The C.H. Robinson (CHRW) Short Thesis

The freight brokerage market is interesting. C.H. Robinson is the world's largest, with 60% of revenue coming from Truckload (TL) brokerage commissions. Most companies report Sales - COS = Gross profit, but CHRW reports it as "Net revenue," and hence, "Net revenue margin" is the spread between what they are paid by shippers and what they pay to carriers for transportation. That spread seems way too high - a 15-20% cut!

There's been a short thesis on CHRW based on two things: 1) Net revenue margins declining into a more balanced market, and 2) The threat of disintermediation from new VC-backed tech players such as Uber Freight, Convoy Inc (backed by Jeff Bezos), Transfix, and others. It seems like the net revenue margin thesis has already played itself out - margins peaked in early 2016 and declined to ~15.5% before rebounding late last year. 4Q17 was the first quarter since 2016 in which pricing outpaced cost, so I'm sure bulls think margins are going to turn around going into 2018, which happens to be the tightest trucking market in history. Freight brokers do best in times of extremes - either when utilization is tight (shippers pay them to find capacity) or when utilization is loose (carriers pay them to find loads). Logically, this means CHRW should do well in 2018. The huge driver shortage, implementation of the Electronic Logging Device (ELD) mandate in December 2017 and enforcement in April 2018, and overheating economy should lead to a fun year for the trucking industry. The question is, will CHRW be able to pass on double-digit spot price increases in transportation and re-negotiate their contracts to reflect the spot market? If they can, the short thesis doesn't matter. On the other hand, if this time truly is different, and they can't pass on price increases, we should see net revenue margins decline to historical lows, but volumes will likely pick up the slack. I'm not sure the market will care if that happens - people like the asset-light, high-ROIC model.

The other part of the short thesis - disintermediation by new tech players - is even more interesting. In my initial DD, I'm leaning toward CHRW's favor. The scale and entrenched relationships they've built over the years will take a long time for the likes of Uber Freight and others to build. Long-term, I'm sure they can do it (and we're all dead), but this is such a fragmented market that it might not even matter.

This is a curious case for me. The questions we need answered are: 1) Will net revenue margins continue to decline in a tight trucking capacity market? What impact will the ELD have on freight brokers if capacity is down 5-10% and most importantly, will CHRW be able to pass on price increases in a surging spot TL market? 2) Are competitors a near-term threat to incumbent freight brokers such as CHRW? How much scale do competitors such as UberFreight and Convoy need to be a legitimate threat? I have some calls set up with the new players and will be doing more work in the coming weeks. Stay tuned. 





TrueCar (TICKER: TRUE) Looks Ripe for a Sell-Off

TrueCar (TRUE) has had quite the turnaround since since 2015, rising from a low of $4.01 to the current $21.23 a share. The problem with TrueCar is that nothing has really changed - the dealers now tolerate them while consumers continue to think they're getting a great deal via the "Guaranteed Savings" TRUE sends to them (they're not). One thing is certain though - the new CEO, Chip Perry, looks like a genius. After Scott Painter resigned as CEO in December 2015, the company has bounced back from its woes and is sitting at the highest units sold in history. TRUE gets $300 per new car sold and $400 per used car sold via TrueCar and its affiliates. Given that gross margins on new car dealer sales are ~4% at best, you can see why dealers hate TrueCar. They are sitting right at their "target" dealer count and by management's estimate there are maybe 2,000 more dealers who could fit into the picture for TRUE. Management's so-called operational leverage is non-existent - if they're not making profits soon, they will never be.

Even the most optimistic sell-side estimates don't have them earning a substantial profit (read: positive) until 2019. There's no where else for these guys to go - this stock is priced to perfection and any slip will have them tumbling back whence they came from. Lock-up expiration for 31.5M shares is coming up July 25, right before earnings. I hope they beat and the stock jumps - I'm looking to put a substantial short on.



Review of Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years

Review: 4/5

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years, written by Paul B. Carroll and Chunka Mui, is an underrated book for investors. Written primarily for CEOs and management teams, the authors examined the most significant business failures from 1981-2006, with failures defined by write-offs of significant investments, the closing down of unprofitable businesses, or bankruptcy. A lot of the findings were nothing new, but the breadth and depth of the case studies make this book a worthwhile read. The first half of the book details these failure case studies across seven categories: 1) Synergy, 2) Financial engineering, 3) Rollups, 4) Staying the course, 5) Adjacencies, 6) Riding technology, and 7) Consolidation. The second half of the book, while useful to companies interested in avoiding the same mistakes, can be skipped for those who want the useful bits for investing and nothing else.

The business failures detailed in Part One are far-reaching and broad, taking the reader through cases that they have probably never heard of. The best chapters, in my opinion, were Faulty Financial Engineering, Deflated Rollups, and Staying the Misguided Course. The Faulty Financial Engineering chapter describes the rise and fall of Green Tree Financial, proving that there is nothing new under the sun. The similarities of Green Tree providing long-term loans on short-term assets to today's recent financial engineering disasters are striking. Green Tree was selling 30 year loans on home trailers with a 15 year useful life - and they were booking all the revenue up-front! My favorite chapter was Deflated Rollups, as my interest in j2 Global might show. A couple of quotes I liked from that chapter:

As great as the concept is on paper, however, rollups, like athletic contests, don’t happen on paper. In the real world, rollups haven’t worked so well. Sometimes, rollups look like an attempt to stitch together a bunch of rock groups to form an orchestra.  

Research says more than two-thirds of rollups fail to create any value for investors. A Booz Allen study of rollups found that almost half had lost more than 50 percent of their market value between 1998 and early 2000, despite the stock-market boom during those years. The study found that companies tended to outperform the S&P 500 until they reached $500 million in annual revenue, at which point investors began probing more deeply and the concept fell apart. 

A certain amount of skepticism is, of course, called for when investing, but that’s especially the case with rollups, because - much to our surprise - we found that many rollups end in fraud. 

