Friday, March 18, 2011

Danger danger: The Wall Street Journal has no idea on how to do hedge fund due diligence

About 30 percent of Bronte's portfolio is shorting frauds.  We are very good at identifying frauds: we are experienced and diligent.

Alas some members of the fourth estate – often those with high profile mastheads – have no idea what they are doing.  This article: “Danger danger, thinking of investing in a hedge fund.  Here are some tips for sniffing out potential fraud” is so misguided as to be comical.

Lets state it up front.  There is a single tip that will allow you to avoid almost all the frauds – just one.  The tip is this:

Do not invest in a fund where the fund manager has access to your assets.

Ok – that needs a little explaining but its not complicated.  If – as an American -  you invest in Bronte Capital you don't give us the money.  We are not even legally allowed to take it.  You send the money to Citco.  Citco is the world's largest hedge fund outsource company – but there are alternatives.  David Einhorn's Greenlight Capital uses one of the bigger banks.  There are smaller players such as Spectrum, Conifer and others.

When you send the money to Citco they hold the assets.  We just trade them by issuing instructions to brokers.  However if we asked Citco to send the money to our personal bank account they would (rightly) refuse.  Moreover Citco value our assets every month and they – not us – send the statements to the clients.  We don't do the valuation so we can't fake it.  We don't hold the assets so we can't steal them.

Private clients surprisingly don't get this.  One of my friends runs a successful (albeit small) fund from his home.  People regularly make out checks out to him.  (If you send us money we will say thank you and send it back...)  The core due diligence test is simply not understood by retail clients – and alas the Wall Street Journal perpetuates their ignorance.

And guess who was the custodian for the assets invested in Bernie Madoff's fund.  BMIS – and that stood for Bernie Madoff Investment Securities.  And Bayou- another large fraud.  Well Bayou of course.  How about Astarra – the fraud I exposed in Australia.  Well their custodian was Trio Capital – a small custodian in the rural Australian town of Albury.  And guess what – Trio and Astarra had the same owners!  What about New World Capital Management – a fraud I wrote up but which was never prosecuted: well the perpetrator himself of course.  I could go on and on and on.  It is really easy to spot frauds and the fact they keep reappearing is testament to people not having a clue how to look for one.

If there is a single due diligence lesson then it is this: ensure that your money mangers have an independent custodian and preferably one of the majors.  And the first step in due diligence is this: don't do your due diligence on the fund manager – do it on the custodian.  Ring the custodian through their switch (not on a phone number provided by the fund manager) and confirm statements of the fund manager with the custodian.*

If you do this you are unlikely to get fleeced.  Simple as that.

Rob Curran misguidedly – and in the interest of the financial establishment tells you what his first red-flag in assessing managers is.  I quote:

The Fund Came to You: The Fund Came to You:  While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy. While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy.

Well politely – garbage.  I have written before on how institutional investors are right people to contact when you want to move the fund from $500 million under management to $1.5 billion under management.  They are absolutely useless at finding the hot fund manager with $5 million under management on their way to five years of 30 plus percent returns.  If you used this rule you would never have invested with Warren Buffett when he ran Buffett partnership.  All of the Buffett biographies make clear he approached well-to-do people like local medical specialists.

But its worse.  If you invest in managers that come to you through funds of funds or institutions you will probably wind up paying double-layer fees to get something like the average of all hedge fund managers.  Our initial client sent us the multi-fund manager record for a major (and successful) fund of fund.



(Click to expand).

He thought this these returns were BS.  I was kinder – these returns ok relative to equities over the same period – and more stable and probably ex-ante lower risk – so I believe this fund of funds has added value.  But the returns are not what you get from a couple of clever guys doing smart stuff.  Moreover there is a real danger in going through the institutional managers – which is that you get something that averages near the financial consensus.  And being in a crowd on Wall Street feels safe but it is actually shockingly dangerous.

