Category: Risk

If God was the Only Active Investor

In active investing the investor aims to outperform an index. In passive investing the investor aims to match or track the performance of an index. 

Now imagine if God was the only active investor in a theoretical market. 

God is all knowing, so he knows all the future cash flows of all the investments available in the market. Since he is the only active investor and all other investors mimic him, all the investments in the market will be priced based on their discounted future cash flows. As such, all the investments will have exactly the same expected return. 

There are two fundamental problems with this thought exercise:

  • If God knows the future cash flows, then he’s not taking any risk. If God isn’t taking any risk, what discount factor should God use? The rate of inflation? 
  • If God is the only active investor, then who is he buying from? If God is the only investor that sets prices and all other investors are trying to mimic his returns, then all the other investors would want to buy when God buys and sell when God sells. Does this mean that no orders will be matched?

Largest S&P 500 Single Day Drop

One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.

Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.

The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).

Analytical vs Statistical Approaches

For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.

The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.

The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.

The Limits of History

But what is data? Data is history.

Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.

The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.

Strawman & Steelman Valuations

A strawman argument is a frequently used tactic in rhetoric and oratory debate. It’s used in business, in politics and Twitter arguments alike. It’s simple and effective. You basically pick an argument of your opponent and rephrase it in a way that makes it easy to refute. Strawman arguments are not real arguments. They don’t even have to be true. 

Peter Thiel argues that for decision making, you should really steelman your opponents arguments. If you try to find the strongest and most compelling reasons for your opponents stand, it allows you to improve your side of the argument or even discover flaws in your own reasoning. 

The same should apply to valuation. You should always try to steelman the potential risk factors that you apply to your investment thesis. 

Investing in Crypto from a Portfolio Perspective

The appeal of cryptocurrencies and digital tokens is for many the possibility of a home run. But betting on one outcome will make your outcome binary. You are either right or you are wrong. In an investing subject that has such high uncertainty of outcome, as blockchain and cryptocurrencies undoubtedly have, trying to determine who the most likely winner is, might not be the optimal investment strategy.

An investor in the blockchain space, even if that investor would be 100% convinced that distributed ledgers will disrupt the finance industry, will face three major problems:

  1. We don’t know who the winners will be
  2. We don’t know what the winner will be
  3. The last mover advantage

We don’t know who the winners will be

Industries tend to consolidate over time. This has been as true with banking and auto manufacturing as it has been true with breweries and paint manufacturing. Online, the power laws of industry consolidation have been even stronger. In the online world, the winner takes it all. The network effects of digital products such as search engines and social networks are so strong that they tend to create natural monopolies. 

There have been thousands of cryptocurrencies and altcoins created so far in the relatively short history of blockchain. If the network effects of cryptocurrencies are anything like in industries that the internet brought us, most of these currencies are destined to die.

We don’t know what the winners will be

One of the biggest allures of blockchain disruption is that distributed ledgers will significantly alter the way humans organize themselves and their endeavours. Some will even go so far as to say that the concept of the company as a way for people to organize their efforts will become obsolete. 

Yet, even though the formation of Bitcoin and other cryptos, such as Ravencoin, have been without the ownership and organization structure of a company, most organizations that are developing products and services on blockchain technology are formed through a corporation. 

Some are a combination of both. An example of this is the combination of the XRP cryptocurrency by the company Ripple. Ripple does not own or control XRP, but it owns a significant amount of XRP which it received when the company facilitated the creation of the XRP cryptocurrency. 

So, where will the value capture be? Will it be on a cryptocurrency level or on a company level? Is it better to have exposure to XRP or Ripple? Currently, this is extremely hard to tell. 

Last Mover Advantage

Bear in mind that Google was not the first search engine. Neither Chrome nor Explorer was the first internet browser and Windows was not the first operating system. Facebook was not the first social network. 

In the words of Peter Thiel, “you don’t want to be the first mover into a market, you want to be the last mover.” It is possible that none of the cryptocurrencies and none of the biggest blockchain-focused innovators currently out there are the last movers in the space. Maybe we are yet to see the equivalent of Microsoft, Google and Facebook of crypto and blockchain yet. 

Portfolio Approach

In an essay called Diversification and the Active Manager, Horizon Kinetics’ Murray Stahl and Steven Bregman bring up a thought exercise whereby an asset manager starts out with a diversified portfolio that includes one overperforming stock and simply holds it over a long period of time.

They take Intel and Microsoft as examples:

“From October 1987 to December 1999, the stock appreciated about 173x. Thus, if a 3% position in 1987 were held in a portfolio and not traded away, it would have become a dominant portfolio position by 1999. In truth, the position would have become so disproportionately large that no active manager would have been permitted to maintain it.  

