. Simultaneously, the price of Amazon has been bid up to an extreme P/E ratio (180.98) and the momentum continues.

While I may be early to the anti-Amazon trade, I don’t think I am wrong. Predicting when the market will accurately value a stock is not possible. You can only buy when there is a mismatch between price and intrinsic value and wait.

IDT

IDT is my worst performer. During the week of March 6th after reporting disappointing earnings, the stock collapsed from $19.50 to $13.11, a decline of 33%. The stock plummeted further to $12.03. I was certainly wrong on this one, but I do not want to sell. $5.66 of that $12 price is cash. IDT has no debt. They also aren’t cutting their dividend and while the core business is struggling, it’s not dying. I’m sticking with it.

MN

Manning and Napier is also not doing well. Active management continues to be punished after the amazing track record of the indexes since 2009. Investors don’t want to pay high fees to asset managers when they can buy a low-cost index fund that will outperform them. Assets under management are declining, which is hurting the business. I don’t think this trend will last forever and in the meantime I am at least being paid a nice dividend yield to own Manning and Napier. The company currently has a negative enterprise value, with the current price less than the cash on hand, which currently stands at $9.19 per share. It’s a ridiculously cheap stock and the slightest glimmer of hope should allow me to take at least one free puff from this cigar butt.

Bubble Basket

David Einhorn refers to a “bubble basket” that he’s short on, which includes Amazon and Netflix. Q1 2017 was a good time for bubble basket. Tesla, a company with no earnings trading at 6.48 times revenue, is up 30% year to date. Amazon is up 18.23% and trades at 180 times earnings. Netflix, trading at 347 times earnings, is up 19.39%. Facebook, trading at 40 times earnings, is up 23.47% year to date. These are simply crazy valuations and I suspect they eventually they will go down in history with the Nifty Fifty.

Snapchat also debuted on the markets this quarter, as a symbolic representation of the frothy mood. The IPO felt like a flashback to the late ’90s, when an IPO and a dot com at the end of a name was a key to instant riches. SNAP has no earnings, $404 million in revenue. $27.11 billion market cap. This isn’t Pets.com crazy, but it’s still pretty crazy.

Einhorn is losing money shorting these stocks, but I still think he’s right. Therein lies the problem with shorting: there is no way to predict how long the market will be crazy and ignore reality. It will eventually happen, but there is no telling how long it will take.

If you’re short and the stock goes up 100%: you lost all of your money. This is why shorting technology stocks in the ’90s was a risky move even though there was a bubble and the shorts were vindicated. If you were early to the short (in, say, 1998), then you would have lost a tremendous amount of money even though the thesis was vindicated in the early 2000s. Take a look at the percentage returns for the NASDAQ 100 from 1998 through 2002:

1998: Up 85.30%

1999: Up 101.95%

2000: Down 36.84%

2001: Down 32.65%

2002: Down 37.58%

“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes

That is why I don’t short stocks or use leverage. Timing is hard, even if you’re a pro like Einhorn. If Einhorn can’t do it, then I certainly can’t do it!

Portfolio Value

On an EBITDA/Enterprise Value basis, many of the worst performing stocks in my portfolio are some of the most attractively valued. Why sell now?

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The frequent under-performance of value strategies is a key reason that they outperform over the long run.

If a fund manager delivered the kind of relative under performance that I delivered this quarter, they would probably be yelled at by their boss or at the very least forced to endure a healthy dose of corporate passive aggressiveness:

It’s moments like this (which can last years) during which there is a strong incentive to simply buy stocks that look like the S&P 500 or had some recent momentum. This strategy is a recipe for long term under-performance.

Behaviorally, it is easier to go with the crowd. If you’re right and the crowd is right, then you’re doing great! If you’re wrong and the crowd is wrong, then at least everybody else was wrong too!

If, however, you take a contrarian opinion and the crowd is right and you’re wrong (as I am with the anti-Amazon trade for now) then you lose your job. Contrarian opinions are eminently risky. Things are even more behaviorally difficult when you look at the companies in a value portfolio. Why am I even investing in this garbage? Everybody knows that retail is dead, Gamestop will be replaced by streaming video games, etc. This makes it all the easier to click that tempting “sell” button and end the pain.

This is why having one investor (me!) and no boss is advantageous and makes for better investing.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

What is the best measure of quality?

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In an earlier post, I examined the performance of different value metrics. My conclusion was simple: cheap stocks beat expensive stocks.

Most value investors don’t simply look for cheap alone. They try to find companies that are both cheap and good. Good is typically defined as companies that can earn high returns on their capital.

Finding these companies is a worthwhile pursuit but it is difficult to pull off systematically because companies earning high returns on capital are going to attract significant competition. I think it is far more difficult to do this than most value investors appreciate. Mean reversion, fueled by competition, inevitably pulls these returns down. Finding the rare birds that don’t succumb to this is hard.  These companies usually have a “moat“, which is hard to identify. Needless to say, this kind of investing requires a touch of genius that I don’t have. When investing, I operate under the assumption that every company succumbs to mean reversion.

With that said, finding these rare opportunities certainly pays off over the long run. You can park money in a company like Coca-Cola or Nike and earn high returns over long stretches of time, while reducing taxes and transaction costs.

The Magic Formula 

Joel Greenblatt sought out a systematic quantitative method to find companies that are simultaneously cheap and earn high returns on capital. The result was The Little Book that Beats the Market. In the book, Greenblatt demonstrated that simultaneously buying cheap companies that earn high returns on invested capital will outperform. He calls this the magic formula and generously maintains a free screener here.

Tobias Carlisle took this a step further in Deep Value and discovered that the quality metric of high returns on invested capital actually reduces returns from the magic formula. He explains in Deep Value how mean reversion tends to bring these returns down. Cheap alone is better than cheap plus good. In other words, it takes qualitative insight to determine which companies have a moat that will allow them to sustain high returns on capital. Tobias maintains a free large cap screen for this here.

I would recommend reading both The Little Book That Beats the Market and Deep Value.

