Value Investing Is My Life

Timothy Collins, Tim Collins

2007-05-21T15:34:00.000-07:00

I am currently reading the book "Saving the Sun" about the
story of the revival of Shinshei Bank. Part Two of the book
focused on Timothy Collins. After reading it, I am liking this
man more.
I first heard of Timothy Collins when Marty Whitman told me about him
in his Yale class, which I had the fortune of auditing. I found out
later that Third Avenue Value Fund owned shares of RHJI International. Tim
turned around Shinshei Bank, one of the biggest banks in the world.
I went to Belgium to visit with the office of RHJ International. Arnaud
Denis, RHJI's investor relations, told me about this book.
Let me put an excerpt from the book,
"In the late 1980s, Collins gave up the investing banking game to work out what he wanted to do with the rest of his life. He was a Baptist and sometimes wondered whether chasing money on Wall Street really fitted in with his Christian faith. For six weeks he worked in a Sudanese refugee camp and toyed with the idea of doing charity work full-time or even entering the church. "I don't go to church every week but I think my family's religion and my belief are an important part of my view of the world," he later explained.
His friend and fellow Christian, the financier Richard Rainwater, persuaded him otherwise. "God didn't make you a poet or an opera singer or a six-foot-eleven center," Rainwater told him. "But you are pretty good at doing this[business.]" So Collins decided instead to donate a large proportion of his earnings to charity and reemerged on Wall Street..."
Classy guy, good ethics. In my investing process, when I find good management, I feel it is my job to tell the story of this man so that the world can be a better place if capital were entrusted with him. Imagine if Warren Buffett was more well known back in 1950s and he compounded his wealth to much higher than it is now. And he donated that entire amount to charity! Now, that's value creation!

"We don't get credit for being shareholder friendly" - Eddie Lampert

2006-04-12T11:03:00.000-07:00

I just came out of the annual meeting of Sears.
There were about 150 people in the room.
I am in the airport and will be brief.
Here are some quick notes.

First some insights and observations.

Eddie mentioned the word "focus" several times. In fact,
he recommended a book, "Crazy Busy" at the end of the meeting.
It is a book by a psychiatrist who dealt with ADD patients. The
psychiatrist's thesis is that at the end of the day, being focused
on one task is superior to multi-tasking. Eddie says he agrees with
that thesis.

Eddie struck me as somebody who is extremly balanced in his thinking.
He always offers 2 sides of the coin when explaining. For example, he
would say we are doing this not because X, but because of Y. He always offers
the is, and the what is not. This to me is a sign of wisdom -- a very self-aware, very wise person. I liken this to Lao Tzu's quote. "Knowing what you know, and knowing what you do not know. That is the way to know."

Anyway, this is my third time hearing Eddie talk. I came out very impressed with his answers and articulateness. I asked him a question about the online commerce of Sears versus Walmart.com, his answers showed he thinks about all these things a lot all the time.

Eddie said that aside from buybacks, dividends, capex spending and
acquisitions, their main focus is to invest in people. Not trying to
be soft, but he repeatedly said that the culture is extremely important
to him and the Sears team. He mentions GE, Dell, Starbucks as examples of the culture.

Eddie said no retailer should aspire for a situation where the real estate is more valuable than the business. It is a shame that they had to sell real estate to other retailers whose business model can develop a better business than themselves.

Eddie said he rarely uses EBITDA. But for Sears, since there is M&A accounting, fresh start accounting (for post bankruptcy situations) and foreseeing that in the near term, capex would be less than D&A, he uses EBITDA for Sears.

I talked to some of the associates at Sears. There was a shareholder of Sears and an employee of Sears since 1970. He said he has seen a lot of great improvement since Eddie came on board. In the past, people viewed Sears and Kmart as sinking ships, he said that the new captain is righting the course. He cited quick decisions being made. He used the example of Sears Essentials. In the past, all the bureacracy would not make a quick decision about ending a mistake.

This leads me to one of the topics Eddie frequently discussed in the meeting.
He cited that aside from buybacks, dividends, acquisitions, and capex, the best
investment for Sears now is in its people and culture. He envisions a culture
where people are comfortable with ambiguity, where people are comfortable with admitting mistakes and failures. He wants to build a company that outlives him.
He mentioned GE, Dell, Goldman Sachs as examples of this kind of culture. He specifically said GE has done a great job of transitioning from Jack Welch.

He tries not be doctrinare about anything. He says a lot of companies forcefeed to their customers. If they make a goal to remodel 100 stores and it is not working, they keep doing it. He says momentum in the right direction should be accelerated and momentum in the wrong direction should be stopped. They could increase their sales by giving away flat panel televisions for 1 dollar. But if their own employees have to use coupons to buy at Sears and would happily buy from Target at listed prices, Sears must learn from it. It's not even about disloyalty, it's about learning what Target's doing right.

Another example of not being doctrinaire was the use of debt. He said sometimes it's good to increase debt. For example, at Autozone, they increased the debt levels. He then said one can argue that Microsoft or Berkshire can benefit from some leverage. On the other hand, Google did not seem to need to raise cash with its present business model, but they raised cash probably because Microsoft has so much cash.

After the meeting, Vivian took us a tour of the new products that Sears has developed. I must say that a lot of thought went into the designs of these products.

I will write more when I get back to New York City.

Rational Prices

2006-03-30T07:54:00.000-08:00

My job is like that of a diamond appraiser. Instead of appraising diamonds, I appraise businesses.

There are very few times in life when prices become very irrational. My job is to be patient and be ready to pounce when that happens. Patience is another word for waiting.

What is a rational price? That is an appraisal that requires knowledge and insights. You need to know accounting, economics, business, commerce, math, probabilities, history.

I love my non-job or I love what I don't do

2005-12-23T09:30:00.000-08:00

Value investing is as much about doing nothing as it is about doing something. What I do everyday is read to expand my circle of competence. Often times, I hear people say I love my work, or I love what I do. I'd rather invert this statement because as a value investor, I love what I don't do, or I love my non-work. Value investing is about doing nothing intelligently. Being able to sit on a stock for three years watching paint dry is even more important than knowing how to decompose the ROE using the Dupont model.

RISK - the four letter word

2005-12-21T09:45:00.000-08:00

The big four letter word in our business is RISK. Most institutions define it as the standard deviation/volatility of stock prices. For me, the only RISK that matters is business risk. It could be caused by competition or any unexpected event. The only antidote for preparing for unexpected events is Margin Of Safety.

For example, this MTA strike that is happening in New York City right now is probably unexpected by 99% of the retailers. Who would have thought this would happen, right? Basically, everyday, we see events that are unexpected by 99% of the people. That is why value investors require a margin of safety. We know there are a lot of unexpected things that can happen, and will happen.

When did you become a Value Investor?

2005-12-20T22:57:00.000-08:00

I became a value investor when I was in junior year at UCLA. In 1989, I read a Los Angeles Times article about Warren Buffett and since then, I have become hooked. I maed my first value investment (outside of Berkshire Hathaway) in Salomon Brothers. I bought the leaps and made 5 times my capital within 3 years.

When and how did you become a value investor? Post your stories.

2005-12-18T18:14:00.000-08:00

This is an email exchange between Patrick Byrne and his brokers. Read it and judge for yourself.

