The Inoculated Investor's  Instablog

Company Background

Altisource is a company that was recently spun off tax free from Ocwen Financial (OCN) and now trades on the NASDAQ under the ticker ASPS. Every three shares of OCN entitled investors to a single share of ASPS and the separation was completed on August 10^th, 2009. The company operates under three different segments/divisions: Mortgage Services, Financial Services and Technology Products. ASPS does business in all 50 states and 4 other countries. While its client list contains more than 75 companies, ASPS relies primarily on OCN and American Express (AXP) for the majority of its revenues. Specifically, relationships with OCN and AXP generate about 2/3rds of total revenue. Accordingly, one of the reasons for the spinoff is to pursue diversification of this customer base. Management believes that as a separate entity ASPS is more likely to cultivate relationships with third parties. However, in the near future there is no reason to believe that ASPS will not still be very dependent on OCN and AXP for business.

As of December 31^st, 2008, the company had 2534 employees, including 651 in Mortgage Services, 1,254 in Financial Services, 479 in Technology Products and 150 in Corporate. The number of employees has likely decreased a good deal since then as ASPS has been very proactive in terms of eliminating positions within the struggling Financial Services division.

Valuation

After trading down to around $10 after the spinoff, the stock has risen sharply to the current price over $13.50. As a result, based on even some optimistic assumptions about future EPS, the stock does not look particularly cheap.

Sources: Capital IQ, company filings, and additional calculations

In addition, even when earnings valuations are not attractive, it is important to look at the balance sheet to see if there is a sufficient margin of safety based on the company’s assets. In this case the results don’t make the stock look any more compelling at the current price:

Sources: Capital IQ, company filings, and additional calculations

At almost 5x book value and 15.7x tangible book, ASPS will never be confused with a Benjamin Graham net-net. In fact, when the earnings valuations are combined with the book value multiplies, it becomes clear that the market is pricing in substantial growth. Now, with the state of the housing and commercial real estate markets, it is very possible that both the Mortgage Services and Technology Products divisions are going see increased demand. Thus, revenue and earnings may continue to grow and eventually justify the multiples. However, the growth multiples leave no room for a margin of safety and thus preclude most value investors from being more constructive on the stock.

Profitability

Having established that shares of ASPS look too expensive for a value investor at the current price level, it is important to analyze the data regarding historical profitability in order to ascertain whether or not this is a company that investors should continue to monitor. Below is a chart on margins and returns:

 *2007 ROE is based on 2007 equity levels

*2008 and 2008 pro forma ROE is based on the average of 2007 and 2008 equity levels

* June 30^th annualized ROE is based on 6 months of income and average equity between Q4 2008 and Q2 2009

^2008 pro forma data includes the add back of a non-recurring interest charge

Sources: Capital IQ, company filings, and additional calculations

From a profitability perspective, it is very positive to see the trend of increasing margins. This could be a sign of increased efficiency and economies of scale that will only improve as ASPS is able to cultivate additional third party relationships. The problem is that it is very tough to know what ASPS’s cost structure will look like as a standalone company. Also, the very impressive margin increases from fiscal year 2008 to the 6 month period ending June 30^th are difficult to gauge in terms of sustainability.

Looking at the data, most of the improvement appears to be coming from revenue increasing faster than COGS and the resultant higher gross margin is helping boost operating income and net income. Also, there could be some pressure on gross margins going forward based on additional SG&A spending in the form of marketing, but the truth is that the margin trends are generally very positive. If ASPS were able to turn the Financial Services business into a profitable segment through additional rationalization of costs, the company wide margins could even improve further. There is no doubt that the emerging opportunities to add revenue and measures to continue to increase efficiency could lead to sustainable gross margins in the 20-25% range. While even that margin structure would not result in the current price looking particularly compelling, if ASPS could establish those margins as a baseline then this absolutely looks like a company and stock to follow on a regular basis.

Competitor Comparison: Valuation and Profitability

ASPS is unique in that it is made up of as assortment of businesses that makes it tough to find perfect comps. However, after some digging, the competitors that emerged as relatively good comparisons were Lender Processing Services (LPS), Fiserve (FIS) and Portfolio Recovery Associates (PRAA). While none of these is perfect, they all have divisions and segments that compete in some way with ASPS. Specifically PRAA’s business model is similar to that of the Financial Services business at ASPS. Next, FIS has a financial institutional services segment that is not too different from ASPS’s Mortgage Services division and FIS offers technology services to its customers. Finally, LPS has a technology segment that caters to the same clientele as ASPS’s Technology Products group and has a loan transaction division that is similar to ASPS’s Mortgage Services group. Thus, out of the three, LPS looks like best comp but FIS is not too bad and PRAA provides an interesting reference point on the margin potential for a well run asset recovery business.

The following chart highlights the average margins and ROE of these companies over the last few years. What immediately stands out is the extent to which the competitors have traditionally much more robust margins (aside from ASPS’s 1H 2009 margins). This could indicate that ASPS has the opportunity to expand its margins as a standalone company to match those of the competitors. Also included are the margins from the 1^st half of 2009 so that investors can begin to ascertain whether or not they are sustainable. (Click on the chart to expand it)

*Sources: Capital IQ and company filings

It is striking how much lower ASPS’s margins have been (on average) over the last few years than those of the three competitors. There is no way to verify this supposition, but it is possible that OCN was not paying ASPS prevailing market rates for its services. Therefore, as those rates reflect current market conditions more and more, it is only logical that both gross and operating margins will increase.

Sources: Capital IQ, company filings, and additional calculations

Investment Conclusion

The original thesis was that the spinoff of ASPS into a relatively uncertain market could lead to a dislocation between intrinsic value and price. Either because of the financial focus of the company (there was a time when all companies that were involved in mortgages were unloved) or due to institutional selling post spinoff, in theory there was definitely some bargain potential. However, after the recent run up and based on a couple of different valuation analyses, the stock looks to be a bit overvalued. In fact, at the current price the market is allocating some higher-end multiples to the stock. Even given the very positive data through the first 6 months of the year, at the current valuation the risk-reward equation is not particularly compelling. Value investors are understandably wary of situations in which they are paying up for earnings growth.

Therefore, this is the kind of company in which John Templeton would have employed the following strategy: determine a conservative estimation of intrinsic value and an associated price that contains a margin of safety and then just monitor the stock. Mr. Market has been extraordinarily fickle and in a flash of irrationality the price could fall into an acceptable range, especially since this company is associated with the dreaded housing and commercial real estate markets. Based on conservative estimates and the OCN dependence, a fair measure of intrinsic value is around $12-$12.50 per share. If standalone, run rate EPS is going to be about $1 by 2010, then applying a reasonable 12x forward multiple produces a value of $12.  Similarly, if run rate EBITDA is going to be about $40M or $1.67 per share, placing a 7.5x multiple generates a value of about $12.50. Therefore, if the stock were to drop to about $10, that would provide a reasonable enough margin of safety to begin accumulating shares. However, if ASPS can continue to show margin improvement and diversify its revenue sources away from OCN, then investors can legitimately become more constructive on the stock as EPS and EBITDA would likely increase further. 