In fact, Intel would be a much better example. Between October 1987 and December 1999, Intel shares appreciated approximately 2,680x. Obviously, a 3% position in 1987 would, as a practical matter, become the entire portfolio by December 1999, irrespective of what performance the other portfolio elements accomplished.  

If one contemplates these facts, the implications can be interesting. It should be self-evident that any portfolio manager who simply held Microsoft and Intel shares would have dramatically outperformed the S&P 500. Again, of course, this would not have been permissible. Nevertheless, in hindsight, this would have been the correct action.”

Building a diversified blockchain portfolio

Aside from basically buying a basket of cryptocurrencies, an investor would also like to have exposure to companies that are building blockchain-related products and services or investing in such projects.

Currently, the number of public companies that have that exposure is limited and many often simply seem fraudulent once you look under the hood. There are however a few stocks that are worth considering to gain exposure to blockchain and cryptocurrencies:

  • Galaxy Digital Holdings (aim to become a merchant bank in crypto and blockchain)
  • Overstock (through its subsidiaries tZero and Medici Ventures) 
  • Hut 8 (cryptocurrency mining) 
  • FRMO Corp (shareholder in Digital Currency Group and a number of mining ventures)

More Thoughts on Crypto

Want to collect interest on your crypto? Sign up for a Blockfi account with this link and receive a $10 bonus in Bitcoin when you fund your account.

Diversification | What it really means

According to Wikipedia, “diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.”

Investopedia has a slightly different take, saying that “[d]iversification is a risk management strategy that mixes a wide variety of investments within a portfolio.”

To many, diversification means investing in the market in general. You can do that by investing in a broad market index, such as an ETF that tracks the S&P500 index. There are also the Russel indexes. Basically, if you own the market, you get the market return.

The Contrarian View on Diversification

But diversity does not necessarily have to mean more. The goal of diversification is not to get the market return but to reduce exposure to a particular event.

What you are trying to achieve by being diversified is to make sure not everything you are investing in moves in tandem. By doing so, you embed optionality into your portfolio.

If you accept this reasoning, you will also agree that a portfolio of 5 stocks can be seen as being diversified if those 5 positions are not affected by the same factors.

Think about it this way: Which of the two portfolios is the safer investment strategy?

  • Portfolio A: A basket of common stock of the 20 biggest financial institutions in the U.S.
  • Portfolio B: A basket of 5 stocks each in a separate industry.

Longevity as an Investment Criteria

In the world of startups and new ventures, the central theme seems to gravitate towards growth and scaling. 

When it comes to growth and scaling, learning how to manage an organization that is constantly getting bigger becomes the biggest challenge. 

However, when you look at the oldest companies in the world, these are all small operations in industries that have hardly changed much throughout the lifetime of those companies. 

Build to Last

Two of the oldest companies in the world are a:

  • Japanese Ryokan 
  • German Brewery

When founders start new companies, most of the time their vision is to disrupt an industry. 

But what if the objective would be to create something that was built to last? If you want to build an impenetrable fortress, you don’t want it to be ever-expanding, would you?

So, here’s a question: What if you were asked to build a company and there would only be one constraint: The total size of the organization would not be allowed to exceed 8 people.

What would you build?

The Columbo Method of Equity Research

Remember detective Columbo? He was a phenomenal character played by Peter Falk in a 1970s TV series called…you guessed it…Columbo. Detective Columbo was a scruffy and simplistic character, dressed in his signature beige raincoat and crumpy white shirt with a loosely knotted tie.

Colombo is no normal detective series, though. As is you would expect, Columbo’s job is to solve murder mysteries. However, the episodes don’t play out with Columbo delving into each case and eventually discovering who is the murderer, in a sharp twist near the end. Columbo is a detective series without the mystery.

In the case of Columbo, each of the 69 episodes begins with the scene of the murder. So, as a viewer, you know from the beginning who the doer is. The rest of the episode is a mental wrestling match between the murderer and lieutenant Columbo.

The Colombo Technique of Investigation

In each Columbo case, the murder is committed by someone close to the victim. This allows Columbo to approach the suspect as a witness or someone who can help Colombo in piecing together the pieces of the puzzle.

https://youtube.com/watch?v=r1_t8RGFb_Y%3Ffeature%3Dplayer_embedded

To the assailant, Columbo seems totally incompetent. The scruffiness of his hair and clothing give the impression that he slept in his clothes. He constantly scratches his head and he asks the assailant for help. His questions are simplistic and make him look like he’s totally out of his dept.

