Performance Pressures Lead To Underperformance...

May 17, 2017 11:07 PM

A few weeks back, I was catching up with a friend of mine who runs a very successful high yield fund and naturally, the conversation turned to the markets.

Me: Congrats on yet another great year in 2016.

Him: Yeah, we beat our benchmark, but I’m sort of bummed. 2016 was the year we really should have killed it. They just gave away money in fixed income.

Me: So, why didn’t you crush it?

Him: Well, even though we made some room at the end of 2015, we went into 2016 over 80% invested—so there wasn’t much room to buy the crash in energy and MLP names like you did. The thing that pisses me off, is that we felt like spreads were too tight near the end of 2015 and we wanted to make room, but we couldn’t.

Me: Huh? Why not? If it’s not priced right, get out of the way.

Him: You’re lucky you run your own money. Most of my investors need regular income. We’ve been giving them about 90bps a month, unleveraged, for over a decade—during a time when rates are ultra-low. That’s why they invest with us. If we were only half invested, even for a few months, they’d go to some other firm that would give them that sort of income. No one is going to stick around at 30 to 50 bps a month, hoping I can time the market.

Me: What about the overall fund volatility? They must hate it when spreads widen and you take mark-to-market losses.

Him: They’re adults. They understand that if a bond goes from 95 to 70, there’s still a good chance it goes out at par. They know how thorough our due diligence process is. We have a long track record with very few failures. They give me leeway there, but they want to know that they’re earning their yield each month.

Me: Isn’t that a silly way to look at things?

Him: Absolutely!! Look, when you think about high yield credits, you don’t really own these things to get a few hundred basis points over treasuries. That’s silly. High yield is risky. The whole industry is doing it all wrong. If it were 100% my money, I’d sit in cash and wait. Every five to ten years, the whole market implodes and you can buy bonds at 30 or even 20 cents on the dollar that will almost certainly go back to par. The assets underlying them are still good—just everyone is in a panic or getting some sort of redemption or margin call. Every year or two, some sector goes kaplooey and you can deploy 20-30% of your capital into that sector at similar discounts to par. Finally, at all times, there are always a few screwy situations where you have a unique perspective and can maybe buy in at 30-40 cents and get par. The big money is made by buying at 20 and getting out at par. That’s a 5-bagger. Tell me how many years I need to own something at 90bps a month to make a 5-bagger? Why bother…??

Me: Fixed income is marketed to people as a dull product—five times your money isn’t a dull return—that’s better than most growth equity guys. Additionally, you get a few hundred basis points while you own the thing.

Him: …But you don’t want to own it for the current yield—you own it because you’re closing that gap from 20 to nearly par. I wish my investors would try to understand that, but it’s hopeless. Fixed income investors want the yield. They don’t want to pay you fees to work on your golf game and wait for the market crashes, so I give them what they ask for.

Me: You know, over the past few years, I’ve made much more money buying the crash somewhere in the world, than buying the good news growth story.

Him: Agreed. It seems like a better way, especially with how the market is set up lately.

Me: What do you mean?

Him: All the investors now; they’re all fast capital. They redeem their portfolio manager as soon as there’s a down quarter. Fund managers know this, so after a few bad weeks, they’re already making sales to raise liquidity—the whole thing feeds on itself. Then, the ETFs pile on with endless liquidations of product. 20 years ago, a bear market would take a year or two to evolve. Now, the whole process plays out in two quarters and no matter what the product is, it dramatically overshoots. When you have a bond fund that owns thousands of individual securities and this fund needs to sell, what do you think happens? Who is actively looking to buy some 2022 maturity, 5 5/8 junior subordinated issue with $50 million outstanding? No one!! If some fund is liquidating, there won’t be any real bids on the screen because no one follows this issue. If you have $3 million face value of some obscure security that you need to dump, what fund is going to take the time and research it and then make you a bid? In the past, some prop desk would step in and warehouse that inventory, but Dodd-Frank killed all that. Now, when there’s a “bid wanted” situation, it’s simply bombs away. That’s what happened in Q1 of 2016. That is what will happen again and again—liquidity is down and when high yield gets hit, it really gets hit as everyone gets redeemed at the same time. In high yield, we should be looking for these dislocations with lots of excess cash—instead of waiting around fully invested earning our basis points.

Me: Agreed. So why are you fully invested now?

Him: I’m not fully invested!! We’re 20% cash—which is my way of saying that I am bearish as all hell. I want to be lightening up—I want to be almost all cash. Spreads are silly tight and interest rates are going up. It seems like an awful time to be fully invested, but I’ll lose my clients if we sit in cash and spreads don’t blow out right away. It’s the perpetual dilemma of asset management. Do what’s right for your clients or your business. It’s hard to do both. In the end, asset management is set up to aggregate assets, not to have great returns.

