Financial Reference

This was one of those weeks financial writers love. They finally have something easy to write.

In case you actually had something important to do, and didn’t hear about the huge losses this week in the market, I will recap the week for you. The market (i.e. the Dow Jones Industrial Average) started the week at 13,850 and ended at 13,250, a 4.5% slide.

Or better yet, here is a graph.

According to the press, the decrease was due to a tightening credit market and mixed earnings reports. Tightening credit markets are evidenced by a more sane LBO financing market. Mixed earnings reports means good earnings, “but we have to blame something for the decline, and it is earnings season…”

The reaction to this type of week is typical. Finally financial writers can write about something important. Something that many average investors are thinking about. “Is this the beginning of the end of this bull market? How should I prepare for the coming bear?”

Well, to be honest, your strategy shouldn’t change.

You mean nothing should change, even after on of the worst weeks in the market? Yes. Because nothing has changed: the bonds that are now considered risky we always risky. The investments that were good buyout candidates (due to good cash generation and low debt) are still good companies to own.

The market, though it’s down 4.5% in the last week is still about the same level it was in May. The market as whole, particularly large caps, offer many opportunities for investment.

This last week was a huge week only in the sense that it will create more attractive investments.

I am bombarded daily with emails promising that if I pay them a monthly fee, I will be able to retire early. Usually, they are offering their unparalleled ability to select stocks. The most common litterers in my inbox are The Motley Fool and, more recently, Investopedia.com.

The most common sales tactic involves a statement like: “This strategy has returned x% over the last y years. Don’t miss out!” Their logic always seems to prey on those who don’t want to fall behind their neighbors. If other people are making this money, I better make it as well. I can’t be left behind.

The reason they do so is they want us to analyze these “investment” opportunities with fear and greed rather than intellect. Fear and greed lead to speculation — the search for short term trading profits. While speculation may work for some, it usually ends with disappointment.

However, if we think of investing as capital allocation instead of as the search for profits, we are far less likely to fall for the speculation-pushers. Investing as capital allocation means that we look for the best long term options for our dollars. It is more akin to acting like the CFO of a corporation, trying to allocate capital to the highest return investments, rather than acting like a gun-slinging Wall-Streeter.

An investor allocating capital looks at the projected returns the company will likely earn on capital and the current valuation. Short-term considerations, such as next quarters earnings or technical indicators are only distractions.

Thinking like a capital allocator, rather than trying to predict future prices has helped me earn great returns for my investors and I hope it will work for you as well.

I received some “research” in the mail the other day about a company called Tubearoo (Ticker: TUBR.PK). Apparently, they are going to be the next MySpace or YouTube and get bought out for hundreds of millions or perhaps even billions of dollars. I’ld hate to be the one who missed out on that. Especially after they sent me glossy research telling me it was going to happen.

There are some major differences between TUBR and the other companies that make a buyout unlikely. In fact, I question whether the company can continue as a going concern.

In the ten years since the company was founded, it has been able to recognize $960 in revenue. Each quarter the company is losing $40,000. They have less than $200,000 in cash and have $300,000 in debt coming due next February. Somehow the price of the stock reflects a market value of around $140 million.

I doubt a company with such a history of non-performance will be able to refinance it’s debt. If they can’t refinance, they will be forced to sell equity if they can; unless operations improve substantially, they may be forced into bankruptcy.

In the meantime, a shareholder will continue to send out research so he can, presumably, drive demand for the supply he is releasing into the market. Every few months he releases more “research” into the market. Please don’t fall prey to such marketing efforts.

I just wish I could short the stock. Since the stock trades as an over-the-counter stock, we can not short it. If we were allowed to short stocks built up by the puffery of interested parties, less people would be sending out “research” like this and fewer people would be trapped by such false claims. Not allowing investors to weigh in and vote in these circumstances is anti-capitalistic and encourages misleading claims. Hopefully one day we will help to bring down such shady operators.

The most controversial new tax law being debated in Congress is a new tax on carried interest. If you listen the media, the debate is about balancing the budget on the left versus “the war on wealth” on the right. What has been lacking in the coverage is facts and logic.

Carried interest is, in effect, profit sharing for the managers of hedge funds, venture capital firms, and other partnerships. These partnerships usually charge the non-managing partners a percentage of profits in addition to a fixed fee. The percentage of profits charged is called a carried interest.

Currently, the carried interest is taxed as a capital gain. The new law would tax it as income. People should not be asking whether this is a good revenue source or whether this is an attack on the rich. The question is whether the character of this gain is a capital gain or income.

The logical answer to this (and this is obviously not a self-interested conclusion as I run a hedge fund) is that this is income. Carried interest is a performance-based bonus earned by the managers of the partnership. Bonuses are taxed as income.

Capital gains are taxed at a reduced rate because the capital has already been earned as income and taxing capital gains at a high rate would, arguably, be over-taxing. Carried interest is not a return on capital already earned. There is, in fact, no capital. It’s awkward to argue that it is a capital gain when there is no capital at risk.

While I empathize with other hedge fund managers arguing against a “new” tax, the problem is that it is a loophole being closed rather than a new tax. The character of the gains is clearly income, rather than capital gain.