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12 августа, 13:29

Some thoughts on the firing of James Damore from Google

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As the world knows by now James Damore was fired from Google for writing a memo that questioned Google's diversity policies.As a holder of Google stock I have a few thoughts on this.Software engineering is a job where you cannot replace one brilliant software engineer with six adequate ones. It really is a job where the best people can lever their work over millions of computers and the whole world.If you are Sundar Pichai (the CEO of Google) your job is to attract, hold, motivate and direct the very best software engineers - and to make sure their work does scale over the whole world.In doing this he literally should not care whether men are better software engineers or mathematicians on average than women. Google should not interested in average. Google should be interested in the best.I will hold Emmy Noether up as better than pretty well all men in all current mathematics and physics faculties. There may be a dozen in the world who can match her.  Probably less. If she pops along you should hire her. Even if women are less good on average at maths than men that should not matter. Emmy Noether is clearly better than anyone else you are going to hire this year.The truth of falsity of James Damore's assertions in the memo literally do not interest me and should not interest Sundar Pichai. His memo made his job of hiring the the best harder. If the best happened to be a woman or another minority they might prefer work somewhere more welcoming.If I were the Google CEO I would not have just fired James Damore. I would have been proud to fire him.There is a lot of talk about Mr Damore receiving compensation from Google for his firing. For what? He broke the Google code of conduct and was fired for cause.Yes, his feelings and the feelings of many delicate petals on the right are hurt.But they are no more entitled to compensation for hurt feelings than anyone else.If Sundar Pichai wastes shareholder funds compensating him I will be disappointed.And don't think for a moment that this is a liberal line. Google is and should be a proudly elitist place for a software engineer to work. And Mr Damore was fired because he offered a phoney elitism (based on gender rather than competence).Phoney elitists like him don't deserve to work in such a place.Mr Damore was right on one thing. Diversity shouldn't be valued for its own sake in such a place either. But I haven't noticed a lack of elitism in Google staff I have met. They positively drip elitism.Diversity is valued though and it seems is valued for the right reason. It gets you a better chance of recruiting the best.John

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03 августа, 08:25

E&P decoding - Pioneer Natural Resources edition

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I think I know what this means but as per usual the internet is full of people who know far more than me. You dear readers are my 20 thousand person expert network. This is from the Pioneer Natural Resources conference call. I would really love people to explain it - preferably word-by-word in the comments. In particular I want to understand the drivers of the pressure changes (which matters for proppants for instance) and how the four-string casing deals with the problem.Thanks in advance:We've mentioned this in all the slides and such, but we did fall behind operationally on our completions in the Spraberry/Wolfcamp, in large part due to unforeseen drilling delays. What happened is the delays were really the result of unexpected changes in pressure regimes in the field.  So what we've seen is increasing pressures in some of the shallow formations that means we have to mud up substantially to deal with that problem and then we immediately then are drilling into lower pressure depleted zones. And we were at the knife's edge of this really through all 2016. But these pressures have changed in a subtle manner such that we now find we had a higher percentage of what we refer to as train-wreck wells, where we have all kinds of problems with lost circulation and other issues because of this pressure change. The easiest way to remediate this is with a drilling plan takes us from a three-string casing design to a four-string casing design. So that's exactly what we've done. We solved this issue. We have addressed it and we've done so by changing the casing design, which has proven to be very successful. One thing it does is it does increase the well cost substantially, about $300,000 to $400,000 per well, and it does increase our time of drilling five days or so. But we're also nickel-and-diming away other costs in these wells to try to get that money back, including changing out surfactants and other things to try to reduce costs and reduce days. So we're not going to stand pat with this increase. We're going to chip away at it and reduce it. Cumulatively, though, what happens is because we've impacted the schedule, we've also then reduced the number of POPs we're going to be completing this year by about 30. Those essentially will move into 2018. That's 100% due to these drilling delays I mentioned, which I believe we now have mitigated. But you have to also factor in the delays not only result in the deferral of wells you put on production, but also loses production days for all the wells that get delayed that are going to be POP'd in the future, particularly later in the next year. But the point is we're now dealing with that. I think we have that squared away. I have a later slide we'll talk about more detail on that.

13 июня, 06:51

Canadian non-standard mortgages: a state of play

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Regular readers of this blog will be aware that Home Capital Group - a Canadian non-standard mortgage lender - is in financial trouble.The gossip is that the regulators in Canada are also putting some pressure on lenders to improve underwriting standards. There is similar gossip in Australia, however Australia has not had the collapse or near collapse of any lenders.Canada Mortgage & Finance Group (CFMG) is a broker in the Greater Toronto Area (GTA). The CEO of CFMG (Ameera Ameerullah) writes a blog on LinkedIn which I have been reading for some time.She has recently posted about the state of play for even slightly non-standard mortgages in the Greater Toronto Area.Below (and without further comment but with her permission) I reprint her latest post.-----------CLIENTS ARE STUCK AND BROKERS SCRAMBLING - WHAT IS THE GOVERNMENT DOING?Private lending rates increased and lending fees increased with LTV being decreased! Clients are stuck and brokers are scrambling to find options for their clients. Clients are placed in a very bad situation as they are in position of being sued since they cannot come up with the extra capital to close on alternative mortgages.THE GOVERNMENT has caused tremendous issue for clients and the brokers community. We need Home trust back in the market. Presently no one is qualifying with the banks due to increased CMHC premium, lending restrictions and lenders requirement...it's killing clients not helping them!Clients been saving for their down payment and closing cost but now they cannot close on their purchase due to down payment requirement and lending restrictions. Qualifying rate and amortization cut back on insured deals is causing greater concern. Most B lenders are affected with what's happening with Home Capital. Both the residential and commercial market is affected.Private first residential mortgage in the GTA is now at 8.99 to 9.99% RATE - 65% LTV to 75% LTV. You'll obtain 80% if you're lucky and be prepared to pay higher rate and fees. Fees are 3 to 4% on a first now on private - This is INSANE. In fact many private lenders are out of capital. Options are minimum! These changes only affects clients and everyone having a tough time to close. Brokers are scrambling now to find alternative option for their clients since Home Trust is not funding and many other lenders who depended on Home trust money are stuck as well. How can a broker get by when they have to place their clients in an expensive private mortgage? There's no room for us to charge a fee so pretty much we are all affected. Only the big banks are benefiting from the Government change and yet they themselves are loosing business as no one can fit their qualifying requirements. Banks are pressuring their BDM to originate business - how can they when the Government ridiculous change affects the entire mortgage industry? Originating business is easy but closing deals have become horrid and clients pocket is feeling it.The Government really need to make some immediate change as they have in the past year because with this trend home buyers are being placed in more debt as cost of borrowing on private capital is expensive. These changes are hurting clients and will hurt the economy. AWFUL STATE THE INDUSTRY IS IN. If one doesn't have about $1600 - they cannot live in a decent one bedroom apartment even by renting. Clients that purchased from builders and are set to close are having a difficult time to close in allocating extra funds.Brokers should start to voice their opinion as this is our industry and if you don't speak up then we are all doomed with our clients!

