Math And “The Third World”

One question I was always wondering is: Is Math simply a tool we use for calculations? Or it contains discoveries of something objective such as the Physics Laws we found about our world?

On one hand, we did use Math as a tool to simply our daily tasks. So it first appeared as a human “artifact” (or human creation), something totally subjective instead of “objective”. On the other hand, we have talked about using Math as a “language” to communicate with aliens, since Math describes a pattern that is universal regardless of our thinking process or culture.

In the end, when I think about all the rules we found in Geometry or other Math, I think it is discovering some logical connections in an objective world. In other words, Mathematicians are not much different from Physicists, in the sense that they are all “discovering” instead of “inventing”.

For sure, it seems that there is a lot of “inventing” (or what Mathematicians would call “construction”) in Math, but these inventions/constructions are just a way to facilitate the discovery process.

For example, prime numbers are so useful and essential to the foundation of Math. They are so easy to understand, even to the elementary students, and yet so hard to master, as we still don’t have an easy way to tell what they are or even how many of them exist given a max-bound. Finding the next prime number becomes a constant discovery process not much different from finding the next planet in the galaxy – we are all dealing with an “objective” world that we are constantly exploring.

However, this objective world is certainly not a physical world. In fact, it is totally independent of the physical world. Math has the abstraction built into it from the start. When we talk about numbers, it is an abstraction, since number 2 is just number 2, it could be 2 people or 2 apples. A “point” should be infinitely small and a line should be “infinitely” thin – certainly there is no such “thing” in the real life.

The word “objective” also means it is independent from our “subjective” thinking. In other words, it is independent from our thinking process, and independent from the “spiritual world”.

This is what I would call “the third world“: the “logical world”, which is independent of both “physical world” and “spiritual world”.

Since it is an independent and “self-contained” system, it brings both a bless and a curse. The bless is that we can build a self-contained system without worrying about the physical world and subjective bias. Also, the “abstraction” can work as a tool for simplification, allowing us to search for essential patterns. The curse is that it could easily get detached from the real life and becomes a “distorted” or misleading “description” of the real world.

For example, many professors in academia care too much about the theory than the reality. They want to discover a self-sustained system that is pure and perfect, so it has no crack or flaw in it. Something that is both “simple” and “true”.

Unfortunately, in reality, there is no such thing. When you apply abstraction, you would definitely lose something in the process.

For example, many economists enjoy their theory on “perfect competition” and “commodity industry”. They have some “good” abstraction in place: if a product is commodity, competitors will continue to join in so that eventually all the profits will be competed “away” with nobody making any money as a result.

Sounds so true and scary? Don’t be, since it is something never truly existed in the real life. In the real life, I would argue that there is actually “no” pure commodity, just as there are no infinitely small points or infinitely thin lines.

Businesses have many ways to differentiate themselves even when their products are considered as “commodities”: they could offer a better service (think Cisco), some customization (like Apple), better “presentation” (again, Apple), better “usability” (again, Apple), better “brand” (like Coca Cola selling sugary water), better ecosystem (like Microsoft), or better “availability” (just pay the shelf-space, or build more local stores like Walgreen, or a coal miner build a mine right next to a power plant).

The so-called “availability” isn’t just physical, as some businesses could always do more advertisement or optimize search words to increase its availability to users.

In other words, while professors like to teach their theories about “commodities”, in real world, you can find that things are never so simple. Their theories only described an extreme case which never truly existed at 100%.

So the “logical world” is powerful, useful and yet it could be misleading as well, if we don’t understand its limitations.

Posted in Uncategorized | 2 Comments

From the “Chicken And Egg” Problem

Last night, my kid brought up the “chicken and egg” problem again: “Which one shows up first? Is it the chicken, or the egg?  If you don’t have the chicken, how can you have the eggs? And if you don’t have the egg, how can you have the chicken?”

To most people, this should not be the first time to hear dilemmas like this. Of course, from the current evolution theory, we knew the term “chicken” is never as simple as what even a 3-year-old would know. Birds came from Reptiles in a very long evolution process. So at some point, there was some species in-between and we don’t know if we should call it as a chicken or not. It all happened in a very slow process, but the riddle or dilemma can never be solved with simple logical thinking – in other words, if you believe chicken is simply “chicken”, and egg is simply “egg”, you can never solve the dilemma.

This shows the limitation of our logical thinking. All our words and concepts are abstractions of the real world. The details have been removed during that abstraction process. Most of the time, we don’t have to worry about those details, and that is the power of logical thinking. However, for those unwary, this limitation could catch you at the moment when you least expect it.

This is why Zen said “everything that can be spoken out is wrong”. That sounds really weird to normal people: if everything we say is wrong, then what is right? The questions like this would actually show how most people are still unaware of the limitations of logical thinking.

When a little kid watch a movie, the most common question he/she would ask is: “is this a good buy or bad buy?” To satisfy their curiosity, you might have to give them an answer, even though you knew it is much more complicated than a simple statement like that.

