Monthly Archives: November 2011

Michael Jordan, Steve Jobs and other socially beneficial psychopaths

I have a lot of time for The Atlantic’s online property and it was no surprise to see the recent announcement that the company now generates more revenue from online content than print.  The genius of the strategy was to focus on quality thinkers who, through their own contradictory personalities, were less inclined to spin off into dogma. Andrew Sullivan, now departed to The Daily Beast but previously a central component to The Atlantic’s success, is a staunchly Catholic, staunchly conservative, HIV-positive gay man and Megan McCardle is a libertarian feminist who probably cringes at the “world’s tallest female blogger” title. Newer member Daniel Indiviglio remains essential reading.

After an endorsement like that you are probably expecting an attempted smackdown at this point but that is not exactly the case. I actually liked Tom McNichols’ Be a Jerk: The Worst Business Lesson from the Steve Jobs Biography and the central point, that those already inclined will use the bio as an excuse to extend their assholery, I accept entirely. There was though, something that bothered me about the piece and initially I couldn’t put my finger on it.

The article ends thusly:


The fact is, Steve Jobs didn’t succeed because he was an asshole. He succeeded because he was Steve Jobs. He had an uncanny sixth sense about what consumers wanted, an unmatched ability to adapt existing technology and turn it into something new, and a commitment to quality that turned ordinary Apple customers into fans for life. Being an asshole was part of the Steve package, but it wasn’t essential to his success. But that’s not a message most of the assholes in the corner offices want to hear.


And therein lies my problem. There is little doubt, based on personal experience, that being an asshole was an essential component to Jobs’ success and, not only that, denying this fact represents a dangerous from of faux egalitarianism.

The first thing that must be kept in mind was that Steve Jobs was not just a member of the 1%. He was, like Michael Jordan or William Faulkner, in the top 1% of the 1% or, in other words, not a normal person or “Child of God like any other” at all. We are talking about a group of people for whom being born with at least one transcendent talent is a necessary but not sufficient condition. They also develop a degree of obsessiveness about honing their skills that at best borders on mental illness and usually goes beyond. For those rare people willing to look under the hood of fandom, the unifying characteristic of this group is an almost complete inability to form relationships with normal, healthy people. Society usually negotiates a de facto contract with heroes like this, accepting (and ignoring) the dark sides – the vicious competitiveness, the rampant alcoholism, the assholery – in return for the benefits, whether they be works of art, championship rings or iPads. The need to closely identify with members of this club is understandably aspirational, but also contains a healthy dose of wishful, delusional thinking.

In a corporate sense, it is not enough to have one leader, no matter how talented or charismatic. It is also necessary to attract other uber-talented people but even more importantly, a leader like Jobs must drag all of his employees into his obsessive, driven world at least to some extent. You do not do this with Montessori, self-actualization based techniques or with monetary incentives. You do it with fear – fear of being fired, excluded, publicly belittled or not living up to your own self-image. Greatness rarely, if ever arises from comfort, happiness and complacency and by all accounts, Apple achieved greatness through its CEO’s ability to extend his ruthless, obsessive, unsettled, perfectionist nature into every corner of the company.  By being a asshole.

It is true, as McNichol illustrates, that many hundreds of idiot managers with little hint as to the true extent of Jobs’ abilities will copy his affectations to the detriment of their staff and society at large. But Jobs, like Jordan and Faulkner before him, are not examples to be followed or even really to be fully understood. To attempt to do so is largely a conceit, an attempt to glean their advantages without the internal misery, single-mindedness and self-exclusion from normal life that the development of their talents required.

Real media training, bull riding and pet lions

There was a time in the late 1990s, early 00s when I was quoted in the print media a lot.  In the early stages, diligent bureaucrats that they were, the company demanded I take a full day of media training and a more pointless exercise I have rarely undertaken, The emphasis on obfuscation and ending each comment with a restatement of corporate initiatives was by and large an exercise in “How to ensure a Reporter Never Calls You Again Under Any Circumstances”.  There is, in the end,  only one real rule about dealing with media, as immutable as death and taxes : never say anything negative about any specific person or entity.  I was about to have this demonstrated in no uncertain terms.

