Daily Dose of Optimism

Some More Wisdom on "Hedge Funds" that Don't Hedge

Jeff Matthew's piece on Friday, Since When Did "Hedge Funds" Stop Hedging?, reminded me of this piece below by Carlo Cannell, from 1999. Cannell's article is more data-driven, whereas Matthews extrapolated wildly from a conversation he heard at Starbucks (as we bloggers are wont to do). My money says that Matthews is right about as early as Cannell was - which means we've got a great year ahead of us in 2007. Enjoy! - Ed

Bogus hedge funds -- those with no short positions -- will not survive the next market downturn
By J. Carlo Cannell (Red Herring - February 1999)

Phoenician sailors earned a thick slice of the profits from a successful voyage. Today a different risk-taker -- the modern-day hedge fund manager, or "hedgie" -- earns a similar benefit on land.

According to Hedge Fund Research, there are now more than 3,200 hedgies, two-thirds of whom operate in the United States. Estimates of their total capital under management vary from $150 billion to $250 billion.

Hedge funds have multiplied because in a bull market there are few better businesses. Assuming a standard 20 percent profit allocation, for example, a hedge fund general partner who started 1997 with $100 million and matched the S&P 500 would have received a paycheck of more than $6 million the next New Year's Eve -- healthy compensation for matching an index.

The rot in this picture is that most of these hedge funds have little or no short exposure. According to Edward Bowman of Hawthorne, the asset management division of PNC Bank, less than 10 percent of what are today called hedge funds have had any real hedge for the past several years.

This fall provided some vindication for the classic hedge. By early October the Russell 2000 was down more than 20 percent for the year; classic hedge funds were up more than 20 percent, but hedge funds as a whole were down more than 40 percent. During the last "trough" for hedge funds, in the early 1970s, there were fewer than 300 funds managing only a few billion dollars. Going forward, will we see an attrition to this level? Yes.

HEDGE HOGS

When things are good for hedgies, they're really good. Hedgies are the ultimate purchase managers, meeting, playing, and dining with scores of interesting entrepreneurs. Travel and computers are often their biggest expense items.

The hedgie mortality rate, however, is high. A shocking survey published in 1998 by Montgomery Asset Management indicates that the average U.S. investor expects the market to return 34 percent annually over the next ten years. The historical reality is somewhere closer to a 7 percent annual return. Fueled by these inflated expectations, some of the long-only managers masquerading as genuine hedgies will fall into a chasm of margin calls and redemptions like oblivious motorists plummeting off a cliff.

THE LONG AND SHORT OF IT

The Harvard-educated sociologist Alfred Winslow Jones is the father of the true hedge fund. In 1949 he structured a portfolio consisting of common stocks that held both long and short positions at all times -- even in a rising market. Mr. Jones's theory was that one can analyze a particular business even though the stock markets can't be reliably forecast. Buying good, well-respected but neglected companies long while shorting wildly overvalued companies should yield above-average results, he reasoned. By 1966 his fund had nearly doubled the results of the Dreyfus Fund, one of the better-reporting funds of the day. "Hedging," Mr. Jones often said, "is a speculative tool used to conservative ends."

KEEPING THE FAITH

A couple of years ago, as I broiled under the sizzle of short squeezes, a colleague told me that "a hedge fund doesn't have to hedge." What does it mean, then, to manage a hedge fund? Why do I deserve these high fees without undertaking the difficult process of researching short candidates -- a specialized and painstaking task that is usually more than twice as time-consuming as researching long candidates?

It hasn't been easy to be faithful. The longest-running bull market in history has toughened and twisted those true hedge fund managers who have survived it. I know one traditional hedgie who regularly vomited from anxiety during trading. Another has become so skeptical of financial statements that he retains private detectives to verify all information.

Windsurfers on the San Francisco Bay are an apt metaphor for today's proliferating hedgies. Both love to perform acrobatic feats in steady, high summer winds. Those winds, like the last 25 years in the equity market, can seem remarkably predictable. But eventually fluke winds do arrive, and the equipment's lack of keel and buoyancy makes the cold water and strong tides treacherous. The windsurfer's sailboard, like the fake hedge fund, is not an all-season craft.

Thoughts like these make cranks like me feel a little better.

J. Carlo Cannell is the president of Cannell Capital Management, an alternative asset adviser.

Happy New Year, Google from 1960 and The Best Book on Investments?

