Tag Archives: inefficiencies

Notes – Original Issue Discount (OID) Tax Implications, Lessons Learned (#taxes, #investing)

In the process of carrying out the KV Pharmaceuticals capital structure arbitrage trade of 2012, I got caught with my pants down a bit as I didn’t think to sell the convertible notes before they stopped trading. As a result, I missed an opportunity to lock in a capital loss for tax purposes at the time, which would’ve helped shield some of the income I made on the puts and thus made the trade as a whole more tax efficient.

Instead, I got a double-whammy of tax inefficiency for my ignorance, a chicken that finally came home to roost in tax FY2013 as the CPA assisting me with my tax preparation informed me that I ended up owing an additional sum beyond amounts withheld in prior periods due to Original Issue Discount (OID) interest income related to my defunct KV Pharmaceuticals play!

At first I was shocked and dismayed– the company went into bankruptcy and the securities were eventually removed from my account entirely earlier this year. How could I owe taxes when I never earned any cash interest and will never get back even a penny from the securities I stupidly held onto?

I talked about it with my CPA (who double-checked with his partner) and then spoke to a rep at TD Ameritrade and the matter is decisively not going to turn out in my favor. I learned that when a bond goes into default it often switches from cash interest basis to accrual interest basis in the eyes of the IRS, and like any good group of thugs they want their blood now, not later. In other words, I owe federal income tax on “accrued interest” I not only never received but never will receive. Because the securities were removed from my account in 2014 and not 2013, it looks like I accrued interest income due to me even though we clearly know right now that I’ll never get it.

Instead, I get a stepped up cost basis on the securities (in the amount equal to the accrued interest not received) so when I finally report the loss for FY2014 taxes, it’ll be a total loss of X + Y instead of just X. I get to shield additional future income with the X + Y amount but I paid real cash up front for the privilege.

If I had known better, I would’ve executed this trade such that the gains and losses all occurred in the same period in 2012. I also probably wouldn’t have gotten into a trade in the first place whose money-making mechanics I generally understood but about whose technical execution and tax implications I was grossly ignorant.

Another expensive lesson learned!

Public Choice Theory In Action (#publicchoice, #economics)

“The councilman is coming! The councilman is coming!”

This comes courtesy of a Los Angeles, CA-based reader:

LA

 

After the city destroyed our front strip while putting in a totally unnecessary crosswalk to appease the theater next door, it sat barren for multiple months, collecting trash and dog shit.  But now that a city councilman is coming on Monday to dedicate the senseless crosswalk, the city has had a crew working non stop the past two days on beautifying it.  Apparently one of the workers told Mr. G– that it couldn’t look that way for the councilman; somehow we mundanes survived living with it, though the suffering was no doubt immense.

Mr. G– adds:

Don’t forget they are taking down our no parking signs that have graffiti and then putting them back up after the douche bag leaves.

Entrepreneurial Opportunity Cost (#socialism, #bureaucracy, #freemarket)

I am wondering out loud here: when people attempt to do some kind of modeling of the various opportunity costs of having government provide X, versus having “the market” provide X, do they factor in the opportunity cost of lost entrepreneurial progress inherent in bureaucratic provisioning?

For example, if someone was arguing that the government should control automobile production, is there any calculus attempted that examines the present value of foregone future improvements in automobile production and design that will inherently be included in bureaucratic provisioning?

A further example– the roads and highways we drive on, which have been provisioned by government for decades, haven’t changed all that much. But cars have made huge technological leaps in terms of how they’re designed and built. Cars have entrepreneurs behind them, roads and highways have bureaucrats behind them.

I’m not sure I am articulating my inquiry as coherently as I might like to but there it is nonetheless!

Another Battle In The Long War: The Solitron Shareholders Meeting ($SODI, #corpgov)

Something that has been impressed upon me over the years as I learn more about business and investing has been the invaluable role that bullshit-detection plays in money dealings. The jungle is everywhere and while man may have found a way to tame his baser desires and impulses enough to enjoy a broad civilization, individual men will always tease the edges of appropriateness by attempting force by other means, namely deceit, misdirection, opacity, feigned confusion, intentional blundering, etc. If you can’t smell bullshit and if you have no means to fight back against a bullshit-peddler, he will run you over and probably try to take you for all you’re worth along the way.

Some people say, “That’s just business!” but that’s been invalidated by numerous contrary, personal experiences where no bullshit occurred and business occurred nonetheless, and more efficiently and for more wealth for both parties, overall. Bullshit is just a grey-area form of aggression, a remnant of the jungle from which we can never fully emerge.

My attendance at the first annual Solitron Devices shareholders’ meeting in nearly 20 years was a descent into that jungle. Here I and several other shareholders came face-to-face with Shevach Saraf, President, Chairman of the Board, CEO, CFO and, among many other titles and distinguishments I should say, a highly intelligent, sophisticated bullshitter.