Our mind is lazy – we tend to avoid confusions, ambiguities and conflicts. For the most part, it is a good thing, as it saves our energy and simplies the tasks. However, if we just deeply believe a simple statement without ever questioning it, we also expose ourselves to huge problems, in a process I would call “self-hypnotization”.

In reality, things are never as simple as we usually believed. For example, I believe most people would believe in “human rights”, which means every human has some basic rights regardless of his/her race, social status, or origin (I pick this example only because this is one of the things that rarely gets challenged).

However, when we think about it, we might find that even defining “human” is difficult, we will encounter questions like:

  • When a baby is not born yet, does it count as a human? If not, why not? Why birth as an event would define a human? Why isn’t a baby breathing inside its mom not counted? If the unborn baby or being-born baby is a human and has equal rights, how can you sacrifice it to save the adult? How can you allow abortion?
  • If a human has very significant mutation, either naturally or human-induced mutation, does that “thing” still counts as a human?
  • If an ape becomes as smart as a human, should it get the same right?
  • Why should human share the same right, but not animals? Is that because animal is in lower class, or not smart enough? If you can discriminate animals by “class”/”race” or IQ, why can’t you use the same standards to discriminate a subgroup of human?

Some may argue that these are just corner cases we don’t have to worry too much about in our daily life. That is certainly true, but my point here is that many of our believes are not based on reasoning (or it is based on deeply flawed reasoning), but on convenience and usefulness. What is most interesting to me is that despite the big flaws in those reasonings, most people never question them, just as most people would not be aware of their day dreams.

In case that you are still not convinced, I will give another example. While giving basic rights and banning discrimination associated with Race, Origin, Gender and Sexual Orientation sounds so right and noble, how many people ever questioned the biggest discrimination of all: Nationality?  How many rights were given to citizens, but not to the immigrants (lawful or unlawful)? If Nationality is something that “should” be used as a basis for discrimination, why not “race” and “origin”?

In fact, in some countries, “race” is more important than nationality (I am not naming those countries here). Of course, people will say, opening up all the rights to every immigrant simply won’t “work”. That is certainly true, but that argument just proved my point: the so-called “justice” is more based on “convenience” than “reasoning”. It certainly had a “reason” to exist, just not the reason you were told to believe in.

In other words, it is not “wrong” to think in terms of “right and wrong”, “black and white”, and “good and bad”. But we have to remember nothing is so true that is not worth challenging. Of course, politicians and religious leaders would never like people to start questioning everything. That would make things really complicated and really hard to control…

Posted in Uncategorized | Leave a comment

Do You Still Believe In “Santa”?

Like me, my son is a pretty naive one. At his 3rd grade, when all his classmates already knew Santa Claus is just a “lie” and told him so, he still believed in Santa. But with so many nay-sayers, he did have a little doubt and asked me about it. When I told him the truth, he felt so insulted and betrayed, a little like a cult follower eventually finds out the truth.

But I told him: “Don’t feel too bad, because you are not the only one. Most adults still believe in ‘Santa’ too, just a different one.”  Of course, the “Santa” I was talking about is a more abstract concept. I meant to say that most people never really had any serious critical thinking. They are mostly brain-washed intentionally or unintentionally by others. They are so strongly influenced by conventional “wisdoms” and never seriously challenged these beliefs.

For example, killing a pet in a big city will feel like a crime (and it probably is), but hunting wild animals feels like legal, suitable and entertaining sports, not mentioning that we are eating animal meat every day.

Today, anyone who starts a war or expand his empire non-stop will undoubtedly be seen as a war criminal, but many such people (such as Julius Caesar, Alexander the great, Napoleon, even Genghis Khan) in history are still being seen as “Heros”.

A much deeper question most people never asked is: who has the authority to define what is right and what is wrong? Certainly not those political leaders or religious leaders. Not moral standards and ethics either, since that is changing a lot over time.

The only answer I can think of is maybe God (or Nature, as our creator) has the authority, and that standard for right or wrong is already embedded inside of us: our instincts. These instincts are more like computer programs for a robot which give rewards (happiness) and punishments (pain) for our behaviors. In other words, if we feel happy, that is only because we did what God (or nature) wanted us to do. So in this sense, happiness is the only criteria for “righteous”. Because it is the God’s will. 

But putting that argument aside, what is most interesting is the fact that most people would never ask those questions. They take everything as granted, as something that would never need any questioning or challenge.

In part, the system works in that way because it is safer in that way. For example, almost all of us have day dreams all the time. However, without knowing what “day dreams” are, most people never realized they had been day dreaming all the time. This is a protection system our unconscious added for us, so that we could have some self-fulfilling fantasies without feeling ashamed about it.

Similarly, herd-following mindset has its own value. It serves the purpose of making a society (a group of people) more stable and more coherent. On the other hand, if everyone has independent thinking, it would present more risk for the society since it could bring more conflicts. Following others would also save energy and reduce search efforts.

Despite its reasons for existence, it could also be dangerous if there is no independent thinking, because in that way, truth is unlikely to be discovered and innovations will be more unlikely.