But Columbo is playing a part. He’s playing dumb. The perpetrator grows confident and starts to get comfortable, even annoyed. The trap is set. In the final minutes of a Columbo episode, the perpetrator has made a mistake and Columbo wrestles him down for the tap-out.

Stock Research and Colombo 

So, how does this relate to equity analysis? In stock research, there is no crime, there is no murderer. As an analyst, you have a stock and you build your opinion based on fundamental analysis.

But therein lies the caveat. You see, it is you who is the perpetrator because once you start your analysis, you start to for opinions. You will start subjecting your mind to all forms of mental biases. You become overly optimistic. You get anchored. You will start to look for confirmation in the data.

“But that’s me, I’m paranoic. Every time I see a dead body I think it’s murdered. Can’t imagine anyone murdering themselves.”  

– Lieutenant Columbo

As an analyst, you have to put on your mental raincoat and find your inner Columbo. You have to take a step back and start to ask yourself the simple question. The overly naive and borderline stupid questions. You have to confront yourself and find start to look for loopholes in your story.

Just One More Thing…

Lieutenant Columbo bombards his suspects with questions. He’s relentless. He keeps coming back with a question. He’s apologetic, he excuses himself. He just can’t help himself, he says. But he keeps coming back for “just one more thing.” 

Mt. Gox | The Meteoric Rise and Fall of a Bitcoin Exchange

Although the history of the Mt. Gox Bitcoin Exchange is short, it is nothing short of amazing. Mt. Gox is a historic name in the world of cryptocurrencies, as it was one of the first Bitcoin exchanges to take off.

At the peak of its height, Mt. Gox’s customer base represented about 80% of the global trading volume. The rise of Mt. Gox, came to an abrupt end in 2014 when it was discovered that the exchange had become the victim of a large scale hack. Being unable to locate over 850,000 bitcoins that the exchange had in its possession, Mt. Gox was forced to close trading and to subsequently file for bankruptcy. 

Who founded Mt. Gox?

Jed McCaleb founded the Mt. Gox and in 2007, he registered the Mtgox.com web domain with the aim of turning it into a trading site for the famous Magic: The Gathering game cards. He then turned the domain to a bitcoin exchange site. 

After sometimes McCaleb realized he was getting more than he bargained for and he sold the site to Mark Karpeles who is a programmer, foodie, and bitcoin enthusiast and he usually calls himself Magicaltux in numerous online forums. Karpeles then rewrote the back-end software of the site and eventually turned the site into the most popular bitcoin exchange in the world. 

Karpeles was born in France and he spent some time in Israel before settling down in Japan. He got married in Japan and in 2011, he acquired the Mt. Gox exchange from an American entrepreneur known as Jed McCaleb. 

When did Mt Gox open?

Mt Gox was among the first Bitcoin exchange on the web but it was not related to cryptocurrency when it was developed. The mtgox.com domain was bought by programmer Jed McCaleb in 2007 for an online trading platform for virtual cards that are used in the game Magic: The Gathering.

In 2010, McCaleb then saw the opportunity to build a place where people can exchange their fiat currency to and from Bitcoin. This was how mtgox.com was launched as a Bitcoin exchange on July 18, 2010. McCaleb then sold the platform to French-born developer Mark Karpeles after a year.

How did Mt Gox get hacked

Mt Gox was first hacked in 2011 and during the first of the two hacks, the attackers were able to infiltrate into the computer that belongs to an auditor of Mt. Gox. This gave them the chance to change the Bitcoin pricing to a single cent. Afterwards, they then obtained the private keys of Mt. Gox clients which had their precious crypto assets kept in hot wallets which are internet-connected. 

The hackers then went on and create selling orders on the accounts and then bought the Bitcoins at this artificially reduced price and they were able to buy 2000 BTC with this way. This hack was estimated to be about $30.000 theft in Bitcoin and this was then dwarfed by the hack that occurred in February 2014.

The second Mt Gox hack was infamously known as the first major cryptocurrency exchange hack when it happened. The hacked value was an enormous $460 million worth of Bitcoin at the time. Although this may not be the largest hack in terms of the value in fiat money, it is considered to be the largest amount of Bitcoin that was ever stolen. 

More than 850,000 Bitcoins were stolen which includes 750,000 Bitcoins that were owned by its customers. At its peak price, the value of the bitcoin stolen is $17 billion while at the current price this will be about $3 billion.

Although Mt Gox stopped all Bitcoin withdrawals on February 2014, the exchange has already been emptied of its Bitcoins long ago. It was reported that Bitcoins were stolen bit by bit since the beginning of 2011. The group that did this investigation then indicated that by May 2013, the firm no longer held its Bitcoins. Mt Gox then filed for bankruptcy not long after the hack because they were no longer able to continue with the operations.