1.       Given your background, how do you look at real estate?

I know this is going to sound a bit strange to people who only started looking at real estate during the boom, but I look at real estate more like a bond than a stock. In other words, instead of thinking of real estate as a rapidly appreciating asset, I look at rental income as being similar to coupon on a bond. When my family invests in real estate, we don’t think about how much more we are going to sell it for in the future. What we try to figure out is how much we can rent it for, what kind of yearly increases we can negotiate, and how much time and capital need to be put in on an ongoing basis. Obviously, during the boom people weren’t interested in stable tenancies and leases that protect against the downside. They looked at real estate as if it were as liquid as stocks and thought properties should appreciate as fast as equities often do after a market correction. However, in periods when there is not excessive speculation and leverage entering the real estate market, these assets are slow growth vehicles. In theory, they should not grow any faster than the rate of increase in rents. Accordingly, when commercial real estate and housing finally do bottom, people should not expect values to recover for many years. Anyone who is holding onto a piece of real estate until the market “comes back” will likely be waiting a long time unless the Fed is able to create another asset bubble.

2.       What has the financial crisis taught you, especially when it comes to investing? How have you evolved as an investor?

I think when I look back on this period of my career, I will be very thankful that I cut my teeth in such adverse market circumstances. It’s much better to learn certain lessons now (when there are only a few zeroes involved) than when the stakes are much higher. The crisis has just reinforced my view of the role of a manager. As Howard Marks so eloquently says, the duty of a money manager is to protect capital and manage risk. It is really that simple. If you focus on a margin of safety, have disciplined buy and sell requirements and strategically hedge downside risk, you are fulfilling your fiduciary duty as a money manager. Along the same lines, it is imperative to remember that leverage is a killer. The common denominator in every bubble I have ever examined is excessive leverage. I am currently reading a book called Funny Money (by Mark Singer) that is about the oil lending boom in Oklahoma and Texas that led to the notorious failure and bailout of Continental Illinois. This episode represented the beginning of the too big to fail era among banks that obviously still exists today and basically defined what moral hazard would look like going forward. I’m sure you will not be at all surprised to learn that root cause of the bank’s flameout was too much and too rapid lending combined with inadequate analysis of credit. Does that sound familiar?

3.       What financial issues concern you the most?

Oh my, I really don’t want to depress the readers! Anybody who follows me knows that I am quite bearish in the short run but am also legitimately concerned about the long run ability of the US economy to remain vibrant and innovative. I think we have structural imbalances that need to be addressed and it makes me sick that the leaders of this country seem unwilling to face these issues. You have to remember that I am not an economist so this is not my specialty. However, it seems to me that America became a “too much and too many” country over the last 30 years or so. We have too much debt, too many stores, too many banks, too many dodgy loans, too many cars and too many big houses. We use too much energy and we pollute too much. Unless the Fed and Obama can find a way to prolong the necessary day of reckoning, I believe we may soon find ourselves living in a “too little and not enough” country. In retrospect it will be clear that we saved too little, put too little money into Social Security, invested far too little in education and did not do enough to address climate change and health care reform. I really hope that I am wrong but I am not as optimistic as Buffett is that future generations of Americans are guaranteed to enjoy a better standard of living than we do.

4.       Do you have an opinion about inflation/deflation?

I think this is probably the most fascinating debate going on right now and the eventual outcome will likely be the main determinant of what asset classes perform and underperform over the next decade. My current view is that at least temporarily we have seen a bizarre combination of commodity price increases, severe credit contraction and wage deflation. This seems to me to be a particularly insidious cocktail and is why Main Street is struggling so much. In the short run, despite the Fed’s attempts to pump liquidity in the system I see deflation as a much more relevant risk. But in the long run it is hard for me to see the Fed exiting their money printing in a smooth way that somehow prevents inflation and simultaneously avoids stifling a recovery. The Fed is kind of like a bull trying to walk out of a china shop. Yeah, maybe it doesn’t break all the plates but it sure leaves some collateral damage in its wake. I guess I don’t share the blind faith that the Fed can be precise in its monetary policy. So, I’m not sure if Marc Faber and Jim Grant are right about the possibility of hyperinflation, but it is hard for me to see how the dollar and our purchasing power are not the eventual casualties of the Fed’s doubling of its balance sheet.

5.       Where do most value investors screw up?

I like to think that the recent turmoil in the markets will separate true value investors from what Klarman calls value pretenders. The latter are investors who only knew appreciating markets, never really considered intrinsic value and thought that buying dips was the same thing as value investing. In a Darwinian kind of way this crisis could have a silver lining, at least in terms of separating the truly skilled from those who benefitted from the rising tide.

When it comes to legitimate value investors, I think there are two common mistakes. The first is thinking that a stock can really be market agnostic. When there is either excessive euphoria or extreme fear in the markets, stocks that should not be correlated to one another seem to move in the same direction. The appropriate lesson is not to become a closet macro fund and try to time economic cycles. The answer is to be like Klarman: focus on company specific analysis but make sure that the macro environment is not unambiguously going another direction. Second, I think that value investors are often too quick to trust the markets to close the gap between intrinsic value and price. I am not suggesting that we all become technical analysts, but it is important not to forget that certain exogenous forces can have a tremendous impact on the markets. Last year we saw what forced and panic selling can do to stock prices and this year we have seen how Federal Reserve liquidity injections can turn a market speculative just about overnight. So I think it is useful to be at least aware of ways that overall market distortions can affect the process of value realization, especially with the number of players out there who have the incentive to manipulate the market.

6.       You have a reputation as a diligent & structured investor. Tell us about your use of checklists.

I am a huge fan of checklists. I soon need to sit down and write down every metric that I evaluate about a specific company. Right now my checklist exists in my mind and on an Excel spreadsheet template that I use for just about every company.   Don’t get me wrong, this is not a DCF model with specific assumptions about growth and an arbitrary terminal multiple. I clearly understand the false precision that comes with such models. I just like to aggregate all the quantitative information--from margins to insider ownership to valuation metrics—in one place. It really helps me frame the company before I engage in a longer write up in which I include the qualitative factors as well. The benefit of this strategy is that it forces me take a very comprehensive view of a company. For example, let’s say a company has an interesting product or division that you think is under appreciated by the market. Without calculating the operating margins for each subsidiary you might not notice that this very profitable division is being dragged down by a low margin business that just sucks up capital. So, even though the number of items on the checklist can lead to a bit of informational overload, I firmly believe that it helps me avoid overlooking important characteristics.

7.       What single trait is most important to cultivate in order to be a successful investor?

Without question being a successful value investor requires a certain temperament. It is very hard to be greedy when others are fearful. Humans are not wired to be contrarians. We like the safety of the herd. Value investors measure the magnitude of an opportunity based on how sick they feel when they make the actual investment. The more consternation establishing a position causes, the better the returns are likely to be. Accordingly, developing an even temperament in which you don’t get excited when stocks are going up or get downtrodden when your positions are moving against you requires a significant amount of discipline.  While I do think some people are predisposed to being able to control their emotions and stick to their investment philosophies, it absolutely takes practice. Even some of the best investors became paralyzed during the free fall in equity markets during the early part of this year and the ones who have been the most successful loaded up on stocks they had strong convictions about during that period. So, as Warren Buffett has said: “By far, the most important quality is not how much IQ you’ve got. IQ is not the scarce factor. You need a reasonable amount of intelligence, but temperament is 90% of it.” Along the same lines, I don’t know if I can take credit for making this up but my mantra is to be passionate about the markets but to invest dispassionately. I think if I can follow that I will end up being an accomplished investor.

