Trading Profits Are Spawned by Similar Forces (An example)

In his essay entitled ‘Why Capital Structure Matters’, Michael Milken asserts that, “History isn't a sine wave of endlessly repeated patterns; It's more like a helix that brings similar events around in a different orbit”. This assertion replayed in my mind when I was reading a book by David Einhorn of Greenlight Capital, entitled ‘Fooling Some People of The All of The Time: A Long Short Story’. In the book, David expositions the factors that predisposed Allied Capital (NYSE: ALD), a RIC that was trading on the New York Stock Exchange, to financial weakness.

When Greenlight started shorting Allied Capital, the RIC had a market cap of USD 2.6 billion, and it was trading at two times net asset value.

As a RIC, Allied Capital had the following features:

• 1. It paid no taxes.
• 2. It passed all its earnings as dividends to its shareholders.
• 3. It was limited by law to 1x leverage.

Because of feature #2, Allied Capital could not use retained earnings to fuel its growth; it was forced to finance its growth by issuing new equity at higher multiples to book value. When it did that, ALD could then use the capital, leveraged at 1x, to make mezzanine loans to unlisted companies (A high risk investment strategy).

…Pitfalls of the Strategy

In a serious economic downturn, Allied Capital would experience severe delinquencies in its investment portfolio. And, the value of the collateral it put up for loans from its creditors would fall; which would trigger margin calls. Because the entity wouldn’t have retained earnings to serve as a loan-loss buffer (refer to feature #2); Allied Capital would only have two feasible courses of action:

• Sell its portfolio holdings to meet margin calls: Allied Capital made mezzanine loans to unlisted companies by acquiring stakes in tranches of the companies’ collateralized debt securities. These securities are generally illiquid, and thus, hard to sell in depressed markets without incurring severe losses. Therefore, If ALD sold some of these securities at fire sale prices; it would be forced to write down the value of similar portfolio holdings. This would have an adverse impact on the firm’s NAV and the value of its collateral, which would trigger a second wave of margin calls.
• Raise more equity to create a temporary loan-loss buffer: In economic downturns, investors usually flee from the risky stock markets to the safe havens of sovereign bonds. In short, the demand for stocks falls in economic downturns, and this puts downward pressure on the prices of listed equities. New listings generally miss pricing and capitalization targets in downturns. Therefore if ALD tried to raise equity capital during a downturn, it would do so at a very low premium to NAV. Thus, in a cyclical downturn the RIC would generally be unable to raise enough equity to insulate itself from the effects of margin calls, asset write-downs and rising delinquencies.

Hence, it is evident that the structure of Allied Capital predisposed it to collapsing in cyclical downturns.

***

The forces that contributed to Allied Capital's downfall resemble the forces that toppled players who were dealing in asset backed credit securities in 2007 and 2008. And, they have eerie similarities to the forces that led downfall of the REITs that burgeoned in the US during the 1970s (You can read about the REIT boom-bust process in ‘The Alchemy of Finance’ by George Soros, Chapter 2).

Simply stated: it appears that great investment opportunities are spawned by similar forces in financial markets. Or as Michael Milken asserted; the history of financial markets is like a helix that brings similar events around in a different orbit. So, it is profitable for one to familiarise oneself with the forces that created alpha for previous generations of investors: they are certain to come into play in the future!

Adding a Social Layer to the Google Experience

Not too long ago, I watched an interview in which Google’s current CEO, Eric Schmidt, stated that Google would be adding a “social layer” to the Google repertoire of services. When he said that, I thought to myself: “I hope that they don’t try to resurrect GoogleBuzz or Orkut”.

As you may know, the aforementioned services were Google’s lacklustre forays into the social networking arena. And, it is very likely that the said ‘social layer’ would be a conflation of those epitomes of evil. Such a Frankenstein monster would detract from the utility of Google’s services; it would be antithetical to Google’s stated bohemian mission (to not do any evil deed).

***

…Social Features that Google should consider

In my opinion, the ‘social layer’ that Eric mentioned should assume the following form:

1. A vertical search option: Recently, I was looking for a method for valuing the (cashflow-generating) software of a tech start-up, so I keyed my search into Google’s search engine and got few relevant results. I tried to modify my search query, but that was a Sisyphean effort. And after a few more tries, I wished if Google’s search engine would just ask me to phrase the query as a question; which it would automatically pose to my Linkedin contacts (via the Linkedin Answers facility), or to my Twitter or Facebook connections (via a status update with the question). This vertical search option would complement Google’s horizontal search capabilities, and this would increase the utility of Google’s search engine.

