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.

The Long War: Changing Ownership, Management Incentives & Reporting Practices (@iancassel, @ragnarisapirate, #corpgov)

Ian Cassel, founder of MicroCapClub.com, made a comment on Twitter today which grabbed my attention:

If a company is over $25m market cap they should have to have earnings conference calls w/ Q/A. Coalition Against Private Public Companies.

Shortly thereafter, he was asked by Jeff Moore of the Ragnar Is A Pirate blog:

How about if they have more than 100 shareholders?

To which Ian replied:

yes another good idea

At this point, I asked:

so you guys are for imprisoning and fining people because they won’t give you info you want?

Ian considered it and responded:

do I think every public company should, Yes. Force probably not, but cld be part of a tiered listing standard

I think this whole idea is worth a comment so I’m now going to give it one.

The first angle with which to approach Ian’s compulsory conference call proposal is the moral one and concerns the question, “Should managers of public companies, whatever their size, be compelled by force of law (ie, threat of fines or imprisonment for non-compliance) to provide the investing public conference calls regarding their earnings releases?”

The answer to such a question would hinge on whether or not, by refusing to hold such calls, these managers were committing an act of violent aggression against the investing public, such as theft, assault or fraud. If refusing to hold an earnings call is an act of theft, assault or fraud, clearly there is justification for compelling such behavior in order to remedy this affront to the rights of the individual members of the public and the answer would be “Yes”; similarly, if refusing to hold an earnings call does not represent the initiation of the use of force against members of the public, the answer to this question is clearly “No”.

I don’t want to waste anyone’s time going into a lengthy exploration of the facts on hand. I think it’s obvious that refusing to hold an earnings call is not an act of aggressive force and I don’t think Ian provided or attempted to provide any evidence that it was. In fact, he suggested this was not an issue to be handled by the law at all. I elaborated as much as I did, anyway, because there may be people reading this who did not understand the issue in this way and may have been confused prior to reading it. For their benefit, I state plainly now, the answer to the question is “NO”.

The second angle of approach is institutional. As Ian suggested in his final comment, the solution to this perceived problem could be handled at an institutional level (in this case, the voluntarily adopted rules and internal regulations of the listing exchanges) by adopting Ian’s preference for mandatory earnings calls at a certain market cap threshold as an observed “best practice” or condition of doing business on the exchange. If a company doesn’t want to follow it, they have the option of not being listed on the exchange observing such a rule. From a moral standpoint, there is no issue as there is no coercion, and compared to the alternative of creating a top-down, one-size-fits-all-companies-and-exchanges external regulation backed by force of law by government, this solution is indeed preferable because it at least allows for the possibility that some companies would not follow this practice and would find other avenues for listing their shares and allowing for equity exchange.

This leads to the third angle which, for lack of a better term, I’ll simply refer to as the “practical” considerations, of which there are several. For starters, I wonder if this is really an issue? In Ian Cassel’s (and Jeff Moore’s, perhaps?) world, it certainly seems to be. Ian Cassel’s world would be a happier place if all the public companies whose market caps were $25M or greater provided the public (of which he is a member and would stand to benefit) an earnings call upon release of each earnings statement. But embedded in such a proposal seems to be the belief that the world should reflect Ian Cassel’s preferences, and everyone else should bear the cost and expense of preparing and providing this information to Ian Cassel (and others of like mind).

Is this reasonable? If having better earnings communications from small companies is important to Ian, and if dialoging with management is a valuable commodity, Ian already has a course of action available to him to pursue such goals: he can make his own independent effort to email, write, call or visit in person the management of these companies and create a relationship whereby they would provide him answers to some of the questions he has in mind; or, he could acquire a sufficient number of shares of the company such that he is the owner of the company and the management is now fully responsible to him and he can have any and all information about the company that he pleases.

Neither of these actions require anyone being compelled to change their current practices. Both require nothing more than the expenditure of Ian’s own effort, time and wealth. If certain companies prefer not to establish such relationships or provide such information to people like Ian, Ian always has the option of walking away from them. And if he doesn’t have the financial resources to acquire such an ownership stake so as to make them more responsive to his inquiries, that would be a problem for him to solve by finding ways to produce more wealth for himself he could exchange with others for the privilege - it is not the responsibility of the company, its shareholders or anyone else.