Backtesting Quality Metrics

I decided to test the returns for myself and try to see which “quality” metric works best when combined with a value factor. The test I ran is limited to Russell 3000 components. My definitions of cheapness were:

  • EBITDA/Enterprise Value is higher than 20%
  • Price to free cash flow is less than 15
  • Price to sales is less than 1
  • Earnings Yield is over 10% (i.e., P/E is less than 10)
  • Price to book less than 1
  • Price to tangible book less than 1

In addition to examining metrics that define high returns on capital, I also included metrics for financial quality, such as the debt to equity ratio and the Piotroski F-Score. Below is a summary of all of the quality metrics that I tested.

Return on Equity – This is the oldest and most simple method of corporate quality. It is simply the company’s net income divided by equity (assets – liabilities). For the purposes of the test, I define high ROE as over 20%.

Return on Invested Capital – Joel Greenblatt’s preferred measure of quality. This is earnings before interest and taxes divided by invested capital. Invested capital is defined as working capital plus net fixed assets. For the purposes of the test, I define high ROIC as over 15%.

Gross Profits/Assets – Robert Novy-Marx created a very simplistic measure of quality, gross profits/assets. He found that this  method works extremely well, because it uses profits further up of the income statement where it is more difficult for a firm to manipulate the numbers. You can read his paper on the subject here. For the purposes of the test, I define good gross profitability as over 30%.

Debt/Equity – This is another simplistic measure of financial quality. It is simply total debt divided by equity (assets-liabilities). For the purposes of the test, I define a good debt/equity ratio as under 50%.

F-Score – This is a more complex measure of financial quality designed by Joseph Piotroski, who is currently a professor at Stanford. Piotroski designed a 9 point scale of financial quality in a paper written back in 2000. Piotroski backtested combining this measure of financial quality with price to book and found that the results greatly exceeded the market. Each component adds to the score. A perfect F-Score would be a 9. It’s too bad F-Scores don’t go up to eleven. The components of the F-Score are defined below.

  • A net decline in long-term debt for the current year.
  • A net increase in the current ratio in the current year. The current ratio is current assets/current liabilities. It measures the liquidity of the company’s balance sheet to meet short-term obligations.
  • A positive increase in gross margins in the current year.
  • Faster asset turnover in the current year.
  • The total number of shares outstanding is flat or decreasing. In other words, the company isn’t issuing new equity and diluting the current pool of shares.
  • Return on assets is positive.
  • Operating cash flow is positive.
  • Return on assets for the current year is higher than the previous year.
  • Operating Cash Flow/Total Assets is higher than return on assets.

The results of the backtest are below. The results are in the Russell 3000 universe with annual rebalancing beginning in 1999.

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The High Return Metrics – ROE, ROIC, GP/Assets

Measures for returns on capital – ROE, ROIC and GP/Assets – actually detract from the performance of EBITDA/Enterprise Value. They add performance to the other valuation metrics slightly, with Gross Profits/Assets being the best.

The middling performance of high return quality metrics is due to mean reversion, or the propensity for high return businesses to eventually succumb to the pressures of competition.

With that said, if you are trying to identify high return businesses, the best metric to use appears to be Gross Profits/Assets.

Financial Quality (The Debt/Equity Ratio and the F-Score)

In contrast, measures of financial quality, such as the debt/equity ratio and the F-Score, supercharge all of the valuation metrics that are examined here. Why is this?

Cheap stocks are only cheap because they are in some kind of trouble. There is an “ick” factor. Any time you run a value screen, you will scratch your head and think “Do I really want to invest in this garbage?”

This is why financial quality metrics are more useful than business quality metrics. If a company has a good balance sheet and is financially healthy then it has time to resolve its problems. Managers have time to implement a new strategy that can turn things around. Even without a new strategy, time will help the financially healthy company. For instance, if the company is in a crowded, competitive industry, the financially healthy company can weather the storm while the highly leveraged firms will go out of business first. Less firms means less competition. Less competition means that future returns in the industry will improve.

This is the essence of the simple Graham method that I follow with my own portfolio. I am looking for cheap companies that have the financial ability to weather the storm that they’re in.

This is also why the high return metrics add a little to the other valuation metrics but detract from the EBITDA yield. Unlike the other valuation metrics tested here, the EBITDA yield is the only one here that uses Enterprise Value in the calculation. Enterprise Value brings balance sheet health into the valuation ratio. For EBITDA/Enterprise Value to result in a high yield, the company must have little debt and a lot of cash on hand. In other words, valuation metrics that use Enterprise Value will identify companies that are both cheap and have safe balance sheets.

RadioShack vs. Best Buy

This reminds me of an article I read over at the Motley Fool. The author explains why Radio Shack fell apart and Best Buy was able to turn around.

Radio Shack had numerous problems, including asking for your phone number when you buy batteries.

Best Buy’s problem is that it basically became a showroom for Amazon. The referenced article explain how Best Buy successfully turned things around by cutting costs, emulating the Apple Store, expanding the Geek Squad and improving their website.

I have a more simplistic explanation for why Best Buy was able to recover and Radio Shack fell apart. Radio Shack had a lot of debt and Best Buy didn’t. Radio Shack’s debt to equity ratio was over 670%. Best Buy’s debt to equity ratio was 41% a few years ago and is 29% today.

Best Buy’s balance sheet gave them an edge: time. They had time to work through their problems and try to find a solution. If Best Buy had Radio Shack’s debt levels, the CEO would have never been able to pursue the turnaround strategy. All troubled companies are trying to turn things around, but only those with financial strength will have the time to do so.

Screening for High F-Scores and EBITDA Yield

One of the most robust combinations tested was the F Score and the EBITDA Yield, with a 17.69% rate of return since 1999. I ran a screen for companies with an EBITDA yield over 20% and an F-Score of 8 or higher. This combination of criteria is very stringent. It only returned 5 results out of the entire Russell 3000. Best Buy actually comes up in this screen, implying that it is still a financially healthy bargain. Output from the screen is below.

Companies

I am not going to buy positions in these companies, but wanted to share the results of what I found. Hopefully this will give you some useful leads that are worthy of further research.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Shoe Dog” by Phil Knight

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I recently finished Shoe Dog by Phil Knight. I love memoirs and biographies. When they are combined with business insights, I am particularly interested.