(1) Allegedly, this is Sam Zell's holiday card: yieldsz

(2) The WayBack machine yields this gem: Google circa 1960

(3) I'm looking to see what people think was the best investing book ...of all time. My only stipulation being, of course, that you have actually read the book. That means, no voting for Graham-Dodd or Seth Klarman if you haven't actually read it. Also, feel free to suggest books I am missing. See: What is the Most Useful Book on Investments You Have Read? on Squidoo. - Ed

Ticker Sense: 2007 Financial Blogger Outlook

Ticker Sense, a great blog from Birinyi Associates, recently solicited my feedback for their 2007 Financial Blogger Outlook Survey. The results of their survey?

[Financial bloggers] average forecast [is] a change of +2.39% for the S&P 500, +2.20% for the Dow, and +3.47% for the Nasdaq.

By way of comparison to the Street, that's pretty conservative. Major Wall Street brokerages are forecasting an average gain of +8-10%.

I provided my generally bullish overally market forecast (+12% on the year, at the time I submitted my picks) along with answers to the rest of their questions. Find the results in three posts, here, here and here. - Ed

Pre-Paid Legal (PPD) - Marketing the Business

I've been following Pre-Paid Legal (PPD) for a while now. The company sells "legal insurance policies" - basically, you pay a monthly fee, and if you need legal services at some point, you can call on a local lawyer affiliated with the company to help you with it. Like insurance, the company makes money if you don't use it.

Most of the commentary I read is negative, with the primary criticism being that the company is a
multi-level marketing scam - where the people selling the product are people who've already purchased it. Apparently, most of the new memberships come from such associates.

However, I read an article in Barron's about a month ago that said the company's services are actually quite handy - this particular investor had actually sampled the service in Connecticut - and was able to use a Pre-Paid Legal lawyer for two separate items, saving a decent amount of money. He conceded that the primary issue with the company was how they marketed their services; that the associate marketing steered the product disproportionately to a market that did not appreciate the benefits.

I'd say that last point is correct. About a few weeks back, someone at the office (I have no idea who) dropped this flyer on the desks of everyone around me.

Download PPD-101-Reasons.pdf

That's Pre-Paid Legal marketing in action. If there is merit to this product, the company would probably be much better off selling their product through insurance agents who are already having conversations with customers about protection. As a result, I'm keeping this one on my short watchlist. - Ed 

130/30 Funds, Starbucks (SBUX), Griping about the TSA, SHLD and Burnout!

* John Templeton on Success: “I don’t understand why everyone doesn’t study success. I suppose there are two reasons why most people don’t. One is ego; the other is stupidity. It’s only common sense to study success – not only in investments, but in all facets of life.”

* 130/30 Funds: An Innovation in Mutual Fund Underperformance: The latest fad in mutual funds is a 130/30 fund, referring to the fund's long exposure of 130% of its assets, and short exposure of 30% of its assets. This is a departure from history, because mutual funds (the dominant mode of asset management in the US, with over $10 trillion in such funds) have not been allowed to sell short. (Why this changed, I can't remember.) Clearly, someone is taking a page from the hedge fund book, which isn't a terrible idea - assuming these funds succeed in attracting assets, they will put fee pressures on hedge funds, which is generally good for investors. However, I remain skeptical as to whether they will notably outperform, or have lower volatility - it is quite possible for a fund's long AND short positions to go in the wrong directions together.

* Understanding burnout: “Happiness equals reality divided by expectations.” - Alden Cass

* I'm a Starbucks addict. Are you? About six months ago, I started drinking Starbucks (SBUX) coffee on the weekends. The first few times, I didn't really realize what happened, but I had so much more...energy. I slowly clued in that Starbucks had much more caffeine than the homebrew I used to make. I've since ratched down the size of coffee I order, but Starbucks is part of my daily ritual. Ever late to the party, I stumbled across this article in Slate about the caffeine in Starbucks coffee. Based on my web research, the reported caffeine in Starbucks coffee varies widely, but all measurements are higher than any other national chain serving coffee. Here's a sample:

The Wall Street Journal earlier this year sent samples of coffee from Starbucks, 7-Eleven, and Dunkin' Donuts to Central Analytical Laboratories. The lab reported that a 16-ounce Starbucks house blend coffee contained 223 milligrams of caffeine, compared with 174 and 141 milligrams in comparable amounts of Dunkin' Donuts and 7-Eleven coffee, respectively. According to the Journal, the average Starbucks coffee drink contains 320 milligrams of caffeine. (This chart from the Center for Science in the Public Interest shows different measurement levels, including the scary finding that a 16-ounce Starbucks grande has nearly three times as much caffeine as a No-Doz.)