8.       What is the hardest bias for you to overcome?

In my case, I am constantly fighting to avoid becoming a victim of confirmation bias. I am definitely guilty of searching out information that agrees with my philosophies and views on the markets. I also often too easily dismiss opinions that are contrary to mine and too readily accept those that mesh with my views. Accordingly, I make a concerted effort to read anything I can find that offers the other side of an argument. Even though it feels just as painful as being outside of the herd, it forces you to understand the contrarian position in a way that can help you make better decisions.

9.       Where do you see yourself after business school?

My goals are very simple. After I graduate I hope to have the opportunity to work for a value fund in which I have access to a portfolio manager who is willing to be my mentor. I anticipate that my research skills will get better with more practice. However, I have never had the luxury of being able to watch a skilled value-focused manager navigate the markets. It is not hard to analyze individual stocks. Managing my own portfolio is a challenge, but nowhere near as nerve wracking as managing other peoples’ money. Thus, if I am lucky I will be able to find a job with a value manager in which I can spend a lot of time observing and learning how to run a portfolio day to day. Eventually my goal is to be a portfolio manager myself and the dream is to run my own fund. I am aware that I am probably many years from reaching that milestone and have more to learn than I can possibly even describe. But I look at business school as a conduit for developing relationships that will help me along the way. I also plan to continue doing a significant amount of company specific research outside of the classroom so I can continue to further my skill set.

10.    What message/advice would you give to readers of SimoleonSense?

My advice to readers is to look in the mirror before you decide how to allocate your precious capital. Investing is black and white in one way: either you have the skills and time to become a professional investor or you don’t. Honestly, while I hope I am qualified I am still working every day to figure out which camp I fit in. The truth is that it is OK if you don’t have the time, the temperament or the skills. You have plenty of wonderful value managers that you can entrust with your money. You can also buy an index and do better than most mutual fund managers. Managing a portfolio of individual companies is a full time job. Please, never forget that. The attention to detail and time required to follow and understand a portfolio of stocks are not trivial. If you cannot perform deep and comprehensive bottom’s up analysis on specific companies I would suggest that you are better off letting someone else manage the equity portion of your portfolio.  I worry that CNBC and Jim Cramer lead far too many people to think this is a game that anyone can play. It is unquestionably not. Just like you wouldn’t want someone performing open heart surgery on you after watching a TV show about doctors, you should not be trying to pick individual stocks after doing a minor amount of research. Let someone who will act as your fiduciary do that for you. 

11. Thank you very much for taking the time to interview with us.

Thanks for the wonderful opportunity to present my ideas. I hope everyone finds my responses valuable. I look forward to having another chance to share my thoughts with your readers.


(Dislcosure: No Positions)

And the subject of the interview is.....well, me. I want to thank my good friend Miguel Barbosa of Simoleon Sense for giving me the opportunity to share my views regarding value investing with his readers. Miguel came up with some fabulous questions and I hope I was able to do them justice with my responses. I am very excited about this unique opportunity to share the lessons I have learned and describe both my background in and passion for investing. For those of you who are relatively new to value investing I like to think it offers a valuable review of some the most basic tenets and principles.


Due to the length of the post I am going to split it up into two separate parts. As always, feedback is welcome and appreciated. Hope you enjoy.

1.       When did you first become interested in allocating capital?

The funny thing about me is that I was a value investor before I had ever heard of value investing as a discipline. In my former life I was a commercial real estate professional and one of my duties was to be a steward of my family’s capital. In that role I analyzed hundreds of opportunities to purchase existing buildings or develop new properties. I think it is a testament to my discipline that from 2003 to 2007 there was only one deal that I actually advised my family members to invest in. During that span I had dozens of what turned into contentious discussions with real estate brokers who were desperately trying to convince me that this was a great time to buy and that paying a 4% cap (which is like an earnings yield on a stock) for a Walgreens in Indianapolis made ultimate sense. I feel bad for the people who were swindled by these brokers and bought near the peak of the bubble. Luckily, even before I had heard of Ben Graham I understood that the return you receive has to compensate for the risks you are taking.

When it comes to stocks, the indoctrination into value investing that has led me to want to manage money professionally all started when I read Ben Graham’s The Intelligent Investor. I know it sounds almost cliché, but there is something about the investment philosophy that Graham details in this book that just clicked with me. If you look at my blog site, I have two quotes from prominent investors that articulate my attraction to value investing better than I ever could:

Seth Klarman (Baupost Group): “It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.”

Mohnish Pabrai (Pabrai Funds): “Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human brain--that for some of us--makes all the difference in the world right away and the patience it requires is part of the wiring process.”

2.       Currently you work as an analyst and run the Inoculated Investor Blog. Why did you start the blog? Where do blogs like yours fit in among the financial journalism and equity research spaces?

Well, my days as an official analyst are over, at least until I graduate from UCLA with my MBA. However, I plan to continue working on the blog as much as I possibly can. The reason I started the blog was that I literally had a running dialogue about the markets and economy in my mind. It was actually driving me a little crazy and I badly needed an outlet. Fortunately for me I was able to launch the site with content that was quite unique. I attended this year’s Berkshire Hathaway annual meeting and I was literally the only person out of the thousands there who was crazy enough to try to write down every word that Buffett and Munger said. As a result, my meeting notes were more complete than those of others and after I posted them the entire value investing portion of the blogosphere was linking to me.  It was a very good way to start off my blogging career.

Since then I have focused solely on adding value to my readers. My goal is to try to make what can be very difficult material accessible to non-professional investors as well as people who work in the markets. I think my particular niche lies directly in between the financial articles you read in the Wall Street Journal and the equity research created by analysts.  I often find the articles in the financial publications to be incredibly cursory and that the research barely scratches the surface. On the other hand, in depth company specific equity research is really only compelling to professional investors.  So, as opposed to using my blog as a glorified version of Twitter, I try to walk the line between boring readers with too much detail and offering insight that any novice could come up with. For example, I often post links to other sites with commentary so that I can expand on the topics covered by others. But I also have a section of my site that has samples of the actual equity research I presented to my bosses. I like to think that this makes my site somewhat unique.

3.       Mark Sellers stresses the importance of clear writing as proxy for clear thinking. You’re a fantastic writer- How does this skill translate into thinking through investment ideas?

What I love about Seth Klarman and Howard Marks is how articulate they are. Something about the way they talk about value investing resonates with me. Along with Buffett, they are my role models as a writer. For me writing is the best way to present my ideas. I readily admit that I am nowhere near as articulate or persuasive when I speak about investing. It is something that I obviously hope to get better at. I have seen firsthand that the way portfolio managers talk about their investment philosophy and discipline can dictate whether investors are comfortable or not.

