The Average Investor Can (And Should) Ignore the 60 Minutes Story About “Rigged” Markets

The piece on 60 Minutes this past Sunday has ignited a discussion about high-frequency electronic trading systems and undoubtedly has spiked sales of the new Michael Lewis book entitled “Flash Boys: A Wall Street Revolt” which digs deep into the topic. Since I have yet to read the book, I am not going to get into many details here, but the big issue is that technology has become so advanced these days that certain people are now able to get insights into what orders are coming in for a particular security, and jump in front of those orders to make a few pennies per share on the backs of smaller investors. It’s gotten so bad (read: unfair) that a company called Virtu Financial Inc, which recently filed documents to go public, disclosed that it has only lost money on one day out of the first 1,238 trading days it has been operating.

Since I work with regular retail investors, the most salient question my readers might want to ask is “Does this affect me?” I would say “No, it doesn’t.” There are definitely counter-arguments to be made, but for the typical investor (who is investing in the stock market and planning on holding a stock for months or years) the existence of high-frequency trading firms should not even be a blip on their radar. The market is not “rigged” against the types of investments they are making. If you want to invest in Company A, you have done your research, and you feel as though paying $20 per share for that stock is an attractive price, then all you have to do is enter a limit order to buy Company A at $20 per share. In that scenario, you know what you are getting, you know what price you are paying, and you feel good about your odds of success. Over time if your investment thesis proves accurate then you will make money, and vice versa. Nothing else really should matter to you.

Now, it is hard to argue that we should embrace or even accept a system where certain groups of people with more money and better technology should be in a position to game the system and earn a profit 1,237 out of every 1,238 days the market is open. Hopefully regulators will do everything they can to close these loopholes in the system. That said, the discussion around whether regular investors should change how they save and invest based on this new book or the 60 Minutes segment are focusing their coverage and attention on the wrong headlines, in my view. Carry on.

Book Review: Bill Ackman vs MBIA in “Confidence Game”

mbiaThe stack of unread books in my office has been getting higher and higher in recent months so I took the long holiday weekend to trim it down a bit. “Confidence Game” by Christine Richard takes readers through hedge fund manager Bill Ackman’s multi-year attempt to blow the whistle on one of the largest bond insurance companies in the world, MBIA, which for years went to great lengths to hype its business model and support its ever-rising stock price. In doing so the company continually mislead investors and played a large role in the credit crisis.

While I thoroughly enjoyed the book, it does go into extreme detail about MBIA’s business model (insuring debt securities so that they could be given AAA ratings and sold easily to investors) and therefore might not appeal to a wide array of readers. However, if you follow Bill Ackman and his hedge fund (Pershing Square Capital Management) and are at all curious about what makes the guy tick and how much work he does on his investments, I think you will find the story very interesting.

You may know that Ackman current crusade is against Herbalife, the large mult-level marketer of diet supplements. Many other hedge fund managers have mocked Ackman’s assertion that HLF is a pyramid scheme, and so far have fared well taking the other side of his short bet against the company. After reading this book, it made me wonder if maybe Ackman has done more work on HLF than many believe. The guy spent as much time digging into MBIA as is humanly possible and was proven right. I’m not saying that means anything about Herbalife (I don’t know the company well at all), but I just found Ackman’s rigor impressive.

If you would enjoy learning more about one of today’s most talked about hedge fund managers, or want to read about a company that has been written about in far less detail than many when it comes to the recent financial crisis (by now I think the Countrywide and AIG stories have been covered enough), I can confidently recommend “Confidence Game.”

The Big Short: Another Excellent Book from Michael Lewis

I took a few days off earlier this week and used the down time at the beach to read Michael Lewis’ latest book, The Big Short. Lewis has written some of my favorite books, not only about the financial markets (Liar’s Poker), but also baseball (Moneyball), and the inspiring story of Baltimore Ravens offensive lineman Michael Oher (The Blind Side) which was made into a hit movie last year starring Sandra Bullock (for which she won an Oscar award).

The Big Short did not disappoint and it further secured Lewis’ spot on my short list of favorite non-fiction writers. Lewis tells the story of a handful of market watchers and investors who both correctly identified the housing bubble as it was happening and made big bets based on their views. Unlike many other accounts discussing the financial crisis, Lewis follows a handful of people who most of us had never heard of before. John Paulson always gets a lot of attention, but small investors such as Michael Burry at Scion Capital and the founders of Cornwall Capital, which started as a $110,000 private investment fund of $110,000 managed in a shed, now are having their stories told and frankly they are fascinating (and they beat Paulson to the punch by 1-2 years).

