Tag Archives: Accounting

the SEC is looking at hedge fund performance claims

December 27, 2011 By in hedge funds, Industry Analysis, Investment firms, Private equity Tags: , , , , , , Leave a comment

the new approach

Today’s Wall Street Journal tells about current SEC efforts to scan the hedge fund universe in search of  potential civil fraud.  The idea is to use computer analysis to identify hedge funds whose results are too good to be true–where the operators rarely, if ever, have a down month, or where aggregate results are sensationally good.  This new direction apparently comes as a result of the agency’s failure to detect the gigantic Ponzi scheme that Bernie Madoff ran for many years–despite being supplied continuous evidence of the fraud by investigator Harry Markopolos.

Markopolos, a financial analyst, was asked by his employers to “reverse engineer” Madoff’s returns and create a duplicate it could market to clients.  A quick look at the numbers was enough for Markopolos to suspect fraud.  It took him less than a day to develop conclusive proof, which he then tried in vain to present to the SEC for close to a decade.

The new SEC interest in hedge funds appears to mimic the Markopolos methods.  The agency is also extending its scrutiny to mutual funds and private equity.

it’s about time

For years, academic studies have concluded that the returns hedge funds report to the public are at best implausible, and most likely false.

My favorite is one led by NYU professor Stephen Brown.  He analyzed investigations done by a hedge fund due diligence firm, HedgeFundDueDiligence.com,  which was hired by potential institutional customers to check out new managers.  It turns out that about a fifth of the hedge funds misled HFDD.com, despite the fact they knew their assertions would be checked.  It also turns out that customers generally hired the dishonest hedge fund managers, despite the due diligence warnings.  Go figure.

The biggest reasons for falsifying returns, in my view, is that reporting is voluntary and that the databases which collect the numbers make no attempt to check the figures.

an example

The WSJ article cites the case of the now-defunct ThinkStrategy Capital Management.  TSCM reported a return of +4.6% for 2008 in its Capital Fund-A, a year in which the fund actually lost 90%.  Chetan Kapur, who ran TSCM, also reportedly inflated his assets under management in reports to shareholders and wrote about non-existent team of analysts supporting him.  Kapur also continued to manufacture and report performance numbers for Capital Fund-A, even after the fund was shut down.

The article says there are lots more where TSCM came from.

I believe it.

 

 

a final note on the Olympus scandal

December 26, 2011 By in Current Market Thoughts, Japanese development, Stock ideas, tobashi Tags: , , , , , , , , , , Leave a comment

a recap

During the summer, the newly appointed CEO of Olympus, Michael Woodford, followed up on an account in a Japanese magazine of severe financial irregularities at Olympus (TYO: 7733).  He discovered a number of failed M&A transactions involving gigantic payments to obscure companies that disappeared from existence soon after receiving the money.

He was fired for his pains.  He promptly left Japan, saying he feared for his personal safety.  Once in the UK, he disclosed everything to the world financial press.

An independent panel was appointed by the Olympus board of directors to investigate the situation.  The panel determined that Olympus had engaged in speculative “financial engineering (zaitech)“, presumably arranged for it by its investment bankers, starting in the late 1980s.  Like virtually everyone else who did this in Japan, Olympus lost its shirt.  It covered the losses up, again presumably using a service (tobashi) provided by its brokers.  This generated a cycle of progressively larger cover-ups and money-losing speculations that lasted over two decades.  The fake M&A was an attempt to get money to pay off creditors and end the cycle once and for all.

what’s new

Olympus has avoided delisting by providing the Tokyo Stock Exchange with accurate accounting statements by a mid-December deadline.  The “new” Olympus has book value of about a third of what it had previously claimed.

The stock lost about 60% of its value since the Woodford firing.

Two American funds managers appear to have held close to 10% of the company’s stock at the time the scandal broke.

