Admin Really Sucks

I hate admin. With a passion. In fact, I'd like nothing better than to light up the pile of papers on my desk right now with a flamethrower. But I can't. I would destroy months of effort. That's why one of the first things I will do when we have decent cash flow in a few months will be to hire a very strong admin person. Someone who can deal with all of logistical issues while allowing me to focus exclusively on investments. Good admins are worth their weight in gold. A great admin may well be paid their weight in gold if it allows us to be successful. We are going to succeed regardless, but I'd rather succeed quickly by thinking, focusing, and analyzing to the nth degree, than succeed slowly by wallowing in admin hell.

World Class

The distinguished Mr. Galt and I share many similarities in our thinking, but none more important than this: That anything we build together should and must be world class in every aspect. That's not to say that things will start out that way. Our hedge fund will not be launched in the same manner as Eric Mindich's fund. Our first $3 billion will come in a little slower than his did. But we share a vision regarding the final state of the finished product. Everything in between will be the critically important small steps along the way.

These small steps are going to be the hiring of some very bright people. We want them to spend most of their time thinking, not selling or doing admin. They should be wired to create, not to replicate. This organization is going to be very flat by design, with three levels of hierarchy max. Hierarchy is really not the right word anyway, we are going to build a meritocracy, where the rewards and honors will fall upon those who make significant positive contributions.

We are not going to broadcast our grand long term plans right now, or maybe ever. But we will say that the launch of the current fund will be followed by others over the next few years. There will be capital set aside for purely opportunistic situations as well. We will place a high premium on computing power at some point too. When we envision our finished product, it looks something like Citadel or Renaissance in scale and in scope.

We got our first check yesterday, so the pieces are falling into place at just the right time.

Getting Ready

If you've had enough philosophy over the last few days, this post will come as a breath of fresh air.

We are very close to being ready to go live. By the end of today, all of our accounts will be set up and we will be able to receive money. We already have checks coming in through the mail, and wiring instructions for others who want to get funds to us via wire. The trading platform has been loaded onto our computers, and we completed training on that system on Friday. We are "dry trading" until January 2, when we will flip the switch with real money.

Our business cards and letterhead is on its way as well. We are settled into the office now and the phone system and computer systems are all working properly. Our lawyers, accountants, and prime broker are all on the same page.

So in short, we are just about ready to go. We are already planning for all of the meetings and other forms of contact that we plan to have in January. Most people have mentally shut down for the holidays, so we are going to book things now for the next two months. The story is obviously a great one to tell, so we are excited about those prospects. Our strategy works pretty well in just about any market environment, but it really works well in this environment, so we can't wait to get started.

Lemme splain it to ya...

It seems that in the 230+ years since Adam Smith was around, many of our presidential candidates still don't understand that by raising taxes on the high-income earners (entrepreneurs), one provides a huge disincentive for them to not produce like they otherwise would. And when the prime movers don't produce, the ones who pay the most in the end are the folks at the lower end of the income spectrum, the workers, the employees, the less-well-educated, the unskilled, the poor.

So why would certain presidential candidates recommend something that badly hurts those they claim to represent? The honest answer is that they aren't very smart. Even most of the poor employees realize that pain rolls downhill. A business owner who can produce with little friction will hire more employees, pay them more, and be happier. A business owner with an increasingly heavy tax burden will be more likely to lay off people, or cut pay or benefits, or go out of business. All of which hurt the little guy.

In a capitalist society, everyone is better off with a wealth gap between the rich and poor, especially the poor. They have much more opportunity to rise up into the middle class. A society with no wealth gap is the epitome of communism. With no incentive to produce, no one does produce, and you wind up with food lines, starvation, unrest, and probably a dictator. Everyone is worse off.

The key to the wealth of a society is the ability of the prime movers (the top 1%) to produce whatever they are good at. It is the politician's job to recognize the value of the prime movers and stay out of their way. That means keep taxes low for the entrepreneur.

The top 1%

In my experience, the top 1% of the people determine the success or failure of most enterprises. Meaning, if you took away the top 1% of the people out of an endeavor, the entire thing would collapse very quickly into rubble. In a small organization (of say 20 people) you are talking about one person at most who holds the key to greatness or futility. A larger organization with 100,000 people could not withstand the best 1000 people being taken away; it would exist in name only less than one year later if it did not quickly replace its talent. The departure of best 3 million Americans (without replacement) would lead to the rapid demise of this country.

The only exceptions to this rule are organizations that are built specifically for high-octane, super-intelligent people: Google, Goldman Sachs, McKinsey, KKR, Blackstone, and a handful of think tanks. Every one of these organizations believes that the dumbest guy in the room should still be pretty damn smart compared to society.