The Big Short uses a different approach than most other authors have in trying to place blame on those responsible for the housing market’s bubble and bust. While some have insisted that Lewis’ focus on those who made money off the crisis does little to help regulators and politicians prevent another bubble from happening by focusing on the big issues, I find this view unconvincing.

In order to tell these stories, Lewis is forced to include nearly every detail throughout the entire process (the book focuses on chronicling the period from 2003 through 2008). It becomes abundantly clear to the reader which parties are responsible for propping up the housing and mortgage market and the problems are discussed in detail. The story works so well, I believe, because the reader can simultaneously see what all of the interested and conflicted parties are doing, rather than only getting one side of the story.

If you have either enjoyed Michael Lewis’ previous books or are interested in reading an excellent account of exactly how the housing bubble kept going for so long, bringing the nation’s banks to their knees, or both, a copy of The Big Short is definitely worth picking up. In only 264 pages, Lewis does a great job telling the story from various Wall Street perspectives.

CNBC’s David Faber Publishes Book Follow-Up To “House of Cards” Documentary

Several months ago I pointed out that CNBC’s David Faber put together a two hour documentary about the housing bust and credit crisis entitled “The House of Cards.” I got lots of positive feedback from readers who watched the special so I thought I would let everyone know that Faber has written a book (just released) on the topic, which branches out from his television special.

The book is called “And Then the Roof Caved In: How Wall Street Greed and Stupidity Brought Capitalism to Its Knees” and it appears the early reviews are superb. On Amazon.com, for instance, the first 21 ratings from customers have all given the book 5 out of 5 stars. If the last few years of U.S. economics and finance interest you, I strongly recommend it if you are looking for some quality reading material.

Book Review: Grande Expectations – A Year in the Life of Starbucks’ Stock

Recently I was asked if I would consider reviewing a new book about coffee giant Starbucks (SBUX) entitled Grande Expectations – A Year in the Life of Starbucks’ Stock. I am not a shareholder in the company, but I am very familiar with the loyal customer base they have been able to amass over the last fifteen years or so since the company’s 1992 IPO. Although I am not a coffee drinker, my mother is among the millions who rarely go a day without visiting the neighborhood Starbucks store.

One of the reasons I agreed to read and review the book is because the performance of Starbucks over the last three years has been a valuable lesson for growth stock investors and I was curious to see what conclusions the author, Karen Blumenthal, would draw based on her research. As you may know, Starbucks shares have been dead money since late 2004 despite the company’s continued growth. Even in the face of the chain’s 20% annual growth rate, investors have been disappointed in recent years mainly because although growth has been strong, the stock’s P/E has been compressing, which more than offset any earnings growth.

Blumenthal essentially devoted a year to following Starbucks. She visited investors (both retail and professional), attended the annual meeting, met with analysts, and spoke directly with the company’s management team, all in an effort to find out what kept the Starbucks story ticking and what issues the company and its investors faced every day.

After reading Grande Expectations, it seems to me that there would be three main groups of people who might be intrigued by the work. The first group is the most obvious, Starbucks enthusiasts. The book does a great job of giving readers an inside look at the company’s history, how it operates, and what exactly management spends most of their time thinking about. If you want an insider’s perspective, Grande Expectations will likely be an enjoyable read.

The book is also being marketed as a investor tool to provide “unique lessons in understanding how the market really works.” On this end, I think it is important to distinguish between which type of investor would benefit from the book. I would recommend Grande Expectations for beginner investors who want to learn more about the basics of how the stock market works, how the industry players are related, and how various segments of the investment advisory business (research analysts, retail shareholders, mutual fund managers, etc) play a role in the investment process.

Blumenthal spends a good deal of time talking not about Starbucks specifically, but how, for instance, a research analyst following the company does his/her job, or how a mutual fund manager decides to buy or sell the shares. If you are interested in learning more about these players, in addition to learning about Starbucks specifically, then the book could be valuable.

Aside from Starbucks watchers and novice investors, I don’t think experienced investors, professional or individual, would learn a lot from the behind-the-scenes look the book offers. These people, myself included, already know how the industry operates and I found myself skimming through some of the book, including parts like one that explained Reg FD or the supposed wall between investment banking and sell-side research analysts. If you are looking for new insights as to how the pros do their jobs, in hopes that it will enable you to boost your investment returns, I would say that would only be case if you are not already an experienced investor.