Shoe Dog focuses on the early years of Nike and focuses almost exclusively on the experience of Nike in the 1960s and 1970s before the company went public. The structure of the book is a part of its appeal. Most memoirs take you on long boring slogs through the author’s childhood, teen years and later life. This book focuses almost exclusively on the most exciting time in Phil Knight’s life: when Nike struggled in the 1960s and 1970s to make its mark. He is also remarkably honest about the experience. He discusses all of the problems he faced and the doubts and stress that went along with it.  With most business memoirs, you get the sense that the writer had it all figured out from day #1. Phil’s story is different. He is also an amazing writer.

I was born in 1982, so throughout my life Nike has always been one of those brands that was as iconically American as a can of Coca-Cola or a Big Mac from McDonalds. Whether it was Marty McFly’s power laces, or Forrest Gump’s trek across America in the Nike Cortez, Nike has been sewn into the fabric of our culture. I never realized how new Nike was until I read the book. Nike had only gone public two years before I was born and the company wasn’t even called Nike until the 1970s.

The Story

Phil Knight’s story begins in college where he ran track for the legendary Bill Bowerman, who would later become the co-founder of Nike. Phil went on to graduate school at Stanford, where he wrote a paper about how Japanese sneakers could take down German brands, just as the Japanese did the same thing to German camera manufacturers.

Phil took the idea with him as he toured the world after college. During his travel throughout the world, he went to Japan. He met with the executives of a shoe company called Onitsuka. He told them that he represented the Blue Ribbon company and wanted to sell their sneakers (called Tigers) in the United States. He bought $50 worth of sneakers and began selling them out of the back of his Plymouth Valiant.

He continued to sell sneakers but needed a full time job, so he earned his CPA and began working for Price Waterhouse. He also spends some time as a professor of accounting after leaving Price Waterhouse. As the ’60s wore on and the shoe business expanded, he ultimately quits and runs the company full time.

The book takes you through the ups and downs (mostly downs) of running the company. The downs are gut wrenching. The book is as much an inspiration for would be entrepreneurs as it is a cautionary tale about the perils that await those who want to go into business for themselves. Nike had multiple near death experiences, including:

  • An early brush with death when Onitsuka threatens to end the relationship with Phil Knight when it was just beginning.
  • Conflicts with an east coast seller of Tigers, a former Marlboro Man living in New York.
  • Constant conflicts with Onitsuka, including a threatened hostile takeover and threats to use other sellers. Phil fought against this (which was the impetus for creating the Nike line and finding alternative suppliers), but this resulted in a court showdown that could have also potentially destroyed Nike.
  • Dancing the razor’s edge of leverage throughout the 1970s. Unwilling to take the company public and use equity financing (he was afraid that it would ruin the company culture), Nike’s early growth was fueled almost entirely with debt, leading to terrible cash flow problems. At one point, payroll checks bounce and Nike’s bank threatens to call the FBI because they suspect fraud.
  • A showdown with US customs. Influenced by lobbying efforts by Nike’s competitors, customs fines Nike $25 million (its annual sales at the time) over customs technicalities. Nike would then have to wage a lobbying war of their own to defeat the injustice.

Through the struggles, Nike and Phil grow. The story of Nike’s growth and the problems it encounters make the book exciting. The story ends with Nike’s public offering in 1980. The following decades are covered at the end, but the focus of the story is almost entirely on Nike’s early development.

Life Lessons

If there is anything to be learned from Phil’s story it is: don’t give into negativity. Things may look dark at times, but it will get you nowhere if you give into negativity and stop trying. There were many times when Phil could have thrown in the towel, but he never gives up no matter how bad his problems are. I suspect a lot of this comes from Phil being a runner. When you are running, you constantly want to stop. Running is about resisting that. Mind over body. Phil takes the same attitude towards business.

Another great lesson of this book: cultivate relationships. You never know where a relationship might lead in the future. One of the most important relationships that Phil developed was with Bill Bowerman. Who could have imagined that his college track coach would help him found one of the greatest American companies of all time? Relationships must be cultivated, because you never know what dividends they might pay in the future.

The Stock

Nike is one of the best performing stocks of all time. Nike is one of those franchise stocks that are extremely hard to identify early on. It’s a Buffett/Munger kind of stock. (Although, Buffett owns Brooks, a Nike competitor, so he would probably disagree with the characterization!)

Nike is one of those firms with an amazing enduring brand and a high return on equity that won’t quit and is seemingly immune to the kind of mean reversion that brings down most high flying businesses (Nike’s return on equity was 27.58% in Q4 2016).

$1,000 invested in Nike stock back in 1981 at the IPO price would be worth $336,046.15 today.  Shockingly, that’s even better than Apple. A $1,000 investment in Apple at the IPO price would be worth $274,490 today.

Indeed, there is something magical about that swoosh.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Is the Bubble About to Burst?

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Q4 2016 Data

In an earlier post I referenced an excellent market valuation model that I found at the Philosophical Economics blog. To sum it up: the model projects the next 10 years of market returns by using the average investor allocation to equities. The theory is that most bull markets are fueled by rising valuations as investors move money from other asset classes into stocks. The model tells you how much “fuel” is out there to push equities higher.

The Q4 2016 number recently became available over at Fred. The current average equity allocation at the end of the year was 41.279%. Let’s plug this into the equation I referenced in my earlier blog post on this topic:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

(-.8 * 41.279) + 37.5 = 4.48%

We can therefore expect the market to deliver a 4.48% rate of return over the next ten years. Not particularly exciting, but not the end of the world either.

Market Timing

Most hedge fund letters this year emphasized how market valuations are at historic highs and take a cautionary approach to stocks. I agree with their spirit because I think everyone should always approach the market with caution. If someone cannot handle losing half of their money, then they have no business in the stock market. A drop of that magnitude can happen at any time no matter where valuations stand. That short-term risk is the very reason that stocks outperform other asset classes over the long-term.

If I were an alarmist, I would agree with some of the hedge fund letters and say: “The market hasn’t traded at these valuations since 2007! Get to the chopper!” This implies that we are on the brink of another historic meltdown in stocks. This is the prognostication that is often heard about stocks today. I think it is misleading.

