My Definition Of Wealth

I am not motivated by money.

That may sound strange coming from someone who works in investment research, and I certainly don’t mean to imply I don’t care about money at all. I have to make money to live a certain quality of life. Money will also allow me to achieve financial independence some day. So maybe I am motivated by money and I just define wealth differently than others.

For me, wealth is not an extravagant lifestyle, a huge mansion or fancy cars and clothes. Rather, wealth is financial security and independence. Wealth allows you to write and say what you want, when you want, and how you want.  Wealth is “fuck you” money.

While I try not to curse much on this blog (requiring a herculean effort at times), it’s important to me that bit of profanity be written out in full. To sanitize the statement is to diminish its power.

The link is to a post by J.L. Collins:

If memory serves, it comes from James Clavell. In his novel “Tai Pan” (highly recommended BTW) a young woman is on the quest to secure 10 million dollars. She calls it her “F-you money,” although the F-word is spelled out in the book. So you can look it up in case you’re wondering just what word it is. And 10m is far more than it takes, at least for me. More monk than minister.

I may not have known what it was called, but I knew what it was and why it is important. There are many things money can buy, but the most valuable of all is freedom. Freedom to do what you want and work for whom you respect.

Those who live paycheck to paycheck are slaves. Those who carry debt are slaves with even stouter shackles. Don’t think for the moment their masters don’t know it.

Much of what we believe about wealth we accept without critical thought. It does not help that we are inundated with messaging glorifying conspicuous consumption. What was the Fyre Festival but a monument to conspicuous consumption and personal vanity? What does it say about conspicuous consumption that the whole event ended up being a massive fraud?

Simply taking the time to examine our beliefs about money, wealth and power has the potential to redefine our worldview and change our lives. At a bare minimum we will better understand ourselves. We might also avoid being stranded on Caribbean islands without access to food and shelter.

Investing Like John Wooden

These days it is more or less common knowledge that our brains are not evolved for investment success. In fact, our brains are evolved to keep us from investment success. I don’t have anything profound to say on the science behind this. If you are interested in the science, I would recommend reading Thinking, Fast and Slow, by Daniel Kahneman.

Rather, I want to focus on how we can deal with our evolutionary disadvantages.

There is much investing literature insisting the solution to our cognitive and emotional biases is simply to think as dispassionately and analytically as possible. That sounds nice on paper. However, I don’t think it is realistic. I don’t believe it is possible to completely cut emotion out of the investment process. I would argue that if you think you have successfully removed emotion from your investment process what you have really succeeded in doing is deceiving yourself.

It is both healthier and more productive to openly acknowledge that investing is a difficult, emotional process. Better to channel your emotions toward productive ends than waste time and energy denying they exist.

For me, this means measuring success by the quality of your investment process and the consistency of its implementation–not the daily, weekly, monthly or even annual tape print. If you have a quality process and implement it consistently, and you strive for continuous improvement, you will do okay in the long run.

Think of this as the John Wooden approach to investing:

When Wooden arrived at UCLA for the 1948–1949 season, he inherited a little-known program that played in a cramped gym. He left it as a national powerhouse with 10 national championships—one of the most (if not the most) successful rebuilding projects in college basketball history. John Wooden ended his UCLA coaching career with a 620–147 overall record and a winning percentage of .808. These figures do not include his two-year record at Indiana State prior to taking over the duties at UCLA.

What’s more, Wooden openly shared his secret sauce:


Here are a couple of the ways I strive to channel emotion into process and not into a self-defeating obsession with outcomes:

  • I keep an investing journal where I document research, investment theses, thesis breaks, trades and post-mortems of exited investments. I will also write own my feelings and views of difficult situations or frustrating outcomes.
  • My emphasis is always on following my process. Making money on random gambles or “lottery ticket” type investments doesn’t count as success. My process does not revolve around “making money.” The goal of my process is to validate or disprove investment theses.
  • Thus, selling out of a bad investment is not failure. Exiting bad investments quickly allows me to redeploy that capital into better quality investments. Some of the worst investing mistakes (think Valeant) have been made by people being unwilling to admit they are wrong.

