I am out of tune with these times

At core I am an old-fashioned value investor. Maybe a growth-orientated one - but the valuation has to make sense on fairly modest assumptions before I get excited.

I owned Facebook in the twenties. I could make the per-subscriber numbers work - and it was a mid-single digit times revenue and it seemed a fairly good bet that revenue would rise a lot and that margins on that revenue would be good. I am not averse to paying six times sales for businesses that are growing fast if the end-margins are likely to be good.

At the time the (incorrect) consensus was that Facebook would not manage the transition to mobile.

I sold my Facebook holding as it went up. Too early I regret - and at least in part unintentionally. I purchased the holding by writing put options perfectly happy to have the stock put to me. I sold by writing call options, modestly happy if it was called. I just had a buy-price and sell price in my head based on what I thought were sensible valuations and decided to pocket a little premium around them. [This is almost the only stock Bronte has ever acquired this way. We did it because the option premium was extraordinarily high and we figured the business was far less volatile than the stock.]

These days I am no longer so in tune with valuation.

Yesterday Facebook did an acquisition that makes no sense to me. I had previously - on Twitter - questioned the $900 million paid by Rakuten (in Japan) for Viber. But that price looks modest compared to the price paid for the (much better) WhatsApp. 

Obviously this makes sense to somebody - and indeed to people who are far cleverer than me. I don't want to second-guess Mark Zuckerberg who has done things and built things and added more value in a week than I might in a lifetime. 

But I would have laid a large bet that Facebook stock would finish down after that acquisition rather than up and I would have been wrong.

I used to be an unremitting bull on the market (a position that is deeply uncomfortable for someone whose skills and inclination are on the short side). I am not bullish now - and have positioned far closer to neutral than any time in Bronte's history.

But I am not comfortable with that position either. Clever people are doing things I don't understand and I am just feeling old and tired. 

John

PS. No position on $FB. Still long $GOOG. 

Blue Nile and Marc Andreesen's theory of public company shareholders, oh and a valuation of Amazon

Marc Andreesen (@pmarca for the must-follow twitter account) has been toying with a theory of public company shareholder. The short (Twitter) version is "At any given time, public co's shareholder base consists entirely of one of: growth investors, value investors, arbitrageurs, or nobody." This has been refined through tweets.

The growth investors will hold a stock as long as the rate of revenue growth does not slow. When it slows they dump - and the shares of really fine companies can fall sharply because the growth rate falls from (say) high single digit to mid single digit. What are objectively great results can see 25 percent price falls simply because the results do not measure up to the expectations of the shareholder base.

The growth investors don't much care about earnings (they come later). But they do care how big the eventual market becomes.

A recent example of a fall (which may or may not be justified) is Amazon who were seen missing lofty expectations for Christmas sales. [The sales numbers were fantastic, just the expectations were more fantastic.]

A fallen growth stock doesn't become fashionable again until it has a lower-than-market price-earnings ratio where it attracts "value investors".  Value investors have a different agenda. They want the business run for cash and maybe for buybacks. Shareholders will pressure management to meet their expectations. [Example: Apple.] If earnings fall or buy-backs slow these shareholders are disappointed.

Below the value investors - and mentioned in later tweets - are the Ben Graham style bottom feeders who get really interested when the stock is trading at half cash. Whereas traditional value investors want the business run for cash the true bottom feeders want the business closed for cash. Zynga at bottom was borderline of interest these investors.

Outside this are the arbitrageurs that just want to rent the stock for a short term deal. No deal and they are disappointed.

This is a generalization. But being a non-conformist at heart I want to look at the places between - stocks dumped by growth investors for example before they become interesting to value investors - or stocks that are approaching Ben Graham levels but still have viable businesses.

Between the cracks are interesting places to look. Zynga was interesting at the edge of being a Ben Graham stock. Google's had a slowdown that lasted one quarter. Buying a growth stock when the slowdown is temporary and lasts one quarter provides great opportunities. See January 2012 where Google dropped a double-digit percentage in a sharply rising market.*

So I am going to look at a twixt-and-between stock: Blue Nile. This is a failed growth stock that doesn't yet have a low PE and has an enormous short interest. The company recently missed and guided revenue and earnings down - which is problematic for a stock with a 50 PE ratio.

The knock on the stock: it has been missing expectations for years.

