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In Which I Answer A Question About The Volatility ETNs

The prevailing wisdom on the volatility ETNs, VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) and iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ), is that XIV will rise over time and VXX will fall as long as the term structure is in contango more often than it’s in backwardation. A recently elapsed period, slightly longer than a year, makes apparent that’s not the case. Over the period from 2-Mar-2015 to 18-Mar-2015, both XIV and VXX experienced substantial net losses. VXX declined -27.5%, while XIV declined -29.9% (Figures 1 and 2). Figure 1. XIV prices Figure 2. VXX prices This loss for both ETNs over a prolonged period occurred while the term structure was in contango 73% of the time – 2.7X more often than it was in backwardation, as Figure 3 shows below. Why is that? Click to enlarge Figure 3. Percent Contango from 2-Mar-2015 to 18-Mar-2016 One way to answer this question is by reference to variance drain. I picked the period 2-Mar-2015 to 18-Mar-2015 for illustration purposes in this article because it happens that the average of percent daily returns over this period is very close to zero for both ETNs. You can see that in Figure 4 below, which shows running totals for the percent daily returns for the indexes of both ETNs. Running totals for each end at zero, which of course means that the average percent daily return was also zero. Click to enlarge Figure 4. Running total of daily percent changes. The concept of variance drain was introduced by Tom Messmore in the context of comparing investment advisors based on average yearly percent returns. In brief, average periodic returns is a mathematically incorrect basis for comparison, since percentage gains accrue multiplicatively, not additively. This is best explained by example. Suppose you invest $100 in asset X. On Day 1, its market value falls by 25%. However, on Day 2, it rises by 25%. The average daily rate of return is (-25% + 25%)/2 = 0%. But your investment has not returned to its original value. Instead, it is now worth: $100*(1-0.25)*(1+0.25) = $93.75 A 6.25% loss. Since multiplication is commutative, order doesn’t matter. Investment Y that performs inversely to investment X, gaining 25% on Day 1, then losing 25% on Day 2 will also lose 6.25%. In general, this can be expressed as: I 0 *(1-α)*(1+α) = I 0 -α 2 , where I 0 is the initial investment. Clearly, the larger α is, the greater the net loss. Note that variance drain is not an actual loss. There’s no counterparty to variance drain. Nor is it a frictional drag in the sense that fees or leverage cost are. Rather it’s a demonstration that average periodic returns do not represent longer-term returns over multiple periods. In the case of the volatility ETNs XIV and VXX, the inverse relationship of their daily percent returns simply does not carry over to longer time periods, except by chance. What this means is that the question of why both XIV and VXX lost value, which several readers have raised in the comment sections of recently published articles on the volatility ETNs, is only a question if one starts from an incorrect assumption – namely that XIV and VXX are inversely correlated over time periods longer than one day. Since they’re not, both may lose value over time. Additionally, during time periods longer than one day when one loses as the other gains, those changes should not be expected to be equal and opposite. It’s also worth noting that excess of contango during this approximately one-year period did not result in XIV gaining value. On the contrary, it lost a substantial amount of its prior value. I’d like to encourage those who trade these ETNs to be certain the risks are well understood. Among those risks is the risk of placing too much faith in axioms and strategies that were formed during a period when the VIX was generally calm and declining. They may not apply during prolonged periods when the VIX is rising or is more frequently spiking. Disclosure: I am/we are long XIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I may initiate or close a long or short position in any of the volatility ETNs over the next 72 hours.