At some point in 1998 I got a typical call from the media asking for comments on the relative performance of different investment styles. My comment at the time was, I thought, pretty innocuous. I indicated that sector rotator managers (in the parlance of the time), having positioned for a conventional late cycle rally in commodities, were blindsided by the Asian/LTCM crises. I actually said “sector rotators like Mr. X”, carefully choosing a no-load fund manager. I worked for a full service brokerage and our brokers would not sell a no-load fund at knifepoint, so I thought I was good. I hung up the phone and went about my business for the rest of the day.

The next morning, the story is printed and for reasons I still don’t fully understand, the reporter had added “Mr. Y and Mrs. Z” to my comments when I had never mentioned them. And here’s the important part – combined, Mr. X, Mr. Y and Mrs. Z composed three of the top five institutional commission generators and Mr. X in particular had called early in the morning and demanded my head on a plate.  Upper management, peon that i was at the time, was only happy to oblige.

Thankfully, this was a rare period where I did not physically sit on the trading floor (they would have walked over and fired me immediately) and got enough warning to escape the building before they could find me. Things resumed as normal, except for the anxiety, the next day when everyone calmed down.

This, I realized, was real media training.  Like a complete moron, I assumed that the media was merely an unwitting pawn, the free marketing wing of my plan to take over the world.  After the incident, I realized I was never in control of anything at all and that my position in the whole process was much more akin to a professional bull rider, with the media as bull.  Sure, I could benefit from the media, but could also get tossed on my head and stomped through little fault of my own.

The bull rider metaphor has interesting applications to investors’ current experience with the market.  Up until the GFC, the general feeling was that the market was a benign, even helpful force, automatically creating future wealth. Post-GFC, the average investor views the market like a pet lion owner in a small condo, or like a penitent to a bi-polar god from Greek mythology.

Longer term, there are benefits to this newfound respect for risk, and recent volatility can be seen as instructive and not just penance for the Great Moderation illusion.  The market, like the media in my example, has its own agenda and was never our friend. Thoughtlessly tossing money at it with the expectation of future wealth was, in hindsight, merely another sign of overall cultural complacency. The punishment may not be commensurate with the crime, but if the gut-wrenching volatility of the past three years results in more financial diligence, then that at least something positive has occurred.

Investors would, I think, benefit from thinking more like a bull rider in the current environment. Recognizing that, while opportunities are available, the bull/market has the upper hand and that the possibility of being blindsided at any time forms a helpful reminder regarding portfolio risk.

There is no spoon: The dirty secret of asset manager analysis

I want to first thank everyone that has commented on the posts so far – reading reactions is one of the greatest rewards from writing the blog. The comments yesterday from PD and Pat Burns highlighted some central issues and intelligent questions surrounding fund and manager analysis, which was great. Today, I want to address what I believe to be the single biggest issue in this field and why, because I never saw away around it and its implications, I successfully removed myself from this business after a long period. The issue is this:

The quantitative results of any large portfolio analysis are predetermined by the market activity of the time slice being studied.

Stated more simply, the most risk-averse strategies will generate the best returns in a bad market by protecting downside and the reverse will also be proven true, that managers with the highest risk tolerance will be highest rated during periods of strong market returns. The conventional method of mitigating this dilemma is to “risk adjust” the results, comparing nominal returns with volatility, historically mean variance but “Post-Modern” concepts like target variance and target semi-variance are also used. I would argue that taken in context, risk adjusted returns can be useful but there are large companies with hundreds of well paid experts and armies of academics willing to argue both sides of that argument.