==

The Jeweller with one of the all-time-great business models

Blue Nile has possibly the most seductive business model I have ever seen. It is an online build-your-own seller of engagement rings.

The modal purchaser of an engagement ring is a man in their 20s or the 30s who doesn't give two hoots about jewellery. The purchase is large (a month's salary?) and is full of terms that he doesn't know (VS2 clarity anyone). He is buying it for someone who he hopes will accept his proposal.

The ideal customer provides no return business. Ever.

The total absence of return business means that the downside for ripping customers off is low. [They are not coming back so if you gouge them it won't matter.] The high-ticket price and the general ignorance of the customer guarantees a rip-off. If the customer is at all sophisticated about human nature they know it.

The shop-keepers know this too. They have glamorous premises (which just adds to the feeling of being ripped off). They use lighting tricks to make the diamonds sparkle. And the sales guys are - in my one-off experience** - a less explicitly testosterone laden version of car salesmen. Slick. Dishonourable. But smooth, so smooth.

Into this comes Blue Nile who offer diamond engagement rings on a build-your-own basis with transparent pricing. You go to their site and choose one stone, three stone, this clasp, that clasp, this quality and size of diamond etc. They tell you if you are choosing a quality of diamond so high you can't tell the imperfections except with a microscope. As you move the slider up choosing a bigger diamond or a higher quality diamond the price changes and you can see the price change so you know how much you are paying for size/quality and settings.

The margin is thin - so there is no way you can feel "ripped off" and it comes in a blue-box which to my (admittedly unsophisticated eye) is just a darker, richer shade of blue vis the expensive boxes sold by Tiffany's.

If you have not played with the jewellery site do so. This is internet shopping at its finest.

It is also a truly great business model. Transparent pricing makes a guy keen to shop there. But the real joy is the negative working capital.

A traditional jeweller sits huge amounts of inventory around waiting for a victim (ahem: customer) to come through the door. They need to sell at a price high enough to get a return on all that inventory. Zale Corporation has $900 million in inventory. That inventory is the majority of their assets and represents about a year of cost of goods sold. The first 10% of margin is just getting a return of 10% on the inventory holding. Tiffany is even worse with $2.4 billion in inventory and annual cost of goods sold of $1.7 billion. They have 17 months inventory sitting around glistening under expensive lights and more expensive security. Margins need to be enormous just to give a return on inventory holdings.

By contrast Blue Nile recognizes diamonds are commodities and doesn't bother with all that inventory. They just buy-to-order. If you want a round-cut three-quarter carrot diamond with an ideal-grade cut and VS2 clarity it will cost you about two and a half grand and one is pretty well like another. So Blue Nile take your money, build the ring to order and ship it to you. Turn-around is not fast but is adequate and Blue Nile operate with negative working capital. At the last (and disappointing) numbers Blue Nile has $34 million of inventory (mostly non-engage ring product) and $134 million in accounts payable. The offset is a cash balance well over $100 million.

And Blue Nile can sell much cheaper than a traditional jeweller. A traditional jeweller with this turnover would carry maybe $350 million more inventory and would require a return on that. They would also need security and insurance for that inventory and would pass that onto customers. On top of that there are no premises and slick dishonourable sales people to pay. All this would add up to more than 20 percent cost advantage.

The advantage that Blue Nile has over its competitors is much bigger than the advantage that (say) Amazon has over Best Buy.

If you had that advantage the rational thing to do is to price really keenly, be as honest and transparent as possible and grow and grow and grow some more.

In other words to do what Amazon does.

One day - sometime in the dim-distant future - growth will slow because you have captured the market and then you price with say a 8% margin and mint money.

The maths will look like this. We don't know what the "end-sustainable sales" are but for every dollar of sales there is 8c of margin. Post tax there will be about 5.6 cents of earnings. Put that on 13 times and the stock will settle out at 72 percent of sales.

If end sales are a billion the market cap will be $720 million. If they are 5 billion the market cap will be $3.6 billion.

This maths gives you the quick way of valuing Amazon. Amazon sales are currently $75 billion. If they quadruple between now and maturation the end sales will be $300 billion. The end market cap will be $210 billion. The current market cap is $165 billion. If Amazon can quadruple sales the stock will be a winner. I think it probably will. But to do really well on the stock sales probably need to rise 600 percent. [We have no position in the stock.]

