Monthly Archives: May 2011

Insider Trading – Great Idea, Too Bad It’s Illegal

We all know that investing is an exercise in uncertainty.  Every time I buy a stock, no matter how confident I am in my analysis, there is a slight moment of anxiety, a tightness in the gut, which whispers, “What if I’m wrong?”  I suspect that other professional investors would offer similar stories.  Such is the nature of the beast.  Wouldn’t it be cool if we could somehow reduce this anxiety, this worry, this uncertainty to zero?  Well, there is – it’s called insider trading and it’s illegal.

How illegal you may ask?  Well, Raj Rajaratnam, the founder of the hedge fund Galleon Group, was recently convicted of 14 counts of conspiracy and securities fraud because of it.  According to news sources, the maximum sentence he could face is 19.5 years.  Through the illegal activities for which he has been convicted, he made $63 million dollars. This may seem like a ton of money, but it pales compared to the total size of his hedge fund ($7 billion at its peak) or even his reported net worth of $1.8 billion (again, at the peak).  So why would a successful and obviously intelligent guy like Rajaratnam do this?  Herein lies the rub…

So, what is insider trading exactly?  In its most basic form, it is profiting from a securities transaction when you are in possession of “insider information.”  Insider information is simply some bit of data that is “material” and “non-public.”  The standard for “material” is that the information has to have the potential to move the stock price.  Something like a really good or bad quarterly report or a merger would be examples of this.  “Non-public” means that the data has not been released externally, that is, that only “insiders” are in possession of it.  So if the president of XYC companies tells you that he is going to buy ABC company for $40 a share and the shares are currently $20, you can make a profit of 100%, risk free by buying ABC now.  No risk, only returns.

Insider information is all around us.  Four times a year, the senior officers of every public company will possess insider information about their quarterly earnings.  Every investment banker, lawyer and corporate office involved in a merger or acquisition will have it.  Board of directors of public companies will be privy to strategic discussion that might involve insider information.  Clearly, possession of insider information is not illegal.   Acting on it is.  The laws guiding the use of insider information are very clear, and all persons mentioned above would be fully aware of the obligations to safeguard insider information.

Another interesting aspect of the insider trader laws is that they do not discriminate between the giver and receiver of insider information used to make illegal profits.  Both are liable if insider trading occurs.  So, if some insider gives material, non-public information to someone who then trades on it, both have violated the law.

Let me return to the question, “Why would an intelligent person do this?”  I’m no psychologist, but I think I’ve watched enough television to put together a few possible answers.  First of all, money is the big score card for Wall Street.  I’ve been told that after the first few million, the money becomes less important as to what it can buy or the lifestyle it can afford, and becomes a marker of one’s status – it’s becomes a defining part of who you are.  The more money you make, the more “winning” you are. Second, success often breeds hubris.  At some point, the same characteristics that lead to success on Wall Street – brains, drive, ambition, charisma, insight, etc, — especially when coupled with a long, successful track record – can lead to a sense of invulnerability.  And, as the proverb suggests, “Pride cometh before the fall.”  Those who end up trading on insider information may think that they will never be caught exactly because they are so smart and successful.  Third, everyone wants a sure thing.  This may be a common trait among all of us.

Recall that when Biff in the “Back to the Future” movie traveled into the future, his only thought was to get a sports almanac so he could go back to the present and make money placing riskless bets on sporting events.  I think this resonates with many of us.  As much as we would like to think that our time traveling would be spent communing with Newton, or watching the construction of the Great Pyramid, secretly we would really like to go back and buy a bunch of Honus Wagner baseball cards.

If the only sure way to remove all uncertainty in investing is to cheat (trade on insider information), and we don’t want to do that, are there other legal ways to reduce the uncertainty inherent in the process?  There are, but alas, they require hard work.  To adequately analyze a company’s stock takes time and effort – reading all public information about the company, crunching the numbers, speaking with knowable people about the stock, looking at past trends and developments, creating possible outcome scenarios, and then applying one’s own special intuition and judgment to the mix.  Even with all this, some uncertainty will remain.  But for some of us, the potential rewards of the exercise, both financially and emotionally, is worth the little bit of angst this uncertainty causes.

