Capital Markets Theory You Can Use

I’ll be the first to admit that financial capital markets theory can be dry as dust and that mostly you should just live your best life in blissful disregard for almost all of it. Today, however, indulge me in discussing a capital markets rule that can help you avoid fraud, seek better investments, and make you a more successful entrepreneur.

IRR
Powerpoint slides like this one are so stupid

A recurring and guiding principle of my financial writing is that most people could benefit a bit from “thinking like a banker,” and this is one of those ways to do that.

Here’s the finance theory: The yield, or financial return, available to you as an investor is equivalent to the cost of capital of the company offering that investment opportunity.

Huh? I know, I know. What does that even mean?

It means that if you earn 0.5 interest on your savings account at the bank, or if you get a municipal bond paying a 2 percent yield, that’s how much the bank and the municipality have to pay to use your money. That’s their cost of capital. Banks and muni bonds are pretty straightforward examples of the theory.

The theory also means that if you end up earning 8 percent per year by owning a public stock for thirty years – from a combination of dividends and price appreciation – that public company has effectively endured an 8 percent cost of capital per year throughout that time. This point is a bit more abstract, since the company might have only paid out, let’s say, 2 percent in cash dividends on the shares. But in aggregate the idea is still true, and here’s why. If the original owners of the shares, or the company itself, had never sold stock in the first place, all of that 8 percent annual investment return would be captured by the company or its original owners, not the outside stock holders. Since it wasn’t retained, that’s their cost for having sold shares thirty years ago. If you make a lot of money owning stocks, it was pretty costly for the founders who originally sold

allen_stanford
Can I interest you in an above-market rate CD?

Of the many applications for this important theory, avoiding fraud is the first to come to mind. Let’s say you’re a Texan of some means in June 2005, looking for a nice high-yielding, but safe, place to park your cash, during that low-interest rate environment. A friendly salesperson offers you a bank CD with Allen Stanford’s Stanford International Bank, with a 7.45 percent 12-month certificate, compared to the average US bank CD at the time of 2.8 percent. Great deal, no?

NO.

Stanford’s company claimed access to unusually attractive investment opportunities. But a key thought for Stanford CD investors should have been this: Why would Stanford’s company incur such a high cost of capital? As an investment rule, if the investment opportunity seems to offer far more than would be available elsewhere, your fraud-detection spidey-sense should make you ask: Why does that company need to pay so much to use my money?

On the more legitimate side of investing, the theory can be quite useful for skeptically evaluating risky things like high yield bonds or initial public offerings (IPOs). Let’s say back in 2011-2012 you were tempted to buy Greek bonds at a highly distressed 15 percent (or more) yield. That’s an amazing-seeming yield for government bonds, and such a nice place, too. They have beautiful islands! The yogurt’s incredible. What could go wrong?

A skeptical thing to remember is that the Greek government itself, if it had the cash, could purchase those bonds themselves in the open market and lock in a 15 percent return on capital through retiring their own debt. Obviously, for that whole time period, it didn’t have the cash, at all. Which is a worrisome thing if you’re contemplating owning their debt. Private bank lenders to Greece ended up taking a greater than 50 percent “haircut” on the value of their loans in 2012.

This cost of capital theory also generally makes me skeptical of IPOs, even of excellent or “hot” seeming companies. Here’s the thought process. If the current private holders of companies believe that the company they own offers a good return on capital in the future, they generally don’t look to sell shares.

snapchat_ghostDid you figure in March 2017 that you’d make a 15 percent annual return buying the IPO for Snapchat (SNAP Inc)? Well, the skeptical thought is that the pre-IPO owners – who know infinitely more about the company than you do – wouldn’t typically give up a 15 percent annual return if that seemed likely. When founders sign up to sell their company through an IPO, I generally interpret them as saying the following: “The best days of growth for this company are probably behind us. I’d prefer to get my money out while the getting is still good. I can make more money elsewhere.”

Now, I know that founders’ decisions are more complex than that – having to do with personal liquidity, pressure from private equity owners, and maybe a strategic need to scale up a business. But still, a factor in their decision is whether they can make a high return in the future, or whether they don’t mind some other damned fool taking that risk from here on out.