Anyway my summary is that the number one method of choosing a fund given by Rob Curran (that is avoid one that comes to you) is counterproductive.  And the number one method of proving you are not defrauded rates a very thin method in the Rob Curran article.

And the Rob Curran article annoys me too – because at Bronte we are careful about trying to construct portfolios without regard to the consensus.  We don't look like institutional managers (no suits).  We don't sound like institutional managers (those accents).  And we we don't think like institutional managers (we don't like style boxes and we will happily change styles if market conditions change).  Rob Curran is telling all the WSJ readers to avoid funds like Bronte or Kerrisdale or any of the other thoughtful start-ups out there.**  And if this criticism sounds a little strident then it should be.  He is defending the financial consensus and the big institutions and frankly I don't think the big institutions covered themselves with glory over the last five years.

Secondary steps to chose the individual hedge fund

You know my view – the really good fund managers are outside the consensus.  Ratbags if you will – but ratbags with risk control.  Danny Loeb was a tearaway when he was younger.  [The rumor is that he posted more than 100 thousand messages on chatboards under the moniker of Mr Pink.]  David Einhorn might look like he is 18 (he is preternaturally young) but listen to what he says and he throws grenades.  (Who can forget the stoushes with Allied Capital and Lehman Brothers?)  And these guys are really smart.  And I guess if you want to chose a hedge fund and you don't want to work too hard you could ring them up.  In the mutual fund space my old boss at Platinum in Australia is far less out-there than those two but he is super-smart and he is not afraid to have people disagree with him.

But you would have missed Einhorn and Loeb when they were young and their best returns were mostly when they managed relatively small amounts of money.  Being an initial year investor in either of these funds was frightfully good.  [Incidentally Buffett's best returns were also when he was younger and smaller.  Buffett partnerships returns were substantially better than Berkshire Hathaway.]

So how do you chose a smaller manager?

Well first remember my test: do they hold the assets themselves of give them to a reputable third party to hold.  Don't forget this rule – it solves almost everything.

Then ask how they get the returns.  Leverage levels matter (they should be low – but 120 long 40 short is probably less risky than just 100 long).  Position size matters.  Short positions should generally be small (or using other mechanisms that limit risk like shorting debt rather than equity).  Long positions can be (much) larger.

Then ask them questions.  Pick an industry that you know really well and they profess to know.  If you can't do that work out some other mechanism to check out that they are not talking through their posterior.  (Clever and well thought through shareholder letters are a good start.  A blog is not bad either!)

Finally there is a test which I do (and which has enabled me to see many frauds) but that is seldom done elsewhere.  Match the stated returns to the ex-ante stated positioning.  For example I have disclosed several times on this blog that I am interested in shorting fraudulent Chinese stocks.  It should then come as no surprise that we are doing (very) well this month.

Likewise alas it was well known that Bank of America was our biggest position as it fell back from the 19s to the 11s.  Bank of America was above 19 in March 2010.  Here are our returns:


(These returns are for a separately managed account for our foundation client.)

The Bank of America position wasn't the only reason for the dud-period in the middle.  We are a global fund and measure ourself in US dollars.  The US dollar appreciated sharply through that period (devaluing our largish Euro denominated positions).  We quite explicitly generally do not hedge currency so you would expect to see currency volatility in our returns.  We also had a position in Maguire Preferred (now MPG Preferred) which gave us a wild though profitable ride.

More to the point – this was done primarily with big cap long positions (and small profitable positions in some defaulted preferred securities) and highly diversified and usually small cap shorts.  The positioning is as explained in my lament post.

Finally I have some strong views about prime brokers.  You should use only funds with US domiciled prime brokers for the reasons outlined in this post.

In other words it is pretty easy to do due diligence on us.

Incidentally the question we are asked almost all the time is "how much money do you manage?"  The implication that you need to be large to be good.  I assure you in almost every case returns are negatively correlated to funds under management.  You want the answer to be low - another inversion of the normal presumption.  Large however is the comfort of crowds - a comfort misplaced in markets.