Me: Why don't you raise a fund that sits in cash and waits for something interesting to happen? Specifically market it that way.

Him: You're kidding right? Maybe I could raise it, but it would have to offer monthly liquidity to have any hope of getting investors. You're almost forced to do something, just to show returns and appear active. Even then, after a year or two, all the cash would be redeemed, unless we got lucky and got a real fat pitch during that time.

Me: That’s why I don’t want outside investors. I want permanent capital. It lets me think smart and act patient. I can sit and wait for the fat pitch.

Him: …And guys like me will be selling to you over and over at bottoms—it’s simply the current market construct where funds allow monthly liquidity on illiquid assets while having to stay fully invested.

Me: I know that all too well and it’s why I wait around with plenty of cash. It’s boring, but that’s where the returns are.

Him: I wish I could do that too…

Remember, something interesting always happens. Patience is key. Until then, it’s a whole lot of fun to travel the world.

Categories: Investment Strategy
Positions Mentioned: none
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So Why Are You Public Again?

October 9, 2014 9:10 AM

Now, I’m the sort of guy who likes to ask taxi drivers for recommendations—everything from best street food to favorite bars—especially when I’m visiting a new city. So, as we piled into the taxi from the airport, I asked the driver for some recommendations. “Don’t leave your hotel—it isn’t safe.” Ok, we’d already been warned the same by pretty much everyone we knew, yet we were still on the way to downtown Detroit for the invitation only, MicroCap Club Conference.

Here’s an epiphany—no matter what you think of Detroit, it probably isn’t true. To start with, no one took a shot at us and there is more to the local economy than cooking meth. In fact, Detroit seemed a whole lot nicer than we expected, after you look past the part about it desperately needing a paint job. The people were friendly, the food was excellent and we wandered around late at night in some “unsafe neighborhoods” without anyone once threatening us. Instead, everyone kept coming over, to warn us that it wasn’t safe and that we should go home—no wonder tourist numbers are down!!

Detroit Taco

The Kuppy rule of Mexican food is that, two bullet holes means tasty, but the best places have at least one window shot out... Let's just say that these were the best tacos al pastor of my life!!


However, I didn’t set out to write the story of Detroit—this is the story of the MicroCap Club Conference. To start with, 75 of the smartest investors were invited to hear pitches from 13 companies that were selected by the club. I was amazed at just how deep the group’s knowledge was—if there was a good business out there, they all knew about it—with a focus on those with a market cap of under $50-million. Which brings me to an unfortunate point, most of these businesses shouldn’t be public in the first place.

I kept hearing great pitches, but over and over again, my question was the same, “So why are you public again?” It all boils down to this, it’s a massive nuisance to be public and it’s quite expensive. You only go public if you intend to raise capital—lots of it—the idea that you can be public and raise a few million at a time, every few years, is just ludicrous. You need to be thinking of raising at least $25 million every five years--if your business plan doesn’t include massive equity-funded growth, you should go private.

detroit eggroll1

So, they take corned beef, a bit of cheese, wrap it in an eggroll and deep fry it. I took a 30-minute cab ride to try this. At first I found it a bit disconcerting to order through bullet-proof glass. Then someone got mugged in the parking lot and I see their logic a bit better now....haha

Detroit Eggroll 2

Unfortunately, greasy hands don't make for great camera skills...

I only want to invest with smart operators—how smart can you be if you have $2 million in EBITDA and you pay $1 million a year to be public? You could go private and make 50% more, talk about an accretive transaction, especially if management already owns a huge chunk of the company. If you cannot see that, then I don’t want to invest with you in the first place.

What good is a company that has minimal float, monthly trading volume of about $100,000 and no need for capital? Sure the shares are cheap and the business is growing rapidly, but the cost of being public will only grow with increased regulation. I went to this conference looking to buy shares, but I should have been thinking of buying whole companies. Over the next few years, hundreds of really great businesses will choose to go private—they shouldn’t have been public in the first place. The guy who figures out how to orchistrate this process will make globs of money for his investors. In the interim, there are a whole lot of companies to learn more about in preparation for this trend. You get explosive growth, plus a final take-out premium when they go private. Happy hunting...


(Click the link if interested in visiting the MicroCapClub)

Categories: Investment Strategy
Positions Mentioned: none
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July 22, 2011 1:25 AM

How do you make money in a boring range-bound market? Well, you certainly need to be resourceful. Finance guys have given us lots of toys to play with; the trick is to know which ones to use and how to use them correctly. I haven’t spoken much about options, but they are a key weapon in my arsenal.