If we go back to my central point, the decision on which fund manager deserves assets in the current environment is determined almost entirely by the decision on whether to emphasize three or five year numbers in the historical analysis. The five year numbers, while including  a couple of months of more welcome 2006 results will also contain the later 2007 onset of disaster and the terrors of ‘08.  The three year numbers, despite the recent sell-off, will be much more favorable to risk-tolerant managers as they will be dominated by the post-March 2009 recovery period and the, in hindsight, relatively sanguine 2010 and 1H 2011. Risk-averse managers will look (relatively) great in the analysis of five year data but will likely look mediocre in the three year. (Admittedly, the manager’s decision on precious metals exposure throws a big, big wrench into the spreadsheets, but that is a separate, asset class issue that deserves it own discussion. )

Which is more useful, the three or five year numbers? We are only going to know after the next 24 months or so. THAT is the central dilemma. The analysis can help understand the performance characteristics of a fund but this is only useful if combined with a correct, forward-looking market call. If markets are going to be crap for the next two years, the analysts that used the five-year numbers will look like geniuses. A strong equity market recovery in 2012 will make them look like morons.

Everybody wants the same thing in the end, high relative returns with a minimum number of sleepless nights.  Human psychology being what it is, however, investors are often their own worst enemies in realizing their goals. Risk-averse investors, for instance, should want to underperform the benchmark in a bull market – it implies a strategy of risk management that will protect them when, inevitably, the benchmark heads lower. One of our favorite phrases was “no one’s managing risk in the index”. Of course the benchmark’s going to outperform in a sustained bull market.  What happens in practice, investors getting frustrated by trailing the index for a couple of years, and then switching their money into more aggressive pools right before a downturn, goes a long way in explaining why most people lose money.

The “time slice” issue and behavioral economics makes the selection of investment management or advice a tricky thing. For myself, I have reached a point where literally don’t care about the benchmark. I have specific future financial requirements and am tailoring my personal investments to achieving those – what happens to the MSCI Global benchmark over some random period of time is of merely passing interest.

I will end off with a point that doesn’t really fit in, but has fascinated me forever: the S&P 500 is actively managed.  (I always picture the kid from The Matrix saying “there is no spoon” when I write that).  There are criteria by which stocks are removed and replaced – that’s the active part – and somehow this process most often generates higher returns than Ivy League mangers who have been studying markets for their entire adult lives.  Huh.

Pundits, coin tosses and typing monkeys

There is a famous broker story, probably apocryphal, that makes the rounds every few years as though it had just happened. It goes like this: a new, struggling broker buys a mailing list of 10,000 potential prospects. They then write two separate newsletters about the same, high beta stock. One newsletter advises a leveraged short of the stock and is sent to half of the list or 5,000 prospects. The other newsletter suggests a leveraged buy of the same stock, and is sent to the other 5,000. A month later, the prospects that got the newsletter touting the wrong side of the trade are discarded. The 5,000 that were on the right side are split into two groups and the same process is repeated with a different stock. At the end of four months, the broker has a list of 625 prospects who can’t believe their luck in finding the next Michael Burry, and will spend the next ten years wondering why, after they transferred their life savings, the magic disappeared.

Remember this story every time you see a “hot” pundit in print or on business television. Punditry is binary, stocks can only go up or down (“unchanged” is declared a win by both bulls and bears) and is in this way similar to a coin toss, at least in the sense of probability. The odds of getting four calls in a row are actually pretty low, (0.5*0.5*0.5*0.5 or 6.3% probability). But, there are enough typing monkeys begging for time on CNBC or Bloomberg that at any given time, someone at least is on this kind of “tear”.

Another, somewhat related issue that because solid, long-term performance attracts assets on its own, the managers begging most vociferously for airtime are those with poorer performance – if they had really good numbers they would be less in need of publicity.

None of this is to suggest that every manager we see on television is a charlatan, its just two more trends representing potential hurdles in the way of investors searching for managers that are actually good at their jobs and not just rolling the dice. Past performance, we are taught, is no indicator of future returns, but they are, I would argue, much more reliable than a four month hot streak.

The Motorcycle Boy Reigns

The words in the title of this post were written on a wall in Coppola’s Rumble Fish, a movie I must have seen 25 times during a largely misspent adolescence. It’s possible that the movie would hold up if I watched it again, but I don’t want to risk it – it is much more likely that for every one instance of cinematographic brilliance there will be ten cringe-worthy examples of thoughtless juvenilia. No worries though, it’s based on a youth novel by S.E. Hinton and I would expect no less. But, there is a line in the movie spoken by Mickey Rourke as former gangleader Motorcycle Boy, that I will remember as long as I live, “If you’re going to lead people, you have to have somewhere to go.”

