This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 25 October 2014.

Earlier this week I was doing some work at the dining room table, deep in thought as I pondered the theoretical advantages of the Capital Asset Pricing Model over the Arbitrage Pricing Theory. Into this comfortable, cosy world, intruded an almighty racket of cheering and whistling, coming from the TV in the lounge. It turned out to be the grand finale of yet another reality TV show, The X Factor. As I watched the confetti and adulation rain down on the winner, I wondered whether or not we would remember her name in a year’s time. For it seems that every subsequent winner of these types of television shows seems to last for a shorter period of time in our consciousness. It’s as though the law of diminishing returns has taken hold of reality TV – if the first winner of X Factor enjoyed a fame factor of 10, this week’s winner can probably expect a 2 at best.

In many ways the life of the winner of X Factor (or Idol, or Big Brother…take your pick) resembles some of the investment fads which burst onto the investing scene – one day it’s the main topic around the BBQ; the next day it’s all over and anybody foolish enough to have been taken in is left ruing the cost of an expensive lesson. An example of this was the recent craze in rare earth metals. The story sounded plausible enough: rare earth metals are a mix of very rare and very expensive metals, with obscure names like Scandium, Promethium and Cerium. Their uses are varied and they play a role in the manufacture of everyday devices such as television screens, cameras, ipods and also a range of medical uses. As their name suggests, they are rare indeed, with major deposits located in China and the US and Australia to a lesser extent. China produces around 95% of rare earths and uses quotas and production restrictions to limit supply. In the height of the mining boom, a small Australian company, Lynas Corporation, began development of a rare earths deposit at Mt Weld, in Western Australia. The plan also included a processing plant in Malaysia. As prices for rare earth metals rose, so did investor interest. At one point in 2011, Lynas Corporation was valued at over $4 billion – an amazing valuation considering the company had yet to make a profit and had accumulated losses of $200 million.

These mundane facts did not stop investors from piling into Lynas’ shares, with disastrous but predictable results. Problems with the processing plant and a collapse in the price of rare earths brought the company to the brink. Anyone who bought shares at the peak would have lost 96.67% of their investment. The moral of the story – think of a fad stock as an X Factor winner, and think where they might be in a few years’ time.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 11 October 2014.

In a recent column I discussed how one of the unscientific indicators we follow in assessing the health of the stock market is whether or not the ‘funny money’ had arrived. This of course refers to the temptation by companies and investment bankers to take advantage of cheap credit to fund a range of ridiculous and complicated deals, usually just before the market falls off a cliff (in this regard, the recent proposed takeover by Glencore of miner Rio Tinto definitely hit a warning light on the funny money dashboard). One of the other unusual indicators we look for is the rise of the ‘Empire Builder’, though this tends to be more company specific, rather than an insight into the overall health of the stock market.

The Empire Builder is a company CEO who displays a number of characteristic traits. Often they are the founder of the company, or they got on board when it was just a minnow in its industry. The Empire Builder is an aggressive deal-maker, with the growth of the company almost solely due to takeovers and acquisitions. Once the takeover target has acquiesced and been folded into the parent company, the Empire Builder is already close to sealing the next deal, looking for the next opportunity. The Empire Builder is also usually feted in the financial press, lauded as a visionary leader who can do no wrong. Most Empire Builders also need a company jet, preferably a long-range Bombardier, needed to be able to visit the far-flung empire at the drop of a hat. The Empire Builder thrives in boom markets, taking advantage of low interest rates and willing lenders to build a global business empire underpinned by vast quantities of debt.

The problem with the Empire Builder, is that he or she is usually harder to spot than the funny money. Most times you only know you had encountered an Empire Builder once they have retired, generally with a large gold watch and an enormous severance package. This is because the financial statements provide no hint of the actions of an Empire Builder. Much like a pyramid scheme needs a willing influx of new victims, the Empire Builder masks his or her activities through consistent increases in company revenue as more and more acquired companies are added to the empire. It’s only when a new CEO is appointed and finds out that no-one had been actually running the company, that it becomes apparent than an Empire Builder had been in the executive suite. You can make money from an Empire Builder however: sell before they retire and use any gains to invest in a real business run by competent management. Use the Empire Builder as a boost to building your own little investment empire.

This article originally published in The Northern Daily Leader on 27 September 2014. 

I recently sat down to do some long term planning – wondering what first car I would buy our son, Jack, when he eventually learns to drive. As Jack only turns four in December, you can tell that I like to have canvassed all my options long before any decision is required. My musings were prompted by the long line of Year 12 P-platers parked outside McCarthy Catholic College every school morning. Some drove small hatchbacks with names that sounded like a schoolies party at the Gold Coast: Fiesta, Spark and Sonic. Others drove mud-splattered four-wheel-drives, while a few unlucky ones were driving mum’s old Volvo station wagon or something similar. Not that there’s anything wrong with a Volvo, or with station wagons in general, it’s just that even I’m not too old to know that neither one of those types of cars are particularly ‘cool’.

