Monthly Archives: March 2012

Defending Analysts: The Mouth of Sauron, Not the Dark Lord Himself

One of the few consistent themes of this blog is that bad things, including client-screwing ethical lapses, happen not because of the rise of individual evil people but as the end result of a steady erosion of principles caused by the temptation of huge pig troughs of potential compensation. In rebutting Josh’s reinforcement of the useless, self-aggrandizing analyst stereotype printed by the FT yesterday we’ll go through how this process works for the typical equity analyst.

First, picture a Laffer curve with some measure of ethical behavior on the Y-Axis, “number of retail clients protected from being fleeced” for instance, and potential commission along the x-axis. To simplify things somewhat, we’ll assume that the moving out on the x-axis to higher cake is primarily a function of payments made to an analyst as a result of commission on investment banking transactions in their sector. The peak of the curve, which will be a different for every analyst is the “too much money to ignore” level, where visions of a decent-sized ranch in the Hamptons replace early-career notions of “helping people with their finances” and general adherence to the extensive but flushable CFA ethics guidelines.

It is important to note here that the vast majority of equity analysts toil away in obscurity, even within their own firms. They cover their companies in sectors where investors currently don’t care or where they are overshadowed by a CNBC-friendly, dominant counterpart at another firm. The 5% of analysts you have heard of cover hot stocks like LULU that are “in play”, attracting oceans of daily market liquidity or in sectors where significant M&A activity is apparent.

Interloper’s General Rule of Understanding Finance applies directly here: Whenever something looks fishy, look to how the situation benefits Investment Banking revenue. That’s where the big checks are – new offerrings and M&A consulting. An analyst covering a stock where this activity occurs goes “behind the wall”, generating a fat personal check in the 100s of thousands when a deal is completed.

Now we’re ready to discuss Josh’s Jamba Juice example where the analyst kept hyping the stock as it collapsed into nothingness. For our purposes, the important part of the story is that the analyst in question was the biggest name covering the stock. Why is this important? Because it implies (almost assures actually) that this analysts’ company would be the primary banker on any capital raising, hopefully a number of them over a decade, that Jamba Juice would do to fund its expected growth. Lots of big checks for I-Banking, and enough potential personal revenue for the analyst that they, at some point, reached the “too much money to ignore” peak of our bastardized Laffer Curve after which the permanent pom poms came out.

This happens all the time and Josh is right to call them out. On the other hand, I find the stereotype unfair, not least because it does not reflect the day-to-day efforts of 95% of analysts who diligently follow their companies and answer client questions to the best of their abilities. More importantly, the analyst is not the driving force in these instances – they are just the visible vanguard for Banking. The I-Bankers just quietly move on to shoo-fly another potential big pile of money when things don’t work out and the analyst is publicly hung out to dry. And no, I am not excusing analyst behavior when this happens, just suggesting that blame be apportioned more generally.

As a group, equity analysts in my opinion are the most ethical of all capital markets staff. They are the ones forced to live with their public declarations. Furthermore, whereas the finance industry inexplicably sidestepped regulatory punishment after the GFC, analysts suffered a disproportionate beating and increased legal liability after the tech bubble imploded. The driving force behind Blodgettgate remember, was banking revenue and yet notably few restrictions were put on Banking as a result. The TMT analysts were a much smaller percentage of the problem than most believe, The Mouth of Sauron rather than the dark lord him-or herself.

Again, I am not defending the crappy, client-unfriendly things analysts do all the time. But in my experience, which features hundreds of research meetings, analysts are not routinely dishonest. Bankers, particularly when retail investors are involved, kinda are – they are looking for the highest fees they can possibly get and they could care less what happens after a deal is done. I don’t have space really to get in to Structured Products, but I will note that the term “cesspool” is unfair to outhouses in this regard.

It is really convenient for an investment bank to have public and regulatory focus on the analysts, as if changing or adding disclaimers will do anything to affect research content. They are an effective screen obscuring where the sausage and all the money really gets made. Analysts are just the rock that must be lifted so that sunlight can reach the Investment Banking department.

Beware the Prince

I’m about as well sorted psychologically as I’m ever going to be but I get to use a shrink as consultant for niggling issues, an arrangement that suits us both. During a recent conversation, we were discussing some completely impersonal topic and after commending my insight, looked at me purposefully and said “But you’re not a Prince”. He started to explain what he meant, but I just raised my hand to stop him. I got it, I just didn’t like it.

