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.