Peter Lynch -- an investor whose historical realized performance we should all be hoping to emulate! -- was just gaga about stock buybacks: i.e., he just loved being long companies who used some of their accumulated earnings to buy back some of their stock. So, if I admire Lynch, and he was the hottest fan of buybacks... why am I so, overall, "meh" about owning stocks of firms that do a lot of buybacks...?
"Anno Domini", my dear sir... the eternal problem of time!-). Lynch's great books, and great performance, are from the 1990's... it's now the 2010's, 20 years later. Companies' management has had plenty of time to figure out that stock buybacks are "costly signals" to the market, and therefore ones with a lot of intrinsic credibility... but the cost, if any is to be paid, is not from their pockets, but, the shareholders'. (Agent-principal issues potentially emerging again;-).
When a company buys back its own shares it clearly signals (costly, thus credibly) it believes shares are undervalued - contrarywise, stopping or delaying a buyback plan would signal it believes shares are fairy valued, or overvalued. CEOs typically hold far more in ("call") options than in shares -- a terribly badly designed incentive that makes them participate fully to the upside, but not at all to the downside.
Let me expound simply on why options (vs, e.g., restricted stock) are a terrible way to provide incentives to top management. Suppose you owned stock of ABC, currently trading for $100 a share. A certain move has 50% probability of moving ABC stock to $90, 50% probability of moving it to $110. As a shareholder, would you like that move?
Surely not -- it leaves you with the same expected returns while increasing your volatility, AKA risk... a crazy tradeoff! Normally, you'd demand higher expected returns to withstand an increase in risk (volatility).
But -- say you didn't own the stock itself, but a call option at strike 100 close to expiry. What would you think of the 90-or-110 move now?
You should be all in favor -- going down from at-the-money 100, to out-of-the-money 90, for the underlying, doesn't decrease the value of your expiring options... it stays at 0 either way. But, should the underlying soar to 110, you're making a 10% profit. "heads I win, tails I break even" is a superb bet, so of course you'll just love such a move which increases risk but not (shareholders') expected returns!
If you give your firms' CEOs options (rather than restricted stock), you're giving them strong incentives to increase the stock's volatility. Increasing future expected value would be great, too, of course... but, increasing risk with no increase in expected returns is clearly way easier... and by granting the CEO who works for you options rather than restricted stock, that (increase volatilily) is exactly the incentive you're giving him or her.
So that's problem #1 with buybacks (and acquisitions too): if they increase volatility but not expected returns, they're a great idea for your options-incented CEO... yet a bad bargain for you, the shareholder.
This is a general problem with giving top management options-centered bonuses. Buybacks have more specific issues, too... but, I guess that's a theme for a future post!-)
Monday, November 29, 2010
How would you like your cash back, sir?
We have examined how, despite Modigliani-Miller's theorem, in the real world we should prefer most firms, under most circumstances, to return to their shareholders some (a sustainable fraction) of the free cash flow resulting from operational earnings -- not to the point of incurring avoidable debt (except in cases where some debt can be had under very favorable conditions, and be wisely used to leverage the firm up in sectors requiring high capex but with a very steady and predictable cash flow as the result -- regulated utilities being the prime, classical example of this situation), but also avoiding excessive accumulation of cash hoards which yield very little (except in rare cases where a company has a proven track record of profitable acquisitions, with successful integration of the acquired firms, and requires substantial cash reserves to continue on that strategy going forward).
If you're still a Modigliani-Miller fan, I'd recommend taking a look at this article. By the way, as an aside, I do strongly recommend the aaii.com site -- it's very cheap and really chock-full with interesting and directionally-right information, even if you're a more experienced investor than they aim to. (if you're a beginning investor, AAII membership is really, truly, seriously, I-mean-it a must, BTW;-).
So anyway, back to the AAII article I just pointed to, which summarizes and discusses Arnott's and Assness's immortal 2003 article in "Financial Analysts Journal". To summarize the summary of the summary: companies that pay dividends have better (not worse, as M-M would predict) capital gains returns, too.
One of the possible explanations is that "high earnings retention and a low dividend payout may signal an attempt at empire-building by current management" -- in other words, such a high retention with low dividends is a negative signal, pointing at the risk of out-of-control acquisition spreads.
Some companies (a very few, with a proven historical track record) can retain earnings and use them to fund acquisitions in a way that's accretive of value to shareholders; by far the greatest majority just can't, and history proves that clearly. Arnott and Assness's "screen" may screen out companies likely to go on shareholder-negative acquisition binges -- and that may explain a lot of why it's predictive.
So, let's accept (for the sake of discourse) the overwhelming evidence that companies who do return some (reasonable, sustainable) fraction of earnings to shareholders, overall (i.e., always excepting many possible exceptions, which, in real-life, do abound), outperform those who hoard that cash.
There remains a problem -- per the title of this article: as an owner of some part of the company, accepting that it should return some of its cash to you, how would you rather get it back?
The main possibilities are, share buybacks, and dividends (which can take many forms). Dividends are "all the rage", lately... and, as a contrarian, I'm always especially wary when I find myself agreeing w/the hoi polloi... but in this one case I have to admit I can't really, credibly, disagree, either;-).
So, I'll follow on with posts on buybacks (when are they good, when are they a problem) and dividends (and the various forms they can take... though today's typical US investors may not realize dividends' multifarious possibilities and their pros and cons!-).
If you're still a Modigliani-Miller fan, I'd recommend taking a look at this article. By the way, as an aside, I do strongly recommend the aaii.com site -- it's very cheap and really chock-full with interesting and directionally-right information, even if you're a more experienced investor than they aim to. (if you're a beginning investor, AAII membership is really, truly, seriously, I-mean-it a must, BTW;-).
So anyway, back to the AAII article I just pointed to, which summarizes and discusses Arnott's and Assness's immortal 2003 article in "Financial Analysts Journal". To summarize the summary of the summary: companies that pay dividends have better (not worse, as M-M would predict) capital gains returns, too.
One of the possible explanations is that "high earnings retention and a low dividend payout may signal an attempt at empire-building by current management" -- in other words, such a high retention with low dividends is a negative signal, pointing at the risk of out-of-control acquisition spreads.
Some companies (a very few, with a proven historical track record) can retain earnings and use them to fund acquisitions in a way that's accretive of value to shareholders; by far the greatest majority just can't, and history proves that clearly. Arnott and Assness's "screen" may screen out companies likely to go on shareholder-negative acquisition binges -- and that may explain a lot of why it's predictive.
So, let's accept (for the sake of discourse) the overwhelming evidence that companies who do return some (reasonable, sustainable) fraction of earnings to shareholders, overall (i.e., always excepting many possible exceptions, which, in real-life, do abound), outperform those who hoard that cash.
There remains a problem -- per the title of this article: as an owner of some part of the company, accepting that it should return some of its cash to you, how would you rather get it back?
The main possibilities are, share buybacks, and dividends (which can take many forms). Dividends are "all the rage", lately... and, as a contrarian, I'm always especially wary when I find myself agreeing w/the hoi polloi... but in this one case I have to admit I can't really, credibly, disagree, either;-).
So, I'll follow on with posts on buybacks (when are they good, when are they a problem) and dividends (and the various forms they can take... though today's typical US investors may not realize dividends' multifarious possibilities and their pros and cons!-).
Saturday, November 27, 2010
are acquisitions good for you?
If you're a shareholder in the company being acquired, probably so; if in the company doing the acquisition, usually, not so much. Why is that? Because acquiring a company generally requires the acquirer to pay a "control" premium over the market's stock price -- that premium goes right into the pockets of the acquiree's stockholders (good for them!)... but it requires justification from the viewpoint of the acquirer's stockholders.
Say company BUY wants to buy out company SEL -- SEL's market cap just before the bid, $2 billions -- bid value, $2.5 billions (a pretty modest premium of 25%). What's SEL actually <b>worth</b>? If it's worth more than 2 billions, why was Mr Market silly enough to be happy to sell us shares at a $2 billions valuation? Well, Mr Market undoubtedly is prone to temporary follies, no doubt about it... but, if I'm the one supposed to finance this buyout (i.e., a BUY shareholder), you still have to show me that this is indeed the case in this specific instance.
If SEL's own assets (book value) are worth $1 billion, the remaining $1.5 billion of the acquisition price will go in BUY's asset account as "goodwill" -- always something worth looking out for: an intangible asset which just means "we paid so much more for some acquisitions than we can prove the acquired assets are worth"... not usually a good sign from my skinflint, value-oriented viewpoint.
From the viewpoint of optimistic, aggressive BUY's management (the kind of people you probably do want in charge of companies you own, overall), acquiring SEL is undoubtedly going to be a triumph -- it will grow their little empire, increasing their power (and likely their compensation in proportion), and it's just sure to work out great as their superior strategic vision strengthens SEL's direction (BUY's managers are of course totally certain that they're better than SEL's... and everbody else;-).
You could see this as a principal-agent incentive conflict problem, I guess, because there are cases in which the acquisition will benefit BUY's managers (increase their power and compensation) but not BUY's shareholders (reduce their overall returns on equity). However, I think that (for the typically forthright and honest -- but often overconfident! -- people who end up in top management) this is not a major consideration -- such cases are somewhat marginal. Normally, when the acquisition's a flop, BUY's management will not be happy either -- and when it's a triumph, both BUY's management and shareholders will benefit thereby... maybe not quite in the same proportions (in either case, win or lose), but that's a second-order consideration.
Rather, I think the natural "can-do" optimism (and, likely, overconfidence) of BUY's management is more likely to skew their vision in favor of acquisitions that would be better avoided (from BUY's shareholders' perspective) than any seriously distorted incentives.
That being said, the way-overused word, "synergy", sometimes does apply. Maybe SEL's bursting with brilliant people and ideas but just can't get capital enough to fund their projects, for example, while BUY can get abundant capital cheap, just because it's bigger and financially sounder. Maybe SEL, being a smaller company, suffers avoidable amount of overhead in supporting functions (such as, say, HR), which can be saved by merging the companies (maybe with some layoffs). Maybe SEL's wonderful products just can't get enough distribution, while BUY's excellent access to distribution channels can help those products make a real impact on the merged companies' top and bottom lines.
All of these situations (and more) are possible... just very hard to evaluate (in terms of probability of playing out, and likely returns if they do) for anybody who's not deeply enmeshed in the specific industry (as management of course will be, but many shareholders, even the "investor types" like me who do tons of due diligence, usually won't).
So, my own rule of thumb is to let past performance be predictive of future results -- I know everything about there being no guarantee there, but, hey, surely there is some correlation!-) I look at some companies and see a great track record of successful acquisitions over years and decades -- whether acquisitions play a supporting role in their overall company strategy (like, say, for AAPL), or a more central one (like, say, for MDT, or, even more, ORCL), they've repeatedly shown that they can successfully integrate newly acquired companies, and regularly do. I look at most companies and I see a track record of disaster, or, at best, a very mixed picture -- e.g., look at EBay's acquisition of Paypal (now arguably the brightest part of the company, with the very best growth prospects)... but also that of Skype (with the huge write-downs of goodwill and the need to hive that part off again in just a few years)...!-)
So, if I was a shareholder or considering buying into AAPL or EBAY (neither is true at this time, nor have I been in either company's stock for years), and a proposed acquisition by said company was announced, I'd react very differently. In AAPL's case, based on past performance, I'd give management enough credit to assume the acquisition won't be a bad hit against the firm's performance, and just might work out awesomely well. In EBAY's, again based on past performance, I'd be much more skeptical -- unless the underlying business logic is crystal-clear enough even to a duffer like me (in which case I'd dig deeper into the financials' entrails), like, say, Paypal's acquisition was, I'd be prudentially assessing the likelihood that management's about to play another Skype on me... and looking for an opportunity to get out of the stock (or just avoid getting into it in the first place).