As a group we like societal anomalies as long as we can feel superior to someone. The sick fascination with serial killers fulfills a violent prurience with the added benefit of guilty Shadenfreude regarding the victims. Positive outliers that make us feel inferior are less welcome. We don’t like those, to the point where psychological self-defensive concepts like “luck” and “cheating” arise immediately like squid ink.

Princes, winners of the genetic lottery in exactly the ways that count most, do exist unfortunately. Princes are separate from savants, the latter with skills so focused in one area that they’re completely useless and awkward in others to make us feel better. For the true Prince, as the name implies, the aptitudes and will are so strong and varied that future success is virtually preordained. They are not only capable of breezing through an applied economics final after no lectures and 30 hours of studying, but also know what you are going to do and say before you do or say anything.

Too many viewings of Good Will Hunting, you’re thinking. I wish that were the case but I actually know a Prince well who has operated so well in the back section of the FIRE acronym that having never been anything but self-employed, he personally owns his own jet (money enough not to waste time) and funds a major post-graduate school that has his name on the door. His social skills are legendary, maintaining varied and rarely overlapping spheres including prominent politicians, assorted billionaires, and his friends from high school. He is also a former professional athlete.

There is another business acquaintance whose history may indicate Princedom, but I don’t know them well enough to say for sure. He shares, and here finally we reach the point of this exercise, an interesting set of outwards traits with my friend, marked stillness and a vagueness equal parts camouflage and obfuscation. Whether this represents confidence, focus, strategy or an inability to connect to us regular mortals I have no idea. But, these characteristics make it extremely difficult for even the most observant meeting attendee to know what they’re dealing with.

Princes (of both sexes, I refuse to use “Princesses” here) do exist, which is the first thing to keep in mind. The second, more business-related point which follows, is that it is a very good idea never to be on the other side of the table from them. I’ve seen the advanced negotiation tactics and I will state unequivocally that an attentive person of above-average intelligence will not even know they are being applied. A lot of it is flattery, not sales, with hearty congratulations for coming up with an idea that “I never would have come up with myself”, even though the counterparty has been subtly nudged in that direction for a week and will have to get a cab home because they have unwittingly thrown their car into the deal. (that actually happened, btw). On the other side of the table, you will have brought a knife to a gunfight while being lauded for your impressive strength.

Money attracts talent and despite widespread charlatanism and scumbaggery, finance likely has more royalty than any other field. Beware the Prince.

Following Bunk Moreland on Gold, Monetary Policy

There is something about monetary policy that drives significant portions of the investing populace insane. As a guess, it’s possible that the physical act of printing dollar bills, and the virtual act of money creation in the banking sector, is enough like magic to tap into the medieval part of the brain to generate the “BERNANKE’S IN LEAGUE WITH LUCIFER!” reaction so common from those compelled to comment on any story involving aggregate liquidity.

People done digging dog face in the banana patch. I can safely write sentences like that because half of this post’s readers have already closed their web browsers and have started composing 2500 word responses to paragraph one. They will marvel at how I can be flip about an issue that is clearly at the core of our democracy. My answer is: I don’t care. Yet.

The simple fact is that for the next week and next month, the value of global currencies will be largely determined by cross-border asset flows. Political news from Southern Europe will be offset by ECB transfers to maintain bank liquidity levels. As with the yen and the yuan, these are policy questions not theological ones. The veracity of MMT theory or the “hocus pocus” of fiat currency will not enter into it. The believers being fully invested already and any notion of intrinsic value being tossed out the window already, gold will rise or fall based on sentiment and technicals. Again, I don’t care. Yet.

Bunk on Money

The forces of hipsterdom have decreed that any discussion of The Wire as the greatest show in broadcast history are cliche. Nonetheless, I am still following the advice inherent in Bunk Moreland’s  Season 5 admonition to McNultey with respect to monetary theory, “That will teach you to give a fuck when it ain’t your turn to give a fuck”. Until bond yields move in some inexplicable degree in one direction, or any signs of a 70s wage/price spiral pop up, monetary theory will have little or no effect on my investing decision making. If either of those things do happen, however, Mosler is going to make some money off me, along with a giant host of other published experts.

Fidelity and Predicting Currency Values

In the mid to late 1990s the consensus economic view was that the US dollar was significantly over-valued, by between 20% and 40% depending on the year and measuring device. At the time, Fidelity Investments built a decent-sized team of macro specialists looking to “add alpha” to the company’s then-famously index hugging portfolios by predicting changes in global currency values. The team was disbanded in five years not due to lack of effort or expertise, but because global currencies trade with complete disregard to economic fundamentals for years at a time. These were all experts in the field, remember, and although I never saw CVs, since we’re talking Fidelity there’s a 98% chance that all of them came from extra-fancy Ivy League schools. They were not, in other words, retail investors attempting to benefit from reading a couple books from the non-fiction bin at Barnes and Noble published by the Smith and Wesson Literary Fund. For me, the primary lesson from this parable is that currencies are not predictable.