This is looking like a day for favorites so now we move from a unre-watchable movie to a book that has been an absolute delight to revisit over the past few days, Jacques Barzun’s Dawn to Decadence. Barzun entered Columbia as a child prodigy in the early 1920s, spent a life in academia and then wrote Dawn to Decadence at age 93 as a summary of everything he’s learned. The premise of this brilliant, completely readable magnum opus is that the cultural trends that drove Western dominance from the year 1500 on  – Emancipation, Scientism, Abstraction, Primitivism among twelve dominant themes – have dried up as motivating forces.  Barzun believes (a quick Google search implies he is still alive at age 103) that in the past, the western world enjoyed general agreement on societal goals and has argued primarily about the means to achieve them. Now, however, he believes the consensus has evaporated, leaving the culture treading water amongst shrill bickering.

I re-read seven or eight chapters of Barzun’s book immediately after reading Barry Ritholz’s post HERE, which includes:



If Americans from across the spectrum agree, why aren’t these desires being implemented by our politicians?

Because our politicians are bought and paid for … lock, stock and barrel.

And the powers-that-be are good at using the age-old divide and conquer trick to keep us weak, divided and fighting at each others’ throat … instead of for what we actually want.

But ultimately, the main reason that we are impotent is that we don’t realize that the overwhelming majority of Americans want the same things we do.


Ritholz’s post appears to contradict Barzun’s assumption of a lack of consensus but here, for possibly the first time in history, the words of Mickey Rourke provide the unifying bridge.  The agreement Ritholz points to is primary one of opposition. We agree on what we don’t like – bank bailouts, political and financial corruption, fraud and inefficient government spending. What we can’t agree on is what we’d like to see replace the current status quo. We don’t like where we’ve been but don’t have any place to go.

This is not a cultural environment where leadership arises so, as hard as it is to watch, we get to see one presidential candidate who doesn’t think “fancy book learnin’” is a requirement for the job and another who’s desperately trying to hide the fact they actually know things. Barzun, I am sure, is nodding grimly at the debates in recognition that they revolve almost entirely around “antis” – immigration, government, the Fed, Muslims, abortion, etc, etc, etc. As near as I can tell the Republicans are not “for” anything, except possibly the process of capitalism, which they like primarily because it will result in “less” government. (I am not, to be clear, advocating the “more” case where government is concerned. You could argue also that the GOP is “for” military action, but that hardly contradicts my nihilism-based accusations).

I can’t recommend Barzun’s book or Barry Ritholz’s columns highly enough but at the same time I refuse to accept the notion of the inevitable implosion of Western culture. We will, though, have to spend more time fighting for things instead of strapping on the blue or red team jersey and going to war to stop the other side.  In the spirit of the season, I’m asking nicely, and all of us I think have at least a tiny role in this, start talking less about what you hate, and start talking more about “better” because it is entirely likely that we will get the leadership we deserve until we do.

How business media can stop hurting America

Jon Stewart is an exceedingly bright and funny man, but is surrounded by this vague, uneasy aura of hypocrisy by allowing convenience to determine when he’s “just a comedian” or “the voice of Gen Y”.  The pervasive irony, the “isn’t this crazy?” exasperation is in the end defeatist, laughter in the face of helplessness. Stewart is today, however, an unavoidable touchstone because I feel compelled to go there in stating, “Business media, you are hurting America”.