The fact that the vast majority of mergers and acquisitions don't work out, is part of why I'm dubious about the possibilities of most companies hoarding big treasure troves of cash -- they enable management to perform more and more acquisitions that I, as a BUY shareholder, would rather see not happen. All of this applies to acquisitions in cash, BTW -- if you have incredibly overvalued stock, and can acquire real value in that weirdly inflated currency (like AOL did to Time Warner a few years ago), hey, more power to you (and then I'd be more worried as a shareholder of SEL!-). But, cash is still worth $1 per buck (despite the Fed's best attempts to the contrary;-), so, as a BUY shareholder, I'd usually rather see that cash in my own pockets, than in those of SEL's shareholders!-)
Say company BUY wants to buy out company SEL -- SEL's market cap just before the bid, $2 billions -- bid value, $2.5 billions (a pretty modest premium of 25%). What's SEL actually <b>worth</b>? If it's worth more than 2 billions, why was Mr Market silly enough to be happy to sell us shares at a $2 billions valuation? Well, Mr Market undoubtedly is prone to temporary follies, no doubt about it... but, if I'm the one supposed to finance this buyout (i.e., a BUY shareholder), you still have to show me that this is indeed the case in this specific instance.
If SEL's own assets (book value) are worth $1 billion, the remaining $1.5 billion of the acquisition price will go in BUY's asset account as "goodwill" -- always something worth looking out for: an intangible asset which just means "we paid so much more for some acquisitions than we can prove the acquired assets are worth"... not usually a good sign from my skinflint, value-oriented viewpoint.
From the viewpoint of optimistic, aggressive BUY's management (the kind of people you probably do want in charge of companies you own, overall), acquiring SEL is undoubtedly going to be a triumph -- it will grow their little empire, increasing their power (and likely their compensation in proportion), and it's just sure to work out great as their superior strategic vision strengthens SEL's direction (BUY's managers are of course totally certain that they're better than SEL's... and everbody else;-).
You could see this as a principal-agent incentive conflict problem, I guess, because there are cases in which the acquisition will benefit BUY's managers (increase their power and compensation) but not BUY's shareholders (reduce their overall returns on equity). However, I think that (for the typically forthright and honest -- but often overconfident! -- people who end up in top management) this is not a major consideration -- such cases are somewhat marginal. Normally, when the acquisition's a flop, BUY's management will not be happy either -- and when it's a triumph, both BUY's management and shareholders will benefit thereby... maybe not quite in the same proportions (in either case, win or lose), but that's a second-order consideration.
Rather, I think the natural "can-do" optimism (and, likely, overconfidence) of BUY's management is more likely to skew their vision in favor of acquisitions that would be better avoided (from BUY's shareholders' perspective) than any seriously distorted incentives.
That being said, the way-overused word, "synergy", sometimes does apply. Maybe SEL's bursting with brilliant people and ideas but just can't get capital enough to fund their projects, for example, while BUY can get abundant capital cheap, just because it's bigger and financially sounder. Maybe SEL, being a smaller company, suffers avoidable amount of overhead in supporting functions (such as, say, HR), which can be saved by merging the companies (maybe with some layoffs). Maybe SEL's wonderful products just can't get enough distribution, while BUY's excellent access to distribution channels can help those products make a real impact on the merged companies' top and bottom lines.
All of these situations (and more) are possible... just very hard to evaluate (in terms of probability of playing out, and likely returns if they do) for anybody who's not deeply enmeshed in the specific industry (as management of course will be, but many shareholders, even the "investor types" like me who do tons of due diligence, usually won't).
So, my own rule of thumb is to let past performance be predictive of future results -- I know everything about there being no guarantee there, but, hey, surely there is some correlation!-) I look at some companies and see a great track record of successful acquisitions over years and decades -- whether acquisitions play a supporting role in their overall company strategy (like, say, for AAPL), or a more central one (like, say, for MDT, or, even more, ORCL), they've repeatedly shown that they can successfully integrate newly acquired companies, and regularly do. I look at most companies and I see a track record of disaster, or, at best, a very mixed picture -- e.g., look at EBay's acquisition of Paypal (now arguably the brightest part of the company, with the very best growth prospects)... but also that of Skype (with the huge write-downs of goodwill and the need to hive that part off again in just a few years)...!-)
So, if I was a shareholder or considering buying into AAPL or EBAY (neither is true at this time, nor have I been in either company's stock for years), and a proposed acquisition by said company was announced, I'd react very differently. In AAPL's case, based on past performance, I'd give management enough credit to assume the acquisition won't be a bad hit against the firm's performance, and just might work out awesomely well. In EBAY's, again based on past performance, I'd be much more skeptical -- unless the underlying business logic is crystal-clear enough even to a duffer like me (in which case I'd dig deeper into the financials' entrails), like, say, Paypal's acquisition was, I'd be prudentially assessing the likelihood that management's about to play another Skype on me... and looking for an opportunity to get out of the stock (or just avoid getting into it in the first place).
The fact that the vast majority of mergers and acquisitions don't work out, is part of why I'm dubious about the possibilities of most companies hoarding big treasure troves of cash -- they enable management to perform more and more acquisitions that I, as a BUY shareholder, would rather see not happen. All of this applies to acquisitions in cash, BTW -- if you have incredibly overvalued stock, and can acquire real value in that weirdly inflated currency (like AOL did to Time Warner a few years ago), hey, more power to you (and then I'd be more worried as a shareholder of SEL!-). But, cash is still worth $1 per buck (despite the Fed's best attempts to the contrary;-), so, as a BUY shareholder, I'd usually rather see that cash in my own pockets, than in those of SEL's shareholders!-)
Tuesday, November 23, 2010
Paper money: a Faustian bargain?-)
I've been enjoying Weatherford's delightful History of Money as an audiobook (that's the one plus of having to commute by car, now that I've moved to Sunnyvale so can't really walk to work in Mountain View as I used to -- in the 20+ minutes of drive each way, instead of radio which at any time might be speaking about interesting things or inane ones [or playing ads -- or thanking sponsors or hustling for donors, if it's NPR;-)], you can listen to cool audiobooks of your choosing!-).
Among its many charming details is a sound "monetary" (and literary) analysis of Goethe's Faust (Part Two) -- remember the immortal verses (in Lange's popular translation to English, cfr Google's version) in which Faust, alternating with Mephisto, pleads to the Emperor in favor of paper money...?
What Faust does with the newly abundant paper money is -- try to drain marshes, build roads, propel the Empire to new, real prosperity, which the scarcity of species previously held back. And (in W's reading) that is why the Angels in the end shield Faust from the devil "for his unending striving"... because that's what the economy is, whether it's held back by scarcity of species or propelled forward by abundance of paper money -- an unending striving to make things better (albeit beset by rogues and Madoffs...), to build real prosperity. The great Poet is not just sounding a worried, backwards-looking alarm against the easy excesses of paper money, as he's usually read -- he's also, in the same breath, pointing to the positive, creative "unending striving" it makes possible (despite all the selfish rogues), for those who really do want to "unendingly strive" to build a better world for all.
In other words (and that's my own parallel, thinking of the "news of today") -- Bernanke is Faust. The superficial observers (most of us) only see the "pact with the Devil" aspect, and want to take away the original part of the Fed's mandate (the one about full employment) to make it focus entirely on keeping the currency sound (as it did in 1929... fat lot of good it did back then, hm? only as nations, including the US, dropped the gold standard, and roughly in the same chronological order as they did so, did each of them manage to start the monumental task of draining the swamp of Depression -- only paper money enabled that, just like only it, the understandably maligned Continentals, enabled the thirteen colonies to finance their terrible wars against England...!). But -- Bernanke's fighting to promote the "unending striving" that's the only possible path to prosperity. In the end, even though the Devil may prevail, the Angels will come in to defend him and save him!-)
Among its many charming details is a sound "monetary" (and literary) analysis of Goethe's Faust (Part Two) -- remember the immortal verses (in Lange's popular translation to English, cfr Google's version) in which Faust, alternating with Mephisto, pleads to the Emperor in favor of paper money...?
The excess of treasure frozen in your lands,//Deep in the soil awaiting human hands,//Lies there unused. The furthest range of thought//Cannot define such riches as it ought...and therefore the Emperor should solve his monetary problems by issuing abundant paper money backed by all the yet-unextracted gold, silver and gems in the land belonging to the Empire? I had always taught of that as the typical "Faustian bargain" -- a devil-inspired one. However, Weatherford's reading is different: Mephistopheles' ends are of course evil (it's definitely possible, even easy, for paper money to be abused to evil, greedy, selfish ends by the State's rulers)... but, not Faust's own!
What Faust does with the newly abundant paper money is -- try to drain marshes, build roads, propel the Empire to new, real prosperity, which the scarcity of species previously held back. And (in W's reading) that is why the Angels in the end shield Faust from the devil "for his unending striving"... because that's what the economy is, whether it's held back by scarcity of species or propelled forward by abundance of paper money -- an unending striving to make things better (albeit beset by rogues and Madoffs...), to build real prosperity. The great Poet is not just sounding a worried, backwards-looking alarm against the easy excesses of paper money, as he's usually read -- he's also, in the same breath, pointing to the positive, creative "unending striving" it makes possible (despite all the selfish rogues), for those who really do want to "unendingly strive" to build a better world for all.
In other words (and that's my own parallel, thinking of the "news of today") -- Bernanke is Faust. The superficial observers (most of us) only see the "pact with the Devil" aspect, and want to take away the original part of the Fed's mandate (the one about full employment) to make it focus entirely on keeping the currency sound (as it did in 1929... fat lot of good it did back then, hm? only as nations, including the US, dropped the gold standard, and roughly in the same chronological order as they did so, did each of them manage to start the monumental task of draining the swamp of Depression -- only paper money enabled that, just like only it, the understandably maligned Continentals, enabled the thirteen colonies to finance their terrible wars against England...!). But -- Bernanke's fighting to promote the "unending striving" that's the only possible path to prosperity. In the end, even though the Devil may prevail, the Angels will come in to defend him and save him!-)
Wednesday, November 17, 2010
Firms' debts and cash: Modigliani-Miller vs the real world
My considerations about "holding cash" in Should you "be in cash" were entirely focused on what an investor should to about it -- my ideas are very different about what a firm (that the investor part-owns: remember that I consider it crucial to think about investing as owning a part of a firm!) should do about it are very different.
The Modigliani-Miller theorem shows that (under totally idealized conditions) it makes no difference at all what a firm does about its finances -- retain earnings or distribute them in whatever way (dividends, share buy-backs, &c), incur debts or sell more equity, whatever -- the theorem is often known as the capital structure irrelevance principle, exactly because it shows that, under certain assumptions, all of these details about a firm's capital structure and financing are just that, irrelevant.
However, much as the maths in question may fascinate me (and much as I may be personally biased towards this theorem by Modigliani being Italian;-), I consider the beautiful theoretical result in question pretty much irrelevant to the real world -- after all, among those "certain assumptions", it assumes efficient markets (which I consider a myth), no taxes (don't you just wish;-), no asymmetric information (ha!-), no agent-principal issues, and more.
In real life, a company's decision to incur debt (and in what form -- long term vs short, bonds vs bridge loans, intermediate forms now a bit out of favor like preferred stocks and convertible bonds) or hoard cash or both, and of whether, how much, and in what form, return "extra" cash to shareholders, does make a huge difference.
In particular: capital markets can and do "just freeze up", as the recent "great recession" amply proved -- making it risky to hold (especially) short-term debt in excess of the liquid assets available to repay it if needed. Acquisition opportunities do emerge, and being able to make a buy-out offer that's mostly or all cash (as opposed to acquiring-company shares) does make a difference (especially in credit-straitened times) to the chance that the offer will be successful. These considerations push many companies to hold a veritable treasure-hoard of cash and cash-equivalents (to the point where I believe that recently many otherwise-excellent companies, today, have gone overboard in this respect, holding far too much cash in their coffers -- mostly an understandable over-reaction to what the credit markets did over the last three years, I believe).
On the other hand, taxes are, of course, a reality, and have long encouraged companies (weirdly, in my opinion) to hold debt -- interest charges can be deduced from taxable earnings, while dividends, owners' capital gains, &c, cannot -- so, if a company needs a certain amount X of working capital to keep producing its earnings, and people who can supply it with capital require a certain remuneration (yield -- including interests for lenders, and dividends and capital appreciation for shareholders), it's cheaper for a certain fraction of X to be debt (up to the point where potential lenders become nervous about the company being over-leveraged and start demanding higher interest rates) than it is for it to be all equity.