Until I am fortunate enough to have investors of my own, my focus will be on presenting my ideas in written form. As an equity research analyst, you are only as good as your written research. You have to be able to present your ideas and recommendations concisely without sacrificing the obviously necessary depth.  PMs are often very busy and you must avoid wasting their time or even the best idea will get pushed aside. For me, I sometimes don’t even know how I feel about a stock until the write up is complete. Until that point everything is so abstract and the information is so segregated in my mind that I don’t have a complete picture. But, once all of my research is aggregated I feel much more comfortable making recommendations and explaining the investment thesis.

4.       Which investors do you admire? Besides these investors who else has influenced you?

I have already discussed this to some extent but I am happy to elaborate. In my young career I have been most influenced by Buffett and Klarman. I actually launched my blog with a post in which I discussed my vision of the optimal portfolio. Ideally, it would contain some Buffett stocks (great companies at a fair price) and some Klarman stocks (fair companies at a great price). I think these men frame value investing in a way that no other people can. It is not a surprise that the best quotes I have ever read regarding investing come from these two luminaries. I also lump Howard Marks in that group even though Oaktree does not focus on equities. The fact that Marks’s words strike me as so profound even though he invests in another asset class is more proof that value investing is a universal discipline that does not necessarily require a specific context. It also shows that the language translates well across asset classes and can even teach some very valuable life lessons.

5.       What is it that you like about value investing specifically? In other words, what about it attracts you?

This is an easy one for me. Anybody who knows me is aware that I am a little cheap. I have been so ever since I can remember. While that translates into plenty of backhanded complements in my social life, I think it makes me uniquely predisposed to value investing. I am just not geared toward taking large risks or investing based on an optimistic future. I know that humans are terrible at forecasting and I would rather focus on what a company is worth right now rather than what it could be worth if all these assumptions prove to be right. I think that is why Graham’s analysis was so intriguing to me. He searched for $.50 dollars almost exclusively by focusing on the balance sheet and refused to pay up for growth. I am generally very cautious when it comes to money and Graham’s investing style that focuses on a margin of safety is perfectly suited for a careful and deliberate person like me.   

6.       What’s your approach to fundamental analysis? What’s your edge?

The development of my edge is a continual process but based on early returns I would suggest that my edge is made up of my willingness to dig and to look where few others are looking. Regarding the former, I don’t look at companies as single entities. Most companies have a number of different operating units or products that have different costs and margins structures. Accordingly, as I dig my goal is to understand each individual business component in terms of what drives profitability, what generates costs and what the opportunities or headwinds are.  More and more I have become a margins guy in that I assess the quality of a business based on the operating margins it produces. There is no question that for the company as a whole free cash flow is paramount to me. However, before I can determine whether cash flows are sustainable, I need to understand a company’s competitive advantage. This is an element that I believe can be evaluated using operating margins. Thus, I think it is the granular knowledge that I require in order to be comfortable with an investment that distinguishes me from investors who focus mostly on earnings.

Additionally, I am not foolish enough to think that I can add a whole lot of value to an analysis of Microsoft. I see huge companies that are well covered by the sell side and are widely owned and researched by institutional investors as basic proxies for the S&P 500. In other words, these stocks are by in large going to move with the market, barring extraordinary company specific news. While large cap stocks can become mispriced, I think it is better to fish in a pond that is more likely to see lasting and significant dislocations between intrinsic value and stock price. Therefore, I like to look at spin offs and companies that are not covered by many sell side analysts. Plus, I have no problem investing in small and mid caps as long as there is ample liquidity in the stock. If you take a look at the companies for which I have research posted on the blog you will see my bias. Hurco, Movado, Ceradyne, IPC Holdings: these are not necessarily household names but they are still successful companies that at certain times have generated attractive returns on capital. So, this is where I think investors are most likely to find compelling value.

7.       Give us an example of your best and worst investments? What did you learn?

Since I am not a portfolio manager, I think it is more appropriate to discuss my best and worst recommendations. As an analyst my job is not to invest for myself but to come up with ways in which my fund or other investors can make money. First, my best recommendations have come in the regional banking sector. The two short calls that proved to be the most prescient were on Wachovia and Guaranty Financial. For those who are not familiar with these banks, Wachovia was forced into the arms of Wells Fargo as the share price neared $0 and Guaranty recently filed for Chapter 11 and the remnants were picked up by Spanish bank BBVA. These stocks were trading in the mid teens and my analysis of their balance sheets and credit deterioration led me to believe that both had the potential to go to $0 (and in fact they both basically did). Neither of these were obscure names. Wachovia was a household banking name and Guaranty had attracted famous investors such as David Einhorn and Carl Icahn. What I learned from my experience with these companies was that if you can develop an edge in a certain industry you can take advantage of the market not fully understanding the prospects or fundamentals of certain stocks. During the boom years investors did not focus on bank credit or capital, they just saw the prices going up, solid ROEs and stable dividends. Accordingly, when things got bad very few people had the experience or the ability to scrutinize the balance sheets of these banks. As a result they either did not sell quickly enough or bought after dips and got clobbered in the end. This showed me that investment opportunities can be hiding in plain sight. It also taught me to never trust that the $100 bill lying on the sidewalk is not actually there just because the Efficient Market Theory says that someone would have picked it up if it were there.

On the flip side my worst recommendations had to do with underestimating the extent of the financial crisis and consumer spending downturn. I remember after the $120 a share Harman buyout by Goldman and KKR fell apart I thought the broken deal could lead to an interesting opportunity. The stock was around $70 and looked like quite the bargain when compared to buyout price. Well, the stock is $27 now as companies who rely on auto sales have been absolutely crushed. My biggest mistake was becoming anchored to the $120 offer price as if that were a measure of intrinsic value. I now understand that the presence of excessive leverage (hence the term leverage buyout) can skew the price of any asset. Additionally, despite the fact that I had a negative macro outlook, especially when it came to discretionary auto sales, I thought Harman had a stable business model that would not be harmed by the coming recession. Accordingly, I failed to adequately follow Klarman’s strategy in which he invests bottom’s up but worries top down. As a result of this and other similar mistakes I am now fully aware that even value investors cannot completely ignore what is going on in the broader economy. In other words, there are very few companies whose fortunes are completely independent of the business cycle or wholesale movements in the stock market.

8.       How do you look at risk & uncertainty?

To me, risk is nothing other than the potential for permanent capital impairment. Risk is not volatility. If a stock goes down 50% it likely is not more risky than it was at the higher price. If your favorite cereal is on sale for 50% off at the grocery store you don’t refuse to buy it because the price has fluctuated.  As long as you still like it you should be comfortable buying twice as much. In this way stocks aren’t a whole lot different from boxes of cereal. My goal as an analyst and investor is to avoid situations that involve obvious risk or capital impairment but to take advantage of uncertainty. Uncertainty comes about when market participants have very little visibility into a company’s future and it can lead to severe dislocations between price and intrinsic value. Whether fear is caused by potential government regulation, concerns about demand, or changes in management, value investors who have in depth knowledge regarding companies can often find ways to benefit from uncertainty. What you don’t want to do is buy something that looks certain because you are likely to pay a premium price.


