It’s All Fun and Games Until…

Tricky business

“Only fools rush in where angels fear to tread” – Alexander Pope, English Poet

“Come on Dad you never want have any real fun”, my daughter protested as she rolled eyes standing with her friends.

I stood looking at the wooden tracks of one of the oldest roller coasters on the east coast (according to the posted sign) and all I could think about was advanced mathematics.

We wandered through a Connecticut amusement park at the tail end of this summer chasing the children from ride to ride.  It was a warm day but somehow, in some way, there was a turn in the air…a faint smell of the mass decay of plant life that occurs in the fall.

As our children and those of our friends approached and disembarked from each ride, a very clear pattern emerged.  The children were truly frightened and uneasy about the haunted houses, cemetery tours and ghost/monster oriented attractions.  Alternatively, they were absolutely fearless when partaking in the breathtaking speeds and plunges of roller coasters and the other gravity defying attractions.

The adults were the opposite.  We yawned our way through the multitude of imaginary ghouls and turned white with fear when forced to go on the speed/gravity rides.

Children are afraid of the supernatural.  The vivid representations of vampires, flesh eating zombies and witches create havoc within their undeveloped brains.  Children do not yet understand that the most horrifying dangers can be caused by….us humans.

“This Bechara guy should be put out to pasture!” yells the peanut gallery.  “Now he’s saying that humans can create situations more terrifying than monsters?”

In a word….Yes.

The ghoul and monster threat is, of course, completely illusory.  On the other hand, the only thing preventing your brains from dashed out on the pavement while on a roller coaster or gravity ride is …..the mathematical prowess of an anonymous engineer.

The speed and gravity rides project an aura of order and stability.  They are massive, seemingly unfailing, structures of iron, wood and steel…but the right amount of stress, wear or damage in the right area…..can send the entire structure crumbling in a mass of death and destruction.

The reason for the adults fear is that we are able to distinguish between the fake risk and the real risk…except in economics and finance apparently…..

Over the past 10 years we have developed a strange inversion of the ability to distinguish between real threats and mere distractions.  Below is a list of the various financial/economic “monsters” we fear as expressed by popular media outlets:

  • Businesses must embrace the programmable world. Or die.
  • Exclusive: Tim Draper is leaving DFJ
  • 11 questions investors should ask Twitter management
  • Why some homeowners are turning down free money
  • Top 50 hedge funds bail on Boeing, buy Facebook

We seem terrified of not investing in the latest tech company or becoming unaware of the latest moves of business personalities.  Also, like children, we are blissfully ignoring the large, seemingly safe, structure of our entire financial system.  The failure of which would materially affect the lives of nearly all of us.

Buried in news, was this “mouth drying” exchange between US Senator Mike Johanns and nominee for Federal Reserve Chairman, Janet Yellen.  The topic was the billions in monetary stimulus (Quantitative Easing) the Fed is pumping into the economy every month:

Courtesy of www.sbrownassociates.com

“Dr. Yellen, here is what I would offer and I think you would agree with me although you probably won’t want to agree with me in a public hearing setting.  But if I think if I were to say to you why don’t you announce today that you are going to draw this down over the next 24 months from $4 trillion to zero, I think you would see the impact of your policies on the value of real estate all across the United States not just in the hardest hit areas.  I think the real estate that I own and others own would go down in value.  I also think that the stock market would have the same sort of reaction that it has had when Chairman Bernanke just suggested that there might be a phase down here.

 Here’s what I’m saying, I think the economy has gotten used to the sugar that you put out there and I just worry that we are on a sugar high and that is a very dangerous thing for the little person out there who is just trying to pay the bills and maybe put a buck away for retirement.  The last thing I will say, the flip side of your policies that you are advocating for are very, very hard on certain segments of our society.  You know, explain to the Senior Citizen who is just hoping that CD will earn some money so they don’t have to dig into the principal what impact you’re having on a policy that says for as far as the eye can see or foreseeable future keep interest rates low, they are hurt by that policy.”

Yellen’s candid admission was alarming, “I agree and I understand that savers are hurt by this policy.