-----------------------
Patrick,

Today I have been informed by Bob at XXXX, that the 50,000 shares of Ostk originally confirmed to have settled on Dec 5th and in the process of being converted from DTC shares to paper, have in actuality not settled and no shares have been received (emphasis added) by XXXX from SSSS (SSSS is selling broker, XXXX is buying broker). The $1.8mm for the purchase of the shares has been debited from your XXXX account, but XXXX has not distributed any money to SSSS and the funds are being held in a XXXX holding account. I am in contact with Bob on a daily basis and we will continue to push SSSS to deliver the shares.

Please let me know if you have any questions.

Thanks, Ted

-----------------

Subject: RE: Ostk purchase

Thanks.

Ted or Samson,

Can you confirm for me:

SSSS was the counterparty to this trade?

When the trade is done, what is the process by which the trade is "confirmed to have settled"?

Please describe this process normally works. No more than 50 words. For example:

The trade: "Ted talks to a broker on the SSSS side and agree on the deal, they each write a ticket with a trade number on it." Or... "Ted does the deal through a computer screen, which tells him that the counterparty was SSSS, and give him a trade number."

The confirmation: "Three days later the DTCC sends an electronic confirmation that 50,000 shares have been debited from SSSS's DTCC account and credited to XXXX'."

Or whatever the truth is. I just made those up, but it is what I imagine. Can you just write for me the correct sentences so i understand?

Patrick

-----------------

Patrick,

In answer to your questions below;

Yes we purchased the shares through SSSS.

I will try to explain the process as best I know and keep it short. I enter the trade when it comes in. My back office brokers pick up the trade and then call the "reps"/brokers that move the stock. In this instance they contacted SSSS. The SSSS broker then goes and tries to fill the order by breaking it down and going to the street. His back office accumulates the shares and then lets him know that the trade is now good. He then calls my back office broker to let them know the trade is good. Usually this would be an electronic confirmation. The selling broker then has three days to collect those shares from where ever he got them and deliver them to XXXX. So on the day of the trade or by the next morning we have a confirmation and a detailed report that the shares are good. That report is the same I provided to Sam (Your rep). When the stocks arrive at XXXX the money is then credited to the SSSS account and the transaction is complete.

I hope this helps or is the information that you need.

Ted
-----------------

Ted,

I have been thinking.

Doesn't this mean that SSSS sold these without having them?

If they sold it, then have to go out and "accumulate the shares"? That is, it was a short sale?

Was it identified as a short sale during the trade?

Can you buy them in?

Patrick

-----------------

Patrick,

It would seem that SSSS did not have the shares when they sold them to us. They are a market mover for overstock.com and so are both placing sells and buys throughout the day. There is no way for us to tell how short they were at what time, I don't think the broker at SSSS even knows the total position of shares when they complete the trade. It never is disclosed as a short sale, all we see is a confirmation that they accepted the trade which means that typically they will deliver the shares in three days. My understanding is that traders and brokerage houses will often on securities borrow the shares if they come up short at the end of the day. Since Overstock is a "hot" stock they are finding it just about impossible to find shares to borrow or buy (emphasis added).

As far as your question about buying them in, yes we could buy them in in this situation. However, if we try I don't know that we will be successful. Talking with my traders they feel that we will run into the same problem, no one seems to have enough of the shares to deliver (emphasis added).

I have talked with SSSS again today and they are at the same position right now.

-----------------

Thanks Ted.

I assume you mean "market maker" and not "market mover"? (Freudian slip?)

Can you do me a favor and ask SSSS: "Whom did SSSS buy the short sold stock from?"

Patrick
-----------------
Patrick,

I talked with SSSS and they said that as far as where they get the shares they execute the buy for us knowing that typically for stocks they can get the shares with in the three days. With Overstock shares they were not able.

They have, as of the 13th, issued buy ins on all shares owed them and are pursuing those shares to complete our purchase.

Ted

A rare interview of James Simons of Renaissance Technologies found ...

2005-12-11T00:38:00.000-08:00

Institutional Investor, Nov 2000 v34 i11 p38

The Secret World of Jim Simons.

Hal Lux

Full Text: COPYRIGHT 2000 Euromoney Institutional Investor PLC/Tel: 44(0)207-779-8999/www.iimagazine.com

How does this prize-winning mathematician and former code breaker rack up his astonishing returns? Try a little luck -- and a firm full of Ph.D.s.

Last April the State University of New York at Stony Brook held a gala reception at the Waldorf-Astoria Hotel in midtown Manhattan to celebrate raising a record $1 million -- a tidy sum for a state school. After cocktails a balding, white-haired man rose from his sear on the dais to thank the sellout crowd, which included such celebrities as Oscar-winning movie director Martin Scorsese, for its generosity.

"I told my wife, 'We raised $1 million for Stony Brook,'" said the speaker, hedge fund manager James Simons. "She said, 'Gross or net?'"

Chances are you haven't heard of Jim Simons, which is just fine by him. Nor are you alone. Many on Wall Street, including competitors in his specialty, quantitative trading, haven't heard of Simons or of his operation, Renaissance Technologies Corp., either. And that's simply extraordinary -- because, gross or net, Simons may very well be the best money manager on earth.

An extreme judgment? Perhaps. Certainly, there has been no end of claimants to the title. And one after another, over the past few years, these celebrated managers have either blown up or folded their tents. After big reverses, Julian Robertson closed down Tiger Management, and George Soros scaled back the activities of his Quantum Fund this year. John Meriwether's Long-Term Capital Management neatly took down the financial world in 1998.

Simons, by contrast, just keeps getting better. Consider his performance over the past decade. Since its inception in March 1988, Simons' flagship $3.3 billion Medallion fund, has amassed annual returns of 35.6 percent, compared with 17.9 percent for the Standard & Poor's 500 index. For the 11 full years ended December 1999, Medallion's cumulative returns are an eye-popping 2,478.6 percent (see graph, page 47). Among all offshore funds over that same period, according to the database run by veteran hedge fund observer Antoine Bernheim, the next-best performer was Soros' Quantum Fund, with a 1,710.1 percent return (see table, page 44).

"Simons is No. 1," says Bernheim. "Ahead of George Soros. Ahead of Mark Kingdon. Ahead of Bruce Kovner. Ahead of Monroe Trout."

And Bernheim's numbers don't include Medallion's 2000 performance. In a year of exceptional volatility and market dislocations, the fund is up 64 percent through September. Over the years, Simons' consistency has been exceptional. Apart from his second year, 1989, his fund has not had a losing year (it was down 4.1 percent that year). In fact, in the past decade, it's never returned less than 21 percent.

"Ten years ago I put a small amount of money into Medallion," says one pleased investor, Richard Gelfond, the co-CEO of Imax Corp., the Canadian giant-screen film company. "Today it's a big amount of money."

Medallion, which closed to new investors in 1993, is focused chiefly on commodities and futures trading. Recently, Simons has expanded his equity business. Last year he launched Equimetrics, a $500 million U.S. fund with a market-neutral trading strategy for institutional investors. Despite market ructions, and the first declining U.S. stock prices in years, Equimetrics this year has returned 24.1 percent through September, compared with--2.23 for the S&P 500 with two thirds the volatility.