Valuation simply predicts the magnitude of future returns over the long run. Higher valuations mean lower returns and lower valuations mean higher returns. That’s it. It does not predict what the market will do over the next 12 months. It does not mean that if you wait long enough, you’ll have an opportunity to buy when valuations are at more attractive levels. Anything can happen in the next year. There could be an oil embargo. A war could break out. Terrorists could strike. Our politicians could cause another crazy showdown that imperils the economy. Trump-o-nomics might actually work. Maybe it won’t. No one really knows and anyone who proclaims otherwise is lying.

It is tempting to look at market valuations as a tool to time the market. Wouldn’t it be great to sell in 2007 and buy in 2009? Get in when the market is depressed and get out when valuations rise and the market looks like it is due for a correction? My view is that market valuations should not be used as a market timing tool. When it comes to timing the market, I think Peter Lynch put it best when he said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This is great advice. Today’s market valuations may be at 2007 levels — but they were also around these levels in 2004 (S&P 500 up 8.99%), 1968 (up 7.32%), 1997 (up 25.72%) or 1963 (up 17.51%). It makes little sense to try to time the market based on valuation or refuse to participate simply because the market isn’t offering the kind of compelling bargains that it presented in 2009. The question is: is this 2007 or 1997?

Stopped clocks are always right twice a day. This is how I feel about the permanent bears. They certainly called it in 2008, but did they call the turnaround? How many of them have been predicting disaster for the last decade and have been proven wrong year after year? There is bound to be another meltdown at some point in the future, but there is no way to predict when that will happen. The wait can be long. While you wait, more money can be lost through unrealized gains than is lost in the actual correction. 2017 may be the year for a major market meltdown of and the end of the bull market. Perhaps. Taking the advice of the permanent bears will help you avoid it, but how much more money was lost listening to their advice since 2009? It doesn’t make sense to refuse to participate in the market simply because the market isn’t offering compelling valuations.

Valuation in a Vacuum

Stock market valuation doesn’t occur in a vacuum. One should always compare the expected returns in stocks against the expected returns in other asset classes. My view is that the best asset to compare stocks to is AAA corporate bonds. The way to think about stocks is as corporate bonds with variable yields. The question isn’t “is the market overvalued?” The question is “Do current earnings yields justify the risk of owning stocks when compared to the returns on safer asset classes?”

This is why interest rates drive the stock market.

“Interest rates act on asset values like gravity acts on physical matter.” – Warren Buffett

Below is a historical perspective of market valuation compared to the interest rates on corporate bonds. The expected 10 year S&P 500 return is derived from the equation described earlier in this post.

Year Expected 10 Year S&P 500 Return AAA Corporate Bond Yield Equity Risk Premium
2017 4.48% 3.05% 1.43%
2012 9.38% 3.85% 5.53%
2007 5.06% 5.33% -0.27%
2002 4.33% 6.55% -2.22%
1997 7.86% 7.42% 0.44%
1992 14.43% 8.20% 6.23%
1987 14.37% 8.36% 6.01%
1982 19.24% 14.23% 5.01%
1977 15.03% 7.96% 7.07%
1972 5.22% 7.19% -1.97%
1967 4.41% 5.20% -0.79%
1962 5.66% 4.42% 1.24%
1957 9.81% 3.77% 6.04%
AVERAGE 2.60%

Historical

As you can see, there are times when the market adequately compensates investors for the risk of owning stocks and there are times when it does not. It is also evident that there is a strong correlation between interest rates and future market returns. Higher interest rates mean that stocks need to deliver higher earnings yields, something that is usually achieved by a market correction that depresses P/E ratios and boosts earnings yields.

From this perspective, the market isn’t wildly overvalued. The current market valuation is largely in line with historical norms based on where interest rates are today.

That is the right way to think about stocks. It is folly to think “valuations are too high, therefore I will not participate because a correction is imminent.” That is short-term prognostication and it is typically wrong. No one knows what will happen over the next year and market valuations won’t provide the answer.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“American Desperado” by Jon Roberts & Evan Wright

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Cocaine Cowboy

Years ago, I saw the documentary Cocaine Cowboys. The documentary was about the transformation of Miami from a sleepy vacation and retirement destination in the 1960s to a hub of drug trafficking and murder in the late 1970s and 1980s. The story was enthralling. It transcended a normal documentary and unfolded like an action movie. The characters include drug traffickers, hitmen, murderers, shady attorneys, the cops on the front lines and the reporters of the era who documented the carnage. The documentary is on Netflix if you want to check it out.

In the documentary, the two most fascinating characters to me were the drug smugglers, Jon Roberts and Mickey Munday. In the documentary, both were portrayed as largely non violent, which made them more appealing. In the documentary, it was the hitmen that were the savage and violent characters. Munday and Roberts were largely non-violent, which made them stand out. They appeared to be far more intelligent than the characters they were forced to associate with. While they were criminals, they weren’t psychopaths like many of the hitmen and drug kingpins that they were dealing with. When I heard that Jon Roberts wrote a book called American Desperado about his experiences, I was excited to read it.

I feel that this blog entry is incomplete without Jan Hammer

The Dark Side

The book revealed a much darker side to Jon Roberts’ persona than what was in the documentary. Jon admits that he is an evil person. His motto for his life was “evil is strong”. While in elementary school, he witnessed his father murder another man and suffer no consequences for it. The young Jon was amazed that in real life (unlike the movies), bad people frequently got away bad things. This was a truly terrible lesson to absorb at a young age. As Jon learned far too late in life, bad things do catch up with bad people. Karma is real.

The early childhood trauma and lack of a positive father figure propelled Jon on a criminal path. In his youth, he was a juvenile delinquent. He spent his time robbing people and reacting violently to anyone who crossed him. He abused drugs and alcohol. After being arrested, Jon was offered the opportunity to avoid lengthy prison time by enlisting in the military during the Vietnam War. In Vietnam, where he behaved like a murderous psychopath. For instance, there is a section of the book where he describes how to skin a person alive. The description is terrifying. His criminal career evolved from early experiences setting up drug deals with the intention of robbing people, drug dealing, to becoming embedded in the New York mafia and managing night clubs.