The Psychology Of Investing

The longer that I’ve been at this investing thing, the more convinced I am that the difference between an average investor and a good investor is all in the mind. I’ve been investing for over 15 years now and I’ve learned a lot along the way. I think it took me the better part of a decade to work out what makes a good business and a quality investment. The much harder aspect of investing is to summon the courage to commit your capital in the face of hundreds of other people telling you otherwise. These people can be respected investment analysts, talking heads on TV, and even your own friends and family. I now have a pretty good idea of what makes my cut as a high-quality business. That tends to be a business that produces high returns on equity in excess of 20%, strong free cash flow generation and conversion of revenue to free cash flow, all combined with a strong market opportunity and rapidly growing topline growth. Now these businesses aren’t necessarily easy to find; however, when you do identify them they are easy to spot. The harder aspect of investing is to commit your capital to these high-quality opportunities that you’ve identified in the face of 101 reasons not to do so. I’ll give you an example. Celgene (NASDAQ: CELG ) is an exceptionally high-quality business with strong rates of revenue growth and good cash flow generation. However, when you look at the stock, it’s had a rough go of things over the last three months. My own purchase is down a good 10% from where I made it. There are all manner of concerns with the stock, most of which I believe will prove to be relatively immaterial over the next five years. The biggest threat is the regulation of drug pricing under the Democrats. There is also the threat that Celgene may be unsuccessful in diversifying its revenue base away from Revlimid, its chief moneymaker. All those things are likely to be unfounded. It’s not in the Democrats’ best interest to make drug discovery unattractive to commercial interests. That will just dry up funding and investment into areas of medicine that have a real human need. Celgene also managed to negotiate a deal with the generic drug manufacturer that will effectively push out its window of exclusivity to almost 2025. That’s almost 9 years for the company to explore new partnerships, invest in new R&D and acquire potential companies that can diversify its revenue base. Yet, despite of this, the company’s stock price remains stubbornly near one-year lows while other companies are now routinely making 52-week highs. I’ve committed capital to Celgene; however, I feel I twang of remorse whenever I check my trading account and see this position solidly in the red while most of my other recent growth investments are now well in the green. I was thinking further about exactly why that is in my case. I don’t think it’s an aversion to losses. Rather I believe that in general we all have a desire for positive affirmation. That’s true for us with our friends with family and even in the workplace. We all want validation that we’ve made the right choices in all aspects of my life. Unfortunately in investing, things don’t this work that way unless you happen to ride a solid growth stock that just consistently appreciates month after month and year after year. You’re not going to get positive reinforcement of your investment decision continually. If you’re looking at taking deep value positions where you have the potential for the greatest upside, you need to lose the desire for positive affirmation and that’s not easy. In fact, it’s really hard because when you see that position continuously in the red, it makes you think that others in the market know something that you don’t or that you have missed something in your analysis. Deep value investing is a pretty lonely game. Invariably it means going against the crowd in almost every bet that you make. And this is where Buffett really stands out for me . More than any other investor, he has shown a unique ability to shut out external influences on his thinking and just go with his gut conviction in purchases of American Express (NYSE: AXP ), Solomon Brothers and to a lesser extent Coca-Cola (NYSE: KO ). These investments were all done at times when those companies were on the nose. American Express suffered from the effects of a salad oil scandal which effectively cut the company’s share price in half. Solomon Brothers suffered from a devastating bond trading scandal which at one point threatened it with bankruptcy. Even Coca-Cola ( KO ) looked like a business that was heading for a sustained slowdown at the point when Buffett invested, with annual revenue growth declining from 17.1% the decade earlier to just 5.2%. I look at my own current list of holdings, and there are more than a few that have suffered or are suffering through crises where investors doubt their ability to make a comeback. CochLear ( OTC:CHEOF ) was the most recent example of a situation where a devastating company event was successfully overcome by the company. Before 2011, CochLear was a high-quality, high-growth business delivering cochlear implants across the world. In fact, the business was the market leader for implants. Unfortunately in 2011, the company suffered from a product recall that sent the company’s share price down by almost 40%. When you are a healthcare company with a reputation for high quality, a product recall event could potentially be a devastating reputational blow. I recognized the opportunity and went in guns blazing . CochLear subsequently recovered lost market share and continues to grow strongly. The net result is that the share price has more than doubled from the lows that it reached during this period of crisis. However, it wasn’t smooth sailing. In fact, the company’s share price was depressed for a period of six months after I made my investment and there was more than an occasion there where I had to reflect and think about whether I’d made the right move. In more recent times, investors have been making assumptions that Chinese economic growth is going to slide to a standstill, and with that, the prospects of Baidu (NASDAQ: BIDU ) and Alibaba (NYSE: BABA ), two of China’s great growth stories will be heading down the toilet. However, both these companies have such strong competitive advantages that I took the view that they will likely prosper for a long time and proceeded to buy. In less than a month, the market subsequently reassessed its view of the Chinese recession and, more importantly, the long-term prospects of Baidu and Alibaba, and I find both positions up more than 17% from where I made my initial investment. The one remaining position that I have which is a real test of my conviction in the company and its ability to overcome adversity is my investment in Chipotle (NYSE: CMG ) that I’ve written about here extensively. The company has significant problems in regaining customer confidence in relation to its E. coli and norovirus scandals. This is a play where you have to believe that customers will ultimately forget these incidents over time, and the company can bring back customer trust and reestablish its position as a provider of high-quality food. However, it’s hard to see this as a long-term outcome when you’re bombarded with images of empty stores and constant analyst downgrades and reminders of incidents on social media of customers getting ill. I look at this investment as a test of my long-term ability to pick a company that has the potential to rebound after significant negative company events, and also as a test of my ability to stick with a position whose outcome is uncertain but which has the potential for significant upside. Investing is as much a test of your character as anything else. It tests the level of conviction that you have in your research and your ideas, and it’s the ultimate test because you literally have to put your money where your mouth is and be prepared to wait a long time to see if your conviction was correctly placed. Those that have the ability to master their emotions and drown out the noise truly have the qualities to be successful long-term investors. Given his track record of making many such successful contrarian plays in the presence of significant negative events and placing large amounts of capital in these plays, I place Warren Buffett at the very top of investors with the greatest mastery of their psychology. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

