Readings – Healthcare In America – The Bitter Pill

If the test of a great article is that it makes you realize how ignorant you are, then “The Bitter Pill” succeeds brilliantly. Published in 2013, in Time Magazine of all places, this piece was recommended to me by a friend who works in the health insurance business as “the best summary of what is wrong with the American Healthcare system, to date”.  And it is.

PDF Version:,2,26,MedicalCostsDemandAndGreed.pdf

Time Website Version:

Hellfire and Brimstone – Electromagnetic Swans and Some Thoughts On Hedging

John Knox, the fire and brimstone preacher key to the Protestant Reformation of Scotland

Electromagnetic Swans

Recently I have been re-reading Nassim Taleb’s Fooled By Randomness and The Black Swan. So I was primed when I saw the headline, “Elliot Warns of Greatest Danger in Electromagnetic Pulse”. Understanding my own bias, and the fact that at any given moment there will be at least ten different hedgefund manager’s warning about twenty different unforeseen dangers and/or once in a lifetime opportunities; I took a few minutes to try and guestimate the probability of there being an electromagnetic storm in my lifetime. And of course, I don’t have an exact answer of what the probability is. The best I can say is that I don’t have any reason to think it’s highly probable but I also don’t have any reason to think that it is totally negligible. The little facts I do have are as follows:

There was a near-miss in 2012, when what scientist called a “superstorm” came close to hitting our planet. The article makes it seem pretty scary but what does a near miss really mean? If you almost roll snake-eyes, (double 1’s with two dice), it does not mean that a snake eyes is a probable combination. Similarly the fact that a solar storm almost hit earth doesn’t really reveal much about the probability of us being hit in the future. As Taleb would say, “we cannot see the generator.”

Perhaps more worryingly, Elliot points out in their letter to investors that a large electromagnetic storm occurred in 1859, knocking out telegraph wires but otherwise leaving that much less electricity dependent time largely unscathed. So we know it can happen. Other than these tidbits, I couldn’t find any evidence of a reliable method of estimating the probability of such an event. Therefore all I can really comfortably say is that the probability is greater than zero and less than one.

Given this level of uncertainty, of my ignorance, it is tempting to drop the subject all together. Some “prudent” people will argue it’s not worth worrying about “once in a lifetime events”. On its face this attitude can seem reasonable, practical, even intelligent; why waste time worrying about something whose probability you can’t reliably estimate?

The flaw in this mode of thought is that it’s not just the probability of a given event – it’s the impact of the “rare” event weighted by its probability that should guide our decisions. Thus to the contrary, our ignorance about a given events probability makes the truly prudent course to be extra concerned, especially if the event would have a severely negative impact. This logic should seem particularly congruent to self-avowed value investors whose modus operendi is to protect against the downside, and let the upside take care of itself.

If such a storm were to happen tomorrow, scientists and Elliot management estimate that we would fare far worse than our ancestors. They predict that much of the developed world would be without power for potentially months, as the hard to replace electronics that enable our power grid would be destroyed by the storm. It does not require a highly developed imagination to see that this would have a profoundly negative impact on economic activity, and more disturbingly, day-to-day life itself.

Financial markets would not likely fare much better than the electrical grid, and probably worse. Hypothesizing for a moment, and assuming you could even find prices for any of these instruments without power; one safe bet is that equities would plummet. The credits markets would freeze and at least the front-end of really high-grade sovereign curves would rally. The U.S. dollar and gold would catch a bid along with a few other safe haven currencies, and from there it gets a little tricky. The long end of the Treasury bond curve might actually sell-off as investors worried about inflation from expected government policies to shore-up the economy. Commodities markets would likely suffer massive declines and the viability of the exchanges might come into question, as many people sought to either default on contracts or take delivery of more precious metals than could be physically settled. Suffice to say, it would be a shit-show.

You may think such statements hyperbole, and if you are confident that the probability of such an event is indeed very low then perhaps it is. But the point I am trying to make isn’t just about electromagnetic storms. It’s about how we should think about what we don’t know, and what that might mean for portfolio construction.

 Principles & Panacea

The most common method of guarding against the markets gyrations is to create a portfolio that is diversified among asset classes. To its credit, many versions of this strategy have served to reduce the volatility of a portfolio over course of the past century (in America). In fact, if you go into any private wealth manager in the United States, they will probably show you a chart like the one below and explain that it demonstrates you are better off investing in a mix of asset classes.


A less common approach to achieving a portfolio that will protect against downside risk is to practice the art of value investing. The thinking being, that owning a portfolio of undervalued assets should create a margin of safety that can serve as a cushion against adverse developments.

I mention these strategies both because they are somewhat well known and contain elements of truth. Furthermore, either of them, if applied with skill, has the ability to achieve superior relative risk adjusted returns over the long-term. The danger to investors lies in mistaking the sound principles that underlie them, and the relative results that can be achieved by them, for an investing panacea.

Returning for a moment to the subject of our fallibility, consider that it does not require a catastrophe for markets to take dramatic and unforeseen directions. Consider the case of one Benjamin Graham, as Murray Stahl relates it in this excerpt from his wonderful essay Benjamin Graham: Investor and Person. There is perhaps no better example of how a fundamentally sound strategy can fail even the brightest star during a severe market dislocation.

Chapter 13 of the Graham memoirs relates his experience as an investor during the Great Depression. The chapter begins by comparing these experiences to Dante’s version of hell. As is well known, Graham was a conservative investor. He makes mention of selected long positions such as Plymouth Cordage. The shares were trading at a price of $70 with in excess of $100 of working capital. Such investments are classic value stocks. Graham mentions others such as Pepperell Manufacturing and Heywood and Wakefield.

The Graham Fund, then known as the Benjamin Graham Join Account, had the following positions in the middle of 1929, just prior to the stock market collapse. The fund had $2.5 million of capital. It owned $2.5 million of convertible preferred shares offset by an equal amount of equivalent common stock short sales. This arbitrage position is fairly common today. In 1929, such undertakings were considered to be very conservative and required very little margin. This was the case in the Graham Account.3 There were also $4.5 million of genuine long positions and $2 million of borrowings against these positions. According to Graham’s then computations this amounted to 125% margin (i.e., 4.5 long on 2 of borrowings, or exposure of 2.25x, for 125% leverage).