Jon had some clashes with made men and was tied to a murder. This led to a falling out with the mafia. Jon had to flee New York City to get away from the police and the mafia. Jon was able to leave the geography of New York and reinvent himself in a new location. He decided on Miami because he had family there. He begins in Miami by trying to live a straight life with a dog training business but quickly strays back into his criminal ways.

Drug Kingpin

Slowly in Miami, Jon evolves in the preeminent drug smuggler in the area. He estimates that his fortune at one point exceeded $100 million. He still engages in violent behavior. He alludes to murders during this time period, but it is not nearly as violent as his time in New York. Still, Jon is relatively tame compared to his counterparts at the time. His lifestyle is unbelievably decadent and he describes this in depth as well.

In one amazing incident, Jon organizes a trafficking operation on behalf of the CIA. He then contends that Barry Seal did this as well, which appears to be supported by evidence. Barry Seal later became an informant. The Colombian drug cartels also ask Jon to kill him. Later, they did this themselves without Jon’s help.

Eventually, Jon is arrested after the government obtains information acquired through an informant and close business associate of Jon’s, Max Mermelstein. He spends years living as a fugitive in both Colombia and Mexico. While in Mexico, he is arrested as a result of their version of America’s Most Wanted. He ultimately escapes from the Mexican prison and hides in the United States in Delaware, until he is ultimately arrested in the early 1990s.

Jon also has a son, whom he genuinely loves. Despite his seemingly tranquil family life in the 2000s, Jon knows deep inside that his demise is coming. He actually says that he spent his life in service of the devil and expects God to punish him with a painful death. Ultimately, Jon died of cancer in 2011.

Mickey Munday

The book left me with a still largely positive image of Mickey Munday. Unlike Jon, Mickey was truly non violent and an incredibly smart guy. He didn’t engage in any materialistic flashiness. He was involved in drug smuggling solely for the challenge and fun of it. He is incredibly innovative. In one amazing section of the book, it is described how Mickey developed a stealth boat after reading about the stealth bomber in a magazine. He equipped the boat with a silent drive and navigated at night without lights while he wore night vision goggles and the boat was invisible to radar. As a nice touch, he would ride the stealth boat while listening to Phil Collins’ In the Air Tonight on his headphones. Mickey didn’t do drugs and his main vice was milk and cookies. He was the most fascinating and likable character to me. I wish Mickey would write a book, as I would love to read more about him.

Recommendation

I liked the book, but I can’t recommend it to anyone who wants to read a book with a likeable protagonist. Jon is a scoundrel. With that said, he at least admits it and doesn’t try to sugar coat it. He is completely honest about the evil in his life. He was a murderer and likely a psychopath. I imagine watching his father commit murder seeped into him and left an impression which impacted his mentality throughout his life. At one point, he talks about the best way to kick someone’s face with a steel toed boot and you can detect that he actually enjoys it, as evidenced by the level of detail in his description. Amazingly, despite a lifetime spent in crime, the most horrific activities that Jon engages in are in Vietnam.

Despite Jon’s admitted evil, he is actually quite charming and at times very funny. A particularly humorous incident involves Jon and OJ Simpson, who apparently had an insatiable appetite for Jon’s drugs. After a drug binge, Jon must take Simpson to an airport on the morning of a game and leads Simpson through the airport in a wheelchair because he is unconscious and will not wake up.

Jon’s story is a fascinating one, but I was also left wondering how much of it was actually true because the stories are so extreme that some of them sound fabricated. To his credit, the co-author Evan Wright attempts to document as much as possible and offers his own commentary on the validity of Jon’s claims. Evan also conducted interview of Jon’s associates and those perspectives are also included in the book.

I can’t recommend this book to everyone, but if you can stomach reading the life of a truly evil man with extraordinary life experiences, then you should check it out.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Psychology of Human Misjudgment by Charlie Munger

This is a great speech given by Charlie Munger. Throughout the speech, Charlie runs through the common causes of human beings to misjudge.

I think it’s important for everyone to understand these concepts, but it’s particularly important for investors. The goal of an investor ought to be to take advantage of human misjudgment. With markets, you’re dealing with the collective judgment of human beings. To make any money, you have to be able to make good decisions and understand why other people are making comparatively bad decisions.

Whenever you find yourself coming to a conclusion about something, I think it’s a good idea to think about this speech and think about whether or not you are succumbing to these common misjudgments.

The common causes that Charlie summarizes in the speech are listed below:

  1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Always think in terms of whether or not someone is gaining from a course of action and whether that lines up with your own goals. “Is my realtor just trying to maximize his commission, or is this house actually a decent value?” Never underestimate the power of incentives.
  2. Psychological denial. The inability of people to accept truths that are too painful to accept.
  3. Incentive-cause bias, or when the interests of two parties aren’t aligned.
  4. Bias from consistency and commitment tendency. This is sticking to your guns over “core beliefs” and refusing to change in the face of evidence to the contrary.
  5. Bias from Pavlovian association, or misconstruing past correlation as a reliable basis for decision-making.
  6. Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
  7. Lollapalooza: bias from over-influence by social proof. Social proof is your desire to agree with other people for the sake of agreeing. The ultimate examples I can think of are both the real estate bubble and the dot-com bubble of the late ’90s. The prices made no sense, but everyone else was doing it.
  8. “To a man with a hammer every problem looks like a nail”. Economists are cited as an example of loving the efficient market hypothesis because the math was beautiful and that was what they were trained to use even though it was largely useless for the problem that they were tackling.
  9. Bias from contrast-caused distortions of sensation, perception and cognition. In other words, limiting yourself to your own experiences when making decisions instead of looking at the bigger picture.
  10. Over influence by authority. Valuing someone’s opinion more just because they’re an authority figure. Also known as the expert fallacy. You’re more likely to listen to someone in a suit than someone in a t-shirt and jeans.
  11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed. I.e., the reaction of a dog when you try to remove its food or the reaction of the American public when Coca-Cola tried to change the flavor.
  12. Bias from envy or jealousy.  “It’s not greed that drives the world, but envy.” – Warren Buffett
  13. Bias caused by chemical dependency, such as drugs or alcohol.
  14. Bias from a gambling compulsion.
  15. Liking and disliking distortion. This is the tendency to agree with the opinions of someone just because you like them personally. Conversely, there is the same tendency to disagree with the opinions of someone you dislike just because you dislike them. In other words, not analyzing the actual merits of an opinion, but basing your thoughts on your attitude towards the person. You see this a lot in politics. When a President does something that the opposing party dislikes, think of the different reactions that would be caused in the same people if someone from their own party proposed the same course of action.
  16. Bias from the non-mathematical nature of the human brain. Letting yourself be fooled by statistical tricks.
  17. Bias from the over influence of extra vivid evidence. Not looking closely at something because the answer seems obvious. Look closer because the truth isn’t always obvious.
  18. Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations. In other words, you need models to understand the world. Your mind isn’t just randomly collecting scattered facts. They have to exist in some kind of structure to be useful.
  19. Other normal limitations of sensation, memory, cognition and knowledge.
  20. Stress-induced mental changes, small and large, temporary and permanent.
  21. Mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
  22. Development and organizational confusion from say-something syndrome. In other words, it’s the idea that you feel you have to do or say something for the sake of doing it, not because it will actually achieve anything. Anybody who ever sat in a meeting in corporate America knows this truth. 90% of the people who say something in these meetings have nothing useful to say.
  23. Combinations of these tendencies. Examples cited include Tupperware parties, Alcoholics anonymous and open outcry auctions. All combine several of the psychological biases that Charlie previously described to obtain a result.