Another practical consideration is the arbitrariness of the threshold for compliance. There’s nothing magic about a $25M market cap (nor a 100+ member shareholder base). The first number seems to be an attempt at defining “resourcefulness”, implying that a company with a certain sized market cap “should be able to afford” such accommodations. But market caps are not determined by managements and company resources, they are determined by the passions and dispositions of the investing public. It’s entirely conceivable that a company of truly inadequate resources (say, a book value of $50,000, just to harshly illustrate the point) could be bid up to a market cap of $25M in some bizarre turn of events. The fact that it has been so valued doesn’t make it more able to provide additional clarity about its business– and even if it did, it still doesn’t have an obligation to provide anyone anything like this. The shareholder base threshold is simple populism and the democratic principle– 99 of the shareholders could own one share at a penny a piece, with the remaining shareholder holding substantial control of the rest of the shares, making them truly insignificant in the ownership structure. But by creating arbitrary rules like this these individuals would create for the company sudden obligations simply by their existence.

Another practical concern is why a person, operating in the microcap space where an edge is often gained specifically because of the lack of consistent, clear information about these companies, would want to see measures taken which would serve to increase the “efficiency” of the market and thereby eliminate a lot of these mispricings and the opportunity to cheaply invest along with them. Sure, once you’ve put your money in you might have a self-interested reason to see everyone else suddenly figure out what a great company you’ve invested in because they have these wonderfully translucent earnings calls, but before that point you’d want to see opacity. Such a rule (compulsory earnings calls) would work to eliminate those opportunities before one could make their initial investment, not just after. As microcap investors, what we’re getting “paid to do”, essentially, is to find these opaque opportunities, get in there, agitate for change company-by-company and work to clear the dirt and smudges off the glass, so to speak. We want that to happen AFTER we get involved and BECAUSE we got involved, not before and regardless.

My final issue is with the cutely-named imaginary organization “Coalition Against Private Public Companies”. The implication is that public companies run like private companies constitute some kind of social ill. But if we look at the facts, it is often the owner-operator/private companies of the world which are most efficiently managed and whose business is best looked after compared to the alternative of entrenched, professional managers and disconnected, alienated and disinterested public shareholders (see this outstanding research piece by Murray Stahl [PDF] for a convincing argument, for instance). Indeed, it is often the public companies which are most dysfunctional– how is it preferable to have a management team obsessed with short-term earnings results, attempts to influence and gain the approval of Wall Street analysts, etc.? It’s perhaps syntactically confusing but what is really worth rebelling against is public private companies, not private public companies.

A public private is a company that SHOULD be private, but is in fact publicly traded (Solitron Devices, discussed numerous times on this site, is a great example) and as a result the minority partners in the business, that is, the various outsider shareholders from the investing public, are treated like nuisances or smurfs whose capital is to be dissipated at the insider owners’ discretion. Such managers have no incentive to responsibly steward the outside shareholders’ capital because it doesn’t belong to the insiders and the outsiders are, in most cases, afforded an ambiguous and difficult, if not impossible, legal process to attempt to assert their equal status as capital owners. The most benefit they can receive from the capital is to issue some of it to themselves as generous salary or bonus payments, to use it as a tool for conducting ego-gratifying acquisition strategies or by sitting on it as a kind of future retirement/pension package to ensure they can care for themselves even in old age by remitting it to themselves as needed.

A private public company, on the other hand, is a company whose capital ownership is diversified and constituted by numerous members of the investing public, but which is managed and operated with the efficiency, passion, dedication and noble conservatism such as one would expect from a competent family dynasty or other limited, owner-operator control group or person. This is a company that treats capital as a precious commodity and always seeks to maximize the returns on its use which all members of the investing public so involved stand to benefit because they are treated as equals even though they have minority status. The fact that this company is publicly traded does not influence the decisions of the management and serves only to benefit all shareholders in the instances in which the management can buy back undervalued shares or issue significantly overvalued shares to raise cheap capital.

Truly, there are very few enterprises on all of planet earth that really provide their owners (shareholders) with outstanding additional benefits by virtue of their being publicly owned and exchanged. The more I think about the issue, the more I wonder why most public companies are public in the first place. Almost every IPO seems to represent an opportunity to cash in on delusional hopes and ignorant dreams rather than a genuine opportunity to “share the wealth” in exchange for some long-term capital necessary to fund profitable growth.