In the modern era the exposure would be calculated as follows:

$2.5M long convertible preferred

2.5M short common stock

4.5M long common stock

2.5M portfolio equity

$9.5M total exposure

$2.5M portfolio equity

380% total exposure

The investment performance results as reported by Graham were as follows.

1929 (20)%

1930 (50.5)%

1931 (16.0)%

1932 (3.0)%

1929 – 1932 (67.7)%

Of course, as is known, Graham managed, subsequent to the Great Depression, to rebuild his fortune and ultimately achieve a level of wealth that he probably could not have imagined in 1929. One factor in the recovery was that in January 1934 his investors generously consented to remove the high water mark and re-instate performance fees.5

However, another important factor is that the application of the principles of value

investing once again generated results in accord with the historical standard subsequent to the summer of 1932.

This brief summary of investment experience invites two questions. First, should

Benjamin Graham have anticipated the investment calamity of the Great Depression? Second, does there exist an inherent flaw in the philosophy of value investing such that the application of margin of safety principles does not always produce a margin of safety?

In answer to the first question, it would have been necessary for Benjamin Graham to have conceived in 1929 that the next four years would witness a circumstance in which production of goods and services for which there was evident demand in 1929 would become remarkably diminished in the ensuing years. Scholars still debate the causes of this phenomenon nearly 80 years after its occurrence. If Benjamin Graham failed to foresee the Great Depression, one cannot find many contemporaries who managed to foresee the calamity. Indeed, luminaries such as John Maynard Keynes or Irving Fisher fared no better than Graham.

In answer to the second question, it is perhaps sufficient to say that value investing is a technique that merely seeks to assess the worth of a given enterprise against its trading price at a given moment. It makes no claim to see the diminutions of value that are caused by economic crises….


One of the greatest investment minds of all time, the founder and master of his craft, operating in conditions of market efficiency that would leave any of investment managers salivating uncontrollably was brought to his knees by the great depression. The lesson, if there is one, is that if it can happen to him, it can happen to you (or me).

So what should investors do? If diversification and a margin of safety are insufficient for protecting against the vagaries of fate, what remedy is there? I don’t have an easy answer but I do have some thoughts:

Limit the use of Leverage

Obviously I’m not breaking new ground with this one. But I lead off with it because it is probably the most important, especially for young investors. I believe Warren Buffett has said he would never leverage himself by more than a quarter of his equity. I am certain he is familiar with the record of his teacher Benjamin Graham during the great depression, and has drawn a similar that very lesson from it. As usual, the admonition is easier proscribe than execute. Leverage has a way of creeping up on you. It is the temptation of scalability – the idea that more can be achieved with less. You have to consistently resist the little voice in your head that says this time is different, to allow that, this situation is unique and deserves to be exploited to its maximum.

Great investors are able to see past this temptation. They understand the dark side of leverage. That it erodes at whatever margin of safety you’ve accumulated, and leaves you exposed to the markets irrationality; the very thing that as an investor you are paid to exploit becomes a potentially fatal liability.

Beware Of Overestimating Your Diversification

Just as we should have humility about the outcomes that will affect our portfolios, the Black Swan concept (the limits of induction), teaches us to have humility about how our portfolio components will perform. For instance, people like to think that owning bonds is an effective hedge against deflation but what kind of bonds exactly? In a real economic catastrophe any bonds with credit risk exposure, not matter how strong, might actually decline in value. A truly devastating economic scenario could actually be viewed as stagflationary and thus one would expect a decline in the value of high duration bonds as well. The point is to think deeply about your positions; they may behave nicely under normal conditions and fail you when you need them most.

Consider Holding Cash

I was already writing this post when I started reading some of Seth Klarmans investor letters. So it struck me when I noticed that he was consistently referencing some of the ideas I had been kicking around with regard to value investing and hedging. One of Klarman’s claims to fame is achieving his amazing investing record whilst maintaining a substantial allocation to cash.

Cash, as an asset, has something of a reputation problem. Most of which can be attributed to its obvious lack of relative yield. To its further shame, many widely cited studies of asset returns have shown cash to be among the poorest performing asset classes in the modern era. The perception of cash as unattractive is so pervasive that even lay people are loath to see cash sitting their account, “not working for them”. And I must confess, at times I too find myself having thoughts along these lines. 

As usual, the accepted wisdom is far from wise or at least incomplete. More enlightened investors such as Klarman see cash something akin to an option whose value will be realized when the next opportunity or cycle presents itself. Where the student sees the empty hand as weak without a weapon in it, the master sees the potential in a limb free of constraint.

Somewhat paradoxically, cash aversion is also common among professional managers and institutional investors. Klarman suggests the reason for this phenomenon is the institutional focus on relative performance. Managers think of themselves as investors and therefore feel it is their obligation to be invested, in something, anything. The institutional imperative to be doing something is too powerful for most to resist. As usual, Klarman said it better than I could. Here he is on adopting an absolute performance orientation. I find it very zen:

Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative- performance-orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market. Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Hold Antifragile Assets

Nassim Taleb defines something as antifragile if it gains from disorder. The most obvious incarnation of antifragile in the world of investments is an option. There is a good deal of debate over whether options are too expensive or worthwhile, and as with everything in investing, there will be exceptions to whatever generalization you arrive at according to the price being asked.

In an attempt at generalization, some have framed the question of options as akin to the age-old question of whether insurance is worth buying. In this context, my only observation is that market catastrophe insurance, though it may be expensive in most retrospective periods, has a unique value proposition because unlike most insurance outcomes that are designed to protect against a localized event – say your house burning down or car being stolen; market catastrophe hedges are virtually certain to provide you with cash during a systemic event. I.E. when everyone else’s house is on fire and they are begging to sell it to you.