And these are all, it should be noted, net numbers. The price of Simons' success is high for investors. He charges a management fee of a stunning 5 percent of assets, in addition to the normal hedge fund rake-in of 20 percent of profits.

To be sure, some investors have had even higher returns in recent years. Hedge fund manager Jeffrey Vinik closed his fund last month after compiling average annual returns of 53 percent since November 1996. And Steven Cohen of SAC Capital Management, reportedly posted returns of 70 percent last year and 49 percent the previous year. Simons, however, has made steady profits over 11 years, compared with just seven for Cohen and four for Vinik.

Simons' risk-adjusted returns are even more impressive. Paul Wick, manager of Seligman Communications and Information Fund, leads all U.S. mutual fund managers, according to Morningstar, with annual returns of 31 percent since 1990. But his Sharpe ratio over the past three years is 0.42; for the same period, Legg Mason's celebrated William Miller III boasts average annual returns of 24 percent -- and a Sharpe ratio of 0.64. Simons wracked up a ten-year Sharpe ratio of 1.89 throughout the 1990s, with a 2.52 ratio for the last five years of the decade. Sharpe ratios are a measure of risk-adjusted returns. The higher the number, the better.

How does Simons do it? Start with a world-class mathematical mind. In 1976, at 38, Simons won the American Mathematics Society's Veblen Prize -- awarded every five years, it is the geometry world's highest honor -- for his work in the excruciatingly esoteric field of differential geometry. His signature work -- a 26-year-old theorem crafted with renowned geometrician Shiing-Shen Chern that is known as the Chern-Simons theory -- has recently emerged as a critical tool for theoretical physicists searching for fundamental laws of the universe. "Chern-Simons pervades a whole class of theories that underlie our fundamental view of the observable world," says Brandeis University physicist Stanley Deser, an expert on supergravity, a discipline of quantum theory that studies elementary particles and their interaction.

"Jim Simons is without question one of the really brilliant people working in this business," says quantitative trading star David Shaw, chairman of D.E. Shaw, which boasts returns above 50 percent this year. "He is a first-rate scholar, with a genuinely scientific approach to trading. There are very few people like him."

Simons surrounds himself with like minds. The headquarters of Renaissance, in the quaint town of East Setauket on New York's Long Island, resembles nothing so much as a high-powered think tank or graduate school in math and science. Operating out of a one-story wood-and-glass compound near SUNY Stony Brook, Renaissance, founded in 1982, has 140 employees, one third of whom hold Ph.D.s in hard sciences. Many have studied or taught in Stony Brook's math department, which Simons chaired from 1968 to 1976. Among their ranks: practitioners in the fields of astrophysics, number theory, computer science and computational linguistics. In notably short supply are finance types. Just two employees, including the head of trading, are Wall Street veterans.

"I have one guy who has a Ph.D. in finance. We don't hire people from business schools. We don't hire people from Wall Street," says Simons. "We hire people who have done good science."

Confident and witty but intensely secretive about his business's inner workings, Simons shuns publicity. He agreed to talk with Institutional Investor only after much pestering (see box, page 42). And some of what he said was, frankly, unintelligible. We made the mistake of asking him to explain Chern-Simons. After half an hour he allowed, "I can't." He meant, of course, to us.

Simons rarely speaks at financial forums, preferring math conferences. He celebrated his 60th birthday with a geometry symposium at Stony Brook that included such lectures as "Generalized Chern-Simons Invariants as a Generalized Lagrangian Field Theory." That's one reason he is little known on Wall Street. Two years ago Renaissance invited Andrew Lo, whose financial engineering program at the Massachusetts Institute of Technology is the prime recruiting ground for quantitative traders, to speak at its headquarters on options replication. "I had heard of Jim Simons the mathematician, but I had never heard of Renaissance until they called me up, says Lo. "I said, 'Jim Simons runs a hedge fund?'"

When he does open up, Simons can seem exasperatingly coy in describing his success. "Luck," he told a gathering of potential investors last spring in Greenwich, Connecticut, "is largely responsible for my reputation for genius. I don't walk into the office in the morning and say, 'Am I smart today?' I walk in and wonder, 'Am I lucky today?"'

In fact, Simons is being straightforward. Luck may be the residue of design to baseball minds, but to a mathematician it's the twin of probability, which can be approached through statistical studies. Renaissance's researchers construct statistical models and proprietary algorithms from exhaustive scrutiny of market data.

Like all quantitative money managers, Renaissance aims to find small market anomalies and inefficiencies that can support profitable trading on billions of dollars of capital. Though all quant shops are alike in their dedication to models -- Let the best algorithm win! -- Renaissance's approach differs from the "convergence trading" popularized by John Meriwether's Long-Term Capital Management and similar arbitrage shops. Convergence traders price financial instruments based on complex mathematical models, find two different instruments that are cheap and expensive on a relative basis and then buy one and sell the other, betting that the prices will, at some point, have to return to their proper level. The Renaissance approach requires that trades pay off in a limited, specified time frame. And Renaissance traders never override the models.

Guided by these models, Medallion's 20 traders conduct rapid-fire buying and selling of a multitude of U.S. and overseas futures contracts, including all major physical commodities, financial instruments and important currencies, in addition to trading equities and mortgage derivatives. This year Medallion made a killing in the volatile oil futures market.

To be sure, Simons' track record is not unblemished. In 1997 he folded a middling market-neutral fund into Medallion after just three years. And a mortgage-backed-derivatives fund he backed in 1995 swooned after enjoying two fine years.

An active venture capitalist and private equity investor in the U.S. and Latin America, Simons sits on the boards of four companies, including Franklin Electronic Publishers, the pioneering electronic spell-checker and book company, of which he owns 22 percent and is chairman (see box, page 41). Simons has recently raised a $200 million fund to extend Renaissance's reach into technology venture capital investments.

Simons' trading record over the past decade is more than luck. The bigger question is whether he can keep it up. A chain-smoker in defiance of statistical possibilities, Simons is 62 and has no designated successor, and the firm is starring to expand into new areas.

Such a situation can be a recipe for disaster for trading firms. But Simons says with scientific certainty: "The things we are doing will not go away. We may have bad years, we may have a terrible year sometimes. But the principles we've discovered are valid."

THE SON OF A SHOE FACTORY OWNER, JIM Simons grew up daydreaming about numbers. "I wanted to do mathematics from the time I was 3," says Simons, who was raised in the Boston suburb of Newton. "Literally. I would think about numbers and shapes.

After graduating from Newton High School, he entered MIT, studying under renowned mathematicians Warren Ambrose and I.M. Singer. (Says Singer: "He's very intuitive. He has a sense of taste for the right principles in mathematics, and that is very rare, let me tell you.") He received his BS in math in 1958 at 20 and a mere three years later, a Ph.D. in math from the University of California at Berkeley. By 23 he was back at MIT -- on the faculty. After one year, he strolled up Massachusetts Avenue and spent two more years as a math professor at Harvard University. There he worked on solutions to such conundrums as the plateau problem and the Bernstein conjecture, which grapple with the properties of multidimensional surfaces.

Though a rising star in his field, Simons quickly tired of academic life. Seeking adventure, he signed on in 1964 as a code breaker with the Institute for Defense Analyses, a nonprofit research organization that performed work for the U.S. Department of Defense. Angered by a New York Times Magazine story that he thought overly optimistic about the military effort in Vietnam, Simons made comments to Newsweek that were critical of the war. After telling his boss about the interview, he says he was fired from IDA.