Here are the steps generalized for any small gun hedge fund manager you might want.

Step 1:  Check the independence of the asset custodian.  This is a black-and-white test.  Any gray in the answer then the fund fails.  Period. Actually if it fails email enforcement@sec.gov and see if you can get bounties for spotting it.

Step 2:  Are they smart?  Test them on some industry. Bring an expert if you have one. Otherwise carefully read their material.

Step 3: Do they keep the position size and the leverage low enough to be safe?  Shorts must be smaller than longs.

Step 4: Do their returns correlate with what they say?  Focus on the particularly good months and the flat months.

Step 5: Is their brokerage arrangement sound (especially do they use US domiciled prime brokers).

And if you are a rich guy and they ring you out of the blue.  They are either trying to steal from you or they are being entrepreneurial.  Entrepreneurial is good – sometimes very good.

Follow the above steps and you will sort the wheat from chaff.

Is it too much to ask the Wall Street Journal to do the article properly next time?


John


*If you ring the custodian at a phone number provided by the money manager you could find yourself talking to a Potemkin custodian – just as people who rang advertising agencies at phone numbers provided by CCME would up talking to Potemkin advertising agencies. No kidding.  When someone gives you a reference do not ring the number they give you – ring the switchboard of the company they work at.  Always.

**Kerrisdale is far more aggressive than Bronte.  Their returns are better too.  But I have wondered openly whether aggression and risk are actually that well correlated - and I would use them as a case example.  I have conducted none of the tests described here on Kerrisdale.

Tuesday, March 15, 2011

What the demise of China Media Express says about the demise of Hank Greenberg and AIG

I met Hank Greenberg in late 2000.  He was chatting mostly to Ajit Jain – the Berkshire Hathaway reinsurance impresario and I was a spare wheel.  But Hank was I thought the most impressive person I had ever met.  He name-dropped shamelessly (he had had just flown back to New York on a private jet after “chatting” with Li Peng).  But he was so far ahead of me on so many issues it made me feel dumb.  He even looked – at least in the brief conversation – as if he were considerably smarter than Ajit Jain – and Ajit is no intellectual slouch.

I was just out of my league...

Anyway there is a view around AIG – a view that I shared – that AIG was built in the mold of Hank  and it required Hank – a certified genius and an unbelievable workaholic – to keep it all together.  AIG you see had a single risk control mechanism: Hank.

In this view Elliot Spitzer by causing the demise of Hank Greenberg caused the demise of AIG – and by extension the demise of the entire financial system.

I thought that might be going a bit far – but it is hard to argue against the proposition that AIG got much more risky without Hank around.

And the stories were legion too.  I know someone who was on a trading floor for AIG in Taiwan.  There was a big error and it potentially exposed AIG to hundreds of millions in losses.  Everyone was kept silent because if it leaked then people would front-run AIG closing their position and thus increasing their losses.  People slept at their desks.

But the next morning – fresh off the private jet from New York – there was Hank.  He had come to take control of the situation – and he stood behind traders as they solved the problems for minimum losses.

Hank was the man.

Now Hank is only a couple of percent the man he used to be.  His multi-billion dollar holding of AIG has been reduced to its last few hundred million.  His main asset is Starr Asia – a holding company for a variety of Asian investments (and some old AIG stock).  It was through Starr that Hank made his investment in China Media Express (CCME).

At peak Starr's investment in CCME was worth over $60 million.  This is nothing to the Hank of old – but the new diminished Hank probably thinks that $60 million is a lot of money.  It might even be a reasonable proportion of Hank's fortune.  As recently as January 2010 Starr dropped another $30 million into CCME.  And by that time CCME was a controversial company.

The demise of CCME

I wrote that China Media Express was either  (a) one of the best businesses in the history of capitalism or (b) one of the most brazen frauds in the history of capitalism.