My personal predisposition is to assume a person is trustworthy until they demonstrate they clearly are not. This is a little different than treating a person as trustworthy– I maintain skepticism and try to be alert at all times, but I don’t start a person at 0 and then work up to 100 on a “trustworthiness” scale, but rather the opposite. As a result, in dealing with Saraf and other representatives of the company in the past, detailed at considerable length here in the past (1, 2), I tried to explain various indiscretions, unkindness and general belligerency displayed by these parties in terms of misjudgments, misperceptions and a potentially historical apprehensiveness, rather than some kind of malintent.

At this point, the veil has been lifted for me and I believe I can confidently state that the bullshit is a calculated tactic and it is laid on, thick, with due purpose.

In the particular case of the shareholders’ meeting, the bullshit started with the “rules for the meeting”, which restricted each participant to a maximum of two questions no longer than one minute in length, with a twenty minute maximum duration. As with most bullshit, this was done in the name of “giving everyone a chance to speak”, but was really a rather naked attempt to intimidate shareholders and prevent them from stating their minds and engaging in significant follow-up questioning. No shareholder present (all 9 of us!) ever demonstrated any concern about domination of the Q&A period by any other shareholder. At the end of the Q&A, Saraf attempted to enforce the twenty minute maximum but was ultimately stymied by a shareholder who requested a longer, informal, follow-up Q&A period, which after 5 minutes of deliberation outside the room with counsel, was ultimately granted.

The second strand of bullshit is woven through the scandalous insinuations that Saraf made of his shareholder base. He deemed it fit to specially remind the gathered investors that he had no plans to do anything illegal and so he would not offer any insider info during the meeting. This is a strawman Saraf seems to trot out often– ask the man anything about the company at all, no matter how innocent and legally-sanctioned it may be, and he proceeds to launch into accusations of villainy aimed at getting an illegal upperhand while putting himself and the company in legal jeopardy. He also made a warning about supposed shadowy elements that were spreading false rumors and lies about the company on the internet, but he did not think to mention who was doing this or what specific claims were made which he could clarify as to their falsity. The impression one is left with is that there are no false rumors or lies being spread and this is yet another attempt to intimidate via bullshit.

Then we had to wade through Saraf’s numerous self-contradictions and general evasiveness in answering questions, most of which began with the expression, “Let me put it this way…”, which in my experience has always preceded a barely-obscured threat, as in, “Let me put it this way, if you don’t do what I am asking you to do, someone might get hurt.” The infamous EPA liabilities which have left the company hamstrung to do anything with the company’s excess capital and which according to regulatory filings earlier in the year seemed to have been extinguished, or due to be extinguished completely, by or around March or April of 2013, were suddenly at one point 30, another point 60 and another time some 72 days away from being resolved.

More bullshit: Solitron has a “sunset technology”, but there’s also the possibility they spend $5M+ of the company’s cash stockpile retooling their factory for new silicon wafer standards; the sequestration has been bad for business, but the company has also gobbled up marketshare from competitors who have gone out of business; the company is at 50% of plant utilization, but wars in Syria and elsewhere are good for business because it means equipment will need to be replaced that Solitron services; the company has struggled with rising inputs costs, but they build everything on spec and have a guaranteed profit-margin built in by the Pentagon; shareholders are now “welcome to contact any board member and ask them questions about the company” but in the past “PLEASE KEEP IN MIND THAT ALL INVESTOR COMMUNICATIONS SHOULD BE DIRECTED TO THE CHAIRMAN OF THE BOARD OF SOLITRON DEVICES, INC.“; Chinese and COTS parts have created huge price competition for the firm, but the firm’s buyers actually require specially-tested, high quality parts only Solitron can produce, and new DNA-marking of chips prevents the use/substitution of foreign knockoff parts, etc. etc.

I could go on and on. The point is it’s just a bunch of bullshit.

And Saraf isn’t the only one peddling it. His vaunted board showed their own knack. Saraf was asked, as a large shareholder, if he was concerned about the price of the company in the open market hovering around cash value. Not only did he evade the question and not answer it, but his new appointee, Mr. Kopperl, piped in with the pithy “Does anyone really know what moves stock prices?” When asked how he makes his investment decisions, Mr. Kopperl said, “Sometimes I buy value, sometimes growth.” But if no one really know whats moves stock prices and you’re philosophically agnostic as to what kind of decisions a company could make that would be good or bad from a valuation standpoint, how could you even invest?

And how would this bolster the company’s claim that the current composition of the board represents people capable of maximizing shareholder value?