If All Investments Were Private

This piece is another one of my experiments, please bear with me. “Measure Twice, Cut Once” – A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” – Warren Buffett Imagine for a moment: The public secondary markets didn’t exist Investment pooling vehicles were all private, and no one published NAV estimates Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation. This includes short-term debts like commercial paper. Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly. In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date. Accounting rules are only partially standardized. Deposit insurance still exists. So does limited liability. In this thankfully fictitious world, what would investing be like? The main factor would be that liquidity would be dear. Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study. The 4 Cs of credit would be present with a vengeance – character, capacity, capital and conditions – and character would be chief among them as J. P. Morgan famously said. This would be true even if one were investing in the stock of a firm, rather than the debt. Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get. You’d have to be very certain of what you were doing. Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms – we take for granted how information flows today, but with private firms, you are subject to the board and management. What do they choose to share with outside passive minority investors? Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.” It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.” Why would private firms choose to be open with outside private minority investors? They want a continuing flow of capital, and with no secondary markets, that can be difficult. Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, ” There’s a sucker born every minute .” Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets. The same would apply to the debt markets. The fourth C, Conditions, would also impact matters. If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights. You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent. The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally compelled, might not find it in their interests to be open. Control is a valuable option, one that is only surrendered when the situation is virtually hopeless. That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.” And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams. Back to the Present “…[R]isk control is best done on the front end. On the back end, solutions are expensive, if they are available at all.” – Me, in this article , and a bunch of others. The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept. All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification. If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens. The same is true of corporations needing liquidity. Buffett said something to the effect of, “Get financing before you need it; it may not be available later.” It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders. (True for me, too.) The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.” Beyond that, realize that character does matter. A lot. The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact. It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless. But consider those that try to warn about financial disasters – they do not get listened to until it is too late. Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc. Very few listen to them, because seeming success talks far louder than an outsider. My counsel is the same as always, just look at the risk control quote above. But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?” Then measure twice, thrice, ten times if needed, and cut once. Disclosure: None