There are parts of the problem I get – for CNBC the Nielsen ratings system does not include viewers at the office, a constituency that forms the majority of the business media audience. This leads to understandable challenges in terms of selling ad space, which in turn results in various formerly-bionic actors selling mattresses and discount electronics to stuff in our orifices during breaks. Responding to this by loudly spouting misleading rhetoric and outright falsehood, however, is not acceptable. To state again and again that because Fannie and Freddy contributed to the GFC that they were a primary cause, and the banking system was largely innocent, is patently false.  To state again and again that because tax increases would not be good economic policy at this point, that this automatically means that fiscal spending should also be prevented at all costs, is similarly destructive. Given the overwhelming body of evidence rejecting these claims, the only two possible reasons for arguing them are dishonesty or intellectual immaturity, and we’re all tired of immaturity representing our upside.

I’m not picking sides here, OWS is little better – screaming about “social justice” from atop their soapboxes as if we haven’t been arguing about the meaning of the term since Plato. Claiming to be on the side of social justice is an unarguable, theological statement little different and no more helpful than Tim Tebow thanking Jesus for helping him get the ball into the end zone, just another declaration of team allegiance.

When faced with opposition, children scream louder while adults, in recognition of their own fallibility and a degree of empathy for fellow citizens, compromise. In order for this to have any chance to occur, we need first a clear statement of facts not organized into rhetorical argument and here is where a Utopian business network has a major leadership role to play.

Details kill dogma, as the late Senator Moynihan used to point out effectively with “you are entitled to your own opinions, but you are not entitled to your own facts”.  When explaining BAC, for instance, instead of having an 0-for-’11 analyst talk about the horrors of regulation, amorphous “earnings power” and “technical support at $5”, there should be an expert without an axe to grind to go through the BAC’s balance sheet so investors can better understand why the stock is trading at ½ book value. Any number of experts are capable of detailing the importance of shadow banking exposure in Europe if given five minute to speak uninterrupted by the term “dumb Socialists”. There are literally hundreds of examples like this – the relationship between gold prices and negative real interest rates is another, where even most professional investors require more detail. There is also no shortage of available, unbiased sources to provide it – Pettis on China, Simon Johnson on Europe, Tyler Cowen on pretty much anything.  We need to hear, in other words, what’s happening and why, we don’t care how it fits into your political worldview.

It is simply not necessary that the increasing complexity of global finance be inversely correlated to the sophistication of news coverage, even of the temptation to simplify increases. Instead of pandering to existing beliefs and biases, business media has to start feeding the near insatiable appetite for deeper understanding of a rapidly changing, and yes, moderately less American, world. Otherwise they will continue to be part of the problem.

A month of interloping: what i’ve learned

The Interloper blog commenced on October 18 primarily as a means to avoid atrophy of in my writing skills, such as they were. In terms of content and with the ongoing OWS outrage in the background, it seemed a safe place to anonymously flesh out general theories as to why things are as they are in finance, less the machinations of evil Bond villains in secret underground lairs than the logical outgrowth of daily-apparent, monetary incentives.

Judging by the comments and emails, the posts generating the biggest, most surprised reactions were those that described the daily activities of finance as the same as any other. After the first post that was linked to widely, Sell Side Optimism Explained, and to some extent “Protip: Find the Worst Public Speaker Possible”, readers seemed horrified that the members of Institutional Sales Desks and Portfolio Mangers are in many ways little different than door to door encyclopedia salesmen. The surprise, I think, finds its roots in the fact that people expect finance to be different than any other industry in some fundamental way, as though it shouldn’t attempt to maximize profits every day like PepsiCo or Pfizer or Wal-Mart.  In this light, OWS and the general disgust towards finance includes a hint of betrayal – we don’t really care if salty snacks include small amounts of corn syrup because its makes them more addictive, that’s just business, but we thought you guys were different. We trusted you. We freely handed over our money and thought you would help us out.

Both within and outside of finance there is an aspirational sense among many that Wall Street is The Big Time, like the NFL, where only the prettiest, smartest, best-dressed and most dedicated can survive. Readers have reacted strongly where, when the veil is removed, this turns out not to be the case.  When I wrote last week in Impenetrable Chinese Wall or Research, Not Both, about analysts often working for Investment Banking rather than trying to correctly predict future stock values, many of the reactions were similar to Bears’ fans disappointment at the seamier side of Walter Payton’s life as detailed in the recent autobiography.