Shaken, Simons quickly found a home back in academia. He took the post of chairman of the Stony Brook math department, where he would spend the next eight years doing pure research. "I felt so powerless about being fired," he says. "I thought, 'They can't fire you if you're chairman.'"

Simons' most famous work is his 1974 paper "Characteristic Forms and Geometric Invariants," which he coauthored with the renowned Berkeley geometer Chern. It represented an important breakthrough in geometry that would become known as the Chern-Simons theory.

Differential geometry, Simons' specialty, is the study of curved surfaces and spaces. We are all familiar with spheres; we live on a very big one, after all. But it turns out that, for mathematicians, they are fiendishly complicated. Geometers establish the properties that separate one type of object from another. Although they have been able to determine the properties of what to laymen are such incomprehensible objects as spheres with ten dimensions, they have not been able to do this with spheres in the third dimension. French mathematician Henri Poincare postulated at the beginning of this century that they ought to be able to do so using simple means. Like Fermat's last theorem, which was finally proved in 1993 after centuries of fruitless efforts, Poincare's conjecture is one of the mathematical world's great remaining mysteries. (The Clay Mathematics Institute has offered a $1 million prize to anyone who can find the solution.)

Chern-Simons was not meant to solve Poincare's conjecture, but it does offer calculations that are useful for distinguishing among shapes in three dimensions. "Chern-Simons offers a route to solve Poincare's conjecture," says Simons, "but it's a difficult route, and there are other difficult routes."

Difficult, yes, but, say mathematicians, an elegant piece of abstract reasoning. "Chern-Simons, that's a beautiful thing," says George Zettler, a former Columbia University math professor, who now trades swaps and options for the mortgage-backed-securities hedge fund Ellington Management Group. But the paper's language defies translation into plain English. A random sample: "The Weil homomorphism is a mapping from the ring of invariant polynomials of the Lie algebra of a Lie group, G, into the real characteristic cohomology ring of the base space of a principal G-bundle." Difficult, indeed.

Chern-Simons has taken on a second intellectual life, because the theory has come to have a major influence in a completely different scientific discipline. In the mid-1980s Princeton University professor Edward Witten, now one of the world's leading theoretical physicists, noticed the applicability of Chern-Simons to physics and popularized an area that is loosely called Chern-Simons quantum field theory. These days Chern-Simons is used as a tool in many areas of physics research, from string theory to supergravity to black holes. "Every day a physicist is working on a new theory with Chern-Simons," notes Dennis McLaughlin, a Princeton-mathematician-turned-McKinsey-&-Co.-consultant.

NOT ONE TO REMAIN LOST IN ABSTRACTIONS, Simons has long had an affinity for business. In 1961, he and a few MIT classmates invested in a Colombian floor tile and pipe company. At Berkeley he tried his hand at trading, looking to invest about $5,000 in wedding gifts from his first marriage. He found that stocks bored him. "I went to a Merrill Lynch broker," recalls Simons. "He said, 'Try soybeans.'"

Simons didn't get really hooked on trading until the early 1970s, when he was at Stony Brook. In 1973 the tile company got sold, and he turned the proceeds over to a mathematician he knew who was trading commodities. "In eight months he had multiplied my money by ten times," says Simons.

Even as he was being hailed for his theoretical work, Simons began to make the transition out of academics, working halftime at Stony Brook and trading currencies with his own money between 1976 and 1978. In 1978 he left Stony Brook completely, to form a private investment fund called Limroy. Initially, he took a fundamental approach, trying to predict factors like Federal Reserve Board policy and interest rate movements. Over the next ten years, Limroy grew initial capital 25 times by investing in everything from venture capital to technical currency trading.

In 1988 Simons decided to launch a fund that concentrated on pure trading. He shut Limroy and launched Medallion in March 1988. Concentrating on futures trading, the fund earned 8.8 percent in 1988 but lost money steadily in 1989 until Simons halted trading in June.

For six months Simons and former Princeton mathematician Henry Laufer, who is still Renaissance's research chief, rebuilt Medallion's trading strategy, shifting from fundamental analysis to the quantitative approach that powers the firm today. "We started to think about a whole new way to look at futures," says Simons.

Back in action, Medallion made its mark through rapid, short-term trading across futures markets. In the early years the types of inefficiencies that could be exploited by quantitative trading abounded. The firm made money by simply arbitraging Treasury bills against Treasury futures contracts. Luck helped too. In 1990, for example, the fund was long oil when Iraq invaded Kuwait.

Simons steadily recruited top-tier scientists. They focused on speeding up systems, studying how to optimize risk allocation and determining trading strategies. By 1993, after three dazzling years, Medallion had reached $270 million in assets and stopped taking new money. And Simons began extending his reach. By 1994 Renaissance, which had started with 12 employees, had 36 on staff, and Medallion was trading 40 types of securities, up from 12. Renaissance had always done all of its trading through outside brokers; the following year it opened its first in-house trading operation. Today Renaissance has 140 staffers -- it plans to be up to 150 by year-end -- and trades 60 different financial instruments around the clock.

"We have three criteria," says Simons. "If it's publicly traded, liquid and amenable to modeling, we trade it."

Three years ago Medallion formed an internal fund-of-funds to invest in outside managers. In part, the fund was looking for new ways to invest excess capital that investors didn't want back. Simons also believed the approach would increase Renaissance's market intelligence and occasionally present opportunities for Renaissance to acquire another fund. Medallion now has $500 million invested in 40 outside funds, including macro manager Louis Bacon's Moore Capital Management.

Expansion doesn't always work, however. Medallion began trading mortgage derivatives in its fixed-income portfolio in 1992. Though not a Renaissance employee, ex--Lehman Brothers mortgage trader Judah Frankel managed the portfolio for Medallion. In 1995, following the 1994 bond market tout, Renaissance decided to make a larger commitment to the mortgage marker and became a co--general partner in a new hedge fund called Matrix, run by Frankel. After gaining 27.4 percent in 1995, the fund racked up a stellar 101.3 percent return in 1996, according to hedgefundnews.com. Then interest rates moved out of the range projected for many of Matrix's trades, and the yield curve inverted. In 1997 the fund gained just 3.3 percent; then in 1998 it lost 20.6 percent of assets. Though several Renaissance executives still have money in Matrix, the company withdrew as a general partner last year. "Inversion was the kiss of death," says Simons. "The fund was unhedged with respect to the yield curve."

Renaissance, he says, would not play such a prominent role in someone else's fund again.

SINCE THE ADVENT OF THE OPTIONS AND derivatives industry in the early 1 980s, Wall Street's banking houses have fallen over themselves to recruit high-powered intellectuals from academia. By contrast, Simons has taken his scientists away from Wall Street, to lavish surroundings in Long Island, not far from the Stony Brook campus where Renaissance began life in office space designed to serve as a business incubator.

Renaissance moved into its East Setauker headquarters three years ago, but Simons and the firm retain close ties to the university. Thanks to Simons' generosity, Stony Brook is considered one of the top ten math departments in the country; several math professors hold the title of James Simons Instructor. In addition to having led for more than a decade the Stony Brook Foundation, which raises and invests a private endowment for the school, Simons has helped the school rake a lead role in assuming the management of Brookhaven National Laboratory for the Department of Energy.