The author's conclusion is that while there are rollups that succeed, failed rollups are not due to bad execution - in fact, the rollup strategy is structurally flawed from the outset and generally produces diseconomies, rather than economies, of scale.

Staying the (Misguided) Course was another good chapter, especially given the modern innovation cycles taking everyone down. The chapter focuses on Kodak, and it was amazing to me that they knew that their traditional film would be threatened by digital (they sponsored a study in the 80s), they just underestimated the speed at which the quality of digital would improve.  

As Kodak demonstrated ably, companies that face a looming threat...tend to consider whether to adopt a new technology or business practice based on how the economics compare with those of existing business-not accounting for the possibility that the new technology or approach to business will eventually kill the economics of the existing business and require an entirely new business model.

Overall, great book - would highly recommend reading the first half as a fresh, structured look into business failures.

J2 Global (JCOM) #3/X - The Big Question - What is JCOM's Organic Growth?

Reading the earning call transcripts through the years, the same question comes up every quarter in various fashions: “What percentage of growth in each segment (particularly their legacy eFax segment, Cloud Connect) is due to organic growth versus growth from acquisitions?”

Management has done a great job side-stepping with the typical answer: “a mix,” “mostly acquisitions,” “we don’t break that out.”

In 4Q16 we got a better answer as to an organic growth rate based on the CEO’s Answer.

Rishi Jaluria - JMP Securities LLC

Hey, guys, thanks for taking my questions. Appreciate the granular detail in your 2017 guidance. Couple of quick questions for you. So, first, just to be clear, on guidance, I want to make sure my understanding is correct. You're 2% to 3% on the Cloud Services side, that's purely organic, so assuming no M&A, is that a fair understanding?

Scott Turicchi - j2 Global, Inc.

No, it does include some M&As that we have in the pipeline. I think there's a couple of deals have closed already that are rather small.

Nehemia Zucker - j2 Global, Inc.

You're talking about like 1% or less in the business, small.

Scott Turicchi - j2 Global, Inc.

But it does include some M&A.

Rishi Jaluria - JMP Securities LLC

Okay. Got it. So, the entire Cloud Services, the bulk of that 2% to 3% is inclusive of M&A?

Scott Turicchi - j2 Global, Inc.


- 4Q16 Earnings Call

Note: They are referring to “Business Cloud Services,” which includes “Cloud Connect” and “Cloud Services.”

Given the number and spread out nature of these acquisitions, it is almost impossible to calculate the true organic growth rates of each segment - but the company does give pro forma estimates of revenue and net income as if that year’s acquisitions were included from the beginning of the current and prior year. Using those numbers I conservatively calculated estimates of how much each year’s acquisitions boosted revenue and net income, and then calculated revenue and net income growth excluding acquisitions.

One thing to note is that the Pro Forma Combined Revenue includes revenue that the company already booked for the year’s acquisitions, so really that number is understated. For example, we know from j2’s EVDY Investor Call in December that EVDY had ~$243M in revenue TTM 2Q15 to 3Q16. When we back out the pro forma numbers from the 2016 10-K, we get a total of ~$228M of added revenues in 2016 due to acquisitions. Obviously that number is way too low but when we add official revenue contribution of ~$53M for 2016’s acquisitions (which includes the $20M revenue contribution from EVDY as well as ~$33M in other acquisitions), we get $288M. How do  know this is the more accurate number? Many of 2016’s acquisitions had publicly available revenue information, including SMTP, VaultLogix, Callstream Group Limited, and FrontSafe A/S. When we add up all the reported revenues (shown later) we get close to ~$290M, and that’s only including companies that had revenue information available either through public filings, management statements, or unofficial sources.

Long story short – to get the actual revenue acquired each year we add the pro forma combined revenue to the revenue from year’s acquisitions (which is already included in each year’s/quarter’s results.)

Note: Since the Pro Forma Financial Information for Everyday Health Acquisition shows that if the acquisition had occurred on January 1, 2015, 2016 Net Income for j2 would have been $103,541, which equates to a -$48,898 net loss for EVDY. Since EVDY was only in j2’s results for one month in 2016, I adjusted both revenue and net income to account for only the one month contribution (2016 in yellow).

As shown above, I estimate that j2 has acquired 98% of its revenue and 34% of its net income since 2008. Why the disparity between acquired top and bottom lines? J2 has relied on its fax business, with declining revenue and huge margins, to prop up the net income side, while acquiring the revenues (most businesses acquired are garbage- low or negative margins). What happens when they run out of fax companies to acquire? How many more acquisitions can really move the needle? They’re getting too big for their britches and this is a house of cards waiting to come crashing down.

A Look at Recent 2016 Acquisitions

Here’s a quick look at those 2016 acquisitions we have revenue numbers for:

Fonebox Australia, which j2 acquired in March of 2016 for $30M, had reported revenues of $9.4M in 2016. In June 2016, j2 acquired the SMTP relay and email delivery products and services business portion of the business for $15M. Revenue for that the SMTP e-mail relay business for the six months ended June 30, 2016 was ~$2.75M, so I assumed yearly revenue was ~$6M.

VaultLogix, which was acquired by InterCloud Systems in 2014 for $16M, was bought by j2 in February2016 for $24M. The Cloud Services segment of InterCloud was entirely comprised of VaultLogix, so a real good look into its operations as well. Referencing InterCloud's 10-K for FY15, VaultLogix had revenues of $9.9M, EBITDA of ~$3.2M, and EBIT of ~$0.4M (when the combined goodwill and intangible asset impairment is stripped out). From the InterCloud press release in October 2014, VaultLogix had generated approximately $12M in revenue and $4.3M in adjusted EBITDA for the 12 months prior to its acquisition by Intercloud. So we have a business that did $2M less in revenue and $1M less in EBITDA than the year prior and j2 paid $8M more for it than InterCloud did in 2014. The rest of the 2016 acquisitions we have numbers on were small – Callstream Group Limited had  revenue of 200,000 GBP (from 240,000 GBP in 2015), operating profit of 14,114, and a loss before taxes 214,368 GBP for the YE 2016 (Annual Report) Frontsafe A/S, based in Denmark, had FY16 operating profit of ~$428,000 USD on ~$3.16M of revenue, compared to ~$614,418 and ~$3.51M in 2015, respectively. MaxEmail was acquired in July of 2016, and the company said it “1% more on the Cloud Connect” business, so we can assume ~$3.5M in revenues.