Will Mt Gox be rehabilitated?

According to TechCrunch, In February of 2019, there is a movement referred to as GoxRising which is working to have an alternative to bankruptcy for Mt Gox. The main idea behind GoxRising is simple and it is that instead of using the bankruptcy courts to give the assets of Mt Gox to the owners of the company, it is making use of civil rehabilitation law so as to return most of the asset to the creditors of the company.

It appears that GoxRising will be successful in these efforts because Tokyo lawyer, Nobuaki Kobayashi has been appointed by the Japanese courts to work on the civil rehabilitation process. This is going to be a piece of good news to those that have lost their assets in the Mt Gox failure because they will likely gain from this deal due to the civil rehabilitation law.

Another potential way this court may end is that the embattled CEO of Mt Gox, Mark Karpeles will likely end up with lots of Mt Gox assets if the bankruptcy process is allowed to move forward. This is because he owned about 80% of the company and when it went bankrupt, it will place him in a great position to get this huge payout under the Japanese bankruptcy law. If this happens, Karpeles knows that his life is in danger as he would receive lots of civil suits from Mt Gox creditors that has lost everything to him. More insults will be added because Bitcoin prices are much higher today than it was in 2014.

With the civil rehabilitation process, it looks like a winning idea to everyone that is involved in this deal and it looks like a way forward. The civil rehabilitation process is expected to take 3-5 years based on the reports from the media. Although civil rehabilitation may be considered to be a time-consuming process, it is still a lot better than bankruptcy.

Read More on Finance and Crypto

Check out our partner publications:

Discount to Net Asset Value | Protect Your Downside

One way to value a stock, especially those of companies that own various subsidiaries or a portfolio of assets, is by analysing the company’s discount (or surplus) to Net Asset Value.

Conglomerate Discount – The Case of Exor

We recently took a close look at Exor N.V., the holding company that controls such publicly traded companies as Fiat Chrysler Automobiles, Ferrari and CNH Industries. Conglomerates like Exor are interesting to analyse as they tend to trade a steep discount on the mark-to-market Net Asset Values (or market-adjusted book value).

In the case of Exor, the company trades at about a 30% discount on the market value of assets on the balance sheet. 

Point of Maximum Pessimism – The Case of Dundee Corporation

If you are a Contrarian Investor, you are trying to go where other investors feel extremely uncomfortable to be. You are trying to go where others are running to the exits, but at the same time, you don’t want to be too early. 

One of those situations is materializing at a Canadian Asset Management Company called Dundee Corporation. After a series of unfortunate events (and decisions), the market capitalization of Dundee is gone from about a billion dollars to about $74 million. 

The company trades at a steep discount to book value, but for good reason. The company has been haemorrhaging money as failed investments have sucked up cash and destroyed shareholders’ capital. 

But investors may have overreacted. Even though the company is taking drastic steps to turn the business around, Dundee’s stock is trading at about a 70% discount to book value. If the company manages to stop the bleeding, a significant re-rating might be in the cards. 

The Fundamentals are in the Footnotes

The whole point of fundamental research or value investing or whatever you want to call it is to get an edge by looking a little deeper than others are looking. This is why you won’t get very far by using stock screeners.

Stock Research on Onverstock.com 

We recently published a stock report on the Fundamental Finance Playbook about Overstock.com. The article is a deep dive into the current status of the company’s online retail business. We try to figure out if the business is, in fact, in a turnaround as management claims, or if the company is at risk of running out of cash.

Previously, the management had stated that they were trying to sell the online retail business but so far nothing has materialized. During our research phase we noticed that during the last quarter, consulting fees on the corporate level had increased significantly. By corporate level, we mean not connected to the operations of the online retail business nor the blockchain ventures.

Overstock engaged Guggenheim in 2018 to explore strategic options for the retail business and find possible buyers. If the consulting expenses are mostly in the “Other” business segment and neither in the retail operations nor the tZero operations, it is plausible that Overstock is already in advance negotiations with potential buyers through Guggenheim.

What that indicated to us, was that there was a possibility that Overstock was already working with Guggenheim Securities, the company that Overstock employed to find buyers, on advanced negotiations with possible buyers. These kinds of transactions usually require heavy due diligence, so it would be quite plausible that costs would ramp up like this.

Two Potential Acquirers 

A week after we published, Patrick Byrne, Chairman and CEO of Overstock said in an interview with CNN that the company was in negotiations with two potential acquirers. It remains to be seen if anything materializes from this, but it goes to show that sometimes the fundamental facts are buried in the footnotes.