Three other posts that got attention, “The Market is Not Rigged Against Your Success – Your Brain is”, “Investors as Consumers, Markets as Video Game” and  “Zero Hedge, Steve Jobs and Who’s Really Responsible for the Despicable Cesspool of New Stock Issuance” can be summarized succinctly under the category “Its your own damned fault”, and I feel strongly about this. There are many things about finance that should be changed through intelligent regulation, but it is also true that investors have to take responsibility for their own shortcomings in participating in the investment world. I have used the analogy before, but ethical decline in finance is similar to the rapidly-declining quality of broadcast television, with the laziness and complacency of the audience as central causes. If investors demanded more of themselves, the development of enough background knowledge to ask better, more skeptical questions of their FAs and greensheets, the industry will be forced to respond. Again, in many cases they are giving you what you want, just like the drivel on CBS in primetime and if you keep responding, it will never change.  The business media, too, has a role to play in this as I tried to explain in “Liesman vs Achuthan and Why Investors Should Be Terrified of certainty”. We all need to get better, and not just wait for someone to fix things for us.

The first month on Interloping has also included more direct investment advice, but this has been focused more on how to think about markets than what to do in the markets. I’m totally comfortable with this – there are far too many bloggers ChessNWineTechnicalTake to name just two, whose trading skills are better than mine ever will be. In any event I am, as apparent in “Tebow Effect: Investing Lessons From NFL Gambling”, far more interested in thought process than purple crayons, with no disrespect to the diligence of chartists.

The past month has been a tremendous experience, and I do not exaggerate when I say that. It is intensely gratifying to detail theories that have been bouncing around in my head for a decade or more and have people read and respond to them. I have few regrets, although I do cringe when reading “Everything Good or Bad About Finance” which came off as far more bitter than I intended. I blame a chest cold and am leaving it up as a reminder. There are a few more ideas in the hopper but when I get to the point of re-hashing, or responding to daily news, I will stop. I have to find one of them job things soon, anyway. I want to thank everyone again for following along, and to again thank Josh Brown, The Reformed Broker, and Tadas at Abnormal Returns, without whom much of what I have written would be sitting gathering dust in this forlorn corner of the Interwebs.

The important distinction between market risk and uncertainty/where to shop

Kid Dynamite highlighted the best quote from HBO’s Too Big Too Fail early on and it’s a good one to keep in mind during periods of high market volatility:

“You’re getting out of a Mercedes to go to the New York Federal Reserve, you’re not getting out of a Higgins Boat on Omaha Beach. Keep things in perspective.”

We all sweat every tick of the market and infinitely parse its behavior but the fact remains that the market is not only a bad metaphor for life in its entirety but also much less reflective of the US economy than most suppose.  About 40% of S&P 500 profits are generated overseas and China, as the marginal buyer of commodities, increasingly determines every day costs like gasoline. What happens in the market and what happens outside your window are much different things, for better or worse, and this implies that tearing our eyes from the screen and looking out the window more often is a good idea when the indexes are slopping around 5% intraday as they have been.

Strategy-wise the problem remains that the widely divergent potential outcomes in Europe, ranging from the relatively benign (ECB/IMF steps in, guarantees sovereign debt and prints oceans of euros) to the almost apocalyptic – disorderly dissolution of the Eurozone, mass bank failures and a general continental descent into Mad Max territory. Valuing equities effectively in such as environment is a near impossibility. Not only are earnings and cash flows subject to non-business policy decisions that could go either way, but the discount rate at which present value could be calculated is, at best, a ballpark guess.

I would suggest that outside of day trading, credit and highly cyclical/global economic-related sectors should be off the table for most investors until either more clarity is evident in Europe or valuation levels fall close to megacheap, March 2009 levels.  This may seem somewhat cowardly, but I refer again to Michael Mauboussin who has gone to great pains to explain the differences between risk and uncertainty. He defines risk as a situation where the probabilities are known, like blackjack, where cogent decisions can be made. Uncertainty involves cases where the odds of success or failure can not be rationally approximated with any accuracy, and in these cases sensible investors should not play. Finance and higher beta cyclicals are, I would argue, in the latter category.