Adding it all up, combined revenues of 8 of the 24 2016 acquisitions is right around ~$300M based on my estimates, with the vast majority of that coming from EVDY. On the Q4 call, management guided to revenues of $1.130 to $1.170 billion, so we’re looking at a $256M-$296M increase in revenue for this fiscal year. The official revenue contribution from 2016 acquisitions was $52.9M, so if we subtract that from our estimate of $300M in acquired revenues this year that’s $250M in revenue not accounted for, leaving us with $6-46M more in projected revenue. Let’s go with the best case scenario here and say that j2 generates that $6-46M in revenue from “organic growth” in their two segments. That’s a projected organic YoY growth of at worst, 0.7%, and at best, 5.2%. But here’s the kicker - this is assuming j2 does NO acquisitions that add to revenue in 2017 (they've already done 5 in Q1!) and these are based on management estimates! What’s the over/under on management acquiring at least $6-46M in revenues, implying negative organic growth? I’d go all-in on that bet.

Disclosure: I have no current positions in JCOM. In the past, I have had short positions in JCOM.

j2 Global (JCOM) #1/X - Delaying the Inevitable

The formula ‘two plus two equals five’ is not without its attractions.
— Fyodor Dostoyevski
“You are a modern day pyramid scheme, built on acquisitions of cloud subscriptions. So keep stacking!”
— glassdoor j2 Global Dublin Review


Couldn't have said it better myself. This is a multi-part series taking a closer look at j2 Global ("JCOM or "j2"), which I first read about a few years ago from a now-defunct blog called Stableboy Selections.


j2 Global (“JCOM” or “j2”) has been a short seller’s nightmare the last few years, consistently beating revenue and earnings estimates while acquiring hundreds of companies. Their high-margin fax business' negative organic growth is hidden through serial acquisitions, while aggressive and misleading non-GAAP/accounting presentation masks the true economic realities of the company. Acquisition-fueled growth is an appealing strategy for management as organic growth starts to slow, stutter, and decline – and j2 has gone all-in on the roll-up strategy.


j2 Global was founded in December 1995 as JFax and went public in 1999. In 2012, the company acquired digital publisher Ziff Davis Inc. for $167M in cash and most recently, in December 2016, acquired health and wellness digital media company Everyday Health for $465M in their largest acquisition to date. They currently operate their business through 2 segments: 1) Business Cloud Services, which includes Cloud Connect (Fax), Cloud Backup, and E-Mail Security/Marketing, and 2) Digital Media, which includes Ziff Davis Inc. and now Everyday Health. Historically, their fax business has been the most significant portion of revenue and EBITDA margin, from a height of 83.2% of consolidated revenue in 2011 to 35% in 2016, dropping to an estimated in 27% in FY2017. They separate their fax solutions into two basic groups: number-based (DID) and non-number based (non-DID), the former of which is the “sticky” and highly profitable portion of their business, with >50% EBITDA margins. In 2012 Cloud Connect (fax/voice) EBITDA was ~96% of total EBITDA and it is currently ~51% of EBITDA despite being only 35% of revenues. They also have a small IP licensing division (<1% revenue) with a typical run-rate revenue of ~$4M/yr. Ziff Davis, the company’s digital media segment, had revenues of $307M in 2016 and Net Income of $15.45M. Based on my estimates, Cloud Services NI was around ~30M, so despite j2’s best efforts the declining fax business (Cloud Connect) was over 70% of net income for the company in 2016.

In order to continue to grow the eFax business, j2 has had to consistently acquire and/or sue smaller competitors. After acquiring these companies, j2 reduces the headcount, jacks up prices, or completely shutters the acquired company, all the while being notoriously hard to cancel. A cursory glance of eFax reviews on Consumer Affairs  or quick Google search will tell you all you need to know about the eFax business – hard to cancel, lots of complaints, bad customer service, etc. That being said, the fax business is their cash cow – without it, j2 doesn’t make any money.

Goodwill, Intangible Assets, Accounts Receivable Growth – Delaying the Inevitable

JCOM’s goodwill and intangible assets such as patents, trademarks, and customer relationships to total assets has grown from 58% in 2011 to 79% today. Similarly, the Intangible Turnover Ratio has consistently declined from 88% in 2011 to 53% in 2016. It is my opinion that the company has an artificially increased balance sheet and is not generating any recurring growth from the majority of its acquisitions. Some of the more infamous roll-ups like Tyco, WorldCom, and more recently, Valeant, produced revenue and earnings growth by taking advantage of the loophole in acquisition accounting rules, boosting operating results with inflated CFFO and earnings. Buying declining and/or limited cash flow businesses and using accounting conventions to cover it up, works until, well, it doesn’t. Tyco, at its peak in 2001, had a Goodwill and Intangible Asset/Total Asset Ratio (Goodwill Intensity) of 32% and in 2002, after it blew up, it stood at 48.62%. In 2001, AOL Time Warner's Goodwill Intensity ratio stood at 61.5%, before its massive 2002 goodwill write-down disaster. That puts j2's Goodwill Intensity in some prime company, and given the types of companies it purchases, its own doomsday goodwill write-down is inevitable.