Alas Blue Nile is not Amazon. Despite what looks like a massive advantage and a near perfect business model Blue Nile just has not grown that fast.

In 2008 Amazon sales were $20 billion. They are now $75 billion. Sales have better-than tripled.

By contrast Nile has disappointed. Sales are only up about 50 percent. And in that time margins have slid so earnings are flat. Earnings are flat at Amazon too but nobody gives a toss. All they care about is the sales growth.

But they do give a toss at Blue Nile. Blue Nile guided for earnings/margins and missed. And their sales growth has slid to low-teens. It raises the question: if they really have a better business model why isn't it growing at the torrid pace that Amazon is growing.

One problem is that marriage just isn't that fashionable. Marriage rates are in historic decline... also people are stinging on engagement rings... but that doesn't quite explain it. Blue Nile remains way too small a part of the market.

The obvious suggestion is that engagement rings are such an emotional purchase that the bride-to-be really wants to see it and hence shops traditionally. And despite the movies men don't often get down on a bended knee and offer a surprise proposal ring-in-box proffered up ready for rejection. [I would have been way too insecure...]

And so the end market for Blue Nile is just not that big.

==

But there are offsets. Blue Nile does have a reputation for not ripping you off. I can imagine plenty of Chinese want loose diamonds as a form of portable wealth. The end-market here could be enormous. If Blue Nile can capture any of that the sales will be huge albeit at low margins.

And there are some technologies out there which will make Blue Nile a very much better business. The Oculus Rift is one of the hottest venture capital concepts. Cheap highly realistic 3-D virtual reality headsets are coming. 3-D scanners will also be under $100***. When you inspect real-estate online you will be able to walk in your headset through the house in realistic, high-resolution 3-D. When you buy jewellery online you will be able to see how it looks on your (or your bride's) hand. And you will be able to tweak it so you know when that stone really is so large it is grotesque. In other words online shopping will be a much better experience.

==

The value proposition in Blue Nile stock

Trailing sales are $450 million. The market cap is $442 million. Sales are growing still but the rate is disappointing. The PE ratio is over 40 but that is because the business is not earning much margin.

It is not a value stock yet. The PE is way too high.

Rather the stock is held by disappointed growth investors. After all this was the perfect business and it didn't perform.

Also it is closer to 1.0 times sales than my magical-end point of 0.7 times sales. It will get to 0.7 times sales one day - either by the price declining further or the sales increasing. Given the low-teens growth rate getting there via growth seems likely to me albeit at a slow-grind for shareholders.

In other words Blue Nile is twixt-and-between. Its not a great growth stock and is hardly a value stock.

It wouldn't be much interest to me except that it has a short interest of 20 percent of the float, is more than 115 percent owned by institutions and is - on the metrics above only about 20 percent overpriced. After all it will wind up as a value stock one day at 0.7 times sales.

We are in a market where lots and lots of stuff is more than 20 percent overpriced. So I don't get it. Can someone please explain the short interest? Do the shorts really believe this deserves to trade at half sales?

==

Why we own it?

When stocks have a very high short interest and the shorts are wrong the stocks are unbelievably large winners. Think Tesla, Netflix and - dare I say it Herbalife.

So far on Blue Nile the shorts have not been wrong. This is a company which is disappointing on growth and disappointing on margins. But as I noted there are things that can go right.

Top of my list is the Chinese developing a fascination with loose diamonds. The amounts of money here are enormous - and as a general rule I don't want to be short Chinese corruption. Chinese corruption is a very big market.

Maybe more certain: the Silicon Valley guys are completely obsessed about the Oculus Rift and immersive and cheap 3-D experiences. They are early (which is their job). Still I don't want to be short a real 3-D stock. Cheap 3-D technology will change the online shopping experience dramatically. I can see Blue Nile sales eventually quadrupling - in which case the stock is very cheap indeed. But that eventual sales growth relies on technologies that will not be widespread this year and are not part of Blue Nile's publicly stated plans.





John




*I remember well. We were long. January 2012 was our worst ever month.

** I am married to my first wife. Shopping for an engagement ring really was and will remain a one-off experience.

***Lidars with the processing power in your phone and the cloud.

Jerry Seinfeld on Jos. A. Bank and Men's Warehouse

The Jos. A. Bank and Mens Warehouse pacman like dance fascinates me. These are companies I don't quite get selling products I don't want. But the companies have surprisingly high valuations and in Jos. A. Bank's (JOSB's) case the business appears remarkably consistent and remarkably profitable.