10 июня, 16:43

Bob Carr and the possible Chinese spies

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Last week Four Corners - the premier news program of the Australian Broadcasting Commission ran a story about the influence of the Chinese Communist Party in Australia.Some of the story was obvious - for instance how Chinese students are coopted to drown out rallies by Falun Gong or other opponents of the CCP. A typical story involves a CCP figure visiting Australia, a bunch of human rights rallies and hundreds of Chinese students bussed to the rally with the intention of overwhelming regime opponents.A Chinese student involved in organising these rallies was interviewed. She made it clear that the embassy helped. Moreover it was clear there was social pressure (or worse) on students to conform - and that non-conformity had a negative effect on the family back home.--But the more interesting part of the story was how these sudden billionaire Chinese businessman (including businessmen who hung out with spies) were giving large donations to Australian institutions and thus getting close to politicians. (Universities were recipients as well as political parties...)And that some of these businessmen - liked hanging out with politicians (and sometimes paid their legal expenses). And then after having received a benefit the said politician expressed views on the South China Sea contrary to the Australian Government).This largess crossed party lines. Both sides of politicians had ex-politicians on what were some very generous consulting gigs.One of these businessmen gave money to the Australian Chinese Relations Institute - an organisation headed by Bob Carr - a former Premier of my home State (New South Wales) and a former Foreign Minister of Australia.The implication was that Bob Carr (and his institute) was in some sense compromised.====I have always liked Bob Carr. He was the New South Wales Environment Minister when I was in my twenties - and I thought he was great. I still do.So when invited to attend a talk sponsored by ACRI I jumped at the chance. Ignoring the usual advice that it is not a good idea to meet your heroes (especially if they are politicians) I rocked up full of excitement.Here is the flyer...When I got there I got a fabulously naïve talk about how various Chinese businessmen making huge waves in Australia were independent businessmen and not in any way arms of the Chinese government. (This includes people who were trying to buy ports near military bases in Northern Australia.)The naiveté was amazing. Some of these newly minted billionaires career went roughly as follows:a). Follow dad into the Peoples' Liberation Army (where he is a senior general)b). Retire in your twentiesc). Start an import/export business. Make a quick 15 million.d). Invest that in a huge land business. Turn that into a quick billion.e). At the age of 35 turn up in another country and throw half that money round buying strategically important assets.But these businessmen were in no way affiliated with the CCP.Whatever: I left thinking I was born on a Monday - but not last Monday.(But I was well satisfied with the drinks and canapés...)--Anyway Bob Carr is in The Australian (Murdoch's national newspaper in Australia) dissing the whole Four Corners story. You can read his defence. It didn't go very near how his own organisation might or might not be compromised.Go on. Read it.I think he would be better leaving things alone.But as he hasn't I thought I might just put the document circulated that night up for all to read. Maybe the China experts here can tell me whether this is merely naïve (which would be my normal guess) or directly paid for by the CCP.Here is the link.As Bob Carr has chosen Murdoch's network to defend his benefactors maybe I should just end with the most famous News Corp slogan: I report, you decide.John