For a process-oriented investor, much of what passes for “investing” seems silly–like poker players on a tilt or dogs chasing cars.

The Problem of Induction


Imagine you are a chicken. Each day a farmer comes and feeds you. After a few months of this you conclude that whenever the farmer visits, he will bring you food. All the empirical evidence supports this conclusion. Then, on an otherwise unremarkable day, instead of feeding you the farmer chops your head off.

That is a gruesome introduction to the problem of induction. (Though I have heard the chicken example many times I believe it originated with Bertrand Russell)

I have been noodling around with scientific reasoning and logic as relates to investment due diligence. What grates on me is that I have come to believe much of what people are looking to get out of a due diligence process cannot actually be achieved. For example, when we due diligence an investment manager the emphasis is on proving the manager is skilled. In reality we cannot prove this. At best we can conclude it is highly probable a manager is skilled. Alternatively, we can prove a manager is not skilled, provided we define a measure of “skill” in advance.

The average due diligence process is grounded in inductive reasoning. We make observations about the investment manager, her strategy and her firm. If the observations are favorable, we generalize that the manager is likely to be skilled and will perform well in the future. Logically this process is flawed.

The Problem of Induction

I first became aware of the problem of induction several years ago via Taleb’s Fooled By Randomness. The issue is we can only use inductive reasoning to conclude something is “likely” or “unlikely.” We cannot use inductive reasoning to prove something is true or false.

The classic example is the black swan. For a long time people believed all swans were white. They did not know all swans were white (they would have to have observed all the swans in existence to prove this). Rather, people inferred an extremely high probability for all swans being white because all the swans observed to date had been white. Then, in 1697, Willem de Vlamingh discovered cygnus atratus in Australia.

A black swan; Source: Wikipedia

In the context of investing we struggle with the naïve extrapolation of past performance into the future. On the basis of past performance I can say, “I believe it is probable this investment manager is highly skilled.” However, I cannot use that data to prove, with certainty, that the manager will continue to outperform in the future. This WSJ article hit piece discussing Morningstar ratings is a practical exploration of the issue (although for the record I believe the WSJ badly misrepresented what Morningstar is trying to achieve with its ratings).

The problem of induction is central to the validity of the scientific method. Science does not prove the truth of hypotheses, theories and laws. It merely verifies they are consistent with empirical results. However, as with inferences about the colors of swans, it only takes one false case to disprove a scientific theory. The philosopher Karl Popper therefore concluded falsifiability is the essential criteria determining whether a theory can be considered scientific.

From Wikipedia:

Among his contributions to philosophy is his claim to have solved the philosophical problem of induction. He states that while there is no way to prove that the sun will rise, it is possible to formulate the theory that every day the sun will rise; if it does not rise on some particular day, the theory will be falsified and will have to be replaced by a different one. Until that day, there is no need to reject the assumption that the theory is true. Nor is it rational according to Popper to make instead the more complex assumption that the sun will rise until a given day, but will stop doing so the day after, or similar statements with additional conditions.

Such a theory would be true with higher probability, because it cannot be attacked so easily: to falsify the first one, it is sufficient to find that the sun has stopped rising; to falsify the second one, one additionally needs the assumption that the given day has not yet been reached. Popper held that it is the least likely, or most easily falsifiable, or simplest theory (attributes which he identified as all the same thing) that explains known facts that one should rationally prefer. His opposition to positivism, which held that it is the theory most likely to be true that one should prefer, here becomes very apparent. It is impossible, Popper argues, to ensure a theory to be true; it is more important that its falsity can be detected as easily as possible.

Applications To Due Diligence & Investment Analysis

This means you cannot “prove” an investment thesis is correct. At best you can gather evidence to build conviction that your investment thesis is “probably” correct. In my experience much due diligence is conducted with an inductive mindset. This leaves due diligence processes vulnerable to confirmation bias.

Should we invert the process?