Surprisingly (or not surprisingly given the author is a journalist, not an investor) the book really does not focus much on the reason why Starbucks stock has underperformed in recent years (P/E compression). Most of the investors cited in the book admit the P/E is high, but continue to hold or buy the stock because of the company’s consistent growth. This logic can be acceptable to an extent, and is the reason why Starbucks deserves an above-market multiple, but paying 40 or 50 times earnings eventually will come back to haunt you. Investors have seen this firsthand during the last three years as shares have moved sideways due to P/E compression completely offsetting earnings growth.

All in all, this book provides excellent insights for novice investors and loyal followers of Starbucks, but falls short in providing extremely valuable investment insights that could not be found in most other investing books already on the market. As a result, I would expect other reviews to be mixed depending on which perspective the reader has on Starbucks stock.

“The Long Tail” by Chris Anderson is Worth a Read

If you ever wanted to read an interesting, in-depth explanation as to why many business ideas far exceeded expectations and became so successful (examples that come to mind include Amazon and eBay), I highly suggest you read The Long Tail by Chris Anderson, a book I just finished this weekend. The editor of Wired Magazine, Anderson explains why companies that have focused on the long tail of product demand curves, rather than only the most popular “hits” in categories such as movies, books, and music, have tapped huge levels of profitability despite far fewer units sold.

Advances in technology, the Internet in particular, have greatly enhanced our ability to distribute thousands more items than ever before. The result has been, and will continue to be, according to Anderson, a shift in customer tastes from hits to choice and selection. Niche markets, often ignored by large media companies, have become more profitable than bestsellers and companies striving to serve those markets well are thriving like few thought they ever would. The Long Tail is an excellent book for those who want to better understand how retailing is being revolutionized by technology, and which companies stand to benefit from these changes.

Finding the Next Starbucks – Part 3 – Compound Interest

“Compound interest is the eight wonder of the world.” – Albert Einstein

The above quote leads off chapter two of Michael Moe’s book, “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow.” Although we learn about compound interest and the Rule of 72 in our high school math class, sometimes it takes some financial related calculations later in life to really drive the point home, enough so that it will have an effect on our saving and investment habits during adulthood.

Moe uses two compound interest examples that are worth repeating here. Although both cases are impossible to be recreated in the real world today, the dramatic numbers should at least intrigue people enough to run the numbers on their own individual financial plans. The results will still most likely be surprising for many of you.

Example #1

Purchase price for Manhattan Island in 1626 by Dutchman Peter Minuit: $24

Value today if invested at 5.0% annual rate of return: $2.7 billion

Value today if invested at 7.5% annual rate of return: $20.7 trillion

Value today if invested at 10.0% annual rate of return: $128.7 quadrillion

Example #2

You have landed a consulting job for the month of January. Your temporary employer has given you the option of earning $10,000 per week or earning $0.01 on the first day and having your daily pay double each day thereafter for the remainder of the month. Which payment plan should you choose?

Earn $10,000 per week for the month = $40,000

Earn $0.01 on first day, double every day = $21.5 million

While these examples are meant to be fantasy, not reality, compound interest is still a very important concept to consider when you are contemplating your saving and investing plans.

This post is the third in a multi-part series discussing the book Finding the Next Starbucks. You may read Parts 1 and 2 in the series below:

Finding the Next Starbucks – Part 1

Finding the Next Starbucks – Part 2

Finding the Next Starbucks – Part 2 – Definition of Risk

Before I delve into some of the specific investment concepts that Michael Moe covers in his book,“Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow,” I want to talk about one of the passages that appears in the first 10 pages that sets the stage for finding a great growth stock. Despite Moe’s focus on growth, he does an excellent job balancing that objective with a value-oriented, contrarian approach (which is a big reason why I think the book is worthwhile for a value investor as well). Consider the following excerpt from Chapter 1. I want to drill down on one sentence in particular, but these three paragraphs are very important for any investor, regardless of what types of investments they are looking for.

“Ultimately, in sports, gambling, investing, and life, there is little value in knowing what happened yesterday. The largest rewards come from anticipating what will occur in the future. As Warren Buffett once said, ‘If history books were the key to riches, the Forbes 400 would consist of librarians.

Fundamental in our pursuit of attractive investment opportunities is my philosophy of risk and reward. I view risk as measuring the potential for permanent capital loss, not short-term quotational loss, and assess the probability of that against what we think the value of the business will be in the future.

It is with this perspective that I fly right in the face of conventional wisdom, which suggests the bigger the return, the more risk one has to assume. From my point of view, large returns will occur when we find an opportunity where the upside potential is substantial, yet the price we pay for it is not. My goal is to find a stock whose price is below what I think the appraised value should be, not what the quotational value is as indicated by the current market price.”