I asked my readers to do some due-diligence for me, taking photos of JOSB stores over the Black Friday sales. I got back a small, biased sample. Most my readers (with a value-manager exception noted below) are not the sort of people who shop there. A typical response I got was this:

This [with attached photos] is the Jos Bank store at the Galleria Mall in Ft Lauderdale, FL. I started taking pictures and they asked why I was doing it. Tried to take the front from both sides and from the escalator so you get an idea, took pics of shelves and prices, hope it helps. This was Black Friday 7:30 pm, I was the only person in the store.

Several other people said that they were the "only person in the store". And yet JOSB reported in their conference call that their sales over the Black Friday period were great. Here is a direct quote from their last conference call:

We're particularly happy with our strong sales in week 4 of November which includes Thanksgiving and Black Friday, and also the first week of December so far which includes Cyber Monday. Customers really responded to our combination of fresh and timely product offerings, strong door-buster pricing and compelling values throughout the store. And we achieved these strong sales without deterioration in the efficiency of our advertising spending and without a deterioration of our gross profit margin rate.

Even by the standards of retail advertising there is double-talk here. The company does have "door-buster pricing" but it also has nine months of inventory, something they justify on the basis that a wide offering is a competitive advantage and that men's fashion changes slowly. "Fresh and timely product offerings" is not something I associate with JOSB. Nor is "fresh and timely" consistent with JOSB's accounts. And the sales aren't "door busters" if the seeming absence of customers is anything to go by.

Whatever: JOSB seems to work. For years they have had great sales from lightly trafficked stores. Indeed Vitaly Katsenelson (someone I make a point of reading) has commented on it in the past. This is from 2008 (at the height of the crisis). Vitaly made a pile of money on the stock:

When I think of the Jos. A. Bank (JOSB), I think of Yogi Berra’s saying “Nobody goes there because it is too crowded.” 

Only in the case of JOSB, it sounds like this: “EVERYBODY goes there because it is NOT crowded.” As most men who shop there will attest, you are lucky to see and handful of customers shop [...] at any given time. Nevertheless, it seems that JOSB operates in a very different economy and there is an incredible disconnect between its performance this year and the rest of the economy as well as other retailers. 

JOSB reported 3rd quarter numbers couple of days ago and they were stellar even by a healthy economy’s standards. 

They were truly incredible considering that negative double-digit same-store sales for retailers have become the norm. JOSB reported same store sales of 7% for the quarter (the company doesn’t report monthly numbers anymore). Total sales were up 13.7%. Operating profits before taxes were up 20.3%. Cash was up year-over-year, and inventory growth lagged sales. Every single metric was simply beautiful.

And Vitaly does shop at JOSB - and proudly shows me his cheap suits. He clearly spends a pile of money without achieving sartorial elegance. [Still he made good money on the stock and I would take that over a decent fashion sense any day...]

One of JOSB's tricks might be that they keep the average ticket per customer very high by getting them to buy several suits and multiple ties and shirts simultaneously with their "buy-one-get-three-free" marketing. A high average ticket means you can have lots of sales but not many customers.

[Contra: selling three suits at once would tend to fill most men's wardrobes. In most houses the wife has three to five times the hanging space of the husband. Six suits would fill mine permanently. Its hard to get return customers when their wardrobe is already packed with clothes.]

The situation at JOSB is so anomalous that people with a better sense of humour than me just decide to laugh at it. I can't do any better than this:






John

Get your opiates for free: Capitalism meets the zombie apocalypse

I think I have found a new low in the pharmaceutical industry: giving away a month's free supply of potentially lethal high-grade opiods.

This ambitious marketing strategy allows more than enough time and supply to create addicts.

The company is Galena Biopharma and their product, under the marketing name of Abstral is sublingual Fentanyl.

Fentanyl according to Wikipedia is a potent, synthetic opioid analgesic with a rapid onset and short duration of action. In other words you get really high, really fast and it doesn't last long. Also according to Wikipedia it is "one of a small number of drugs that may be especially harmful, and in some cases fatal, with just one dose".