As I’ve mentioned in the past, cars can be a lot like investing. Some drivers (and investors) prefer their cars (and investments) to be fast and noisy, prone to swerving all over the place and with the odd occasional crash. Others prefer safety over speed and are quite happy getting from A to B at a sedate pace and without all the angst and concern that accompanies a crash (both in automotive and financial terms). And just as cars can be hotted up with mag wheels, spoilers, LED running lights, mega-watt subwoofers and an exhaust so wide you could fit your leg in there, so too is the world of finance prone to a bit of over-engineering. In fact, one of the informal indicators we follow when assessing the state of global and domestic financial markets, is the answer to the question: “Has the funny money arrived yet?” By ‘funny money’ we don’t mean the arrival of Billy Connolly bearing dollar bills – what we mean is, have financial markets started to get just a little bit too creative? Have well-paid investment bankers begun to invent creative and confusing ways of turning one dollar into ten? Is the financial press full of acronyms such as CDO, SIV and CLO, or words like credit derivatives, structured products and synthetic arbitrage?

The funny money usually makes an appearance near the top of any investment market, when money is cheap and it seems like the good times will never end. Private equity deals, leveraged management buyouts and ludicrous takeover bids all get funded by the funny money, usually just before the bottom falls out of the stock market (remember the almost entirely debt-funded private equity takeover bid for Qantas in late 2006?). So has the funny money arrived yet, or will the party continue on for longer? We think the latter, although Billy Connolly may not be too far away.

This article originally published in The Northern Daily Leader on 13 September 2014.

We recently had a meeting with a potential new client who was interested in our firm’s services. During the discussion Steve (not his real name of course) related a story of how he invested some money many years previously through a local stock broker. It was around $50,000 in a number of ‘blue-chip’ shares. Soon after the money was invested, and unbeknown to the broker, Steve started buying and selling the shares that had originally been purchased. The stockbroking firm on the other hand, would regularly send Steve a quarterly report theoretically showing what the shares were now worth and how they had performed. Of course the report bore little resemblance to reality, as Steve had bought and sold the shares many times over. Over the course of the years, Steve managed to turn his $50,000 into a healthy portfolio of around $500,000, mostly through jumping in and out of somewhat speculative shares. And all the while the quarterly reports from the stockbroker kept arriving, showing how the now fictional portfolio had performed.

Eventually Steve made a few bad investment choices and ended up losing all the money that had been invested. From $50,000 to $500,000 and then to $0. And in the background the stockbroker was still sending the quarterly reports showing what the initial investments were now worth. By the time someone at the broking firm realised that they had been sending out reports for a portfolio which didn’t exist, it was nearly fifteen years later. The money had well and truly been lost, but guess what the value of the fictional portfolio was showing? Based on reinvestment of any dividends, the portfolio was supposedly worth around $1.5 million. So if Steve had simply forgotten about his initial investment and had rung his broker up fifteen years later, he would have found out he was a millionaire.

I tried to replicate this myself, using an imaginary $10,000 investment in each of Woolworths, BHP, Wesfarmers and CBA at the start of 1994, twenty odd years ago. If you had reinvested any dividends since then, your $40,000 would now be worth around $770,000. That’s an annual average return of just under 16% for twenty years. So while everybody else worries about wars, recessions, global financial crises, market collapses, bank failures, mining and housing booms and busts, you could have simply and happily collected your average annual return of 16%. No stress, no fuss. Of course, if those four shares had been more like ABC Learning and HIH and less like CBA and Woolworths, the outcome would have been very different. But still, it makes you think, doesn’t it?

This article originally published in The Northern Daily Leader on 30 August 2014.

Some years ago I offered to give my father a few lessons in using a computer. Dad had never worked in an office and home PC’s only became commonplace after my sister and I had left home, so he had very little familiarity with computers. I knew we were in trouble however, when I switched on the computer and gestured to the screen, saying “This is your desktop, it’s where you keep shortcuts to programs”. Dad looked strangely at me and said “That’s not a desktop, that’s a computer screen”. Things got worse when I handed over the mouse and got him to navigate around the desktop. He ended up with the mouse on the edge of the table, about to fall off onto the floor and the cursor jammed against the far right of the screen. “What are you doing?” I said. “It’s stuck!” he said, “I can’t move it!” I gave him a withering look and told him to pick it up and put it back on the mouse pad. “What do you mean?” he said, “I can’t just pick it up. What will happen to the small arrow on the screen if I do that?” At that point I decided we had had enough for one day and ended the lesson. Some challenges in life are just too great to be conquered and teaching my father how to use a computer fell into that category.