Dr. Yellen I kind of look at these factors and I think I could go on and on with some other items and I must admit, what am I missing here?  I see asset bubbles and I think if you were to announce today that over the next 24 months you are going to bring that balance sheet down from $4 trillion to zero or $1 trillion, I think if you even said over the next 4 years we’re going to bring it down from $4trillion to zero you would see how big those asset bubbles are, wouldn’t you agree with me on that?”

So what the big deal?  Hasn’t it all “worked” so far….and what wrong with a “little” (~80 billion a month?) sugar to drive up asset prices?

My friends, some of us are wandering around the economic amusement park and we detect a faint smell of decay in the air…We are looking at what seems to be an orderly structure…with the potential for catastrophe.  The right amount of stress, wear or damage in the right area and…..

Have a great week,

 

Michael Bechara, CPA, CFE, CRMA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

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Valuation Mirages

3174917_sWe all have seen the familiar movie vignette of the lost man in the desert suffering from severe dehydration.  The scene is typically one of a man staggering across blistering hot sand dunes in tattered clothing while muttering to himself.

Far off in the distance he sees a vision of palm trees and a cool pool of water beckoning him.

An oasis!

He quickens his pace, excited that he has found his salvation.  After reaching the edge of the pool he dives in, only to be greeted with a mouthful of hot sand.

The mirage has struck again!

Unfortunately the current investment climate seems to reflect the familiar Hollywood mirage scene.

It’s sort of a version of “yield dehydration” that can cause hallucinations and erratic behavior amongst those searching for a return on capital.  Outside of the select few with access to the Fed’s discount window, the lonely retail investor stumbles across the barren investment landscape as he is tempted by several mirages.

Let’s take a quick tour of the most common investment options:

Cash – Good soldiers don’t die they just fade away

The above quote from General Douglas MacArthur describes cash pretty well.  Putting your capital in savings accounts/CDs has typically been seen as the safest investment.  Unfortunately, you are likely to witness its value erode over time.  With the Fed targeting inflation at 2% and typical savings/CDs well below this level you know your purchasing power is decreasing over time.

One of the central functions of money is a store of value.  Simply stated this is the idea that if one doesn’t spend money today he can hold cash and spend the money at a later date.  The current climate suggests that money not spent today will buy less in the future.  It seems cash currently produces a negative return.

Bonds – A spring under compression

When buying a bond you are lending the issuing entity money.  When lending money you must worry about several risks.  One of the most basic risks is interest rate risk.  The issue here is that interest rates are being held low..very low.. by the Fed as part of the effort to stimulate the economy.  No one knows when the stimulus will end and when interest rates will be allowed to normalize, hence the metaphor of a spring under compression.  When will the Fed let go and when will interest rates rise suddenly to reflect the realities of the market?

For example, one could buy a bond paying 2% today and find that in a short time interest rates have risen rapidly to say 4%.  What would that do to the value of your bond?

Real Estate –You don’t own the property; the property owns you

Some of you may remember the 1980s comedian Yakov Smirnoff who was famous for comparing Soviet Russia to America in his jokes and gags.  One of his most famous lines was, “In America you go find party…in USSR, the party come find you.”

So it is with real estate investment these days.  For those owing rental properties the initial visit to housing court is quite similar to finding out Santa Claus is not real.  The process of enforcing your property rights (the right to collect rents or evict) is byzantine at best and typically the end result is a significant period of lost rents.

In addition, property taxes have become so significant in some areas that the concept of property ownership itself is called into question.  Do you really “own” something if a significant yearly “rent” is due to the local municipality?

Commodities Futures – Trust is dead

No one seems sure about exactly what has gone on in the commodity markets lately.  From the commodity accounts at MF Global “disappearing” to recent allegations that some metal markets have been tampered with, an investor would be wise to be very cautious about investing in this area.

Money disappearing from commodity accounts or artificially high prices paid for commodity investments are not hallmarks of a fair and transparent market.

Stocks –Playing “Marco Polo” at the edge of a cliff

I am sure many of you are familiar with the children’s game of Marco Polo.  One child is blindfolded or closes their eyes and yells “Marco.”  The other children then respond by yelling “Polo!”  The objective of the blindfolded child is to tag the other children while being guided to their location by listening to the shouts of “Polo!.”