The optimal debt-to-equity ratio, BTW, depends on the specific firm (and, in large measure, on what industry the firm is in): regulated utilities, in particular, have steady, predictable, "boring" income flows (and "boring" is a good thing for a lender), so they may leverage up with very substantial amounts of debt and still pay decent rates of interest -- while their lack of substantial growth prospects makes potential shareholder demand higher dividend yields than they do from firms in other industries (shareholders in utilities aren't looking for prospect of big capital gains). So, the assessment of whether a certain firm (that you're considering investing in) may be over-leveraged (a big risk to shareholders) or under-leveraged (holding too much cash -- not a risk, but depressing to prospective returns on equity), must depend on analyzing these factors.
And then sometimes there's a bubble in bond markets (we've been going through one of those for a while now!), and solid companies (ones where nobody's worrying about their going bankrupt) can sell bonds at ridiculously low interest rates (like MSFT's recent bonds that pay less than 1% interest!) -- when (for a company with no real risk of bankruptcy, and still some hope of future growth though quite possibly well beyond the "early tumultuous growth" phase of its life cycle) bonds pay much less yield in interest than stocks do in dividends, it's no doubt prudent and responsible for management to "take the near-free cash" by selling such bonds (as long as the resulting increase in the cash hoard is returned to shareholders in some way, or at least used responsibly to fund reasonably-profitable growth, rather than held entirely in sterile cash or squandered in wasteful acquisitions, perks, &c).
Of course, that parenthetical "as long as" condition can be quite a problem (and that's where agent-principal problems can emerge...), but, that's a discussion well worth its own post. The gist of this one is, rather, that whatever the theory (Modigliani and Miller's theorem) has to say about it, there are proper, prudent and profitable ranges of debt/equity ratio for a firm (depending on its industry sector, credit-market conditions and prospects, and other such considerations) and a prospective investor (or lender) would be well advised to take them into due consideration (carefully avoiding "gut" reactions about firms having "too much" debt, or "too much" cash -- either condition is quite possible, and occasionally even both are observed together!, but each such case must be weighed on its individual merits).
In future posts I plan to discuss acquisitions, and the issue of how (as well as whether and how much;-) to return "excess cash" to shareholders rather than hoard it (and/or use it to pay down some debt prematurely) -- dividends (regular and special) and stock repurchases. All of these issues are enmeshed with potential problems that can be couched in principal-agent terms (i.e., potential conflicts of interests and incentives between the firm's owners and its management), and indeed one could say that the agency dilemma is at or near the core of each and every one of them...
The Modigliani-Miller theorem shows that (under totally idealized conditions) it makes no difference at all what a firm does about its finances -- retain earnings or distribute them in whatever way (dividends, share buy-backs, &c), incur debts or sell more equity, whatever -- the theorem is often known as the capital structure irrelevance principle, exactly because it shows that, under certain assumptions, all of these details about a firm's capital structure and financing are just that, irrelevant.
However, much as the maths in question may fascinate me (and much as I may be personally biased towards this theorem by Modigliani being Italian;-), I consider the beautiful theoretical result in question pretty much irrelevant to the real world -- after all, among those "certain assumptions", it assumes efficient markets (which I consider a myth), no taxes (don't you just wish;-), no asymmetric information (ha!-), no agent-principal issues, and more.
In real life, a company's decision to incur debt (and in what form -- long term vs short, bonds vs bridge loans, intermediate forms now a bit out of favor like preferred stocks and convertible bonds) or hoard cash or both, and of whether, how much, and in what form, return "extra" cash to shareholders, does make a huge difference.
In particular: capital markets can and do "just freeze up", as the recent "great recession" amply proved -- making it risky to hold (especially) short-term debt in excess of the liquid assets available to repay it if needed. Acquisition opportunities do emerge, and being able to make a buy-out offer that's mostly or all cash (as opposed to acquiring-company shares) does make a difference (especially in credit-straitened times) to the chance that the offer will be successful. These considerations push many companies to hold a veritable treasure-hoard of cash and cash-equivalents (to the point where I believe that recently many otherwise-excellent companies, today, have gone overboard in this respect, holding far too much cash in their coffers -- mostly an understandable over-reaction to what the credit markets did over the last three years, I believe).
On the other hand, taxes are, of course, a reality, and have long encouraged companies (weirdly, in my opinion) to hold debt -- interest charges can be deduced from taxable earnings, while dividends, owners' capital gains, &c, cannot -- so, if a company needs a certain amount X of working capital to keep producing its earnings, and people who can supply it with capital require a certain remuneration (yield -- including interests for lenders, and dividends and capital appreciation for shareholders), it's cheaper for a certain fraction of X to be debt (up to the point where potential lenders become nervous about the company being over-leveraged and start demanding higher interest rates) than it is for it to be all equity.
The optimal debt-to-equity ratio, BTW, depends on the specific firm (and, in large measure, on what industry the firm is in): regulated utilities, in particular, have steady, predictable, "boring" income flows (and "boring" is a good thing for a lender), so they may leverage up with very substantial amounts of debt and still pay decent rates of interest -- while their lack of substantial growth prospects makes potential shareholder demand higher dividend yields than they do from firms in other industries (shareholders in utilities aren't looking for prospect of big capital gains). So, the assessment of whether a certain firm (that you're considering investing in) may be over-leveraged (a big risk to shareholders) or under-leveraged (holding too much cash -- not a risk, but depressing to prospective returns on equity), must depend on analyzing these factors.
And then sometimes there's a bubble in bond markets (we've been going through one of those for a while now!), and solid companies (ones where nobody's worrying about their going bankrupt) can sell bonds at ridiculously low interest rates (like MSFT's recent bonds that pay less than 1% interest!) -- when (for a company with no real risk of bankruptcy, and still some hope of future growth though quite possibly well beyond the "early tumultuous growth" phase of its life cycle) bonds pay much less yield in interest than stocks do in dividends, it's no doubt prudent and responsible for management to "take the near-free cash" by selling such bonds (as long as the resulting increase in the cash hoard is returned to shareholders in some way, or at least used responsibly to fund reasonably-profitable growth, rather than held entirely in sterile cash or squandered in wasteful acquisitions, perks, &c).
Of course, that parenthetical "as long as" condition can be quite a problem (and that's where agent-principal problems can emerge...), but, that's a discussion well worth its own post. The gist of this one is, rather, that whatever the theory (Modigliani and Miller's theorem) has to say about it, there are proper, prudent and profitable ranges of debt/equity ratio for a firm (depending on its industry sector, credit-market conditions and prospects, and other such considerations) and a prospective investor (or lender) would be well advised to take them into due consideration (carefully avoiding "gut" reactions about firms having "too much" debt, or "too much" cash -- either condition is quite possible, and occasionally even both are observed together!, but each such case must be weighed on its individual merits).
In future posts I plan to discuss acquisitions, and the issue of how (as well as whether and how much;-) to return "excess cash" to shareholders rather than hoard it (and/or use it to pay down some debt prematurely) -- dividends (regular and special) and stock repurchases. All of these issues are enmeshed with potential problems that can be couched in principal-agent terms (i.e., potential conflicts of interests and incentives between the firm's owners and its management), and indeed one could say that the agency dilemma is at or near the core of each and every one of them...
Sunday, November 14, 2010
Should you "be in cash"?
Of course you should have some portion of your wealth in cash (or cash-equivalent, but make sure the "equivalence" does hold: many thought of the weekly-auctioned muni bonds as such, and the crisis showed them they were wrong...) as a buffer against emergencies (no-penalties CDs, and ones with very small pre-withdrawal penalties like 60 days' worth of interest, may be a good way to keep most of that buffer -- I've seen that these days the best such offers, esp. from online-only banks, surpass 1.5% APYs, which sure beats the tiny-fraction-of-a-percent you can get from treasury bills and the like; just make sure you're fully covered by FDIC insurance!). That's the part of your wealth, a small or big fraction as you may decide to make it, that's not "investable" (not with any safety and peace of mind, that is -- and those qualities are just priceless!-). That's not what I'm talking about -- nor is the obvious fact that repaying any high-interest debt you may owe is probably a better use of any money you can spare than just about any other "investment" (with the possible exception of a good low-cost 401k with generous employee-matching of your contributions).
No, I'm talking about the "investable" portion of your wealth -- whatever's left after repaying high-interest debts, if any, and keeping a "safety cushion" in cash sufficient to give you whatever amount of surety and peace of mind you prefer. Is there ever any case for keeping some fraction of your investable funds as cash?
A controversial topic, to be sure -- some are horrified at cash's low or even (in real terms) negative yields, other (typically with more experience) are adamant about "always having some dry powder" (readily investable cash) to take advantage of whatever weird opportunity batty-though-likeable Mr Market might be presenting them with next. And (what a contrarian would I be otherwise?-) I agree with neither extreme position.
Let's start with a Warren Buffett quote (you can never go wrong with those!-), one which doesn't mention cash but is actually very relevant to this issue...:
At times in history when cash-equivalent holdings were (in real terms) devaluating in double digits (remember the '70s, anybody...?-), holding cash was a really serious ongoing cost... but, at times like this one, when the real rate for holding cash-equivalents is so close to zero, that doesn't really matter.
The only real cost of holding cash is the opportunity cost, which would occur if good investment opportunities occurred (with strong safety margins, probabilities of success, and expected returns) and were not taken. But that's balanced by the opportunity cost of not having investable cash, "dry powder", to take advantage of a good investment opportunity should one occur tomorrow -- the two considerations should just about balance each other out, removing any bias against "holding some dry powder" as well as any bias towards always holding some.
So, the decision should always depend on the case-by-case, bottom-up analysis of the actual pitches Mr Market is pitching at you all the time; if none are attractive enough to meet your criteria for margin of safety, probability of success, and profit potential, keep waiting (but don't keep waiting if and when the good pitches do come, just based on a fetish for always "holding some dry powder" -- if you never actually invest it, it's not really investable cash anyway, right?-).
No, I'm talking about the "investable" portion of your wealth -- whatever's left after repaying high-interest debts, if any, and keeping a "safety cushion" in cash sufficient to give you whatever amount of surety and peace of mind you prefer. Is there ever any case for keeping some fraction of your investable funds as cash?
A controversial topic, to be sure -- some are horrified at cash's low or even (in real terms) negative yields, other (typically with more experience) are adamant about "always having some dry powder" (readily investable cash) to take advantage of whatever weird opportunity batty-though-likeable Mr Market might be presenting them with next. And (what a contrarian would I be otherwise?-) I agree with neither extreme position.
Let's start with a Warren Buffett quote (you can never go wrong with those!-), one which doesn't mention cash but is actually very relevant to this issue...:
The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'."Not swinging" (because the right pitch, i.e., investment opportunity, hasn't come yet) means "staying in cash" (with that fraction of your funds) rather than using them for inferior investments that don't meet your own personal criteria for margin of safety, probability of success, and potential returns. "Keeping some dry powder" no matter what means never "swinging" (again: for that specific fraction of your funds) no matter how perfect for you the pitch is. Clearly, neither can be right: you should swing when the right pitch comes, but, not before!
At times in history when cash-equivalent holdings were (in real terms) devaluating in double digits (remember the '70s, anybody...?-), holding cash was a really serious ongoing cost... but, at times like this one, when the real rate for holding cash-equivalents is so close to zero, that doesn't really matter.
The only real cost of holding cash is the opportunity cost, which would occur if good investment opportunities occurred (with strong safety margins, probabilities of success, and expected returns) and were not taken. But that's balanced by the opportunity cost of not having investable cash, "dry powder", to take advantage of a good investment opportunity should one occur tomorrow -- the two considerations should just about balance each other out, removing any bias against "holding some dry powder" as well as any bias towards always holding some.
