Investment Reflections

Why Have Financial Crises Become More Frequent?

October 12th, 2011 by Yehuda Fruchter   |   No Comments

Hi Frank,

A brief history read would demonstrate that financial crises have been a staple of our economy for a long time. However, it does seems clear that the frequency of financial crises has increased significantly in the last 12 years or so. Since 2008, the volatility in financial market appears to reflect fears of a new financial crisis nearly every single year, as you mention.

The question is why have financial crises become more frequent?

I think there are two basic answers to this conundrum:

1. Casino Capitalism has usurped all other forms of capitalism.
Casino Capitalism is a recent interpretation of capitalism that is unfortunately now driving political and economic policies. Casino Capitalism is founded on the belief that having individuals acting in their own selfish interest to bet on the direction of financial prices, is the best way to allocate economic resources in society. A practical description of Casino Capitalism would be that economic resources of society are best allocated when you have tens of thousands+ of people sitting in front of Bloomberg and trading monitors all day betting on a myriad of abstract, and mostly fabricated, financial products. There are many flaws to Casino Capitalism, but obviously the main drawback is that the economy becomes increasingly dependent on emotional reactions to what are ultimately unpredictable short-term price movements of financial products that have little relationship to reality. Basically the economy becomes like a roulette wheel. As capitalism becomes more unpredictable, uncertainty rises, and crises become more frequent.

2. An Explosion of Derivatives Has Made It Easier than Ever Before in the History of Capitalism to Make Huge Sums of Money by Betting on a Crisis
With the proliferation of derivatives for large financial institutions, and even now for retail investors (e.g. ETF’s like SKF), the amount of money that can potentially be made from betting on crisis has never been greater or easier. And when there is money to be made, you can be sure that capitalists will try as best as they can to tilt the odds of profit in their favor. So with big bets riding on a crisis, it’s no wonder that somehow new crises develop out of nowhere nearly every year and these crises are exaggerated to a degree that are almost comical relative to their actual economic relevance. While in former economic periods the profits were greatest when a capitalist created something of value or invested in promising enterprises, there is now a huge incentive in our economic system to create crises and wreak economic havoc and confusion in order to profit from a decline in financial asset prices.

Margin of Safety: Why Does It Exist?

October 5th, 2011 by Yehuda Fruchter   |   1 Comment

“Even as I approach the gambling hall, as soon as I hear, two rooms away, the jingle of money poured out on the table, I almost go into convulsions.”

FYODOR DOSTOEVSKY, The Gambler

There are a myriad of intellectual problems and contradictions inherent in valuing public-traded equities. Given this valuation conundrum, why is there always a massive mountain of money thrown at stocks if there is apparently no logically coherent system to value these stocks, in theory?

This is a question that has occupied my mind for years, and becomes especially acute during long Market corrections. How does one find the courage to buy stocks when the margin of safety of publicly-traded stocks is unknown? Why does a margin of safety exist?

Today, it occurred to me that the answer to this conundrum is quite simple: The Gambling Instinct. Human beings have a propensity to gamble and the stock market provides a perfect outlet for this gambling instinct.

So where is there a margin of safety? It’s not because of earnings, book value, or any of the other myriad of explanations given to support public stock prices.

The real basis for a margin of safety is based on the sound prediction, supported by basic human psychology that the gamblers will be back.

Electronic Medical Records: Will Streamline Health Solutions Benefit from the Gold Rush?

September 23rd, 2011 by Yehuda Fruchter   |   1 Comment

Those readers who are following our Streamline Health Solutions (STRM) recommendation, may find this recent recent Bloomberg article of interest.

Bloomberg reports that tech investors and entrepreneurs see a gold rush akin to the social media boom in the Electronic Medical Records (EMR) industry. Interestingly, many in the industry see major consolidation as a raft of companies enter the EMR field. “Industry consolidation is real, and it’s happening now,” says Allscripts Chief Executive Officer Glen Tullman. That has companies scrambling to lock in customers early. “Because the switching costs are so high,” those with the biggest market share have the best shot at surviving, says Sean Wieland, a technology analyst at Piper Jaffray.

At Envoy Global Research, we still believe that Streamline Health (STRM) represents a very interesting opportunity for those looking for small cap investments in the healthcare information technology (HIT) market. Considering the company’s current revenue base as compared to the enormous potential of EMR in the healthcare information technology market, we think that STRM has very significant upside potential over the next 3 to 5 years. The company can essentially be looked at as a venture capital type of investment in the public market.

For those who are unfamiliar with Streamline Health (STRM), the company’s core technology is a secure document management repository called accessANYwareTM that collects, indexes, and intelligently routes unstructured, document-based medical and financial data throughout the enterprise. Streamline Health’s solutions assist hospitals in meeting the requirements of “meaningful use” to become eligible for significant incentive payments as outlined in the HITECH act (a provision of American Recovery and Reinvestment Act of 2009), and they are an integral part of an enterprise-wide Electronic Health Record (EHR).