As far as I can tell, Klarman held out of the money options to protect against market declines. Or at least he did in the years between 1995 and 2000 (which is all the letters I’ve been able to find – feel free to send me more Klarman also famously profited from buying put options on Japanese equities in the late 1980’s and subprime CDS preceding the housing collapse (nice work if you can get it). The below excerpt from his 1995 letter makes it pretty clear that, at lest in those days, he thought it was worthwhile to hold such antifragile assets:


And here he says it again:


And again:


And again, with some more remarks on holding cash:


It is worth mentioning is that the Market Hedges portion of the Baoupost (Klarman’s) portfolio usually ranged between 0.5-2% of assets, with Cash & Cash Equivalents of 15 – 35% of assets. I’d love to know how far out of the money Klarman was looking, and in what tenor, and why. Unfortunately that level of detail is likely beyond my reach. Even so, it’s interesting to see that he thought it worthwhile to invest up to 2% of his portfolio in what is commonly derided as an “expensive” or “wasting” asset. I wonder if he still does…..

Klarman Table2

Think Carefully About Short-Selling

As I understand it, short-selling put the hedge into hedge fund and thus it should come as no surprise that short selling is an integral part of many sophisticated investors approach to markets. The general expectation being that short-selling will be utilized as a method of generating alpha through a reduction of market risk and individual security selection. On the other hand, the potential for unlimited losses (asymmetric risk), the general proclivity for the markets to rise, and the overall difficulty of finding attractive positions, has lead many investors to shun the enterprise completely. Suffice to say, there is no shortage of opinions on the subject.

Having mixed feelings about it myself, I was keen to see what Klarman had said and done in this arena. Though, knowing he is an avowed value investor, it didn’t come as complete surprise when he voiced disinclination towards the practice:

We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect.

I should point out, Klarman is discussing short selling in regards to the specific market positioning of 1999. So while I do believe the quote reveals something about his attitude towards short-selling generally, it should not be read as Klarman forswearing short-selling totally. Klarman’s passage reminded me of a less famous but equally a credentialed Baoupost alumnus who has his made his opinion on short selling public. In the depths of the financial crisis, David Abrams made the following remarks at a conference on value investing hosted by Columbia Business School:

And the final thing too, within the whole industry is the long / short side. People have to, whether your managing a fund like that or investing in a fund like that, you have to be doing some fairly deep soul searching now because the government’s after you, politicians are after you, there’s no way to do it without taking counter-party risk, and how do you feel safe with counter-party risk? Maybe it will subside and it will be fine but you know, you’ve got to be doing some deep soul searching now.

To clarify that a bit, Mr. Abrams is making the point that short selling has two weaknesses. The first is what we might term regulatory risk; the risk that the government or relevant regulatory body will suspend the rights of institutions to sell short. This happened during 2008 when U.S. and U.K. regulators banned short selling on approximately ~800 financial firms. Thus Mr. Abrams seems justified in imploring investors to think deeply about the value of a strategy that has the possibility of being prohibited just when it is most desirable. His second point about “counterparty risk” is more technical. It refers to the fact that when you short securities you must necessarily borrow them from someone else – that someone else is your counterparty. Almost always this someone else has the right to demand the shares back on any given day and thus, you keep your short position at the pleasure of your counterparties.

Honestly, I don’t know what conclusions to draw from his points. They are tempting to dismiss as unlikely events, the kinds of things that happen to other people. Most likely he is correct in taking a middle ground by recommending one think very carefully about relying solely on short selling as a method of protecting against adverse market events. As usual, the risks of the method must be balanced against the potential rewards of the specific situation. It is not supposed to be easy.

Social Perspective & Conclusion

I once did a post on John Maynard Keynes and value investing. So I was delighted to find that Murray Stahl had achieved a superior treatment of the subject in one of his market commentaries. One quotation by Keynes stuck a chord with me when I read it. Here it is:


 Howard Marks talks about how second order thinking is required to be a great investor; that ability to look beyond the immediate, to consider the consequences of consequences. How few investors consider the affect of their actions on the broader functioning of the economy (except to say that it is positive), and less still of their potential impact on the psychology of their fellow investors? I think Mr. Marks would agree that Keynes had the right stuff.

Keynes’ observation is about more than just stoicism in the face of a market decline. It alludes to a hard reality that in the age of Alpha obsession people would often rather forget. That reality, as it pertains to hedging, is that as much as people can and should try to protect themselves from adverse market outcomes, it would be extremely difficult to maintain, let alone build wealth, in the face of a catastrophic event. No less especially because the vast majority of financial instruments are in one form or another, promissory notes against future economic activity; as much as we all want to be Ubermensch, and self sustaining scallop farmers, the truth is that what we call our economy is really just a social system, and to a much grater extent then many would care to admit, our wealth in any period of meaningful duration is more likely to be a function of Beta than Alpha. I think Dr. Franklin said it best when he proclaimed, “We must all hang together, or assuredly we shall all hang separately.”

Weak Shorts, Weak Longs – My Mistakes of 2013


“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Charlie Munger

A lot of things went right in 2013. My portfolio handily beat the S&P’s stellar performance. But I don’t want to focus on that. This post is about the mistakes I made, and the lessons I’ve tried to learn. For those who don’t want to read the whole post, I’ve summarized the take always below:

1. Be careful not to let an edge turn into an ego trip. ONLY take a position when you have an edge.

2. Learn to do nothing. Never be afraid to walk away from an investment. As WB puts it, wait for the fat pitch!

3. Once you get what you were looking for from a catalyst, cover your ass!

4. Short selling is very hard.  Be very picky and never bet too much.

Meta Analysis Disclaimer

There is a lot of noise in any given year or even years investing results, so much so that even with the benefit of hindsight it can be difficult to say what was a mistake and what was correct. Acknowledging that, let’s just say I’m going to go over mistakes that fall into the known mistakes category, and ignore the unknown mistakes category – and even more troubling – I’ll ignore the possibility of these trades I label mistakes actually were correct ex-ante.