In other words, you would organize due diligence with the goal of falsifying an investment thesis. If the thesis cannot be falsified, you invest. As a risk management discipline, you then establish a series of easily falsifiable statements constituting “thesis breaks” (e.g. “Company A will average double-digit revenue growth over the next 3 years”). When a thesis break is triggered, the investment is re-evaluated or removed from the portfolio.

Practical Considerations

At a high level, evaluating an investment opportunity can almost always be boiled down to the following:

People: Management has integrity and is aligned with investors.

Process: Processes are disciplined, repeatable and based on sound economic principles.

Performance: Past performance supports management’s ability to execute.

The due diligence process should not be structured to verify these statements as accurate. It should be structured to prove they are false. In practice to guide your work you would need to establish a whole series of falsifiable statements underneath these broad headings. For example, under People:

  • Management has never committed or been associated with securities-related offenses.
  • Management has no prior record of personal or business bankruptcy.
  • Management has never been convicted of a felony or misdemeanor offense.
  • Management owns >10% of shares outstanding / maintains significant personal investment.

In my view this is a more straightforward, disciplined and logically sound method of organizing a due diligence process. To a non-practitioner the distinction may seem silly. However, the structure is designed to minimize confirmation bias—a common and dangerous cognitive bias in investment research and portfolio management.

The Pursuit of Truth

Bridgewater Associates has a reputation for being something of a cult. I do not have direct experience with Bridgewater or its founder Ray Dalio other than reading some of their research and thought pieces. So I’m not really qualified to weigh in on the cult aspect. What I do appreciate about Bridgewater’s culture is that it is fanatically process-oriented, to the point of resembling a spiritual quest. Check out these snips:

Source: Website for Ray Dalio’s Principles
Source: Bridgewater Website

Now, this post is not meant as Bridgewater commercial. Bridgewater is simply a real-life example of firm that seeks to understand Truth, and has reaped the benefits of the process. If you understand the Truth of how the world operates, making money using that knowledge is trivial.

This might seem like a banal observation. I promise it is not. In my view a majority of investment organizations have it backward. They are focused on outcomes. The Truth of what caused those outcomes is irrelevant. It is easier from a business perspective to simply rationalize things in ways that appeal to clients. It is clients who pay the bills, after all.

The result is that investing becomes an endless performance chase. This is the finance equivalent of Buddhist samsara. It is an endless cycle of birth, suffering and death.

By now you might think I am off the deep end. Yet I am not the first person to connect practical issues in asset management to broader philosophical concepts. Patrick O’Shaughnessy has written an excellent post covering related subject matter, “Two Star Managers and the Wheel of Fortune.” In it he shares this Taoist story:

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit.

“Such bad luck,” they said sympathetically.

“We’ll see,” the farmer replied.

The next morning the horse returned, bringing with it three other wild horses.

“How wonderful,” the neighbors exclaimed.

“We’ll see,” replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

“We’ll see,” answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

“We’ll see” said the farmer.

As I was writing this I read an excellent piece by Morgan Housel discussing the impact of lived experience on investors’ views of financial markets and investment strategy. It includes this chart:

Source: Collaborative Fund Blog

Here is a bridge from the Taoist story to our lived experience as investors. It illustrates how something as simple as the year we were born can have a dramatic impact on our lived experiences, and by implication our worldview. If we only ever filter the world and the markets through the lens of our personal experiences (and biases), we will see things as we would like to see them rather than how they truly are.

This may blind us to opportunity. It may also blind us to risk. Even thinking of “opportunity” and “risk” as discrete concepts can be reductive and limiting. Typically where there is risk there is also opportunity, and vice versa. This is especially true of investments that are out of favor or misunderstood. To this day, skilled structured credit investors are making good money off toxic mortgage-backed securities originated prior to the financial crisis. Since they have deep, objective knowledge of the securities and the market, they are able to see past the label of “toxic” to the underlying value.

If you can understand the Truth, making money is trivial.