And I am sure that the fear of being wrong is much easier to stomach than is the fear of being caught…

Prudence, Speculation and Ignorance

As any regular reader of this blog can attest, I get a bit grumpy sometimes.  It’s not really my nature, but occasionally I see things in the media that really grind my gears.  The recent kerfuffle about gasoline prices is the latest thing to stick in my craw.  To the average person it must seem that some monolithic entity is raising gasoline prices simply to punish them.  In my view, neither the government nor the media make an honest attempt to dissuade this opinion.  The fact that oil company executives are invited to Congress to discuss the matter only reinforces the notion that the oil companies are somehow conspiring to punish all consumers of gasoline.  I am not an oil market expert, nor am I a paid spokesperson for the oil industry.  Yet, I feel the need to set the record straight on why we’re paying more at the pump, if for no other reason than my own sanity.

PRUDENCE.  My cousin Bill runs a trucking company.  Under normal circumstances, labor is his biggest expense.  With diesel prices where they are now, fuel is his biggest expense.   Every other freight mover is in the same situation.  Being the experienced business person he is, Bill can calculate with some precision his annual fuel consumption.  In his yearly budget, he also tries to estimate the cost, the dollar value, of this fuel.  “Wouldn’t it be wonderful,” he thinks to himself, “if I could somehow ‘lock-in’ the cost of my fuel for the year?”  Bill then hears about oil futures.  This is an instrument that allows the buyer to receive a contracted amount of oil (or heating oil, or pig bellies, etc.) at a future date at a set price.  By buying an oil future, Bill can hedge the cost of his fuel expense.  As fuel prices rise, so does the value of his futures contract, offsetting the impact of higher diesel prices on his business.  But buying futures is rather expensive, so Bill learns that he can buy on option on the future and have nearly the same “prudent,” hedging impact on his business with less money down, as it were.  As this practice catches on and oil prices rise, all freight operators may find it “prudent” to hedge this way. Obviously, all this buying of futures and options on futures puts upward pressure on oil prices.  But to be clear, the intent here for these buyers is to be “prudent” and help their business.

SPECULATION.  As oil prices rise, other people who do not own trucking companies think that buying oil futures and options might be a good way to make some money.  Hedge funds, mutual funds, prop traders and even individual investors can jump on this bandwagon and buy oil futures.  As one might expect, all of this buying also puts upward pressure on oil prices.  We have yet to discuss any fundamental reasons (all of the above could be labeled “technical” reasons) why oil prices start to rise.  The turmoil in Libya would be one good excuse for traders to begin buying oil futures.  Once the trend begins and the buying of futures accelerates, everyone so inclined can jump in.  Buying an oil future is no guarantee of profit.  In fact, when the price of oil backed off recently, one article I read suggested that hedge funds lost $100 million in one week because of this.  This is the nature of the capital markets.  Investors, even speculators, put their capital at risk in search of profits.  They understand that losses are also possible.  Notice how so far in our discussion about prices, that the oil companies are nowhere yet in the picture.

IGNORANCE.  Since 1992, an e-mail has been circulating that proposes a simple and elegant solution to rising oil prices – boycott one of the big-brand gas stations!  The “logic” of this note is that by boycotting brand A, the company will have to lower gas prices and we will all be happy.  When I received this e-mail from a well-intended family member, I sent back a rather pointed reply detailing the many flaws in this approach.  Retail gas stations are not all owned by the oil companies.  Many are independently owned by local business people. They buy gas from a distributor who buys it from a refinery, that buys oil and gas from the oil companies.  Margins at the gas station are thin, probably only a few cents on the dollar.  They tend to raise prices quickly as oil prices rise, but cut them more slowly when it falls.  All gas stations in any given area are affected the same way by higher oil prices.