I am not going to give out a lot of examples in this small article. All I can say here is that once I have started my own independent thinking, I found many things are indeed questionable. It is like finding a new world. What is truly amazing is that I should have found it much earlier.

Posted in Uncategorized | Leave a comment

Why “Shareholder value” Is Often A Lie

“Shareholder” – The over-simplified Term

We often hear that businesses are supposed to maximize shareholder value. It certainly sounds reasonable to beginners, but once you get to know more about stocks, you will find shareholders are rarely a single group with some common interests.

Instead, we can usually identify 5 groups of shareholders:

1. Operators/Management.

Management are the operators of the business. They manage and control the business’s daily activities. Although they don’t have the ultimate control of the business, they have strong enough influence to the business and board of directors.

For sure, management are often shareholders as well, but their interests also come from being able to draw compensation on a long term basis. When they have enough influence to the board, they could also treat the company as an unlimited source of cash flows for themselves.

Besides getting long term compensation, there is also pride, love, and sense of power involved. The job itself might be rewarding enough, so much that it is beyond the financial interests a regular shareholder would have.

By nature, management are the ones who interact daily with employees, so they might have natural attachment to employees or at least try to avoid confrontation at a minimum.

For all these reasons, management rarely have the same interests as the other shareholders:

  • They don’t like to lose control. It is often a matter of pride and sense of power.
  • They like to draw as much compensation from the company as possible.
  • They don’t like to sell the company even when given a good offer.
  • They don’t like to do restructurings and lay off people, even when it is really needed.
  • They don’t like to liquidate an unprofitable business even when they believe it is hopeless (think Berkshire Hathaway’s textile mill)

2. Controlling Owners.

Controlling owners are the large shareholders who actually control the board. Some have close to majority shares, while others have different class of shares with more voting power (such as class B shares with 10 times voting power).

Controlling owners sometimes have more aligned interests with long term shareholders, but they are rarely the same. This is because controlling owners have both control and insider information.

Insider information covers the past and present status of a company, giving them more certainty to predict the future.

“Control” is even more powerful, since it gives them certainty about future actions and potential changes that could happen to the company.

Because of these two advantages, controlling owners could also play tricks against minority shareholders. For example, there are quite a few Hong Kong companies that play the same type of tricks over and over to dilute minority shareholders in a big way.

Just recently, Landing International (HK: 0582) announced a pro-rata share offering at HK$0.05 per share for 102 billion shares (yes, you read it right, it is not “million”). The current share base has 20 billion shares outstanding. So this is 500% dilution. To understand the offering price, I should mention that the share was traded at HK$0.10 just the day before the announcement and HK$0.20 just one month ago. The company’s book value is HK$0.50 per share.

The company also has HK$5.2 billion cash and about HK$4 billion debt. So it has net cash to begin with, why does it need so much dilution and so much capital (HK$5 billion capital injection)? The controlling owner declares this is to pay off the loan made by the controlling owner himself.

I should also mention that this is not the first time they dilute shareholders in such dramatic matter, it is the 3rd time they do it since they acquired control in 2013.

Some people might think this is a “fair” offer because it is pro-rata. In theory, it might sound right, but again, people tend to forget that it is the controlling owner who has the control and insider information here. If you are one of those minority shareholders, do you want to put more money into this apparently suspicious company? Do you know how many insider dealings they could have later on? Do you really trust their accounting books?

So the mere action and announcement would already scare away the minority shareholders, leaving them 500% diluted at unbelievably low prices relative to their costs and the company’s book value.

3. Short term shareholders.

Short term shareholders don’t intend to hold the shares for many years. They want to take a “free-ride” and prepared to jump off the wagon at any time.

To them, the so-called DCF value (discounted cash flow) is a joke. They only care about the market value and how much and how fast they can sell.

With this purpose in mind, they would like a company which can make numbers and produce a stable trend. They like companies which can tip them off at the expense of other shareholders. They like companies which will sell at a premium to the highest bidder tomorrow no matter if the bid is below or above the long term intrinsic value. They like companies which care about short term earnings than long term returns and don’t want to make any real long term investments (unless the investment could make the “story” more attractive). And they like the company to buy back shares no matter what the price is since it would boost the short term share prices.

Many activists are also in this type. Although they claim that they represent the shareholders’ interests, they tend to be short term oriented, and their solution could be conflicting with the company’s long term interests.

4. Long term shareholders.

For long term shareholders, DCF makes more sense, at least theoretically. Even in this case though, “value” is still only meaningful in a relative sense. For example, since nobody knows what discounted rate should be used, we can never tell whether someone should prefer $3 for 10 years later or $1 for now.

Also, how much cash a company should hold and how much leverage a company should use is really a subjective decision, which depends on the personality of the decision maker.

5. Options holder.

Since management and employees usually hold a lot of long term options, this type of shareholders is also important to consider. Since they only hold options without any cash flow needed to excise them until many years later, their downside is practically zero at the moment they get the options, and their upside is infinite.

Naturally, options would encourage them to be very aggressive to pursuit growth and leverage regardless of the risk and downside. The limited time window of options would also encourage them to be more short term oriented.