The newest chairman of Olympus appears to me to be proposing that:

–the company’s board needs only a symbolic shakeup (where one or two members make a ritual expression of regret and resign), and

–Olympus should recapitalize by issuing stock to other members of the Fuji group, like Canon or Fuji Film.

my thoughts

Olympus is a typical Japanese technology-related company.  It’s torn between the need for constant innovation to keep up in  an increasingly complex and rapidly evolving world and its presence in a social/cultural environment where preserving the status quo is acknowledged as perhaps the highest goal.

Current management seems to be in the process of arranging a “traditional” solution to Olympus’s problems–one that doesn’t probe too deeply and where a new corporate direction launched by change of management is completely out of the question.  It sounds like other Fuji companies are willing to help this happen.

In other words, business as usual in Japan.

My guess is that this is the most likely outcome.  After all, except for what I think of as counter-culture companies run by younger Japanese, this has been standard operating procedure when companies get into trouble for the twenty-five years I’ve been watching the Japanese stock market.

Any signs that this time will be different should be studied carefully for potential to be a bellwether of change. (I’m not optimistic, though.)

I’m most curious about the foreign professional investors who  held large positions in Olympus.  Didn’t they know anything about Japan?  Did they really think that buying companies with low price to book or price to cash flow ratios would bring the same kind of success it does in the US?  Didn’t they see that this approach has failed time after time in Japan?

Apparently not.

developing competence as an equity investor

December 18, 2011 By in buying and selling, Constructing a Portfolio, developing competence as an investor, Trading Tags: , , , , , , , Leave a comment

Zen…

The teachers of many sports or craft skills use a Zen-like scale to rate students on their progress toward mastery of their specialty.  The scale typically has four levels, that are often expressed as:

–unconscious incompetence

–conscious incompetence

–conscious competence

–unconscious competence.

…and investing

I think these classifications have some relevance for us as individual investors.  Here’s my take on each–

1.  unconscious incompetence.  This is where everyone starts out.  You know you’re smart–certainly smarter than most of the people you see on stock market cable shows.  You’re successful at your career.  You’re informed about economics.  You read the financial press.  You look at stock prices every day.  You think that’s enough.

People at this stage misunderstand two related things (at the very least I did):

–investing is a craft skill.  Almost every concept is easy to understand.  Complexity comes from the way simple ideas are repeated and combined into intricate and less-than-obvious structures.  Here, experience is more important than having a stratospheric IQ.

–the person on the other side of the trade knows much more than you suspect.  Typically, it’s someone who has served a five-year apprenticeship under an experienced professional investor and has maybe ten years of experience working on this own.  That translates into 50 hours a week gathering information about stocks.  More than that, the person probably spends most of that time focusing on a single stock market sector–or even a single industry, or a subsection of that industry.  Yes, some of these professionals actually have two years experience 7.5 times (meaning they’ve been spinning their wheels for most of their careers–thank goodness for that).  But even so, that’s 5000 hours studying the stocks they tend to buy and sell.  How good is the hot tip from your buddy Charlie in comparison?

2.  conscious incompetence.   Some people remain in stage one forever.  They either don’t evaluate their investment performance vs. their objectives or a benchmark, or their underperformace doesn’t register because it doesn’t square with their self-image.

Others–here I’m much more familiar with what starting-out professionals do that with ordinary individuals–begin to understand that this activity, like almost any other where professionals are involved, is harder than it seems.  They react to the situation in two ways:

–they stop doing the things that lose them the most money, and

–they begin to work harder at learning the ropes.  If they can, they find a successful investor who is willing to teach and who will take them as an apprentice.

3.  conscious competence. At this stage, an investor knows:

–enough accounting to read company financial statements with ease and understands the important financial variables in a company’s success

–enough microeconomics (which is mostly common sense, in my view) to evaluate a firm’s competitive strengths and weaknesses

–how to create a detailed spreadsheet to estimate future earnings (or to forecast other relevant metrics)

–from reading 10-Ks or elsewhere, the financial history of the companies and industries he’s interested in

–that his research process, and his plan for monitoring the key variables his research has uncovered, generally lead to success.

