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. (I guess maybe I did)

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.

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 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.

The Dumbest Friend Test

Conceptually, cycles might be the most important thing in finance and economics. There are lots of cycles in finance. Probably the most important of these is the credit cycle. If you would like a fun and easy-to-follow primer on the credit cycle you should watch this video from Ray Dalio:

Anyway cycles are pervasive in financial markets and in my view it is as important to watch qualitative indicators as quantitative indicators to mark a cycle’s progress. As an example, I was recently in a meeting with a successful investment manager who said “it was not time” to short stocks again (the last time he shorted stocks heavily was in the early 2000s as the technology bubble collapsed). I asked him what would indicate “it was time” to short again. “When clients are calling me with stock tips,” he said.

I am fascinated by the cryptocurrency phenomenon partly because I have not seen a market run really, really hot since I have been investing (though I sure have seen some faddish silliness). People talk about the S&P 500 being overvalued these days but the S&P 500 has got nothing on crypto when it comes to sheer investor euphoria.

So I propose a simple qualitative test to help determine whether a market is running really, really hot. Ask yourself: what is my dumbest friend doing? If your dumbest friend is “easily” making money hand over fist it is probably safe to say that market is running hot. To illustrate here is Simon Black via Zero Hedge:

I vividly remember having a conversation several years ago with a woman about her real estate investments in the United States.

It must have been around 2005 or 2006… the peak of the property bubble.

She was a psychologist from somewhere in the midwest, telling me about how she was flipping off-plan condominiums in Florida.

Basically she would put money down to secure a condo unit in a building before it broke ground, then sell her contract to someone else at a higher price when the building was closer to completion.

I remember as she told me this story she was practically cackling at how quickly and easily she was doubling and tripling her money, and at one point said, “It is just soooo easy for me.”

Those words stuck.

I remember thinking, “Investing isn’t supposed to be easy. There’s supposed to be risk and hard work involved.”

But she wasn’t alone. Legions of amateur investors were piling into the market doing exactly the same thing.

Everyone seemed to be flipping condos. And everyone seemed to be making money.

It didn’t add up.

I remember one investor explaining to me how he would flip his condo contract to someone else when the building was 30% complete. Then that buyer would flip the contract to another investor when the building was 60% complete. Then another sale when the building was 80% complete, etc.

“But who is the person at the end of the line?” I asked. “Someone has to eventually live in all of these condos and be willing to pay the highest price.”

“Oh there will ALWAYS be plenty of people who will live here,” he told me.

The Hard Sell

“Mnuchin warns of equities fall without tax reforms”

One of the commenters says it best: “This is the hard sell on tax reform??”

This is just the latest example of how financial market performance has turned from output to input for policymakers in recent years. Granted, Mnuchin’s comment is more political propaganda than policy prescription. It’s worse at the Fed. At the Fed, preemptive strikes on market volatility have become standard operating procedure.

From Chris Cole’s excellent research piece, “Volatility and the Allegory of the Prisoner’s Dilemma” (linked above):

Pre-emptive central banking is a very different concept than the popular idea of the “central bank put”. The classic “central bank put” refers to policy action employed in response to, but not prior to, the onset of a crisis. Rate cuts in 1987, 1998, 2007-2008, and Quantitative Easing I and II (“QE”) programs were a response to weak economic data, elevated financial stress, and large drawdowns in credit and equity markets. To differentiate, pre-emptive central banking refers to monetary action in anticipation of future financial stress to avert a market crash before it starts,even if markets appear healthy and volatility is low. In executing a pre-emptive strike on risk, policymakers rely on changes in faster moving market data (e.g. 5yr-5yr breakeven inflation) rather than slower moving fundamental economic data (e.g. CPI and unemployment). Although well-intentioned, their actions have created dangerous self-reflexivity in markets by artificially suppressing volatility and encouraging rampant moral hazard. Central banks have exchanged ‘known unknowns’ for ‘unknown unknowns’ creating the potential for dangerous feedback loops. A central bank reaction function is now fully embedded in risk premiums. Markets are pricing the supportive policy response before action is even taken. Bad news is good news and vice versa because the intervention is more important than fundamentals. Pre-emptive strikes on risk are contributing to the massive growth and popularity of any asset or strategy with a short convexity or mean reversion return profile. The unintended consequences of this massive short convexity complex will be born from phantom liquidity, shadow gamma, and self-reflexivity.