Fentanyl has a legitimate use - for intense "breakthrough" pain spasms for someone already being treated around the clock with a heavy opiod like morphine. The legitimate user is probably a terminal cancer patient with bursts of pain so intense that morphine just doesn't cut it. In that case the seriously addicting properties of the drug are not particularly relevant and the benefit of use is indisputable.

Outside that it is hard to think of a good use for this drug.

The drug has killed plenty of people including a few notable rock-n-rollers. Read Wikipedia for the gory details.

Galena's hot new product is a sublingual version of an old drug. The marketing (on their website) argues this drug is really fast. To quote: "Patients preferred Abstral for speed".

However to give it that extra marketing pizazz they are giving it away. Here is the pitch - which I believe as a matter of policy should be criminalized.* [I note that tobacco companies are not allowed to give free samples of cigarettes - and it is curious that same does not apply here.]

The advert has an irony of its own. It shows a new-age style woman completely blissed out (with a smiling kid) and the slogan "time better spent".

We have US corporations doing hippy-alternative-lifestyle drug marketing for drugs that are especially effective in turning you into a zombie. Capitalism meets the zombie apocalypse.

It is as if Tim Leary was reincarnated as a cynical capitalist going for the mega-dollars.





John

I don't think I can overstate just how evil I think* this is. Fentanyl is very fast acting and is sometimes used in cutting heroin to make it more saleable. Drug dealers test the quality of heroin by "tasting" it. If it acts quickly then it is presumably good. [See Lou Reed singing about "sweet taste".]

Because Fentanyl is fast-acting it is sometimes cut in to make the taste more immediately effective. However because of Fentanyl's properties it can turn the batch of heroin deadly. There is a Fentanyl laced batch in the US at the moment - the latest victim was probably Philip Seymour Hoffman. See this story about a "killer" batch of heroin with about 100 victims.


It is a strange world where Herbalife is considered an unethical stock. I have met several people who (for good reason) claim their life was saved by Herbalife. Herbalife may be an insidious cult like AA. But like AA it makes people healthier.

This is a company which will end people's lives. Oh, and give away the product for free.


===

For the record, this is the company's black-label warning on Abstral:

IMPORTANT:

Do not use ABSTRAL unless you are regularly using another opioid pain medicine around-the-clock for your cancer pain and your body is used to these medicines (this means that you are opioid tolerant).

Keep ABSTRAL in a safe place away from children.

Get emergency medical help right away if:

• a child takes ABSTRAL. ABSTRAL can cause an overdose and death in any child who takes it
• an adult who has not been prescribed ABSTRAL takes it
• an adult who is not already taking opioids around-the-clock takes ABSTRAL

These are medical emergencies that can cause death.
If possible, try to remove ABSTRAL from the mouth.

---

*Whether giving away highly addictive drugs should be criminalized was a subject of debate amongst people I ran this blog post past. The range of opinion was from libertarian to nanny-state. My strong view that this behaviour should be criminal is a political view that others I respect differ from. For some the attitude was that it is very nice of the company to give away the drug to people in terminal pain, and if it creates some addicts - well that is their fault isn't t.

A metadata summary: the Herbalife letters

There were three letters sent by Senator Markey about Herbalife. One went to the SEC, one went to the FTC and one went to Herbalife.

The meta-data for the three letters is different, and sometimes there are subtle differences in the signature block and the resolution at which they are printed. The dates on the letters also change.

For completeness here is the metadata for each letter.


SEC Letter

Markey's site: 1/22/2014, made on a Hewlett Packard MFP

Ackman's site: 1/21/2014, made on a Hewlett Packard MFP

Post's site: 1/23/2014, made on an OmniPage CSDK 18, with the "copier@persq.com" author


FTC Letter

Markey's site: 1/22/2014, made on a Hewlett Packard MFP

Ackman's site: 1/21/2014, made on a Hewlett Packard MFP

Post's site: 1/23/2014, made on an OmniPage CSDK 18, with the "copier@persq.com" author


Herbalife Letter

Markey's site: 1/22/2014, made on a Hewlett Packard MFP

Ackman's site: 1/23/2014, made on an OmniPage CSDK 18

Post's site: 1/23/2014, made on an OmniPage CSDK 18*

 * The Ackman and Post files are identical here. No other letters are identical.

I will leave the conclusions to readers.



John



PS. Michelle Celarier now refers to me on Twitter as an abuser. She suggested that I was "full of sh-t" for indicating that the dates were notable.