Earnings will be extremely difficult to predict over the next few months but there are secular trends that will, or are occurring and these are the areas investors should putting their analytical skills to work. Economic growth rates have little correlation with health care sectors, as an example, although each subsector is subject to its own specific drives, government policies primary among them. Admittedly, demographics has historically been a difficult theme for investors because relative growth in older populations happens at a much slower rate than the market’s attention span can handle. However, if investors are looking for opportunities in the event of a major sell-off, these are the areas where they go shopping with the least amount of concern as to future global economic growth rates.

There are other market sectors where secular trends with insulation from potential poor general growth rates are apparent. The massive shift to wireless telecommunications continues(the most recent data I’ve seen predicted more than 100% annual growth rates for wireless data traffic) and surprisingly, luxury goods and organic-related food companies have shown consistent profits only partially susceptible to changes in global GDP. Consumer staples stocks with specific growth drivers, growing market share in Asia for example, can become extremely attractive during in weak markets. Again, indicating that these sectors have less economic risk does not necessarily imply less risk overall.

Not to sound like your broker or Institutional Salesperson, but periods of investor paralysis are ideal for building a shopping list of companies in lower beta sectors that may get thrown out with the bath water of a temporary meltdown. Establishing a “must-have” price for a few of them (which, btw, won’t matter if you’re too scared to pull the trigger when it hits them. Remember that execution matters more than design for strategy) could set you up for outsized, relatively less stressful returns for a considerable period.

Everything good or bad about global finance becomes more intelligible when you understand that trades are the unit of production

Everything good or bad about global finance becomes more intelligible when you understand that trades are the unit of production. Investment banks make money on every transaction, from the tiny fractions of pennies per share for HFT to the 7% of $700 million the bankers made from the Groupon IPO.  Investment advice, which many companies will tell you is their product, is in truth just a form of marketing – better advice generates more units, trades.

The current market environment is the worst type for trade generation. The huge number of moving pieces in Europe and the irrationality of political policy making is creating investor paralysis and the trade production line has all but ground to a halt. The mass firings at UBS and Citi are in this regard no different than shift cancellations at GM or Ford. It is in environments like this that investors should pay closest attention to the advice from the industry. The smell of desperation is in the air, Christmas is coming, bonus pools are dwindling to non-existence and the nice guy at the other end of the phone may be forced with the option of either lying to you or having his Aston Martin repossessed. Or worse yet, fired.

There are hundreds of phrases constantly bandied about any trading floor, some providing useful reminders for pros like “market’s never wrong” and other reserved exclusively for suckers. One of the latter, “market always looks forward” is only trotted out when things are really bad, asking clients to ignore potential disaster and look to the amazing opportunities over the long term – Chinese consumer! Solar power! Lithium! Never mind that most traders on the floor have their fingers over the sell button waiting to hammer away at your bids. As I said, not good times.

I’m writing this post today because of charts like THIS from professor Cowen and THIS from the FT.  And tweets like this morning’s “USD funding stress just went to 11” from @credittrader.  All of them remind me directly of the day in mid 2007 when I typed GCDR into Bloomberg, saw the terrifying spike in AIG CDS prices and knew we were all well and truly screwed. (I don’t, for the record, believe markets are heading all the way back down the rabbit hole. May of the factors that caused the GFC are better understood and bank stocks are already cheap.  But still).

History will likely remember Citi CEO Charles Prince’s statement “as long as the music’s playing, you’ve got to get up and dance” as the most telling of the GFC. Outside of the industry, people were horrified, but inside it only generated grim nods, then and now.  The walls may be closing in but we have to generate trades today and besides, “who knows?”, maybe its not as bad as everyone thinks.

This all sounds pretty grim and might sound Chicken Little-ish if the ECB steps in fully backs European sovereign debt, as it seems they’ll have to at some point. That event will doubtless engender a massive rally, but we’ll still be left with economically crippling austerity in the Eurozone and a mounting number of nasty- looking cockroaches crawling out the China story.