Given the auditor has resigned and is suggesting fraud, the company is suspended and well – all sorts of other ugliness – we know which now.  It was one of the most brazen frauds in the history of capitalism.

And we know who was the biggest victim: Hank Greenberg.

And given Hank's much diminished status this was not chump change.  It was a meaningful hit.

If your one-man-risk-control unit can be fooled by something so obvious then why couldn't it also be fooled by someone offering 25 bps extra carry by double-levering life insurance statutory funds into the AAA strips of subprime securitizations?

China Media Express – apart from being a really fun story – punctures the last Hank Greenberg myth – a myth that I personally believed.


John

PS.  I think we can conclude that Ajit Jain really was the most impressive person at that table.  I sure as hell wasn't.

Monday, March 14, 2011

Banking and supercatastrophe

The second substantive post on this blog was about 77 Bank - a bank in Sendai - the capital of Miyagi Prefecture.  This is the epicenter of the Tsunami/Earthquake damage.

The original post - like this blog at the time - probably had less than 20 readers.

I have repeat the post below.

Warren Buffett once said that Fannie Mae had more supercatastrophe risk in it than Berkshire Hathaway.  He figured the really really big hurricane or earthquake could do more damage to Fannie than Berkshire even though Berkshire is the largest supercat insurer in the world.

Buffett was - I suspect - right.

We now unfortunately have a gruesome test of Buffett statement on finance and supercatastrophe.  There is probably more uninsured damage in the destruction of North East Japan than in any other event in history - and uninsured damage falls sharply on banks.

77 Bank - deeply concentrated in the disaster zone - is the test.  It is not a test I would want to repeat.  But I think we will - at the end of this - be able to confirm Buffett's observation that banks don't like supercats.

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The original post - which was titled Japanese Regional Banks - a mirror on America

77 Bank is a regional bank in Sendai (the capital of Miyagi prefecture). The Japanese guys I know think of Sendai as a backwater – a place where the “cool guys” hang out on motorcycles wearing purple clothes. Economically it is just another rapidly aging backwater where the young (other than those that hang out on motor cycles wearing purple clothes) are moving to Tokyo.

The name 77 Bank harks to tradition. During the Meiji restoration the Emperor gave out numbered bank charters. Traditional regional banks still label themselves by the number. www.77.co.jp and many other numbered sites belong to banks.

77 Bank has a very large market share (near 50%) in Sendai. The market is more concentrated that the great oligopoly banking markets of Canada, Australia, Sweden etc. It should be profitable – but isn’t.

Here is its balance sheet:



(click for a more detailed view).

Note that it has USD42.6 billion in deposits. This compares to $35.8 billion for Zions Bancorp – as close to an American equivalent as I can find.

77 only has USD26.4 billion in loans though. If you take out the low margin quasi-government loans it probably has only USD20 billion in loans.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much.

It’s a big bank. It has next to no loan losses because it has no lending.

Here is an income statement:























(click for a more detailed view)

Profits were USD87 million on shareholder equity of 3251 million. You don’t need a calculator – that is a lousy return on equity for a bank without credit losses.

You might think that given that they have no profitability and no lending potential they might be returning cash to shareholders. Obviously you are new to Japan. Profits are 27 yen per share and the dividend is 7 (which they thoughtfully increased from 6).

In a world where banks everywhere are short of capital 77 bank is swimming in it. Here is the graph of capital ratios over time:

















This bank has an embarrassment of riches – and nothing to do with them.

Welcome to regional Japan.


An American Mirror

The title of this post was “An American Mirror”. And so far I have not mentioned America.
America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

There are also mirror image lands – 77 is our mirror image.


Macroeconomic investing calls

We live in a world with considerable excess (mostly Asian) savings. Banks with access to borrowers made good margins because the borrowers were in short supply. Savers (or banks with access to savers) were willing to fund aggressive Western lenders on low spreads.