PPS. There was an enormous put option purchased on Herbalife before the letter was released to the public. This was reported widely but Dealbook at the New York Times is as good a link as any. These options were purchased about a week before any of the dates here. Many people have suggested insider trading based on that Dealbook article. I have my doubts. The British Prime Minister Harold Wilson famously observed that "a week is a long time in politics". I would be very surprised indeed if there were public versions of the letter circulating a week early.

Michelle Celarier is sitting on a major story

I wrote two posts yesterday (today Australian time actually).

I demonstrated that there were multiple versions of the letters that Senator Markey wrote concerning Herbalife.

The version on Bill Ackman's website has an earlier date than the one on Senator Markey's website. Moreover the one on Bill Ackman's website had been produced with a scanner.

The New York Post website carries the Ackman-website versions. Michelle Celarier claims that she got those versions from Senator Markey's website.

At first glance this looks problematic. The metadata on the New York Post versions includes the following: "Author: copier@persq.com".

It is thus plain that the letters were produced by Pershing Square.

However, even after my post Michelle Celarier believes she got the letters from Senator Markey's website:

I see no reason to disbelieve her.

However if she can prove this she is sitting on a pretty good story. Bill Ackman, billionaire hedge fund manager, gets to produce letters for Ed Markey's signature and gets them put on Ed Markey's website without alteration.

I look forward to reading that story in the New York Post.







John

Michelle Celarier has issued an update on her Twitter stream. She now acknowledges that she received the letter from Pershing Square.

As the letters were clearly market sensitive there is one detail that is still missing - the date at which the letters were received by The Post. The letters on the New York Post website are dated the day before Senator Markey released his letter.

Here is Michelle Celarier's update. I thank her for being so open with us.


J

Michelle Celarier is mistaken about her sources

Earlier today I posted two versions of Senator Edward Markey's letter regarding Herbalife. Read that post first.

The Bill Ackman version was dated January 22, 2014.

The Edward Markey version was dated January 23, 2014.

This letter was highly market sensitive, and trading on it in advance would be insider trading under either the Stock Act or the Supreme Court decision in the R. Forster Winans case.

I have no evidence however that anybody traded. I only note the sensitivity of the letter.

I also tartly noted that Michelle Celarier's New York Post article on Senator Edward Markey's letter had the letter dated January 22, 2014 - the same date as the letter on Bill Ackman's website.

--

This caused a minor stir in the Twittersphere. Witness this exchange between Josh Brown and Michelle Celarier.

Previously Michelle Celarier insisted that she pulled the letters of Markey's website and that maybe Markey had updated them at some later stage:

As Michelle Celarier has called me "full of sh-t as usual" I feel the need to defend myself.

I note, other than the date, there is one substantive difference between the letters on Ackman's website and the one on Markey's website.

Here is the signature block on the Ackman-website letter:

Note that the signature is in grey.

And here is the signature block on the Markey-website letter.

Note that the signature block is in blue.

I have checked many letters on Senator Markey's website.

As far as I can tell he always signs in blue.

The conclusion I have is that the letter on the Ackman website is a scanned letter.

This conclusion is confirmed by looking at other details. The Ackman-website letter for instance renders Edward Markey's letterhead unreadable:

(The picture really is that faint.)

By contrast the Markey letter has a readable letterhead:

The document properties are also different. The Markey version was produced on a Hewlett Packard MFP.

The Ackman-website version was produced on an eCopy ShareScan.

The letter put up by the New York Post was not the original letter. It was a scanned letter. It was also produced on an eCopy ShareScan and it has the same legibility issues as the Ackman-website letter.

Michelle Celarier is likely mistaken about where she got the letter from.






John

An update is warranted: Google Cache clearly shows a letter dated January 22 was at one stage on Senator Markey's website.

However this does not obviate the fact that Michelle Celarier's copy of the letter was a scanned copy with Pershing Square consistent metadata. However it does remove some suspicion as to timing of receipt of the copy.


J

Senators for billionaires: Edward Markey edition

Long ago I thought that Bill Ackman's thesis on Herbalife was silly. It was "I am a billionaire hedge fund manager and I can get the government to help me".

A year later and Bill Ackman has managed to get a Senator to help him. Edward Markey (Democrat, Massachusetts) famously raised "the Herbalife issue". It whacked the stock.

I confess I might have been wrong.