So, the decision should always depend on the case-by-case, bottom-up analysis of the actual pitches Mr Market is pitching at you all the time; if none are attractive enough to meet your criteria for margin of safety, probability of success, and profit potential, keep waiting (but don't keep waiting if and when the good pitches do come, just based on a fetish for always "holding some dry powder" -- if you never actually invest it, it's not really investable cash anyway, right?-).
Saturday, November 13, 2010
Own, or own not: there is no 'hold'"!
I realize "hold" -- an advice between "buy" and "sell" -- is a very old concept: "don't initiate a new position (or add to an existing one), but don't exit (or reduce) your current position, either, if you have one". However, except in a long-past world of very high commissions, it has never made sense to me!
Maybe it does to traders... I wouldn't know: I'm an investor, not a trader. Say I either already own a portion of P% a business, and I'm extended an offer of $X if I will sell that portion; OR, I don't already own any part of the business, but I'm extended an offer of $X if I want to buy such a portion (IOW, assume no commissions -- with various super-discount online brokers offering commissions in the very low single digits for stock trades, you might as well, if you're buying or selling any significant amount). Mr Market is making you such offers to either buy or sell all of the time, of course.
Surely, either offer makes sense for you to accept (if you do understand the business well enough to be in it at all, so you can give a reasonable estimate of whether the business as a whole is, or isn't, worth $X/P%, or some amount above it, or below it -- if you have no such understanding, then, of course, it's absurd for you to even consider being involved in owning that business at all!). So what is that "hold" business, where apparently neither offer is worth your consideration?! The business is not worth any more than $X/P%, either you'd accept the offer to buy it; but neither is it worth any less than that, or else you'd accept the offer to sell it. If the offer is "exactly at the money" and happens to match precisely the business's value, then I guess even a one-penny commission, or a cost of a penny for your time executing the transaction, would make both offers best rejected -- but surely such accidental perfect match is an incredibly rare coincidence, no?
It makes perfect sense for you not to want to add to your existing position because of differentiation considerations -- you may sensibly have boundaries on what % of your portfolio you're going to allocate to a specific stock, or sector, and accepting an offer to buy more might put you over (then, unless the bargain's absolutely irresistible and you may get your desired balance again by selling something else that's good but not awesomely great value, it's proper to regretfully reject). But such situations are very specific to an individual portfolio -- and that's not the context in which "hold" recommendations are most usually issued.
There may be tax issues, such as wanting to ensure a certain profit or loss is taken in a given tax year, or turning a capital gain into a long-term one -- but that's even more specific and out of the context in which "hold" assessments are pronounced by analysts and other Solons.
I think that "Hold" is just, at some level, an institutionalization of human defects like inertia (AKA laziness: it's microscopically less effort to not trade than to trade!-) and the "Endowment Effect" (what I already own magically becomes worth more just because I own it, which makes it special -- aka "Divestiture Aversion", and one of Thaler's key contributions to the field of behavioral economics). Except, of course, where "hold" is used as an euphemism for "sell, but I can't use the `Sell` word because then I, as an analyst, would be shunned and cut off by the management of this company which I need to keep covering because that's my job"!-)
I was happy to finally hear somebody agreeing with me, after all these years -- specifically, very happy because he "somebody" is the manager of a fixed-fee advisory hedge-fund-like service I've just joined, "Motley Fool Alpha". The way he put it was "if a position is worth being held, it's worth being initiated anew. To think/act otherwise, is slightly irrational" -- hear, hear!
If Yoda was an investor, he'd no doubt put it something like I used for this post's subject...: "Own, or own not: there is no 'hold'"!-)
Maybe it does to traders... I wouldn't know: I'm an investor, not a trader. Say I either already own a portion of P% a business, and I'm extended an offer of $X if I will sell that portion; OR, I don't already own any part of the business, but I'm extended an offer of $X if I want to buy such a portion (IOW, assume no commissions -- with various super-discount online brokers offering commissions in the very low single digits for stock trades, you might as well, if you're buying or selling any significant amount). Mr Market is making you such offers to either buy or sell all of the time, of course.
Surely, either offer makes sense for you to accept (if you do understand the business well enough to be in it at all, so you can give a reasonable estimate of whether the business as a whole is, or isn't, worth $X/P%, or some amount above it, or below it -- if you have no such understanding, then, of course, it's absurd for you to even consider being involved in owning that business at all!). So what is that "hold" business, where apparently neither offer is worth your consideration?! The business is not worth any more than $X/P%, either you'd accept the offer to buy it; but neither is it worth any less than that, or else you'd accept the offer to sell it. If the offer is "exactly at the money" and happens to match precisely the business's value, then I guess even a one-penny commission, or a cost of a penny for your time executing the transaction, would make both offers best rejected -- but surely such accidental perfect match is an incredibly rare coincidence, no?
It makes perfect sense for you not to want to add to your existing position because of differentiation considerations -- you may sensibly have boundaries on what % of your portfolio you're going to allocate to a specific stock, or sector, and accepting an offer to buy more might put you over (then, unless the bargain's absolutely irresistible and you may get your desired balance again by selling something else that's good but not awesomely great value, it's proper to regretfully reject). But such situations are very specific to an individual portfolio -- and that's not the context in which "hold" recommendations are most usually issued.
There may be tax issues, such as wanting to ensure a certain profit or loss is taken in a given tax year, or turning a capital gain into a long-term one -- but that's even more specific and out of the context in which "hold" assessments are pronounced by analysts and other Solons.
I think that "Hold" is just, at some level, an institutionalization of human defects like inertia (AKA laziness: it's microscopically less effort to not trade than to trade!-) and the "Endowment Effect" (what I already own magically becomes worth more just because I own it, which makes it special -- aka "Divestiture Aversion", and one of Thaler's key contributions to the field of behavioral economics). Except, of course, where "hold" is used as an euphemism for "sell, but I can't use the `Sell` word because then I, as an analyst, would be shunned and cut off by the management of this company which I need to keep covering because that's my job"!-)
I was happy to finally hear somebody agreeing with me, after all these years -- specifically, very happy because he "somebody" is the manager of a fixed-fee advisory hedge-fund-like service I've just joined, "Motley Fool Alpha". The way he put it was "if a position is worth being held, it's worth being initiated anew. To think/act otherwise, is slightly irrational" -- hear, hear!
If Yoda was an investor, he'd no doubt put it something like I used for this post's subject...: "Own, or own not: there is no 'hold'"!-)
the "cult of growth" and why it's all wrong
O'Shaughessy's book "Predicting the Markets of Tomorrow : A Contrarian Investment Strategy for the Next Twenty Years" is "on fire sale pricing" at Amazon -- the specific offer I pointed to is at $3.99 (with the advantage of fast free shipping if you're on Amazon Prime), others are as low as $2.53 (plus shipping, though). Anyway, for anywhere around that price, it's definitely worth getting!
The author's a guru in top-down, long-term strategies based on picking large-ish numbers of stocks based on capitalization, style (growth vs value), sector, &c; he claims that the last 20 years (1986-2006) have been historically "incredibly good" for large-cap growth stocks, and that markets revert to the mean so value stocks and small caps are much better choices for the next 20 years (he's got centuries of data to back up his contentions, too).
Of course, investors tend to think that the last 20 years "define" what's "normal, expected" behavior -- like the proverbial generals, always preparing to win the last war, most investors pick strategies that might have served them well had they been in place for the last 20 years... and are going to be woefully disappointed by applying them from here on. Whatever's least loved and appreciated now (because it underperformed recently) is going to be underpriced (exactly because unloved) and thus outperform going forwards -- that's the root of the "contrarian" in the book's title.
But but but... don't we all know that growth is the key determinant of a stock's value (through the computation of the latter as present value of the stream of all future earnings)? Nope -- that's a widespread fallacy. Growth may create value, but it may just as well (perhaps more often) destroy value -- because the pursuit of growth does not generally come for free, but rather costs capital, sacrifice on margins, and the like.
The best book I know to show this in analytical, accounting-popularization detail is Bruce Greenwald's recent but truly immortal classic "Value Investing: From Graham to Buffett and Beyond" -- really an incredibly good book (and far from costly!-) which I strongly recommend to every reader for many reasons, but what's really unique about it is exactly its cold-headed, precise analysis of growth and how much, exactly, is it worth to me as an investor.
You really have to read the book for all details and persuasive, worked-out examples, but, let me try to summarize. Growth can be indifferent, positive, or destructive of value -- it all depends on whether a company his growing "within its franchise" (with competitive barriers to competitors), in which case growth can indeed be good for the stockholder (but the amount of growth of this kind that is at all possible is delimited by the franchise's boundaries!); on a level playing field (no competitive barriers), in which case growth can at best be indifferent (negative whenever an acquirer overpays for an acquisition, negative whenever there's the slightest execution defect, ...); or against competitive barriers (against a strong and awake entrenched competitor), in which case growth destroys value for the stockholder (since the cost of capital to pay for and maintain that growth is higher than the growth's returns).
For the management of a company, growth is always great, as it enhances their power, builds up their little empires, increases their compensation (esp. the value of their generously awarded stock options): for the owners of a company, though (and that's the way you should think of yourself if you want to be a real investor, not "a trader"!-), one needs to be much more critical and selective about, which kind of growth you're buying! You can frame this as typical "agency problem": what's best for the agents (management) isn't necessarily so for the principals (stockholders).
Growth has its place -- both organically, i.e. "within the franchise", and by acquisition, should it ever happen that the acquirer doesn't wildly overpay for the acquiree (has that ever happened in the history of the world?!-) -- but nowhere as much as currently popular valuation mythology posits. (The "discounted stream of future payments" valuation model, no matter how neat and indisputable it may appear on its face, has this misconception to mark among its many other problems... but I guess that's a topic for another, future post!-).
The author's a guru in top-down, long-term strategies based on picking large-ish numbers of stocks based on capitalization, style (growth vs value), sector, &c; he claims that the last 20 years (1986-2006) have been historically "incredibly good" for large-cap growth stocks, and that markets revert to the mean so value stocks and small caps are much better choices for the next 20 years (he's got centuries of data to back up his contentions, too).
Of course, investors tend to think that the last 20 years "define" what's "normal, expected" behavior -- like the proverbial generals, always preparing to win the last war, most investors pick strategies that might have served them well had they been in place for the last 20 years... and are going to be woefully disappointed by applying them from here on. Whatever's least loved and appreciated now (because it underperformed recently) is going to be underpriced (exactly because unloved) and thus outperform going forwards -- that's the root of the "contrarian" in the book's title.
But but but... don't we all know that growth is the key determinant of a stock's value (through the computation of the latter as present value of the stream of all future earnings)? Nope -- that's a widespread fallacy. Growth may create value, but it may just as well (perhaps more often) destroy value -- because the pursuit of growth does not generally come for free, but rather costs capital, sacrifice on margins, and the like.
The best book I know to show this in analytical, accounting-popularization detail is Bruce Greenwald's recent but truly immortal classic "Value Investing: From Graham to Buffett and Beyond" -- really an incredibly good book (and far from costly!-) which I strongly recommend to every reader for many reasons, but what's really unique about it is exactly its cold-headed, precise analysis of growth and how much, exactly, is it worth to me as an investor.
You really have to read the book for all details and persuasive, worked-out examples, but, let me try to summarize. Growth can be indifferent, positive, or destructive of value -- it all depends on whether a company his growing "within its franchise" (with competitive barriers to competitors), in which case growth can indeed be good for the stockholder (but the amount of growth of this kind that is at all possible is delimited by the franchise's boundaries!); on a level playing field (no competitive barriers), in which case growth can at best be indifferent (negative whenever an acquirer overpays for an acquisition, negative whenever there's the slightest execution defect, ...); or against competitive barriers (against a strong and awake entrenched competitor), in which case growth destroys value for the stockholder (since the cost of capital to pay for and maintain that growth is higher than the growth's returns).
For the management of a company, growth is always great, as it enhances their power, builds up their little empires, increases their compensation (esp. the value of their generously awarded stock options): for the owners of a company, though (and that's the way you should think of yourself if you want to be a real investor, not "a trader"!-), one needs to be much more critical and selective about, which kind of growth you're buying! You can frame this as typical "agency problem": what's best for the agents (management) isn't necessarily so for the principals (stockholders).