The Wrong Question

Where I work, we are not in the business of stock picking. Nonetheless, clients sometimes ask us to weigh in on individual equities. Often these questions come in the form of “should I buy Oil Company A or Pharma Company B?”

This is the wrong question. Even if you are proceeding from the assumption that stock picking is a worthwhile endeavor, it is the wrong question.

For starters, underlying this question is the assumption that at least one of the two stocks is a good investment. However, it is quite possible (even likely) that neither is a good investment. The entire exercise proceeds from flawed premises.

Unsophisticated investors almost invariably generate investment ideas based on availability bias. They don’t actively seek out non-consensus opportunities. They gravitate toward what they already know, or information that is readily available in the media or in stock picking newsletters (shudder). This in turn leads to “research” driven by confirmation bias.

People who grew up with a grandparent buying blue chip stocks for them like blue chips. People who work in tech like tech. Ditto for aerospace. And so on. This is also why so many people own large amounts of employer stock in their 401(k)s despite the vast body of personal finance literature advising otherwise. No ex ante consideration is given to risk management or opportunity cost–what the investor could earn in a broadly diversified equity portfolio.

Another problem with the question “should I buy Oil Company A or Pharma Company B?” is it completely ignores the issue of time horizon. Do you plan on holding this stock forever? For three years? For one year? For a couple of quarters? A day? As Cliff Asness is fond of saying, you don’t want to be a momentum investor on a value investor’s time horizon.

I consider myself a value-oriented investor, but I would bet on momentum over value for short time periods. In response to a question about performance evaluation, I once told a colleague I would be comfortable owning a certain mutual fund for the next 20 years, but not for the next 5. My statement was met with uncomfortable silence. From his reaction you would think I had spoken a koan. (maybe I had)

I could go on by delving into financial statement analysis, but that’s beside the point. By using “should I by Oil Company A or Pharma Company B?” as a jumping off point you are skipping steps. You are making a security selection decision divorced from any larger context or purpose.

In other words, you are gambling.

Now, the purpose of this blog is not to admonish people for gambling. I enjoy the occasional negative expectation game as much as the next person. However, it is hazardous to your wealth to conflate gambling and investing.

The First Mutual Fund

Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Equity shares were scarce among the listed securities, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans, or negotiaties,as they were known in the Netherlands. Issued by merchant financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.


The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.

Finding a Place in the Market Ecosystem

In my market ecosystem post I described different types of investors and the roles they might play throughout an idealized company’s life cycle. Writing that post caused me think more deeply about my own investing philosophy and the role I play in the market ecosystem (this is one of the reasons I write).

I used to think of myself primarily as a value investor: someone who is out there looking to pick up dollars for fifty cents. There is a still a part of me that is deeply attracted to these types of investments due to the margin of safety they afford.

However, another part of me is attracted to compounding machines. In order for an investment to compound over time it needs to generate high returns on capital and also offer ample opportunity to reinvest that capital for similarly high returns. This is identical to the reinvestment assumption underpinning the IRR and YTM calculations.

Traditional value investments may not compound very well. Many are maybe single digit revenue growers but with strong free cash generation. What keeps them from compounding at high rates is that the cash cannot be reinvested in growth initiatives (maybe the market is mature). Even worse, a management flush with cash may start doing stupid things to “buy” growth (such as play venture capitalist).

However, compounding machines tend to be more expensive than traditional value investments. It can be tough to find them with a fat margin of safety, particularly these days when valuations across the quality spectrum are stretched. This is mitigated somewhat by the fact that it is easier psychologically to hold a compounding machine for a very long time. A compounding machine by definition merits a richer valuation.

Therefore, what are more and more interesting to me are businesses that have reached inflection points. Ideally these are businesses that have been dumped by growth investors and are at increasing risk of being dumped by value investors but where the business nonetheless has a reasonable probability of inflecting positively. Low debt levels are important here as leverage can be catastrophic for a business in transition.