It was suggested to Saraf that more disclosures from the company about its business would help the market better understand the company and its prospects and arrive at a fairer valuation. Saraf did not acknowledge whether this transparency would be beneficial to shareholders interested in seeing the marketplace better assess the company’s prospects, but he did say that he wasn’t interested in putting out a press release every time the company got a new certification or secured a contract. Bullshit!

The most puzzling event of the day was the withholding of votes for Schlig and Davis (and their subsequent dismissal with no replacement nominees named), and the approval-by-vote of the two new directors, Gerrity and Kopperl. These guys are black boxes as far as I am concerned. They sound like country club buddies and there was no explanation as to why they were qualified to represent SHAREHOLDER interests though, Saraf was quite clear, their industry experience made them qualified in his mind to represent company interests, which essentially means Saraf’s interests as things have been run so far.

Large shareholders seem to be more confident. They’re convinced Saraf is more cooperative than he seems and that he will do the right thing when it’s the right time to do so. I think the laws of the SEC are a legal cover for bullshitmongers. From where I stand, it’s an almost impenetrable fog. But maybe when you own 5% or more, you have other methods of cutting through the bullshit.

It is indeed going to be a Long War without them.

If you want more, here’s Nate Tobik’s take at OddballStocks.com.

Videos – Toby Carlisle, Q&A Notes at UC Davis Talk on Quantitative Value (@greenbackd, #QuantitativeValue)

Click here to watch the video (wear earphones and bring a magnifying glass)

UC Davis/Farnam Street Investments presents Toby Carlisle, founder and managing partner of Eyquem Investment Management and author of Quantitative Value, with Wes Gray

Normally I’d embed a video but I can’t seem to do that with the UC Davis feed. Also, these are PARAPHRASED notes to the Q&A portion of Toby’s talk only. I ignored the “lecture” portion which preceeded because I already think I get the gist of it from the book. I was mostly interested in covering his responses to the Q&A section.

The video is extremely poor quality, which is a shame because this is a great talk on a not-so-widely publicized idea. I wish there was a copy on YouTube with better audio and zoom, but no one put such a thing up, if it exists. I hope Toby does more interviews and talks in the future… hell, I’d help him put something together if it resulted in a better recording!

I had trouble hearing it and only thought to plug in some earbuds near the end. Prior to that I was contending with airplanes going overhead, refrigerator suddenly cycling into a loud cooling mode as well as my laptop’s maxed out tinny speakers contending with the cooling fans which randomly decided to cycle on and off at often the most critical moments. I often didn’t catch the question being asked, even when it wasn’t muffled, and chose to just focus on Toby’s response, assuming that the question would be obvious from that. That being said, I often conjoined questions and responses when there was overlap or similarity, or when it was easier for me to edit. This is NOT a verbatim transcript.

Finally, Toby recently created a beta forum for his book/website, at the Greenbackd Forum and I realize now in reviewing this talk that a lot of the questions I asked there, were covered here in my notes. I think he’s probably already given up on it, likely due to blockheads like me showing up and spamming him with simpleton questions he’s answered a million times for the Rubed Masses.

Major take-aways from the interview:

Q: Could we be in a “New Era” where the current market level is the “New Mean” and therefore there is nothing to revert to?

A: Well that’s really like saying stocks will revert down, not up. But how could you know? You could only look at historical data and go off of that, we have no way to predict ahead of time whether this “New Mean” is the case. I think this is why value investing continues to work, because at every juncture, people choose to believe that the old rules don’t apply. But the better bet has been that the world changes but the old rules continue to apply.

Q: So because the world is unknowable, do you compensate by fishing in the deep value ponds?

A: I like investing in really cheap stocks because when you get surprises, they’re good surprises. I find Buffett stocks terrifying because they have a big growth component in the valuation and any misstep and they get cut to pieces; whereas these cheap stocks are moribund for the most part so if you buy them and something good happens, they go up a lot.

Q: (muffled)

A: If you look at large cap stocks, the value effect is not as prevalent and the value premia is smaller. That’s because they’re a lot more efficient. There’s still only about 5% of AUM invested in value. But the big value guys portfolios look very similar; the value you have as a small investor is you don’t have to hold those stocks. So you can buy the smaller stuff where the value premia is larger. The institutional imperative is also very real. The idea of I’d like to buy 20 stocks, but I have to hold 45. That pushes you away from the optimal holdings for outperformance.

Q: (muffled)

A: The easiest way to stand out is to not run a lot of money. But no one wants to do that, everyone wants to run a lot of money.

Q: (muffled)

A: The model I follow is a bit more complicated than the Magic Formula. But there are two broad differences. I only buy value stocks, I only buy the cheapest decile and I don’t go outside of it, and then I buy quality within that decile. ROIC will work as a quality metric but only within the cheapest decile. ROIC is something Buffett talks about from a marketing perspective but I think in terms of raw performance it doesn’t make much sense. There’s definitely some persistence in ROIC, companies that have generated high returns on invested capital over long periods of time, tend to continue to do that.  If you have Warren Buffett’s genius and can avoid stepping on landmines, that can work. But if you don’t, you need to come up with another strategy.