2. An autopilot-StumbleUpon-type facility: There are times when I just want to browse the web aimlessly, looking for nothing in particular. And I wish if Google’s products could help me to do so. I use the Gmail service and Google’s search and blogging products religiously, and it is within Google’s capabilities to create an astute algorithm that uses my browsing and search history (and my recent emails and blog posts) to ‘StumbleUpon’ web content that I would find interesting. They could add a button or command (like pressing ‘Ctrl+1’) in the Chrome browser that enables me to activate the proposed feature at will. Succinctly: I would like the Chrome browser to have clairvoyant-like capabilities that enable me to find entertaining web content that I wouldn’t otherwise access. Google should also make it easy to share the content on Twitter or Linkedin through the use of simple commands (like ‘Ctrl+T’ for Twitter and ‘Ctrl+L’ for Linkedin).

Evidently, my version of the ‘social layer’ is less sexy than anything that Google can conjure-up. But as Facebook has demonstrated time and time again: simplicity enhances the user experience. Instead of trying to thwart Facebook and its social networking cohorts, Google should be working with them to bring a social feel to the Google gamut of services!

What Social Networks can tell you

I’ve been browsing through Nicholas Christakis et al’s book entitled Connected: The Surprising Power Of Our Social Networks, and it inspired me to resume fiddling about with D-Wave's quantum computing software, Orion.

Here's a problem I formulated:

Let's say you have a class with 7 students, who have the following Names and Student Numbers:

You know the following about these students:

• Mary gossips with Josephine and Johnetta.
• Johnetta gossips with Peter.
• Peter gossips with James and Judas.
• Judas gossips with Isaac.

From that information you can construct the information network / grapevine below:



In the grapevine above, the blue vertices represent the males, the pink ones represent the females. The numbers represent the respective student numbers of each vertex (which represents a student), the lines connecting the vertices represent 'gossip relationships'. From the network above, we can tell that girls generally gossip together and guys generally gossip with other guys. As you can see from the chart, Johnetta is the bridge between the girls network and the guys network, and Peter is the bridge between the guys network and the girls network.

Analysis of this graph yields these metrics (never mind what they mean):



Now, lets say that you want to find the largest clique in the gossip network, and its respective constituents.

You would go to Orion, and enter this problem matrix (to be solved by the Clique Problem Solver):

P edge 7 8
e 1 2
e 1 6
e 2 6
e 2 4
e 4 7
e 4 3
e 7 3
e 7 5

And you would get a result that looks like this:

1100010 3

What this basically means is: The largest clique in the gossip network is comprised of three individuals; Mary, Johnetta and Josephine [1]. Generally, members of this cohesive subgroup will tend to share information, have homogeneity of thought, identity, beliefs, behavior, even food habits and illnesses.
Now, here is the beauty of this whole exercise, if you entered the same problem matrix in Orion and selected the Maximum Independent Set solver, you'd get this output:

1010100 3

This basically means that the greatest possible set of unrelated individuals will consist of 3 people; Mary, James and Isaac. These people basically don't have direct 'gossip relationships', and will exhibit the most differences from each other in terms of thought, identity, beliefs, behavior, even food habits and illnesses. If you want to form the most diverse workgroup from the gossip network, it would be made-up of those individuals [2].

What can this information be used for:

• Word of mouth marketing campaigns.
• Finding out who the real leaders of a group, like a terrorist cell, are.
• And whatever your imagination can conjure.

 I guess that you get the gist of it.

[1] Geordie Rose, the CTO of D-Wave Systems, the Quantum Computing Company, gave me a pointer on interpreting Orion's output. Thanks Geordie!
[2] Diverse workgroups are the best at solving complex problems.

The Gold Standard Fallacy

Citizens of the U.S.A. (and foreigners alike, especially those who hold U.S.-Dollar denominated securities that are not inflation hedged) are becoming increasingly concerned about the United States of America's exponentially increasing supply of money, which grew 12% in 2009, and the nation state's ballooning budget deficit.

A crescendo of voices from academia are proposing a diverse range of fixes to curtail this growth of money supply and the budget deficit. Generally, the remedies that have been put forward to assuage the U.S. society's pains from the said 'money supply ailment' include; limiting the government's financial intervention in private sector affairs, and a return to the "gold standard" of fiat currency supply management.

In fact, it appears that a growing number of academics and policymakers assert that the specie gold standard is the panacea for the tendency of central banks to debase currencies (through ill-conceived policies and the inept regulation of money supply).

In my opinion, that assertion only holds for countries that have a limited accessible endowment of gold, and or, 'thin' reserves of gold. And, it becomes a fallacy when it is applied to countries that have a readily accessible large endowment of gold, and or, abundant reserves.