Anyway, Mnuchin’s comments have nothing to do with tail risk. He is just beating the unwashed masses with a stick to keep pressure on Congress to deliver juicy tax cuts.

This is classic dumb money messaging. You know it’s dumb money messaging because it focuses on market prices and not valuations (traders and arbitrageurs should consider themselves exempt from my nasty sarcasm by definition). Hard selling works well with dumb money because dumb money doesn’t understand how cognitive and emotional biases impact financial decision making, or how to formulate capital market expectations. Mnuchin is basically saying to Average Joe, “if tax cuts don’t go through your 401(k) is going to crater.” That’s the true message and the true target.

See also: literally every penny stock promotion. Or the movie Boiler Room.

Lethal Risk Management Failures: The Battle of The Narrows

For some reason people find risk management boring. I do not understand why. Some of the most influential and fascinating events in history were a direct result of poor risk management. The sinking of the Titanic; the near collapse of the global financial system in 2008; the Ford Pinto’s fuel system. One of the things I find fascinating about catastrophes is that they typically do not follow from a single point of failure—risk management failures are really systemic failures and are therefore worth considerable attention.

I am currently reading a book about the decline and fall of the Ottoman Empire (The Ottoman Endgame: War, Revolution And The Making Of The Modern Middle East (1908 -1923), by Sean McMeekin). The Ottoman Empire controlled Turkey, the Balkans and much of the Middle East and North Africa for several centuries. It entered the terminal phase of its decline (the exact reasons for this are still debated) in the late nineteenth century. The First World War ensured its demise.

Despite this unhappy end the Ottomans achieved some notable victories during the war: preventing the British and French navies from forcing the Dardanelles for one and thwarting the ANZAC landings at Gallipoli shortly thereafter for another. This post is concerned with the first of these military debacles, which I believe has something to teach us about systemic failures and risk management.

This post is structured like a Tarantino film. We will see the outcome first and then explore why things went down the way they did. The date is March 18, 1915. The place is the Dardanelles Narrows (below is a visual). Simply imagine a fleet of British and French warships steaming into the Narrows and you have got the idea.

Image Source: Wikipedia

Now I will turn things over to McMeekin:

Just past noon de Robeck sent in the French squadron, commanded by Vice Admiral Guepratte, to see what they could do from shorter range. Guepratte obliged with his usual dash, sending the Gaulois, Charlemagne, Bouvet, and Suffren up the Straits, right into the teeth of the Narrows defenses. Now the guns were booming on both sides, with the channel all but choked in smoke and rocked with one detonation after another. At 1:20 p.m., the Bouvet came within range of the Hamidie battery, which rained down fire on the French ship. At 1:50 p.m., Hamidie scored two direct hits from a 355 mm Krupp gun, causing an immense explosion, with a “column of smoke shot up from her decks into the sky.” The Bouvet, listing to her side, then ran over a mine, capsized, and sank within minutes.

[…] Toward 4:00 p.m., the Irresistible had come in range of the deadly Krupp monster gun at Hamidie, which hit her fore bridge and set it on fire. At 4:09 p.m., de Robeck observed that the Irresistible “had a list to starboard”: she had raised a green flag, indicating a serious hit on that side. Though having passed out of range of Hamidie, the then drifted into range of the Rumeli Mecidiye Fort, which rained down shells on her. All the officers could do was evacuate wounded men onto the swift destroyer Wear, which pulled up alongside, and prepare for possible towing.

[…] At 4:11 p.m., the Inflexible, hitherto undamaged, ran over a mine and immediately began to list, down by the bows, in more serious trouble than the Irresistible. Inflexible, at least, was near enough the mouth to limp away from the battle: the Irresistible, having passed up the Asian shoreline into the teeth of enemy fire, was not. Trying to salvage something from the burning, de Robeck sent in HMS Ocean to tow his wounded battle cruiser – only for Ocean, too, to suffer a huge explosion at 6:05 p.m. — leaving both ships helpless under enemy fire at short range.