Renaissance headquarters feature a gym, lighted tennis courts, a library with a fireplace and large private offices for every employee. All back-office and administrative functions are handled our of the firm's New York offices.

Unusual for a hedge fund, the heart of Renaissance is not its trading room -- an uncluttered room where a score of traders buy and sell around the clock -- but rather an auditorium with exposed beams that seats 100 and features biweekly science lectures. Last month a molecular biologist presented research on colon cancer. "When you hear someone talk about an interesting use of statistics it helps trigger your thinking," says one Renaissance employee.

The atmosphere is college casual, if intense - think of a perpetual exam week. Though a natty dresser, Simons sets a properly idiosyncratic tone. "He has been known to show up at formal business meetings without socks," says Jerome Swartz, Simons' next-door neighbor on Long Island and an Equimetrics investor.

Married to his second wife, Marilyn, for about 25 years, Simons has four children, two of whom are still school age. At Renaissance he works out of a tidy office with fashionable leather furniture and a large, somewhat gruesome painting of a lynx killing a rabbit. "I used to have it in my house," says Simons. "My wife didn't particularly like it."

Staff turnover is nearly nonexistent. Every six months all employees receive cash bonuses based on fund performance. The six-month benchmark is said to be 12 percent -- and it's almost always easily surpassed. Most employees also hold equity in the firm. Simons frequently takes the entire staff and their families -- more than 300 people -- on lavish weekend vacations. Earlier this year he flew everyone to Bermuda.

Renaissance is divided into three basic groups: computer and systems specialists, researchers and traders. Once a week Simons meets with the research group, discussing in detail the progress of trading strategies under development.

Job candidates don't have to know any finance -- in fact, Wall Street experience is a black mark -- but they must present a talk on their scientific research to the entire firm before being offered a job. Most staffers seem to know little about the rest of the financial services industry, or even the hedge fund business. Asked about the performance of legendary futures trader and Renaissance rival Paul Tudor Jones, one researcher says, "Who's Tudor Jones?"

For a man who believes in luck, Simons doesn't leave a lot to chance when it comes to recruiting the staff that builds his trading models. As the. firm's assets grew, Simons recruited topflight mathematicians and scientists, including University of Virginia physics professor Robert Lourie and Bell Labs numbers theorist Peter Weinberger, to research new trading strategies. In recent years Simons seems to be especially keen on stockpiling computational linguists who have worked on building computers that can recognize speech. He has hired away a good part of the speech recognition group from IBM. Corp.

Why computational linguists? "Investing and speech recognition are very similar," says one Renaissance researcher. "In both, you're trying to guess the next thing that happens."

AS A TRADER, SIMONS TRIES TO OVERCOME fundamental laws, nor discover them. In the case of quantitative finance, the law is the efficient-markets hypothesis and the belief that markets should be difficult, but not impossible, to beat.

In his rare discussions of trading, the Renaissance president emphasizes that trading opportunities are by their nature small and fleeting. "Efficient market theory is correct in that there are no gross inefficiencies," Simons told the Greenwich Roundtable last year. "But we look at anomalies that may be small in size and brief in time. We make our forecast. Then, shortly thereafter, we reevaluate the situation and revise our forecast and our portfolio. We do this all day long. We're always in and out and out and in. So we're dependent on activity to make money.

Renaissance essentially attempts to predict the future movement of financial instruments, within a specific time frame, using statistical models. The firm searches for something that might be producing anomalies in price movements that can be exploited. At Renaissance they're called "signals." The firm builds trading models that fit the data.

When the trading starts, the models run the show. Renaissance has 20 traders who execute at the lowest cost and without moving markets, crucial requirements for quant investors trading on narrow margins. But the models decide what to buy and sell. Only in cases of extreme volatility, or if the signals appear to be weakening, does the firm sometimes manually cut back. Says Simons, "We don't override the models."

Even in structuring its hedge fund-of-funds portfolio, Medallion takes a quantitative approach. The fund balances the positions of its outside portfolio to ensure that, overall, the fund has no stock market exposure; it is, in other words, a "beta zero portfolio. Last year the fund-of-funds, on a risk-adjusted basis, even beat trading returns, posting a higher Sharpe ratio than the 2.31 recorded for the overall fund and accounting for about 7 percent of the Medallion's revenues. Nevertheless, investing with outside managers poses certain challenges. "We treat these funds as instruments," says Simons. "But unlike the deutsche mark, managers change their character over time. It's messier to model those time series, but it's not impossible. We do our best."

Renaissance has also pioneered advanced trading technologies that make it possible to earn money on small margins. When few firms were thinking about electronic trading, a Renaissance subsidiary quietly installed a direct trading link to the German futures exchange. "The world is moving in our direction," says one Renaissance executive. "If the NYSE went all electronic it would be great for us."

Though Simons won't reveal the specifics of his trading, it's possible to get a glimpse of Renaissance's style by looking at Equimertics, the U.S. market-neutral, long-short portfolio, started in April 1999 partly to expand Renaissance's base of institutional investors. Where Renaissance's traditional strength is rapid trading, Equimetrics hopes to apply the same principles to low-turnover trading.

Equimetrics was developed by Robert Frey, its CEO, an eight-year Renaissance veteran who previously worked in the secretive Morgan Stanley & Co. analytical proprietary trading group. All trades in the Equimetrics portfolio are made strictly from proprietary, computer-model-driven strategies, which pick from a universe of about 1,500 highly liquid common and preferred stocks. Typically, the portfolio holds about 1,000 positions, with stock index futures used to adjust the overall risk. No stock is expected to account for more than 5 percent of the portfolio, which will turn over only one to three times per year. The portfolio's leverage is a modest 2- or 3-to-1. (At the end of the second quarter, Renaissance held stock positions of about $2 billion in all its funds, according to Securities and Exchange Commission filings.)

So far the strategy is working. Last year, in nine months of trading after the fund's April 1999 launch, Equimetrics gained 12.1 percent, compared with 14.2 percent for the S&P 500. But this year, with the index down 2.23 percent through September, the fund was up 24.1 percent; the volatility of the fund has been just two thirds that of the index.

An Equimetrics report issued to investors in August, shows the nature of some holdings. As the S&P 500 climbed 6.2 percent and Nasdaq rose 11.7 percent for the month, Equimetrics was up 4.4 percent, holding a portfolio with its highest sector weightings in technology (17 percent long, 14 percent short); industrials (5 percent long, 3 percent short); and energy (9 percent long, 7 percent short). The portfolio's short positions had a high price-earnings ratio, 26.7, compared with 18.6 on the long side, and long positions were focused on companies with much higher average market capitalizations -- $35.8 billion -- compared with an average $19.6 billion for the shorts.

All sectors had a net exposure of 2 percent or less, except consumer noncyclicals, which had a --6 percent exposure. "As market indices soared this month, the short positions took losses, but Equimetrics' long portfolio generated strong returns particularly in technology, financial and energy stocks," notes the Equimetrics report to investors.