Longtime readers of this site will know that I have a position in Mercer International (MERC: Nasdaq). The shares nearly doubled in price from when I first wrote about them, but in the past month, they’ve been rather weak. I attribute this to two causes; to start with, NBSK prices have come off a bit from multi-decade highs. This is natural following months of increased prices. The more relevant issue is that Mercer is redeeming $37 million in convertible notes. These notes convert at $3.30 a share and naturally, owners are choosing to convert these to shares and sell them. Clearly, not all 11 million shares created by this event are being sold into the market—the majority have likely been hedged long ago—however, even a few million shares of selling are pressuring an illiquid summer market and influencing the share price.

MERC chart

While there’s no way to figure out when this selling will end, I feel the selling is starting to get pretty crazy. The shares trade for something like two times run-rate cash flow from operations. I already have a full position, but at a lower price, I’d certainly be willing to own more.  This is where options come into play.

Over the past few days, I’ve written the November, 2011, 10 put for roughly $1.35. This means that I collect $1.35 in premium and in November, if the shares are trading for less than 10, I’m going to own more shares. Let’s do some quick math;

10 – 1.35 = 8.65                    1.35 / 8.65 = 15.6%                      

In very rough terms, I’m risking 8.65 if the shares go to zero as I’ve already been paid 1.35. That premium is a return of 15.6% on the 8.65 that I’m risking. One of two things will happen in November; either the shares are higher and I’ll earn my 15.6% which is roughly a 50% annualized IRR—clearly a very positive outcome—or I’ll own more shares of Mercer International at a cost basis of 8.65—which isn’t too bad either. For disclosure purposes, I recently bought a bunch more at 10, so 8.65 sounds like a gift. In either case, I’m a very happy hedgie.

Stock Options

Of course, if the shares go significantly higher, I’ll feel silly having only made 15.6%, but that’s why I have my core position. This is simply a way for me to either get more shares cheaper, or earn a yield in a no yield environment. I have a huge cash position, writing Mercer puts certainly beats the few basis points that my broker pays. Of course I have to take on some risk to play this game, but I want to own Mercer anyway. A few extra wouldn’t bother me one bit.

It goes without saying that you should NEVER write puts unless you have the cash to buy the shares if they are put to you. Puts have a way of making you feel real safe as you go about collecting your yield for months at a time. Eventually you will be forced to own something—usually a price that is much lower than what you ever thought it could trade at. Make sure you have the cash. Otherwise, you will be very disappointed. Every year, I hear of someone with a huge loss on some option they wrote and I wonder why it is that they wrote a few times their equity in puts. Don’t be that person. Only write on things that you want to own and at the prices you are willing to own it at. Don’t just write puts because they pay well—generally, the more generous the payout, the more dangerous it is.

In summary, options are a valuable return enhancer when used right. In the low yield environment that we currently face, they are a great way for me to utilize my cash balance and wait for better opportunities.


Disclosure: My investment partnership owns shares shares of Mercer International and has written November, 2011, 10 strike put in MERC. We may adjust these positions without further notice. This is not a recommendation to buy or sell any security.

Categories: Investment Strategy
Positions Mentioned: none
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Three Types Of Positions

January 27, 2011 11:56 PM

In my world, there are three types of positions—investments, speculations and trades. Before you buy a share, you need to mentally assign each position a category; otherwise you will regret it later on. Once you have your categories, it is bad form to change them. Risk control is critical and you have to make sure you adjust your positions correctly over time.

Let’s start with the most obvious category—investments. I invest in companies that I believe in—often looking for secular tailwinds to further power growth. These are businesses with strong competitive advantages, good management and high returns on capital. I intend to own these businesses for years.


Since I know these businesses well, I do not get scared by bad news or price volatility. At lower prices, I will usually buy more shares. I rarely sell them as they go higher. I’m not looking to make thirty percent or something—I’m looking to make five-fold or more. I don’t want to cut my gains short. I put these positions away and try to ignore the prices each day. I only sell when the shares have become ridiculously overvalued, or something has changed with the business or secular trend that I have been watching. I consider BDSec, Energold and my core gold position to be investments. Unless something changes, I intend to hold these.