[…] Doubtless believing the rumors about panic in Constantinople […] Keyes and Churchill seem to have applied them to the shore batteries without thinking things through from the enemy’s perspective. The Turks and Germans, after all, had just witnessed three enemy battleships sink to the bottom under their Straights under their fire from shore; the crippling of the modern, near-dreadnought-class battle cruiser Inflexible; and the rout of the entire French squadron. Over six hundred men had perished on the Bouvet alone, with the British suffering another sixty casualties. By contrast, only three Germans had been killed and fourteen wounded, with Turkish losses scarcely higher, at twenty-six killed and fifty-two wounded—a reasonable price to pay for knocking out fully a third of the invading fleet (six out of eighteen ships).

Image Source: Wikipedia

What Went Wrong

The root cause of this disaster was that allied military planners refused to accept that the Ottomans had the resources, wherewithal or ability to put up this kind of defense.

This was partly a result of poor intelligence. The British did not appreciate the extent to which German military advisors had improved the overall competency of the Turkish officers and soldiers defending the Straights. This is always a risk in war. Rarely does one have perfect information.

The bigger mistake — and one that should have been preventable — was that military planners did not want to believe the Ottomans were capable of such a defense:

Just as they had heard what they wanted to hear in the [Russian] grand duke’s (vague) request for a diversionary strike, so did British policymakers believe what they wanted to believe about the enemy’s dispositions–and fighting capacity […]

[I]n December, Captain Frank Larken, commanding HMS Doris, had subdued the minimal shore defenses of Alexandretta (Iskendurun) simply by showing up in port and getting the Ottoman vali to agree to dynamite two rail locomotives in lieu of bombardment, in a curious face-saving compromise.

The British certainly had experience with more robust Ottoman fighting spirit, during an earlier operation in Mesopotamia (modern day Iraq). McMeekin again:

Shatt-al-Arab was a British victory, to be sure: but it had been a bloody slog, requiring a month to secure a lightly fortified waterway that had been all but abandoned by the Ottomans since Enver was committed to his Caucasian and Suez offensives.

As I see it, British military planners failed to appreciate the risks associated with the Dardanelles operation because they had little incentive to appreciate them. They were engaged in a massive, unproductive slaughter in Western Europe and were eager to achieve tangible results somewhere else on the global battlefield. A direct strike at the Ottoman Empire would serve that purpose nicely. What’s more, because the French were touchy about British military action in certain other parts of the Middle East, options outside the Dardanelles were limited.

Warren Buffett coined the term “institutional imperative” to describe this type of inertia:

In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence.

So it was with the British in 1915.

Critically, there is no risk management process that can counteract the institutional imperative. As Buffett points out in his 1989 letter, “any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” No amount of fact-finding or analysis will help. Only prudent leadership can prevent systemic failures resulting from institutional inertia.

Bubble Logic

I have been reading a lot about cryptocurrencies lately. Before I go any further I must recommend two podcasts. They are:

Hash Power Part 1

Hash Power Part 2

These are impressive pieces of work. They were produced by Patrick O’Shaughnessy of the very excellent Investor’s Field Guide (you should also subscribe to Patrick’s regular podcast, Invest Like the Best). What I appreciated most about the podcasts is that they feature a number of intelligent, level-headed people trying their hardest to crack the toughest investment puzzle in recent history. These are not scumbag stock promoter types pumping and dumping ICOs. If you are interested in this kind of thing you should really check it out.

Anyway, back to the salient question(s). Are cryptocurrencies actually worth anything? If so, what are they worth?

I took a stab at this myself not too long ago. It was a useful exercise although it did not exactly end with concrete results. So despite having learned even more about blockchain and cryptocurrencies in the meantime, I remain stuck.

How am I supposed to invest in something that I cannot value?