Here are some reasons I like this approach:

  • These businesses tend not to screen well on backward-looking quantitative measures. This makes them more likely to be overlooked and less likely to be owned by sophisticated investors facing pressure to deliver strong relative performance versus benchmarks (active mutual fund managers, pension funds, endowments). Taking a position in a stock at an inflection point introduces significant career risk into the equation for these players.
  • These businesses usually face significant uncertainty, which causes their market valuation to overshoot and undershoot significantly relative to intrinsic value.
  • If you fish for these businesses in the smaller cap segment of the market (under $1 billion and preferably $250 million or less) that is an additional constraint on large institutional investors that contributes to a structurally inefficient market niche.
  • If you are able to fish in the niche described above, the trading volumes for these stocks can be thin which means the price gets bounced around whenever someone buys or sells. This may present attractive buying opportunities as you build a position (but it can hurt if you need to exit the position in a hurry–another example of the advantages conferred by a permanent capital base).

The biggest risk to this investment approach is buying into a value trap. Thus, that ought to be the central focus of a risk management discipline. I am pondering how best to codify this but I think it starts with the decision to average down.

To summarize some valuable insights from John Hempton (whose portfolio management discipline I admire), one should never average down any of the following:

  • High leverage (financial or operational)
  • Technological obsolescence
  • Potential fraud

Related concepts I have been examining are use of the Kelly Criterion in position sizing and implementing some kind of explicit Bayesian updating process. Details to  be determined and perhaps discussed in a future post.

Is your favorite marijuana stock a fraud?

Woman_smoking_marijauanaThe cannabis industry is the bane of my existence as an investment analyst. It is a wretched hive of scum, villainy and penny stock fraud, and yet the “legalization story” is so compelling that retail investors are drawn to the space like moths to a flame. This is lottery ticket investing at its finest only many clients don’t seem to realize that the lottery is rigged.

Fortunately it is pretty straightforward to pick these things off from an analytical point of view. As a public service I will share some tips that may be helpful in avoiding obviously fraudulent stocks. Most of these can be generalized to other investment opportunities.

Stock Fraud Red Flags

#1: The stock is a microcap/penny stock (trades on the OTC bulletin board or pink sheets). Penny stocks are riddled with fraud. There are a lot of them and the SEC doesn’t have the time and resources to run around investigating every shady operator in existence. Trading volumes are usually thin which means the prices are easy for insiders and assorted other scumbags to manipulate through a variety of schemes (the most common being the pump and dump). Not all microcaps are frauds but they are much riskier fare for unsophisticated investors.

#2: Thin trading volumes and/or a price history showing huge spikes and crashes. This can be indicative of market manipulation.

#3: Screwy financials. Shady penny stocks tend to share some common attributes in their financials. Here are some (in no particular order):

  • Seemingly large mismatches in revenues and expenses (e.g. revenues of a couple hundred thousand dollars and operating expenses of several million dollars) that don’t seem aligned with investment programs, R&D or product ramps.
  • Inadequate capitalization, such as a few hundred or a few thousands of dollars in cash in a bank account and no other assets, but grand ambitions of market penetration and dominance.
  • Large accumulated shareholder deficits in place of shareholder equity.
  • Substantial liabilities associated with conversion options on convertible debt. This type of financing is variously referred to as “toxic debt” and “death spiral financing.” It can also be used to perpetrate a pump and dump scheme.
  • Going concern flags from auditors.
  • Material weaknesses in internal controls flags from auditors.
  • Business summaries that discuss a past history of operating as different companies or in entirely different industries. One way these frauds perpetuate themselves is by repeatedly merging and reverse merging shell companies to operate in “hot” industries like cannabis.
  • Large volumes of related party transactions. It is particularly egregious if cash is flowing from a public entity to a private entity controlled by insiders.
  • Limited independent oversight of the executive. Some of these stocks will have a CEO who is also the CFO and the sole board member (or variations on that theme). This could be a sign of a lean startup operation but it is also indicative of limited risk control–especially with regard to cash controls.
  • Patterns of late SEC filings or requests for clarification on filing data from SEC staff.