Under the guidance of a recently appointed new CEO with an excellent track record, Streamline Health, is currently undergoing significant transformations that may position the company for large growth in the next few years. Notably, Streamline is very focused on offering its HIT solutions on a Software as a Service (SaaS) basis. The company’s recent quarterly conference call provides an excellent overview of the changes at the company and the opportunities over the next few years.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in STRM. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Are Stocks at a Bottom?

September 23rd, 2011 by Yehuda Fruchter   |   No Comments

Whenever stocks suffer a major decline it is natural for investors to ask whether stocks are at a bottom? Specifically, what signs can you look for to signal a stock market bottom?

In attempting to answer this question, it is first important to review three key facts about stock market bottoms:

  • It is impossible for anyone to know when there is an exact stock market bottom.
    The complexity of modern financial markets and the sheer vastness of the financial system, make it impossible to accurately understand or predict overall Market dynamics.
  • It is not important to buy at the bottom.
    The goal of investing is to buy low and sell high, not to buy at the lowest price and sell at the highest price. Buying somewhat near the bottom will provide significant profits, as long as you have patience and the financial fortitude to withstand some near-term losses (remember, if you can’t suffer losses, you can’t win in this stock market game – Fear of Losses Leads to the Dark Side).
  • Stocks do not bottom when economic or business fundamentals improve. In fact, many times stocks bottom on the worst possible news.
    This quote sums up this last point quite well:

    “Market bottoms are less about an improvement in the fundamental situation, whether the economy or outlook for earnings, and a lot more about getting rid of all the anxious investors.” – Bruce McCain, CIS, KeyCorp.

Despite the above points, it is still, of course, vital for investors to buy low, and so we need to establish some guidelines to at least help us navigate stock market corrections.

In my view, what causes a stock market bottom is a slight change in investor sentiment. Stock prices are, in reality, mostly influenced by human emotions, which are entirely transitory, and quite malleable. Nobody can withstand any emotion, let alone fear and despair, for any extended period of time. Eventually, because of some tiny spark of positive news, emotions change and fear turns to relief, and despair to hope.

One of two things always happens around stock market bottoms for the Market, in general, and for individual stocks: Either there is a realization that the economic reality is not as bad as was feared, i.e. there is relief, or there is a belief that the dire economic situation is not getting any worse, i.e. there is hope.

So when searching for a bottom in either the stock market as a whole or in individual stocks, it is important to look for news (or more appropriately interpret the news) that indicates either that economic fears are exaggerated and/or that the fragile economic situation has been stabilized.

In terms of the current market sell off, I think there are two approaches here. As for the US, I do believe the economic risks are exaggerated, and the current crisis seems to actually benefit the US in many ways. As such, I would imagine that in due time, the economic news for the economy, in general, and for companies, in particular, will show that the reality is not as bad as we feared. As for the Euro crisis, I think it is clear that the situation is actually spiraling out of control. So for the Euro, I would look for news or political actions that signal stabilization.

Incidentally, if you invert the above reasoning for finding stock market bottoms, you come to some pretty guidelines for finding stock market tops, both for the Market, in general, and for individual stocks. Basically, stocks top when either there is a realization that the economic reality is not as good as was projected, i.e. expectations are dashed, or there is a belief that the strong economic situation is not going to get any better, i.e. things have peaked. The tricky part about tops is that business fundamentals always look so good at the top, it’s difficult to comprehend why expectations are not met and/or why the situation has peaked. For this reason, it is always important to be wary of good news and to think of selling on positive news.

Why are Computer-Based Models Producing Big Returns?

September 22nd, 2011 by Yehuda Fruchter   |   No Comments

There was an interesting article today in Barrons on how Hedgies Using Computer-Based Models Producing Big Returns.

One of the reasons given in the article for the success of computer-based models is that they are “doing well in this environment because their models effectively identify macro risks and allow managers to hedge against them.”

I think this explanation is probably false. I think the reason why computer-based models sometimes outperform, has more to do with their lack of human emotions, as opposed to the actual theories behind the models. In fact, most of the good models used are, surprisingly, based on simple theories, and the more complex theories are, in general, simply fantasies which work till they don’t work.

The problem for humans, is that when a human trader or investor gets involved in buying/selling decisions, strong emotions come into play, which greatly influence results. Humans are by nature greedy and fearful. Greed and fear work to undermine every economic pursuit, even if the underlying investment theory is correct.

For example, it is greed that keeps us from selling stocks that are obviously overvalued. Computers, of course, have no emotions. So unlike humans, computers, will have no problem, selling a stock when it reaches a fair valuation. A computer will not worry, like a human would, about missing the next few points of upside.