Although I could not find the total number of acquisitions the company has done since inception we can calculate it with information given to us from management and press releases. Management states in Q1 of 2015 that they had done 109 transactions and spent $1.1B since 2000. In 2015, they did 24 acquisitions, spending $314M and in 2016, they did 22 acquisitions for a total of $591.1M ($493.7M of which was Everyday Health). They have also done 5 more in Q1 of 2017 for an undisclosed amount, so we have a total of 160 acquisitions since 2000, spending $2B in the process. Since the start of their true acquisition spree in 2012, management has spent $1.56B in acquisitions while EBIT only increased $81M, from $162M to $243M, and management’s favorite metric, “adjusted EBITDA,” has grown from $194M to $396M.

Growth in accounts receivable and Days Sales Outstanding has also been persistent. A/R turnover, calculated with both average yearly receivables and year end receivables has grown every single year from 2010. Similarly, DSO has grown from 19 days in 2010 to a current 54 days using the average method, and from 21 to 83 days using the year end method. Receivables have grown much faster than sales, with sales CAGR of 21.5% since 2010 and receivables growth of ~60%.

j2 is either overinflating the value of their receivables or not writing off uncollectible accounts.

Peak LaCroix, An Entertaining Annual Letter from National Beverage Corp

Are we at peak LaCroix yet?

 LaCroix Cake and Cupcakes from a Whole Foods in Brooklyn

LaCroix Cake and Cupcakes from a Whole Foods in Brooklyn

National Beverage Corp (FIZZ) reported Q3 FY2017 results earlier this month, with 15% YoY Sales growth and a 62% YoY EBITDA increase. Shares are up ~115% after reaching a low of ~$39 following Glaucus Research Group's report recommending a short last September. The company is currently trading at ~26x EV/EBITDA and ~5.4 EV/Sales. Short Interest has fallen a bit recently but is still ~19% of float.

I took the liberty of reading their most recent Annual Report and Letter to Investors from the CEO, Nick Caporella (who owns ~74% of outstanding shares). Enjoy some snippets from the Letter and Annual Report:

"Since May, the beginning of our fiscal year, we have witnessed an acceleration in our momentum. Why? . . . This results from ‘exponential’ growth of distribution, both at the shelf and in new geography, and far more importantly, the impossible-to-calculate per-capita velocity of our consumers’ consumption!"
"P.S. ‘Short interest’ truly means . . . No Interest!"

This stuff reads like a comic book. I couldn't believe I was reading a ~$4B company's annual report!

With every package of Healthy Innocent LaCroix and Shasta Sparkling SDA (soft drink alternative) that is sold, we are accelerating the evolution – the transformation from once-upon-a-time acceptable – to today, technically great and smarter!”
"Someone will feature a story in the future that portrays a beautiful can of sparkling water with the word Innocent printed on it, a Tesla electric car and a Smartphone with a Health App . . . The Beginning’ the story will read! Inevitable . . . sure thing!!"
 "Today, our Company is an enterprising innovator, leaving the traditional superhighway behind. Our new course, our new pathway is called . . . ‘Inevitable’ and our vehicle’s name – ‘Exponential!’ At destiny’s resting place, we will have clearly resolved the magic of our mission . . . Indeterminable Value!’"

More to come on this company. I started a (very) small short position recently, but I think it has some room to run.

Disclosure: I am short FIZZ

C4K Interview with Jim Chanos

Great interview with Jim Chanos by Capitalize for Kids. He sees potential problems in North American exploration production space, Chinese roll-ups (including BABA), and auto sector (plus TSLA). Chanos also talks to the impact of information distribution changes throughout his career. 

P.S. If you happen to watch Billions, you'll notice they slipped him in the most recent episode (pic below).


The Theory of Poker and Fundamental Theorem of Investing

In the seminal poker book The Theory of Poker, author David Sklansky describes the Fundamental Theorem of Poker: 

Every time you play a hand differently from the way you would have played it if you could see all your opponents’ cards, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose. Conversely, every time opponents play their hands differently from the way they would have if they could see all your cards, you gain; and every time they play their hands the same way they would have played if they could see all your cards, you lose.
— The Theory of Poker

The Theorem is essentially describing positive Expected Value (+EV) play. If you could see your opponents cards, you would always make the correct mathematical decision to call, raise, or fold based on the EV of your play. Michael Mauboussin, one of my favorite financial writers, details how to use EV in his book More Than You Know (highly recommended). The EV mindset is crucial to have when making decisions under uncertainty, as we are in both poker and investing. I've attached a quick primer called A Guide to Casino Mathematics that explains EV and its ramifications.

Sklansky is very well-known in the poker community for his writing. He is described as "...flamboyant, a self-described anti-authoritarian with a knack for 'outside the lines' thinking." He also attended Wharton for a year before dropping out to be a professional poker player/gambler - guess the anti-authoritarian in him couldn't take it. Although everyone knows about his book The Theory of Poker, he also wrote many others, notably No Limit Hold 'em: Theory and Practice with Ed Miller, Hold 'em Poker for Advanced Players with Mason Malmuth, and Small Stakes Hold 'em: Winning Big With Expert Play with Miller. His newest book, DUCY? Exploits, Advice, and Ideas of the Renowned Strategist, has a section titled "The Fundamental Theorem of Investing," which he defines as:

Before making any investment, you must be able to explain why the other party is willing to take the other side of the deal...if you cannot come up with a good explanation, your buy, sell, or bet is almost certainly not as good as you think.
— DUCY? Exploits, Advice, and Ideas of the Renowned Strategist

He goes on:

The principle is very clear. You should always determine as accurately as you can why the other party is willing to sell, buy, or do other business with you. Unless you have more and better information than he (or the market) has, or you are confident that his reasons are wrong, you should seriously consider changing your mind.

People want to believe that they are smarter, more knowledgeable, and so on than they really are. Since virtually everyone wants to preserve that belief, you must constantly guard against it. Before making any important decision, look carefully at the information you have and the way you have analyzed it. If you don’t understand the other party’s perceptions and motives, stop and find out what they are.
— DUCY? Exploits, Advice, and Ideas of the Renowned Strategist

When Sklansky describes his Theorem, he is describing the well-known yet elusive "Edge" with a capital E. When going through a trade or investment checklist, whether that's done mentally or on paper, meeting Sklansky's Fundamental Theorem of Investing should be a requirement. Similar to the idea of variant perception, we must ask ourselves:

"Who is on the other side of the trade? Why are they selling/buying? Are they hedging or making an outright bet? What kind of market player is it? 