Truth be told, he didn’t really need to learn how to use a computer. Dad’s speciality in life was playing golf and it was something he was very good at. Some people become lawyers or accountants or professional sportsmen (or women), and others become IT experts. Modern society allowed my father to specialise in his field, giving him the resources to hire a computer expert if he ever needed one. The same can be said of any profession or occupation. The surgeon offers her services to people who know little of surgery, but is more likely to hire a builder than try to build her own home. The builder in turn might be extremely efficient at building houses, but probably pays an accountant to do his taxes. And so on and so on. And as you would expect, the same principles apply to investment advice. It’s sometimes hard to tell, given the ongoing stories of bad advice, fraud and irresponsibility, but investment advice is its own specialised field. The real problem is that the barriers to entry are too low – as pointed out recently in The Sydney Morning Herald, hairdressers require a greater level of training than the minimum level set for financial planners. A bad haircut is only going to matter for a few weeks, but the impact of bad financial advice can last a lifetime.

This article originally published in The Northern Daily Leader on 16 August 2014.

One of the most interesting writers to emerge in the field of finance in recent years is Nassim Nicholas Taleb. Taleb has managed to forge a successful, if controversial, career in literature, following on the back of a long stint as a derivatives trader on global equity, commodity and currency markets. Taleb’s first book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets was a critique of our ability to correctly understand randomness and its impacts, both on a daily basis and also in regards to investing. Taleb believes that we tend to discount the probability of severe negative events occurring – an approach akin to old line about ‘picking up pennies in front of a bulldozer’. It’s all very well making a small steady return, but when things go horribly wrong it ends really badly (i.e. you get squashed by the bulldozer). As an example, Taleb described financial option sellers as people who “eat like chickens and go to the bathroom like elephants”, meaning that they earn a small steady living selling options but when it goes wrong it’s a huge disaster. Taleb’s view was that we ignore the unknown and unforeseeable events and focus too much on those events we can predict with greater certainty, erroneously believing we understand and can predict all outcomes. Taleb advocates an investment approach which allows you to benefit from a ‘fat tail’ event (an extreme event with a low probability of occurring, but a large payoff – taken from the description of a non-normal distribution as ‘fat-tailed’).

In essence, Taleb believes in an investment approach which entails putting the majority of your money in the safest inflation-linked investment you can find (US Treasury Inflation-Protected Securities probably) and a small amount in an outrageous bet which will make an obscene amount if the sky ever falls in. There is a certain attractiveness to this approach – you can be confident that your money is safely invested, and when financial disaster does strike, your 1-in-1000 bets will pay off handsomely and you can start thinking about what colour to paint your private jet. The problem for most people however, is that the safest inflation-linked investment you can find is not going to generate much money for you to live off (a recent sale of such US Treasuries was done at a yield of 0.249% – even the interest on a bank savings account is higher than that) and the timing of the great money-making event is uncertain itself. Yes it may be coming, but you may run out of money long before your low-probability but high-payoff bet ever comes off. Taleb’s books are an entertaining read (if you can see past the machismo, self-aggrandizing and thinly-veiled insults which occasionally threaten to crowd out the good bits), but it’s no investment guide for retirees.

This article originally published in The Northern Daily Leader on 2 August 2014

A guy I used to work with, Dom, had a wonderful sense of humour. A couple of Irish tourists, Phil and Eamon, were in town visiting Phil’s brother. Dom wanted to show Phil and Eamon a slice of country life and invited them to come rabbit shooting one night on his property outside town. The day Phil and Eamon were due to come shooting, Dom found a dead brown snake in one of his paddocks. Although it was already dead, Dom put a bullet in its head and hung the body in a nearby tree. That night Phil and Eamon arrived for their rabbit hunt. After a few hours of driving around shooting rabbits, the boys were standing around the vehicle having a break, when Dom yelled out ‘Look! Snake!’ and gestured wildly into the darkness. Before Phil and Eamon could move a muscle, Dom raised his rifle to his hip and fired off a hasty shot into the dark. “I think I got it” he said, before leading Phil and Eamon toward a distant tree, where his torch light fell upon the dead brown snake with a neat bullet hole in its head. To say that Phil and Eamon were amazed would be an understatement. In their minds they had just witnessed one of the greatest shots of all time – a brown snake shot through the head, from 400 yards away, in the pitch dark and without even aiming! For weeks afterward Phil and Eamon would breathlessly recount Dom’s amazing shot to any who would listen, much to Dom’s immense enjoyment.

Without even knowing it, Dom had accurately recreated his own version of the Texas Sharpshooter Effect. This sleight of hand is where an aspiring marksmen would fire away blindly at the side of a barn and then paint targets around the bullet holes; inviting friends and family to come and view his or her amazing sharpshooting skills. A financial version of the Texas Sharpshooter Effect is a clever illusion of performance called backfill bias. Fund managers create a host of new managed funds, all employing different strategies and holding different investments. After a few years the underperforming funds are quietly closed, while those which have generated positive returns are loudly and widely publicised. The unsuspecting investor has no idea of the truth of the matter however, blindly accepting the past performance history at face value. The reality is that the outperforming funds which make it through the elimination process owe their survival more to luck than skill. If you fire enough bullets you’re likely to eventually hit one target, though this has little reflection on your skill with a firearm. So the next time you’re thinking of putting money into a managed fund, think of Dom and his dead snake and perhaps think again…