I have been out of the serious money/info flow for a few months, so don’t construe my current pessimism as anything other than the jaundiced view of, for the time being, an outsider.  On the other hand, I would emphatically suggest investors big and small pay very close attention to advice they’re getting and, more importantly, verify them against the global credit markets where the banks themselves are forced to play with their own money (you see why Credit Trader scared the bejeebers out of me with that tweet).  In the end, they need to generate trades, its what they do, but you in all likelihood can afford to wait.

We can have an impenetrable Chinese Wall or equity research, not both

The largest, most prominent investment bank I worked for used revenue per employee as the primary means of measuring internal profitability. The commission revenue from each group or cost center was divided by the number of employees in that group to determine the most efficient allocation of human resources. If your group’s revenue declined significantly, help in the form of balance sheet allocation, expertise or other support was offered to restore higher levels. Eighteen months after that, if things were still bad people would start getting whacked or moved to where the money was coming in.

You would assume that given the public prominence of investment analysts and the likely $50 million per year in salaries and costs it took to pay for them, this process would also apply to their department but it did not. The reason for this was that, outside of investment banking profits, there is no revenue stream attached to equity research.   Think about that for a second – no direct revenue for a $50 mill annual cost outlay.

Epicurean Dealmaker noted that the banking fees for the Groupon partial IPO were about $49 million, 7% of the $700 million deal size and I think we can all agree this is a decent pile of cake. Rest assured, every investment bank pitching its services to Groupon management had their analysts “behind the [Chinese] Wall” telling Andrew Mason whatever he wanted to hear about how great his company is and, most importantly, how high an initial price they could get they deal off at. For the record, none of the bankers or analysts in this room gave a rat’s ass what happened to the stock price after issue and neither would you if you were waiting on your share from the $50 mill pig trough.*

Banking is where the big money comes from to fund equity research.  There are indirect revenues arising from analysts talking to PMs about their stocks and then trading through the Desk, but it takes a lot of trades to add up to $49 mill in commission.

Notice that retail investors are nowhere involved with the math here despite forming the largest readership for research reports. Good analysts making good calls do help the firm, but 98% of the commission generated by retail trades goes to some combination of the company and the broker, not the analysts. So, the next time you find yourself complaining about the quality or bias in equity research reports remember that the analyst is in no monetary way incentivized to make you happy.
This was all supposed to change after Blodgettgate, but there’s a problem; if you fully separate investment banking from equity research there islittle or no financial reason to provide research. There may, if you move the math around, be enough benefit to provide the odd report but certainly the notional $50 million budget for the research department gets slashed to pieces,  with salaries attracting much less ambitious and talented people. (I would love, btw, to be in the meeting where brokers are informed that their commission payouts are getting cut with the difference going to the analysts. There’d be a wall of burly security guards between them and management in that meeting).
For all their faults and for all the complaining I have done, if read correctly and with an understanding of potential biases there remains a wealth of information about companies in the average research report. Access to multiple sources, as I had, allowed for comparisons between the projections of different analysts and left me with few excuses for bad investment decisions**.  The system as it stands was workable, at least for me.

We have to decide in the end whether we want to continue things as they are or to build an impenetrable Chinese Wall that prevents analysts from benefitting from banking deals. We can’t have both. The latter course will almost inevitably lead to a drastic reduction in the quality of equity research reports regardless of what you think of them now. It could very well be a case of “be careful what you wish for”.




*this doesn’t apply to the rare cases where an analyst behind the Wall takes stock down personally, but that isn’t a great indicator. As a Head of Research once told me “I like to judge the frothiness of markets by how many of my analysts are taking part in private placements”.


** The one area that is impossible to defend the status quo are cases where unbeknownst to the general public, a major banking deal is about to get done. All of the research reports written by the investment banks vying for banking business go more positive as part of the pitch. In some cases, the newfound “optimism” can be indistinguishable from a change in the company that makes it a good investment.  Few things could piss me off like advocating a stock or sector right before the announcement of a big secondary offering.


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