Human investors should try to emulate computers and eliminate emotion from all investment decisions. This is easier said than done, of course. The pull of greed and fear are almost impossible to overcome and it is the rare individual who doesn’t succumb at one time or another to these powerful emotions.

Do Small Cap Value Stocks Offer a Safe Haven During Market Corrections?

September 21st, 2011 by Yehuda Fruchter   |   No Comments

A common question for most investors is whether they can survive market corrections by hiding out in small cap value stocks. In theory, a low valuation should provide some downside protection for an investor.

However, as the current market correction has demonstrated, this theory is false. In fact, as you can see below, during the 2011 stock market sell-off, small cap value is getting absolutely killed. The sector that has fared the worst is actually micro cap value.

As of September 20, 2011, the US Russell Indexes show the following:
YTD Russell 2000 Index: -11.20%
YTD Russell 2000 Value Index: -13.60%
YTD Russell 2000 Growth Index: -8.80%
YTD Russell Microcap Growth: -13.49%
YTD Russell Microcap Value: -17.60%

It’s possible, of course, that the Russell Indexes are faulty, to the extent that their criteria for inclusion in the value or growth indexes are misguided. However, without analyzing these criteria, I still believe that the Russell indexes, taken as a whole, provide a good “birds-eye” view of how small caps are performing in the Market.

So why doesn’t value provide some degree of downside protection during market sell offs? The answer appears to be, that as covered in other posts, the stock market is more a function of liquidity preferences, than equity valuations.

In every major market sell-off, nearly all stocks will decline. However, the reality is that stocks with the least liquidity, i.e. small cap value and micro cap value, will go down the most, irrespective of specific equity valuations.

Does that mean that valuation is a meaningless pursuit when it comes to equity selection? We’ll get to this important question in another post.

What’s the Difference Between this Internet Bubble and the Last Internet Bubble?

June 30th, 2011 by Yehuda Fruchter   |   1 Comment

Here’s the only difference between this current Internet bubble and the last Internet bubble: The current Internet bubble is much bigger and it’s just getting started! A fair estimate is that the current bubble will be, or is already, at least 10X bigger than the previous Internet bubble. I’ll get to the implications for investors from this unprecedented new equity bubble, in future posts. But for now, here are some of the basic facts.

When Amazon.com went public back in May 1997, the company’s post-IPO valuation was a measly $440 million (Reference). Yahoo! went public at around a $1 billion valuation (Reference). Ebay, which went public in September 1998, had a valuation of nearly $2 billion on the day of offering (Reference).

In terms of current Internet bubble, here are a view reference points. LinkedIn (LNKD) recently went public and now sports an $8.5 billion market cap! That’s 20X Amazon.com’s IPO valuation. Demand Media (DMD) has a post-IPO valuation of $1 billion. And now for the real bubbles: Zynga is projected to have an IPO valuation of up to $20 billion. Groupon is also claiming a $20 billion IPO valuation. Living Social, a Groupon copy cat, is planning a $10 billion to $15 billion IPO.

A quick questions: Is the potential business opportunity over the next decade of, for example, Living Social, really 20X greater than the potential business opportunity Amazon.com encountered 14 years ago?

And in terms of capitalization: just using some conservative estimate of the amount of potential IPO’s (using SharesPost.com), and the future valuation of these companies (using comps), would yield an unprecedented capitalization of current Internet companies as a either a percentage of US GDP, US technology companies in general, or even the entire Internet economy. How does the total capitalization of these new Internet companies compare to the potential profit contribution of these companies in the US economy?

These are two interesting questions to consider. But for now, it pays to remember that finance is always about the future, not current reality. Therefore, anything is theoretically possible and justifiable in the world of finance, since it is our imagination which determines the future.

Banking Expert: Bailout Not Necessary, Industry Can Take Losses

September 25th, 2008 by Yehuda Fruchter   |   No Comments

Here’s an interesting interview with banking industry expert, Bert Ely, who says that the banking industry can handle this mess internally and does not need subsidies.
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

Some interesting quotes:

I have run the numbers looking at the capacity of the industry to pay the tab. Assuming that bank insolvency losses don’t get way out of line, which I don’t think they will, then the industry can handle it. It’s not going to be cheap, but the banks can handle it and clean up their own mess. The losses will feed back through the industry to depositors and borrowers in the form of lower rates on deposits and higher cost of loans.

Look, all of the fallout we are seeing in the markets today is part of clearing the detritus from the last speculative bubble. The housing bubble has to be allowed to collapse in order to clear the markets. We have a very necessary correction process underway. But this process creates a lot of pain and loss. I don’t like that, but we have to clean up the mess and take the pain in order to get the economy back into balance. In collapsing bubbles you have collapsing companies. Japan tried to muddle through and they had a lost decade. I hope we are not going to do that.

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