(Disclosure: No positions)

It’s Labor Day Weekend. What are you doing sitting at home? Go out and spend! There are endless numbers of sales going on at your favorite retailers. Forget that your credit card is maxed out, you are late on your utility payments and that you are trying to get the bank to reduce the face amount of your mortgage. If you don’t leave the house to buy things and eat fancy dinners there is no way the US is going to recover from this recession. It is your duty as an American to help us spend our way out of the current economic malaise, irrespective of the additional debt you are forced to take on to achieve this universally desirable goal. The idea that people should save their money and live within their means only applies to those countries over there in Asia. Americans are innovative and resilient. We are not going to let something as trivial as an excessive amount of debt (that must eventually be paid back) get in the way of living the life we have always dreamed of. Please, take your cues from the US government and borrow and spend more so we can get back on the path towards limitless prosperity. Don’t worry about those who say we cannot consume our way out of a debt-induced crisis. They are either un-American or are just jealous of our position in the world.

Forgive the hyperbole but this is disturbingly similar to the message being sent to the American public by both the corporations that rely on consumer spending to reward shareholders and pay huge bonuses and the government that seems to think that if we can just go back to 2006 everything will be fine. I think the widely popular Cash for Clunkers initiative embodies perfectly the sentiment espoused above. Have a car that is already paid off but think you could use a shiny new ride? The US government can help. In exchange for your old jalopy and a car note that only increases your debt burden, the government will subsidize your desire to drive around in style. And guess what? A wonderful side effect is that your purchase will help the struggling automakers that the US government now owns. It’s a win-win for everyone. Well, except for maybe your balance sheet that now is even more strained.

It was with all of this in mind that I came across a posting on Zero Hedge with commentary from the chief economist at Saxo Bank. An idea that I don’t think gets anywhere near as much attention as it should is the one whose premise is that the US consumer has basically hit a debt wall.

To me, it looks like the consumers have finally hit the wall where there is essentially no pent-up demand left. After decades of systematic and constant demand stimulation via artificially low interest rates and the emergence of the “demand driven economy” (as if there ever was any such thing!), we have succeeded in borrowing so much from future demand that our present GDP has been overstated by 10-30%. How many resources have been put to use in order to make American consumers push their excessive debt-financed consumption to new highs? How many malls, shopping centers, financial intermediaries, debt extension companies and SUV dealers have been set up for which there is no long-term use? And by how much has that overstated prior GDP figures, since these types of companies were mal-investments and need to be written off?

In my eyes, it wasn’t the subprime housing market that caused the crisis; that collapse was just a symptom of the consumer no longer being able to service his/her debt. In other words, this was a balance sheet and solvency crisis from the beginning. Yes, maybe that caused a liquidity freeze but that was also just a symptom. I think when historians look back on this period they will easily conclude that the Anglo Saxon world accumulated so much debt that one day that burden became unsustainable and caused a necessary but painful unwind of the economy. I also think they will look at government initiatives that pulled forward demand and induced irrational spending (such as Cash for Clunkers) kind of the way we look at the economists of influence in the 1930s. They will ask without any lack of condescension: “What in the world were they thinking?” Instead of a debt crisis our current leaders saw a liquidity freeze. Instead of encouraging frugality and debt repayment (however painful that would have been in the short run) they expected people to consume in order to prop up a failed economic system that was far too dependent on frivolous spending.

Has it occurred to anyone else but me that we take the fact that 70% of US GDP is based on consumption as if that number were ordained by God? Seriously, that percentage is quoted so much you almost start to believe that it is etched in stone or is the secret code that leads to sustainable prosperity. What if it really means our economy was incredibly imbalanced? What if it means that Obama’s attempts to make us spend more are actually making things much worse? No company ever fixed its over-levered balance sheet by engaging in even more debt fueled spending. So, how is that the US consumer is going to achieve this miracle? From the piece by Saxo Bank:

The Keynesians never get tired of telling us that 70% of GDP is consumption. This is obviously a misleading statement as if we can consume ourselves rich. If we want growth in the Western economies, this percentage has to come down and investment and savings should be higher. This is the only long-term solution to the extreme difficulties that we are confronted with. Only by growing our capital base will we be able to increase production and growth. It is time we learn from the Chinese or simply look in the history books and be inspired from how the economy of our ancestors could grow even though they didn’t consume 70% of their income immediately. (Emphasis mine)

The future economy of the Western countries will be investment-driven  if driven at all. Unfortunately, it also means that the companies that are most dependent on consumption will be underperforming in the years to come. Demand is permanently impaired and will not come back to 2007 levels soon.

What this implies is that the underlying demand for consumption that existed during the boom years may be reduced or limited for a long time as people repair their balance sheets. As I continue to stress, the US has an incredible amount of excess capacity of businesses that depend on an unsustainable amount of spending. We built too many malls, too many restaurants, too many drug stores, and made the conscious decision that convenience trumped economic realities. Why else would there be a drug store, bank, nail shop, and convenience store on every single major intersection of every city and town in the US? These amenities were built to cater to peak demand (that may never be revisited) and were based on the idea that supply and demand did not matter because the consumer was always willing to spend for proximity and convenience. Now these ideas are being turned on their heads as people are forced to spend less, eat at home more often, eliminate discretionary purchases and go out of their way to save money. This is a particularly toxic combination of incentives from the perspective of those companies that relied on a complete lack of fiscal restraint in order to prosper.

Based on all of this, what can we conclude about the potential impact on stocks of this excess capacity and reduced consumption? Well, it can’t be good for restaurants that need people to eat out as opposed to cooking at home or for retailers that offer goods whose purchase can be foregone without much of a detriment to an individual’s lifestyle. Powershares Dynamic Leisure and Entertainment (PEJ) is an ETF that holds stocks such as Carnival Corp (CCL), Darden Restaurants (DRI), Cheesecake Factory (CAKE) and Starbucks (SBUX). From a low of $6.15 in November 2008 this ETF has just about doubled and trades around $12. Call me naïve, but based on the evidence of an increasing and perhaps prolonged consumer retrenchment, the recent appreciation of this stock seems a bit out of line with the fundamental realities. Or how about Powershares Dynamic Consumer Discretionary (PEZ)? Betting on companies such as Ralph Lauren (RL), Bed Bath and Beyond (BBBY) and Gap (GPS), this ETF has rallied from a low of $11.79 in March and now trades at more than $18. This is despite the fact that retail sales numbers continue to be absolutely terrible and the number of analysts voicing concerns about the upcoming holiday shopping season is a bit startling.

Therefore, for investors looking to profit from the consumer being increasingly tapped out, there are a number of options. Here are a few that make sense but of course involve the risk of the thesis being wrong or for the market to remain exuberant and disconnected from the fundamentals for longer than anticipated. Keep in mind these are just some suggestions presented in order to stimulate further thought.