15 мая, 03:45

Taking the bull case for Valeant seriously

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Last night I had dinner with a friend who had a friend who was buying Valeant. Whatever - it led to a discussion of Valeant fundamentals - and that in turn led to this blog post.The stock has been on a tear lately - rising from $10 to $13.59 in the last week - poking above $14. To some degree this is just standard volatility for a bombed out stock. But it was prompted by Valeant producing results with a sharp rise in "adjusted EBITDA" and guiding for higher adjusted EBITDA. As the FT put it Valeant "bumped guidance".The Valeant adjusted cash flow caperI want to explore this "adjusted EBITDA" number. Then I want to lay out the valuation directly.Valeant has a history of producing little or no GAAP earnings but very large adjusted cash flow. The adjustments are after a collection of exceptions chosen by management and not subject to audit. This blog has demonstrated in the past that some of these exclusions from cash flow are recurring expenses. That said here is the history going back to the final quarter of 2012.QuarterMeasures presented$million2012-04Adjusted Operating Cash Flow4232013-01Adjusted Operating Cash Flow3452013-02Adjusted Operating Cash Flow4232013-03Adjusted Operating Cash Flow4082013-04Adjusted Operating Cash Flow6072014-01Adjusted Operating Cash Flow6362014-02Adjusted Operating Cash Flow5002014-03Adjusted Operating Cash Flow7712014-04Adjusted Operating Cash Flow6242015-01Adjusted Operating Cash Flow7082015-02Adjusted Operating Cash Flow7732015-03Adjusted Operating Cash Flow8652015-04Adjusted Earnings*5412016-01Adjusted Earnings, Adjusted EBITDA**442, 10762016-02Adjusted net income, Adjusted EBITDA***487, 10872016-03Adjusted net income, Adjusted EBITDA#543, 11632016-04Adjusted net income, Adjusted EBITDA##441, 10452017-01Adjusted net income, Adjusted EBITDA###273, 861NOTESAlas this table of changing measures requires some notes.*In the fourth quarter of 2015 the company presented a late annual report. It announced preliminary earnings that contained a new measure: "adjusted EPS". The "adjusted EPS": was not reconciled in any way to previously announced "adjusted cash flow". The "adjusted earnings" in the above table are is the total adjusted earnings that was used to calculate the "adjusted EPS".**In the first quarter of 2016 the company reported an adjusted EPS number and and adjusted EBITDA number  started guiding for an adjusted EBITDA number. You would think this number to be broadly consistent with previously used "adjusted operating cash flow" numbers. It wasn't. Remarkably there was an unexplained mismatch between the 2015 first quarter adjusted EBITDA number and the originally reported "adjusted operating cash flow". The old number was 708 million as in the above table. The new number was 1127 million. Somehow as Valeant was collapsing they surreptitiously changed their adjustment to even further increase their stated adjusted cash flows.***In the second quarter of 2016 the company reported an "adjusted net income" which was inconsistent with previously reported numbers. The previously reported number was "adjusted operating cash flow" of $773 million in the second quarter of 2015. Now they reported "adjusted net income" of $751 million for the same quarter. I cannot reconcile the old $773 million number to the new $751 million number.#In the third quarter of 2016 the company produced an "adjusted earnings" and adjusted EPS number. There is a number for adjusted earnings in the previous corresponding period (that is the third quarter of 2015). That number is $845 million. Again I cannot reconcile this number to the previously stated number.##In the fourth quarter of 2016 the same issue arises but this time with respect to adjusted EBITDA which is now reported as $1374 million in the fourth quarter of 2015.###In the first quarter of 2017 the adjusted EBITDA presented for the first quarter of 2016 was $1008 million. Again it cannot be reconciled to the previously reported $1076 million.Huge cash flows - company is on its kneesIts pretty obvious here that the "adjusted" numbers need to be taken with some salt. Firstly the adjustments simply do not reconcile quarter on quarter. Secondly despite all these adjustments GAAP earnings look limp and the company is on its knees.In the last quarter the GAAP earnings look fine until you realise that more than 100 percent of them come from writing down previously accrued deferred tax liabilities. The earnings are good because the company won't be paying as much tax in the future (possibly because losses are large and unrecoverable).The headline: guiding up non GAAP adjusted EBITDAThat said the headline for the Valeant numbers were that they bumped up guidance for their own non-GAAP measures. (They do not and never have guided GAAP numbers.) Here is the key text:Valeant has raised guidance for 2017, as follows:2017 Full Year Adjusted EBITDA (non-GAAP) in the range of $3.60 - $3.75 billion from $3.55 - $3.70 billionThis guidance reflects the impact of the sale of the CeraVe, AcneFree and AMBI skincare brands. This guidance does not reflect the impact of the sale of the Dendreon business, which is expected to close mid-year.What this does not state is that they missed previously announced revenue guidance - and missed it quite badly.This was the previously announced guidance (announced with the fourth quarter 2016 results):Valeant has provided guidance for 2017 as follows:GAAP Total Revenues in the range $8.90 billion - $9.10 billion,Adjusted EBITDA (non-GAAP) in the range of $3.55 billion - $3.70 billionBut in the first quarter revenue came in at $2.109 billion. That is a really big drop. You would have to think that Valeant is going to miss its annual earnings guidance by $500 million or so. The FT article notes an 11 percent decline in revenue.The common sense testI am an old fashioned sort of guy. There are really only two ways you can raise real EBITDA (and hence I would think that there are only two ways you can raise adjusted EBITDA).The first way is you increase revenues.The second way is you decrease costs.I think that is the end of the story.So Valeant revenues are on track to miss guidance by about half a billion dollars. But they are going to beat their adjusted EBITDA number.This can only be done if they have decreased their costs by an unanticipated half a billion dollars.Possible: but I would like to know what costs they are cutting that they had not previously anticipated.Remember this is a company that was notorious for cutting costs (possibly to excess) whenever they purchased an asset.This was the company who fired almost all non-revenue producing people.Scientists doing research: fire them.Compliance officers: fire them.So I am left with a choice. EitherThe entire myth of Valeant - that it was a ruthlessly low cost operation is bullshit and there are still plenty of unanticipated costs to cut allowing the company to miss on revenue and beat on adjusted EBITDA, or They are cutting hard into revenue producing staff, but this is going to raise adjusted EBITDA or The adjusted EBITDA number and guidance is BS.As you can guess common sense leads me to the third choice. The adjusted EBITDA number and guidance remain BS.Alternative valuation measuresYou can't value this company against the "adjusted EBITDA" because - as this post demonstrates that number is almost certainly BS.You can't value this company against earnings because (other than writing off future tax liabilities) this company has no earnings. So you are left trying to value it against revenue. So lets play this game. Let's presume that Valeant revenue is as good as Gilead revenue. Gilead is of course the super-champion drug company with $90,000 drugs that cure nasty diseases like Hepatitis C. It is one of the finest drug companies in the world - and is strongly profitable.Assuming that Valeant's rag-tag of declining generic drugs with increasing competition is - per dollar of revenue - as good as Gilead - is of course generous.But lets assume that...Gilead Revenue is running at $29 billion per annum. The revenue is declining though because the drug works - and people are being cured of Hepatitis C. The market cap is 86.3 billion and cash and equivalents are 11.9 billion. The enterprise value is just under 75 billion - so this is worth just over 2.5 times sales.If you project pretty gnarly falls on Gilead Revenue (simply because their drug works) it is hard to get below 3 times sales for Gilead.Valeant sales are about $8.4 billion. Put that on three times sales and you can't even cover the debt. The equity will wind up being worth a brass razoo. --Now I am being harsh. Growing pharmaceutical companies with franchises and new drugs in the pipeline regularly trade at 4.5 times sales. If you put Valeant on 4.5 times sales you something in the mid 30 billion range - but only if Valeant sales rapidly stop their catastrophic decline. Valeant debt is about 28.5 billion. That gives you potentially - and this is if everything goes right and you put it all on a pretty decent multiple of revenue - about $7 billion in residual equity value. The market cap is about 4.7 billion now.So if all goes really well you can make some money. But you need to make some pretty heroic assumptions. Firstly you need to assume that the various litigation that is inevitable doesn't impair that too much. (I think it will...)Then you need to assume that the revenue doesn't continue to fall. (I think it will. The company will not be allowed to charge over $200 thousand per year for drugs like Syprine indefinitely. There is probably half a billion to a billion in revenue that will go away simply as competition hits the massively overpriced generics. Actually half a billion is generous.On top of this you have to ignore the inevitable competition that will come to their biggest drug (Xifaxan). That drug will have a generic supplied by Allergan.All up I forsee well over a billion dollars of likely revenue declines.Finally you have to ignore the lack of integrity that allows you to guide up "adjusted EBITDA" when the revenue misses by a lot and where you have not obviously cut costs.Still - if this is the gamble you want - good luck to you. There are easier ways to make money.John