If I were to join a group agitating for change, I’d like to imagine it’d be called the “Coalition To Privatize Public Companies.” But honestly, I have no use for imagination, nor for agitation. I don’t seek to have others bear my cross, even as a joke or a day-dream. No, this is in fact a principle (one of several) of my efforts as a private, individual investor in the public market place and I intend to pursue it throughout my career.

It’s part of my long war.

Post-Mortem: KVPHQ Capital Structure Arbitrage Trade ($KVPHQ, #CapArb)

A “valueprax” investment post-mortem explores the aftermath of a portfolio investment, successful or unsuccessful, with the intent of acknowledging the good, accepting the bad and attempting to find humor in the ugly. Success and failure alike carry valuable lessons; in support of the constant effort needed to avoid cognitive bias, the post-mortem is the table upon which all cards are laid and reality is fully embraced, rather than selectively avoided.

The Thesis

The thesis for this trade was elaborated upon in some detail in a series of posts over at CreditBubbleStocks.com. Essentially, KV Pharmaceuticals, the maker of an orphan drug called Makena which is used to treat pregnant women who have previously had complicated pregnancies, was the victim of a poor business model. They endeavored to charge $1,500/shot for a drug that could be easily replicated by pharmacists with generics for $10/shot. Physicians, the FDA and the government healthcare (Medicare/Medicaid) system all frowned on this behavior by the company by avoiding their products in favor of the generic alternative.

The result was a cash and earnings shortfall which left KV Pharmaceuticals with a challenged capital structure, summarized in an early post at CreditBubbleStocks.com:

There are two classes of common stock. The A class has a higher dividend but much smaller voting rights than the B class. The fully dilluted A+B share count is ~90 million, giving the company a $90 million market capitalization. Meanwhile, there are $225 million of senior secured notes due 2015 trading at 60 (market value $135mm) and $200 million of convertible notes due 2033 trading at 16 (market value $32mm). [In addition to various other obligations including payments owed to the previous owner of Makena.]

The nature of capital structure pricing and the legal force of competing claims within the capital structure dictate that discrepancies involving discounted debt and greater than de minimis common equity valuations can not be sustained over the long-run and the prices of these securities should eventually converge toward a common, non-contradictory narrative of the state of the business. Corporate debt trading at a significant discount to face value in the markets implies financial distress and a risk of insolvency, which further implies that common equity has no value, as the financial claims of debtholders are superior to those of preferred and common equity holders. Debt holders are due their principal at time of maturity, so if the bond market is saying they aren’t going to get all of their principal back it implies the equity holders have claims with zero economic value.

The Research & Analysis Process

Unlike an earlier cap-arb trade I did involving the securities of the now-bankrupt Energy Conversion Devices where I performed fairly extensive due diligence work on my own, in the case of KV Pharmaceuticals I simply grabbed the coattails of CBS and held on for dear life. “Research” involved following the postings on KV at the CBS website. “Analysis” involved considering what the posts were about and coming to terms with the argument for the cap-arb trade.

When I felt sufficiently comfortable with the thesis, I decided to place my bet.

The Execution

As with the previous cap-arb I did, the trade itself was theoretically simple but turned out to be technically complex. To set up the capital structure arbitrage the investor wants to buy the distressed bonds and synthesize a short on the equity. The belief here is that the equity is over-valued (assuming it’s worth zero) and the debt is under- or fairly-valued.

If the equity turns out to be worth something, the investor will lose on the equity short but gain on the debt long due to a full recovery. If the company is in fact insolvent and seeks bankruptcy protection with a zero equity value, the investor will gain on the equity short and could potentially lose on the debt long, though in practice it’s more common for the debt, already trading at distressed prices, to not lose a whole lot more in that situation.

I faced a couple challenges particular to this investment, the first being that the particular issue of debt I was looking for wasn’t widely available and took some time to come by. The second challenge was that the company was not that liquid and the options issuance (I wanted to synthesize a short by buying puts) available had wide bid-ask spreads and low volume and open interest.

This second aspect of the technical execution of the trade proved to be my folly.