Speculations are entirely different. These are educated guesses. Unlike an investment, it is harder to know if you are right or wrong. Often, it is a binary sort of situation or one with some elements of risk. For this reason, you have to size the position differently. I am fine with owning a whole lot of gold. I don’t want to own as much of a speculation. There is a not remote chance that I will be wrong. As a speculation goes in my favor, I want to sell a few shares. If it doubles, I sell some more. By the time it has tripled, I want to take a lot of my initial capital out and play with the “house’s money.” This isn’t because the business is bad or because I don’t like management, it is simply because there is more risk involved. Over time, if you are diligent about protecting your downside, you will make money on your winning speculations, but you will have losers as well

On a different note, if the shares decline in value, I am less likely to add to the position. It isn’t because I don’t like it—rather it is because I want to limit how much capital I can lose in any speculative name. I would consider Andean, Apex Minerals, Fibrek and Mercer to be speculations. I’m probably right about at least two of these four—I just don’t know which ones. Fortunately, I don’t think I will lose too badly on any of them if wrong.

Trader Yelling

Finally, there are trades. These are positions where you think you have some sort of quantifiable advantage over a period of time. Risk control is absolutely critical. I put these on when I think my downside is limited and there is a near term catalyst. Once I have a gain, I immediately set a stop loss. I simply refuse to lose more than a few percent on one of these positions. More importantly, I size them even smaller than investments or speculations. Thus far, Man Financial and US Global Investors are the only trading positions I have talked about. These are short term and I do not take many of them. I only do them when I see a clear catalyst and a lot of upside if right.

The danger is that you have a trade that starts working—all of a sudden you think you’re smart and you turn it into an investment. That’s trouble because now you don’t know what to do when it goes against you or how to manage it as it goes higher. I like to be very disciplined about these sorts of things. You need a game-plan before you put the position on otherwise you are bound to let emotions get in the way of intelligent decisions. This may all seem very basic--it is. However, I am surprised how many people get caught off-guard when something goes wrong.

I have a hunch that volatility is going to begin increasing after some months with abnormally low volatility. You need to be prepared and you need to know how you want to adjust your exposure beforehand. Investment, speculation or trade? What is it? Make sure you know now.

Categories: Investment Strategy
Positions Mentioned: none
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You Can't Argue With Stupid

December 23, 2010 2:14 PM

Over the years, I’ve developed a lot of rules for investing. These rules are meant to stop me from doing foolish things and over time, these rules have saved me a fortune. I am now adding another rule—You Can’t Argue With Stupid.

Let’s face it; some people just are not cut out to be public company CEOs. Everyone has their skills. Some guys are great with people and some guys are great politicians. Som guys can cut costs and some can motivate the troops. Some guys know how to really tell a story and get shareholders excited while some guys do brilliant acquisitions. However, it takes a special person to be a public company CEO. You need to be able to do all of the above and do it with a level of integrity that is almost unmatched in the real world.

It’s rare that you find a perfect CEO. Instead, you find someone with strong skills in some places and hope that they don’t completely blow it in other categories. Of the key skills, you NEED someone who is strong in operations. After that, you can be more forgiving. If they cannot tell the story, you just accept that the shares will always trade at a low multiple—I can live with that. What is dangerous is when a CEO doesn’t understand corporate strategy. That’s the place where you can lose everything.


When you look at creating shareholder value, you have to toil for years to build value. It’s very easy to destroy value. One stupid acquisition can do it, the same goes for raising capital at the wrong time. Some people are just comically bad at this stuff. There is nothing worse for a company than a CEO who thinks he’s good at it when he’s not. These guys are just walking patsies and they’re egged on by their investment banker buddies looking for fees. It’s a train wreck that you can see coming.

I cannot tell you how many times I have had an investment that seemed cheap and I was confident in everything except the CEO doing something stupid. Almost every time, my fear was eventually confirmed. As a large shareholder, you often get an inkling that something is about to happen before it happens. You can call the CEO up and try to stop it, but you just can’t argue with stupid. If they want to do something boneheaded, then they probably will. Now, you are stuck. You look at the company, it seems cheap and you justify holding on because it’s too cheap to sell. I mean, what are the odds that the CEO will do something that stupid a second time? Probably pretty high actually.


From now on, my rule is that I am hitting the bid as soon as one of these guys makes a sizable corporate mistake. If I cannot trust the guy, I am gone! I don’t care how cheap it is. I don’t care how many shares I have or how difficult it will be for me to get out. I’m not going to patiently sell and hope for a better price because the shares are cheap. No! I am going to blast my way out and just be done with the damn thing. You just can’t argue with stupid. Bad CEOs are walking time bombs. The shares might be cheap, the business might be going fine, but a guy who will destroy value once will destroy value a second and third time as well. I have been too patient with these guys in the past. I have tried to reason with them and educate them. Going forward, this will have to change. I’m selling all my shares before they can destroy everything.

Categories: Investment Strategy
Positions Mentioned: none
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