Actually with respect to Markey I am wrong.

There are TWO versions of the Herbalife letter. One is from Bill Ackman's website.

Here is a picture:

You will note that it is dated January 22, 2014.

And one from Edward Markey's website:

It is dated January 23, 2014.

I would normally comment no further, but I can't help myself. You see the version the New York Post carried under the Michelle Celarier's byline is the Ackman version.

I gather the Kennedy Family consider themselves the rightful heir to Markey's seat. [It is the Kennedy's traditional seat.]

It can't hurt their cause that Markey is demonstrated to be the tool of billionaire Wall Street types.




J

PS. Hat tip http://twitter.com/TheSkeptic21

Unfriending

Facebook has become totally unusable to me. There are a small number of people I don't communicate with every day - but who are old friends or were friends and I want to keep the option of re-contacting. Also family.

Having 250 plus Facebook friends who met me professionally or through this blog eventually made Facebook meaningless. I didn't use it any more.

Besides I don't really have 300 friends and nor do most of you. And I don't really know the 3000 people in my Google contacts.

So, dear readers, I unfriended you all.

Strangely though not a single person contacted me and wondered why I had unfriended them...

In other words nobody noticed and cared.*

Facebook revenue is still rising fairly fast. Relevance is another matter.

John

No position in the stock. Was long a while ago - but stuffed the timing up for small profits.

*That nobody cared of course can be taken both ways. Maybe I should go back to self-loathing...

When the hedge doesn't work

I run a hedge fund which means I am meant to hedge risk. However if you hedge away all your risk you hedge away all your returns.

So you have in your head (or computer) some model of how the world works and what things should be correlated and what should not and you make your bets accordingly.

If your model is good and your position (stock) picking is good you should outperform some market (maybe a 40% bonds, 60% equity portfolio) at lower risk than the above portfolio.

But alas the hedges are necessarily imperfect hedges. [Perfectly hedged portfolios make cash returns - which at the moment is zero before fees...]

And with imperfect hedges sometimes the hedges don't work.

It doesn't matter how famous you are or how clever you are - you still have to deal with the time when your hedges don't work. It happens to all of us. [Truly - if you find a hedge fund manager who says they have never had "model failure" then find another fund manager.]

Its in this context (and noting his massive returns last year) that I remind my readers of a Bloomberg news interview with Tepper less than two months ago.




In this interview Tepper restates his case for equity markets being cheap enough and cheap compared to (say) bonds. I don't think it is a bad case - I don't think large caps are expensive. But they are more expensive than a few years ago. [See previous Bronte comments on the state of the market here and here.] [For the record I think there is a bubble in biotech and non-telecom stocks that are purchased primarily for their dividends and English language small caps that are not financial institutions.]

The real action in the above interview happens about four and half minutes in where Tepper outlines his short case for bonds. He is not short them because he thinks that there will be inflation (in fact he doesn't think there will be). Rather he is short them as a hedge against the consequence of the Federal Reserve trying to exit QE policies.

Bluntly that hedge did not work this week and particularly on Friday.

Equity markets had their worst day in yonks. The airlines (Tepper's biggest position) were not exactly good either (as they were typically off over 4 percent - double the market).

Bond markets however had a very good day. Long bond indices rose several percent in value.

In other words Tepper was long the bad stuff, short the good stuff and the short was meant to be his hedge.

His hedge did not work. Badly. I suspect he was down more than 4 percent on the day - maybe double the equity market.

As I said every single decent manager will have days when the hedge does not work. There is no implied criticism of Tepper here. [I watched that interview because I admire him...]

And I doubt his clients would be worried either. I have never watched Appaloosa pitch to clients but I suspect the risks are accurately described and I suspect David Tepper would say to his clients that if they cannot handle a low-single-digit down day or two they should not be clients. [I know Bronte would want to dissuade such people from being clients...]

But I also know what David Tepper is feeling. At Bronte we also had the worst day in our history (although it was not as bad as I think David Tepper's day was).

First you feel a little beaten up. But at some stage you need to (seriously) examine the possibility you are wrong. And at that point the emotion turns to self-loathing. It is surprising but many of the best asset managers I know really hate themselves. It's an occupational hazard - and indeed may be a pre-requisite to being really good at this game.

That said, self-loathing is not a very productive emotion. You shouldn't just stand there like a deer blinded by headlights.