4.  unconscious competence.  This is the Zen stuff.  In sports, it’s the idea that after you’ve done enough conscious practicing, you’ve engrained knowledge deeply enough that you can/should cultivate “the zone.”  You try to stop thinking out what you intend to do and let your unconscious run the show.

In the most literal sense, I don’t think there’s a place for this in investing.  The reason?  –the activity is much more complex than any sport, so accumulated experience isn’t enough to rely on.

Nevertheless, there is something analogous.  For example:  you may encounter a new investment idea.  You know it will easily take a month or more to do the research you need to make an informed decision to buy or not (for me, it usually takes me over a year to become completely comfortable with a stock).  On the other hand, you see that the stock is already beginning to outperform as others become aware of it.  What do you do?

At some point I think every seasoned professional develops a sense of what research tasks are crucial and which amount to crossing the ts and dotting the is, and can be done after buying a small position in the stock.  In effect, you develop a feeling of confidence that a stock has a chance to be an outstanding performer that’s based in part on unconscious processing of information that you aren’t yet able to articulate consciously.

Some veteran investors (me among them) consider this a competitive advantage.  They rarely, if ever, talk about this.  On the other hand, some use “hunches” as a substitute for doing basic research work.  That’s very bad.  If investors like this are not “managed” by their subordinates–analysts or portfolio managers–they threaten to bring down whole investing operations.  Still others shy away from the idea of unconscious thought completely, and remain at stage 3.  I think it’s foolish not to use all the tools at your disposal, but such investors may simply be recognizing their limitations and acting accordingly.

a former MF Global CEO is now managing NYC pension investments

December 6, 2011 By in Derivative instruments, Industry Analysis, Investment firms, Portfolio management, Securities regulation, Trading Tags: , , , , , Leave a comment

in the Wall Street Journal

In an odd article at the top of the front page of  the December 1st Greater New York section of the Wall Street Journal, the newspaper heralds NYC’s hiring of Kevin Davis, a former CEO of MF Global, who was replaced there in late 2008.  Mr. Davis has been overseeing commodities investments for the city’s Bureau of Asset Management for about three months.   Lawrence Schloss, himself a former director of MF Global, selected Mr. Davis for the job, saying he has 26 years of experience and was the best candidate to apply.

details

The article goes on to to relate, without analysis or comment, that:

–Mr. Davis is earning a salary of $175,000–which is less than 1% of his compensation during his last full year at MF

–MF Global’s stock lost over 90% of it value during his tenure

–MF was subsequently sued by pension funds for misrepresenting its risk management practices, a case that MF recently settled by paying $90 million.

any significance?

There’s nothing in the article, other than its prominent placement, to indicate that there’s anything amiss with the hire.  And the placement may be more the result of political differences between the city Comptroller and News Corp than of anything else.

Two things strike me, however:

1.  NYC, like many government bodies, seems to be an advocate of the penny-wise-pound-foolish school of investment manager compensation.  A competent commodities person would make many times what the city is offering.  Mr. Davis may have been the only candidate to apply.

2.  The event that ultimately led to Mr. Davis’s demise at MF was discovery of $141 million in losses from unauthorized wheat trading by a broker in MF’s Memphis, Tennessee office.  According to theFinancial Times, the trader wasn’t a “rogue” who evaded management controls; the company’s computer systems weren’t programmed correctly.

Two years later, we’re finding again that MF Global’s computer recordkeeping systems are inadequate.  In fact, the records are in such a shambles that no one has been able to figure out how much customer money is missing from the firm–other than it’s a lot–or where it went.  I doubt Jon Corzine found top-notch recordkeeping systems when he arrived at MF and dismantled them (for what it’s worth, he doesn’t strike me as the kind of guy who would have looked in the first place).  My hunch is that they’ve been inadequate for a long time and that no one investigated properly, or extensively enough, after the 2008 trading losses.  There may well be much more to the MF Global story today than deficient computers.  But I think anyone using the in-house systems should have immediately realized their inadequacies and at least insisted they be fixed.