1. SZK is the Proshares Ultra Short Consumer goods inverse ETF. It is levered in that it seeks “daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Consumer Goods index.”  The problems with levered ETFs are well documented so beware of the possibility that the returns will not track twice the inverse of the index over longer periods of time. Having said that, from a high of over $125 in November 2008 the stock is trading not much above its 52 week low of $51. This ETF has been a casualty of the recovery trade and if an when the recovery peters out, this one could explode to the upside.
2. For investors who are inclined to short individual stocks, I would look for companies that offer products that are very discretionary in that cash-strapped and over-levered people can live easily without their goods. Specifically, a company such as Pool Corp (POOL) that has more than doubled off of its 52 week low could be compelling on the short side. I know the company derives a good deal of revenue from sales of pool maintenance supplies but it is easy to imagine homeowners and builders not installing many new pools for years to come and cutting back on maintenance expenses. Or what about ATV and snowmobile supplier Polaris (PII)? The stock has rallied to almost $38 from its 52 week low of about $14.50 in March of this year. It’s tough to believe that there is a whole lot of consistent demand for off road vehicles that are often used for enjoyment as much as utility. Obviously, more research would be required in order to short either of these companies. I am just using them as examples of businesses that I see as constantly battling to overcome an increasingly more frugal and cautious consumer.
3. Finally, investors can look for companies that will benefit within an environment in which people are looking to save money. Two of my favorite companies that fit this description are Jack in the Box (JACK) and Safeway (SWY). Neither of these solid companies with very stable balance sheets has participated very much in this rally. Both are still way off of their 52 week highs despite the fact that they have much more resilient business models than the companies whose stocks have run up so much recently. JACK has one of the best value menus of all of the fast food restaurants, is in the middle of a prudent re-franchising initiative and owns the fast growing Qdoba concept. SWY offers one of the best private label assortments of products of all of the large food retailers and will benefit from the very promising Blackhawk gift card subsidiary. Even better, according to CAP IQ, both trade at under 10x trailing 12 month earnings per share. Given that valuation, it is hard to imagine a scenario in which these companies that should see additional demand for their moderately priced products (or at very least just hold up better) will not prosper even in sour economic conditions.

(Picture of the debt wall courtesy of rooseveltinstitution.org)

(Disclosure: No Positions)

With Q2 productivity figures being released today, I thought it might be interesting to take a look at the results and try to assess the trend in terms of sustainability. According to the data released by the Labor Department, in Q2 productivity increased at an annual rate of 6.6%, the most rapid increase in six years. The AP article points out that increased productivity often (in more normal times) leads to a higher standard of living as wages rise as output increases. However, these are not normal times. With unemployment at 9.4% (and counting) and businesses struggling as a result of the drop in consumer spending, it is unlikely that we will see increased wages any time soon. Plus, much of the gains in productivity were a result of drastic cost cutting that may have been prudent in the short run but could end up mitigating the strength of the eventual recovery. Therefore, it might be a bit premature to celebrate this impressive increase in productivity for a number of reasons.

Accordingly, the question going forward is whether these productivity gains are onetime events or are symbolic of an ongoing trend. One factor that may influence the outcome (at least over the next 2-3 quarters) is the swine flu. Let me remind you that I am not an economist so this is not meant to be anything more than a general assessment of the potential impact of H1N1. What I do know is that sick workers are not productive workers. In addition, people who are forced to stay at home, either because they are sick or they have to take care of sick children, certainly do not add to aggregate productivity.

Plenty has been written about the risks associated with an outbreak of swine flu. In his daily musings, David Rosenberg of Gluskin Sheff often cites H1N1 as one of the reasons he thinks the market could pull back. While I tend to agree with Rosenberg on a number of issues, I don’t think it is particularly useful to cite such a nebulous threat as a major risk without looking at some actual numbers. So, I thought I would do just that. Most of the following calculations are back of the envelope in nature but should be useful in quantifying a range of potential outcomes.

The most official analysis of swine flu in the US has been done by the very important sounding President’s Council of Advisors on Science and Technology (PCAST). Apparently the US government statisticians got tired of issuing overly optimistic budget estimates and decided to make some alarming projections about the number of people who might be infected by or killed by swine flu. Here’s a brief summary from the New York Times:

The report posited an epidemic that could produce symptoms in 60 million to 120 million people and cause as many as 90 million to seek medical attention; up to 1.8 million could be hospitalized, 300,000 could flood into crowded I.C.U.’s, and 30,000 to 90,000 people could die.

Even some members of the advisory panel think their estimates may be a bit high. In any case, this is a virus that is no more lethal, and possibly less lethal, than normal flu strains.

In the initial outbreaks last spring, an estimated 800,000 New Yorkers, 10 percent of the city’s population, developed symptoms attributed to the swine flu virus. Only 54 died — an encouragingly low death rate. Most infected people got better without medical treatment.

Let’s do same math to see what this all means. First I am going to take all these estimates at face value. Who knows how many people actually came down with swine flu or how many really died in NY? There are probably thousands of people who had swine flu and didn’t even know it. There are probably just as many (if not more) who saw the news regarding H1N1 and convinced themselves that their allergies or run of the mill flu were actually the dreaded swine flu. With those distortions in mind, using the data from last spring in NY, the kill rate was .00675%. Assuming the full 120M people in the US get the flu, the government’s projections indicate a kill rate of .025% on the low end (30K deaths) to .075% on the high end (90K deaths). But if we apply the NY kill rate to the 120M figure, we get only 8100 deaths. That’s a big discrepancy. Not that 8100 deaths would not be horrible, but that outcome is a lot better than 30-90K. Let’s hope the government’s pessimistic assumptions about deaths resulting from swine flu are as far off as they are when it assumes 4% GDP growth in 2 years.

So, if the probability of an epidemic that kills tens of thousands or even millions of people is relatively low, then what is the main risk of an outbreak? According to the PCAST, it has more to do with the infrastructure available to handle millions of sick people:

The report concludes that the 2009-H1N1 flu is unlikely to resemble the deadly flu pandemic of 1918-19. But in contrast to the benign version of swine flu that emerged in 1976, the report says the current strain "poses a serious health threat" to the nation. The issue is not that the virus is more deadly than other flu strains, but rather that it is likely to infect more people than usual because it is a new strain against which few people have immunity. This could mean that doctors’ offices and hospitals may get filled to capacity.

Our health care system has not recently been tested by a mad rush of people to emergency rooms, hospitals and clinics so it is hard to know how effective the response would be. With the current state of the system I am not optimistic. However, as discussed by Naomi Klein in her book The Shock Doctrine, after 9/11 and the bird flu crisis in Asia, George Bush and Congress made it a point to allocate a significant number of government dollars to the stockpiling of vaccines. (Of course, true to form in the Bush years this was a nice windfall to the pharmaceutical companies that make these vaccines and to any Homeland Security contractors who would be called upon to help facilitate the distribution of these products.) The only problem is that the particular vaccine that (in theory) protects against swine flu is still being tested and may not be ready until October. By that point schools will have re-opened and the prospects for mass contagion will be much higher than they are now.

For the purposes of this discussion, I believe that the most important impact to analyze is that on business productivity and stock prices. If companies have millions of sick workers absent every day between now and the end of the Q1 2010, I am inclined to believe that the recent positive productivity increases may not last or at least will not be as robust. According to this data from the Census Bureau, there are around 298.8M people in the US. I have seen other data that claims this number is projected to be as high as 306M, but since this data is broken down by age it serves my purposes without much potential skewing.