The equity markets have been on a tear lately, reaching towering highs.  Investors have been enjoying the ride so far following the market’s shouts of “Polo!” to ever higher destinations.  Unfortunately this game is being played at the edge of a cliff as the market’s highs have been encouraged by the Fed’s QE program.  The danger here is that one could find themselves following the shout of “Polo” and buying into the market only to realize that QE has ended or has “tapered” and the formerly solid ground beneath their feet has disappeared.

“So what are we supposed to do…nothing?”, moans the peanut gallery.  Another question might be how is today different from any other time in history?

Many of you may have noticed the common thread in our discussions of the various investments above.  Until the various attempts to alter market realities end, unscrupulous market participants are reigned in and property rights receive greater priority, investing will remain plagued by mirages.

Have a great week,

 

Michael Bechara, CPA, CFE, CRMA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

845-282-3899

 

 

 

 

 

 

 

 

 

 

 

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Don’t Hate Me Because I’m Beautiful

Long suffering Weekly Recon readers know of my fondness for the 1980s.  One of the most memorable commercials from that era was the Pantene shampoo commercial where the unforgettable Kelly LeBrock breathlessly says, ”Don’t hate me because I’m beautiful.”

I always got the feeling that not that many people hated Kelly LeBrock.

Of course the commercial was ridiculous because human nature is to be drawn to beauty and to appreciate beautiful things.  We all strive to make our homes, offices, cars, and even garages as inviting as possible.

“Oh yea, so what about things like modern art, punk rock haircuts and grungy fashion outfits”, sneers the peanut gallery.

True, some say those things are beautiful, but deep down they are more about rebellion against human nature than anything else.  Even their most ardent supporters will admit that when pressed.

True beauty is not really about masking things but rather more about revealing them.  Beauty is in a sense…..truth.  We are drawn to people and things that we believe are genuine.

In our business most people prefer the straight shooter over the shifty politicized manager.  They may not necessarily like, or agree with, what the person has to say but most of us find significant comfort in knowing exactly where the other person is coming from.

On the other hand when people encounter managers that are less than genuine, there is a significant discomfort even if the message seems logical on the surface.

It’s in our human nature to identify things that don’t seem to be as they are.  It could be ingrained within us as a survival mechanism from our more primitive days.

Which is probably why retail investors are so wary as of late.

Many have commented that one of the most beautiful things to experience is a secular rising or bull equity market.

So why are so many people saying that the current bull market is one everyone loves to hate?

Simply put?…Because the beauty is not genuine.

The chart below shows quite clearly that the current bull market is almost entirely the result of Quantitative Easing (QE) by the Fed.  Yep, the easy money that has been available since 2009.

 

 

 

 

 

 

 

 

If the above chart left anyone in doubt, let’s follow it up with an even simpler chart courtesy of zerohedge.  In the spirit of the 80s we have added some explanations referring to another famous commercial:

 

 

 

 

 

 

 

 

 

 

The Venus flytrap lures insects with sweet smelling sap only to suffocate them and over the millennia predators have camouflaged themselves as seemingly harmless objects such as grass or logs.

Many believe that the current bull market is a chimera and is simply beckoning the unwary to buy in only to summarily close its jaws and swallow any invested capital.

Perhaps the Pantene commercial was so successful due to the undeniable beauty of Ms. LeBrock.  The corollary conclusion might be:

No Mr. Market we don’t hate you because you are beautiful, we hate you because you are phony.

 

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The Management Meeting – Deconstructed

 

It was late spring in the Virginia suburbs of Washington, D.C.   

All of the guys in the department had fought to get on this particular audit because of the time of year and the location.  A young staff internal auditor named Mike Bechara waited in the “bullpen” with the other staff auditors to see who would be picked by the senior auditor for the job.   

The “Senior” was a guy from Western Pennsylvania.  I’ll call him Dave.  As Dave came down the corridor of cubicles, the rest of the Staff crowded around him.  Not yet 30 years old (and not used to being in a position of authority) he cockily eyed the crowd and with a gruff nod of his head he mumbled, “Bechara…lets go.” 

In my early 20s (and not used being magnanimous) I smugly shouldered my way through the crowd and followed Dave into the Manager’s office for the pre audit briefing.   