When it comes to paying dividend vs. buying back stocks, options holder would by all means favor buybacks, no matter how high the stock price is. After all, dividends have nothing to do with them.


To be fair, there are a lot of common interests among all the shareholders too, but as you can see, the real picture is much more complicated than what you would usually read in the news media. It is also hard to argue what is right and what is wrong, plus what can you do even if you could tell? (unless you are the regulators)

Therefore, for investors, it is critical to understand who you are and what role you play, and try to find a shareholder base that meets your needs.

For example, if you are one of those long term shareholders, you would want to partner with some good controlling owners or a management who has long term shareholder’s interests in mind, those who would treat other minority shareholders fairly, and think about the company’s long term future.

On the other hand, if you are one of the short term investors, you might want to find a management that knows how to do promotions and tries their best to make the wall street happy.

Overall, people of the same type can usually get along. If a stock is dominated by short term investors, the absence of a long term oriented CEO or controlling owner can be a good thing, but collectively, they might lead the company to do something harmful to the long term performance.

On the other hand, a long term oriented company with long term investors as its shareholder base could be “unfriendly” to short term investors who have no patience for long term fundamental returns.

In any case, no matter whether you are a long term or short term investor, you have to be careful about any powerful management or controlling owners who behaved unfriendly to minority shareholders. Studying their history and the company’s history is an important part of due diligence. To do that, just reading all the past annual reports is far from enough, since that material is too official and strongly biased. Instead, you should look at the cash flows, value returned to shareholders, online reviews and investors’ past discussions.


Just as “value” is an over-simplified term, “shareholder” is also an over-simplified term. Experienced investors know what to look for beneath the surface. So next time when you hear people talking about “maximizing shareholder value”, you might want to silently ask yourself: which shareholder are they talking about?

Posted in Uncategorized | Leave a comment

The Economics Of Buying Your First Home

I have always told my friends that not everyone needs to learn advanced Math, but almost everyone should take two classes when they are in high school: Psychology and Finance.

All our education, taking so many years, and getting so competitive, are mainly to prepare some workers to be used by large or small businesses. The goal seems to be making enough money and make a good living. Money is certainly useful, but it is more like a weapon, it is powerful, it is needed, and it could help you, but it could hurt you too (if you don’t know how to use it properly).

That is why we need to learn Psychology, to understand what makes us happier.

What about Finance? People spent so much time on learning and worked so hard everyday, but most of them only spent very little time on learning how to invest the money they earned. Gambling on stock market without the know-how, or being too conservative can and did cost them a lot.

One basic lesson for Finance for everyone is that regular people (layman) usually makes money on real estate investing, but loses (or gains much less) money on stocks. It doesn’t have to be the case, but it has been the case for decades. One main reason for this is that stocks have businesses behind them and these businesses are very complicated for regular folks to understand well. The stock market also has a lot more short term fluctuations than the real estate market, which is used/produced/taken advantage of by the sharks or wolves of wall street.

On the other hand, real estate is much simpler (relatively), with much less short term fluctuation (long term cycle is still there though), and more importantly it is a “non-scalable” strategy. “Non-scalable” means people who have a lot of money can’t use the same strategy, since finding a real estate deal requires a lot of time searching it, it may also require extended knowledge about a local area, and each transaction is separate, all of these require personal care.

Of course, stocks have its advantage too, such as more diversification, global reach, and not require a large sum of money. But to invest in stocks, you need a lot of time to study it, follow it, or you need to find a trustable expert to do it for you.

So real estate investing is better for regular folks, but the “crown jewel” here is buying your first home. And I will explain why that is the case.

Suppose there is a betting game, which requires you to bet $50k, and you have 90% chance to double your money, but 10% chance to lose all that bet, and you only need to pay $10k out of your own pocket (you can borrow $40k from “the house”, and you don’t have to pay it back if you lose!), and best of all, there is no income tax for your profit, would you do it?   (When you think about it, if you don’t have to pay back the money you borrowed if you lose, the upside is 500% with 90% probability, and downside is 100% with 10% probability. )

It certainly sounds too good to be true. But that is what you get when you buy your first home. To get your vote, and encourage home ownership, government has sweeten the deal a lot, to the point that it really sounds too good to be true (to investment experts). I will list out the benefits here:

  1. 20% downpayment without any liability to pay it back, and no forced liquidation as long as you can pay the mortgage every month.

Leveraged investing is not something new. You can borrow money to invest in pretty much everything, but if you are “under water”, say if your stock goes down 20% when you leverage 5 times, your portfolio will be liquidated and you will be on hook to pay anything left to pay if the liquidation doesn’t pay back all the loans.

You don’t get the same treatment with your first home. In 2008, so many people defaulted, and still get to walk away without having to pay anything back – they even got to live in the house for one year without any payment before the foreclosure finally happened.

Essentially, the bank or government (most mortgage loans are bought by the government even though it might be originated by the banks) is on the hook when lending money to you.

2. The loan interest rate is ultra-low, so low that you can’t get the money in any other way.

When we borrow a mortgage, we often find that the interest rate is so low, often just 1% above what the bank pays us for the CD deposit. How can the interest rate go so low?