10 мая, 10:05

Selling our Telecom position

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Several people on twitter and some in person have asked me for an update on my very bullish position on Verizon - especially since the results were not as good as expected last quarter.I promised I would be forthcoming - but that I wanted to spell it out to our clients first. This is an extract from a client letter.I want to start with the original bull thesis.The original thesisThe original thesis came from watching Randall Stephenson (the CEO of AT&T) talk at a Milken Conference in 2012. The original recording is here. The relevant portion of the video starts at about minute 18.Randall Stevenson tells a story of the iPhone’s introduction. The introduction of smart phones ran the company out of capacity in parts of country. [Apple offered the iPhone exclusively through AT&T in the USA.]In New York the problems were intense. The complaint in New York was that the iPhone was a great phone so long as you accepted you could not use it as a phone. Jon Stewart mocked the coverage with unusual brutality on the Daily Show (link).AT&T solved this by more and more capital expenditures. At the time, capex ran at around US$20 billion per annum. AT&T was – other than the government – the single biggest capital spending entity in the US.Stephenson (speaking in 2012) said that the same problem would recur as usage continued to grow massively. But this time Stephenson argued it is different. He asserted that AT&T would not be able to solve this problem by more capital equipment. Spectrum congestion was inevitable.He saw this as apocalyptic, but we saw potential pricing power and improving profitability.We were doing simple arithmetic and getting very large numbers. Most Americans if given a choice between their pay-tv provider and their smart phone would choose the smart phone, but they currently pay more for their pay-TV.We figured that if there were a shortage of capacity then the phone companies would get a lot of pricing power. Our figuring was that with $10-15 per month of extra pricing power Verizon would wind up as a very good stock indeed. And we did not see a reason to stop at $10-15. [It wasn't hard to develop a model where Verizon wound up worth more than Apple.]This of course led us to do a lot of research into telecommunications technology to see if we could verify Mr Stephenson’s claim of inevitable shortage. And as we discovered nothing in this space is ever as simple as Mr Stephenson’s blanket claims.So – at the risk of offending people with deep knowledge of how mobile telephony works – we are going to give you a crude understanding of the issues. We do it by simple analogy.Imagine us in a very large room (say a big indoor stadium), you with a receiver and me with a transmitter flashing a red light.  I could flash you a signal. Morse code would do.  With Morse code I could flash things to you at a maximum rate of about five characters per second. That is not very fast. Alternatively I could use a computer to control my flashing light and you could use a computer to read it.  I could then flash signal to you at about the intensity of a CD player. It’s quite a lot of information. More than enough for you to run the internet at a reasonable speed.  The first and most important way in which we have got more capacity is by using better and better signal encoding and decoding. In mobile telephony, we refer to the generations of transmission technology as analog, 2G, 3G and 4G (namely LTE). It was our assertion that this trend had reached its natural limit.  Now imagine there are 10,000 people in this room. I could flash a signal to all of them with my red light. And if I equipped all of them with a smart decoder (say a little computer built into your phone) then I could flash the signal encrypted – and they could decrypt it, pick out their bit of the signal and discard all the rest of the signal as white noise.  The problem now is that my red-light is shared between 10 thousand people and whilst it is very fast if used for one person it becomes quite slow when used for 10 thousand. There are multiple potential solutions. One solution is to beam my red light to every person individually – say using a laser. This is effectively what is done in a fiber-optic cable. The laser in the cable goes to me, and a different laser goes to you, and they are not mixed because they go down different fiber-optic cables. This offers anyone on the end of a fiber optic cable almost unlimited capacity. The problem is that you have to be connected to the fiber optic cable - and we use these things mobile.  There are possibilities of beaming radio-waves to people too, though for the most part this is laboratory stuff, not stuff already implemented by phone companies. [That said – it is said by some that the reason that AT&T wants to buy Straight Path is that their spectrum was good for beam forming.] Another more realistic solution for most purposes is cell division. Instead of using one big red light to signal everyone in the stadium, I could instead build hundreds (maybe thousands) of small transmitters each beaming a low intensity beam to small groups of people or even individuals.  There is no real limit to the amount of cell division if I make the power of the antenna low enough. That is, in part, what WiFi does. The power of a WiFi transmitter limits its range to about thirty meters. This means my WiFi transmitter does not interfere with your WiFi transmitter because they are more than say sixty meters apart. The amounts of information that can be carried on WiFi is enormous precisely because the transmitters are so low powered and so numerous.When someone says that they are going to “run out of spectrum” they are in some sense kidding you. One can always produce more capacity by cell division. The only problem is that it rapidly becomes enormously expensive. To cover America with WiFi one would need to build billions of transmitters. Cell division is expensive. Really expensive. Then there is another alternative. A cheap one. Just use another colour to transmit. Transmit to one person using red light and someone else using blue light. If my colours are far enough apart on the spectrum chart then they will not interfere with each other. Using another colour is another word for using more spectrum. Spectrum is an alternative to cell division and hence capital expenditure. Spectrum has value if it allows a carrier to avoid capital expenditure.This leads us to the three ways phone carriers (like AT&T or Verizon) have managed to carry more wireless data:a). Advances in encoding technology (from 3G to 4G, for instance),b). More cell division (deploying more equipment) thus shrinking the number of users sharing a single cell,c). Deploying more “colours”, also known as more spectrum.We then spent a lot of time researching the limits to each approach, and we focused on spectrum because Randall Stephenson led us there.Not all spectrum is equivalent. Some can go through walls (low frequency radio). Some cannot (eg visible light). But going through walls is important if I want to use my mobile phone inside.It turns out that to a rough approximation light can go through an object half its wavelength thick. (The physicists will pick objections to this statement.) But light at 600 MHz will go through the walls of most buildings but light at 5000 MHz (where upper-band WiFi is located) will not.This makes 600 MHz spectrum much more useful for mobile telephony. It is sometimes called “beach front spectrum” for this reason.There is a lot of high frequency spectrum available, but it does not have good propagation characteristics. Sprint – the US carrier - is unlikely to ever run out of such spectrum. There is, however, a limited amount of “beach front spectrum” available which has very good propagation characteristics.Thus the high frequency players like Sprint or T-Mobile in the US tend to offer cheap unlimited packages (because they have a lot of spectrum) but have lousy coverage.By contrast low frequency players (AT&T and especially Verizon) tend to have limited capacity (as there is limited low frequency spectrum) but great coverage (because it propagates well).In this sort of market we wanted to own the low-frequency players, as they own what is limited and valuable. But the low-frequency players do not have unlimited pricing power, because customers might jump to high-frequency players offering a cheap – albeit inferior – product.We purchased positions in shares in low frequency players who we believed would own increasingly valuable spectrum. We figured all we needed to do was wait.And the data was largely supportive. Verizon Wireless revenue grew quite quickly, even when the fixed line business was declining. Here is a slide of Verizon Wireless revenue from the 2013 Q4 Verizon earnings presentation (slide 7):Note eight percentage points of Wireless revenue growth – and very fast EBITDA growth.You could not see this in the Verizon accounts because the landline business was declining, but our logic was that the landline business would stop declining and the wireless growth would continue.The thesis was reinforced when very high and increasing prices were paid for spectrum in recent auctions in many jurisdictions in the world.We went so far as to download from the Federal Communications Commission a list of spectrum ownership by county in the US and match that with the population data from the census. We used spectrum prices that we saw being used by major parties in big auctions. Prices are usually considered in dollars per MHz per head of population. We concluded that Verizon offered the best valuation and that using this model owned $500 billion worth of spectrum. If the spectrum prices that we observed being paid were rational then Verizon in particular was really cheap.The Verizon position had an additional advantage: the penalty for being wrong appeared low. After all, if we were wrong, then we owned Verizon, a high-dividend paying “grandma” stock.AT&T’s behaviorOne fly in the ointment of our thesis was the continued bizarre behavior of the major carriers – especially AT&T. If the spectrum story was as good as we thought, then if you ran a telephone company you would not dilute your stock under any circumstances. You would largely use spare cash to buy back your stock and would bide your time until the loot flowed in from rising prices.If you believed Randall Stephenson’s story that is what you would do.Instead AT&T purchased DirecTV – a large satellite TV company.At one stage we had a large AT&T position. Their behavior convinced us to sell. Besides Verizon was better on the spectrum valuation model described above.Still this irked us. Perhaps we were wrong…The thesis brokeThere were several things that, should we observe them, would tell us we were wrong. These were:a) The price of spectrum at major auctions or major transactions not continuing to rise;b) Verizon, in particular, or low frequency carriers in general offering increasingly large bundles at lower prices; andc) Wireless revenue growth slowing.We were unconcerned about price competition for small data bundles (say 2GB of data per month) because we figured there was enough capacity to offer everyone a few GB of data. But we were very concerned if discounts were offered on large bundles of 10GB or more. Most importantly we did not want to see the reintroduction of unlimited bundles.Alas our thesis broke pretty rapidly on all three criteria over the past six months. The incentive auction (that is the recent US spectrum auction) produced much lower spectrum prices, Verizon reintroduced unlimited bundles, and revenue growth slowed--and then slowed some more (it is still positive, but only just).The entire position was sold.Obviously the engineers at Verizon think they can handle all the extra usage that will be piled on what we thought was their limited bandwidth.When the thesis is wrong it is time to sell.How bad could it getWe actually think it could get quite bad at the carriers. The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition. In that case the competitive forces will drive prices down to the low marginal costs – and it will be impossible to recover fixed costs.When the fixed costs are debt financed, bankruptcy often follows. That is precisely why the airlines have been bankrupt many times. The marginal cost of filling the otherwise empty seat is very low – and competition at times drives prices to those very low marginal costs.If wireless telephony capacity really is unlimited and the carriers insist on price wars then the future is bleak indeed. (For shareholders, if not for consumers.)We have gone from thinking the carriers were exceptionally good longs to believing they might be good shorts. We are not there yet: we would like to see falling wireless revenue first. But if spectrumisn’t truly scarce this could get ugly.John