Debt Ceiling – Distinguishing Edge From Ego

This first mistake is a very clear example of how to behave when you have an edge and how not to behave when you don’t. When the S&P sold off in the fall of 2013 due to concerns about the government’s ability to pass the debt ceiling, (again) I was closely monitoring the situation. At one point it was 11pm EST and news stories began to appear on Twitter and the Wall St. Journal stating that the house was very close to reaching some sort of compromise. One look at the level of S&P futures told me that the market either hadn’t incorporated the information or chose to disbelieve it. Though I believed in congress’ ineptitude, the deadline for a deal was fast approaching and I judged it likely that there was some truth to the news reports. Realizing that a breaking story happening outside of regular trading hours actually offered a small investor such as myself an advantage, I felt I had enough of an edge to merit backing up the proverbial truck, and so I did. I bought as many S&P mini-futures as a safely could. Over the course of the next day the market rallied nearly 20 points and I made profits worth about 20% of my equity.

This entire rally happened on the back of no concrete deal. Merely the hint that something was close to being agreed upon. Now this is where I made my big mistake. Somehow, someway I got it into my head that this yet to be seen agreement would disintegrate due to the usual partisan squabbles. Now it’s one thing to conjecture something, but it’s another to make trade out of it. Honestly, and embarrassingly, I think that instead of attributing the money I had just made to a well timed play on shaky information, I started to believe that I was George Soros re-incarnate. So of course, I gave back all the money I had just made when the market continued to rally and I was stopped out.

What I’m trying to take away from this mistake is how easily edge can lead to ego and how dangerous that is. George Soros says the market is always wrong but that he’s always fallible too. To me those two statements are like an equation that has to balanced because if it doesn’t you wont be in the game for long. Taking a big position when you believe you have an edge is justified so long as the security is liquid and you can cap your downside. Taking a big position when you have no edge is just a road to ruin. In short, I need to be careful that I don’t let luck or even a brief edge creep into ego. Hopefully getting burned once will be enough.

HLF – Weak Shorts, Weak Longs

“ Cause it’s so hard to do and so easy to say, but sometimes, sometimes you just have to walk away.” – Ben Harper

Herbalife, oh herbalife, how many hours have fallen by thy name? They should use this stock as a case study at Harvard business school because I think everyone involved is crazy, myself included. I became interested in this stock like everyone else because of the controversy surrounding it. So I took the time to watch Mr. Ackmann’s presentations, read long and short opinions on the interweb, and looked at the financials. Net, net I came to the erroneous conclusions that it made sense to be short the stock going into the end of the year, and the firm’s audit report deadline. I lost money shorting the stock because of horrible position management. That said, I believe there is a broader lesson to be drawn from Herbalife, a lesson that is more about choosing the proverbial table you play at then how a given hand goes while your there.

I said I was intrigued by the controversy surrounding the stock, and what I’ve come to conclude is that the controversy was legitimate. The longs were vulnerable to the possibility of the marketing schemes collapse and increased government regulation (of whatever form), and the shorts were vulnerable to continuing profitability and squeeze pressure from both opportunistic investors and the company. The shorts also lacked both proof of fraud and a precedent of real government intervention. Of course anything can be an attractive at the right price but HLF was (hardly) ever there.

Herbalife is a case of weak shorts and weak longs. Everyone, both sides, are choosing to play a hard game, when the reality is I don’t have to. I think making things harder than they have to be is probably one more the most pervasive errors in investing. We, me, people, spend a lot of time, do a lot of research and as a result feel like we need to have a conclusion to show for it. So we make wagers that we don’t have to because we feel like we deserve to have an opinion based on all the work we’ve done.

People talk a lot about being unemotional about investments but not nearly as much about remaining unemotional about our investment candidates. Likewise, people often say investing is hard, but sometimes it’s the not investing that’s difficult. Stepping away from something you’ve put your time and energy into is hard. There is a huge psychological barrier against it.  To combat this tendency I’m going to start making a list of all the things I’ve learned while researching the stock. Then I’m going to look at that list and say to myself, even if I don’t invest now, these are all the new things I know that can help me with future investments. That way I’ll be able to feel like I haven’t wasted my time, and more importantly, stop myself from wasting my money.

JCP – Know Your Business

JC Penny was a situation where I didn’t understand the business well enough. My thesis was that with Ron Johnson out and Mike Ullman in, the company had enough cash and assets to get it through the turn around 2.0 without diluting current equity holders.  I believed I had done my research, I read financial statements, created an elaborate financial model of the capital structure and checked to see how others opinions compared with my own. I ended up being wrong about the capital structure, and the company had to raise equity because their business (suppliers) demanded it. This mistake was a result of not sufficiently understanding the stock and/or business. It was a small comfort to see that Kyle Bass and Hayman Capital were in the same boat I was. Sometimes even smart people with better access to experts get things wrong.

MUSA  – Using Leverage With Catalysts

“Bulls and Bears make money, but Pigs get slaughtered.” – Anonymous

“Experience is what you get when you didn’t get what you wanted.”  – Howard Marks

MUSA which has been previously profiled on this site was a recent spinoff trading at a significant discount to its peers. In addition, it had ethanol assets worth more than their carrying value that it was going to dispose of, and windfall income from the sale of RIN credits. My thesis was that the first earnings call would bring the Wall St’s attention and lead to the stock trading higher. Since I thought knew the timing of an event which would be the catalyst for a higher valuation, I decided to use options to increase my leverage. Lo and behold the stock did climb nearly ~20% to $45 in the run-up to and following the first earnings release. And of course, instead of congratulating myself on the windfall I had just made I decided to try and avoid paying taxes in 2013, and see if the stock could get to my price target of $51 per share. Now I did sell some options but not nearly enough and soon after J.P. Morgan put a price target of $45 on the stock, and a slight sell-off crushed the stock back down to ~40 per share turning my formerly spectacular profit into an abysmal loss.

I may have been wrong to buy those options in the first place. Spinoffs can take a long time to develop a following. Joel Greenblatt says you should give the market 2-3 years to correct a mis-pricing.  Assuming I was correct to have the position in the first place, I should have sold much more of it as we moved away from the “catalyst event” in question. Another lesson I’ve learned is that while options are great when they work for you, when you own illiquid options in a stock you believe in it is extremely painful to start caring about daily price fluctuations.