When we put it together, “high leverage and long term loan with no terms attached” + “no liability for the loan other than losing some of your credit” + “ultra low interest rate” are truly unbelievable treats, but this is all built on top of two credit systems:

The first is your own credit. The salary you have is a stable income source (your “credit”), and it should be used to make some borrowing against it and not wasted. And the loan is collateralized, meaning your house will be taken away if you can’t pay mortgage.

The second is the government’s credit. When government buys the mortgage from the banks and later sells it to investors, it has an implicit loan guarantee on it. Investors are willing to accept this “agency” debt (“agency” like Fannie Mae which represents the US government) for very low interest rate because it is virtually risk free. If anything happens (another 2008 for example), you can bet on government to pay it back. What if government can’t pay it back? That almost will never happen, we have yet to see one government to default on a loan made in its  own currency (Yes, Greece wouldn’t have had default if it had borrowed loans in its own currency), since the worst that would happen is just printing more money.

So this is a “benefit” given by the government, but government is not a person, it is an entity owned by all of us. Essentially, this “free lunch” is provided by all the rest of us who don’t buy a house. It is not our choices to not provide that “free lunch” to other first time home buyers, but not taking it for those who need and can afford a home under such a favorable term would seem unwise.

3. Real estate generally goes up over long term.

Like any other financial assets, real estate will also have a boom and bust cycle, although it is generally a very long cycle and has relatively stable trends in the short/mid term. However, over even longer term, such as 10 – 20 years, real estate generally goes up, unless the country had a big bubble in the past, or local economy is in deep trouble.

It goes up because of inflation and city growth. Chances are the place people find more jobs is exactly the place that real estate will go up faster.

4. No income tax (or capital gain tax) on profit up to $500k per couple.

Again, almost no other investing can avoid tax except buying your first home. And that could make a big difference. This is another benefit our government gives to home buyers on behalf of all the other tax payers.

With all the good things, does this mean this “free lunch” is risk-free? It is certainly not, just like other investments, it would have some risks, but I would say much less risks. You just need to be careful on some of these points:

  1. Generally, you should NOT time the market when buying your first home, unless the bubble is too big and too unbelievable. (Usually I define a bubble as being at least 3 times of its fair value, but it also depends on the growth rate of the country and local economy.)
  2. One major benefit of buying first home is to save on the rent expense. So if the mortgage payment has to be many times more than the rent for the same house, you might need to be more careful. (If the mortgage is twice of the rent, it is not ideal, but still not too bad. If you wonder why that is the case, it is because part of mortgage is to pay  down the loan over time, and the mortgage doesn’t go up over many years, but your rent would go up over time.)
  3. You might need some cash in hand, so you wouldn’t go default when you lose your jobs for 1-2 years.
  4. Housing price is tied to local economy, so if you expect foreseeable big trouble in local economy, you might need to be more careful.
  5. The benefits listed above only apply to the first home purchase. For investment homes, generally it is still a favorable investment, but the things will get a lot more complicated than the first home.

Many first home buyers in an up-trend face this dilemma: it looks too expensive to buy, especially when you compare it with the last few years. As a result, they often try to time the market and hope to catch it when it drops back, only to find that it continues to go up for many following years, and not enjoying the benefit of their first home in the process. This is because they failed to understand the economics behind the first home purchase. It is a very good deal for most people, of course it could get better when the price drops, but you may not want to bet on that to happen.

Posted in Uncategorized | Leave a comment

Liquidity and Ponzi Scheme

Every time, when I saw some news talking about how investors lost hundreds of billions of dollars because index dropped 3% in a day, I can’t stop thinking that this kind of news is designed to get attention of the unwary public.

Theoretically, the value of stocks is the share price times the number of shares. But that calculation totally ignores the liquidity factor. Just because some crazy guy is willing to pay 10 times of what the share is worth, it doesn’t make every shareholder 10 times richer. This is because the shares being traded is only a tiny percentage of all the outstanding shares.

However, this is exactly how the manipulators design the game. If the shares are being traded in a price range, it gives a misleading impression that the shares are worth that much. After all, the market is efficient, right? In reality, it is far from the truth. Otherwise, try to explain those bubbles in the history.

In some sense, Ponzi Scheme is using this liquidity factor to fool people. At any given moment, as long as the people who demand redemption is only a small percentage, or the people who seek redemption (sellers) are less than the people who get sucked into this game (buyers), the manipulators (or call them the game designers) will have no problem to keep this game going. However, when all the existing stockholders want to seek redemption, you can be pretty sure that there is no way it can still be able to maintain the same or similar price.

Perhaps this is not news to many experienced investors/traders, but what is more interesting is that many investors/traders are participants of this Ponzi Scheme when they have already knownthis is a Ponzi Scheme!

This actually happens quite often in the stock market for those momentum players. Some of them are the unwary public, but many of them do know that the stocks are not worth much. But as long as it can keep on going up, why don’t enjoy the ride? Last year, the Chinese stock market had a crazy run from March to June when many stock traders, including many who just joined the market for the first time don’t really believe there is much value in those stocks. Yet, most of them think they can get out before others do, and there is plenty of money to be made during this crazy bull run.