Before making a decision, take a step back and think about whether or not any of these biases are at work. The more we can avoid these biases, the better decisions we can make.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Price of Politics by Bob Woodward

 

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I recently completed Bob Woodward‘s The Price of Politics.  The book chronicles the debt showdown of 2011 and the lead up to it. I wouldn’t recommend this to anyone who wants to have a positive feeling about the direction of the country or the federal budget, but I would recommend it to anyone who wants a good understanding of where our politics unfortunately rest today.

Background

For those lucky people who don’t remember, in 2011 the United States approached the debt ceiling. The debt ceiling is a limit set in law placing a dollar limit on the total amount that the United States can borrow. Raising the debt ceiling is typically passed as a matter of procedure and occurs without much of a fuss. 2011 was different. To understand why, Woodward recaps the rise of Obama and the Republican controlled Congress.

Obama was elected during the financial crisis. My own view is that the efforts of the Federal Reserve along with TARP prevented a full-scale Depression. In 2008, we faced the exact same situation that the United States faced in 1929, but we avoided a full scale Depression because we didn’t repeat the mistakes that the Federal Reserve made in 1929. We increased the money supply and saved the banks. In the early 1930s, the Fed enabled a decrease in the supply of money and let banks fail. Milton Friedman explains:

Anyway, I am getting off track. While we avoided a Depression, we still had a horrific Recession. The recession greatly limited revenues to the Federal Government. Spending rose in the form of 2009’s $787 billion stimulus bill. As a result, the deficit exploded. Contrary to popular belief, TARP wasn’t the primary cause of the increase in the deficit. In fact, TARP was paid back and the government made a profit from it.

By 2011, the deficit increased from less than 60% of GDP to over 90% of GDP.

With the exploding deficit, the unpopularity of the Affordable Care Act and high unemployment due to the lingering effects of the recession, the Republicans were swept into power in Congress in the 2010 midterm elections.

The Showdown

Once Republicans entered power, a showdown was inevitable. The Republican’s primary goal was to use their Congressional power to address federal spending and the deficit. Their approach to the debt ceiling was rather straightforward: put together a bill that decreases the deficit by the amount that the debt ceiling would be increased.

Throughout the book all of the personalities clash with each other and their own party. Woodward’s book chronicles every wonky detail of the debate. To sum it up: they never really reached a compromise and the US nearly defaulted. The debate was so ugly that it led to a downgrade of US debt.

Woodward details the efforts of the White House and Congress to hammer out a deficit reduction deal to occur alongside the increase in the debt ceiling. A deficit reduction deal was sorely needed (and still is), despite temporary improvements due to an improving economy. There was a constant back and forth between the White House and Congress.

Particularly striking was how disjointed the process was. Obama and Boehner were negotiating separately from Joe Biden and Eric Cantor. All of the top people were out of touch with their own political bases, who would howl wildly at any talk of a deal and spook their leadership. Anger from the bases (Democrats mad about cuts to entitlements, Republicans mad about increased taxes) often spooked the leadership if they were on the brink of a deal. There were a few opportunities for a Grand Bargain which would have significantly reduced the debt. Obama and Boehner point the finger at each other for the failure of the Grand Bargain, but after reading the book I’m convinced that both of them blew it. They both backed away from provisions of the bargain once their base started complaining about it.

There is an old Vulcan proverb . . . only Nixon could go to China.

The failure of a Grand Bargain is a major lost opportunity of the Obama administration. Only Nixon could go to China, and only a Democrat could have reformed our entitlement mess. If Obama were able to sign entitlement reform, the budget outlook of the United States would have been greatly improved for decades.

In a normal political climate, the Democrats would have agreed to some spending cuts that made them uncomfortable and the Republicans would have agreed to some tax increases that made them uncomfortable. In a divided government, neither side can get everything they want. Neither party had complete control of government, but they both acted like they did.

I thought at the time that both sides were simply engaged in political posturing. I figured they would reach a deal because they always reach a deal. However, after reading the book, I came away with the feeling that we really dodged a bullet. Many in each party were actually willing to risk a default because they thought a default would hurt the other side more. There were Democrats who thought that a default would be blamed on the Republicans and there were Republicans who thought it would do more damage to the Obama administration. In other words, elements of both parties toyed with blowing up the US economy in an attempt to do political harm to the other side.

The effects of a default would have been truly horrific. Even though bondholders would still be paid, Tim Geithner lays out the effects of a technical default to the President in one chilling segment. A default on obligations would have permanently rattled markets and bond investors would then demand much higher interest rates on US government debt for decades. A double dip recession would have likely resulted as well. Another recession at this time would have been devastating. In 2011 we had barely recovered from the last Great Recession. The unemployment rate in 2011 was 9% and another recession would have probably pushed this above 15%. Both parties were well aware of this potential catastrophe and yet they both almost let it happen.