77 Bank has been the recipient of those low spreads. It has not been a fun place for shareholders as the sub 3% return on equity attests.

The economics of 77 Bank (and many like it) will change if the world becomes short on savings. There is NO evidence that that is happening now – and so 77 Bank will probably remain a lousy place for shareholders.


The market produces what the market wants

This is an aside really. We live in a world with an excess of savings. This is equivalent to saying that we live in a world with a shortage of (credit) worthy borrowers. So we started lending to unworthy borrowers – what Charlie Munger described as the “unworthy poor [whoever they might be] and the overstretched rich”. We know how that ended.

Unfortunately the financial system cannot make worthy borrowers. It can only lend to them when it can identify them.

This Subprime meltdown heralds the death (for now) of lending to the unworthy. The shortage of the worthy however is as acute as ever – and money for the worthy is still very cheap.

The subprime meltdown does not solve 77’s problems.

Saturday, March 12, 2011

China Media Express: all will be revealed

China Media Express (Nasdaq:CCME) has been my favorite drama on Wall Street (see posts here and here and here).

The stock is now suspended without news.  We do not even know who called for the suspension.

It is time for the big reveal...

Just to amuse you though I want to run you through an email exchange I had with Snowball - the anonymous blogger at "Good Stock Bad Stock".  I read his blog irregularly.

You see Snowball is a self-confessed "beginner" value investor - but he managed to write a seemingly balanced piece on CCME.  He then suggested he was going long.  So out of the kindness I wrote him a letter to try and convince him out of it.

This is how it ended:

You wrote an ambivalent piece on CCME.  I am not sure there is much to be ambivalent about there.  Indeed your idea that you might find 10 of these - half will be frauds - and you will be up is a first cut. 
But can I put it another way.  Taleb argues that you flip a coin 50 times and it comes back heads 50 times.  You then ask a mathematician what it will be on the 51st throw.  The mathematician says it should be 50 percent heads, 50 percent tails.  After all probability is uninfluenced by prior events.  
The trader is more canny.  He says it will be heads.  The coin is rigged.
Of course the trader is right. 
Now have a look at the overlap between S-Chip scandals and CCME.  And ask yourself whether your 50-50 guess is right. 
You know what I think: the coin is rigged.


Snowball I think heeded the advice.  I think Snowball owes me - but I guess we find out today!



John

Friday, March 11, 2011

French intelligence on Libya

The Libyan National Oil Company website - like the internet in Libya generally - is down.

Below I have copied a section (from the Google Cache) on relationships with Total - the Paris based oil major.  It is clear that Total is thick with the Gadaffi regime.

So it comes as a big surprise to see Total (ahem the French Government) recognizing the Libyan rebels as a legitimate nation and exchanging ambassadors.  France does not sell arms to rebels or terrorists.  Recognition of the rebels as a nation is a basis for supplying them weapons.

France has gone further and is the major proponent of a no-fly zone.  It has also advocated bombing Libya.

Given the very substantial French oil interests in Libya it is absurd to think that Sarkozy (first and foremost a French Nationalist) did this without either the tacit acceptance of Total or without Total's interests in mind.

France is not keen to go to war (even with jets and no casualties) in support of American oil companies.  They think differently about their own oil companies.

Anyway I think we can conclude that Total (ahem the French Government) has a very different view of the outcome in Libya to that which I am getting in American and Australian media.  Moreover given the very strong presence of Total in North Africa I suspect their intelligence is better than the CIA and far better than (say) the New York Times.

Just noting.

Also noting that Britain is joining the French in calling for EU recognition.  Maybe BP also has a few tricks up their sleeve.