In this post I want to illustrate, using examples that I have cherry-picked from history, that hyperinflation cannot be prevented by just pegging a currency to something "real", as some economists assert. If governments fail to keep the money supply's growth at rate that is at par with GDP growth, hyper inflation will materialize. I'll borrow one example from Malian history and the other from Spanish history:

Story 1: Mansa Moussa / The Emir of Melle / Lord of the Mines of Wangara / Conqueror of Ghanata / Futa-Jallon / Kankou Musa / Kankan Musa / Kanku Musa / Mali-koy Kankan Musa / Gonga Musa / the Lion of Mali goes to Mecca

According to the writings of a fourteenth century Arab scholar called Messr. Abu-sa'id Uthman, Mansa Moussa was the King of imperial Mali, and its colonies that stretched from Ghana to Songhai, when Mali was at its Zenith. It is estimated that Mansa Moussa's reign lasted for a total of 25 years. Historians assert that his reign did not begin before AD 1307 and that it had ended by AD 1337.

Mansa Moussa was a Muslim, and is credited with building centers of learning throughout the Malian empire, and it was during his rule that the first university in the world was built at a location in Timbuktu.

In 1324, i.e. around the time when the Aztecs commenced the construction of Tenochtitlan and approximately when the Ottoman Turks began the creation of their empire, he took the hajj, an obligatory pilgrimage (for Muslims) to Mecca that earned him a spot in history as one of the world's most extravagant rulers.

On his hajj, he took with him:

• An entourage of sixty-thousand people adorned in the finest silk,
• Eighty camels carrying over two tonnes of gold,
• Twelve-thousand servants, of which five hundred carried staffs of gold that each weighed four pounds.

And he dolled-out most of the gold he had with him to poor people he encountered as he was traveling. In fact, he was so generous that he didn't have the wherewithal for his return journey and had to borrow money to finance the 'homeward trip'.

A concomitant of these unprecedented acts of generosity was inflation. His massive generosity undermined the value of gold and caused inflationary pressures that plagued Egypt for twelve years. Inflation is too much money chasing on too few goods, and Mansa Moussa's generosity flooded Egypt with gold, whilst production was left unchanged.

Story 2: The Spanish search for El-Dorado (The realm of the gold-covered King)

Note to Reader: This story isn't about gold, it's about silver. Just pay attention the dynamics: they would exist, in their exactitude, if gold was used as the unit of exchange in those times.

During the middle-ages, there were many tales of fantastical realms that had extreme wealth, could enable men to regain lost health and lands in which men could forever live a Utopian existence. One of these fantastical lands was El Dorado, the realm of the gold-covered King, and the Spaniards believed that it was somewhere in Latin America.

In 1524, i.e. 208 years after Mansa Moussa made his inflationary pilgrimage to Mecca, Francisco Pizarro González, a Spanish conqueror, went to what they termed upper Peru, which is now part of modern-day Bolivia, in search of El Dorado, the realm of the gold-plated King.

With him were forty horses, and eighty men who were armed to the teeth and ready for combat. After defeating the Incas, who were the indigenous owners of that territory, in the battle of Catarmarca, González discovered the Cerro Rico (which literary translates to the 'rich hill') silver deposits in a mountain located in Potosi. There they extracted silver, using forced labor, and shipped it to the Spanish crown. This mine was one of the many mines that shipped over two billion ounces of silver over period of 250 years of Spanish colonial rule.

To quote the celebrated Economic Historian and author, Professor Niall Ferguson, "they thought that they had become rich beyond the dreams of avarice". But they were wrong.

With their increased supply of money they couldn't buy more things, as they thought, because the flood of silver that they had created was chasing on a fixed amount of goods. Simply put, they had caused inflation.

Conclusion

In a system where the specie gold standard is used to manage fiat currency supply, which is analogous to a system wherein gold coins and ingots are used as an official unit of exchange, the amount of currency in circulation is equivalent to the amount of gold held in the reserves of its central bank. This means that the market dynamics that occurred 700 years ago when Mansa Moussa made his hajj, and 500 years ago when Spain had discovered silver deposits in its colonies, can occur in such a system.

Thus, this implies that if a country, that employs the gold standard, has an abundance of gold reserves, and a declining base of production, there will be inflation. And, conversely, if the country has a rapidly growing production base, and declining gold reserves, it will experience either a recession or a gut-wrenching depression.

It doesn't matter whether a country uses the gold standard, silver standard or nothing at all. If the growth in money supply outpaces the growth in productivity by a wide margin, inflation will always materialize.

So instead of talking about returning to the gold standard to preserve the value of a currency and to ensure price stability, people should be saying that "the increase in money supply should move in tandem with the GDP most of the time."