So, now let’s do some math and make some very simple assumptions. First, if the work force includes people ages 20-64 then there are 179.6M working age Americans (60.1% of the population). Oddly enough, the swine flu seems to infect people under the age of 65 disproportionately. While that certainly affects more people in the work force, it may also be a reason why there will be a limited number of deaths as younger people tend to have stronger immune systems. Despite this anomaly, I am going to assume that working age adults also make up 60% of infections; with the reduced infection rate among older people being offset by an increased rate among school kids.

So, using the estimates from PCAST, the number of workers who could become infected by swine flu ranges between 36M (60% of 60M) on the low end and 72M (60% of 120M) on the high end. Based on the July 2009 data from the BLS, the average nonfarm workweek was 33.1 hours. Thus, if each of these people were forced to take off one half of one work week between now and the end of Q1 2010, the number of lost hours could be between 600M and 1.2B. These numbers do not even include days off that are taken to take care of sick kids. If people under 20 make up 30% of infections (with people over 65 representing the 10% balance) then that could add between 18M (30% of 60M) and 36M (30% of 120M) kids out of school that need to be watched over by at least one parent. Even on the low end, if those parents were to take half of a work week off it would translate into another 300M in lost hours. You can see how quickly this toll adds up.

Now these are obviously very crude estimates. They also don’t include the impact of deaths, prolonged illnesses that require hospitalization, the decreased efficiency of sick workers or offsets such as people recovering over a weekend. However, I think when these swine flu estimates are combined with regular flu-induced sick days, there could be a sizable impact on Q3, Q4, and even Q1 2010 productivity. However, any suggestions that the fall swine flu season is similar to a grim reaper hanging over the US stock market seem to be exaggerations. Despite the initial media-exacerbated scare regarding H1N1, it does not look like it will cause an alarming number of deaths, at least not any more than the average flu. Therefore, with the Armageddon scenario seemingly off of the table, it is important to recognize that the most likely outcome is an overly strained health care system and a lot of people missing work. If we are lucky all swine flu will cause is longer waiting periods to receive medical attention, some reduction in economists' future productivity estimates, and cuts of EPS targets by a penny or two by sell-side analysts. In other words, from what I can see there is certainly no need to panic about the health implications of H1N1 or the negative derivative effects on the market.

(Picture courtesy of BusinessWeek.com)
(Disclosure: No positions)

Faith can be blinding. Decades of built up trust can all be lost in a single day. These are truths that investors all over the world were reminded of the day Bernie Madoff’s $65B Ponzi scheme came to light. As a result of the magnitude of his crimes and the resultant suffering of charities, feeder funds and investors, the investment management industry will never be the same. I’m not insinuating that people will no longer entrust their wealth and savings to professionals. But I do believe that the Madoff stain will not disappear anytime soon. Perhaps one day Madoff will even replace Ponzi as the namesake of this nefarious scheme.  Regardless, as a result of the lasting memory of the Madoff affair, even if it is only a faint whisper, those of us who aspire to make a career in the investment management business will live with more intense scrutiny and be expected to slowly re-build the trust that has proven to be so fleeting.

Maybe this is a good thing. In fact, it was a blatant lack of scrutiny and diligence combined with the deification of the man that allowed Madoff to perpetrate his ruse for so long. It appears that Madoff’s status along with his penchant for secrecy and a catastrophic diffusion of responsibility among his investors dissuaded most from questioning what stuck out as improbable returns. If you make your operations opaque enough or claim to have some undeniable secret sauce, only the most sophisticated and vigilant investors will question the consistent results. Madoff apparently compensated for those brave few by threatening to kick them out of his club and thus prevent further access to an asset that came to be known as the “Jewish Bond.”  That was all it took to keep those other than a lone soldier named Markopolos quiet. In the end, all it took was the near collapse of the entire global financial system to induce an admission of fraud and defeat.  If you were ever dubious regarding the enormous power of hope, this scandal should put any and all doubts to rest.

Specifically, what did Madoff’s investors hope? They hoped the returns were real. They hoped that nothing about his operations were illegal. They hoped that even if he had some unfair advantage it was a result of nothing more than something as trivial as front running. They hoped his elevated status in the financial community would shield him from regulatory and legal scrutiny. They hoped that they could get out before it all fell apart. Human nature dictates that we can always come up with an excuse for inaction or inertia. Just one more check and then I will get out. Just one more year of market-beating returns and I will take my chips off the table. Just one more day as a part of this exclusive club and I will leave the game for good. In the end Madoff’s drug proved to be too powerful for even the most “sophisticated” investors to kick the habit.

Glancing up at the title of this discussion, you might wonder what in the world this has to do with Goldman Sachs (GS). Well, it struck me recently that many of the elements of GS’s success are similar to those that made Madoff so successful. Don’t worry; this is not going to be another one of these Goldman bashing pieces that have become so ubiquitous recently.  I want to it be more of a thought exercise for those who believe that what happened to Madoff’s investors cannot happen to them. By highlighting some of the comparable mechanisms I hope to remind people of the ever-present and inherent risks associated with any investment. Why is this so pertinent now? Well, with what appears to be a speculative rally driven by individuals who seem to be blind to downside risk, I think any analysis that suggests the need for caution can be very valuable.

Without further ado, here is a list of themes that seem to be present among investors in both GS and Madoff:

1. Belief in supernatural skills that led to a God-like personification
2. Comfort with the opacity of the investment strategy
3. The irreplaceable benefit of an elevated standing in the financial community
4. Widespread suspicion of wrongdoing (or at least marginally acceptable behavior) with little action by investors to learn the truth

Let’s start with assessing the first item on that list through some personal anecdotes regarding Madoff via Bloomberg:

For Swiss banker Werner Wolfer, the memory of his first encounter with one of Bernard Madoff’s emissaries nine years ago is as clear as the waters of Lake Geneva.

 “It all looked so good,” says Wolfer, who has a master’s degree in economics from the University of St. Gallen.

“With every year passing, the worries were a little bit less,” Wolfer says.

To hear Patrick Littaye talk, the Wall Street money manager could walk on those waters. “It was like a religion,” Wolfer, 57, says of the promise of steady returns, which would be echoed by other acolytes. “These people firmly believed in the story.”

Unfortunately, nothing about investing should be a story or should invoke religious comparisons. Successful money management requires a diligent and disciplined process and any claims to have a magic formula should be looked upon with extreme skepticism. While I am certainly not a proponent of the Efficient Market Hypothesis (EMH), there is one aspect of it that is 100% accurate: there is no such thing as a lasting free lunch. Riskless arbitrage opportunities, other than in extreme situations like the ones we have seen in the past year, are often closed immediately by the market. Thus, Madoff’s investors accepted their returns without acknowledging that sometimes substantial rewards are accompanied by extreme risks.

Similarly, the investors who have driven the share price of GS back up over $160 seem to have blind faith in the company’s ability to profit in any market circumstances. Unfortunately, they have reason to believe this is a reality:

Goldman Sachs Group Inc. made more than $100 million in trading revenue on a record 46 separate days during the second quarter, or 71 percent of the time, breaking the previous high of 34 days in the prior three months.

Trading losses occurred on two days during April, May and June, down from eight in the first quarter, the New York-based bank said today in a filing with the U.S. Securities and Exchange Commission. The company made at least $50 million on 58 of the 65 trading days in the period, or 89 percent of the time.