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06 мая, 06:04

Trex's mysteriously high margin: a business analysis problem for you...

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Apple is a definitively high margin manufacturer. Everything about that company screams high margin.The stuff feels expensive and (frankly) is expensive. But you are willing to pay for it because (a) it defines your identity and how you feel about yourself, (b) really does work pretty well and (c) has very good ways of keeping competition out - so you can't buy a true substitute.On top of that Apple has software sales which (typically) are fatter margin than manufacturing.Let's spell out just how high margin.Here is Apple's 2017 second quarter results (link). Note these results are unaudited and in millions of dollars.Reported sales were $52,896 million, Gross Profit was $20,591 million, and Operating Income was $14,097 million.These are stunning numbers (especially because of their size) but lets spell them out as percentages...Gross margin was 38.9 percent.Operating margin was 26.7 percent.Just stunning numbers.--At Bronte we have the (justified) view that any manufacturing company with margins fatter than that needs some explaining.So let me present you Trex Company.Trex makes decking. Plastic decking. Outside many houses in middle America is timber deck often with a barbecue - or at least a grill - sitting at the end. This is a place for barbecue, socialising and - of course - beer.The beer is very important.The deck is also a frustration for owners because exposed to the weather the deck needs to be maintained regularly - and at a minimum oiled every year or so.Sure the frustration can be offset by more beer. And I guess that makes it okay.But these days you have an alternative - you can have fake timber decking. The fake timber is made of plastic and the sales pitch is that it looks just like timber but all you need to do for maintenance is sweep it.Plastic decking is sold as a superior alternative to timber.There are lots of suppliers. There is Trex Company, Fiberon, Azek and others. Beyond that Home Depot and Lowes have their own house brands (eg ChoiceDek available only at Lowes).So with plenty of competition for a building product where most people will not know the brand names (and where the purchase is large and so you might wish to shop it) you would expect lowish margins.But you would be wrong. The margins are stunning.Here is the last quarterly result (link). This time the numbers are in thousands of dollars rather than millions...Reported sales were $144,806 thousand, Gross Profit was $65,169 thousand, and Operating Income was $41,900 thousand.Again we should spell them out as percentages...Gross margin was 45.0 percent.Operating margin was 28.9 percent.Whoa - Trex Company - with lots of competition - is fatter margin than Apple.--So what is happening here? How the hell does Trex do it?There is your business puzzle for today.And if you are a journalist with a middle-America beat there is a great story here for you. This one is just made for the USA Today or non-business mainstream media.JohnDisclosure: short a little Trex (which traded badly on these results).This is not a death-grip short like say Home Capital Group. But it is a source of some amusement. I like puzzles like this.