I bring this up because the biggest challenge our organization will face in the first couple of years will be the ability to attract the best and brightest talent. That is every organization's biggest challenge; it is not unique to us. John Galt and I are determined to surround ourselves with folks who strive to be the best in everything they do. That sounds really cheesy and trite, but if you are around long enough, you start to realize that this is the rarest type of person, and the most coveted. A handful of top people can handle the workload of hundreds, and more importantly, they generate ideas and thoughts that the masses cannot. Those are worth their weight in gold, and they will be rewarded in kind.

Beware of the Behemoth

I was fortunte enough in 2000-2002 to watch with amusement many botched analyst recommendations. One prominent commercial bank put the Buy on EMC at 80, and then rode it down over a period of two years all the way to 3. At that point, they said that the fundamentals had changed, and they put the Sell on. Naturally, EMC slowly came back from that point. Never trust a commercial bank to get investments right.

But here's the scary thing: A big commercial bank is built to make money even when every important decision it makes is wrong. Incompetence in most areas does not mean that you should necessarily short it. Big banks are like out-of-control wrecking balls. Even though the operator may have left the control panel long ago, the ball will keep swinging wildly and knocking things down.

So the decision by Morgan Stanley to make Citi its number one short idea for 2008 is a curious one. Nobody doubts that there is probably more bad news to come out of Citi. Nobody doubts that the leadership of most investment banks and hedge funds could run circles around Citi's management team. Nobody doubts that you could take away 25% of its employees tomorrow and it would still be horribly bloated and inefficient. But to put a short on a major bank after it has already fallen nearly 50% in a few months is dangerous. Especially in a falling interest rate environment, where banks tend to do well.

Professionals lambasted commercial banks in 2002 and 2003 for their horrid mismanagement of investor portfolios. The major financial news sources had nearly an article every day about the wisdom of banks trying to manage money in the face of their own incompetence in this area. Yet, bank stocks rose tremendously during this time, even as they were pilloried in the media. The lesson here is that investment firms are built on brains, and banks are built on redundancies and safeguards. Morgan Stanley would do well to avoid the wrecking ball right now.

These Are the Best of Times

There is one sentiment that we are hearing more frequently these days from friends in the industry. "Aren't you guys trying to launch a hedge fund at a bad time?" After all, money was flowing into emerging hedge funds through July, and now that flow has slowed to a trickle as many investors have fled to bigger, more established names. The sub-prime mess has made people fearful of potential blowups, and their first emotional reaction tends to be panic selling.

Well, we don't have any sub-prime issues here, nor will we, but that is not the point. If you were to ask most investors (accredited investors, fund of funds, large institutions, etc) if they invest rationally or emotionally, nearly all would answer that they invest rationally. In fact, they would pride themselves in their ability to outthink the rest of the market. Yet when the black swan hits the market, they are among the first to retrench. By moving towards the perceived safety of a large entity, they are exhibiting all the wrong tendencies most people want in a money manager ("Even if I'm wrong, everyone else will be wrong too, and I won't look bad in comparison. They can't fire me for being with these bigger guys"). This drives the investment decision far more than anything else. So much for their clients' money. So much for their investment mandate. So much for rational thinking.

We saw this in commercial banks in 2000-2001. They had unexpectedly large inflows of capital as investors fled investment banks during the bear market. The safety that investors sought was merely an illusion; commercial bank portfolios performed terribly during that time, even relative to the market. Investing is outside the core competency of a commercial bank, and millions of investors paid the price.

The truth is that it is a wonderful time to launch. Our strategy is built to work under any conditions, but conditions such as these are ideal and should get us a couple of more points a year versus our long-term expectations. We explain it in very clear, easy-to-understand terminology with an emphasis on how the math works. We only show the worst-case scenarios, never the best case, because it helps people to understand their downside risk. Plus we like to surprise on the upside fairly often. All the hedges we put in place leave a clearly defined range of expected returns that fits well within most people's comfort levels. The lack of leverage and ample diversification are there to add more layers of comfort and safety. Many larger funds do not have these protections in place, so the safety sought in turbulent times can sometimes be elusive. Bigger does not always mean better, and almost never means safer.

Times like these tend to weed out most of the emotional investors anyway, so the investors we attract now will most likely be with us for a very long time. Truth be told, the market desperately needs the emotional investors. The volatility they bring to the party helps us a great deal. But they will not be investors in our funds.