So two take always; one, only use options (or lots of leverage) when you are sure about a catalyst event, and two, once that catalysts delivers the juice you were hoping for, start selling down the position, cover your ass – don’t wait.

 The Wages of Sin – Pandora, Tesla, TTS, Et al.

“We don’t short stocks because we don’t like trading misery for money.” – Charlie Munger

2013 taught me that shorting stocks is very hard.  I think the most important lesson was to never short a company whose product you would actually use or want. I don’t care how overvalued, unless there is fraud, it’s probably not going to be a strong short. Whatever your conditions for being long a stock they should be doubly stringent for going short, and the position size greatly reduced because of the negative convexity shorts exhibit.

Timing is another important element of short selling that I can improve upon. As a small investor, it is fairly easy for me to get in and out of positions, and because shorting is so difficult (especially in a bull market), I think it would be wise to use that to my advantage.  This goes especially for weaker shorts where I believe I’ve identified a catalyst/trigger event. Using technical factors to try and position oneself into an event could very much help limit losses associated with a rising market or single name. Of course if the stock were pure scum with no discernable trigger you probably don’t want to play games jobbing around the position. But with more “event driven” short opportunities, I think this kind of positioning game could help performance. On the other hand, I’m sure it would also be a lot of work to implement.

In Sum

All in all, 2013 was a great year, and I can’t complain but I can try to improve.

Coattailing Sears Canada – $SCC

You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders. – Warren Buffett


Sears Canada is an example of what Warren Buffett calls coattailing.  That is, putting other peoples ideas into your own portfolio. I came across this stock when reading the Horizon Kinetics Q4 investor letter.  You can and should read their excellent letter here - but essentially – their thesis is that based on recent transactions, the company has leases that could be monetized to the tune of  ~3.00 billion. Given that the company currently has a  ~ 1.3 billion market capitalization this represents a significant asset cushion, and a potentially attractive investment.

That said, intelligent investors will want to know, what are the assumptions going into that ~3 billion of asset? Here’s what the folks at Horizon said:

“So, if the company agreed to vacate six stores for $644 million, how much might the rest be worth? The annual report provides information that the average size of the full-line department stores is a bit over 128,000 square feet. In that case, the $644 million, for those 11 stores amounts to about $450 per square foot. Now some would say, and they’re probably right, that these were among the best-located, most valuable Sears Canada stores, and that the remaining 111 full-line stores are worth far less.

Ok. Our investigations suggest that merely to construct a mall store costs well above $100 per square foot. If we assume that the remaining full-line stores are worth only that much, then 111 stores x $100/sq ft x 128,800 sq ft/store = $3.03 billion, or $29.78 per share. That was over twice the market value of Sears Canada at the time.  Nor does that calculation include the 300-plus other properties. Nor does it include the top four full floors of the Toronto Easton Centre, the premier shopping center/office tower/hotel complex in Toronto, which the company did not vacate as part of the October transaction.”

Cynics might assume that any company selling so cheap must be up to its eyeballs in debt. That’s not the case here. With about ~230 million in cash on the books,  ~700 million in net current assets, ~50 million in debt, and ~412 million in retirement obligations – the company is well capitalized.

As for the operating business, it was cash flow positive for eight years up until 2013. Now however, the business, (like most other big box retailers) is under pressure. Cash from operations over the trailing twelve months has been -33 million. These losses are not devastating to the investment thesis so long as they are constrained to the present level but it is a risk. A mitigating factor is that Sears Canada has Sears Holdings and thereby Edward Lampert as a controlling owner. Bearing in mind that a considerable portion of Mr. Lamperts net worth is invested in Sears Holdings, it seems reasonable to assume he will take steps to maximize shareholder value should the losses mount.

Other Risks

Anything times zero is zero, Buffett said. A total loss is a “zero.” No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up. Long-Term, however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero. – Alice Schroder, The Snowball

At first glance SCC seems like a homerun; a well known brand with backed by significant asset coverage and an incentivized owner-operator is probably as much as an investor could wish for. What gives me pause is that this bet has aspects, which to me, make it a derivative of the Canadian real-estate market.

As some may be aware, there has been hypothesizing of a Canadian housing bubble for some time now.  Though skeptics have largely pointed at the residential market, I feel it’s safe to assume that a credit bubble lifts more than one boat.  The most obvious and important being the commercial being real-estate market. Any decline in said market would likely have negative impact on the realizable value of the real estate assets held be SCC. In addition, a declining housing market would likely have a profound impact on an already leveraged consumer base.  Considered together, these vulnerabilities conjure the vision of a declining real-estate market and weakened consumer eroding both the asset coverage and core business at Sears.

Of course, the question is not merely whether the scenario is possible, but rather how likely? The answer is unknowable, at least to me. Nonetheless, it seems likely enough to give any investor second thoughts about about loading up on Sears Canada.

Disclosure: Long SCC

Rationally Considered – Handicapping The Odds of Fraud at $TTS



On November 14th, Gotham City Research published a report alleging that the Tile Shop (TTS) was using an undisclosed related party to fraudulently inflate its earnings. Later that day the company responded with a statement denying every allegation except that they do business with an export trading company owned by one of their own employees. The next day a number of banks put out research notes recommending the stock, stating that they believe the company’s financials are accurate and the core business sound. After all this, the company is trading at an enterprise value of about ~ 920 million, a generous valuation that for me begs the question, is this a fraud or not?

TTS V.S. Topps Tiles U.K.

I’m not going to cover 90% of what Gotham did in its report, so you should go read it if you want the whole story. What I’m going briefly discuss is, after know everything Gotham has said, what does a “normal” tile retailer look like, and what can that help is infer about TTS? Gotham used the long bankrupt Color Tile Inc. as an example of what tile economics should look like. I think that’s a decent comparison, but using a now bankrupt company seems a touch rocky to me. So instead I went and looked at Topps Tiles; a specialty tile retailer in the U.K., that I think makes for an equal or better comparison. Topps Tiles has 320 store locations in the U.K., $275 (USD) of revenue in 2012, is publicly traded and has a market capitalization of approximately 175 million GBP or 262 million USD.