#4: Executives have past association with crashed penny stocks. This is maybe the most significant red flag you can find. Most shady operators in this space are professional or semi-professional scumbags and so they move from scam to scam to scam. Google is your friend here (Googling NAME + SEC can be remarkably fruitful).

#5: Screwy online presence. Fraudulent companies will have potemkin websites designed to provide a veneer of legitimacy. But if you dig a little deeper there are weird inconsistencies such as half-built pages, non-functioning forms or sham social media accounts that are never updated.


#6: The stock is pitched almost entirely on total addressable market (TAM). Lots of people like to smoke weed. I get it. There are hundreds of billions of dollars up for grabs. But would legalized marijuana not be a commodity product? Beyond the initial gold rush fervor it’s not clear to me, why, in the long run, the weed business should be so great viewed through the lens of returns on capital. Competition will be fierce if and when cannabis is legalized. The market will be flooded with entrants who will compete away the margins. And what’s to stop some super well-capitalized adjacent player like Philip Morris from rapidly entering the weed space and ramping up capacity? I may be completely wrong about the details. My point is simply that the economics are more complex than “if you build it, they will come.”
I will conclude with a point I cannot emphasize enough. I will put it in big, bold, all-cap type for extra emphasis:


In a past life I did a little freelance journalism. I have friends with years of experience in journalism, including business journalism. Believe me when I tell you that journalists are not paid to do proper due diligence.

In most cases the journalist is assigned a story by an editor. The editor says “go talk to this weed guy, weed is hot right now.” The journalist dutifully goes and interviews the weed guy and reports on what the weed guy has to say. Most journalists are not looking into the weed guy’s background and they are certainly not digging into the weed guy’s company’s financials. They may not even be comfortable interpreting financial statement data. In fact, they may never even set foot on the business premises (budgets are tight in media these days). So the journalist will see what the weed guy wants him to see. This is all well and good if you are in the entertainment business but not so much if you are an investor.

John Hempton summarizes the issue neatly in an old post dissecting the Sino Forest fraud (Sino Forest was a Chinese timber company that fabricated acreage). He writes:

Where I am less sympathetic is to Paulson’s statements that staff went to see the operations (and hence they judged they were real) and also to the line that they did a thorough review of the financial statements.

If you go see Sino Forest’s operations you will see what Sino Forest wants to show you. They will show you trees. You can’t tell whether that is 5 thousand hectares or 500 thousand hectares. Seeing trees does not answer the question. There is no point looking at things that are not going to tell you anything anyway – and so Paulson’s staff member wasted his time looking. That is an amateur-hour mistake.

If you are going to look at the operations (and it is often worthwhile) then do the work properly and look through the eyes of a competitor or a customer or a supplier. And find them yourself rather than talk to sympathetic ones supplied by the management.

When management say good things about themselves that provides no actionable investment information. When management say good things about a competitor that is golden. When suppliers you have found yourself say good things about a company that is useful. When management say bad things about their business that is useful.

Speaking to management and hearing good things about them said by them does not help in investment and hence does not constitute actionable analysis.

Not all penny stocks are frauds. Nor are all marijuana businesses. However, in my experience retail investors often struggle to distinguish between compelling narratives and attractive investment opportunities.

The reason for this boils down to availability bias. Retail investors assume that the information that is readily available to them is also the most useful. In reality it is just the opposite. The rosier the outlook, and the easier it is to find information confirming that view, the more skeptical you need to be with your due diligence. It is in the fraudster’s interest to make sure positive information is widely and readily available.

Life and Death in the Equity Market

Deep value investors at work.
In my humble estimation most investors have a limited view of the market ecosystem. This is the fault of the financial advice industry (which emphasizes performance comparisons to sell products and services) and also the financial media (which emphasizes performance comparisons even more than the financial advice industry).

When you look at markets from that point of view, there are “winners” and “losers.” The “winners” are always doing so at someone else’s expense. Usually mom ‘n pop. Or mom ‘n pop’s ineptly managed pension plan.