The Experience & Lessons Learned

I didn’t double check this but I think I put the trade on originally back in May. I finally sold my puts (Sep 22 2012 2.50s) today. I still own the bonds, which are now trading at essentially a de minimis value, having lost approximately 90% of their value. Overall, the trade lasted about four months.

At the time I was placing the trade, I was traveling and not near a reliable internet/computer connection. That made researching securities and placing the trades incredibly challenging and stressful. In the future, I would not advise myself (nor anyone else) to attempt to place anything but the simplest of trades under such circumstances. It ended up resulting in me making a poorly informed decision (explained more below) and stressed me out during what was an otherwise enjoyable trip.

Another issue I faced is that I did not understand the technical details involved in pricing the option securities involved. I had trouble determining how many and which options I needed to buy to properly hedge my bond exposure and create the cap-arb. This is a limitation of my own understanding of option pricing theory which could have been remedied by intensive study of options reference materials which I decided I did not have time to engage in before or since I placed the trade. This is a behavioral issue– I admittedly did not understand the technical details of professionally executing this trade but assumed it would not be a big issue (probably, in my mind, relative to all the imaginary profits I’d be making when this thing went off with a bang).

The experience of being invested, itself, was fairly easy to endure in this case. KV’s business situation continued to deteriorate over the course of the trade. The company went through all the tell-tale signs of continuing, aggravated distress, including: falling share price, falling bond price (!), odd IR boilerplate related to trading activity, unfavorable announcements and news developments from regulators, etc., all the stuff you’d imagine would not be happening at all, especially not simultaneously, with a healthy company.

However, I again faced execution challenges when the company delisted its stock. I wasn’t sure if this was an appropriate time to “cover” and sell my puts, or if I should hold on, imagining they’d become even more valuable once the company delisted as I anticipated the stock price, already nothing more than a bloody stump, would be completely demolished following delisting.

In short, my lesson was that while I can follow the logic of a cap-arb thesis, I have real and continued shortcomings in terms of my knowledge of how to technically execute on the thesis which introduce significant risk into the equation. It is not the trade which was risky, it was me doing the trading.

That being said, I did come away with the sense that, while I am the right “scale” for opportunities like this (these inefficiencies exist because larger players won’t bother with them), without significant leverage, which may in fact be available through careful, expert use of options, these trades represent the opportunity to pick up pennies in front of a steamroller. If things go right and you’re not leveraged, you make a little money, but if you screw something up you can cost yourself even more.

The Outcome

In the end, the thesis was absolutely correct. KV Pharmaceuticals filed for bankruptcy protection in order to restructure their financial obligations. Their market cap fell from an initial ~$90M to the current ~$3.5M and the stock was delisted. Unfortunately, the debt I purchased also fell dramatically in value and right now it looks like the recovery on it will be pretty pathetic, if anything.

The trouble is, I didn’t technically execute well. I bought some in-the-money puts that were earlier dated (Sep 2012). I sat and watched my bonds get eviscerated even as it became clear there was no benefit in being hedged because the company was essentially a one-way trade (short) as they faced a going-concern issue. Meanwhile, the puts just didn’t perform because of what I paid for them– as they traded up a bit I didn’t receive much benefit because I bought at such a wide initial bid-ask spread. I probably could’ve more intelligently bought the puts so as to make a killing at this point in the game, but I didn’t know how to, that was beyond my expertise then and now.

Additionally, there were numerous points at which the puts were worth substantially more than what I ultimately paid for them (40-60% more at various points) but I never took advantage because I was greedy and assumed the share price would keep going down as everyone realized it was hopeless and the puts concurrently traded higher. Instead, volume dropped on the puts as people closed out their trades and the value of the options dwindled as they neared expiration (which is tomorrow). Fearing a total wipeout on the puts, I threw them into the market at market price this afternoon, happy to be rid of them and at a 20% profit.

Unfortunately, this was a fraction of what they had been worth at various points and was not enough to compensate for the loss in the bonds, such that even though the thesis played out as anticipated, I lost money on this trade.

I’ve learned my lesson now. I have one more cap-arb that’s ongoing and I’ll let it play out before selling. But I’ve realized I’m in over my head on this stuff and I don’t have the time and knowledge to get myself up to speed. I am my own worst enemy on this stuff, truly the biggest risk of permanent loss of capital lies within me.