Now, there is a pragmatic solution I have not really discussed (also mentioned by one of Patrick’s interviewees). That is, you can simply look at cryptocurrencies as call options (or, if you prefer less financial jargon, as lottery tickets). Viewed through the lens of portfolio construction this is far and away the best way of approaching the problem given the dramatic skew in the distribution of potential returns. Max downside is 100% of the original investment. And max upside is what? A 1000x gain? More? That is a pretty attractive option.

Yet it still doesn’t sit right with me. It feels too much like gambling. Which isn’t the worst thing in the world. I enjoy the occasional trip to the casino. However, conflating investing and gambling does not seem like a real answer. In fact it seems like bubble logic: gamble a little so you won’t miss out and regret it.

ICOs, Rigged Games & Frontier Justice

I want to spend a few moments ruminating on a timeless truth of finance and investing: smart money loves a rigged game.

In the aftermath of the 2008 financial crisis nothing better exemplified this than a hedge fund called Magnetar. While other investors were content to bet that toxic mortgage-backed securities and their issuers would fail, Magnetar helped structure and issue toxic securities and then bet those same securities would fail. You see the advantage? In the first instance you hope a security will go to $0. In the second instance you know it will go to $0, because you designed it that way.

Fast forward to today and Bloomberg is reporting on “hedge funds” flipping ICOs:

More than 80 percent of ICOs are doing presales, according to Lex Sokolin, global director of fintech strategy at Autonomous NEXT. For most of the 500 or so tokens launched and listed on exchanges this year, flipping “is very prevalent,” said Lucas Nuzzi, senior analyst at Digital Asset Research. “This has been a problem in this industry, and one of the reasons why there is an overwhelming amount of low-grade ICOs being launched.”

Some 148 startups have raised $2.2 billion this year, according to CoinSchedule. And sorting winners from losers is already hard, since most startups are doing ICOs armed only with a white paper outlining their idea and not much else.

That’s raised red flags with authorities trying to figure out how to protect consumers in what’s been an unregulated corner of the markets. In July, the U.S. Securities and Exchange Commission warned investors to beware of fraudulent practices and said any tokens sold as a stake in a company rather than ones tied to an application must abide by securities regulations.

“It would shock me if you don’t see pump-and-dump schemes in the initial coin offering space,” SEC Chairman Jay Clayton said Sept. 28. “This is an area where I’m concerned about what’s going to happen to retail investors.”

Here is the scam game. There is nothing dumb retail money likes to buy more than lottery ticket type assets. You saw it with tech stocks in the ’90s and you see it with ICOs now. It’s the reason unsophisticated investors trade small cap biotechs and penny marijuana stocks.

The smart money knows this. However, the smart money prefers not to play the lottery. Playing the ICO lottery would do nothing but put smart money on a level playing field with dumb retail money, which is self-defeating. Hence a great deal (but certainly not all) of the smart money has absolutely zero interest in holding any digital asset for the long term.

But what if the smart money could be the lottery? After all, it is much better to be in the business of selling lottery tickets than the business of buying them. ICO flipping gets you pretty close without actually requiring you to commit fraud.

This is The Greater Fool Trade. The fundamentals of the asset as an investment are irrelevant. You are scalping tickets and for an investor of modest sophistication that is an attractive position. You are arbitraging the greed and stupidity of others. Add 2-3x leverage and you’ve got yourself a “hedge fund.”

Frontier Justice

Before you despair of capital markets, consider that if the majority of ICOs are as fundamentally worthless as they seem, The Greater Fool Trade will eventually end in a catastrophic blowup (see also: tulips; One day we will wake from a fitful slumber and there will simply be no one willing to bid any higher. The whole ICO complex will collapse. This is the logical end to any investment strategy that trades on the first derivative of greed. Many of the ICO flipping “hedge funds” will be destroyed in this cataclysm, precisely because they will have gotten too greedy themselves. They will stay in the trade for too long and with too much leverage.

Thinking on this symmetry I am reminded of these lines from late in the movie Unforgiven:

Will Munny: Hell of a thing, killin’ a man. You take away all he’s got and all he’s ever gonna have.

The Schofield Kid: Yeah, well, I guess he had it comin’.

Will Munny: We all got it comin’, kid.