Another point of ignorance I see is the venom often spewed at Exxon Mobil (XOM).  I do not own the stock and have no particular opinion on the stock or the company.  Yet, I see tons of misinformation about the company everywhere on the Internet and in the media.  In my view, Exxon’s only sin is being very big.  With a market cap of nearly $400 billion, it is the largest company in the U.S.  Its revenues of $383 billion also put it at the top of nearly any list you can find.  Yet, its net margin (a measure of profitability) is around 8%, much smaller than other big companies like Apple (AAPL) – 21%, Google (GOOG) – 29% or IBM (IBM) 15%.  According to Yahoo Finance, its income tax expense was $21 billion in 2010, five times as large as Apple’s and four times the size of IBM’s. Despite this, one can find commentary suggesting that Exxon pays no taxes!  Part of this is ignorance; part might be part of some agenda.  Either way it’s the wrong way to look at the issue.  All companies involved in exploration, development and extraction do amazing things.  Imagine the technology and money needed to drill for oil 2 miles below the ocean’s surface.  These companies spend billions on new technology to bring more energy to our use.  I suspect that they will even be the ultimate winners in so-called alternate energy sources as well.

My bottom line here is that consumers should not blame the oil companies for higher gasoline prices – it’s much more complex than that.  Also, we should not expect the government to “fix” this.  Our nation’s history is strewn with countless examples of unexpected negative consequences arising from politicians’ desire to “fix” problems by trying to control prices.

Survey Says: 80% of Americans are Clueless!

According to a recent CNN survey, 80% of Americans think that the U.S. economy is in “poor shape.”  In my view, this single data point speaks volumes about our country.

1)     With all due respect to my actuary friends, do surveys really reflect “our” views on any issue?  I remember in business school, our professors telling us that polls and surveys can be used as tools to shape opinions, not merely reflect them, by how the questions are phrased.  I suspect that there are standards to which the polls and surveys must adhere, but given that most stories that ran this story only cared about this one conclusion makes me a bit suspicious.

2)     How would the average person surveyed measure the health of the economy?  Economists tell us that the recession ended in June of 2009.  Over 1 million jobs were added to the economy in 2010.  The stock market has risen over 100% since March of 2009.  We could even cite stats such as rail car loadings, freight shipments, consumer spending, manufacturing indices, car registrations, etc. which all point to a growing and improving economy.  Anyone who has looked at any of the pertinent data would have to conclude that the economy is not in “poor shape.”  So where did “the people” get their opinion about the economy?

3)     More people watched the Super Bowl than voted in the 2010 mid-term election.  I sense that many Americans are focused on living their lives (and enjoying them as best they can) rather than analyzing the economy.  The fact that 8.5 million people watched the latest season premiere of “Jersey Shore” reaffirms my supposition.  Each of the big network evening news programs has fewer viewers than this…

4)     Thank the Founders for avoiding a pure democracy.  With greater frequency I am seeing survey results (like this one) that fill me with dread and fear.  I shudder at the thought that these polls and surveys could be turned into laws and regulations.  As bad as “mob rule” sounds, “mob ignorance” sounds worse.

I am not an economist, but I know how to measure the economy.  It’s not in “poor shape.”  I am not a pollster, but I can smell a tainted survey from a mile away.  I’m not sure who benefits by the population thinking that the economy is in “poor shape,” but I think someone must.  I am not a politician, but I do vote, and I really think what people may be suggesting with this poll is that politicians may be underperforming expectations in regards to helping our economy get better.