Obviously, we won't always be able to answer these questions, but asking them and trying to answer them will lead us to better trading outcomes.



The Increasing Returns Framework

In the past few years, we've seen an incredible amount of Schumpeterian creative destruction. We've seen the rise of Google, Apple, Facebook, Amazon, and the fall of almost everyone competing with them, including Dell, Hewlett-Packard, Microsoft, RIM, Motorola, Nokia, etc. We've seen Amazon destroy brick-and-mortar retailers (Barnes & Noble, Borders, Gamestop, Best Buy). Those operating under the false ideology of mean reversion in the technology sector will continue to be destroyed. Horace's quote, "Many shall be restored that are now fallen; and many shall fall that are now in honour,"  only applies under economic framework that does not apply to the new economy and its constituents.

The "Increasing Returns" framework is based on a paper written in 1996 by W. Brian Arthur in the Harvard Business Review called "Increasing Returns and the New World of Business." Arthur divided the business world into two distinct buckets: 1) The Marshallian theory of diminishing returns and perfect competition and 2) The theory of increasing returns. The former can be characterized by mean reversion, negative feedback, equilibrium. The latter is dominated by positive feedback and instability. Using Soros' Theory of Reflexivity as a guide, we could also similarly divide these two categories into non-reflexive, near-equilibrium conditions and reflexive, far-from-equilibrium conditions. 

The world of diminishing returns includes commodity-type business and manufacturing. The increasing returns world is the current world of technology and information-processing, i.e. the knowledge economy. In this world, if a system/product gets ahead, it will get further and further ahead, and if it loses, it will continue to lose. Arthur outlines the properties of increasing returns: market instability, multiple potential outcomes, unpredictability, the ability to lock in a market, the possible predominance of an inferior product, and fat profits for the winner. It is a winner-take-all (most) market, which is why we've seen the rise of the "Big 4" (AAPL, GOOG, AMZN, FB) to the detriment of anyone competing with them. 

Keeping in mind the principle of ever-changing cycles, going long increasing returns businesses and short everyone else has worked and most of the losers of this game are terminal shorts. The problem is that, by now, most of the losers have been snuffed out or have high short interest. But this framework will continue to apply and there will be more opportunities.

Here's a copy of the paper.

Keynes the Stock Market Investor, Hint: He Wasn't That Good

I recently read the research paper “Keynes the Stock Market Investor.” It’s worth a read. Keynes is a legend and Chapter 12 of Keynes’General Theory is one of the most important passages in the history of investment. The funny thing is he was awful at the beginning of his trading career. According to the paper, his alpha was 7.74% from 1922 to 1946; nothing to sneeze at, but really? I would think the Great Keynes could do better than that. He was 83% long going into The Great Crash (1929) and got crushed. Where did he make his alpha? He loaded up 2/3 of his portfolio in gold mining stocks starting in 1933…when FDR took the U.S. off the gold standard. Obviously, Keynes was in cahoots with FDR and the former had always pushed for the end of the gold standard. In late 1933, Keynes wrote “An Open Letter to President Roosevelt” to push FDR to enter the gold markets, which he did, and Keynes made a killing on his mining positions. Before this period, his returns were atrocious. Insider trading, per se, did not exist in the way it does today and he made most of his money from knowing FDR and his plan to push up the price of gold. He was a much better writer, thinker, and pioneer than he was a speculator.

Here are some highlights from the paper:

Having started out as a strategic macro manager, we show that Keynes changed into a bottom-up stock picker in the early 1930s, from which point his purchases of his long-term holdings began to outperform the market on a consistent basis.
When an undergraduate, he had written in 1905 to his friend, Lytton Strachey, "I want to manage a railway or organize a Trust, or at least swindle the investing public; it is so easy and fascinating to master the principles of these things” (Moggridge, 1992: 95).
When subsequently reflecting on his investment record for King’s, Keynes confessed that: “We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle” (CWK XII: 106). The difficulty he felt he faced as a macro manager was that: “Credit cycling means in practice selling market leaders on a falling market and buying them on a rising one and, allowing for expenses and loss of interest, it needs phenomenal skill to make much out of it” (CWK XII: 100).
In August 1934, Keynes wrote to Francis Scott, the Provincial Insurance chairman, clearly stating his change of view: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes” (CWK XII: 57). He attributed his subsequent success managing the College investments to his decision to concentrate on a few core holdings, considered cheap relative to their intrinsic value and held for several years (CWK XII: 107).
Keynes was obviously well connected but was he an insider? The investment community then did not have the same view of insider trading that we have today. Other than directors who owed fiduciary duties to their company not to trade on price-sensitive information, insider trading by investors in general was not subject to regulation until 1980 in the UK (Cheffins, 2008: 39–40). It is certain that Keynes was in receipt of what today would be deemed price-sensitive information – he was, for example, aware of a change in the UK bank rate before it occurred in 1925 (Mini, 1995).
Keynes displayed contrarian behavior over all intervals and all investment horizons.
Keynes did not chart an unhindered course of investment success from beginning to end, as has been previously assumed. His initial setbacks buttressed his influential metaphor of financial markets resembling a beauty contest, and led him to bemoan the seeming inability of the “serious-minded” investor “to purchase investments on the best genuine long-term expectations he can frame” (Keynes, 1936: 156). In such a market, smart investing is not necessarily rewarded.

Interview With a High Frequency Trader

From Zero Hedge

Some parts that stood out to me...

TCR: It sounds like the average investor is seriously outgunned. But what about a retail investor with a longer timeframe who only makes 1-2 trades a month? Does he need to worry about high-frequency trading?