The thought pattern (and this thought pattern can be ex-ante programmed into a computer if you want) has to turn to risk management - how do we behave if we continue to be wrong? At what point should we pull-the-plug and accept that we just don't get it.

The purpose of this blog post is to explore what to do with the portfolio when the hedge is not working. That is a discussion we are having at Bronte because this week it has not been working (although not in a very serious way). And I have written this from the perspective of a stock-picking long-short equity manager. [The discussion has the same intellectual components from the perspective of a computer driven trading shop - but I can't speak to the specific detail.]

Bronte's portfolio positioning

Because I don't want to give away all the tricks of the trade I am going to describe Bronte's portfolio in an idealized position. [Day-to-day situations vary.]

We have a long book which is mostly large cap like Verizon (although includes a few disclosed mid-caps like Herbalife) which should have a beta of roughly 1. On a day-to-day basis Herbalife is our highest beta stock.

We have a short book which is full of the widest and wildest range of scum, villainy, stock promotes and general nonsense we can find. The typical short position is a biotech scam stock or something like that. Some of these are very high beta indeed and the short book has a beta of about 2.

We may typically be 130 percent long, 50 percent short - but beta-adjusted we are only a net 30-40 percent long. Day to day movements usually reflect this. On a day when the market is up 1% we are typically only up 0.3-0.4 percent. When the market goes down a percent we typically go down a similar amount. To keep the maths simple I presume an ex-ante portfolio beta of 0.4 for the rest of the discussion.

As we have been right a fair bit of the time in our specific stock picks we have accumulated returns that are way better than equity market returns even though we believe we have been taking less than equity market risks.

This week however our performance has been bad. We have tracked down roughly 150 percent of equity market returns. Friday was - as I said - the worst day in our history - but the loss was only 150 percent of equity market returns...

But whilst Friday was the worst day in our history this month has not been the worst month in our history. We have only had one month where the model looked truly broken - and that was January 2012. We wrote it up at length for our clients. In that month we went down roughly 6 percent when the markets went up roughly 5 percent.

As our day-to-day beta is roughly 0.4 we should have been up roughly 2% in a 5% up market. Our 6 percent loss was about 8% of under performance - by far the worst month we have ever had.

In January 2012 we got both ends of our portfolio wrong. Some of our longs went down in a good market. Our shorts ripped up in our face. The letter we wrote at the time noted the largish losses we were taking on Google. [Google was one of our biggest positions and it fell from $660 to $580 or so that month. As discussed in the letter we purchased a tiny amount more...]

However Google wasn't where the action was. Our shorts ripped up in that month - some costing us more than 30 percent. Ex-ante we estimated their beta wrong.

Lets model how this looks.

Our ex-ante position was

130 long,
50 short,
Total position 180 - ie gross leverage of 1.8 times.

At the end of the month our longs had gone up say 2 percent (substantially less than market).
Our shorts had gone up 18 percent (substantially more than market).

Our position would thus be:

132.6 long
59 short
adding up to 191.6

However we have had losses - on these numbers adding up to 6.4 percent. Our capital has decreased from 100 to 93.6.

Our gross leverage has thus increased to 191.6/93.6 - or roughly 205 percent.

This is kind of shocking - we had 6.4 percent of losses but our gross leverage increased by 25 percentage points.

This is a real hedge isn't working situation. We had no choice but to cut positions - and we cut them fairly aggressively. We would have loved to add more Google into that slide - we really would have loved it. But we couldn't. We were forced to cut positions - and could only add more Google because we chose to cut other positions.

--

Now lets compare this to this week. Our shorts have been going down - but our longs have been going down far more. (Witness Herbalife's big decline and Herbalife is not our only bad stock this week.)

Our aggregate position size has been shrinking more or less in line with our capital. We are not becoming dramatically more leveraged. And because we are not becoming dramatically more leveraged we can sit it out.

David Tepper's leverage probably* won't have changed by more than a couple of percent either. He can sit it out too.

And so we can examine (and will examine) individual positions but the market hasn't pointed a gun at our head and forced us to take off positions. Inaction is thus an acceptable policy.

So I can just go back to self-loathing then. I guess David Tepper can do the same (but I suspect he hides it better than me...)




John

*I am not privy to Tepper's aggregate positioning. All I know is from the above interview - hence the word "probably".