Make no mistake. Markets are competitive. But they are also vibrant and nuanced. As with any ecosystem, most of the “organisms” in the market contribute to its health in some way.

David Merkel tackles the market ecosystem in two excellent pieces:

Broadly speaking, he writes about the differences between “balance sheet players” such as banks and insurance companies and “total return players” such as hedge funds and mutual funds. These entities have different investment objectives and constraints and so behave very differently in the markets.

I want to go through a similar exercise. Of course, what is written below involves simplification and generalization. I also focus specifically on equity markets for simplicity. The real world is more complex. But I hope this helps readers think about markets in a more nuanced way.

Traders vs. Investors

At a very high level you can separate the market ecosystem into traders and investors. Traders have short time horizons (sometimes as brief as a few seconds, in the case of high frequency, algorithmic trading). Investors have long time horizons (sometimes as long as decades, in the case of Warren Buffett). Perhaps more importantly, traders and investors make different contributions to the health of the market ecosystem.

Traders’ Contributions To The Market Ecosystem

Traders buy and sell based on anticipated changes in the supply and demand for securities. They contribute to the health of the investment ecosystem by making markets and keeping bid/offer spreads narrow, which reduces the cost of trading for other market participants.

Arbitrageurs are a subset of traders that enforce price relationships among various financial instruments. For example, arbitrageurs ensure that ETF share prices track closely to their net asset values. You can read more about this process at

Many traders are completely unconcerned with the direction of markets. Rather, they attempt to capture small pricing inefficiencies at relatively high frequencies. 

Some traders simply execute transactions for longer term investors and attempt to do so as efficiently as possible. For a large investor that is far from a trivial task. It is one thing to buy $10,000 worth of KO shares and quite another to buy $10,000,000 worth of shares. The latter will move the market.

Investors’ Contributions To The Market Ecosystem

Investors buy and sell securities based on market prices relative to their estimates of “intrinsic value.” Investors contribute to the health of the market ecosystem by ensuring security prices properly reflect underlying economic value. Broadly speaking, there are two subspecies of investors in equity markets: value investors and growth investors.

Some people mistakenly believe value investors seek to buy assets at a discount to intrinsic value while growth investors buy at a premium. This is not true.

Value investors typically demand a much greater “margin of safety” (extra discount from intrinsic value) to buy a security. They tend to gravitate toward businesses that generate profit and excess cash flow, but have modest growth potential. An example of a value stock would be Exxon Mobil or another large integrated oil company. Growth rates are less important to value investors than cash flow and profitability. Value investors tend to focus on what could go wrong in the future versus the potential reward if things go well.

Growth investors gravitate toward businesses where future profits and cash flows are potentially much greater than they are today. These are stocks such as Facebook, Amazon, Netflix and Tesla. Some growth stocks are profitable today (Facebook). Others are kind of profitable (Amazon). Others generate large losses (Netflix, Tesla). The level of profitability today is of less concern to a growth investor than the potential profitability in the future. Growth rates and addressable market size, on the other hand, are of paramount importance to growth investors. Growth investors would prefer to own businesses that will change the world and accept the risk and uncertainty that goes along with that stance.

Popular misconceptions regarding value and growth investors stem from the fact that growth investors tend to own stocks that trade at relatively higher valuations, as measured by ratios such as price to earnings. Regardless, growth investors are always buying at a discount to their estimate of a stock’s intrinsic value.

Life And Death In The Equity Market

When a stock is born (or, rather, goes public), it may start as a high-flying growth company. The business may not be profitable, but as long as it is growing revenue and can capture an increasing share of a large addressable market then growth investors will own the stock. These investors ensure the stock’s price properly reflects the growth potential of the business. The main risk for a growth investor is that a company’s growth rate slows much faster than anticipated.