John

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Cache of the website of the Libyan National Oil Company




7
نبذة عن الشركة وطبيعة نشاطها محليا:-
توتال للاستكشاف والإنتاج ليبيا
تعتبر شركة توتال متواجدة في ليبيا منذ 50 سنة. واليوم شركة توتال للاستكشاف والإنتاج ليبيا إحدى الشركات المتعاقدة مع المؤسسة الوطنية للنفط في العديد من المشاريع، أهمها تطوير حقل المبروك الواقع شرق خليج سرت، حقل الجرف في البحر الواقع بقرب من الحدود التونسية. كلا المشروعان يتم تنفيذها مع الشركة الأخت شركة توتال للنفط ليبيا ( سي. بي.تي.ال).
وقعت شركة توتال للاستكشاف والإنتاج اتفاقية استكشاف وإنتاج مع المؤسسة الوطنية للنفط بمنطقة A42 في سيرنايكة (شحات)، وبمنطقتي NC191-192بحوض مرزق ومناطق سرت.
شركة توتال شريك في NC115- NC186- NC187 و NC190 والمشغلة من قبل شركة ريبسول في حوض مرزق.
Company profile and its local activity
Total EP Libya
Total has been present in Libya for the past 50 years. Today, Total E&P Libye is in partnership with the National Oil Corporation on a number of projects, among which the development of the Mabruk field in the East Libyan Basin of Sirt, and the Al Jurf field at sea, next to the Tunisian border.  Both these projects are operated by a sister company, Compagnie des Pétrole Total Libye (CPTL).
Total E&P Libye signed with NOC exploration and production agreements on the area A42 in Cyrenaica, as well as on the areas NC191-192 in the Murzuk and Sirte regions.
Total is a partner on the block NC115, and blocks NC186, NC187 and NC190, operated by Repsol in the Murzuk basin.
7

8
نبذة عن نشاط الشركة دوليا:-
توتال شركة مساهمة
توتال شركة  طاقة متعددة الجنسيات فعالة في الاكتشاف والمبادرة لتلبية احتياجات الطاقة البشرية.
تحتل شركة توتال المرتبة الرابعة بدراجة عالمية على مستوى الرأي العام التجاري في المنتجات الكيميائية، الزيت والغاز، وتعمل في أكثر من 130 دولة ولديها أكثر من 95,000 موظف من جنسيات مختلفة.
 بالإضافة إلى إدارة أعملنا حسب أعلى مستويات السلوك المهني، نحافظ على الالتزام وبالشفافية والحوار.
 إستراتجيتنا مكرسه لمواجهة التحديات في جميع أعمالنا عند تطور المصادر الطبيعية، حماية البيئية، اندماج عملياتنا في الثقافات البلدان المستضيفة والحوار مع المجتمع المدني.والاحترام للآخرين
Company international activity profile:-
TOTAL SA
Total is a multinational energy company committed to leveraging innovation and initiative to provide a sustainable response to humankind’s energy requirements.

The fourth largest publicly-traded integrated oil and gas company and a world-class chemicals manufacturer, Total operates in more than 130 countries and has over 95, 000 employees.

 In addition to conducting our business according to the highest standards of professional behavior, we maintain an ongoing commitment to transparency dialogue and respect for others.

We are strategically dedicated to meeting the challenges faced by all our businesses when developing natural resources, protecting the environment, integrating our operations into host country cultures, and dialoguing with civil society.
8
8
نبذة عن نشاط الشركة دوليا:-
توتال شركة مساهمة
توتال شركة  طاقة متعددة الجنسيات فعالة في الاكتشاف والمبادرة لتلبية احتياجات الطاقة البشرية.
تحتل شركة توتال المرتبة الرابعة بدراجة عالمية على مستوى الرأي العام التجاري في المنتجات الكيميائية، الزيت والغاز، وتعمل في أكثر من 130 دولة ولديها أكثر من 95,000 موظف من جنسيات مختلفة.
 بالإضافة إلى إدارة أعملنا حسب أعلى مستويات السلوك المهني، نحافظ على الالتزام وبالشفافية والحوار.
 إستراتجيتنا مكرسه لمواجهة التحديات في جميع أعمالنا عند تطور المصادر الطبيعية، حماية البيئية، اندماج عملياتنا في الثقافات البلدان المستضيفة والحوار مع المجتمع المدني.والاحترام للآخرين
Company international activity profile:-
TOTAL SA
Total is a multinational energy company committed to leveraging innovation and initiative to provide a sustainable response to humankind’s energy requirements.