First up, what are gross and EBITDA margin? TTS sports some of the badest (best) in the business, at 70% gross and ~27.5% EBITDA. The more mature Topps Tiles has a gross of 59% and an EBITDA of around 11% between 2010 and 2012.  Many people, myself included, have doubted whether TTS can maintain such outstanding margins as it becomes a national retailer, and Gotham wen’t so far as to deny that the gross margin is even real. The reality is that no one but the company knows the truth about gross margin. For now, all that we can say is that a gross margin of 70% doesn’t seem to be the norm for large flooring retailers.

Margins are very important but the inventory levels are what I find really interesting. This was a major focus of Gotham’s report, and something I missed completely when I looked at the company earlier this year (shame on me). In its report Gotham cited a metric called Days Sales Inventory, which is calculated as ((Inventory / COGS) *365). And indeed, TTS has some very high days sales inventory. Since 2007 DSI has been at or above 250, and currently stands at a striking 411 on a trailing twelve-month basis.

DSI Delta

However, I feel i must mention that when looking at both companies one thing I noticed though is that because of how DSI is calculated, a company with a higher gross margin will tend to exhibit a higher DSI.  This puts TTS at a comparative disadvantage for no reason other than it supposedly buys cheaper. (See exhibit above) Therefore I took the step of adjusting Topps Tiles gross DSI for the difference in margin between the companies. The result, even with this adjustment TTS exhibits much higher DSI than Topps Tiles in every period.


Forgetting DSI for a moment, comparing the two companies in more absolute terms provides an even better sense of the profound amount of inventory that TTS is carrying on its books. Topps Tiles has 320 stores and $275 million in sales in 2012. It carries $41 million (USD) of inventory to support its operations. TTS has 80 stores and $ 218 million of sales in the TTM period, and carries $71.8 million of inventory as of Q3 2013 or 75% more than Topps Tiles.

Why and how can a company that is supposed to have better gross and EBITDA margins be carrying so much inventory?

Cockroach Theory

I ended the last section with a question because that’s all I have. As far as I can see there is no direct proof that TTS has done anything illegal – only circumstantial evidence (the exception being not disclosing a related party.) This brings me to what short sellers sometimes call cockroach theory. The analogy is that just as if you’ve seen one cockroach the likelihood is that there are others, if you see one instance of misconduct, the likelihood is that there is more. TTS has already showed us at least one cockroach by admitting to the non-disclosure of the related party. Taken together with the massive inventory levels and the other issues brought up by multiple reports, I’ve come conclude it is more likely than not that something rotten at The Tile Shop.


As Mr. Munger would do lets leave off by examining the counterfactual; what if TTS is not a fraud? In that case what we’re left with is an incompetent management team, an unproven business model, a highly leveraged capital structure, plenty of shareholder lawsuits, material weakness in financial reporting, and a shit-load of tile.

Disclosure: Short TTS 

Memo Attention Apple: A Map to Pandora’s Jugular

Memo Attention Apple: A Map to Pandora’s Jugular


I am disgusted with myself for not seeing what was right in front of me, and I am disgusted with iTunes Radio for the same thing. Since September, I have been short Pandora (P), believing that iTunes Radio would be a powerful competitor, powerful enough to knock the luster off P’s Tech-bubble 2.0 valuation. Essentially, I was betting that Apple would continue its legacy of creating products that offer a superior user experience. Instead, what they released was a half-baked add-on whose only purpose seems to be demonstrating that Apple (AAPL) has forgotten its roots. Unlike other Apple products, iTunes Radio seems to be based on the thesis that people will value features over depth of experience. This is a shocking and disturbing outcome for Apple shareholders, since the entire Apple Empire has been built on delivering products that are the antitheses of such geeky reasoning. The good news is that iTunes radio is highly fixable. Here’s how to do it.

Forget the Features! (Know Your Customer)

Apple has put a lot of emphasis on the breadth of its catalogue, and the higher sound quality on offer. This is a mistake. While both of these things are worthwhile, they are only marginally additive to the average user experience, which is the only thing that really counts.

First the catalogue, lets face it; most people listen to the hits. Yes you will find one in a hundred people who want to hear 1950’s French pop music but most of us don’t want to hear much more than we would on traditional radio. Ask any musician, the Pareto Principal in full effect when it comes to the average persons musical tastes. That is to say, 80% of the people only care about 20% of the music, and the real numbers are probably much more like 95% to 5%. This is simply not a differentiating factor for the average streaming radio user, end of story.

Sound quality is the other oft-touted feature that offers only the most marginal improvement to the average users experience. Think about yourself in the car, how bad does the sound quality have to get before you change the station? For me, if it’s a song I like, things have to get pretty awful before I touch the dial. The idea that users are going to flock to iTunes for higher sound quality is ludicrous. Look at how many people use the crappy ear-bud headphones Apple gives out. If quality was really a motivating factor, everyone would be walking around with Sennheiser headphones – they’re not.

Fix the Algorithm! (Quality of Selections)

This is a difficult claim to make. But I’m gonna do it anyway. The iTunes radio song selection algorithm is broken, and needs to be fixed. Reasonable minds will enquire; do you have any data to support that conclusion? And the answer is no. I have only my own experience. Nevertheless, I feel confident in asserting that the iTunes algorithm is at present, far inferior to the one Pandora employs. I’ve reached this conclusion after trying ten of my favorite artists on both stations and comparing the musical selections each platform played. The result; I was blown away at how bad iTunes radio performed at selecting relevant songs. That said, I encourage readers to run a similar experiment for themselves, and come to their own conclusions. Don’t take my word for it – go try it out.