Tell me that these results do not seem to be as improbable as Madoff’s long term returns in both up and down markets. This astonishing data means that from January to June (let’s call it 130 trading days) GS only lost money on 10 of those days. That’s almost like a baseball player batting .920 for half a season. A player who achieved that feat would immediately be deemed the best hitter to ever play the game. Since trading is a zero sum game, meaning that there is a loser on the other side of each winning trade, results like this should be impossible. Unless of course, the winner is cheating or has a skill level that is unlike that of mere mortals. Statistics like these illustrate how both Goldman and Madoff achieved such a mystique on Wall Street. Further, when the number of days that GS not only made a trading profit, but also made over $100M is added to the equation, the whole thing starts to look too good to be true. Obviously, the lesson from the Madoff affair is that what appears to be too good to be true, probably is. From the same Bloomberg article linked above:

“It’s very counterintuitive to think that they’d be able to generate this much profit and this much revenue in the middle of an ongoing recession,” said William Cohan, a former banker at JPMorgan Chase & Co. and Lazard Ltd. and author of “House of Cards” about the collapse of Bear Stearns Cos.

Next, let’s examine the parallels when it comes to the opacity of the investment strategy. We know Madoff advertised that he used a split strike conversion strategy to generate his returns. But when pressed on the details, he tended to be very vague or become defensive. As mentioned above, if he felt people were too inquisitive he would threaten to return their investment. Similarly, GS does not give a whole lot of information about how it generates such tremendous trading profits. We know for sure that it coincides with increased risk though. At the end of Q2 2009, GS’s value-at-risk (the amount the company could lose in a single day) was $245M, up from $184M in May 2008. Furthermore, GS continues to hold a huge number of what are known as Level 3 assets on its balance sheet. These are by definition the most opaque assets.  For those of you who are unfamiliar with this term, according to wikinvest, Level 3 assets are:

Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement…Level 3 assets trade infrequently, as a result there are not many reliable market prices for them. Valuations of these assets are typically based on management assumptions or expectations.

In other words, kind of like how Madoff made up his returns by printing fake trade receipts, GS gets to decide the value of $54B of 8.7% of its total assets. Also, just as Madoff’s investors had no way of learning more about his strategy, GS is understandably tight lipped about its Level 3 assets and trading strategy. Now this secrecy is not unique to GS. No bank gives away information that could hurt its own positions. But the question investors have to ask themselves is whether or not the amazing returns and the carrying value of assets are likely to be legitimate.

Next, when it comes to status there is no end to the amount of influence that GS has on policymakers and regulators. The number of GS alumni who have held or currently hold influential government positions is very well documented. What that leads to is the perception among investors that GS is protected, not only from legal scrutiny but from adverse market consequences. I worked with some former Goldman guys and there was a palpable understanding that GS would inevitably be the first one to get “the call” or a head’s up from the powers that be. If Hank Paulson’s calls to GS CEO Blankfein during the AIG crisis are any indication, this phenomenon is not just assumption, but a reality.  Accordingly, this elevated status has the potential to lull investors to sleep. If you believe that the government will always bail out GS or provide sufficient forewarning prior to a crisis, you will invest without the potential downside in mind. This is what is known as moral hazard and can lead to a mispricing of risk among investors.

Similarly, Madoff’s status had a comparable lulling effect on his investors. He was on the Board of Directors of the National Association of Securities Dealers (NASD). He also had very close ties to Securities Industry and Financial Markets Association (SIFMA), served as the non-executive Chairman of the NASDAQ, and was considered a pioneer when it came to electronic trading. The positions he held led his investors to assume that there was no way he could be doing anything illegal. Even worse, his insider status among the industry’s self regulatory body legitimatized his returns in a way few others things could. Plus, there appears to have been an implicit expectation that even if he was engaging in some dubious practices, his reputation would allow him to escape with only a slap on the wrist or a stern talking to.

Finally we come to what I think is the most fascinating similarity between GS and Madoff. This particular bias comes about when investors have an inkling that something that is not quite kosher is going on but for the most part decide to ignore their misgivings. Apparently in Madoff’s case his investors suspected that he might be front running trades, a practice that is illegal, but not seen as unethical as the scheme he was actually running. From The Economist:

According to reports, some of those who put their faith in Mr. Madoff suspected that he was engaged in wrongdoing, but not the sort that would endanger their money. They thought he might be trading illegally for their benefit on information gleaned by a separate business within his group, which made a market in shares. The firm had been investigated for “front-running”, using information about client orders to trade for its own account before filling those orders.

Basically people were suspicious but they were not going to risk speaking up and killing the golden goose. I would assume that after a number of recent incidents, this feeling has become extremely prevalent among owners of GS shares. First off, there is the amazing trading record. I’m not sure any bank in history has achieved such astounding results over 2 consecutive quarters. Even the most gullible person should question how these returns are possible. Next is the perception that the government often gives GS information that the market is not privy to. At very minimum this practice could spark complaints of conflicts of interest and lead to civil litigation, especially given the standing of many Goldman alums. However, the SEC does have rules regarding insider trading (or at least used to) that may have been violated during multiple occasions over the last few years. While this probably will not be a problem while GS’s friends are in power, we know that regimes change and those who think they were invincible suddenly find themselves on the wrong side. Although many investors are comforted by the fact that GS is nicknamed “Government Sachs, there is no way to know when prior affiliations and actions will become liabilities.

The third piece of news that should be disturbing to investors came to light when the world learned that some of the company’s proprietary software had allegedly been stolen. At a hearing regarding this theft the US prosecutor explicitly said that this code could be used to manipulate the markets. Well, if that is the case, doesn’t that mean that GS could be using it for illicit purposes? In addition, how would we know if it were? I think the Madoff case proves that the implicit assumption that GS is not using the code to juice its profits just because it could be construed as illegal or because of the company’s lofty reputation is very naïve. Lastly, there was a revelation in the last few weeks that apparently GS engages in a practice called huddling in which certain clients get advanced notice of research analysts’ stock opinions. While GS has vehemently defended this practice and has assured the market that it has done nothing wrong, the implication that GS gives specific firms information that has not yet been published seems a bit shady. This is especially problematic because the market often reacts sharply (for some unknown reason) to analysts’ upgrades and price target changes.

In conclusion, I have no idea whether or not GS has crossed any legal or ethical boundaries. However, I have to admit that some of the parallels between Madoff’s operations and those of GS are quite eye opening. It could be true that GS is just smarter and more connected than everyone else, in which case the company is probably bulletproof. But, I think people should remember that this is precisely what investors thought about Madoff. We now know that premise turned out to be a once in a generation magnitude lie. So, my suggestion to those who either own shares of GS or are contemplating a purchase is to keep all of the things I have highlighted in mind. There is no sure thing in this world and asymmetrical rewards don’t come without risk. Most importantly, the major take away from the Madoff fiasco is that returns that appear to be too good to be true probably are and that if you have an inkling that some of the profits may be from dubious practices, it might be smart to take your money elsewhere. Lucky for you, you have an easy way out that Madoff’s investors did not. All you have to do is click your mouse.

(Picture courtesy of Businessweek.com)

(Disclosure: No Positions)