Although my main focus in life is making money for my clients, I do understand how government policies and the economy can affect this focus.  Along with many others, I hope that our policy makers see this survey what I think it might be – a call to action to “make things better.”  Whatever that means…

Musings on Risk

Lately I’ve been thinking about the word “risk.”  It seems that when discussing the capital markets many people use the word incorrectly.  In our everyday, normal existence, we have no problem identifying and understanding risk.  We teach our children that touching a hot stove or crossing the street with a red light are “risky” behaviors.  We know immediately that sky diving is a hobby fraught with more risk than, say, philately, numismatics, entomology or even etymology (although some gerunds can be a bit dicey…)

But when this same innate sense of risk that serves us so well in most aspects of our lives is applied to the capital markets, especially the stock market, our sense of perspective get totally distorted.  Many people equate “risk” in the capital markets with “losing money.”  That is to say, if one loses money in an investment, it was “risky.”  Before I count the number of heads nodding in agreement with the above statement, let me say without qualification that it is false.  “Risk,” as it applies to the capital markets, has nothing to do with losing money, especially realized losses.  “Risk,” as it applies to the capital markets, is simply a measure of the volatility of returns.  That is to say that a “riskier” investment will probably have a broader range of potential outcomes than will a less risky asset.

An easy way to understand this is to consider the least “risky” asset – cash.  Let’s say you can get a 3-yr CD from your bank at an annual rate of 1.75%.  Barring the bank failing, the risk inherent in this return is zero.  That is to say the variability from what you expect (1.75% per year) is zero.  The return is positive; the volatility of expected returns is zero.

Now consider a bond.  Right now the U.S. Treasury 10-year bond is yielding 3.286%.  This means that if one were to hold this bond to maturity the annual return will be 3.286%.  Could there be some volatility in this return?  If one would hold the bond to the end, the return is pretty much locked in.  However, the dollar value of the bond can fluctuate with changes in interest rates, so it would look like one is “making” or “losing” money over that period of time.  Hence, the volatility of returns (especially if one needed to sell the bond before maturity) would be greater than zero.  Thus, a bond is a “riskier” investment than cash.  But, as one would expect, bonds offer a higher potential return than cash.

Now consider a stock.  Here the variability of returns is enormous – from -100% to multi-year returns well over 1000%.  But, this math is misleading.  Most stocks don’t lose money for investors (over time) and only a few will provide the crazy returns at the other end of the distribution.  If one considers the stocks market as a proxy for a portfolio (a collection of stocks, if you will), we see that the returns are generally higher (and positive) than those for bonds, but the volatility is also higher.  The following chart shows this “normal” relationship between stocks and bonds.

We can also see that the longer one’s investment horizon is the more pronounced the difference will be between stock and bond total returns.

But what about the decade of the 2000s where stock returns were lower than bonds?  How does that work?  This is where the concept of valuation becomes important.  There have been only two decades in the last 100 years where bond returns exceeded those of stocks – the 2000s and the 1930s.  Both of these periods began with the stock market’s valuation near record levels following a huge bull market.  This chart shows how valuation affects potential returns for the stock market.

So in addition to the volatility inherent in stocks, one must also pay attention to their valuation.

Let’s consider some examples of “risky” behavior I have witnessed in the capital markets.  I have seen a young research associate get cash from his credit card to buy no-earnings Internet stocks on margin.  I have seen an IT specialist invest $100,000 (which I assumed was a large portion of his net worth) in one stock.  I’m not sure how the research associate faired, but I do know that the IT guy ended up selling his one stock position for about $800,000.  Even though he made an 8-fold return on his investment it was an incredibly “risky” move.  Remember, that making or losing money has nothing to do with the “risk” of an investment.

I also know some people who sold most or all of their stock portfolios in early 2009.  They thought they were reducing “risk” by moving to cash. They did this, but they also missed all the returns the market would have given them following the end of the bear market.

One way an investor can reduce the “riskiness” of owning stocks (which offer the highest return) is to own a diversified portfolio.  Holding about 30 stocks, as long as they represent all the major industrial sectors of the stock market (holding 30 healthcare stocks, for example, offers limited diversification benefits), provides the potential to achieve market returns with manageable volatility.  Picking cheap stocks may actually enable an investor to beat the market, again without taking more risk than simply owning the market.

Risks abound in nearly every aspect of our lives.  Understanding what “risk” really means in the investment arena can help us get through the tough times (as well as the boom times) and enable us to make mature, sensible and ultimately helpful decisions about our investments.