The assignment was for a pre-appointment audit.  We worked for an insurance company and before the company would sign up a new agent they would perform a pre-appointment audit to evaluate the financial condition and integrity of the agent.  

Later that week, upon arriving in the sunny Virginia office of the agent, we were ushered into a conference room to set up.  As I unpacked my stuff I prepared to execute the hard work of financial analysis, examining reconciliations and evaluating systems.  

Dave had other plans.   

Mike, you’re coming with me to the management meeting.  The boss said I have to “professionally develop you”, he informed me.   

The management meeting!  The Promised Land! 

Long known amongst the staff as a fluff meeting designed to get the Seniors away from the hard detail work, I was ecstatic at being able to attend.  As we were ushered into the executive office of the agency’s President, Dave warned me, “Don’t say anything stupid.” 

As the meeting started, the President in a booming voice began to spin tales of how he was the mover and shaker about town; how he had closed insurance deals with celebrities and about how he met a Senator on the tarmac of the airport to sell him insurance.  Interspersed between these tales of business prowess, he made mention of the luxury items he had accumulated personally (houses, boats, cars) during his time in business.   

As I listened I forgot Dave’s admonition about speaking and asked, “Are there any areas of the business that you are concerned about?” 

The agent looked at me like I had asked him if he wore deodorant.   

“My concern is that I am here in the office teaching you about my business instead of out there getting more!” he growled back.  

Dave remained stone-faced and just looked at the agency President.   

Of the hundreds of risk assessments, internal audits and investigations I have performed over my career, I can consistently point to the meetings with management as the key arbiter, the pivotal point in making big decisions about whether to extend credit, consummate a merger or sign any agreement.   

I recently read a great piece by ConvergEx’s Nick Colas where he supplies his own experiences in management meetings from an investor perspective.  Here are some excerpts from this great article.   

http://www.scribd.com/doc/130343558/Stuff-Managements-Have-Told-Me-ConvergEx 

Meetings between public company managements and investors are the bedrock of the fundamental investment process.  The reason for that, however, is often lost in translation.  It is not, for example, because most investors or analysts are systematically better at reading “Body language” about the quarter or new products.  Seriously – they aren’t.  No – the reason that management meetings are useful is because, over time, managements let down their guards and act like regular people.  And in those moments, truth – about character, about wisdom, about judgment – comes rolling out 

Even today many teams, whether they are audit teams, field exam teams or due diligence teams, underappreciate and undervalue the process of meeting with management.   

Perhaps it’s our data driven driven society where we think we can financially engineer our way out of any problem, from a bad acquisition, an underwater debtor or perhaps even an economic slump….. 

At any rate, let’s go back to our management meeting in sunny Virginia.  The agency President went on and on describing how he would do anything to close a deal.  When Dave asked him about his financials, his customer concentrations or his software systems he became agitated and dismissive.  At one point he exclaimed “The back office people handle all that, and anyway, what’s important is that I can deliver the business!”

We ended the meeting and went back to doing our analysis work.  I had a hard time concentrating as I thought I blew it in the management meeting.  “Dave had basically told me to keep quiet and I asked a stupid question”, I thought to myself.   

At the end of the review the financials looked fine and we had no major issues.  I asked Dave if he thought we would sign the agent.  He didn’t answer but just gave me a sort of half sad smile.   

Back at the office later that week, I was shocked to find out that we did not sign up the intrepid Virginia agent.  I got pretty nervous as I naively thought that the agent backed out and went with another underwriter.  After all hadn’t the numbers and the analysis checked out?  Wasn’t he a big time player in his area with a lot of contacts and business? 

Before lunch I saw the Manager of Internal Audit coming down the corridor towards the bullpen.  The Manager?….coming to the bullpen? 

I looked around for a box to use in cleaning out my desk, but before I knew it the Manager was in front of me speaking rapidly:

 “Dave just updated me….Good question…Next time don’t be intimidated…ask a follow up question.”    

It was not until years later that the agent was involved in some questionable practices with another underwriter.   

Have a great week,  

 

Michael Bechara, CPA, CRMA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

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Does This Risk Make Me Look Fat?

I sat on the couch staring blankly ahead, keenly aware of my impending doom.   The bags from the department stores lay strewn about the room overlapping one another and forming mosaic patterns before my glazed eyes.   