Growth has its place -- both organically, i.e. "within the franchise", and by acquisition, should it ever happen that the acquirer doesn't wildly overpay for the acquiree (has that ever happened in the history of the world?!-) -- but nowhere as much as currently popular valuation mythology posits. (The "discounted stream of future payments" valuation model, no matter how neat and indisputable it may appear on its face, has this misconception to mark among its many other problems... but I guess that's a topic for another, future post!-).
Monday, November 8, 2010
online discount brokers, part 6: OptionsHouse
So as I mentioned a few times in the previous parts of this series, among the online discount brokers I checked out thoroughly was OptionsHouse -- and I'm leaving them for last because (spoiler...!-) they're the one I ended up with.
Their user interface, while nowhere as complex as Interactive Brokers', is definitely not as slick and neat-looking as Zecco -- and, alas, it's all clunky old Java, not spiffy new Web 2.0 - ish Javascript, HTML, and CSS... no use of multiple browser tabs the way a pure Web solution offers -- a session is one separate browser window with "simulated" pop-ups on it.
The harshest criticism I could offer of OH is that their UI looks a lot like what it might if I had designed it: full functionality, working pretty solidly (except that occasionally a pixel or two at the borders may go missing...), but pretty "bleah" looks, and especially a surfeit of information that can feel overwhelming at times (besides mediocre graphical aesthetics, that's part of why I've never been and never will be a good UI designer: no intuition for what information the user might want at a certain time and an "when in doubt, show more large tables of numbers" attitude;-). Alas, I don't even like using interfaces I designed myself, even less ones designed by others in the same engineery, un-designy spirit!-). [[On the plus side, I'm now going to be part of a beta test phase for a new generation of interface intended to be more customizable and usable]].
Other minor criticisms I can extend to OH include the peculiar limitations of their separate "tools" -- the profit analysis one seems to only deal with simple options (the ones you don't need a tool to help check, in other words -- none of the fancy combinations!-), the ones for exploring put spreads and call spreads only deal with a very small set of ETF rather than arbitrary optionable stocks, &c. (I can do such analysis myself on a spreadsheet or the like of course, but why bother to offer tools that look like they might be useful and then hobble them like that...?-).
I personally don't miss the social networking approach that Zecco focuses on so much, because I do my investment-related social networking on fool.com (including paid services -- actually, after years as a satisfied customer of various Motley Fool paid services, I've just upgraded to the Motley Fool's "all you can eat" "Duke Street" premium offer which gives me access to every service on the site); but I know that my wife Anna does miss it (as well as the Twitter support offered by Zecco but not OH).
But -- this is just about all that I can criticize about OptionsHouse after trying them pretty intensively recently. Their sign-up forms and procedures are, overall, the simplest, and their customer service the most courteous and efficient, that I had ever yet met in a lifetime of having to deal with brokers, banks, &c; the site's functionality, while (as mentioned above) not attractively presented, I've found complete and quite satisfactory; their training materials (webinars &c) quite useful.
I like their commissions (it would be nice if it was easier and faster to switch between the two rates of options commissions, the one that's optimal up to 10 contracts and the one that's optimal for 10 contracts and up [[they both end up as $10 commission for trading exactly 10 contracts!-)]], or even better if the two were merged into one with a seamless switchover at the 10-contracts point... but, I so rarely trade more than 10 contracts at a time, that it doesn't really matter much to me!) -- maybe not quite as low as Interactive Brokers' in many cases, but lower than Zecco's, Merrill Edge's, and just about anybody else (I did spot a few offerings that came in even lower, but http://www.brokerage-review.com/'s cover of those definitely doesn't make them attractive -- none get the 5 stars there that OptionsHouse, Zecco, and a few costlier brokers, do!).
And, OH's commissions are very simple to figure out (the reverse of IB's, where you may have to worry e.g. about orders that add liquidity versus ones that drain it (???), and even simpler than Zecco's and Merrill Edge's "X free stocks trades per month if you meet a set of conditions, otherwise Y but Z if T unless U..."...;-). Stocks at $2.95; options (on the cheap-up-to-10 schedule) at $5 (plus $1 per contract over five). That's all, and it really is refreshing (OK, there's a "first 100 trades free" special offer to further sweeten the pot for newcomers, but if you trade very actively you know from the start that said quota won't last you all that long -- it's just a nice little extra bonus for newcomers, as are the alternatives of getting reimbursed for wire or ACAT fees, or getting a free year of the Wall Street Journal... I picked the "100 free trades" special offer over the others, simply because, at $295 in savings, it's worth more than the alternatives;-).
Now that one of the new Motley Fool paid services I've just subscribed to ("MF Alpha") focuses on a balanced long-short portfolio (kind of like a hedge fund, but you do your own trading and there's no 2-and-20 nonsense, just a fixed yearly fee whatever size portfolio you're trading!-), I was worrying about OH's ability to find stocks to borrow for a short sale -- I had never done shorting before (even though I know all about the theory, and how long-short mixes are supposed to statistically outperform!), and the discussion boards for MF Alpha and MF Big Short are full of stories of people having trouble borrowing shares from shorting, from such big-name brokerages as, say, ETrade (MF Alpha recommends IB because of that -- plus, I suspect, the fact that the people doing the recommendation are professional, full-time investors and traders!-).
So I checked this out with a few example short sales (drawn from MF Big Short's recommendations) -- specifically a couple of firms that others had had trouble shorting recently on other brokers -- and I'm much less worried now, since everything went as smoothly, seamlessly, and trouble-free as it possibly could. (Looking forward to actively shorting for the first time in my investing life, actually!-).
So anyway, I'll be sure to let you all now if there are any further developments -- for now, I feel really satisfied about OptionsHouse (and if you don't hear anything for me for a while you can take it as meaning that the satisfaction level remained constant!-).
Their user interface, while nowhere as complex as Interactive Brokers', is definitely not as slick and neat-looking as Zecco -- and, alas, it's all clunky old Java, not spiffy new Web 2.0 - ish Javascript, HTML, and CSS... no use of multiple browser tabs the way a pure Web solution offers -- a session is one separate browser window with "simulated" pop-ups on it.
The harshest criticism I could offer of OH is that their UI looks a lot like what it might if I had designed it: full functionality, working pretty solidly (except that occasionally a pixel or two at the borders may go missing...), but pretty "bleah" looks, and especially a surfeit of information that can feel overwhelming at times (besides mediocre graphical aesthetics, that's part of why I've never been and never will be a good UI designer: no intuition for what information the user might want at a certain time and an "when in doubt, show more large tables of numbers" attitude;-). Alas, I don't even like using interfaces I designed myself, even less ones designed by others in the same engineery, un-designy spirit!-). [[On the plus side, I'm now going to be part of a beta test phase for a new generation of interface intended to be more customizable and usable]].
Other minor criticisms I can extend to OH include the peculiar limitations of their separate "tools" -- the profit analysis one seems to only deal with simple options (the ones you don't need a tool to help check, in other words -- none of the fancy combinations!-), the ones for exploring put spreads and call spreads only deal with a very small set of ETF rather than arbitrary optionable stocks, &c. (I can do such analysis myself on a spreadsheet or the like of course, but why bother to offer tools that look like they might be useful and then hobble them like that...?-).
I personally don't miss the social networking approach that Zecco focuses on so much, because I do my investment-related social networking on fool.com (including paid services -- actually, after years as a satisfied customer of various Motley Fool paid services, I've just upgraded to the Motley Fool's "all you can eat" "Duke Street" premium offer which gives me access to every service on the site); but I know that my wife Anna does miss it (as well as the Twitter support offered by Zecco but not OH).
But -- this is just about all that I can criticize about OptionsHouse after trying them pretty intensively recently. Their sign-up forms and procedures are, overall, the simplest, and their customer service the most courteous and efficient, that I had ever yet met in a lifetime of having to deal with brokers, banks, &c; the site's functionality, while (as mentioned above) not attractively presented, I've found complete and quite satisfactory; their training materials (webinars &c) quite useful.
I like their commissions (it would be nice if it was easier and faster to switch between the two rates of options commissions, the one that's optimal up to 10 contracts and the one that's optimal for 10 contracts and up [[they both end up as $10 commission for trading exactly 10 contracts!-)]], or even better if the two were merged into one with a seamless switchover at the 10-contracts point... but, I so rarely trade more than 10 contracts at a time, that it doesn't really matter much to me!) -- maybe not quite as low as Interactive Brokers' in many cases, but lower than Zecco's, Merrill Edge's, and just about anybody else (I did spot a few offerings that came in even lower, but http://www.brokerage-review.com/'s cover of those definitely doesn't make them attractive -- none get the 5 stars there that OptionsHouse, Zecco, and a few costlier brokers, do!).
And, OH's commissions are very simple to figure out (the reverse of IB's, where you may have to worry e.g. about orders that add liquidity versus ones that drain it (???), and even simpler than Zecco's and Merrill Edge's "X free stocks trades per month if you meet a set of conditions, otherwise Y but Z if T unless U..."...;-). Stocks at $2.95; options (on the cheap-up-to-10 schedule) at $5 (plus $1 per contract over five). That's all, and it really is refreshing (OK, there's a "first 100 trades free" special offer to further sweeten the pot for newcomers, but if you trade very actively you know from the start that said quota won't last you all that long -- it's just a nice little extra bonus for newcomers, as are the alternatives of getting reimbursed for wire or ACAT fees, or getting a free year of the Wall Street Journal... I picked the "100 free trades" special offer over the others, simply because, at $295 in savings, it's worth more than the alternatives;-).
Now that one of the new Motley Fool paid services I've just subscribed to ("MF Alpha") focuses on a balanced long-short portfolio (kind of like a hedge fund, but you do your own trading and there's no 2-and-20 nonsense, just a fixed yearly fee whatever size portfolio you're trading!-), I was worrying about OH's ability to find stocks to borrow for a short sale -- I had never done shorting before (even though I know all about the theory, and how long-short mixes are supposed to statistically outperform!), and the discussion boards for MF Alpha and MF Big Short are full of stories of people having trouble borrowing shares from shorting, from such big-name brokerages as, say, ETrade (MF Alpha recommends IB because of that -- plus, I suspect, the fact that the people doing the recommendation are professional, full-time investors and traders!-).
So I checked this out with a few example short sales (drawn from MF Big Short's recommendations) -- specifically a couple of firms that others had had trouble shorting recently on other brokers -- and I'm much less worried now, since everything went as smoothly, seamlessly, and trouble-free as it possibly could. (Looking forward to actively shorting for the first time in my investing life, actually!-).
So anyway, I'll be sure to let you all now if there are any further developments -- for now, I feel really satisfied about OptionsHouse (and if you don't hear anything for me for a while you can take it as meaning that the satisfaction level remained constant!-).
Sunday, November 7, 2010
online discount brokers, part 5: Zecco
On reading reviews such as this one and this comparison, and looking how spiffy zecco.com is as a site with very Web 2.0-ish features and supporting apps like ZapTrade, I was pretty happy to try out Zecco -- my wife Anna, in particular, really looked forwards to the social networking features of the site, Twitter &c. Opening a joint account was fast and easy, though strangely the sequence only had a way to indicate one userid for the joint account -- what part of "joint" don't they understand...?! Ah well, we proceeded anyway, and figured out that customer support would be able to link both of our userids to the account later, as we immediately proceeded to request.
Wrong, and an incredible design bug in their software architecture: they offer no way to have more than one userid on one account, even if that account is a "joint" one. So the part of "joint" they don't understand is: 100% -- they are absolutely, incredibly, totally, infinitely clueless about what a joint account is all about. Especially with their social networking features, Anna having to log in as me, or vice versa, in order to access our joint account, is obviously unacceptable. Suddenly I started having huge doubts about putting any of my money in the hands of people so incredibly clueless about application architecture -- what else had they "oops, forgotten" (or mis-designed) that we'd only find out about later, at some painful and unfortunate moment...?