The fourth largest publicly-traded integrated oil and gas company and a world-class chemicals manufacturer, Total operates in more than 130 countries and has over 95, 000 employees.

 In addition to conducting our business according to the highest standards of professional behavior, we maintain an ongoing commitment to transparency dialogue and respect for others.

We are strategically dedicated to meeting the challenges faced by all our businesses when developing natural resources, protecting the environment, integrating our operations into host country cultures, and dialoguing with civil society.
8

Thursday, March 10, 2011

Keeping up appearances

The Forbes list of the world's billionaires has been published.  Bess Levin and most the rest of the press focus on the big three (Carlos Slim, Warren Buffett, Bill Gates).

I notice the slowly rising position of Liliane Bettencourt - the world's richest woman and controller of cosmetics and hair dye company Loreal.  Hair dye is the foundation and core of that business.

What can I say about Liliane?  Charming, gracious - and yes she dyes her hair.





J

PS.  Written as someone who was in a race between gray and bald.  Gray won.  If gray becomes too desperately unfashionable for men buy Loreal.

Tuesday, March 8, 2011

The high frequency traders are just making it up

Whilst I am on the subject of rapid trading I can't let this go by (courtesy Josh).  Its picosecond trading: quoting efinancialnews.com...

Speaking at a London conference on Tuesday, Donal Byrne, chief executive of Corvil, a high-speed trading technology company, caused a ripple of audible incredulity throughout the room when he suggested that trading speeds could be reduced to picoseconds in the not too distant future.

Josh who (a) reviews everything and (b) has a decent eye for garbage – made the obvious point.  A nanosecond is a very short time.  Light travels about 30cm in a nanosecond – so if you want nanosecond trading your computers need to in the same box – and probably your chips need to be on top of each.  And even then it is problematic as the data for matching the trade will need to travel through the chips many times to be processed.

Light takes about 20 picoseconds to travel through a silicon chip.  Presumably it has to do that a few times to complete a trade.  So picosecond trading is an Einstein speed-of-light counterexample and Donal Byrne and his company are in line for a Nobel Prize.

Josh is more gentle than me – so I am gonna say it:  Donal Byrne is a technologist speaking garbage.

When the leaders in the field start speaking easily identifiable egregious crap you know the game is nearing the end.  And so it is for high frequency trading.  If there were any decent return on capital for technology to make trading faster that return is likely to be pretty thin.  (I would not invest in any fund that talks about that as its "edge".)

Of course we can all get smarter rather than faster.  Including it seems Mr Byrne...



John

Monday, March 7, 2011

Audacious stock promoters or gungslinger day-traders

Lucas Energy is a small cap company which appears to be honest but surrounds itself with shady characters.  The company buys shut-in and otherwise exhausted oil wells and rehabilitates them – a classic Ben Graham cigar puff play.  The wells may be cheap – and maybe you only get one puff before they finally give up the ghost – but because you picked the cigar butt off the ground the return on equity is adequate.

The company adds a little spice to the returns by cutting in various penny stock companies on wells.  (See for example Savoy Energy - now sub 1c - who uses Lucas Energy as an operator.)

The penny-operators pay good money for lousy (but producing) properties and the stock promoters thus announce their production numbers.  No mention of course that these are the last puffs on a cheap cigar – but hey at least these penny-stock promotes are real producers unlike some I have blogged about from time to time.

And besides you can't knock Lucas energy for selling overpriced cigar-butts.  After all Lucas Energy is in the business of trading in exhausted oil wells and if someone wants to buy a share in one why should Lucas stand in their way?  The motives of the buyers are not Lucas Energy's business.