GARRETT: HFT affects all investors to an extent, because stocks are now priced differently than in the past. The market used to consist mostly of investors analyzing cash flows and balance sheets, trying to calculate a company’s fair value. HFTs, on the other hand, react to movements in stock prices alone. That is not necessarily a bad thing, but since HFTs are responsible for two-thirds of the trading volume, we have the strange situation where they can set the price based on what they perceive others’ perceptions to be.


GARRETT: Exactly. Fundamental investors used to dominate the market. They would buy and sell based on companies’ results.

Today, HFTs outnumber humans in trade volume and thus are a stronger force on prices. HFTs buy and sell based on what they perceive others’ perceptions to be, as quirky as that sounds. So instead of analyzing revenue and expenses, computers analyze how other market participants act, and trade accordingly.


TCR: It seems that normal investors can counteract this by investing for the long term. HFTs create a lot of noise, trying to guess what other traders will do. But ultimately, if a company is profiting, its stock will do well.

GARRETT: Precisely. You don’t want to get into a trading battle with them. But if you have a long-time horizon, fundamental investing can still work.


Just waiting for Knight Capital redux. To speculators: stop using hard stops. They're dead. 

Value Investing: Investing For Grown-Ups?

How Big Is Almost? Or, Why the Finance Professiorate is Clueless About Manager Effectiveness

I found this paper via Niederhoffer's blog, Daily Speculations. Andrew Redleaf runs Whitebox - he is a smart guy. This has to be one of the coherent rejections of the efficient market theory ever written.

How Big Is Almost? Or, Why The Finance Professiorate Is Clueless About Manager Effectiveness


The professors missed the essential question. Their miss, however, was not a “mistake.” They missed it not because they did their research badly but because they did it well, not because they were sloppy but because they were scrupulous in their adherence to basic standards of scientific research. They were required by their own protocols to exclude the very force they were investigating, the power of human judgment.


And yet all this “cheating” is exactly what adroit money managers do not only in the narrow realms of technical analysis but in the general hunt for alpha as well. We assume that potentially profitable anomalies appear and disappear as market conditions change. We assume that such anomalies are almost certain to be more powerful and profitable for some sets of securities than for others. We look into the nooks and crannies of the market for trends that we can exploit profitably now, with some securities now. We hypothesize strategies that seem suited to current market conditions, test them, and then trade on promising results.


"Randomness or “incomplete knowledge” is a subjective phenomenon. Different observers will have more or less knowledge and more or less uncertainty as a result. Moreover we can gain knowledge by dint of hard work, natural talent, and sometimes luck. We can be well prepared or poorly prepared to make a decision, discover special relativity, or buy a security. Even our best efforts to increase our knowledge may be insufficient. We may know a lot but not quite enough. We may fool ourselves about our positive expectation. There is no guarantee that our search for knowledge will bring us close enough for success. But neither is there any basis for a dogmatic assumption of failure—or futility."

Keynes Explains The Current Market

Let's do ourselves a favor and stop trying to intellectually understand this market move. There's a reason that markets don't move up and down in straight lines, and it has nothing to do with "fundamentals." The economy is recovering, Greece is saved, austerity is destroying the EU, this is the start of the new bull market, we're headed for inflation, or deflation. None of that shit matters. From Chapter 12 of Lord Keynes' General Theory.

In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.



Bernanke on Deflation and Japan, 2002

Bernanke, you magnificent bastard, I read your book!

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

 First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States. 

Welcome to the lower zero bound and policy driven markets. The rules of the game have changed and politicians/central bankers are in the cockpit. I think the Fed will do QE3 in June. Is that why risk assets are rallying? If we are indeed in a liquidity trap, and monetary policy is ineffective, then fiscal stimulus is the only answer. At this point, the marginal return of further QE cannot be high and Bernanke is (almost) out of bullets. Does anyone think we will get an optimal fiscal policy anytime soon in a political system of partisan brinkmanship? Interesting times.

Hugh Hendry, Plasticine Macro Trader

Steve Drobny's book The Invisible Hands includes one of the best interviews of a fund manager/trader. Ever. The chapter is called The Plasticine Macro Trader and it is none other than Hugh Hendry, manager of the hedge fund Eclectica Asset Management. This is how we should be thinking and trading. Also, he's highly entertaining. Read the entire thing, but here's some snippets:

"The Plasticine Macro Trader" is an equity specialist who says he sources trade ideas from the voices in his head and manages risk by being a piece of plasticine-malleable and flexible, able to take down gross exposure aggressively to limit downside risk.
Today’s long-only stars operated during a period of time where investors did not require a macro compass. Today your average long-only guy does not spend much time looking at interest rates, currencies, debt levels, and other key macro variables. I have even been to conferences where fund managers have boasted, “I don’t know where oil prices are going; I don’t know where interest rates are going; I don’t know anything about the government.” I, on the other hand, spend all my time trying to formulate views on these things and yet these guys brag that such factors are irrelevant. All they care about is that they own the best companies in the world. For the last 30 years they could get away with that nonsense, but now at a historic turning point they are being found out.


Again, remember, I believe there is a degree of predictability to what has been happening in markets for the last 10 years. I believe that our generation is embarking upon a long period of unwinding financial excesses. Stock market returns could be terrible for the foreseeable future. If you believe people like Niall Ferguson, debt deflation eliminates all of the gains from the preceding boom, it purges everything. By 1974, we had eliminated all of the real gains from the American stock market since 1906. If we consider Japan as an example, the Topix would have to trade at 300 (or one third its present level) to be comparable with the lows reached during the 1970s on Wall Street. At this point, all of the real gains since the index was reconfigured in 1969 would have been eliminated.

This reveals the challenge of running a portfolio that is more macro orientated. We are constantly trying to challenge ourselves by looking for opportunities in low delta, cheap trades that run in direct opposition to the consensus. Can you imagine how much oil you could have sold short at $50 in July 2008 for almost no premium and with such a spectacular return? Yet instead of buying puts, I was buying calls because the fundamentals just reinforced the trend. I got sucked in; lesson learned. This is why I try to listen to people like Prechter who say there are more than fundamentals at work.