I can't believe this mis-feature hasn't raised a hue and cry among the users and would-be users of Zecco yet -- hey, even flipping Merrill Lynch (hardly the top technology dog in the online brokerage arena;-) obviously offers the clearly mandatory feature of having two userids co-owning a joint account! I guess most Zecco users must be using individual accounts, not joint ones (or else they're joint just in name, and one spouse actually does all the trading -- but that's not how Anna and I work, thanks be!).
We pushed ahead anyway, figuring the other advantages could maybe make us deal with this one for a while, while we lobbied to have this absurd restriction removed.
Disappointment number 2 was, no foreign exchanges allowed, only American ones. I guess I must have misread some review or other, because I was under the mis-apprehension that they did support trading on non-US exchanges. Ah well, guess that's a rare feature for US brokers, and you really need to go with Interactive Brokers (and brave their fearful complexity) if you're keen to do some foreign trading (which for a permanent-resident alien like me isn't really that "foreign" -- e.g., I might have liked to try getting some of Enel Green's IPO stock at the Milan bourse... Milan doesn't really sound "foreign" to an Italian citizen, even though he may be currently residing in the US;-). Guess I shouldn't really charge this one against Zecco in particular, but it did disappoint me at the time (no doubt because of my misreading from a review somewhere that they did support foreign trading).
Disappointment number 3, and the killer, came the first time we tried to trade options -- and found out that, despite filling all the required fields in the initial application (including trading experience, total income and wealth, the fact that we've read the mandatory brochure on options, &c) and being under the strong impression that we therefore were approved for options trading... we were not! To get approved for options you need to fill out a paper form, fax it in, and wait -- standard operating procedure for most brokers (and not as bad as ones like Merrill or Vanguard that require snailmail and plenty of phone calls for the purpose), but their initial signup procedure (the one that was so slick, fast and inviting) was definitely misleading in the matter.
Moreover, and worse, to get approved for the "highest levels" of options trading, you need hefty account minimums, like $150,000 for some and $250,000 for others, or the like -- so we couldn't even try option trading on Zecco before fully funding the account with the highest amounts we ever planned to move there. Worse still, like most brokers, they seem totally convinced that selling cash-secured puts is a very risky, very high-level kind of option trade -- while everybody knows, or should, that it's mathematically equivalent to selling covered calls (which they, and most other brokers, consider the safest kind of option trade). See Ken Fisher's Debunkery book, point 13, about this idiocy (though Ken wrongly says that it's the options fans that don't get the mathematical equivalence, when it's really the brokers such as Merrill and Zecco!-).
At this point, we were already fully options-approved on OptionsHouse (which we had started at the same time as Zecco -- but OH's signup process, while a tad less fast and slick, had made it perfectly clear from the start what all you needed to get options trading approval at the various levels, so we had faxed the needed forms and docs right from the start and they had processed them expeditiously -- plus, OH had no weirdly high account minima to get approved for, e.g., cash-covered put writing). Plus, this was the third disappointment, and I'm told that (in the US, and especially in California where it's actually a state law;-), "three strikes, you're out".
So we decided to transfer the balance back to our bank account... and were aghast to see the transferable balance marked as $0 (two-plus weeks after we had originally funded the account, and well after Zecco had let us trade stocks based on that very substantial balance). We immediately contacted customer service and got some mild handwaving about some bug in their system, and how we'd need to get in touch with them on the phone to get our money back (!) -- by this time, this was starting to smell strongly like a mini-sized Madoff case to me... what broker or bank has ever essentially refused to transfer out cash that's available in your balance, except a fraudulent one?!
Of course, the times during which you can actually talk to human beings about your account are always incredibly inconvenient for people who work (almost independent of who's your broker or bank), especially when it's a joint account so both husband and wife need to be on the call, and they work at pretty separate places during the working day -- not to mention the huge delays always involved (again, not Zecco-specific, they're all terrible -- Merrill probably the worst, as in slowest, in our recent experience). That's a good part of why requiring phone calls (rather than online transactions) is idiotic and hateful (Vanguard is even worse at this than Zecco).
Fortunately the next morning when I tried the transfer again it did go through -- so apparently the customer service person was not lying about there being a bug in their system: looks like there was indeed a horrible, gaping bug making it impossible at random times to get your money out. If we hadn't already decided to go away, this experience on its own would have been way plenty to convince us to: I just can't work with a bank or broker whose systems, while spiffy-looking, are so incredibly buggy as to stop me from getting my money at times, depending on the systems' whims, and I just can't believe that anybody else could possibly choose to do so, if they realized this possibility.
Maybe one day they'll fix this bug, and at least some many others they have (for example, they say they're entirely reworking their options trading platform, which apparently has many problems today -- I wouldn't know, since as I mention I wasn't allowed to trade options there, but I imagine that if even they admit it needs to be redone from scratch, it must be pretty lousy indeed... and they've been open how long, only deciding to finally fix their options trading platform by 2011?! jeez...).
But I most certainly will not be waiting around for such a time, just as I am not waiting for Merrill to get their act together and at least get me back to the level of service I got back when I did my trading directly on Bank of America (which booted me out, forcing me onto the MerrillEdge platform as they shut their own, in the summer of 2010) -- rather, I want to take my business to competitors who do have their act a little bit more together.
Fortunately, at the same time as Zecco, I was trying OptionsHouse -- and, while perfection is not of this world, I found myself much better there, as I'll tell about in my next post in this series (where I'll also mention what details on OH I found to be not perfect, and what prospects are there to see them improve soon), so that's going to be my main broker going forward (right now I'm gradually liquidating positions on Merrill and moving cash to OH -- generally much easier and faster than transferring an account as a whole; fortunately I'm not adverse to take my capital gains right now, before taxes perhaps go up on Jan 1 unless Congress manages to get its act together to avoid that, though for the same tax reason I'd rather take most of the capital losses next year instead -- that will slow things down a bit, but fortunately I have many more capital gains than losses so most of the account will be moving this year).
Meanwhile, if you're looking for an online discount broker, I recommend the http://www.brokerage-review.com/ site -- I don't agree with all their reviews (e.g., they give five stars to Zecco, as well as OptionsHouse, Scottrade, TradeMonster, OptionsXpress, TradeKing, QuesTrade -- like a rating agency slapping AAA's on every mortgage-backed derivative, a review site granting the highest stars to seven different brokers is clearly not as selective, and thus not quite as useful, as it could be;-), but they do give many details and mostly well-considered opinions. I do find their OptionsHouse review to be mostly on-target, though;-).
Wrong, and an incredible design bug in their software architecture: they offer no way to have more than one userid on one account, even if that account is a "joint" one. So the part of "joint" they don't understand is: 100% -- they are absolutely, incredibly, totally, infinitely clueless about what a joint account is all about. Especially with their social networking features, Anna having to log in as me, or vice versa, in order to access our joint account, is obviously unacceptable. Suddenly I started having huge doubts about putting any of my money in the hands of people so incredibly clueless about application architecture -- what else had they "oops, forgotten" (or mis-designed) that we'd only find out about later, at some painful and unfortunate moment...?
I can't believe this mis-feature hasn't raised a hue and cry among the users and would-be users of Zecco yet -- hey, even flipping Merrill Lynch (hardly the top technology dog in the online brokerage arena;-) obviously offers the clearly mandatory feature of having two userids co-owning a joint account! I guess most Zecco users must be using individual accounts, not joint ones (or else they're joint just in name, and one spouse actually does all the trading -- but that's not how Anna and I work, thanks be!).
We pushed ahead anyway, figuring the other advantages could maybe make us deal with this one for a while, while we lobbied to have this absurd restriction removed.
Disappointment number 2 was, no foreign exchanges allowed, only American ones. I guess I must have misread some review or other, because I was under the mis-apprehension that they did support trading on non-US exchanges. Ah well, guess that's a rare feature for US brokers, and you really need to go with Interactive Brokers (and brave their fearful complexity) if you're keen to do some foreign trading (which for a permanent-resident alien like me isn't really that "foreign" -- e.g., I might have liked to try getting some of Enel Green's IPO stock at the Milan bourse... Milan doesn't really sound "foreign" to an Italian citizen, even though he may be currently residing in the US;-). Guess I shouldn't really charge this one against Zecco in particular, but it did disappoint me at the time (no doubt because of my misreading from a review somewhere that they did support foreign trading).
Disappointment number 3, and the killer, came the first time we tried to trade options -- and found out that, despite filling all the required fields in the initial application (including trading experience, total income and wealth, the fact that we've read the mandatory brochure on options, &c) and being under the strong impression that we therefore were approved for options trading... we were not! To get approved for options you need to fill out a paper form, fax it in, and wait -- standard operating procedure for most brokers (and not as bad as ones like Merrill or Vanguard that require snailmail and plenty of phone calls for the purpose), but their initial signup procedure (the one that was so slick, fast and inviting) was definitely misleading in the matter.
Moreover, and worse, to get approved for the "highest levels" of options trading, you need hefty account minimums, like $150,000 for some and $250,000 for others, or the like -- so we couldn't even try option trading on Zecco before fully funding the account with the highest amounts we ever planned to move there. Worse still, like most brokers, they seem totally convinced that selling cash-secured puts is a very risky, very high-level kind of option trade -- while everybody knows, or should, that it's mathematically equivalent to selling covered calls (which they, and most other brokers, consider the safest kind of option trade). See Ken Fisher's Debunkery book, point 13, about this idiocy (though Ken wrongly says that it's the options fans that don't get the mathematical equivalence, when it's really the brokers such as Merrill and Zecco!-).
At this point, we were already fully options-approved on OptionsHouse (which we had started at the same time as Zecco -- but OH's signup process, while a tad less fast and slick, had made it perfectly clear from the start what all you needed to get options trading approval at the various levels, so we had faxed the needed forms and docs right from the start and they had processed them expeditiously -- plus, OH had no weirdly high account minima to get approved for, e.g., cash-covered put writing). Plus, this was the third disappointment, and I'm told that (in the US, and especially in California where it's actually a state law;-), "three strikes, you're out".
So we decided to transfer the balance back to our bank account... and were aghast to see the transferable balance marked as $0 (two-plus weeks after we had originally funded the account, and well after Zecco had let us trade stocks based on that very substantial balance). We immediately contacted customer service and got some mild handwaving about some bug in their system, and how we'd need to get in touch with them on the phone to get our money back (!) -- by this time, this was starting to smell strongly like a mini-sized Madoff case to me... what broker or bank has ever essentially refused to transfer out cash that's available in your balance, except a fraudulent one?!
Of course, the times during which you can actually talk to human beings about your account are always incredibly inconvenient for people who work (almost independent of who's your broker or bank), especially when it's a joint account so both husband and wife need to be on the call, and they work at pretty separate places during the working day -- not to mention the huge delays always involved (again, not Zecco-specific, they're all terrible -- Merrill probably the worst, as in slowest, in our recent experience). That's a good part of why requiring phone calls (rather than online transactions) is idiotic and hateful (Vanguard is even worse at this than Zecco).
Fortunately the next morning when I tried the transfer again it did go through -- so apparently the customer service person was not lying about there being a bug in their system: looks like there was indeed a horrible, gaping bug making it impossible at random times to get your money out. If we hadn't already decided to go away, this experience on its own would have been way plenty to convince us to: I just can't work with a bank or broker whose systems, while spiffy-looking, are so incredibly buggy as to stop me from getting my money at times, depending on the systems' whims, and I just can't believe that anybody else could possibly choose to do so, if they realized this possibility.
Maybe one day they'll fix this bug, and at least some many others they have (for example, they say they're entirely reworking their options trading platform, which apparently has many problems today -- I wouldn't know, since as I mention I wasn't allowed to trade options there, but I imagine that if even they admit it needs to be redone from scratch, it must be pretty lousy indeed... and they've been open how long, only deciding to finally fix their options trading platform by 2011?! jeez...).
But I most certainly will not be waiting around for such a time, just as I am not waiting for Merrill to get their act together and at least get me back to the level of service I got back when I did my trading directly on Bank of America (which booted me out, forcing me onto the MerrillEdge platform as they shut their own, in the summer of 2010) -- rather, I want to take my business to competitors who do have their act a little bit more together.