Finally, I think understanding the “investor’s return = company’s cost of capital” idea can make you a better startup entrepreneur. If you’re an entrepreneur and you truly believe in your company’s product even though it’s still in an early-stage of development, why (OH WHY?!) would you be in a rush to sell part of your business to angel investors? I know you need the money now. But if you succeed wildly in the future then the cost of that capital will be nearly infinite. If you believe in your company’s prospects, selling a piece of it is an outrageously expensive way to raise money. More founders should fight with tooth and claw to never sell equity in their company, and certainly not at an early stage.

Please see related posts:

 

Twitter IPO

Facebook IPO

 

 

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Platinum Partners And How To Spot A Fraud

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Perp Walk, Platinum Partners

Police arrested seven executives connected to the $1+ billion hedge fund Platinum Partners in late December, for fraud.

The charges against them include overvaluing assets and a Ponzi-like practice of paying departing investors with new investors’ money.

Platinum Partners reminds me of lesson number one on spotting financial fraud: If an investment fund never, ever, shows a loss, it’s probably a fraud. I’ll tell a story of how I learned this lesson well, back in 2008.

But first, the rest of the Platinum Partners story. In October 2015, Bloomberg News reported on Platinum Partners’ astonishing investment track-record. One of Platinum’s main funds reported gains in 118 of 119 months – from 2005 to 2015 – a particularly rocky time for investing. Platinum never even lost money in 2008, when every other risky fund lost money.

And Platinum did not invest in safe, low-return strategies either. Rather, they sought out unusual niches in litigation-finance, payday-loan funding, and life-insurance strategies, the kind of investment that pays off when someone dies.

Bloomberg quotes a hedge fund researcher who analyzed Platinum’s business, and came away skeptical:

“When you see nearly flawless returns, it’s intriguing, but also potentially worrying. Even cursory due diligence showed that a number of their dealings ended in death, litigation or handcuffs. Those are the kinds of red flags you can see from outer space.”

In that time Platinum reported an annualized return of 13.5 percent. As it turns out, however, this kind of flawless track record usually only happens when somebody cooks the books.

(Attention fraudsters: You need to be subtler about your fakery. Also: This is not actual financial or legal advice!)

My investor’s experience

The way I learned this number this lesson – that the absence of monthly losses means it’s probably a fraud – involves a story about an investor in my own investment fund, which I began in 2006.

One of my earliest investors was a wealthy man (I’ll call him William) who was introduced to me with the “good” and the “bad” of his investment style explained upfront. The “good” was that he’d allocate a small amount of money early on in the life of a fund with small managers like me, who needed to build up a track record over time. If I produced steady positive returns, William would increase his investment. The “bad” was that if I ever experienced a down month, meaning negative returns, William would probably pull all his money out of my fund very quickly.

flawlessIn the investment management world this is a problem because we all want to attract “sticky” money that won’t leave the fund at the first downturn. And some negative months are inevitable in any risky fund. Nevertheless, I accepted his investment. As a small investment manager, I decided I needed the assets.

I experienced my first significant down month in the Summer of 2008. I made a phone call to William, knowing he’d be more upset than my other investors. Whoo-boy, that call went badly. He insulted not only me, but my wife (who he had never met) in one of the least pleasant conversations of my life. As I had expected, he asked for his money back at the earliest possible moment, which would still be months later.

I next spoke to William on the phone in mid-December 2008. By then, the financial world as we knew it – following the collapse of AIG, Lehman Brothers, Fannie Mae etc – had been completely upturned.

By December, however, William was awfully polite and cheerful with me, and I quickly figured out why. I’d be sending him his money back, with only a minor loss. He had much worse problems than his comparatively small investment with me.

Bernie_madoffThe news of Bernie Madoff’s ponzi scheme had broken a week earlier. Madoff’s claim to fame, prior to exposure, was never suffering a single down month. Of course, William had been an investor with Madoff.

Not only that, however, William had realized by late 2008 that he had invested with at least two other less well-known funds that turned out to be fraudulent Ponzi schemes, one in Florida and the other in Minnesota.

Here’s the thing about William’s strategy: If you invest in lots of funds, and then pull out your money from any funds that have a monthly loss, then you have inadvertently created an algorithm for putting money into the largest number of Ponzi schemes possible.
In the investment world, “you only find out who is swimming naked when the tide goes out,” said a guy. (Ok, that guy was Warren Buffett.)