What is not known are the secrets of the algorithms that can pick stocks smartly enough to beat the market with a portfolio that's short and long and trade efficiently enough to hold down costs to a bare minimum. Simons explains his firm's approach as the financial econometrics equivalent of blocking and racking. "We search through historical data looking for anomalous patterns that we would not expect to occur at random. Our scheme is to analyze data and markets to test for statistical significance and consistency over time," says Simons. "Once we find one, we test it for statistical significance and consistency over time. After we determine its validity, we ask, 'Does this correspond to some aspect of behavior that seems reasonable?'"

RENAISSANCE'S RAPID GROWTH, AND ITS continued diversification into new markets, creates enormous risks for the firm. Even as it grows its core Medallion business, Renaissance is trying to master new, difficult areas, from venture capital to low-turnover trading to investing in outside managers. All have produced blowups at other successful investment firms; some rely on talents far afield from Renaissance's scientific focus.

His firm, insists Simons, remains squarely focused on scientific finance. "I don't think we would do well getting off of that stuff," he says.

Simons, however, will no longer be chief scientist. He's contemplating retirement in three to four years. Going emeritus, so to speak He plans to indulge in some "old guy" stuff like traveling.

And then there's math. Last year Simons and his old college professor I.M. Singer started fooling around with a fiendishly involved problem. Both are too busy to plug away consistently, but when they get together, says Singer, the ideas start flying.

"It's a fundamental problem concerning the interaction between math and physics," says Singer. "He could possibly make a wry serious contribution. I have been urging him to come back."

It's doubtful his investors will be so eager to lose him to the world of theory.

The further ventures of Jim Simons

Renaissance Technologies fund whiz James Simons first traded stocks in the early 1960s, while in graduate school at the University of California at Berkeley. Soon after, he had tried his hand at venture capital, when, with some college buddies from the Massachusetts Institute of Technology, he invested in a Colombian floor tile and pipe company. That lucrative deal eventually gave him the capital he used to go into trading full time in the late 1970s.

Otherwise, though Simons remains an active venture capitalist, his track record is decidedly more mixed than his stellar trading history. Still active in Latin America as an investor in the Sanford Group, the industrial holding company that grew out of the investments he and his MIT classmates made, Simons visits the region twice a year.

But technology nowadays plays a prominent part in his U.S. portfolio. Simons got involved in the early personal computer, technology-gadgets and electronic-book markets through a 1981 investment in Franklin Computer Corp., which was founded that year as one of the original general purpose personal computer companies. But in 1984 the company filed for bankruptcy after being forced to settle a copyright infringement lawsuit brought by Apple Computer. It emerged from bankruptcy the following year under new management.

Through another company, Simons had helped to develop new technology that would give Franklin a second life. In 1979 Simons and scientist Peter Yianilos, an expert in artificial intelligence and speech recognition, had founded Proximity Technology, a pioneer in hand-held electronic book technology and spell-check software. The technology was futuristic. "The first book cost $800 to produce," recalls Yianilos.

Franklin bought Proximity in 1988, a year after Proximity had helped it develop the first blockbuster hand-held computer, a $69.95 spell-checker called Spelling Ace. Franklin's shares jumped from from 2 1/8 to more than 10. In 1990 the company was renamed Franklin Electronic Publishers. But despite such product innovations as electronic bibles and wine guides in the 1990s, the company's shares languished, with the exception of a brief run-up to 44 in 1995 when the company came out with one of the first electronic books. In October the stock was trading at 10 1/4, up from a 52-week low of 3 3/4.

Through an offshore trust, Simons, now chairman of New York Stock Exchange--listed Franklin, owns 22 percent of the company, a stake worth about $16 million. This fall the company is releasing a new multimedia device called eBookman, which will allow users to read and listen to books downloaded from the Internet. "Whether Franklin will someday be a huge success, I don't know," shrugs Simons.

A bigger score came in the late 1980s, when Simons invested in Numar Corp., a traditional oil services company, which had become a leader in applying magnetic resonance imaging technology to oil and gas exploration. Numar went public at 12 1/2 per share in April 1994 and was sold in 1997 to energy services and construction company Halliburton Co. Halliburton bought Numar for $430 million, making Simons' 900,000 shares of stock worth about $45 million, four times what they were worth at the time of the IPO.

Through his partnership in an investment firm called Long Island Venture Fund, Simons is a major shareholder in a dot-com direct marketing operation called MyPoints.com, which was taken public in August 1999 by Robertson Stephens. Simons now has a chance to feel dot-com pain, with the stock trading at 2 1/2, down 97.5 percent from its 52-week high of 97 11/16.

The plane truth about trading from Simons

A theoretical-mathematician-turned-hedgefund-manager-and-venture-capita list, Renaissance Technologies founder and president James Simons has left his mark on fields ranging from futures trading to electronic books to theoretical physics. Publicity shy, Simons wont reveal any of the specific trading strategies that have allowed him to post one of the great long-term investing records of all times. But in a recent day of interviews with Senior Editor Hal Lux, Simons talked about his various academic and professional lives, what they have in common and what they don't.

Institutional Investor: Do you still do any math research?

Simons: I think about math, but not with any particular success. When I left academia, there were still a couple of problems I was interested in that I'd like to work on when I retire. About a year ago I started doing some work with professor at MIT. I don't know that I have the brains for it anymore. This work is really different from the deep thinking you do in math.

Is there a connection between the math you did and your trading?

None. Absolutely none.

Yet you hire mathematicians and scientists to do much of your work. Why is that?

Mathematics and science are two different notions, two different disciplines. By Its nature, good mathematics is quite intuitive. Experimental science doesn't really work that way. Intuition is important. Making guesses is important. Thinking about the right experiments is important. But it's a little more broad and a little less deep, So the mathematics we use here can be sophisticated. But that's not really the point. We don't use very, very deep stuff. Certain of our statistical approaches can be very sophisticated. I'm not suggesting it's simple. I want a guy who knows enough math so that he can use those tools effectively but has a curiosity about low things work and enough Imagination and tenacity to dope it out.

Why are the numbers so good this year for your hedge fund, Medallion?

Once in a while the phenomena we exploit are particularly present. We like a reasonable amount of volatility. In our business we want some action.

Yet for many firms the market has proved increasingly difficult.

Many of the anomalies we initially exploited are intact, though they have weakened some: What you need to do is pile them up. You need to build a system that is layered and layered. And with each new idea, you have to determine, Is this really new, or is this somehow embedded in what we've done already? So you use statistical tests to determine that, yes, a new discovery is really a new discovery. Okay, now how does it fit in? What's the right weighting to put in? And finally you make an improvement. Then you layer in another one. And another one.

Are markets more efficient than when you started?

Considerably more efficient. There was a time when we were trading Treasury bills and we were looking at the discount structure of the bills. We said, Something is crazy here. Far-out bills were trading at some huge discount, but the 12-month physical bill was not exhibiting any such discount. Something was wrong. This was certainly something that a Long-Term Capital Management would have eliminated in a microsecond. So we just kept looking at it and saying, Why is this? The answer was that no one was picking up that inefficiency. So we bought up a whole bunch of Treasury bill futures, hedged the position in various ways, kept our fingers crossed, and sure enough, it came in. It could have gone the other way, I suppose, but not for very long, because the chickens had to come home to roost. But those kinds of opportunities don't exist now. The commodities markets used to trend pretty heavily -- long-term trends -- but those don't really exist anymore.