Fortunately, at the same time as Zecco, I was trying OptionsHouse -- and, while perfection is not of this world, I found myself much better there, as I'll tell about in my next post in this series (where I'll also mention what details on OH I found to be not perfect, and what prospects are there to see them improve soon), so that's going to be my main broker going forward (right now I'm gradually liquidating positions on Merrill and moving cash to OH -- generally much easier and faster than transferring an account as a whole; fortunately I'm not adverse to take my capital gains right now, before taxes perhaps go up on Jan 1 unless Congress manages to get its act together to avoid that, though for the same tax reason I'd rather take most of the capital losses next year instead -- that will slow things down a bit, but fortunately I have many more capital gains than losses so most of the account will be moving this year).
Meanwhile, if you're looking for an online discount broker, I recommend the http://www.brokerage-review.com/ site -- I don't agree with all their reviews (e.g., they give five stars to Zecco, as well as OptionsHouse, Scottrade, TradeMonster, OptionsXpress, TradeKing, QuesTrade -- like a rating agency slapping AAA's on every mortgage-backed derivative, a review site granting the highest stars to seven different brokers is clearly not as selective, and thus not quite as useful, as it could be;-), but they do give many details and mostly well-considered opinions. I do find their OptionsHouse review to be mostly on-target, though;-).
Saturday, November 6, 2010
online discount brokers, part 4: Interactive Brokers
If you're a trading professional, I'm sure you've already heard of Interactive Brokers -- no other brokerage service I've ever heard about comes even close to matching them for depth and breadth of offerings (including, in particular, powerful Application Programming Interfaces -- APIs -- to let you design and implement your own interactive or automated trading platforms -- if, of course, you can afford to hire a few good Java or C++ programmers, otherwise, don't bother:-).
As a kind of a "side line", they also support individual investors... though most of the time it kind of feels like a "second thought" (it probably was, come to think of it) glued on top of their main business model of serving extremely sophisticated professional needs with a dazzling variety of possibilities and the most complicated (even though probably the cheapest in most cases) array of pricing models I've ever heard of in my life.
I have to admit -- in the end, they intimidated me; just picking and choosing the specific set of options that I wanted to buy (including for example various kinds and levels of more or less real-time information on their site, each priced in complex ways...: nothing is really simple and bundled in their worldview!-) scared me off, not to mention the lurking issue of "how will I figure out how much I'll be paying in commission each time I trade -- am I enhancing or depleting liquidity, does that matter to pricing depending on what exchange or set of exchanges I'm trading on, etc, etc...?".
I may have missed out on a good thing -- maybe. I've just joined Motley Fool's new "Alpha" service (I've long been a happy customer of some subsets of the Fool's services, and this one eventually convinced me -- a hedge-fund-like long-short real-money portfolio service, open for a very limited time to a small set of high-net-worth [[but perhaps not qualifying for an actual hedge fund]] investors, but with a fixed yearly fee [[no 2-and-20 nonsense there!-)]] and complete disclosure of the trades and their rationale, for you to replicate yourself in your own portfolio -- worlds apart from the typical hedge-fund advisors that just want you to blindly trust them with investing your own hard-earned, hard-saved cash!-)... and now I wonder if I should have signed up with IB.
You see, though decades of experience as an investor, I had actually never placed one short sale in my life -- before today (Saturday), when I tried one on my currently favorite online discount broker, just so I can check come Monday morning if it's triggered properly. But MF Alpha is a long-short portfolio -- a big part of its attraction, of course. I'm quite familiar with all the theoretical results (and practical confirmations) about how long-short strategies can outperform "pure" ones in both good markets and bad ones, as well as with every detail of how short sales are actually handled, margin requirements, and so forth... I'd just never actually put any of this theory into practice (hey, my family kept taunting me for years because, as a kid, before actually trying to make paper planes, I bought and studied a book about their practical and aerodynamical issues...!-).
So, MF Alpha strongly recommends Interactive Brokers -- not just because of their dirt-cheap commissions and margin interest (my currently favorite broker is almost as good in these respects, as well as really much simpler!-), but specifically because IB appears to excel over all other brokers in actually getting hold of (a loan of) the stocks you're selling short, while even well-known names such as ETrade have had problems with this crucial issue in the past. Alas, not having ever been a short seller before, that is one issue I never thought to check...! (And when I was choosing my new broker, I had no idea yet that I'd be doing some short-selling so soon!-).
Ah well, let's hope I've been lucky this time. But, if you can deal with the complexity that scared me off, and are really keen on substantial short-selling (or trading on all sorts of weird international exchanges, something Interactive Broker is the only cheap service to offer, that I know of), do give them a try (and let me know how well it's working, though I'm sure plenty of my MF Alpha co-members, currently busy opening their IB accounts, also won't fail to enlighten me;-).
But I, for once (as I should be more often), was humble, and in the end the choice for me boiled down to two simple, good, cheap online discount brokers: Zecco and OptionsHouse. More about them (and how things ended up for me) in my next couple of posts!
As a kind of a "side line", they also support individual investors... though most of the time it kind of feels like a "second thought" (it probably was, come to think of it) glued on top of their main business model of serving extremely sophisticated professional needs with a dazzling variety of possibilities and the most complicated (even though probably the cheapest in most cases) array of pricing models I've ever heard of in my life.
I have to admit -- in the end, they intimidated me; just picking and choosing the specific set of options that I wanted to buy (including for example various kinds and levels of more or less real-time information on their site, each priced in complex ways...: nothing is really simple and bundled in their worldview!-) scared me off, not to mention the lurking issue of "how will I figure out how much I'll be paying in commission each time I trade -- am I enhancing or depleting liquidity, does that matter to pricing depending on what exchange or set of exchanges I'm trading on, etc, etc...?".
I may have missed out on a good thing -- maybe. I've just joined Motley Fool's new "Alpha" service (I've long been a happy customer of some subsets of the Fool's services, and this one eventually convinced me -- a hedge-fund-like long-short real-money portfolio service, open for a very limited time to a small set of high-net-worth [[but perhaps not qualifying for an actual hedge fund]] investors, but with a fixed yearly fee [[no 2-and-20 nonsense there!-)]] and complete disclosure of the trades and their rationale, for you to replicate yourself in your own portfolio -- worlds apart from the typical hedge-fund advisors that just want you to blindly trust them with investing your own hard-earned, hard-saved cash!-)... and now I wonder if I should have signed up with IB.
You see, though decades of experience as an investor, I had actually never placed one short sale in my life -- before today (Saturday), when I tried one on my currently favorite online discount broker, just so I can check come Monday morning if it's triggered properly. But MF Alpha is a long-short portfolio -- a big part of its attraction, of course. I'm quite familiar with all the theoretical results (and practical confirmations) about how long-short strategies can outperform "pure" ones in both good markets and bad ones, as well as with every detail of how short sales are actually handled, margin requirements, and so forth... I'd just never actually put any of this theory into practice (hey, my family kept taunting me for years because, as a kid, before actually trying to make paper planes, I bought and studied a book about their practical and aerodynamical issues...!-).
So, MF Alpha strongly recommends Interactive Brokers -- not just because of their dirt-cheap commissions and margin interest (my currently favorite broker is almost as good in these respects, as well as really much simpler!-), but specifically because IB appears to excel over all other brokers in actually getting hold of (a loan of) the stocks you're selling short, while even well-known names such as ETrade have had problems with this crucial issue in the past. Alas, not having ever been a short seller before, that is one issue I never thought to check...! (And when I was choosing my new broker, I had no idea yet that I'd be doing some short-selling so soon!-).
Ah well, let's hope I've been lucky this time. But, if you can deal with the complexity that scared me off, and are really keen on substantial short-selling (or trading on all sorts of weird international exchanges, something Interactive Broker is the only cheap service to offer, that I know of), do give them a try (and let me know how well it's working, though I'm sure plenty of my MF Alpha co-members, currently busy opening their IB accounts, also won't fail to enlighten me;-).
But I, for once (as I should be more often), was humble, and in the end the choice for me boiled down to two simple, good, cheap online discount brokers: Zecco and OptionsHouse. More about them (and how things ended up for me) in my next couple of posts!
Friday, November 5, 2010
online discount brokers, part 3: conservative option plays and the importance of cheap commissions
Many risk-takers love options and the huge leverage they can give their gambling -- but a growing number of prudent, conservative investors are acquiring a growing taste for the extra income they can give their conservative portfolio, and I count myself among the latter. Thomsett's classic "Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk", and simpler, breezier books such as Kadavy's "Covered Call Writing Demystified" (the latter comes, when you email requesting them, with some useful spreadsheet that I had no trouble loading into Google Spreadsheets and customizing to my preferences), blaze the way, as do websites such as this one.
BTW, Ken Fisher's new and overall worthwhile book Debunkery "debunks", in its point 13, the myth that selling naked puts is any riskier than selling covered calls -- though he omits to mention that for that purpose it's crucial to have your put entirely cash-secured [no margin!!!], and strangely seems to think the mathematical equivalence means that selling covered calls is risky, while obviously the reality is that selling naked, cash-secured puts is just as secure and conservative, and that the people needing to hear about this are conservative-investing options buffs (which is silly, since popular books by and for such readers, such as Groenke's "Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income", show the equivalence quite as clearly and describe it in more detail) -- obviously those who need to hear it said and repeated are the regulators and the majority of brokers that make it so much harder for the investor to qualify to sell cash-secured puts, as to sell covered calls (requiring more experience, a margin account, higher minimum account sizes and/or income and wealth, or any other such silly differentiation between two mathematically identical strategies!!!)
Anyway, buying a call is like buying a lottery ticket: limited risk (just the ticket's price or the call's premium), potentially huge upside (the jackpot lottery prize, a sudden hockey-stick in an underlying price that owning the call option lets you get for a pittance)... and yet not a sensible choice for an investor, because the probability of winning the big jackpot is just too low, so the expected value of the purchase is definitely negative. But consider that (net of commissions, and we'll come back to that key point!-) the trading of options is a zero sum game: if it's negative for the buyer, it must be positive for the seller. The seller of lottery tickets will once in a while be giving up a huge upside (when he sells the rare ticket that happens to be fated to win the jackpot -- he could have kept it for himself and cashed the jackpot...!-)) -- but gets a steady, modest, secure stream of income through his selling, nevertheless. That, roughly speaking, is what you can get by selling covered calls (or cash-secured puts, but despite the mathematical equivalence I've noticed that selling calls is a bit more lucrative than selling puts: maybe there are more gamblers wanting to buy calls, than ones wanting to buy puts, and option prices after all are set by demand and supply -- the underlying math matters, but doesn't entirely determine the prices in the market).
But let's get back to that "net of commissions" provision, which is very important. In the previous post I've noticed that for a moderatively active investor/trader on stocks, like me, MerrillEdge's 30 free stock trades a month end up meaning basically free trading (say $50/year for a few trades exceeding the monthly limit out of 200 total yearly ones) while (e.g.) Schwab's commissions could cost me about $2000/year (Fidelity's a tad less, Ameritrade's a tad more, but, same ballpark).
But now consider that out of (e.g.) the 30 stocks I own, every month I may want to sell calls on about 20 (I'll use another future post to explain why you don't want to sell calls on every stock every month, and why selling monthly options is best -- at least if your commission's low enough), say typically for about 6 contracts (600 shares) each, with a typical expected profit of (again, typical numbers) $200 for the premium and another $400 if exercised (out of the typically 240 calls [out of the money!] that I sell every year, experience tells me that only somewhere between 20 and 30 will be exercised in a typical market -- fewer in serious bear markets, more in crazy bull markets -- call it 25!-); so, expected revenue around 240 * $200 + 25 * $400 = 58,000/year, about 12% of the portfolio's overall value (and _that_ 12% yield is why I'm so keen to sell covered calls!-), gross of commissions (and taxes).