Well, by December 2008, William was buck-naked at low tide with sharks surrounding him and a steady bleed from his right knee, metaphorically speaking. And it couldn’t have happened to a nicer guy. Yes, I still remember our June 2008 conversation.

But back to the main lesson: If you relentlessly seek out investment funds that never have negative returns – rejecting all those that sometimes lose money – after some period of time you will be left with a very peculiar basket of funds. As I learned from my investor William, that basket will be full of frauds.

fraudI haven’t reached out to William to find out if he’s invested in Platinum Partners, but I wouldn’t be surprised, assuming he hasn’t changed his investment strategy since 2008.

Now, maybe you’ll allow me to extend the metaphor a bit, from investment managers to people.

We naturally seek out flawlessness and celebrate genius. We crave apparent greatness. We want amazing people not just in finance but in many other aspects of our life.

But the frauds tend to be the ones who never admit of doubt. They never accept criticism; they never take responsibility for errors. They never have a down month. As for me, I’m much more impressed by the good ones – in money management and elsewhere – who constantly point out the limit of their own powers. They allow for errors, and they own up to them.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

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Trump Part V – The Constitutional Crisis

Trump_disgustingWe can and have survived security crises. We can and have survived economic crises. My worst fever dreams are about how much Trump has already threatened to spark a constitutional crisis. Authoritarians often start out acting within constitutional norms but work to subvert institutions that limit their power, over time.

Trump does not respect or seem to understand the constitutional point (Article 1, Bill of Rights) about freedom of speech, when he demands an apology from actors at the Broadway show Hamilton making a political statement. He does not seem to respect the freedom of the press when he threatens the Washington Post with “such problems” when he is elected, or when he threatens to change libel laws to allow him to sue newspapers and journalists, many of whom he professes to hate.

Trump does not respect the freedom of religion when he says Muslims resident in the country may need to sign up with a specific registry. He undermines both the rule of law and the separation of powers when he attacks the court investigating his Trump University fraud – because of a specific judge’s ancestry.

US_ConstitutionEven in this period before Trump assumes the presidency, he has threatened numerous unconstitutional actions. Are we far away from a regime in which we could see far more unlawful search and seizure? (Article 4, Bill of Rights) Torture? Violation of the emoluments clause? (Article 1, Section 9) Constitutional threats spring up around Trump like mushrooms after a particularly rainy season.

Even short of Constitutional threats, he’s already ripped up traditions and best practices that are often as important as codified law. The fact that he repeatedly lied about not releasing his tax returns because of an IRS audit – thus flouting modern tradition about financial disclosure from Presidential candidates – shows he will push the limits on unwritten norms, when it suits him.

His plan to not put his business into blind trust – but rather turn it over to his children – opens up his administration to being the most corrupt in history.

His attempt to make his son-in-law a White House advisor – despite clear anti-nepotism laws against it – is outrageous.

This limit-pushing instinct, combined with a disregard for Constitutional checks on power, make Trump a danger to the Republic. At every turn he attempts the immoral, illegal, or unconstitutional choice. It’s going to take alert and brave members of government and society at all levels to keep the US Constitutional issues front and center, and viable.

As Matt Levine pointedly reminded us the day after Trump’s election, the Constitution and other laws are only as good as the people who are willing to enforce them. Otherwise laws just become silly pieces of paper, worthy of little notice, or the kind of things to knowingly flout like speed limits that few heed on a highway. That’s why it’s a little extra frightening right now that the opposition party in Washington is so weak. Are there Republican leaders who can stand up to Trump? I really hope so.

1st_AmendmentIt should be obvious by now – even before he takes office – that, as President, Trump will attempt to violate many of our most important constitutional protections and best practices in his first few years in office. The question will be whether and how people respond. Chavez, Putin, and Hitler all managed to eliminate checks and balances to their power in their early years in office.

Do our leaders roll over and allow him to get away with it?

Will we all let Trump get away with it?

 

Please see related posts:

Trump Part I – Fever Dreams

Trump Part II – Review of Recent Elected Authoritarians

Trump Part III – The Use of Security Crises

Trump Part IV – The Economic and Financial Crisis

Trump Part VI – Principled Republican Leadership

And related posts:

Candidates Clinton and Trump: Economic Policies

Candidate Trump on US Sovereign Debt

 

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