Hardcore partisans blame the showdown on the other side. Republicans will point to Obama’s handling of Republicans prior to the 2010 election and his incompetence as commander-in-chief during the negotiation. He even outsourced it to Joe Biden for a period of time. Democrats will say that Republicans were unwavering in their resistance to tax increases and too intimidated by the newly minted Tea Party movement. This approach amounts to two toddlers wrecking a living room and then pointing at each other and saying simultaneously “he started it!”

Conclusion

It’s hard to come away from the book without feeling that our political system is completely and utterly broken. Today’s Democrats look at Republicans as the reincarnation of the Third Reich. Republicans look at Democrats as the reincarnation of the Soviet Union. A simple budget debate that would have been resolved rapidly 30 years ago is now an ideological showdown against the forces of “evil”, depending on your perspective.

My own view is that it’s the fault of baby boomers.  The debt showdown was about simple math in which everyone needs to sacrifice some of their position to hammer out a simple deal. Unfortunately, Washignton is dominated by baby boomers and they are more apt to view the showdown as an ideological showdown between the forces of good and evil.

The roots of baby boomer extremism is in the incredibly intense ideological showdown of the 1960s. It’s shocking to me how much hardcore conservatives and liberals share resemblances to the radical student movements of the 1960s. Unwilling to compromise, convinced that entire institutions are filled with evil and willing to use any means necessary to achieve their ends. It’s not a coincidence that as soon as baby boomers ascended to a majority of Congress in the early 1990s that our politics became increasingly divisive, reaching its apogee of dysfunction during the 2011 debt showdown. Partisanship so extreme that government was almost unable to fulfill the basic function of paying its bills.

There is a reason that the most famous baby boomers have nothing to do with governing or managing. They are interested in tearing things down and building a new. They are wildly creative – giving us people like Stephen Spielberg and Steve Jobs – but the downside to that creativity is that they’re not interested in basic management and maintenance of existing institutions, to the point where our existing institutions become completely dysfunctional. The budget showdown is about simple math and that’s probably how prior generations would have ultimately looked at it. To boomers, the budget showdown is about moral priorities and those who object to their view aren’t just wrong, they’re immoral and possibly evil.

My views on this are fueled by my reading of another book that I’ll have to review at some point on this site, The Fourth Turning by Neil Howe and William Strauss. Ever since I read the book, I find myself looking at current events through a generational perspective and nowhere is this more apparent than in politics.

The good news is that the baby boomers are getting old. Members of Generation X and Millennials are far less ideological than their parents, with roughly double the number of political independents. As the baby boomers leave politics, my expectation and hope is that sanity will return to our politics and showdowns of this magnitude won’t happen again. Our debt problems aren’t going away, but that doesn’t mean they can’t be resolved through arithmetic and rational thinking. It may take a new generation to tackle these problems. It’s too bad that Republicans and Democrats weren’t able to act like adults and take advantage of the unique opportunity that they had in 2011 to resolve this problem.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ed Thorp: The Man Who Beat Las Vegas and Wall Street

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I just finished Ed Thorp‘s new book, A Man for All Markets, and give it a strong recommendation. Ed Thorp is a genius who mastered card counting, built the first wearable computer to beat roulette and created the first market neutral hedge fund. The book takes the reader on a fascinating adventure through Thorp’s Depression-era childhood, his academic career in mathematics, his successful assault on Las Vegas and his wildly successful career in the financial markets.

Lifelong Learning

One of the things that struck me about Edward Thorp was his enduring lifelong love of learning, which fueled much of his success. Edward Thorp didn’t have a one-dimensional interest in mathematics. He was constantly fascinated by new ideas which likely led him to study unconventional subjects such as gambling. In his childhood he experimented with radio, attempted to win mathematics competitions, conducted funny experiments (such as attempting to create a hot air balloon and playing a prank on a local swimming pool with red dye that turned the entire pool blood-red). These funny pranks and interests show a deeply inquisitive mind willing to learn new things. While few of us are anywhere near the intellect of Ed Thorp, that’s an important lesson to take away. Remaining curious and developing a lifelong love of learning is a positive attribute that we should all strive to achieve.

The Original Black Scholes

I never knew that Thorp developed the original black scholes model, but he developed this and used it to make money for himself in the 1960s. He wrote about it in a 1967 book about it along with other arbitrage strategies, Beat the Market . Thorp was looking for a way to successfully invest his money that he accrued through his gambling activities and best-selling book Beat the DealerHe tried stock picking and wasn’t pleased with it, looking instead for something more precise and scientific. He ended up employing his own brand of convertible arbitrage and his own version of the Black Scholes model, before Fisher Black and Myron Scholes wrote their 1973 paper about it. In 1997, Myron was awarded the Nobel prize for an insight that Thorp discovered first. While Fisher Black and Myron Scholes appeared to have engaged in outright theft of Thorp’s ideas, he is surprisingly cool and level-headed about it. I suppose the lesson of this is that it doesn’t pay to hold grudges and needlessly create enemies. In fact, Thorp maintained a good relationship with them and was pleased that they were able to prove his idea. In any case, Thorp put the ideas to work in the world’s first market neutral hedge fund, Princeton Newport Partners.

A Unique Perspective

Something I thoroughly enjoyed about the book was reading Ed Thorp’s outlook on financial and political issues. What was fascinating to me was how non-ideological Thorp’s approach is. It’s hard to pin him down as a conservative or liberal. He does not subscribe to any kind of orthodoxy. Thorp’s approach is pragmatic and relies primarily on logic.

For instance, when discussing welfare, Thorp isn’t opposed to welfare as would be standard conservative orthodoxy but he also doesn’t subscribe to the standard liberal worldview. Thorp’s attitude is that welfare and unemployment benefits are necessary, but believes that these individuals should be put to work as occurred during the Great Depression’s Works Progress Administration.