The bright side of this, (if you can all it that) is that the affect of the inferior algorithm on the user experience is so obvious, I honestly cannot imagine that it’s not being worked on as we speak. In addition to the tweaking of the broader algorithm, we can reasonably expect improvements in iTunes performance as data from user input is incorporated into the system. Pandora for instance benefits from years of people plugging away at their thumbs up / down icons, helping to fine-tune what gets presented to users and the algorithm itself. As Apple accumulates more feedback from its users it should be able to improve its algorithm to the point where it is competitive. But it’s vital that this happens ASAP. A critical point is that the algorithm doesn’t have to be as good as Pandora’s but it has to be better than it is or things will never work out.

A second order result of poor song selection is that on iTunes radio you quickly run up against your station song skip limit. This is detrimental to new user conversion, hitting the skip limit on multiple stations makes people much more likely to abandon the platform out of sheer frustration.


With regard to the skip limit, it’s worth pointing out that Pandora (pictured above) at least gives you a nice, short explanation of why you can’t keep skipping, and how to listen to more music. iTunes radio on the other hand provides only the somewhat terse message: “You can skip six songs per hour on each station.” Being nice and helpful still counts for something in this world, not to mention it’s cheap. Apple, take note.


As my girlfriend was kind enough to point out, one good thing about Apple’s message is that it tells you how many how many songs you are allowed to skip per station. Pandora’s by contrast is ambiguous and can make users nervous about using the skip button.

Pandora Helpful Hints

While we’re on the subject of niceties, another nice thing about Pandora is that they provide suggestions of similar artists you might like to make a station for (pictured above). Something akin to this would be especially helpful for iTunes radio because it would minimize user loss due to the frustration that occurs when you run up against the skip limit. Put another way, I’m already mad when I run out of skips, I don’t want to have to think about what else I might want to hear. Anyone familiar with the paradox of choice will immediately recognize the value of this or any feature that minimizes the users cognitive workload.

Fix The Feedback Interface! (Ease of Feedback)

“What I propose is a road map to modify our man-made systems to let the simple – and natural – take their course. But simplicity is not so simple to attain. Steve Jobs figured out that ‘you have to work hard to get your thinking clean to make it simple.’ The Arabs have an expression for trenchant prose: no skill to understand it, mastery to write it.” – Nassim Taleb, Antifragile


User feedback is not only an important part of tuning the song selection algorithm, it’s an integral part of the user experience as well.  And so the fact that iTunes radio serves up an inferior interface puts it at a disadvantage on both fronts. I call it inferior is because it’s simply more difficult to use. It takes two clicks to perform any preference action aside from skipping the song. First you have click this little star button (pictured above), and then chose one of three menu options (pictured below). Pandora by contrast offers every single preference option just one click away. It’s hard to express how this little difference can be such a big deal. Steve Jobs would get it. The only other way I can think to put it is that people are really, really lazy. I want to feel like I’m in my favorite armchair listening to the radio, not organizing my iTunes library. Easy – get it?


The other problem is that the feedback options aren’t sufficiently granular. The positive feedback options are ok. You can choose between, “Play More Like This” and “Add to iTunes Wish List”. On the negative side however, your only choices are, “Never Play This Song”, and to skip. This dichotomy comes to feel like a nuisance, especially when you run out of skips. Additionally, the “Never Play This Song” button is ambiguous.  Are we never playing this song again on just this station, or on all stations? I suspect it’s the former but the ambiguity will definitely make many users hesitant to use the button at all. The fix for this is that every preference action be only one click away, and non-committal / non-threatening.

This failure, yes the failure of the iTunes radio user interface is surprising for two reasons. One, this is what Apple is supposed to be good at. Two, they have Pandora to copy! And therein lies the solution. I don’t know whether the thumbs up / down interface is patented, but it shouldn’t take hiring Dan Brown to come up with some alternative symbols. This should have been a layup and they blew it.


Make it an App! (Accessibility)

iTunes radio isn’t easy to find, and thus far maybe that’s a good thing. In fact, I would wager that half of Apple users have never opened the platform, simply because they don’t know where it is. More importantly, even after you figure out where it is, it’s annoying to have to go into iTunes to get it. This could be easily remedied if Apple would make a separate App for the radio. Even if that app were just a shortcut to bring you into the radio part of the Music App, it would go a long way to making the product user friendly. Make it preinstalled, make it easy to see. You’ll be amazed how many new users you get.


Tim Cook should have been draping the bloody carcass of Pandora across his shoulders at the last Apple event, as proof that Apple is still primus inter pares. Instead, iTunes radio is languishing in the depths of OS 7 – a blemish on an otherwise unparalleled legacy of delivering products that recognize the primacy of user experience above everything else.

Before I wrap up, let me be clear about something; Pandora is overvalued. But not because it doesn’t make any money, it’s overvalued because intelligent investors wouldn’t pay $5 billion plus for a startup with a replicable product that’s surrounded by competitors looking to take a bite out of it. Not the least of which (Apple) also happens to be the distribution platform for 1/3rd of its users. Pandora has been granted a stay of execution thanks to Apple’s shoddy implementation of what has the potential to be a far superior product. However, as I have demonstrated, the road to Pandora’s ruin is not complicated.  Apple could implement most of the changes in a weekend. The only question is whether the giant in Cupertino has enough of its former mojo to strike the killing blow sooner than later.

$TTS – The Louis Vuitton of Tile? – I Think Not


Tile Shop Holdings, (TTS) is a tile retailer that went public in September of 2012. Since then, it has benefited form the markets re-infatuation with anything housing related and currently trades at a ridiculous 26x EV/EBITDA. In the past month the share price has declined 29% due to an earnings miss and allegations by short seller Infitialis research that the company’s products contain hazardous amounts of lead.  After reading Infitialis’ otherwise excellent report, and hearing the company’s response on the most recent earnings call; I deem it unlikely that any action by regulators will be forthcoming. With that in mind, I wrote this article to demonstrate that, even without the threat of poisoning its customers, Tile Shop has issues that, from an investor perspective, are just as poisonous as lead. These include, a fundamentally flawed business model, an overleveraged capital structure, aggressive expansion strategy, declining insider ownership, management misconduct, and oversight failures – all packed into a company that is overvalued in even the rosiest scenario imaginable.