What is however perplexing is the sudden trading in Lucas Energy shares.  Lucas is Amex listed and used to trade 100 to 300 thousand two dollar shares a night.  This was generous turnover for 16.6 million shares outstanding and a fair whack of those locked up in the hands of management.  I never quite understand why the float of the company needs to turn over ever 50-70 days however this turnover is high – but not unusually so.

Suddenly the market view of Lucas changed.  The precursor was a press release stating that a well in the Eagle Ford trend was finished and they expected it to flow at 500 barrels of oil per day.  This is a fractured well and like most fractured wells should have a large initial flow with a rapid decline rate.  More to the point Lucas only has a 15 percent interest in this well (and a similar interest in another soon to be drilled well).  These are valuable assets but they are not huge assets.  (The value of course being dependent on the decline rate which you would expect to be high - but is at the moment unknown.)

But that is not what the stock market thinks.  Lucas has traded from a low of below $2 in late February to a high above $4.50 on Friday.  More to the point the volume has gone ballistic – 800 thousand followed by 20.7 million, 10.6 million and 25.5 million shares.  The average holding period of the float is now under a day.  These are large numbers as the trading float is probably below 10 million shares.

We could be in the world of hyper-trigger day-traders – but I would be surprised if a single one of my readers knew what Lucas Energy was.  Yet the market sees fit to make this - of all things - one of the most actively turned over stocks since the height of the dot-com-day trader bubble (turnover being measured relative to float not in absolute dollars).

What if anything rational explains turning over float quite this fast?

I see two hypotheses – and I don't know how to pick them apart.  One is that there really are a bunch of gunslinger day-traders (or their computers) here and that all-of-a-sudden they see the reason to trade the entire float of this company more than three times in as many days.

The alternative is that this is a pump-the-volume and see if you can attract suckers story.  The suckers of course could include the gunslinger day-traders.

I can't tell – but the SEC has the power to tell – and when a stock with long associations with penny-stock hucksters has volume like that I can't imagine why the SEC are not looking.  If the stocks are doing round-trips amongst a few players faking volumes then a prosecution should be easy. If however day-traders are really behind it then they are even more removed from economic reality than I thought.  (Day traders like this in energy stocks look a little like day traders in tech stocks in 1999.  Not the top - but certainly a reason for thought...)

I just look in wonder.  There is no model I know where turning over the stock of a company three times in three days is a productive way to allocate capital.  But hey – that is just the stock market – and despite doing this for years I still find stuff like this strange.


John

Thursday, March 3, 2011

Diversions: Champian Fulton

I live in Sydney and have good weather and beaches.  But I miss things.

Less now: communications are wonderful.

My friend Champian Fulton now has a You Tube channel.




Tuesday, March 1, 2011

Health care and fiscal reform

This is one for everyone who thinks the US is insolvent.

The US budget is clearly problematic.  Social security is not a big problem (and people who argue otherwise clearly have not thought strongly about the numbers).  Medicare however is a huge problem - and extraordinarily underfunded.

But a picture on the Wall Street cheat sheet shows how large the opportunities are...






The USA health care spend is at least 3000 dollars per capital too high relative to outcomes versus any other OECD country.  It is probably closer to 4000 per capita.  Times 307 million people there is 900 billion to 1.2 trillion dollars on the table in dealing with health expenditure.

I have written about how you might squeeze the roughly trillion dollars out before - but there may be other ways of doing it.  

However that roughly trillion dollars of excess costs is a lot of peoples' income.  They are not going to want to get squeezed and they will lobby (probably very effectively).  It ain't gonna be easy no matter how you do it.

Still any government that gets this right can right America's fiscal situation with almost no other policy action at all.  What others see as waste I see as an opportunity for America - and a reason why America is ultimately more solvent than the bears imagine.

Comments.




John

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