Thorp is certainly no friend of Wall Street and takes a critical eye towards the actions of investment banks. A standard liberal response would be to load up Wall Street with as many regulations as possible. A standard conservative response would be that laws created by Washington, DC (such as the community reinvestment act) forced the banks to take unnecessary risks and that they therefore are not directly responsible for the outcome of the crisis. Thorp acknowledges the bad behavior of banks and believes in sensible regulation, but thinks that we would do much better off by enabling shareholders to better combat bad behavior by the management of public companies rather than pursuing excessive regulation.

Thorp also has a very unique perspective on the 1980s junk bond boom. While acknowledging that Michael Milken was responsible for illegally enabling insider trading, he believes that Milken was not a target solely for his illegal acts. Milken’s illegal activity was magnified and pursued by the authorities because Milken financed an assault against the established corporate order. The established corporate order was far more entrenched politically and pleaded with politicians to shut him down. Thorp also has an unfavorable attitude towards Rudy Giuliani, whom he believes pursued these scandals less out of a sense of justice and more for political gain.

He’s also quite critical of the hedge fund industry, arguing accurately that hedge funds rarely deliver returns that justify their high expense ratios. This is quite ironic because Thorp launched one of the first modern hedge funds.

A Wild Trade

One of my favorite stories in the book involves an amazing trade that Thorp came across in 2000 at the height of the internet bubble. It is a story that could come straight out of Joel Greenblatt’s You Can Be a Stock Market Genius. It also gives insight into the level of financial insanity that fueled the internet bubble.

Back in March 2000, 3COM owned Palm Pilot. 3COM spun off 6% of its interest in Palm in an IPO. Due to the mania that was consuming market participants at the time, every technology or internet oriented IPO would immediately be bid up to an insane valuation on the first day of trading. Palm was no exception, but the level it was bid up to was truly absurd. After the first day of trading, the market valued the Palm IPO at $53.4 billion but valued the parent company (that owned the other 94% of Palm) at only $28 billion! In other words, the 6% share of Palm was valued more than the other 94% owned by 3COM plus all of 3COM’s other business interests. Thorp shorted Palm and went long in 3COM, in an incredible trade that would never have been possible if markets were efficient.

Investment Ideas

Thorp is a strong advocate for buying index funds, but he also offers a couple interesting ideas for investors to make above average returns.

The first fascinating idea is taking advantage of Savings & Loans that issue new equity. Thorp will open up a deposit account in a savings & loan that he suspects will eventually take a new equity offering public. Because depositors get a share of any new equity issue, Thorp then applies for a position in the new equity offer which typically sells for nearly double of the original price that Thorp paid for it. If he feels the savings & loan is well-managed, Thorp will hold onto the position for much longer periods of time. Thorp opens up multiple deposits in S&L’s throughout the country and then patiently waits for an equity offer. This was immensely profitable in the run up to the S&L crisis when S&L’s were hungry for new capital. The game has slowed down in recent years, but it sounds like those opportunities can still be identified.

The second idea is buying closed end funds at a discount and shorting closed end funds at a premium. This was an idea I was previously familiar with (Graham was an advocate of the strategy, at least the long portion of it). Closed end funds are publicly traded investment vehicles that can only be redeemed through trading activity. There are fixed number of shares and market participants determine the price. However, like a standard mutual fund, you can easily assign a net asset value to the shares. Unlike a mutual fund, you can’t redeem your investment at NAV, you have to sell it to someone in the open market at whatever they’re willing to pay.

In other words, there is no guesswork involved in determining the value of a closed end fund, but the shares trade openly and the price relative to the NAV frequently changes. Shares of closed end funds frequently trade at a significant discount or premium to their NAV. Efficient market types will say that these price discrepancies occur because the market is speculating on the riskiness or promise of the assets that the closed end fund owns. However, during the financial crisis, Thorp was able to acquire closed end funds that owned nothing but treasuries (an essentially risk free asset) at a substantial discount. Barron’s maintains a nice list of closed end fund NAVs and premium/discount that investors can take advantage of.

Bernie Madoff

A particularly fascinating passage in the book is one in which Thorp uncovers the Madoff scandal all the way back in 1990. While auditing investments for another firm, Thorp investigated Madoff because the firm had investments with Madoff. Thorp at first suspected that Madoff’s slow and steady returns every month (Madoff “earned” 1-2% every single month and never lost) might be fraudulent. Thorp confirmed this suspicion when, after checking with the exchanges, he confirmed that none of Madoff’s alleged trades actually happened. Thorp could have alerted the authorities back then, but he suspects they wouldn’t have done anything about it, so it wasn’t worth getting into the weeds. He’s right, of course. Harry Markopolos came to a similar conclusion and tried to alert the authorities about it and no one would listen (in fact, the SEC investigated and cleared Madoff of wrongdoing), and Harry spent years worrying that Madoff would try to take him out in some way. It sounds like Thorp made the prudent choice without making a big splash: advise his client to get out and lay low about the finding.

Conclusion

Edward Thorp is a living, breathing refutation of the efficient market hypothesis. He’s an iconoclast who refused to accept the conventional wisdom about markets or casinos. He had a lifelong love of learning which he allowed to pursue a fun (and profitable) adventure. His journey is a fascinating one that I thoroughly enjoyed. I recommend the book to anyone interested in a great story about a unique genius.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Domino’s: Mean Reversion in Action

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I love this story. Not simply because I love pizza (my philosophy is that even bad pizza is good pizza), but because it’s a great example of mean reversion in action. One should never write off a company that is struggling. Companies with a poor return on equity can take steps that can turn their situation around and often do.

By 2010, Domino’s stock was devastated. The stock was down 57% from 2005 to 2010. It was struggling with a battered and beaten brand in a boring industry. They successfully turned the situation around with some creative thinking and hard work. Since the strategy change, Domino’s is now up 1,453%. That beats the storied Amazon, which is up 557% over the same period. It all happened in a boring, conventional industry with a company that Wall Street wrote off.

Domino’s isn’t currently the kind of stock I would buy. It is currently trading at 42 times earnings. It’s a great company but I’m not getting any margin of safety from the investment. With that said, there were numerous opportunities in the 2010-2012 period when it had a solid margin of safety.

It is a story like this to keep in mind the next time a growth investor asks you “why are you investing in this crap?” Crap can turn to gold. It happens more often than is typically appreciated.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.