Wednesday, September 17, 2014

Random thoughts about investing

The Wall Street Journal has a fascinating interview with a venture capitalist, Bill Gurley, who says that "the venture-capital community or startup community is taking on an excessive amount of risk right now," i.e. it's a bubble, but that his firm continues to invest in startups because "choosing not to play the game on the field doesn't work."

Many investing gurus laud the benefits of specializing and developing extensive knowledge of one specific industry or asset class, but Gurley's interview demonstrates that specialization has at least one big drawback: if an investor defines himself as doing one thing, he'll have to keep doing that one thing regardless of how unfavorable market conditions become. Gurley is a venture capitalist, so he feels compelled to keep investing in startups even though he knows the risk/reward is terrible.

VIC writeups
I'm wary of VIC recommendations that get high ratings (6+) on a large number of votes. It suggests that all of the event-driven and value funds that would be interested in buying the stock have already bought it. My guess is that the best-performing recommendations have above-average ratings (5.3-5.7) and relatively few votes-- most people don't know about them yet, but the ones who know about them like them.

The housing market
Contrary Investor has a great article describing how investors are fueling the US housing market's rebound. It's a perfect example of reflexivity: investors have piled into "undervalued" real estate because they think it's bottomed, and their piling in has creating the price rise they anticipated.

Lehman Brothers
The Lehman Brothers bankruptcy examiner's report is eye-opening. Lehman's risk limits were meaningless: whenever management wanted to increase risk, the raised the limits or simply ignored them. During 2006, Lehman began dramatically increasing its exposure to leveraged loans but excluded them from its risk calculations. Then management belatedly included them and realized it had exceeded its risk controls for the previous several months.

Lehman's CEO was routinely unaware of important business and balance-sheet issues until other people brought them to his attention. Even if he had tried to stay informed, it would have been difficult for him to understand everything Lehman was doing because "At the time of its bankruptcy filing, Lehman maintained a patchwork of over 2,600 software systems and applications... Many of Lehman’s systems were arcane, outdated or non‐standard."

It's tough for investors to analyze large banks when their own managers can't.

Fifth Third Bank
John Hempton has an older article about Fifth Third Bank that's worth reading. He argues that 5/3 was able to dominate the Midwestern banking market because it had an entrepreneurial culture that rewarded managers for limiting operating costs and loan losses. This let 5/3 undercut its competitors in offering loans to the highest-quality borrowers and still make a lot of money. Eventually 5/3 saturated the Midwest, which left it with two choices: lower its loan standards or expand geographically. It chose both, buying a lot of brokered home equity loans from outside its home market, and suffered the consequences when the housing bubble burst.

My takeaways are that:
• Even the best companies face limits to their growth strategy.
• When they reach those limits, they often make bad decisions in an effort to continue growing at the same rate.

Ebay and Bill Me Later
Ebay's acquisition of Bill Me Later may be another example of a company reaching its growth limits and recklessly pushing past them. Two things give me pause. First, it looks like Ebay seriously overpaid for BML in 2008, which raises the risk that it's growing BML's loans too quickly in order to justify the purchase price.

Second, Ebay finances BML with its offshore cash. Apparently it can do this without paying repatriation taxes. A Reuters article quotes the CEO as saying, "BML is a really productive use of the offshore cash. It earns a lot more than just 1 percent... [We're] taking every opportunity to repatriate cash when we can." Reading between the lines, it seems that being able to use the stranded offshore cash has induced Ebay to make loans it wouldn't otherwise make.

1 comment:

  1. Consumer lending is a sword that can cut both ways. On one hand, you can make a lot of money by selling debt to debt addicts. This is more true when you have little competition.

    On the other hand, of course you can hurt yourself with dumb lending.

    Because Ebay isn't a pure play on Bill Me Later, there isn't an opportunity here long or short by understanding BML.

    If anything I think that Ebay's biggest problem is that it may be overpaying for acquisitions. Like other Silicon Valley companies, it wants to become a hot startup company by buying up hot startup companies.

    Its greatest assets are Ebay and Paypal. These companies will be able to make unusual returns on capital because it's so difficult for competitors to replicate what they do.


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