Long-Term Capital Management was, like Renaissance, a quantitative trading firm. Did you learn any lessons from its collapse?

Everyone in the company read the book about LTCM. It makes you wary in a general sense. Our approach is very different. We don't start with models. We start with data. We don't have any preconceived notions. We look for things that can be replicated thousands of times. A trouble with convergence trading is that you don't have a time scale. You say that eventually things will come together. Well, when is eventually?

How did LTCM's collapse affect you?

If anything, it was positive. We did very well during that period. Tumult is usually good for us. We don't have credit lines of any significance. We don't do a lot of leveraged-type financing. People were calling us from various banks asking us about our balance sheets. I had our guys calling our counterparties: "Tell me about your problems." Generally, those kinds of times -- and also in '94 -- when everyone is running around like a chicken with its head cut off, that's pretty good for us because they seem to evidence the patterns that we know how to take advantage of.

Is there a size limit for a firm like Renaissance?

There undoubtedly is, but frequently one does not discover that number until after you're past it. The budget this year is to end with 150 people. If you were to have asked me five years ago, "Could you run Renaissance with 150 people efficiently?" I would have said, "What the hell would they be doing?" That's why we're on the third expansion of this building. For years people have asked me, "How much money can you manage?" And my honest answer has been, "About twice as much as we now manage." And that's still my answer. We now manage a little less than $4 billion. Can we manage $7 billion or $8 billion? Yes. Could we manage $70 billion? Of course not. I wouldn't have a clue as to how to manage that. It's inconceivable to me to manage that much doing what we do now, but maybe new things would come along. They always have.

Are you prouder of your mathematical legacy, or of this firm?

I would say about equal. The math stuff I did, the outsize reputation that some of it received, came well after I stopped doing it. I wouldn't say that either one is a source of more satisfaction.

Did you always want to be more than an academic?

In college, while I was busy learning mathematics, it occurred to me to start a movie theater. There was only the Brattle Theater in Cambridge. And I thought maybe there's room for another one. Fortunately, I did not start a movie theater. There were periods when I would only think about mathematics, but then I would think, "Gee, maybe there's something else." Through high school, anything related to business seemed absurd to me.

Will you retire anytime soon?

To myself, I have said, "I'm 62; by the time I'm 65, I'd like to pass the baton."

When you retire, will you go back to math?

There are other things I would like to do. I have a charitable foundation. I'd like to travel. But I expect I would try anyway and go back and do some mathematics until the point it occurred to me that this was a waste of my time. I don't know how quickly that would be. But I'd try, yeah.

Bus. Coll.: 130R1478

Article A67940157

Charlie Munger Interview on Kiplingers

2005-12-05T10:03:00.000-08:00

An interview with Charlie Munger by Kiplinger's. Charlie Munger, of course is a great influence on my thinking about the markets and life in general.

http://www.kiplinger.com/personalfinance/features/archives/2005/11/munger.html

My 2 cents on all this Naked Short Selling Stuff

2005-11-30T20:51:00.000-08:00

After reading all I can find about this naked short selling stuff, I can't help but conclude that Patrick Byrne is really on to something. Anybody with an IQ above 120 should come to the same conclusion, if they read what is out there.

I have obtained permission from Patrick Byrne, CEO of Overstock.com to post the following posts he made on a popular investing web site. Read the two posts and see for yourself

Post #1

Here is something odd for those following this story:

Back on August 8th I bought some 25,000 shares (I think the filing ended up showing 50,000 shares because I bought the rest that day or the day before). Oddly, I could not get delivery of them for weeks and weeks. I am not talking about, "paper certificates". I am talking about simply seeing the trade clear. All along, my broker was saying that Morgan Stanley could not deliver on their side of the transaction.

I will now relay an email between myself and my Broker Dealer (whom I will call, "BD") that occurred when it finally cleared, after weeks of unhappy phone calls.
===============================================================
September 29
9:11 AM
Good Morning Patrick:

The 25,000 shares of OSTK originally transacted for on August 8th, came in during the night and we have initiated the process of converting to paper. Settlement is taking place today.

Please call with any questions or concerns, and have a wonderful day!

XXXXXX
==================================================
1:47 PM
Dear XXXXX,

I would like to hear from you or someone on your trading desk what exactly is the meaning of, "The 25,000 shares of OSTK originally transacted for on August 8th, came in during the night".

What does "come in" mean (since they clearly are not mailed pieces of paper)?

How did they manage to keep from "coming in" for 50 days?

From whom did they come in?

Respectfully,
Patrick

=============================================================

2:15 PM
Patrick:

To the best of my knowledge it means that the incoming shares appear in the electronic system (SEI) which displays the stock trade transactions via PC, and this evidently takes place , like bank processing, as an overnight transaction. The August 8th date is the date I have recorded in my notes as the date of your second purchase of shares of OSTK, the date ZZZZZZZ entered into the transaction with Morgan Stanley to purchase the 25,000 shares.

I am going to ask some of our professionals from the trade area to respond, and hopefully give you a better explanation of how the shares move to BD from another brokerage house.

As to the 50 days the shares did not come in, the only answer we have obtained from the Morgan Stanley people when we repeatedly pressured them is this: "you have to understand that this is an extremely hot stock". Obviously not an answer that makes any sense; but an answer that was repeated time and time again as we made calls to the management at Morgan Stanley.

I will forward additional information to you as soon as I am able to obtain it from the BDBDBD group.

Thank you!
==================================================================

Now Fools, I don't know about you, but I find this pretty weird. Let them post more photos of me with UFO's flying out of my head, but something seems messed up in a system that allows this.

(By the way, Morgan Stanley lawyers, when you read this you are going to get ticked off and want to fire off a letter threatening to sue me. Better check with your stock loan desk first to see if you want discovery. Go ahead: make my day.)

Here is the punch line: my Pop bought 200,000 shares right at the end of August. He still has not gotten delivery. Again, I am not speaking of certs. I speak simply of the settlement of the trade. His broker is saying that the other brokerage house is unable to settle the transaction.

Any guesses as to who that brokerage house is? I'll give you three guesses. It is one of the big ones.

Does this strike anyone else here as odd? I mean, I can understand the fellow Tiddman who was writing, more or less, "Byrne, just focus on the business." Ironically, I am entirely from the value school and agree that in almost any circumstance one should just focus on the business. But given that simple stock purchases seem to be cracking the system, and given that I believe we have somewhere between 5 and 20 million electronically counterfeited shares in the market, and given that I suspect there is some relation between these two facts, and given that I think this situation may well be endemic in the market, I think at some point I am supposed to do something about it. Well, someone is, anyway. I could be wrong, though: when it takes 50 days to get 25,000 shares of stock to clear, Lord knows I'm not in Kansas anymore.

Respect,

Patrick

Post #2

Heart of the Matter,

Nice work. You have exactly the right feel for what is going on. These guys will always ask for "proof" and then deride whatever is submitted (even before they get a chance to review it: see how the 5 or 6 lapdog journalists in New York blared against our affiants before they ever read the affidavits). But the truth is, when it comes to Refco, or the more general harm that naked shorting is doing to the markets, I don't feel we have proof: all we have is a lot of data that, taken collectively, create a foreboding picture. The only people who have the complete are the SEC picture (though there is even doubt about that). However, the SEC's refusal to be forthcoming on the facts, and their stiff-arming every attempt to acquire proof one way or another, does not fill me with confidence that, were all the facts known, we would rest easy at night.