Margins & Model

Everyone sort of lives with their rulers in the past and doesn’t look at coming changes.” – Stanley Druckenmiller

 TTS exhibits gross margins close to 75% – this is simply not sustainable.  The biggest reasons for this are that tile is by and large a commodity product, and retailing it is a business with low barriers to entry. Home Depot, Lowes and even smaller competitors can just as easily buy it from vendors, and sell it for cheaper. But even if it wasn’t a commodity product, the company’s margins are way higher than those of other national retailers that sell highly differentiated goods. For instance, Apple sports a gross margin of around 40%, and remember, they invented the iPhone! Other premium brands with lower gross margins include Coach 72%, Lulu Lemon 50%, and Abercrombie & Fitch 62%. TTS isn’t selling Gucci loafers or Louis Vuitton bags, and its margins will come to reflect that as it tries to become a national franchise.

The best case a reasonable TTS investors should hope for is that it can replicate the gross margin of U.K. based Top Tiles, and achieve a 60% gross, a margin that would leave TTS firmly on the wrong side of profitability.

The other problem at TTS is the SG&A spend. As a percentage of revenue it was ~ 56% in the most recent quarter. And while management is hopeful they can bring that down to the historical 50%, they give no indication of having the ability or even the intention to lower it any further (despite helpful hints by sell-side analysts to suggest otherwise). This high margin-operating model may have worked for a few specialty stores in Minnesota but as the Tile Shop is soon to learn, what works in the minors doesn’t always cut it in the big leagues.

Capital Structure & Strategy

For FY 2013, the company has plans to expand its store count by 17 stores, and hinted at another 20 in 2014. With only $3.85 million of cash on hand as of September 30th and $85.4 million in debt, the company is taking a big risk attempting such an aggressive expansion. Simply put, the company is overleveraged and any bump in the road may be detrimental not only to equity holders but also to lenders willingness to extend credit.

In addition to the daredevil capital structure, investors should be concerned with the speed of the undertaking. Difficult as growing a business is under any conditions, it becomes exponentially more difficult when you try and do it quickly. Issues such as inventory management, location selection, employee quality and supervision, to name just a few, don’t get any easier to manage when you have Wall Street eying you with a stopwatch. Sprinting ahead at full speed increases the odds of a stumble, a stumble TTS cannot afford.


Never underestimate strong ownership is what I like to say, and I can’t say that about TTS.  As of November 2012 Nabron International, a trust controlled by the Chan brothers (one of which is a former Enron board member), was the largest single stakeholder with an interest in  ~36% of the outstanding shares. As of June 18th 2013, Nabron had reduced its interest in the company to ~20%, a near 56% reduction in a little over six months. Similarly JWTS, the private equity firm managing the SPAC, has reduced its stake from 13% in November 2012, to 8.4% as of June 10th. Finally, despite receiving share-based compensation, CEO and founder Robert A. Rucker has also reduced his stake from 19.9% in November 2012, to 15% as of June 2013.

All of these investors obviously have better places to put their money than TTS equity – why don’t you?

Management & Conduct

As short sellers Infitialis mention in their report, the CEO of TTS was convicted of fraud in civil court related to divorce proceedings from his now ex-wife. For me, this isn’t a good thing but it’s not necessarily the end of the world.

The other management issue brought to light by Infitialis is the fact that the former Senior Vice President of Operations, Mr. Joseph Andrew Kinder is on probation due to his involvement in a domestic dispute – another bad sign. Since then, it appears Mr. Kinder has been demoted in favor of the recently hired Chris Homeister. Mr. Homeister was previously Senior VP at Best Buy, a company with a poor record of competing on the national stage.

Last but not least, in 2012 the company was found to have a material weakness in its disclosure controls and procedures. As I understand it, the company didn’t have enough people in place at headquarters that were financially competent, nor did they have a sound process for closing the books at the end of year.

In and of themselves none of the aforementioned issues is detrimental to the company’s future. However, when taken together, the picture sure isn’t pretty. At the very least, it should cause investors to think twice about the business they are buying into, as well as the team that will be managing it.


Now, for a moment, lets try and forget about all the things I just mentioned. Let’s put on our optimist hats, and see if we can make the current valuation make sense.

Looking out to FY 2016, I put together the below valuation model that makes the following (heroic) assumptions.



First and foremost, TTS EBITDA margin goes to 30% of revenue. Historically the company has earned about 27.5%. Therefore this assumption extremely generous, especially given that its peers are earning EBITDA margins around 12%. Gross margin remains at the princely 74%, well above peers, while SG&A reverts back to 50% of revenue.



TTS expands its footprint to an average of 150 fully operational retail locations in FY 2016. This would correspond to a 23% compound annual growth rate for stores. To achieve such a rapid expansion without any margin contraction is highly unlikely, but hey we’re looking on the bright side here. Not only does the store count expand, but also increases revenue per store to $3.00 million per store or 7% more than they did in 2012.

Enterprise Value


We’re going to assume an 11.5x EV/EBITDA multiple in 2016. That’s a higher than what Home Depot currently commands, and it’s a national franchise with a honed operating model, experienced and competent management. I also assume debt will increase to $150 million to finance this growth, while cash moves up to $20 million.


What’s the result of all this future gazing? Despite our psychedelic concessions to the gods of delusion the company still stands ~ 17% overvalued based on Friday’s closing price.

Sensitivity Analysis

Stepping away from never, never land for a moment, I’ve put together a set of sensitivity analyses to get a sense of where more realistic assumptions might value TTS. Below are two sensitivity analyses that still assume the generous revenue per store and store growth assumptions included in the first model but employ more reasonable margins and enterprise multiples.


Highlighted in peach are the areas that I consider plausible scenarios. As you can see, even the most optimistic forecasts of this subset still expect the company to be overvalued by around 50%.



In addition to the all the fundamental problems, from a more technical and/or psychological standpoint, whatever lollapalooza effect was propelling the stock to its previously astronomical levels has clearly broken-down, and when that magic’s gone, it’s hard to get back. In sum, for TTS the party is over, and the hangover is just beginning.