Have the courage to be different, the courage to risk the ire of others for the sake of being right; to fight rather than embrace compromises everywhere. We have to encourage rebellious notions such as playfulness and curiosity. There is no one correct way of doing things that is set in stone. Periodically managers should be open to trying different approaches.

George Soros explains a version of this phenomenon when he says, “Invest first, and investigate later.” But this is heresy in the institutional money world. When I suggest stuff like that, the number crunchers and the box tickers write down, “crazy guy” and make their polite goodbyes. But every so often a heretic turns out to be a genius.

My complaint with hedge funds today is that they are a safe option. It feels good giving them money; no one demurs. Likewise, it feels good allocating money to gold. But if it feels so good and is easy to allocate to whatever strategy or instrument is in vogue, then maybe that is a signal to take a step back. The kind of investing that I do, that yields the really big returns, always involves fear and a sick feeling of the consequences of being wrong in isolation, away from the shelter of accepted opinion.

Even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following. So I guess I am a trend-following contrarian. I come back to describing myself as a disciplined deviant. But every description that I have for myself is an oxymoron, and when I present my views, most people just think I’m a moron.

I have Tourette’s syndrome—I say “fuck” at all at the wrong times. One of my mentors taught me how to articulate that Tourette’s and then play the odds, become trend following and recognize when the elasticity becomes so extreme that your Tourette’s becomes valid and has the possibility of profits.

No, I don’t think their success is luck; they have become legends because they can be wrong about future events and yet they still make money. Take Soros and the insights he generously provides to the outside world in books such as The Alchemy of Finance, where he keeps a journal of his thoughts during a tumultuous period in the mid-1980s. With the benefit of hindsight, we know that he is often wrong and yet he always makes money. Having years with 100 percent returns while getting some trends wrong means there is an instinctive genius in his trading that I don’t fully comprehend. I’m still trying to learn. Meanwhile, most of the things that I write actually do come to pass, yet I don’t make the same returns as people such as Soros or Tudor Jones. I’m obviously missing something. The key is choosing your moments to fight with the market, and I’m beginning to learn when to avoid a fight. The wonderful thing about life and getting older is learning from your mistakes. If you don’t learn from your mistakes, you get kicked out.

I jokingly claim that my best investment decisions come from being a paranoid schizophrenic. I hear voices in my head. Subconsciously and explicitly I seek to create a macro prejudice. And so there’s an ongoing debate by those voices in my head. But the scary thing is that I make investment decisions based on these voices. And so does everyone else. I just talk about it openly and honestly. When I make such decisions I become very fearful, paranoid like a schizophrenic, that these decisions may jeopardize my investors and my portfolio. I would contend that this fear makes me a better investor.

I really struggle to be long any equity today. If you put a gun to my head, or even better, my macro prism, I might buy some agricultural names. Farming was the very worst place to be invested from its mid- 1970s nominal price high. In real terms, the price of corn, wheat, and other agricultural commodities have fallen by 80 percent, whereas the American stock market has risen nine times from its real price low in 1982. Perhaps ags have a chance once more?

That’s the hook; it is one thing to create the intellectual color but it doesn’t go into the portfolio until it starts to gain the attraction of relative momentum. I need the legitimacy of other curious strangers before I get involved.

Last summer I was on CNBC talking up Potash [Corporation of Saskatchewan], saying it was the best positioned company in the world when I suddenly realized everyone was agreeing with me. So I got out. Thank God I can reject my own advice because from July to October of 2008 its performance was diabolical.

The thing that I’m most fearful of is a focused fund, or a portfolio of 20 best ideas, which is a concept that marketed well a few years ago. The reason this idea can prove disastrous is that “best” is an emotionally charged word. Giving up on your best idea is the same as admitting that you’re wrong, something crucially important but very difficult to do.

I don’t believe that there is any real diversification left in the world today, at least not the kind of diversification to which you refer. And the shocking nature of the results in 2008 demonstrates this fact. We live in a world of binary events. Over the last 10 years, markets have oscillated between inflation and deflation, and people are either all in or all out. What we’re trying to do is make sure that we’re leaning at the right time, correctly anticipating the oscillation.

My take on it is that it is a waste of time to assume that I can outsmart the smartest people on the planet. Most hedge fund managers disagree. They present to pension funds saying, “We are the smartest people you could give your money to.” My presentation, on the other hand, is, “How do smart people keep fucking it up?” And the answer is because orthodox intelligence is subject to the whims of irony and paradox: nonlinear distribution events catch these managers out time and time again. Recognizing that such events happen with a greater tendency than they are supposed to statistically, you get a chance to extract gains from them.

The same “upside down” logic prevailed in 1979 when Volcker became chairman of the Fed. You had this new sheriff in town who was honest and tough. He was going to raise interest rates to make the economy very weak in order to parch the system of its inflation. He was a dream come true for a bond bull, and yet bonds got destroyed whilst gold doubled to $800 in three months. (See Figure 13.8.) The problem was that Volcker had to come clean on the Fed’s dirty little secret. In order to have the legitimacy to be so hawkish, he had to admit that the problem was inflation; investors panicked and scrambled to protect themselves with gold. A hawk produced a melt-up in gold. Could the dovish Bernanke produce a similar melt-up at the long end of the bond market?

The hysteria with Milton Friedman’s notion that inflation is always and everywhere a monetary phenomenon places too little significance on the overleveraged nature of our society. It is of course orthodox thinking and it’s hard to say it’s wrong, but I believe it’s wrong. But this is the prevailing mood in investing today.
We are spending all of our time looking for inflation because the Fed will be slow in raising interest rates while the roof is caving in. The private sector’s desire to unburden itself of debt is so great that debt deflation seems much more likely. And if it rolls over with everyone loaded up on risk again, playing commodities and inflation expectations, bonds could go parabolic. The bull market in government bonds is one of the greatest bull markets of all time, and bull markets of that magnitude do not end with a whimper.

Typically my work is all about creating context to establish an environment where I might want to take risk. The challenge with risk management is finding the appropriate moment to expose yourself to that risk. I don’t think the right moment has come to pass for Japan just yet, but this is an idea that I have fermented for five years. Back then, I said that for the trade to work, we would need an extraneous economic shock which pushes dollar/yen down to around the 80s, and we have essentially been there. I am always in danger of wanting too much, but I am looking for those levels again in any subsequent round of global risk aversion. If that happens, I fear the Japanese will debauch their currency in an attempt to generate inflation to monetize their considerable public sector debts. With the majority of the private sector still invested in post office savings, such a step would cause a panic to buy equities and the Nikkei could go back to 40,000. Typically it requires 25 years to break a previous nominal price high in an asset class that has suffered a bubble. So who knows, maybe this is the trade for next decade? They have covered the place with kerosene, now all they have to do is light the match.

I live an interesting life. I made 50 percent in October 2008 and my biggest investor fired me. He said he had a manager that was down 30 percent on the year, but that manager “gets it,” so he was going to stay invested with him. Meanwhile, I made 30 percent on the year and I get fired because I don’t get it? This is the curse of my life. I seem to collect all sorts of witty dinner party anecdotes from my experiences, but I pray for a less interesting life.

Markets are irrational but they are right at every moment. They are right until they are wrong. You have to marry the notion of being right or wrong with being right with the timing of a given proposition. This is not a business that indulges intellectual prejudice.

Trade Like Bukowski, "Copper" the Public's Ideas and Play At All Times


Charles Bukowski dishes out betting advice in his poem, "the guillotine."


the guillotine

I knew my black friend long ago when we both worked in the same 
pit of agony, now I see him occassionally in the grandstand at the
track, he sits alone and works hard at the Racing Form (I long ago
threw that away, noting that almost everybody had one and that 
everybody lost). anyhow, I saw him last Sunday.
"hello, Roy . . ." "hello, Hank . . ." "I like the 9," I said.
"maybe," he said, "but there is one horse that
can't win . . ." he told me it was the 4 horse.
the 4 was reading three-to-one; I walked down and cancelled the 9
     and bought
a ticket on the 4, then I went out and watched the race. 
the 4 got up in the last jump and it did
which is my system: I listen to somebody badmouth a horse and I 
bet it, this is much better than any
Racing Form.


"These professionals win because they know the 'inside' principle of beating the races, the same principle that must be used to beat any speculative game or business from which a legal 'take', house percentage, or brokerage fee is extracted. That principle is "COPPER" THE PUBLIC'S IDEAS AND PLAY AT ALL TIMES! That is not abstract theory -- it is practical percentage." Robert L. Bacon, Secrets of Professional Turf Betting


Some Selected Quotes From A Little-Known Classic on Speculation

From The Psychology of Speculation: The Human Element in Stock Market Transactions by Henry Howard Harper.

Since trading in stocks has the appearance of being an easy way of making money, it is one of the most alluring pursuits of modern times; and from this very fact, although legalized for all, it is susceptible of becoming one of the most dangerous habits known.

In a bear market a discouraged bull is at least not despised ; he may find a sympathetic sufferer; but in a bull market no one ever wastes any compassion on a bear, or admits sympathetic kinship with him.

But the more he reasoned and studied the charts, the more unprecedented and obstinate the market became. One thing he failed to consider was, that the favorite caprice of the stock market is to violate precedent, and to do the thing least to be expected of it.

But there is far greater danger in excessive optimism than in excessive pessimism, for the reason that optimists are inclined to back their hopeful views by indiscriminate purchases of stocks at high prices, while pessimists are seldom disposed to back their views at all.

It was a wise custom of the ancients to build their pyramids with the big end on the ground; but modern builders of pyramids in the stock market have reversed this time-honored practice, and most of them build their stock pyramids with the heavy end up; therefore they invariably topple over after reaching a certain height.

On the losing side there are at least three distinct classes to be found at all times in stock market circles: one class who know nothing about the market, except what they read or hear; they are guided by floating rumors, the advice of well-meaning friends, and the spumous counsel of market tipsters. There is another class who arbitrarily suppose they have learned everything there is to know about the market; they possess a large store of cynicism and skepticism, and their market maneuvers are guided by a monumental self-sufficiency that would be a valuable asset in trading but for the fact that it is worthless. There is a third class who, although they really know the practices, theories, precedents and possibilities of the game, are not temperamentally qualified to utilize this knowledge in their transactions.

He therefore enters "the game," as the stock market is oftentimes called, with his eyes open, and the cards all faced up on the table. But if he deviates from sound principles and resorts to dabbling in stocks that he knows nothing about, except from hearsay among traders and market tipsters, and undertakes to guess the maneuvers of cliques who are manipulating them, he has no one to blame but himself for indulging in such an expensive folly.

The most important thing in golf, and the hardest thing to learn, is to keep the eye on the ball while in the act of hitting it; and the hardest thing to learn in stock trading is to keep the eye off the market, hold firmly and patiently to good resolutions, and not try to get rich too quickly.

Every stock market cycle shatters some precedent ; every era produces new phenomena.

To sum up the whole situation in a word, those who would make money speculating in the stock market should first understand that it requires as much caution and business acumen as any other money-making enterprise, plus some knowledge of the psychological handicaps; also plus the rare faculty of maintaining a complete mastery over one's impulses, emotions and ambitions under the most heroic tests of human endurance. All speculations, and even the most conservative investments, have some slight element of risk; all lines of business are more or less a gamble; marriage is a gamble; political preferment is a gamble; in fact nearly everything in life, including our very existence, is an uncertainty; yet people are not thereby discouraged from entering into any and all of these ventures. Those who look only for certainties have far to search and little to find in this world.