Q: (muffled)

A: Intuition is important and it’s important when you’re deciding which strategy to use, but it’s not important when you’re selecting individual stocks. We can be overconfident in our assessment of a stock. I wonder whether all the information investors gather adds to their accuracy or to their confidence about their accuracy.

Q: (muffled)

A: All strategies have those periods when they don’t work. If you imagined you ran 4 different strategies in your portfolio, one is MF, one is cheap stocks, one of them is Buffett growth and one is special situations, and you just put a fixed amount of capital into each one [fixed proportion?] so that when one is performing well, you take the [excess?] capital out of it and put it into the one that is performing poorly, then you always have this natural rebalancing and it works the same way as equal-weighted stocks. And I think it’d lead to outperformance. It makes sense to have different strategies in the fund.

Q: (muffled)

A: QV says you are better off following an indexing strategy, but which market you index to is important. The S&P500 is one index you can follow, and there are simple steps you can follow to randomize the errors and outperform. But if you’re going to take those simple steps why not follow them to their logical conclusion and use value investing, which will allow you to outperform over a long period of time.

Q: (muffled)

A: Not everyone can beat the market. Mutual funds/big investors ARE the market, so their returns will be the market minus their fees. Value guys are 5% of AUM, can 5% outperform? Probably, by employing unusual strategies. Wes Gray has this thought experiment where he says if we return 20% a year, how long before we own the entire market? And it’s not that long. So there are constraints and all the big value investors find that once they get out there they all have the same portfolios so their outperformance isn’t so great. There’s a natural cap on value and it probably gets exceeded right before a bust. After a bust is then fertile ground for investment and that’s why you see all the good returns come right after the bust and then it trickles up for a period of time before there’s another collapse.

Q: (muffled)

A: I think the market is not going to generate great returns in the US, and I am not sure how value will do within that. That’s why my strategy is global. There are cheaper markets in other parts of the world. The US is actually one of the most expensive markets. The cheapest market in the developed world is Greece.

Q: Did you guys ever try to add a timing component to the formula? That might help you decide how to weight cash?

A: Yes, it doesn’t work. Well, we couldn’t get it to work. However, if you look at the yield, the yield of the strategy is always really fat, especially compared to the other instruments you could invest the cash in, so logically, you’d want to capture that yield and be fully invested. I think you should be close to fully invested.

Q: What about position sizing?

A: I equal weight. An argument can be made for sizing your cheaper positions bigger. I run 50 positions in the portfolio. In the backtest I found that was the best risk-adjusted risk-reward. That’s using Sortino and Sharpe ratios, which I don’t really believe in, but what else are you going to use? If you sized to 10 positions, you get better performance but it’s not better risk-adjusted performance. If you sized to 20 positions, you get slightly worse performance but better risk-adjusted performance. So you could make an argument for making a portfolio where your 5 best ideas were slightly bigger than your next 10 best, and so on, but I think it’s a nightmare for rebalancing. The stocks I look at act a little bit like options. They’re dead money until something happens and then they pop; so I want as much exposure to those as I can. I invest globally so the accounting regimes locally are a nightmare. IFRS, GAAP to me is foreign. You have to adjust the inputs to your screen for each country as a result of different accounting standards.

Q: digression

A: Japan is an interesting market. Everyone looks at Japan and sees the slump and says it’s terrifying investing in Japan but if you look at value in Japan, value has been performing really well for a really long time. So, if the US is in this position where it’s got a lot of govt debt and it’s going to follow a similar trajectory, you could look at Japan as a proxy and feel pretty good about value.

Q: (muffled)

A: I’ll take hot money, I am not in a position to turn down anyone right now. It’s a hard strategy [QV] to sell.

Q: (muffled)

A: Special situation investing is often a situation where you can’t find it in a screen, something is being spun out, you have to read a 10-K or 10-Q and understand what’s going to happen and then take a position that you wouldn’t be able to figure out from following a simple price ratio. It’s a good place to start out because it’s something you can understand and you can get an advantage by doing more work than everyone else. It’s not really correlated to the market. I don’t know whether it outperforms over a full cycle, but people don’t care because it performs well in a bad market like this.

Q: What kind of data do you use for your backtests?

A: Compustat, CRISP (Center for Research Into Securities Prices), Excel spreadsheets. You need expensive databases that have adjusted for when earnings announcements are made, that include adjustments that are made, that include companies that went bankrupt. Those kinds are expensive. They’re all filled with errors, that’s the toughest thing.