But -- what about the commissions...? With MerrillEdge's 4.95+0.75/contract (and $4.95 on exercise), they would be: 240 * (4.95 + 0.75 * 6) + 25 * 4.95 = $2391 -- call it 2400 (we're using round numbers anyway!-), reducing profit to 55,600 before taxes. With Schwab's $8.95 + 0.75/contract (as an example, since it's smack in the middle between cheaper Fidelity and costlier OptionsXpress), and $8.95 on exercise, we'd have 240 * (8.95 + 0.75 * 6) + 25 * 8.95 = $3451, almost 50% higher cost than MerrillEdge's, reducing pre-tax profig to 54,550. I know, no world-changing difference, but, high enough to smell bad to this skinflint!-)
Whence, the quest for cheap commissions becoming especially important for options trading (and very very frequent trading even just of stocks, of course, but that's not really my case). I'll reveal what broker I ended up choosing a couple posts from now, but, as a foreshadow -- its commissions are $2.95 for stock trades, and $5 for up to 5 contracts (plus $1/contract over five -- there's another possible commissions schedule you can opt into, changing only before the start of the trading day, if you usually trade more than 10 contracts at a time). So in this case we'd have 240 * 6 + 25 * 2.95 -- $1513, a full third less than MerrillEdge, and that kind of saving really gladdens my heart!-)
The online discount broker I tried next after MerrillEdge, Zecco, has commissions of $4.50 for stock trading, $4.50 + 0.50/contract for options [Merrill gives qualifying customers 30 free stock trades/month, Zecco 10, but in each case I'm assuming the free trades, just like the "first 100 trades free" &c offers of other brokers, are exhausted on trading actual stocks, before options trading and exercise is considered], so the cost would be 240 * (4.50 + 0.50 * 6) + 25 * 4.50 = $1912, only 15% more than the one I ended up with and a good 20% less than MerrillEdge -- so that wouldn't have been so bad, price-wise, it's for other reasons that I found myself really unsatisfied with them... but, I'll go into that in the next post.
Anyway, buying a call is like buying a lottery ticket: limited risk (just the ticket's price or the call's premium), potentially huge upside (the jackpot lottery prize, a sudden hockey-stick in an underlying price that owning the call option lets you get for a pittance)... and yet not a sensible choice for an investor, because the probability of winning the big jackpot is just too low, so the expected value of the purchase is definitely negative. But consider that (net of commissions, and we'll come back to that key point!-) the trading of options is a zero sum game: if it's negative for the buyer, it must be positive for the seller. The seller of lottery tickets will once in a while be giving up a huge upside (when he sells the rare ticket that happens to be fated to win the jackpot -- he could have kept it for himself and cashed the jackpot...!-)) -- but gets a steady, modest, secure stream of income through his selling, nevertheless. That, roughly speaking, is what you can get by selling covered calls (or cash-secured puts, but despite the mathematical equivalence I've noticed that selling calls is a bit more lucrative than selling puts: maybe there are more gamblers wanting to buy calls, than ones wanting to buy puts, and option prices after all are set by demand and supply -- the underlying math matters, but doesn't entirely determine the prices in the market).
But let's get back to that "net of commissions" provision, which is very important. In the previous post I've noticed that for a moderatively active investor/trader on stocks, like me, MerrillEdge's 30 free stock trades a month end up meaning basically free trading (say $50/year for a few trades exceeding the monthly limit out of 200 total yearly ones) while (e.g.) Schwab's commissions could cost me about $2000/year (Fidelity's a tad less, Ameritrade's a tad more, but, same ballpark).
But now consider that out of (e.g.) the 30 stocks I own, every month I may want to sell calls on about 20 (I'll use another future post to explain why you don't want to sell calls on every stock every month, and why selling monthly options is best -- at least if your commission's low enough), say typically for about 6 contracts (600 shares) each, with a typical expected profit of (again, typical numbers) $200 for the premium and another $400 if exercised (out of the typically 240 calls [out of the money!] that I sell every year, experience tells me that only somewhere between 20 and 30 will be exercised in a typical market -- fewer in serious bear markets, more in crazy bull markets -- call it 25!-); so, expected revenue around 240 * $200 + 25 * $400 = 58,000/year, about 12% of the portfolio's overall value (and _that_ 12% yield is why I'm so keen to sell covered calls!-), gross of commissions (and taxes).
But -- what about the commissions...? With MerrillEdge's 4.95+0.75/contract (and $4.95 on exercise), they would be: 240 * (4.95 + 0.75 * 6) + 25 * 4.95 = $2391 -- call it 2400 (we're using round numbers anyway!-), reducing profit to 55,600 before taxes. With Schwab's $8.95 + 0.75/contract (as an example, since it's smack in the middle between cheaper Fidelity and costlier OptionsXpress), and $8.95 on exercise, we'd have 240 * (8.95 + 0.75 * 6) + 25 * 8.95 = $3451, almost 50% higher cost than MerrillEdge's, reducing pre-tax profig to 54,550. I know, no world-changing difference, but, high enough to smell bad to this skinflint!-)
Whence, the quest for cheap commissions becoming especially important for options trading (and very very frequent trading even just of stocks, of course, but that's not really my case). I'll reveal what broker I ended up choosing a couple posts from now, but, as a foreshadow -- its commissions are $2.95 for stock trades, and $5 for up to 5 contracts (plus $1/contract over five -- there's another possible commissions schedule you can opt into, changing only before the start of the trading day, if you usually trade more than 10 contracts at a time). So in this case we'd have 240 * 6 + 25 * 2.95 -- $1513, a full third less than MerrillEdge, and that kind of saving really gladdens my heart!-)
The online discount broker I tried next after MerrillEdge, Zecco, has commissions of $4.50 for stock trading, $4.50 + 0.50/contract for options [Merrill gives qualifying customers 30 free stock trades/month, Zecco 10, but in each case I'm assuming the free trades, just like the "first 100 trades free" &c offers of other brokers, are exhausted on trading actual stocks, before options trading and exercise is considered], so the cost would be 240 * (4.50 + 0.50 * 6) + 25 * 4.50 = $1912, only 15% more than the one I ended up with and a good 20% less than MerrillEdge -- so that wouldn't have been so bad, price-wise, it's for other reasons that I found myself really unsatisfied with them... but, I'll go into that in the next post.
online discount brokers, part 2: costlier ones, and why I eschew them
I barely looked at anything that would raise my cost of trading substantially above what I get from MerrillEdge (at what they call "Superior" status, which just means I have a good total for the amounts in Merrill and BoA accounts and/or do many trades): commissions of $4.95 to trade stocks or ETFs (with the first 30 trades each calendar month for free), $4.95 plus $0.75 per contract to trade options.
I'm a skinflint -- I don't like paying money unless I feel I'm getting full value for what I'm paying, and (ideally;-) then some. So, rates such as Fidelity's (stocks $7.95, options $7.95 + 0.75/contract), Schwab's (stocks $8.95, options $8.95 + 0.75/contract), AmeriTrade's (stocks $9.99, options $9.99 + 0.75/contract), OptionsXpress's (stocks $9.95 up to 1000 shares, a cent per share if more than 1000; options $1.25/contract with a $12.95 minimum, higher unless you're an "active trader" doing at least 35 option trades/quarter), and so on up, turned me right off those popular choices.
Some investors of an ilk quite similar to mine (prudent, conservative, fundamentals-focused) may not care -- they do very few stock trades, and never options. But me, I like for example to "scale into" a position -- buy some stock in a good company that I've decided is substantially undervalued, but not my full intended position at once; buy more if Mr Market gets even more wrongly (I hope;-) pessimistic; and so on down (possibly "filling up" on dips to the full position I always hoped to hold) -- so it may easily take me several smaller trades to build up to a position that could conceivably have been acquired at once (but dearer;-). (Sometimes, but for some psychological reason less often, I do the reverse when a stock becomes fully-valued-and-then-some so that I want to sell it).
Plus, I like differentiation -- sometimes, I guess, I overdo it a bit (say, 50 positions -- no Peter Lynch's portfolio, but a tad too broad for my stock portfolio size, which even for a keen differentiator should be fine at even half that many) -- so the number of trades to build my full portfolio is similarly multiplied.
Then there are little tricks, such as...: say that, researching some particularly interesting idea, I end up deciding that there are, not one, but two or three good companies more or less in that niche, all a bit undervalued by the market. Then, I might buy a "seed position" in each (for a total amount that's, say, about half of the final position I mean to have in that specific play); then follow carefully the market's behavior with respect to the individual companies (as well, of course, as the companies' fundamentals!) and play it by ear.
Say for example that the two companies' (A's and B's) fundamentals are and remain equivalent (for the prospects in the time frame I care most about, say the 3-5 years range typically), but Mr Market in its unending manias raises A's stock 5% (putting it that much closer to a fair valuation) while sinking B's by another 5% -- then I can sell off A, double my stake in B, and end up with a fully position in B (and out of A) substantially cheaper than I would via the "buy the full stake outright" approach. (If Mr Market did exactly the reverse, for whatever passes for "reasons" for his behavior, I'd be just as happy owning A instead -- I'm a skinflint, after all, so I focus on getting a low cost basis!-).
All of this means that doing (say) 20 or 30 stock trades in a month is not at all strange for me, and some months I even go a bit over 30. So, just for the stock, what I get more or less free at Merrill (OK, call it $50 for a few trades exceeding the 30/month quota) would cost me, say, $2000 a year at Schwab -- sorry, but for skinflint me that just doesn't feel good... why toss away every year the price of two superb laptops like Apple's new 11" Air (my wife Anna just got one -- I got the 13" version, but hers is cuter, smaller and lighter, as well as cheaper!-)? What am I getting in return for such a splurge, again?
My penchant for safe, conservative options plays makes this kind of consideration even more important -- but I guess that's better left for another, later post.
Thursday, November 4, 2010
online discount brokers, part 1: why I had to start looking
On this latest spell of my life as a US resident, I started out with Bank of America's "self-directed trading" service -- nothing fancy, but usable, and I did love the 30 free stock trades per month (given that my account size met their threshold).
Alas -- this summer they automatically switched my account over to "Merrill Edge", the "Wealth Management Platform" (ha!) they got from their acquisition of Merrill Lynch.
Among many minor inconveniences, I found out I couldn't trade options any more -- had to apply all over again. I did, and found out I was only allowed to sell covered calls -- no options buying any more, no selling cash-secured puts any more (!).
Selling covered calls is my main use of options (since I'm a pretty conservative investor!), but I missed the ability for occasional buying of some puts or calls to temporarily hedge a position, and the somewhat more frequent use of cash-secured puts as an alternative to a buy limit order to perhaps purchase a stock if it goes down enough.
I nevertheless endured, kinda golden-chained by the free stock trades I guess (I'm a real penny-pincher!-), until Merrill mysteriously locked me out of my online accounts for weeks, on varying claims about "funds due" (when I had plenty of cash in the account!) or "sale-not-long" (whatever exactly they mean by that).
Phone customer service was almost invariably good (with the exception of one guy with a strong Brooklin accent who appeared to be looking for a fight, and even though he was totally clueless about what the problem was still kept trying to pin it on me), eventually excellent when we (me and my wife -- we trade usually together and by consensus) were finally escalated to a manager who gave us his direct phone number (saving us the incredibly long waits any normal call to customer support usually involves), online-rate trades ($4.95 for stocks -- he couldn't unfortunately gave us the free trades we would have gotten if actually online) rather than the ridiculous rate for human-assisted trades as long as the mysterious lock-out remained, and really bent over backwards to try to find out about the problem and fix it for us.
Alas, he couldn't -- though it eventually disappeared, as it happens, just after the settling date following the expiration date for some calls I had sold (a couple of which got exercised); so I suspect their bug may be related to the one that recorded me as selling the same covered calls twice at a few minutes' time difference (when I had stock enough to cover only one of the two sales -- and remember, I'm not allowed to sell uncovered calls, so, even had I tried -- which I obviously didn't, as I'm not crazy yet;-) -- their SW obviously should have blocked me!-).
That customer-service manager was incredibly good in his follow-through, even offering to waive the fees for account transfer to some other broker, if, given how we justifiably felt after that episode, we just wanted to get rid of Merrill altogether (which we definitely did!-).
So, I had to start looking around -- and I did, and I plan to post one or more follow-on "episodes", in the course of the next few days, about what transpired afterwards...
Subscribe to:
Posts (Atom)