29 апреля, 11:32

Home Capital Group - it is time for the Canadian regulator to act

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Home Capital Group is an aggressive Canadian home lender that has hit a very rough patch. If you want a history Twitter will do it well. They have been fighting with Marc Cohodes (a very well known short seller) and you will find a timeline of the unfolding disaster by following Marc's tweets. [Disclosure: I have known Marc for 17 years and we are friendly.]The crisis came this week when Home Capital Group entered into an emergency loan. The press release is here - but the salient points are repeated below.TORONTO – April 27, 2017 – Home Capital Group Inc. (“The Company” TSX: HCG) today announced that its subsidiary, Home Trust, has secured a firm commitment for a $2 billion credit line from a major Canadian institutional investor. The Company also announced it has retained RBC Capital Markets and BMO Capital Markets to advise on further financing and strategic options. The $2 billion loan facility is secured against a portfolio of mortgages originated byHome Trust. Home Trust has agreed to paying a non-refundable commitment fee of $100 million and will make an initial draw of $1 billion. The interest rate on outstanding balances is 10 per cent, and the standby fee on undrawn funds is 2.5 per cent. The facility matures in 364 days, at the option of Home Trust. The facility, combined with Home Trust’s current available liquidity, provides the Company with access to approximately $3.5 billion in total funding, exceeding the amount of outstanding High Interest Savings Account (HISA) balances. Home Trust had liquid assets of $1.3 billion as at April 25, plus an additional portfolio ofavailable for sale securities totalling approximately $200 million. Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA deposit balances that has occurred over the past four weeks and that has accelerated since April 20. The Company will work closely with the lender to have the funds available as soon as possible.This on the face of it is an extraordinary loan. It is secured by giving the collateral and costs something between 15 and 22.5 percent depending on how much is borrowed.Its also extraordinary because of what it does not mention. It does not mention who the lender is and it does not delineate what the precise capital is.But we know that this is being used to pay High Interest Savings Balances. We know there is a run on the bank here here and the run is several hundred million dollars per day.This is desperation financing. They are securing mortgages (average interest rate below 5 percent) to borrow funds that cost 15 percent or more. The negative carry is huge. A financial institution cannot stay in business under these terms.The stock reacted - dropping 60 percent in a day. The Canadian exchange busted some trades about $8.20 (because it thought that they were done in error). Mine were amongst the busted ones. I was perfectly happy to sell at that price however in their wisdom the exchange thought that mine was a fat-finger trade. [Disclosure - transaction to sell 30,000 shares at 8.19 was reversed.]--Anyway the next day we found out who the lender was. It was the Healthcare of Ontario Pension Plan (HOOP). This was unusual because Jim Keohane was on the board of Home Capital and also the CEO of HOOP. Likewise Kevin Smith - Home Capital's Chairman - was on the board of HOOP.The cries of conflict of interest were loud and undeniable.The next day Keohane resigned from Home Capital's board and Smith resigned from HOOP's board.--Then (Friday Canadian time) Jim Keohane gave the most extraordinary interview. You can find the whole thing here:http://www.bnn.ca/video/home-capital-not-a-risky-investment-for-us-hoopp-ceo~1111585But it is extraordinary because it gives the following details.a). The loans are secured by 200 percent of their value in mortgages (which makes the investment almost riskless - and Mr Keohane goes to some lengths to describe how low the risk is), andb). Me Keohane says the deal is more akin to a "DIP deal". DIP stands for debtor in possession and he is thus saying the deal is bankruptcy finance.This is an extraordinary position for Mr Keohane to take. He was an insider to both institutions (a true conflict of interest).What he is saying is that he isn't taking any risk because he has taken all the good collateral and he expects Home Capital go go bankrupt.And note that he will make 15 to 22.5 percent return (more if the loan is repaid early in a liquidation) whilst taking no risk.I have two words to say to this: fraudulent conveyance. In a rushed deal (one that truly surprised the market) done with undisclosed insiders up to four billion of the collateral and maybe three hundred million dollars of book value has been spirited away. And at basically no risk the recipient of all this largess.Wow that was audacious.  More audacious than just about anything I have ever seen on Wall Street.Jim Keohane seems to recognise what he has said because almost immediately he says that he doesn't know what the acronym DIP stands for.That surprised me: Mr Keohane uses the phrase DIP Financing precisely and accurately and in context and then says he doesn't know what it means. You should note that Mr Keohane is a very sophisticated fixed income player. (If you want a guide to how sophisticated read this...)The position of the Canadian GovernmentThe Canadian Regulator is put in an extreme bind. Up to $300 million of value has been spirited away from a highly distressed institution.The regulator however has guaranteed a very large amount of funding of Home Capital (guaranteed deposits). They should be alarmed at up to $4 billion in collateral being spirited away to HOOP. This effectively subordinates the insured depositors and in the event of Home Capital's failure will cost the taxpayer several hundred million dollars.This is not an idle concern. The funding itself indicates that it is very likely Home Capital will collapse. And a former director described this as akin to DIP Financing.If I were the regulatorIf I were the regulator I would be doing my duty here. My duty here is to protect the taxpayer.Very rapidly Home Capital needs to find a buyer to assume the government insured obligations. It does not matter if this happens at 20c per share. Indeed from a regulatory perspective it is better if it happens at a low share price because it gets rid of claims of bailouts inducing moral hazard.If Home Capital cannot find a buyer then it should be liquidated. Immediately. And the transaction with HOOP should be reversed under standard bankruptcy rules for reversing fraudulent conveyance. There is no reason that taxpayers should accept subordination to a loan yielding 15-20 percent.Indeed regulators have a duty to stop that sort of thing.JohnDisclosure: I am short a modest amount of Home Capital stock so I have a vested interest in its collapse. Canadian taxpayers are on the hook for billions in guarantees. They have a bigger vested interest. Either way this one is toast. But a special sort of toast which allows HOOP to keep all the cream and jam spread.Also note: this is the first Australian or Canadian mortgage lender to near collapse. That is an important step in the end of the property bubble.--It is also worth noting that Wikipedia give a standard list of indicators that fraudulent conveyance has taken place. Most appear to be triggered here.Becoming insolvent because of the transfer;Lack or inadequacy of consideration;Family, or insider relationship among parties;The retention of possession, benefits or use of property in question;The existence of the threat of litigation;The financial situation of the debtor at the time of transfer or after transfer;The existence or a cumulative effect of a series of transactions after the onset of debtor’s financial difficulties;The general chronology of events;The secrecy of the transaction in question; andDeviation from the usual method or course of business.

24 апреля, 12:34

A letter to my local State member

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Consider this a diversion from the usual finance posts on this blog.Today my concern is State politics in New South Wales, Australia.--In New South Wales we have just had a moral-conservative Premier who enacted late-night alcohol bans in large parts of Sydney justified from a moral panic about alcohol fuelled violence. This has destroyed much of Sydney's nightlife.I can imagine Anthony Bourdain doing a show on Sydney. It would be embarrassing. This city has become dull.The departed Premier also banned greyhound racing - which in Australia is a sort-of-poor-man's-horse racing. The dogs are a working class pursuit - sometimes involving cruelty to our canine friends (but probably not much worse than the cruelty to horses racing them). Electoral politics forced the Premier to reverse that ban.--Since then the New South Wales Premier has changed - and so I saw my chance to write a letter to my local politician.I have not received a response from him - so I am putting the letter here for wider circulation.Dear Rob StokesMember for Pittwater,  I am a member of your electorate. Address ***. I want to make sure that under Gladys Berejiklian the New South Wales Government continues its attempt to morally regulate everything enjoyable in human society. This was the tradition established by our departed and sorely missed honourable spoilsport and former Premier. You have banned drinking in large parts of Sydney. I applaud you. People should not be allowed to have a good time.  But you chickened out and reversed your entirely admirable ban on greyhound racing. I am deeply alarmed.  Worse: I have come across the new trend of corgi racing.  Here is a corgi race - the Ladbrokes Barkingham Palace Gold Cup. It looks like a lot of fun - and thus should be banned. Corgis are blessed creatures, dour hunting dogs suitable for keeping Her Majesty, Queen of Australia, company. But use of them to have a good time is abuse of the finest traditions. And an insult to our Queen and hence our system of Government. I want to make sure that you recommit to banning dog racing in New South Wales, and of the utmost importance you should commit to banning corgi racing. The suitably sour legacy of Mike Baird should be honoured by no less.And the Queen would approve.I await Mr Stokes' response and will post below.