* If you've taken a plane in, say, the last few years, you know the TSA has instituted a bunch of "practices" for making us safer, all of which seem more designed to annoy passengers than protect them. Seth Godin had a great write-up based on his experience over Thanksgiving weekend. Here's an excerpt:

[At the airport,] the JetBlue team decides to tell a story about confidence and empathy, about competence and kindness. They staff the security line with talented people, they plan a route through the terminal, they figure out what the TSA is going to want.End result: fast lines, happy employees, loyal customers.

Just on the other side of the line are the bureaucrats at the TSA. They tell a story too, but it couldn't be intentional. "No Cake!" the screener yells. "No pie either!" and they make the person traveling to her family throw out her home-baked cake. [...] Is this the sort of government we want? We deserve? We should pay for? [Ed sez: great question!]

* I told you I'm watching Sears Holding (SHLD)...and so is Deutsche Bank, who said a few weeks back that shares could be worth $327 (vs. ~$175 today), based on $10 billion in their real estate and $1 billion from their brands.

* Finally, a political gem: Charles Schumer on Chuck Webb: "He's not a typical politician. He really has deep convictions," said Schumer, who headed the Senate Democrats' campaign arm.

Feel Clever While Saving Money on Printing

About a year ago, I began using my laser printer to "time-shift" my online reading, so that instead of using quality weekend time, I can read in marginal periods like: commuting (taxi, subway), or after exercising, on a stationary bike or treadmill. Here's a recent tidbit on Chesapeake Energy's (CHK) CEO:

"Much of that reading occurs before dawn when Mr. McClendon works out in a four-story corporate gym on Chesapeake's campus. Near the racquetball courts is Mr. McClendon's workout machine. Attached to the wall is a plastic file holder marked "Aubrey's Reading File -- Please Do Not Disturb."

Printing is like a low-tech Tivo or Del.icio.us - but instead of relying on ever-complex digital devices to store information, I simply create a pile of paper that I can read, digest - and dispose of - in whatever manner is convenient at the time. This practice has become so common for me that I eat up toner at home like nobody's business.

After spending about $200 on toner cartridges in the span of a few months, none of which seemed to quite achieve the 2,000 pages per cartridge as advertised, I began looking into alternative solutions.

I took a chance on TonerRefillKits, a company that sells the equipment to refill a toner cartridge yourself. I have to say: I am a satisfied customer. This was a great way for me to save money on printing, and it also allowed me to feel clever for performing a simple mechanical procedure.

Here's how it works: You need to purchase a $13 kit from the company to perform the "operation." The core of the process is this re-purposed soldering iron, with a special head designed to melt a circular hole in the toner's plastic casing.

After heating the iron for about 3 minutes, you press the heated bit against the toner box, burning a hole like this:

As you probably already know, the smell of burning plastic ain't great, but it's a small sacrifice - just keep a window open. Then, take this bottle of laser toner (which is an exceptionally fine, black powder - and extremely messy in the event of an accident) and do your best to pour the toner neatly into the hole you made. Note the toner particles around the cap of this particular bottle - I had a bit of a spill myself.

Once you've filled the hole with toner, insert a specially sized cap into the hole (which they provide)...and you're ready to print again.

With the removable cap in place, you can easily refill the cartridge several times, without a need for the soldering iron. The cap fits snugly, and I am generally comfortable that it won't come out and leak toner all over the place.

How much did I save? The cost of additional toner from the company is about $25.00, and each bottle works for several refills (up to 3). Compare this cost with an entirely new toner, for about $70 (from the original manufacturer). For about 10,000 pages of printing, I figure the difference is (a) old method: 4 toner cartridges at $70 vs. (b) new method: 1 toner cartridge at $70 and 3 refills for $25 - total cost of $280 for toner vs. $95 for the toner+refill.

So, consider giving it a shot: save money, feel handy. A great combo! - Ed

I curse the casual brilliance of your life strategy!

Words to live by...courtesy of BusinessWeek