Knowing What You Don’t Know

Knowing that you don’t know is among the most important aspects of investing, for both professional and non-pro investors. The most financially dangerous response to an information vacuum is to reach desperately for a framework that makes things intelligible. It is particularly dangerous to grab at one that just happens to fit your personal politically ideology. (Your most vicious associates will brand you an economist if you do this too often).

Take it for what its worth, but my advice would be to watch and consider. Read Cullen Roche on MMT. Watch the exchanges between Senator Paul and the Fed Chairman. Look for signs and accept those that are contradictory to your current understanding. Don’t, in other words, paint yourself into an ideological cul-de-sac that may cost you a lot of money to climb out of. It is time to learn, but there will be plenty of opportunity to become a believer when its time to give a fuck.

Cumulatively Disillusioned: A Partial Defense of Greg Smith

Disaffected  ex-Goldmanite Greg Smith clearly possessed a Puritan streak bordering on the Messianic and this led many to immediately, reflexively discount his New York Times op-ed. Particularly tiresome were the “What did you expect? You were playing with the big boys” reactions borne of equal parts chest-thumping self-congratulation (“only some of us really know its a war out here”) and a sense of betrayal (“don’t shit where you eat”).

Binary interpretations are most digestible in the media and the fact that no one’s motivations are unconflicted, least of all Mr. Smith’s apparently, was tossed aside as a matter of convenience.  There are, I suppose, a small group of professionals who head to work each morning 100% convinced in the validity of what they do and the commensurate compensation that results. The rest of us mortals consistently measure the balance between the cost of employment – in terms of time, family stress, the shit-eating from senior psychopaths – and the financial and social-related rewards.

Finance as an industry is different from most in its aspirational qualities – few people grow up dreaming of managing a slaughterhouse but tens thousands diligently hit the books dreaming of becoming the next Steve Cohen. Those successful at reaching a major trading floor or investment banking department usually spend the first week in awe of their surroundings, one assumes with a feeling similar to the first time a freshman football player runs out of the tunnel on game day in front of 100,000 screaming fans.  It is, or was for me at least, the realization of a dream.

When you bust your ass to achieve something it is extremely difficult not to become fully invested in the mythology that drove you there. Disillusion takes time. In the first couple of years, when the veterans make sidelong cynical comments you sneer back and classify them as bitter old men on their way out. Furthermore, you’re a peon and the worst of the conflicts are hidden from you.

As with any field, with experience the view changes.  You take notes in meetings where the sole agenda is how to hide fees from clients, the Head of Retail decrees caveat emptor on triple dip broker strategies stuffing fee-based accounts with products with huge initial commissions. The trade desk openly front-runs big retail orders and this is carefully steered from regulatory view. The negative side of the motivation ledger begins to get filled out but still, on balance you are doing the work you want to do.

In cases where the money climbs in near-perfect inverse correlation with disaffection, this makes things more difficult still. New house, new Merc, new spouse, private school for the kids are all within a responsible budget at current salary levels. Not if you change industries though – there just aren’t that many options where $500K is worst case scenario. This is particularly true if the primary skill set is predicting asset prices in a largely virtual world.

It would be stupid to suggest that the above scenario covers everybody in finance. There is no shortage of satisfied professionals in the industry who correctly assume that they provide an honest, highly difficult and intellectually challenging service in the support of clients and the economy at large. It does seem, however, to cover the experience of Mr. Smith and to some extent my own (although my reasons for quitting the previous position were much different than his). I would argue furthermore that this arc – initial wonderment and satisfaction steadily eroded by cumulative disgust  – is extremely common among financial professionals. Most current employees have been fortunate enough to find a position where the visible self-serving skullduggery of their employers remains at low levels acceptable to them. A minority are greedy scumbags who don’t care.  But there are a number, larger than outsiders might think, who feel like Greg Smith likely did last year, trapped by circumstance in an environment markedly different form the one they expected. And, for the courage to jump off the bandwagon while accepting the self-immolation of his career, and for publicly doing what he felt was the right thing (misguided or not), I give him credit. Good luck to him.