Much of that may seem logical and obvious to a value investor. However, to a growth investor it may be a bit off-topic. After all, they focus on growth first, with valuation often trailing in importance. By combining the two, as Moe suggests, you can significantly boost your chances of finding the next great growth stock.

I want to expand on one part of that passage:

“Conventional wisdom, which suggests the bigger the return, the more risk one has to assume.”

It amazes me that “risk” is almost always defined as how volatile a stock is. If you open a college level finance textbook , risk is almost always defined as how much a stock moves up and down relative to some other benchmark. In most cases, a stock’s beta is used to compare an individual stock’s “risk” with that of the overall market, the S&P 500 index. So, a tech stock with a beta of 1.50 is much more “risky” than a utility stock with a beta of 0.50.

I strongly disagree with this assertion, and it appears Michael Moe also objects to this conventional wisdom. Should the words “risk” and “volatility” by synonymous? I don’t believe so and let me explain why. Consider two stocks you are evaluating for a one year investment horizon. Both stocks currently trade at $50 per share. After doing a careful analysis you determine that:

*Company A has a 70% chance of rising to $60 in one year, and a 30% chance of falling to $40 in the same time frame. The stock’s beta is 1.50.

*Company B has a 50% chance of rising to $55 in one year, and a 50% chance of falling to $45 in the same time frame. The stock’s beta is 0.75.

Which stock is more risky?

If you consider risk to be volatility, you are going to say Company B is less risky. If you calculate the expected value of Company B stock in a year, you get $50.00 per share, a zero percent gain.

If you consider risk , as I do, to be the odds of permanent capital loss, you will conclude that Company A is less risky. Not only is your expected value in a year higher ($54.00, a gain of 8 percent), but the odds of losing money are only 30 percent, versus 50 percent for Company B.

I would argue that Company A is less risky despite the fact that the betas of each stock imply that Company A will move twice as much, in percentage terms, during the typical trading day. In my view, risk and volatility are different animals. For me, risk is defined as the probability that I lose money during my desired time horizon for a particular investment.

If I’m investing for one year, I want to minimize the odds that after the year is up, I am underwater on the investment. How volatile the share price is during that year is pretty much irrelevant to me because if my analysis is correct, the stock will be worth more than I paid for it after a year’s time.

This post is the second in a multi-part series discussing the book “Finding the Next Starbucks.” You may read Part 1 in the series here: Part 1 and be sure to stay tuned for more posts in the series.

 

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Finding the Next Starbucks – Part 1

I just crossed another book off of my Amazon Wish List and got the idea to feature monthly book reviews on The Peridot Capitalist. It might be a stretch to pin myself down to reading a new book each and every month, so I won’t make any promises. But let’s just say that I will plan on sharing positive reading experiences with you all in the future. I won’t commit to a specific review frequency in order to ensure that I make suggestions because they are worth your time, not just because the calendar flipped to a new month.

Anyway, I just finished “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow” by Michael Moe, founder and CEO of ThinkEquity Partners. At first I was leery of the book simply because of the title. In my opinion, many investors obsess over finding the next Microsoft or Google, when in reality, the odds of doing so are close to zero. The end result is people getting caught up in “story stocks” without any regard for the stock’s valuation relative to what a reasonable growth assumption would be.

The most recent example of this was Sirius Satellite Radio (SIRI). For months it was the stock I got more questions about than any other. I wrote about it several times back in 2004 and 2005, explaining how the shares were trading at levels that couldn’t be justified with any degree of confidence as far as future financial projections were concerned.

Still, you could tell many people really thought Sirius could be the best performing stock of the next decade and they just had to own it. The single digit price tag fueled the urge even more, as they thought the stock was so cheap. Well, today Sirius stock fetches a mere $2.77 a share (down about 70% in less than three years) and is fighting to merge with their only competitor in order to stay afloat. Sirius and XM Satellite (XMSR) were worth more than $20 billion combined back then. Today that figure stands at just a little over $7 billion.

Despite my initial skepticism, Michael Moe really never started to lead readers down the path that usually results in buying Sirius at 9 bucks. As a result, I was pleasantly surprised with the book because it was able to focus on growth investing, but also did not ignore the valuation component. Too often people assume that if a company grows fast enough, they will make a killing regardless of the price they pay. The book outlines some very good lessons to follow when investing in growth companies, and although I didn’t agree with everything contained in the 300 plus pages, Finding the Next Starbucks is definitely worth a read.

Since it will take quite a bit of space for me to discuss the major points I think are important in the book, I will spread out my comments over several posts in coming days. Stay tuned for more to come and perhaps we can get a solid discussion going as well.