Starting to sweat a little, I took a couple of deep breaths to relieve the tension and stress.  As my wife emerged from the other room, I mentally scrambled for an answer, for a response, one that would satisfy the question that has plagued man for millennia.   

Finally the moment arrived.  As my wife turned back and forth in front of the mirror she delicately unfurled the infamous question: 

“How do I look in this dress?”,    

As my mouth went dry, the garage door burst open and in came my son from outside.  Like a defending angel he swooped through the kitchen and into the living room, giving his mother a hug as he flew by.   

“Nice dress Mom, you look so pretty”, he said nonchalantly as he passed.   

“Oh thank you son,” my wife responded, clearly proud of her boy.   

Seeing my window of opportunity I took flight behind my son as he rocketed into the next room and back out the garage door.   

For some reason wives insist on torturing their husbands with the clothing opinion ritual.  No matter the answer, positive or negative, the reaction is the same; an extended discussion about color, fit and style.  For the woman already knows how she looks in the dress, she merely is looking for someone to challenge her conclusions.   

It’s ironic that corporations behave in similar ways.  In many respects, an enterprise risk assessment is a corporate version of “How do I look in this dress?”  Most of the corporate executives and managers believe they have a good handle on the risks facing the company.   

This is not strange, and in fact, is not a bad thing at all.  We would expect those in charge of managing risk to have some pretty strong ideas about the challenges they are dealing with.  The problem arises when they do not seek to confirm or challenge their views of risks.   

In our risk work we typically run into three types of management teams.  In describing them I found it helpful to point out the ancient Greek philosophical terms that management typically uses to justify their position; the ethos, pathos or logos.    

We know it all. 

The most myopic management teams do not accept any challenge to their views.  They rely heavily on the ethos or the appeal to authority to convince themselves and their employees of the right answer.  “I am an executive therefore I know”, is the mantra.   

This type of management team typically only wants us to interview a very small number of executives.  They do not have an economic worldview and dismiss it as big picture “speculation.”  The results are predictable, the “groupthink” is confirmed and the dogmatic view of the business eventually reaches its predictable conclusion.   

Let’s explore possibilities…but there is no way we could be wrong!

The second type of management team is willing to entertain other views; but only deems as valid those that support the current belief system.  In this scenario the pathos or appeal to emotion is used.  Management has developed a core set of beliefs about the business typically expressed in lofty emotional terms.  Any information that challenges the underlying assumptions is seen as questioning “motherhood and apple pie.” 

In the investment world we call this confirmation bias.  Information and analyses are sought that support a predetermined conclusion.   Any dis-confirmatory information is derided as not credible, irrelevant or just the uninformed opinion of the rank and file and is quickly suppressed.   

We are a strong confident team…but we can always improve or adjust. 

Like a good investor, the third type of management team has a view of the economy, their industry and competitors.  All views are welcome, openly examined and either adopted or discarded.  The logos or appeal to logic is the guiding light here.   

This management team actively looks for dis-confirmatory information and seeks to challenge their own assumptions.  This process accomplishes two important functions 1) It opens new discussions that may yield an adjustment in their approach to managing risks 2) It increases their confidence in the current approach by forcing a critical discussion.   

The moral of the story or ..in Greek the NOIMA or MATHIMA

Ultimately in business, and in life for that matter, those that are able to critically examine their worldview, assumptions and approach tend to have a greater number of positive outcomes.   

 

But back to our little fashion show…..  

Later that evening, I was waiting downstairs to go to the social function my wife was preparing for earlier.  I began to wonder what she would be wearing.  My thoughts were interrupted by the click of high heels on the hardwood floor of the stairs.   

Turning my head, I saw my wife glide down the stairs in an absolutely stunning outfit.   

As she carelessly walked by me on her way into the kitchen, I stammered “Wow, you look fabulous.” 

“I know”, she coolly replied as she gathered her purse.   

Not able to restrain my thoughts, I asked the obvious question, “Then why did you ask me what I thought earlier?” 

“Just looking for some dis-confirmatory information”, she smiled back while shaking her head.     

Have a great week,

 

 

Michael Bechara, CPA, CRMA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

 

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