With respect to that, I just won’t touch these kinds of trades anymore.

Review – Fooling Some Of The People All Of The Time (#investing, #shortselling, #fraud)

Fooling Some Of The People All Of The Time, A Long Short (And Now Complete) Story, Updated with New Epilogue (buy on Amazon.com)

by David Einhorn, published 2010

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library.

So much could be said about Einhorn’s “Fooling Some Of The People All Of The Time” that I’ll necessarily have to ignore much of it to keep this review to the point. And let me say up front that I believe the main point of Einhorn’s book is that frauds may not be transparent, but the people perpetrating and enabling them often are and on that note I believe it’s clear that Einhorn is the hero and the Allied Capital crowd are the villains. If the opposite be true, Einhorn certainly has me “fooled.”

For what amounts to a legal caper (not a crime caper, a legal caper) involving all kinds of humorless characters, including the liars at Allied Capital attempting to perpetrate a fraud, the duplicitous analysts and journalists seemingly working on their behalf to help cover it up and a menagerie of lawyers, government officials and SEC investigators — can you get any more humorless than that group? — “Fooling” is darned entertaining. Funny, too. I found myself chuckling at the outrageous prevarications of the guilty parties on more than one occasion.

It’s not just a good story, though, it’s something of an instructive modern parable, political, financial and even economic in nature.

Einhorn’s sojourn into the bowels of the Allied Capital fraud began before the current financial crisis but carried into it. Knowing this, it’s both fascinating to see the struggles of someone who had come upon the margins of the crisis before it had become a crisis as well as frustrating to see that the Allied Capital saga is yet another facet of that crisis and one which, despite Einhorn’s having published a whole book about it, has yet to see much coverage in the mainstream press. Three years into what is becoming a growing pile of frauds and wasted resources, many politicians and interest groups are unabashedly calling for the expansion of the Small Business Administration and its various loan programs, rather than the shutting down of a completely compromised institution.

Financially, “Fooling” tells two tales: one is of a bold, dedicated individual (Einhorn) and his small band of loyal followers (Greenlight Capital staff) and friends (private citizens like Jim Brickman) who, despite the odds and the constant doubting of the hoi polloi nevertheless persevered in their struggle for truth and were ultimately vindicated by the facts and their profitable short position; the other is the story of that same man and his merry band who put an ungodly amount of time and resources into investigating a fraud that ultimately represented only about 8% of their portfolio, begging the question, “How much of this was about ego-gratification versus responsibly representing the interests of Greenlight’s partners?”

Knowing that Einhorn and Greenlight continued to make other successful investments along the way, more than once you find yourself wondering if Allied Capital would prove to be some kind of a Pyrrhic Victory. Certainly it’s reasonable to question whether Greenlight wouldn’t have fallen victim to another fraud they had invested in at Tyco if they had spread their attention and energies more equally amongst their various positions.

In the end, it is the economic parable which reigns supreme, however. The Allied Capital case is one of those seeming empirical confirmations of free market economic tenets. One by one, the various watchdogs and regulators prove either useless, incompetent, disinterested or entirely corrupted, from the federal SBA, SEC and even FBI, to the ratings agencies, to the Wall Street establishment analysts to the sacred Fourth Estate itself. It is only Greenlight Capital, and finally the market place at large, motivated by the profit principle, which has any incentive to actually root out and expose the fraudulent financial activities at Allied.

Einhorn’s triumph demonstrates that it isn’t about people but processes, the fundamental and natural incentives of the two competing and mutually exclusive principles of profit versus welfare.

I give it 4/5. This book is not perfect but it’s enlightening in more ways than one. “Fooling” does an excellent job of revealing the way modern capital markets work and while Einhorn mostly manages to stay above the vulgarity of his opponents, the Allied feud proves that to win a confidence game it’s helpful to have both the truth, and some talented lawyers and public opinion-setters, on your side.

(Originally published on EconomicPolicyJournal.com)

Interview With Jim Chanos On Shortseller Psychology, China (#ChinaCrash, #shortselling)

Jim Chanos interviewed by Opalesque TV, discussing the differences between long and short investor psychology, and the economic dynamics in China: