Byrne's Eye View

Everyone who writes about finance knows that selling short is risky because there's no limit to how much you can lose. But this is because people who write about finance rarely think like value investors. Consider: the stock is at $10, you think it's worth $5, so you sell it short with 4% of your portfolio, expecting to make 50%. Over the next month, the stock rises by $5, to $15. Now it's (a little bit more than) 6% of your portfolio. Bad news? Possibly, but now the expected profit is 67% ($10/$15, instead of $5/$10), and perhaps the odds of realizing that profit are higher as the stock gets more egregiously overpriced.

I think that, contrary to convention, short-selling is what I think of as a pure value trade -- a trade which, once you make it, fluctuations in market price cause the same change in portfolio allocation that you'd make anyway.

Unfortunately, the only other pure value trade I can think of is the currency-standardization trade. If you expect that A is a better currency than B, and thus that people will standardize on A, every time A rises relative to B it becomes a better standard than B. This is probably why gold bugs sound the way they did in 1962 (read Barrons from that time -- a good business school library should have it -- and you'll find the same kind of arguments you hear today).

As the gold thing should illustrate, there are many more pure trades outside of the value school. For example, venture capitalist and global macro expect Peter Thiel seems to be talking about the same thing in this essay. What he ignores is that most all-or-nothing bets have a time limit, and that people who bet on the current bubble being right are, in general, poor to the extent that they make this bet. Or put another way: Wilbur Ross could invest a month's worth of the dividends, management fees, and interest he's getting on his steel, coal, and textile holdings, and he'd have a bigger bankroll for betting on the Singularity than the average venture capitalist. But if Thiel has picked the right bubble, he's making a great pure trade on it.

Momentum investing consists of mostly pure trades: if it doubles, buy it, if it doubles again, allocate twice as much of your portfolio to it (done!). Macro investors make those trades, too -- a thesis like "Money is flowing into Singapore" is more or less identical to "Buy financial assets in Singapore while they appreciate, and sell if they drop."

What's odd is that investors shy away from these simple trades. The daily turnover makes it clear that investors are more concerned with what Coca-Cola will make next quarter than with what they can make over a century and a half. I suspect that investors hate these trades because they require so much conviction: when you leave everything after your decision up to the market, you're showing a lot of faith in that decision.

The average investor will accept a lower return, if it includes ample opportunities for second-guessing.

1. Did any major investor or investment manager start to show worse results after Reg. FD? I have heard countless anecdotes -- usually starring Drexel Burnham Lambert -- about how in week one, the analyst plays golf with the CEO, in week two, the mutual fund manager talks to the analyst and buys the stock, and in week three, the company announces record earnings. But surely if some fat cat had actually gone from beating the market by 5% a year to trailing it by the same amount, somebody in the media would notice. Among the investors that I admire and the ones I don't I haven't seen any decrease in performance since 2000.
2. How many companies that go public before they have a real business end up being legitimate?

The price decline of thinkorswim Group (SWIM -- InvestTools until a few months ago; they're in the "Investor Education" -- high-priced trading seminars -- business) convinced me to look over the company's history, and the first thing I did was examine their earliest available annual report, and the first thing I noticed there was that InvestTools traded over the counter, and was the product of a merger between two other OTC stocks, each of which had declined about 95% in the prior year. So it looks like the usual OTC hocus-pocus (with which I'm familiar only because about 1% of OTC stocks are legitimate companies run by people too ornery for Sarbanes-Oxley). The difference: less than a decade later, this company was worth over $1 billion.

Like many OTC companies, InvestTools' new subsidiaries were also involved in some kind of penny-stock scam, in this case involving a brokerage (known as "World Trade Financial" until some time in 2001, when it hastily turned into "Amber Securities"). This company lives on only in the old SEC filings of InvestTools (unless this is the same group under the old name), but it should worry investors that within the last decade, the company they still value at half a billion dollars was involved in such behavior. Perhaps there's a simple misunderstanding. But I don't see that kind of history with firms of a similar size, even those that were once traded OTC. In fact, a company like Ash Grove Cement (one of the aforementioned 1%) has about the same market cap as SWIM, but doesn't have any of the reputation issues even though it trades on the least-regulated exchange there is.

Investors considering thinkorswim due to the low P/E, high ROE, amazing growth rate, etc., are advised to read over the company's first annual report. It definitely tells you where they're coming from, and probably tells you where they're going.

Congressman Nick Rahall demands that oil companies "use it, or lose it": he wants them to forfeit any oil lease they aren't using, and not to be awarded any new leases.

Is there some kind of standardized test that only admits people to the House if they show economic dyslexia? This idea is ridiculously stupid. Example: let's say Exxon has a lease that is, currently, just-barely-economical; they can extract oil for $125/barrel (including overhead, depreciation, etc). But they're also aware that new technologies they're prototyping now will allow them to extract it for $50/barrel in five years.

Normally, they would do the sane thing and wait -- they own the lease, but the sensible thing to do from the global economy's perspective is to exploit it when it's maximally profitable, not the second they own it. With this bill, they'd be drilling and extracting (and polluting, and moving more capital from non-energy to energy investment, hurting the rest of the economy) in order to do the right thing at the wrong time. They might even realize that drilling is unprofitable now, but will be profitable in the future -- they could end up pumping oil, then dumping it somewhere because it's not worth selling, solely so they can keep control of the assets they own long enough to use some of them sensibly.

The kicker: many people are angry about the fact that oil has suddenly gone way up in price. Economic theorists say that this shouldn't happen, because if oil is expected to go up in price, oil companies will just slow down their drilling -- if their oil-in-the-ground appreciates at 10% each year, it's like a high-yield bank account. But of course if enough of them do that, current oil prices rise(supply has dropped) and future prices drop (supply is higher) until oil is ready to appreciate at a rate that makes companis indifferent between extraction-cost-now-oil-later and oil-now.

There are ways to mess this relationship up. One is to give people a reason to think that they won't control their oil in the future (so it's better to pump now and take the money than to wait for more money they might not get). This is what happens to Russia and Nigeria. Many commentators seem to think that the pressure to show high quarterly profits is equivalent -- that somehow, these companies are controlled by sinister executives who take advantage of their economically uninformed shareholders by producing high short-term profits but sacrificing long-term growth.

Perhaps. But I can't help but notice that the oil industry is run out of Houston when prices are low, but run by Washington when prices are high. And somehow, executives with twenty-year tenure over immortal corporations have a longer-term outlook than politicians up for reelection every few years. We now have a system in which oil is a business when the oil business is unprofitable, but oil is a populist piggybank when we need the industry most. This is the worst imaginable way to run things.

By the way

According to Wikipedia, Rahall's sister is paid $15,000 a month by Qatar. Rahall is a big fan of Qatar, incidentally. Although he wins in a landslide every race, some may be interested in the campaign site of Rahall's opponent, Marty Gearheart. There is a 'donate' button.

Carl Icahn is blogging. Finally, Mark Cuban is no longer the richest blogger.

Note that Equity Private is even more excited than I am.

Zac Bissonnette, reader and blogger, disagrees with my assessment of Adams Golf. With the caveat that Zac has clearly been following the stock longer than I have, and done more research, I'd like to present and address his claims.

The comment about bad management is mystifying -- do you remember what Adams was 5 years ago? On an operational front -- in terms of rebuilding the company -- Chip Brewer has done an amazing job.

Whether you start out losing money or making money, "good management" is incompatible with investing large sums in the business without corresponding growth in sales and profits. Corresponding doesn't mean positive -- it means in excess of (at worst) the increases in capital, and (at best) what's available elsewhere. A manager who makes 10% on capital, and asks for more money so he can make 9% on a larger capital base, is not doing his job: he's siphoning money away from higher-return enterprises. In this case, Chip may be a great operator. He may be the kind of guy who can turn a business that loses 10% on capital into a business that earns 5%. But a good manager should know not to allocate money for poor returns.

Your comment that "their business model is to hope that their Chinese partner doesn't hire an American salesman." is misinformed.

Adams designs (Check out the R&D organization) and assembles the clubs. They purchase component parts from Chinese manufacturers. This is what EVERYONE does.

This is a fair point, so I'd like to research it more. It's fine to turn commodity inventory into a branded product, if that's what they're doing. But it's a little odd to rely so heavily on a single supplier. There aren't many business that turn undifferentiated inputs into competitive outputs, but which deal with larger sellers than buyers. The only examples I can think of are companies that buy from local monopolies -- e.g. all the homebuilders have to buy their gravel from the local gravel company (transporting it isn't worth it) so they get 100% of their supply (for that product) from one seller, and sell to many buyers.

Has anyone looked at the returns on capital for gravel companies versus homebuilders? The gravel business is incredible. If I had to pick an automated trading strategy to retire on, it would be: buy and hold index funds, and every time a gravel or aggregates company trades at less than tangible book, buy it until it's 10% of the portfolio and hold forever.

Adams has a history of profitability (That could change this year because of increased marketing expenses) and has continued to strengthen its brands -- number 1 iron set at retail, number 1 hybrid on all the tours.

I talked to one securities analyst recognized as the expert on golf stocks and he told me that if Adams wanted to put itself up for sale, he could "put together a deal in a week."

I should hope so. As we seem to agree, this is a company that needs selling. A smart buyer could probably dump most of that excess inventory, and cut SG&A, and end up with something earning a little more free cash flow on a lot less investment. That would be a great move. If I saw evidence that management was moving in that direction, I'd change my view of the company. But it's all too easy to buy one of these now, and realize in ten years that earnings have increased slower than inflation, that all the extra cash is going back into that super-slow compound growth, and that the only exciting moments in the company's life are when it has an inventory writedown, a customer blowup, or its huge overseas supplier decides to squeeze a little more.

One more thing: it's important to take into account the seasonality in Adams' business: the vast majority of sales come in Q1 and Q2, and then the receivables convert to cash in Q3 and Q4 and the cycle starts again as the company builds up inventory: the end of the first quarter is the company's low-point for cash/balance sheet quality, and then it strengthens over the course of the year.

I was doing year over year comparisons to get around the seasonality issue.

One the most recent conference call, I (and someone else) asked about the increase in receivables/inventory: the mgmt, which is extremely non-promotional so I doubt they would bother lying, said it had to do with production delays and late shipping on the new XTD stuff: shipped later in the quarter, so receivables collect later etc.

A very sharp finance professor I talked to a while ago pointed out that most corporate fraud doesn't start as a way to show huge growth -- it's usually a way for a company to maintain its growth rate when it starts seeing diminishing returns. I'd add that often, the problem isn't fraud, but gambling. When they realize that their business can't get the returns they want from management as usual, they bulk up inventory, stuff the channel, and hope that the market turns around before the whole thing falls apart. Perhaps the good folks at Adams Golf really are expanding at a breakneck pace. Perhaps they are cautious and non-promotional, causing this growth to show up in their demand for capital rather than their ability to produce free cash flow.

But that's too much of a qualitative 'perhaps' for me. Management has turned the company around, from a money-loser to a value-destroyer. There's no shame in running a bad business well. But there's no money in it, either.

Goldman and Deloitte & Touche have a unique solution to the Cheyne Capital liquidation conundrum: they're turning the notorious failed SIV into... another SIV.

Goldman Sachs Group Inc. and receivers Deloitte & Touche LLP agreed to auction some of the assets of a $7 billion investment vehicle set up by hedge fund Cheyne Capital Management (UK) LLP, in a model that may be used to wind down similar credit funds.

Deloitte will sell a portion of the assets of SIV Portfolio Plc, previously known as Cheyne Finance Plc, said Neville Kahn, a receiver at Deloitte in London. The auction will set the price at which any unsold assets would be transferred to a new company set up by Goldman. The new company will then issue notes backed by the assets, Kahn said.

It's amazing how ingrained these instincts are. Even after the last half of 2007 and the first half of 2008, these guys can't look twice at a distressed asset without wanting to securitize it. Even if it's already securitized, and only distressed because of that.

I have a Google query question: I know how to use the Boolean terms like AND, OR, NOT, etc. to exclude some false positives, include multiple possible matches, etc. But what I'd really like is a "Not Just" option. For example, if I'm looking for resumes (about 20% of my day job), and I want to find someone who went to Columbia, I know that I'll have to search for "Columbia" because most people don't bother to call it "Columbia University". And I also know that I'll get lots of people who a) live in Columbia, SC, or b) were admitted to the bar in the District of Columbia. Unfortunately, a) excludes people who went to Columbia and then moved, and even worse, b) excludes people who may have gone to one of the top law schools in the country and then practiced law in the capital, and who are thus probably very good candidates, indeed.

So I'm looking for a way to either tell Google or a job-search engine to ignore bad search strings containing good ones, but not to exclude them. I imagine it's Computer Science 101 to construct an ignore-but-don't-exclude out of normal Boolean operators, or perhaps Computer Science 401 to prove that this is impossible.

From the first time I read Security Analysis, I used to vaguely think that a high current ratio was a sign of a good stock to follow: if a company has lots of inventory to dispose of and receivables to collect, they can generate cash even if they run into operational problems. I recognize that this hasn't been the conventional wisdom during my lifetime, except perhaps in the late 80's and again a year or two ago, when an LBO firm really could swoop in and turn those inventories into cash. But now that I've read this thorough but not especially compelling biography of Harold Geneen, I've learned to look at a current asset-heavy balance sheet with actual revulsion¹.

So when I look at the recent financial statements of Adam's Golf (freshly-listed on the Nasdaq, ADFG), I recognize the kind of company that, as recently as a year ago, I would have seen as a screaming bargain. Their current assets are about $30 million each of inventories and receivables, along with about $1 million in cash. Their current liabilities total $20 million, so this (profitable) company's $36 million market cap puts it at a 10% discount to the value of assets that are, in accounting theory, convertible to cash within a year. A one-year 11% CD with a net income attached doesn't sound like a bad deal.

But looking over their history reveals that this company is a mess: over the last five years, sales have not quite doubled, but inventory has risen from $9.13 million to $28.75 million, and receivables are up from $8.55 million to $18.01 million. So it looks like they have to grow their capital base faster than their earnings, which should lead to perpetual disappointment from stockholders, along with the occasionally lurch in profit thanks to an obsolescence writedown or a bankrupt customer. Their cash flow statement confirms this: their net income melts away into higher working capital, so even though the rest of the cash-flow statement doesn't show anything, the business is barely able to hold their cash on hand stable while keeping up their growth.

And get this:

A significant portion of our inventory purchases are from one supplier in China; we purchased approximately 46% and 62% of our total inventory purchased for the years ended December 31, 2007 and 2006, respectively, from this one Chinese supplier. This supplier and many other industry suppliers are located in China. We do not anticipate any changes in the relationships with its suppliers; however, if such change were to occur, we have alternative sources available.

That's right: their business model is to hope that their Chinese partner doesn't hire an American salesman. These guys are extracting a gross margin of 43% for having a few friends among end retailers. I'm betting that this unnamed supplier could find a salesman who wants less than a 43% commission.

If this were a letter attached to a 13-D, I might include a few suggestions:

• Curtail expansion. Don't take on another product line or customer unless the necessary increase in working capital is less than the increase in earnings.


• Take a look at existing product lines and customers, and any time you can liquidate 10% of your inventory and receivables at the cost of a 9% or less drop in earnings, do it.


• Quickly -- quickly -- get that cash back to shareholders through dividends (if you announce the gradual liquidation in advance) or buybacks (if you don't).


• Consider whether it's really worth it for a small company to be public at all. Filing reports and complying with SarBox is expensive. Are shareholders really getting benefits from all this activity? The company's most valuable asset seems to be their deferred tax asset. There's a chance that shareholders could benefit if the company bought out some high-profit cyclical business in order to shield a few years of great earnings. But the expense of finding a company, buying it out, and actually making the carryforwards apply could be too much for this to be worth it.

There might be a good company hiding in the mess that is Adams Golf. If there is, it's probably too small to be public. If there isn't, nobody is likely to take Adams private. It must hurt shareholders to sell their stock at four times last year's earnings, and at a discount to net current assets besides. But I fully sympathize with the sellers who have knocked the company's value down by 33% in the three months it's traded on the Nasdaq. I don't know how cheap the company deserves to be, but it looks like management is gradually chipping away at the company's business value, and raising the risk the company faces at the same time. The small chance of better management is not worth the risk that, five years from now, the company will once again be selling twice as much, and hauling around four times as much in current assets to do so. This is no way to run a business.

[1] A little of this is because Schoenberg's biography treats accounting as a very dramatic subject. Perhaps that's because Geneen's biography is mostly about accounting until the very end, when he's mixed up in some nasty bribery scandals. So Schoenberg has to treat the overhaul of depreciation schedules or the revamping of inventory monitoring as some kind of high heroics. The shareholders at Jones & Laughlin, Raytheon, and ITT certainly could have considered Geneen a hero for his work at those companies.

I recently found a copy of this biography of Robert Maxwell. I've wanted to read about Maxwell's actual career ever since I heard that he was used as a fictional foil to a thinly-disguised Rupert Murdoch.

The fictional portrayal falls flat -- they were English-speaking media barons who made most of their money in acquisitions, so it sounds like they'd often bump into each other. But besides a bidding war or two, and the coincident near-collapses of their media empires in the early 90's, they rarely crossed paths.

But what's interesting about Maxwell is that he's completely misunderstood. The usual narrative is that Maxwell was simply a fraud. He bought companies with money he didn't have, took from them money he didn't own, and would have kept it up had his crimes not been exposed, leading to his suicide. Actually, he was a complex sort of fraud: he started his career money-poor but asset-rich, thanks to his extensive contacts in postwar Germany and the USSR. Most of his early business deals arbitraged this: he bought scientific books from German publishers who had to have an English contact to stay in business, he traded up to a British wholesaler, and after that company fell apart he used his remaining assets as a basis for a publishing and education conglomerate.

Maxwell tended to buy companies on the cheap because they were poorly managed, poorly capitalized, and about to go under. It's no accident, then, that his operations often lost money. Like Templeton, he bought when there was blood on the streets, and like Templeton he was occasionally bloodied himself.

What's surprising, then, is how Maxwell's empire collapsed. He ran his public and private companies in parallel, and occasionally made deals between them to keep everything stable. What ruined him wasn't fraud -- it was hubris. When shares of his public company, Maxwell Communications, started dropping, he mortgaged them to buy more; when he ran out of collateral, he started selling his private assets to put more money into the public stock. As his company continued to lose value, he used up all of his collateral, fled the country, and was found dead (circumstances say suicide, autopsy says stroke, conspiracy theorists blame the KGB or Mossad) a few days later.

Maxwell's juggling of public and private partnerships is reminiscent of Enron: some Enron executives used the partnerships to extract money from the company, but they also used partnerships collateralized with Enron stock to keep the company's earnings high. Unlike Maxwell, it took a huge staff of accountants inside the company and out to keep things running -- amazingly, Maxwell handled a similar structure all on his own. Like Enron, what brought him down wasn't that he'd overstated earnings, but that he had borrowed too much on the expectation that his stock would always trade at what it was worth, rather than what the market worryed itself into believing. Even though Maxwell lied, it's hard to see him as a crook: what ruined him was that he believed too strongly that he was doing the right thing all along.