As a business matures, its growth rate declines and its market share stabilizes. Ownership will transition to value investors who will want to see profitability, cash flow generation and the return of cash to shareholders through dividends and share buybacks. The main risk for a value investor is that growth rates and markets never stabilize, but instead continue to spiral downward. This is called a “value trap” and it is a value investor’s worst nightmare. Another, less prominent risk is that the management will do stupid things like divert free cash flow or take on debt to do silly acquisitions to “buy” growth. A major reason value investors want to see free cash returned to shareholders is to prevent management from doing stupid things with it.

Most businesses will eventually enter terminal decline. There are many reasons for this but the outward signs include falling profitability, sharply declining market share and increasing amounts of debt. Eventually, if a company does not make significant changes, it will become insolvent. When a company reaches this final stage of its life cycle the “deep value” or “distressed” investor steps in to own the stock. The distressed investor evaluates the various securities in the capital structure to identify their value in a restructuring or liquidation. Thus the distressed investor seeks to buy at a discount to liquidation value. The main risk for a distressed investor is an adverse event or legal decision involving the business that unexpectedly changes the liquidation value of the securities in the capital structure.

When a company finally liquidates, its capital may ultimately end up recycled into young companies in the public and private markets.

And so the cycle can begin again.

Big Piles of Money

Source: Morningstar/Pitchbook
Private equity is sitting on a huge pile of money. The line of investors runs out the door. In fact, private equity today reminds me a lot of hedge funds circa 2002-2005. It is the hot space. Flows have gone bananas. But will all of this money find a good home?

I am skeptical.

It is now a commonly held view that strong asset flows led to diminishing returns for hedge fund strategies over time. In general, too much money chasing limited opportunities is never a recipe for exceptional investment performance. What would otherwise be good investments become bad investments and what would otherwise be marginal investments become terrible investments.

As Seth Klarman puts it, everything is a buy at one price, a hold another and a sell at another. When a lot of money chases a limited opportunity set, prices rise. This may be good for today’s sellers but not so much for today’s investors.

I empathize with private equity investors because while there is a whole lot of money out there looking for a good home there are simply not many good homes available.

It is also now a commonly held belief that all the good companies stay private. I am not sure that is true when you have an enormous private company like Uber engaging in bizarre valuation gymnastics to manipulate its paper value. I am more inclined to argue that across the board, high valuations and easy money have turned what might otherwise be good companies into bad investments. Meanwhile, certain businesses go public that probably should not even exist if investors hope to see their capital again.

The title of this post is a play on the very well done NPR special, “A Giant Pool of Money.” (You should listen to it) The thrust of that piece was that artificially low interest rates drove investors to inflate a speculative bubble in US housing and related financial instruments, which in turn led to the global financial crisis of 2008.

Think how attractive a mortgage loan is to that $70 trillion pool of money.

Remember, they’re desperate to get any kind of interest return. They want to beat that miserable 1% interest Greenspan is offering them. And here are these homeowners paying 5%, 9% to borrow money from some bank. So what if the global pool could get in on that action?

There are problems. Individual mortgages are too big a hassle for the global pool of money. They don’t want to get mixed up with actual people, and their catastrophic health problems, and their divorces, and all the reasons that might stop them from paying their mortgages. So what Mike and his peers on Wall Street did, was to figure out a way to give the global pool of money all the benefits of a mortgage– basically higher yield– without all the hassle and risk.

So picture the whole chain. You have Clarence. He gets a mortgage from a broker. The broker sells the mortgage to a small bank. The small bank sells the mortgage to a guy like Mike at a big investment firm on Wall Street. Then Mike takes a few thousand mortgages he’s bought this way, he puts them in one big pile.

Now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next 30 years, the life of a mortgage. And he then sells shares of that monthly income to investors. Those shares are called mortgage-backed securities. And the $70 trillion global pool of money loved them.

The above was reported in May 2008.

To date the underlying issue has not been resolved. As I write this the yield on the 10-year Treasury sits at 2.32%. Today the giant pool of money is not flowing into US housing and mortgage bonds. Instead it flows into private equity, high yield debt, leveraged loans and technology stocks. Plenty of it is eyeing cryptocurrencies.

But fundamentally it is doing the same thing it did in the mid-2000s. It is chasing returns.