What happened to them eventually? Well, I don’t know individually, but collectively, you know for sure that they are determined to lose in a big way.

This brings another paradox of the market efficiency theory. Something clearly not “efficient” to those fundamental investors can become efficient for some other market participants. Even though you know this is a ponzi scheme, it doesn’t mean there is no money to be made here. In fact, the FANG stocks are still the best stocks in this weak market, right? (Other than Google, I believe the other 3 are all much overvalued.)

But when you factor in the liquidity factor, it is not that hard to see where the bubble stocks are. Why did you see a big value gap last year between the valuation of BABA (BABA) and Soft Bank (SFTBY)? Can Netflix (NFLX) raise new equity capital easily at today’s valuation, or maybe that is why it has to get more debt instead? What about LNKD (LNKD) dropping 45% in a day?

That is also the reason why companies with bubble stocks like to use the stock as a currency for acquisitions or stock based compensation. These transactions are both non-cash, and also hide the fact that there isn’t much real liquidity for investment purposes at that high valuation.

What is more interesting here is that it is actually a “win-win” situation for almost all stakeholders. For the acquirer’s management, they just expanded their empire, gaining more power and better pay. For the acquirer’s short term investors, the acquisition will show higher growth rates without affecting earnings or FCF, and therefore may bring more premium on valuation. For the acquirer’s long term investors, using expensive stocks as a currency is creating value for them.

What about the company being acquired? They get some premium (usually 30% or more) during the transaction, but what if the shares are 3 times overvalued? Don’t they lose eventually? Well, that really depends on their size and time horizon. Also, if this game can continue for long enough, the acquirer may gain enough “value” to make the overvalued stocks to be really worth that much, which is exactly what happened in 1960’s conglomerate scandal. (Even though the conglomerate was overvalued at the moment, if it can continue to use overvalued stock to exchange for many fairly valued smaller businesses, the value created from this process could later make it worth the price at that particular moment!)

How can “value” be created in this zero-sum game and make every player happier than before? That is the “magic” of Ponzi Scheme. Before the music stops, you really don’t know who the loser is, and all the “current” participants could all be winners if there are enough losers joining this game later, but you also know that collectively, there will be a lot losers for sure.

Ideally though, these companies also like to raise equity capital when the stocks are overvalued, but that is much harder to do because it is too much risk for the investors to take so much stock at such a high valuation (again, the liquidity factor is in play). So the best they can do is often just some convertible bonds or warrants. (After all, day dreams are only worth that much.)

Posted in Uncategorized | 1 Comment

The Double-Agency Problem In Investing

In investment, the “agency problem” is commonly known, which refers to the fact that the management of a company usually acts on their own interests, at the shareholders’ expense.

There many examples of such problems:

1. Expensive Acquisitions.

Among all the bad actions, expensive acquisitions are the most damaging ones. Managers often come up with all kinds of excuses to show shareholders why this is a good deal, and how much synergies they could achieve after this deal. The reality is their pay/bonus is often proportional to the size of the company. Even without the financial reward, they surely enjoy the increased power as the company becomes bigger.

2. Large bonus and stock based compensation.

It is quite often that the bonus for a CEO or CFO is much larger than his/her base salary. I have often seen CEO taken a bonus at 0.5% or 1% of the market cap every year, sometimes even when the company is having a bad performance or losing big!

Well, 0.5% or 1% may not sound like a lot, but if that 1% is saved and added back to income, it will transfer to a big proportion relative to the earnings.  So if the company if valued at P/E 20, the earning is 5% of the market cap. Adding 0.5% on top of that, it translate to 10% extra earning, or at the same P/E multiple, it will give 10% more share price.

This is just the bonus of top management, not counting the bonus of all the executives and board. Very few small investors would go and check proxy statements for these details.

Besides taking bonus, they are also very good at boosting their return on options, and dressing up their financials.

First, by not issuing dividend or issuing a smaller dividend, they could buy back shares instead. What is the difference? Regular dividend doesn’t increase the value of options, but share buyback does. So without moving a finger or delivering extra real operating performance, just by buying back shares (no matter how high the price is), they can make good gains on their options.

The ironic thing is that shareholders actually like to see share buybacks. It just shows how pitiful the shareholders are in the mercy of the management. They like share buybacks because quite often there is the other even worse alternative: they can find out that the management is using the cash on balance to make an expensive acquisition, or mess up the business and eventually go under, which means there is no return at all for shareholders, ever.

Even if there is no expensive acquisition, cash hoarding makes the management feel safer, but makes investors poorer simply because the cash is sitting there without being deployed. The time value of money is lost, and no compounding returns on that cash at all. This kind of hidden value destruction is not to be overlooked, but not obvious to all the small investors. At the end of the day, a manager good at capital allocation and act on shareholder’s interest can be even more valuable sometimes than a manager very good at operations.