Philosophy Time

You'll get two posts today, because our world headquarters was overwhelmed by admin yesterday. Between the lawyers, the accountants, and the prime broker, we had lots of paper flying. I can't wait to get this part out of the way so we can make clients some money. We probably ought to tell a little more about how we plan to accomplish that...

Our philosophy is that the markets exist where simple math meets human behavior. On one side, you've got a very rational, logical, orderly world (somebody cue Supertramp!) with well-defined rules and a striking absense of exceptions. On the other side, you've got complete chaos, with emotions running wild, people trying to follow a herd, not realizing that they are the herd, and poor decisions being made faster than we can laugh at them. This is our world. We put ourselves squarely at the intersection of rationality and irrationality. It's why we've always made money. If you are where the calm and the storm meet, you can channel and guide the resulting energy into positive returns.

As an simple example, if investors are taking a stock all over the map during volatile times, we can't control where the stock will ultimately wind up. But we can predict with a high degree of accuracy the points it will hit along its wild ride. By setting up bumpers at a select few of those points, we are able to channel a good portion of the return into our clients' pockets. We also set up brick walls just in case we are wrong. This way, our worst case for being 100% wrong isn't very bad, but our best case for being 100% right is very good. If we get it right half the time (or even less than half), we will still collect outsized returns with fairly low risk. So our hedges do an awful lot for us, in protecting investor money and adding to the returns. It's more complex than that of course, but the basic philosophy is surprisingly simple. We just have a bigger tool kit than most other people.

So bring on the chaotic mob and let them run into the orderly math. It's our job to make sure we wrap the math around the mob tightly enough. Sort of like not being able to stop Michael Jordan, but only hoping to contain him. We are the containment experts of the market.

Mortgage 911

If I put a gun to my head and pulled the trigger, I should not expect a reprieve from some higher authority, someone to give me another chance. If I knowingly and purposefully do harm to myself, I am abdicating my right to seek help from my fellow man.

So why on Earth did millions of Americans sign up for a major financial obligation they knew they couldn't meet? Sure, some of them could afford their houses at the time, and then life took a strange turn and they can't afford it now. But most of them fall into a few categories.

1. Dumbass - They just aren't bright enough to comprehend the implications of what they are agreeing to.
2. Keeping up with the Joneses - See #1. The Joneses are smarter than they are and make more money than they do.
3. Life happened - The job was eliminated, the wife has large medical bills now, the two kids are in college now, blah blah blah, etc. When getting a mortgage, you've got to worst-case everything, and plan for disasters. That means leave yourself some serious buffer room.
4. Evil mortgage broker - See #1. The buyers are most likely weak-minded fools who said yes to the first thing that sounded good. They didn't do their homework and now they are stuck.

So here's what I think the government bailout plan should look like:





That's right. Nothing. There shouldn't be a bailout plan. The government does not exist to protect you from your own stupidity. However, Bush and Paulson have joined forces to help over a million homeowners who bought at the top to get out of their mess. Wouldn't it be nice if this hedge fund could get government assistance when we buy securities at the top and then ride them down for over two years? Where's our handout, our free lunch? The government could just undo our bad trades and let us off the hook, right? (HA HA HA, please note extreme sarcasm)

What's going to happen is that the wrangling between banks, the G-men, and homeowners will continue for a while and create more investment opportunities. So while we really don't have a dog in this fight, we will be watching carefully at how this all goes down to take advantage of the blunder. It's sort of like being on the other team when they hand off the football to a fullback who's covered in grease. You know there's going to be a fumble and you've got to put yourself in a position to run it back the other way.

Have a safe and productive weekend!

Don't Frag Yourself ...

...or, How To Take Lemons and Turn Them Into a Large Pitcher of Margaritas.

Watching the flow of money has always fascinated me. It is astonishing how often money flows in predictable directions, even when the situation calls for the polar opposite movement. Whenever there is a crisis in a certain area, there is an inevitable abandonment of that sector and a sudden investment in "safety." But crisis always brings opportunity, if one spends a little time investigating the larger picture. The "safe" investment can vary, but it is almost always not anywhere near where the opportunity is, and often is a poor stand-alone investment. Following the crowd works when you need to go to the bathroom, but rarely is effective during an investment upheaval, because the crowd turns into lemmings and marches straight off a cliff, leaving the rewards to a small band of opportunistic traders who stay behind and sift through the wreckage looking for the opportunities.

Professor Robert Shiller of Yale University is at the forefront of a field of finance called behavioral finance, which examines how human emotions affect the process of making investment decisions. He has done a great deal of work to try to explain why the vast majority of investors will panic and sell at the bottom, or jump in and buy at the peak (after their hair stylist and landscaper have jumped in). 100+ years of market volatility have not changed the behavior of investors one lick; therefore there is something hardwired in many people that lead them to make poor decisions time and time again. The efficient markets hypothesis has as one of its core assumptions that humans are rational beings, and will act rationally in a variety of situations. Nothing could be further from the truth. The human race is lucky to still exist at all, given its abysmal history of rational decision making.