The Rules: Interloper Adjusts to Investing as an Outsider

Fifteen years ago if a retail investor, even a giant one, needed to know a PE ratio they had to call their broker. In essence, this was the value proposition of the brokerage industry – they were the ones with the information investors needed, and charged accordingly. In many ways the advice business remains structured around this outdated concept despite its obsolescence, and Josh Brown has gone to great pains to explain why this is so.

The ubiquity of online data and opinion has completely reshaped investor requirements. The base facts are completely commoditized and what is now necessary is prioritization and context, someone to advise on which data points matter most at any given time. This thought formed the underpinning of most of the initiatives at my previous position – I spent less time attempting to reinvent the financial wheel and more in organizing available facts into plausible narratives. Importantly, I was doing this for everybody, which entailed that at any given time there were five or six often-contradictory scenarios to maintain. If I were just doing this for my PA, I could pick the most plausible projection and just follow that.

Which brings us to now. Whereas before I would add newly released data to existing spreadsheets tracking trend projections now there is so little truly important data available (i.e. CDS quotes) that attempting to cobble together a spreadsheet is not worth the time and effort. Furthermore, there are none of those quick chats with analysts to tease out the details unpublished in for research reports. (Analysts are constrained – not idiots. They know lots of stuff that can’t, or won’t print). I am, in effect, now an Outsider little different from diligent retail investors and this has changed my investment style completely. I’ve organized the general changes in methodology into three rules, which reflect my own experience and are not meant to be exhaustive:

Outsider Investor Rule 1: You need to have a view. There is no way, as an Outsider, to adequately follow even five or six potential market outlooks with enough depth to make their conclusions worth risking your cash. A flexible economic/market outlook makes the sorting process of new developments a binary operation – fits or does not fit. Investors without a plausible scenario in mind may feel more open-minded, but are also more likely to sell copper miners on a weak durable goods number and buy them back on stronger NFP. Without a view, in other words, new data is not organizable into a usable context for investment decisions.

None of this is to suggest blind adherence to an uncertain set of predictions. The “does not fit” column has to be maintained, if anything more diligently than the “does fit” to prevent losses.

Outsider Rule #2: Secular over Cyclical. Reducing economic sensitivity in a portfolio can drastically reduce portfolio risk and the labor involved in investment decisions. Investors in construction equipment, for instance, will be forced to white knuckle every dubious Chinese economic data report for the foreseeable future, three or four times per month. There are, however, investable trends that will happen, at varying speeds, regardless of the economy. The average age of the developed world population will rise in complete disregard to global industrial production levels. Mobile data transmission will increase by 100% or so for at least the next five years.

Investing in secular trends is not necessarily easier, but it does reduce the number of variables to be considered. Biotechnology companies, as a notable example of a counter-cyclical sector, are beset by competitive and regulatory pressures and are not guaranteed outsized returns. But, the same is true of cyclical companies to some extent and unlike them, the value of biotech stocks do not hop around by three or four percent every morning at 8:30. Orthopedic stocks, as another counter-cyclical case from health care, are inexplicably twitchy but there are few plausible scenarios under which demographic-based end demand will not provide a fertile backdrop. For cyclical sectors, a 1997-like growth hiccough in China would place an open manhole in front of shareholders.

The risk/return trade-off does dictate that investors following rule #2 to the letter are limiting potential returns generated by a global economic recovery. All portfolios should have some economic growth exposure, but the amount should be roughly inversely correlated to how much time is available for research and general obsessing over existing holdings.

Outsider Investor Rule #3: Know Your Limitations. The proliferation of ETFs has proven an effective tool to avoid specific company risk through diversification. In the end however, time-constrained Outsiders must consistently be aware that they do not have time to fully understand the whys and wherefores of their portfolio performance. Unexpected things, bad things, will happen that we never see coming. Conversely, we are likely to trail the index for significant periods of time because we “missed” something. Outsider psychological well being, I think, is dependent more on the acceptance of this fact than any other. To fight it is to open the door to a “headless chicken” investment style that is more likely to buy a yacht for your broker than yourself.

In Wall Street, Gekko reinforces the stereotypically aggressive, chest-thumping characteristics of finance by having Bud read “Art of War”. The book still comes comes up, although references are usually limited to the “manly men” strategies on how to destroy opponents. For Outsider investors, however, the best advice comes at the beginning:

 It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle.

Or, to paraphrase another timeless classic: The first rule of Outsider is to recognize that you’re an Outsider.


Personal note: I’m getting very close to a new position, just awaiting a contract. Its an amazing initiative and, for those few people worried about it, should mean more available Interloper writing rather than less, although under my real name. If anyone’s seen an “Idiot’s Guide to Un-anonymizing Yourself” I’d appreciate it if they could point it out.


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