17 февраля, 02:25

Syntel - a plea for help

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I don't often use the blog to find people who can just "tell me the story" but I am becoming increasingly puzzled by Syntel (SYNT:NASDAQ), an Indian outsourcing company and a competitor of Infosys and similar companies.This is a company I have had continuously analytically wrong - but made (very small) profits. I would rather be lucky than smart (and in this case I have been lucky) but with you dear readers I hope to be lucky and smart.I found Syntel on a systematic search for companies that were so incomprehensibly profitable that fraud was a reasonable suspicion.Syntel was one of about thirty that came up. (Incidentally that same search generated some longs when we worked out why the businesses were so profitable...)Anyway Syntel was full of red flags which made us investigate further for fraud. (We found no evidence of fraud in the end - but we did look.)Here are our red flags.Syntel has a fatter margin than most Indian outsourcing companies. On a quick search of Thomson Reuters the margin is about 5 percentage points fatter than most of the competitors. We could find no convincing explanation.The fat margin meant the company was extraordinarily profitable. Which is well and good - except that they never paid a dividend and never bought back any shares.The past profits - almost in their entirety - sat in cash and short term securities - undistributed in India. When this happens in China it is a very strong red-flag.The company was run by a husband and wife team. The board seemed very incestuous - controlled by the said team.A search of LinkedIn showed an enormous number of key staff who had left to competitors - sometimes for seeming demotions.The Indian outsourcing industry has had accounting frauds before (see the major fraud at Satyam) and so I had marked Syntel as something to research and maybe do a big research piece on.I was not the only person who thought the cash balances (which got to over a billion dollars) were weird. Here is an extract from a Seeking Alpha article referencing a conference call:"Great, thanks. I wanted to come back to cash, unfortunately it's really the only question I have. We've heard for years, cash has been a board discussion and it's evaluated every quarter. Can you share what reluctance has been from a board level to put the cash to work from an M&A perspective? And then given, there's been sluggish growth for a couple of years, has the board's attitude towards M&A change at all or is it still just as cautious as it has been in the past?" Result? Complete shutdown from management - not surprising. Further, there is no chance of activist involvement here given founder Bharat Desai's stranglehold on ownership (owning two thirds of the common shares outstanding). This was of course something I knew going in, but it is something for investors to consider that are weighing their position in the company.When management have a billion dollars sitting around that they do not use and will not explain the use of then we wonder whether something really fishy is going on. This company just seemed too profitable. And when something is seems too good to be true it often is too good to be true.Failed researchAt Bronte we are a fairly paranoid about companies that seem too profitable. We see 2+2=4 and think we ought to investigate for major fraud.We spent about a week on it and got nowhere. We simply could not find anything beyond these red-flags. However I could not convince myself of the excessive profitability either - so I kept a small - and I mean tiny - position short - just to force me to monitor results in the hope I would finally really work it out.Alas this disappeared into the (fairly extensive) list of things that I wanted to spend a couple of months researching - maybe to put out an extensive (and negative) research report.And then it was forgotten.---Comprehensively wrongThere are those moments when you realise you are comprehensively wrong. Syntel gave us one of those moments. They paid a dividend.Not an ordinary dividend - a billion dollars - $15 per share in dividend which is a lot given the current stock price is $20. All of those stored up cash and securities were liquidated and sent as cash to the shareholders.Whatever: we thought the company might be faking its margins - but it is was not. And we know for sure it wasn't because they sent a billion dollars of cash out to shareholders. It is easy to fake accounts (they are numbers filed electronically with the SEC). It is to our knowledge impossible to fake the distribution of cash to shareholders. And so we were comprehensively wrong. We turned around and bought back our short (remarkably at a small profit).What to do when you are comprehensively wrong...I have learned from experience that when I am comprehensively wrong about a short it is often very profitable to turn around and go long the same stock. Usually I short funky companies and they are funky for a reason - they are designed to bamboozle onlookers.But sometimes funky companies are funky because they have worked out something truly new - some better mousetrap - and they just seem weird. Those companies make good speculative longs. So we bought a tiny position in Syntel and decided (so far with little luck) to investigate it as a long. One of the things we decided was that because the cash was real (see the dividend) then the underlying business really was as it seemed. And we read the past dozen or so conference calls and decided the management were mostly matter-of-fact. They would tell you when the business was turning better or worse. And they were probably right. Given management statements and past results the stock was - we guessed - trading at about 9 times earnings of $2.40 or so for 2017. Given shareholder friendly management (see that dividend) and what seems a superior business (see that margin) that did not seem unreasonable.--Today's resultsSyntel today announced results that were not (very) inconsistent with guidance but they simultaneously guided down pretty sharply and the stock was off 17 percent. The small (dumb luck) profits we made on the short we have mostly given back. That said the results are not objectively bad. Cash is building up on the balance sheet again (and we know that is real). Margins are still superior for the business. All-in-all it still looks on the accounts like a better-than-decent business.And I am still none-the-wiser about what makes this business tick, why its margin is so much superior to the competition and why the management have this odd capital allocation strategy where they do nothing for years whilst cash builds up and then pay massive dividends.I am looking for readers - preferably customers of or competitors to Syntel - to explain what is really going on.Because - to be frank - I just don't understand.John

10 января, 06:56

A puzzle for the risk manager

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The last two posts were essentially about picking a value-stock portfolio and managing the risk. And they were lessons that I thought I could implement. This is stuff I find harder. So I am looking for your input.--This is the portfolio of a fairly well known value investor in March 2008. I have taken the name off simply because it doesn't help but there was roughly $4 billion invested this way.To put it mildly this portfolio was very difficult over the next twelve months. Sector allocation Positions Banks - Europe 24% Fortis, ING, Lloyds, RBS Banks - Japan 14% Millea, MUFJ, Mizuho, Nomura Banks - USA 8% Bank of America, JP Morgan Technology - PC & Software 18% Linear Technology, Maxim Integrated products, Oracle Semiconductor equipment 14% Applied Materials, KLA Tenecor, Novellus Systems Beer 20% Asahi, Budweiser, Group Mondelo, Heinekin, InBev Media 15% Comcast, News Corp, Nippon Television Other 14% eBay, Home Depot, Lifetime Fitness, William Hill Net effective exposure 127% Shorts -16% Net exposure 111% Cash -11% The PE ratios mostly looked reasonable and all of these positions could be found in quantity in the portfolios of other good investors. Its just the combination turned out more difficult than average.Your job however is to risk-assess the portfolio.Even with the considerable benefit of hindsight how would you analyse this portfolio?What would you say as risk manager that made the portfolio manager aware of what risks he was taking?What would you say if you were a third party analyst trying to assess this manager?What is the tell?Remember the portfolio manager here has a really good record and the "aura" around them. They are smarter than you.And yet with the restrospectascope up there is stuff that is truly bad.They had four European banks making up a quarter of the value of the portfolio. Most European banks went through the crisis hurt but not permanently crippled. Permanently crippled came later with the Euro crisis.The four European banks here (Lloyds, RBS, Fortis, ING) however received capital injections so large that they were effectively nationalised. If you had thrown darts at European banks it might have taken hundreds of rounds to pick four that bad... They could not have been picked this bad by chance - they had to have systematic errors here.There is something really wonky about this portfolio - and it is not by chance - so there was something faulty about the way the portfolio was constructed.JohnPS. It is fair to say some of the portfolio (News Corp for example) was awful in the crisis and came back stronger than ever. And some that I would have thought ex-ante high risk (such as the semi-conductor capital equipment makers) turned out okay - having "ordinary" draw downs in the crisis and recovering them since.PPS. I kept the document this came from because at the time I thought the portfolio was absurd and would end in tears. But some of my thoughts then were wrong too - especially re the semiconductor capital equipment stocks.

04 января, 15:04

When do you average down?