I don't think you can change the behavior of humans, but you sure can model it scientifically. It is possible to make accurate predictions of where money might flow in almost any situation. In the future, you will see us taking advantage of people's innate desire to self-destruct, although we are a few years away from that. Professor Shiller's work is still mostly in the theoretical stage; there are very few hedge funds taking full advantage of human irrationality. That is why there are winners and losers. If every poker player had the same style and same risk tolerance, then no one would make any money in the long run, they would just swap money around in the short term and break even in the long term. Therefore, poker would not exist.

It is important to know that because the vast majority of people get it wrong most of the time, there are investment opportunities created by this behavior alone. What companies are doing is also important, but not as important as knowing where the money will likely flow next. I've stopped wishing that people will behave rationally. We as a species are not capable of it. We don't need to be faster than the proverbial bear to get ahead, just faster than the guy next to us.

Bottlenecks

Eli Goldratt wrote that in any operation of any sort, bottlenecks are the critical points where the entire process can slow down or even stall out. I tend to agree with him. Bottlenecks are the most evil, pernicious, torturous constraints known to mankind. They waste your time and cost you money, and worse yet, force you to focus your attention away from your mission.

A bottleneck needs to be eliminated at all costs, with all guns blazing and artillery coming in too. Run for your life from anyone who proposes that bottlenecks can and should be managed. If you find in your life that you are working around bottlenecks instead of eliminating them, you are sacrificing long-term prosperity for short-term relief. Your only real options are to push forward or get the hell out of the way. If you choose neither, you have become a bottleneck yourself.

Traffic is the most obvious bottleneck of widespread public knowledge, and things like traffic lights and stop signs are only managers of bottlenecks. They don't eliminate the problem completely, they just slow the process of movement down enough so that there are no catastrophes. But in the end, the collective congestion is a larger catastrophe in itself.

For the last couple of weeks, our bottleneck has been the legal process of getting our partnership established. No accounts can be opened at any financial firm without it. Without accounts opened, investors cannot send in money, nor can we pay routine bills. Without that, we are not in business.

Fortunately, during this slow process, we have accomplished a great deal since moving in that we would have been hard pressed to complete later. I am happy to announce that the legal process has been completed, and we are once again full steam ahead. We should have wiring instructions to send to investors by Monday. Launch date is first business day of January.

On a side note, we hope to have our Bloomberg in place by the end of the year. Our strategy depends heavily on a highly detailed level of data that only Bloomberg can provide.

Where Is The Factory?

We are back from the weekend, and while driving around, I was struck by the unique nature of Atlanta as a distribution point. Obviously Hartsfield is the world's busiest airport; nearly everyone in the country has stopped over for a few hours on their way to somewhere else. The metro area is filled with regional distribution points for many industries. I don't know of any other American city that has the rules on trucking that Atlanta does. 18-wheelers are not allowed on the interstates inside the perimeter, and must use the right two lanes anywhere in the metro area. This does very little to help the traffic problem, but it's better than nothing. So there is an awful lot of moving people and stuff around Atlanta. People and stuff that almost always came from somewhere else.

So it should be no surprise that the same holds true in financial services. Every major investment bank has had an office in Atlanta for at least ten years. Insurance companies, commercial banks, and other financial firms have scurried to hire armies of salesmen to capture the unmistakable demographic migration from other areas of the country to the Southeast. If you want to speak to a local sales representative for a financial firm, there are 30,000+ ready and waiting to serve you.

But where is the factory? You will be hard-pressed to find the generators of ideas here. The manufacturing of new investment products and solutions is nowhere to be seen. There are a few small firms scattered about, but less than a handful have any national name recognition. Most people identify SunTrust as the top financial institution that is based in Atlanta, and they are right (Invesco is completing the transition from London to Atlanta). But since commercial banks are by definition devoid of thought, there is not much else for Atlanta to point to as a real thought leader.

Which is why I am excited, because we are going to be as much of a think tank as we are a hedge fund. There are so many investment vehicles to help clients make money and lower risk, and the salesmen don't know or understand about 90% of them. How are their clients going to understand? They aren't. We have our eyes on Citadel, Renaissance, and D.E. Shaw as examples of how to do it right. Those firms are factories of the mind, and their clients are much happier than any others. And when we need salesmen, we know exactly where to find them.