Adding insult to injury, after taking millions or even hundreds of millions in stock options, management often want investors to ignore that cost completely. They emphasize on EBITDA, Free Cash Flow or non-GAAP earning figures which don’t contain any charge on options/stock related expense, because those are “non-cash” charges. A simple word “non-cash” wipes out all the dilution effect they have created consistently year after year.

This is what they often do: they dress up the earnings by wiping out the “non-cash” stock based compensation, showing a better earning, and use the “cash” to buy back some shares to eliminate the dilution effects created by the stock based compensation, effectively moving the cash from operating cash flow to the financing cash flow, boosting both operating cash flow and free cash flow. And after all this, they call that share buybacks as “returning” to shareholders.

Not only the small investors who don’t understand the trick get cheated, even the knowledgable professional analysts on buy side and sell side often forget about the tricks when they do the valuations.

It is also not just some of the companies, virtually all the high-tech companies routinely and traditionally come up their non-GAAP figures, with analysts helping their course: all the earnings forecasts are non-GAAP earnings, and forward P/E is using non-GAAP earnings for calculation. Another trap for small investors. For many high tech companies, such as Google, Tesla, or Netflix, just the options/stocks based expense could make a huge difference on their P/E calculations.

3. Accounting manipulations.

The more I learn about investment, the more accounting tricks I could find. And eventually I found out that the accounting manipulations are actually the “norm”, not just for the “criminals”.

To be fair, most of them are relatively mild, such as taking up revenue earlier, or recording a one-time charge-off in order to boost up the following quarters’ earnings. These are smoothing out the earnings, but not having a huge long term effects. People tend to focus on the kind of financial fraud like Enron did, hiding huge losses in off-balancesheet entities, but the type of earning manipulations I just talked about can be damaging to small investors as well, since they often misjudge the stability of the earnings, or get surprised by a sudden change of the business fundamentals. As a result, they tend to sell at the worst moment, and buy at the worst moment.

In the case that the company’s fraud does get discovered, and get fined, guess who suffers? It is the company who pays the fine, or the shareholders who pay the bill! At the mean time, managers’ legal costs are often covered by the legal insurance the company (shareholders) purchased for them!

4. Shares with different voting power.

Suppose a “friend” comes to you and ask you to invest in his company.

He says: “you can own 90% of my company if you put in 90% of the capital. Oh, BTW, forget about the fact that I only put in 1% of capital, based on the current (manipulated) earning power, my company is worth 10 times of the book value now. So my 1% of capital is worth 10% of the company now. After you get 90% of my company, you will be entitled to enjoy the 90% of the earnings. However, you will own the class B stocks, and I own class A stocks, since my class A share have 10 times of voting power than your class B share, despite the fact that you are the 90% owner of the company, I am still the controlling owner, and I can decide whatever I want to do with the company and its earnings, and pay however big the bonus to myself, including giving myself any type of stock based compensations. In another word, I will eat the “meat”, but you are entitled to 90% of all the leftovers, if there is any. Oh, don’t worry, there could be some dividend at some point, when I want to throw some bones to investors to boost up the share price so I can get a new round of share offerings at a high price.”

Now, does that sound like a good deal to you? But you should thank your friend, because he told you everything you are supposed to know. Not like most of the IPOs, although this kind of facts are included in the SEC documents they have to file, they (and the investment bankers they hired) would tell you none of such things when they sell your their version of the stories.

5. Poison pills and entrenched positions.

You might think managers are more like employees, and shareholders are the true owners. Theoretically, that is true. But practically, the management knows how to get an entrenched position, putting their friends on the board, and putting “poison pills” in the “change of control” contingencies.

Because shareholders are scattered and often not knowledgable enough, they often feel powerless to fight the management. Even when they do, it often results in a long struggle, causing distraction to day-to-day business (which often means deteriorating business) and distress on share price for the uncertainty (unless most shareholders are too angry at the management). Once you invited the wolves in (or tried to own a share of that wolf den), it is hard to get rid of them…

6. Misleading investors.

Some of the problems listed above such as expensive acquisitions can be prevented if the management has significant stake in the company. So if the CEO and chairman own 20% – 30% of the company, it is unlikely that they would intentionally make an expensive acquisition to sacrifice the shareholders’ interest. However, even in that case, it won’t prevent them from hiding the bad news or staying over-bullish to mislead investors. To be fair, the CEO should be bullish about the company, and they actually have a job to maintain the company’s public image. However, there is a grey area between staying optimistic and protecting the company’s reputation vs. giving false or misleading presentations to misguide investors.

Any over-bullish statement or attempt to hide the worrisome facts would mislead the investors and make them overpay for the stocks. Obviously, this problem doesn’t exist when the investors actively manages the company themselves. Therefore, it is another type of agency problems.

Ok. Those are some of the agency problems. It means that small investors have to find a trustable management who cares about them, but they are often not empowered by the knowledge and skill to tell who is trustable. What about just buy a mutual fund and rely on those professional money managers?

That is the second “agency problem” I want to talk about here, which is not as widely known.

People bought mutual fund either because they don’t have the knowledge to pick stocks, or because that is the only choices in their 401ks (401k often doesn’t allow investing in individual stocks directly).