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The last post explained why I think a full valuation is not a necessary part of the investment process. A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.Valuation might normally be a set of questions along the lines of "what do I need to believe" to get/not get my money back.But I would prefer a simple modification to this process. This is a modification we have not done well at Bronte (at least formally) and we should do better. And that is the question of averaging down.--Warren Buffett is famously fond of "averaging down". If you liked it at $10 you should love it at $6. If it goes down "just buy more". And in the value investing canon you will not find that much objection to that view.But averaging down has been the destroyer of many a value investor. Indeed averaging down is the iconic way in which value investors destroy themselves (and their clients).After all if you loved something at $40 and you were wrong, you might love it more at $25 and you almost as likely to be wrong, and like it more still at $12 and could equally be wrong.And before you know it you have doubled down three times, turning a 7 percent position into a 18 percent loss.Do that on a few stocks and you can be down 50 percent. And in a bad market that 50 percent can be 80 percent.And if you do not believe me this has a name: Bill Miller. Bill Miller assembled a startling record beating the S&P ever year for fifteen straight years and then blew it up.Miller had a (false) reputation as one of the greatest value investors of all time: In reality he is one of the biggest stock market losers of all time and a model of how not to behave in markets.How not to behave is be a false value investor, buying stocks on which you are wrong, and recklessly and repeatedly average down.--At the other end traders who (correctly) think that people who average down die. The most famous exposition of this is a photo of Paul Tudor Jones - with a piece of paper glued to his wall stating that "losers average losers".And yet Warren Buffett and a few of his acolytes have averaged down many times and successfully. And frankly sometimes I have averaged down to great success.At least sometimes - the Bill Miller slogan is correct: "lowest average cost wins". Paul Tudor Jones may be a great trader - but he is not a patch on Warren Buffett.--I would love it if I had an encyclopaedic knowledge of every mid-cap in Europe and could buy the odd startlingly good business when tiny and cheap. But the task is too large. The world is complicated and I can't cover everything.But when I look at tasks that can be achieved by a four-analyst shop I have one very high on my list of things we can do and should do: We should get the average down decision right more often.So I have thought about this a lot. (The implementation leaves a little to be desired.)--At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.At the first pick the question then is "when are you wrong?", but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.So the question becomes is not "are you wrong". That is not going to add anything analytically.Instead the question is "under what circumstances are you wrong" and "how would you tell"?--When you put it that way it becomes obvious that you must not average down (much) on highly levered business models. And looking at Buffett he is very good at that. He bought half a billion dollars worth of Irish Banks as they collapsed. They went approximately to zero. But he did not double down. He liked them down 90 percent, he did not like them more down 95 percent.By contrast these are the stocks that Bill Miller blew up on: American International Group, Wachovia, Washington Mutual, Freddie Mac, Countrywide Financial and Citigroup. They were all levered business models.By contrast you can probably safely average down on Coca Cola: indeed Buffett did. It is really hard to work out a realistic circumstance in which Coca Cola is a zero. And if it is still growing there is going to be a price at which you are right - so averaging down is going to go some way to obtaining an average cost near or below that price. Of course even Coca Cola is not entirely safe. You could imagine a world where the underlying problem was litigation - where some secret ingredient is found to be a carcinogen and where the company faces an uncertain future of lawsuits. It is not likely - and if it happens you are going to get at least some warning that this is a circumstance on which you could be wrong. Whatever, outside that circumstance on which you might be warned, Coca Cola is not a leveraged business model subject to bankruptcy and is almost entirely unlikely to halve four times in a row. You can average that one down.Operationally levered business modelsNot every business model is as as safe as Coca Cola. Indeed almost every business model is more dangerous than Coca Cola. A not financially levered mining stock can halve five or six times. If you have a mining company that mines coal at $40 per tonne, has no debt and the price is $60 a tonne it is going to be really profitable. But prices below $40 (highly possible) will take profits negative. Add in some environmental clean up and some closing costs and it is entirely possible that a stock loses 95 percent of its value. Averaging down when down 40%, some more when it halves, and then halves again and it will still lose two thirds of its value. The difference between averaging stuff like that down and doing what Bill Miller did is only one of degree.It is still a disaster. And you will have proven Paul Tudor Jones adage: losers average losers.ObsolescenceThere is another iconic way that value investors lose money - and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999.You might thing it was worth owning Kodak as a "cigar butt stock" - plenty of cash flow and deal with the future later. There was a reasonable buy case for Kodak the whole way down. But technical obsolescence is always a way you should be wrong. When the threat is obsolescence you are not allowed to average down.Bill Miller averaged Kodak down. Ugh.---If I could improve our formal stock notes in any way I would like an ex-ante description of what circumstances we are allowed to average down a particular stock, and how much.We have a default at Bronte - and the default at Bronte is that we have a maximum percentage for a stock (typically say 9 percent but often as low as 3 percent depending on how we assess the risk of the stock) and as the fund manager I am allowed to spend that whenever I want but I am not allowed to overspend it. If we have a 6 percent position with a 9 percent loss limit and it halves I am allowed to add three percentage points more to the exposure. But that is it. Simon, being the risk manager, isn't particularly fussed if add the extra when the stock is down 30 percent of 50 percent, but I can't add it twice. If it is a position on which we agree we are allowed to risk 9 percent then I am allowed to risk 9 percent.We will not fall for the value investor trap of losing 18 percent on a 7 percent position.We have made a modification of this over time. And that is ever six to nine months I get another percentage point to add. That is at Simon's discretion - but the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more.But we can and should do better with ex-ante descriptions under the circumstances in which we are prepared to add and circumstances where we are not. The problem is that you can wind up in a mindset where you always where you want to add, where you think the world is against you and you are right and you will just be proven to be right.Clear ex-ante descriptions of the issue (which require competent business analysis) might help with that problem.--The bad case of averaging downThe iconic bad situation to average down is a levered business model involving fraud. It is surprisingly common because people who run highly levered business models have very strong incentives to lie or to cover it up when things turn to custard. I can think of two recent examples: Valeant and Sun Edison.Much to my shame I added to my (small) position in Sun Edison as it fell. Ugh. But also this was a highly levered business model and thus by definition the sort of place where losers average losers. I should not have done it - and I won't in future.But the highly levered business models apply fairly generally. When Bill Ackman rang Michael Pearson and asked if there was any fraud at Valeant he already had the wrong mindset. Then he added to a large holding in a company with over 30 billion dollars in junk-rated debt. Losers average losers.Incidentally our six month rule (before you were allowed to add) would have saved Mr Ackman a lot of extra losses. Time has revealed plenty about Valeant. And it would have saved me at Sun Edison too.--Whilst I think that someone asking me (as per the last blog post) for a valuation on every stock is absurd, I think it is entirely reasonable for them to ask "under what circumstances would you average down". If you can't answer that you probably should not own the stock. I should insist on it with every long investment.John