So does mutual fund help in this case? The answer is “no” for most funds.

Just take a look at the cost structure of mutual fund. Usually it charges 1% of the total balance no matter what the performance is. So the money managers get paid no matter what the performance is.

Looking at this, most people don’t ask the question like: why do they even get paid when they don’t achieve a good performance? For their labor? Do I even know how many hours they have put in their work? And how much for one hour?

The second question is: if they get paid for the same amount, what is their incentive of delivering a better performance?

Some might argue that if they are not doing well, they get penalized because people will choose a different fund. That is neglecting the fact that it usually takes a long time to tell how good the performance is. Also, quite often, the number of people that would buy a mutual fund depends more on marketing and relationship related deals, than just performance.If you can get the news media to sell your version of the story, it would work more than a charm. If you can persuade your partners to carry your fund as the only choice in the 401k plan, you don’t care too much about your performance as long as it is not too bad.

That is exactly what money managers are seeking. They don’t need to get a very good performance, but they want to make sure it is not too bad, relative to the index or general market. In other words, they care more about the relative performance, than the absolute performance.

The result of this is that they won’t buy when market is cheaper, and won’t sell when market is more expensive, they just tag along the general market. But that is actually not true, it is actually just the opposite, for an open-ended mutual fund: they buy more when the market is more expensive because they get more money flowing in during a bull market (everyone want to catch the good trend), and they will sell more when the market is down and getting cheaper because more money is flowing out their fund during a bear market (forced redeeming). That is why some mutual fund managers are forced to sell at the very panic moment of the market in October 2008. Some of them don’t even know how to choose which one to sell, so they sell in alphabetic orders! They sell stocks with symbols from A to N today, N to Z tomorrow! The net effect is that they end up buying back the same thing they sold at a much lower price! Although it may be unfair to blame the money managers for this action (since it is the individual investors who made the bad decision), it does add to the transaction costs of the mutual fund.

Now, what about buying a fund that was performing well? Many friends told me that they would check the 10 year performance of a fund, if it is going up steadily (Good return with low volatility, essentially higher sharpe ratio), it should be a good choice.

That sounds reasonable right? But it is actually very deceiving. To understand this, I need to tell an old trick first. If you send out 1000 mails to 1000 people recommending different stocks, predicting a stock will rise in the next week, natually, half of them will work, half of them will not. Then you select the 500 people who got the predictions that happened to have worked, and send them some new recommendations again. After repeating this trick 6 times, you will have 15 customers left who got recommendations that worked 6 times in a row. For those customers, they would believe you are the “oracle” since it is very hard to get right 6 times in a row (only 1.5% possibility in statistics). And chances are they would trust you as their money managers.

Many investment firms use exactly the same trick: they don’t own just one fund, they start many different funds with different investment strategies. Some will work well, some will not. Over the years, they close out the funds that didn’t work well (which naturally should have lost most of its customers anyways), and only brag about the ones what worked well. This is a basic “survivorship bias” at work.

So given the double-agency problem, how can a small investor choose? Maybe they should get away from the stock markets and not invest at all?

The answer is “no”.

While stocks could have all kinds of problems, we must remember that it is often the highest return and most flexible investment vehicle regular people can have access to. People could invest on other things like real estate, but that also requires some good knowledge, large amount of capital and often come in limited choices (limited in local area and subject to local property tax policies).

Holding cash is not a solution, as the government often tries to steal from savers by printing money in a non-responsible (and invisible) way. Despite all the uncertainties in the stock market, the damage caused by inflation when you only hold cash is a “certain” way to lose.

Also, we must not ignore the compounding power of investment. At 10% return a year, 50 years would turn $10,000 to $1,170,000.  As Charlie Munger said, if we have some basic investment skills and stay rationale, we will be “determined” to be very rich eventually.

I would often put “compounding” and “diversification” as the two most powerful magic tricks in finance.

So small investors should definitely consider stock investments, but need to follow the right approach. There 4 choices I can think of:

1. Learn a lot about investment, and be an expert at it.

This approach will pay back in a big way eventually, but certainly not for the majority. They simply don’t have the time and the interest to get the expertise.

2. Learn some basics about investment, and invest with good temperament.

This should work fairly well for most of the novice value investors. But small investors usually don’t have good temperament. So it is not realistic for the majority either.

3. Buy a low cost passive index mutual fund.

This is the method Buffett suggested. If done consistently over many years, it should yield fairly good result due to the compounding power of any investment. If you are not so sure about the economy of US, you can also buy a diversified index fund over the entire world.

4. “If you don’t know jewelry, at least know your jeweler.”

It is much easier to know your jeweler than try to be an expert at jewelry. So if you know a good money manager, you can just trust him/her and rely on his/her skills.

It might be difficult for small investors to access a good hedge fund, but there are still some mutual funds with good managers. Also, some investment companies like Berkshire Hathaway are essentially working like a fund, although it is not as tax efficient as a fund (but still pretty good if it owns business directly or not selling stock investment until after many years).

Posted in Uncategorized | 1 Comment