Take Refco (please). It is absolutely true that we don't have proof that the $431 million liability buried underneath Refco is a barrel of naked shorts. All we know is that the Sedona case was one of the only times the SEC stepped in on the side of the company being abusively sorted, so one could assume the abuse was particularly egregious; we know that Refco's name was all over the case for accepting instructions to short Sedona mercilessly clearing from Rhino Advisors, whose trades they cleared. We know Sedona was naked shorted (estimate: 50 million to 200 million shares); we know that Rhino Advisors saw criminal charges then blew up; we know that the SEC investigation of Refco centered on Bennett and Santo Maggio; we know Maggio's duties included the stock lending desk; and we know the SEC spent a couple years “negotiating" a suitable penalty with the Refco. We know that Michael Garcia, the US Attorney for the Southern District of New York, said that the liability was marked-to-market every day but that he would not disclose what it was. We can watch the subsequent trading in Sedona and see that a certain European bank crosses the market every day, offering stock below the bid so that the stock can never trade up (though this be illegal), almost as though someone fears a squeeze. And we know that all parties have bent over backwards to prevent the details of the $431 million liability from leaking.

Together, all these facts lead some people suspect that there is a barrel of toxic waste underneath Refco marked, "naked shorts: SDNA". Party hacks demand, "Where's the proof?" in an attempt to distract you from the simple truth that the facts are knowable in this case, someone knows them, and those people are doing everything in their power to prevent the facts from becoming known to the public.

For the newbies: why is this so significant? Sedona has about 87 million shares of common stock issued. Pretend for a moment that there really are 100 million naked shorts, buried underneath Refco. Since it trades at 14 cents right now, Refco might be carrying that as a $14 million contingent liability. Suppose they try to clean it up someday. They take $14 million into the market and try to buy 100 million shares. The stock currently trades about 50,000 shares/day. Buying all the volume, it would take 2,000 trading days to cover their short. More realistically, the stock would squeeze and its price would rise, and buying those 100 million shares would take not $14 million, but …. Who knows? $140 million. $500 million? By extension, if a significant amount of the $431 million is made up of these types of liabilities, "marked-to-market" but not "marked-to-where-the-market-would-be-if-Refco-actually-had-to-deliver," the process of actually settling these trades, or the >$6 billion like them apparently scattered throughout the system, could be greater than the liquidity in that system.

Are we right about the possibility that the overhang of naked shorting has destroyed companies and represents a serious threat to the stability of the market, and that the SEC has its thumb on the scale in favor of hedge funds and against entrepreneurs? Again, the answer is knowable, someone does know it, and that someone is sitting somewhere in the SEC. But getting the data out of the SEC that would confirm one way or another is difficult (thus allowing the same guys to parrot the party line over and over: "You see, you don't have any proof!")

Yet what the party line hacks miss is that what we don't know is nearly as instructive as what we know. Let me give you some examples, starting with Overstock's case and then going more broadly. In each of these points I will try to be clear about what I know and what I don't know, and ask the reader to keep in mind this question: does the boundary of Byrne's knowledge make one more or less confident that this is a problem that can safely be ignored?

1) Given that we are on the Reg SHO Threshold list, and have been since January 27 (with, as I recall, a couple weeks absence in March-April), I know that there are FTD's (naked shorts) in OSTK.

2) OK, so we are on the Reg SHO Threshold list. How many naked shorts are there?

Well, I know that our threshold was set to be .5% of our shares outstanding (which is close to 20 million, so call this 100,000) + however many unsettled naked shorts existed on Jan 3, 2005. How many was that? The SEC and NASSDAQ, do not say (refuse to, actually). All I know about it is that it is some number.

And how far over the threshold are we? Again, the SEC and NASDAQ will not disclose this, so again, all I can say for sure is that it is some other number.

So thanks to the SEC's heroic efforts to crack down on this practice by passing Reg SHO, I now know that OSTK's level of FTD's equals some number that is over our threshold by some number, and that this threshold is itself equal to 100,000 plus some other number. Great.

Got that? And yet the party line guys want to say that my lack of knowledge on the subject of how many naked shorts there are in the system, precisely, should count as a point against me. To which I respond, at some point, doesn't this nonsense count as a point against the system? If it was a de minimus amount, would it be this hard to find out that amount?

3) Overstock is not, of course, alone on the Reg SHO list. There are a couple hundred companies in the same situation. In June, a Freedom of Information Act request revealed that by day, every day on NYSE and NASDAQ, 100 million - 250 million shares fail to settle (about 5%). This has permitted some decent people to perform the following analysis (some strangers did it, and got in touch with me to tell me this: I have not checked their work closely but it seems pretty solid on its face). They measured how much the FTD's moved every day, backed out of this number the trading in the very lightly traded stocks on the Reg SHO list, and came to the conclusion that 125-130 million or so of FTD's were concentrated in about 30-35 stocks. That comes to about 4 million FTD's per company. Earlier in this message I walked through the math on what might happen if folks were required to deliver on all their FTD's in Sedona. If you want to know what might happen if they were forced to deliver on all outstanding FTD's of all these companies, you could probably take the Sedona calculation, and square it.

4) Anyone who follows this so far can see that it establishes prima facie grounds for suspecting this might be a pretty deep problem. I, for one, think that it points in the direction of the proper understanding of the construction of Reg SHO, in particular, its grandfathering of past FTD's and its apparent bias towards the hedge funds engaged in naked shorting. The explanation is simply that the problem is so deep that the SEC fears that the system might implode if they actually forced these FTD's to settle, and that they are temperamentally inclined to favor the interests of Wall Street over the interests of Main Street anyway. But still, the party line guys will say, “But where is the proof?! Where is the proof?!?!?” They seem to forget that evidence plus reason is a kind of proof, especially in the absence of countervailing arguments, as we are experiencing today. However, if they insist on proof that this is not all some madman's fantasy, I suggest they turn to the FAQ's of the sec.gov website itself, and a discussion to be found there on Reg SHO.

http://sec.gov/spotlight/keyregshoissues.htm

Why did the SEC grandfather all failures-to-deliver up to January 3, 2005? In the SEC's words (IV F):

“The requirement to close-out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions that were established prior to the security becoming a threshold security. This is known as 'grandfathering.' For example, open fail positions in securities that existed prior to the effective date of Regulation SHO on January 3, 2005 are not required to be closed out under Regulation SHO.

“The grandfathering provisions of Regulation SHO were adopted because the Commission was concerned about creating volatility where there were large pre-existing open positions.”

OK, check. I believe that the system might implode if they forced these trades to settle. The SEC's own words are that they grandfathered the level of failures on January 3, 2005 because they were “concerned about creating volatility where there were large pre-existing open positions.” I believe that is the “evidence” these guys are demanding, HeartoftheMatter.

Where is the evidence that they have their thumb on the scale in the favor of hedge funds? Again, they are pretty explicit about it in the same FAQ (V 11):

“The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to 'squeeze' the firms improperly.”

Again: check. As far as the SEC is concerned, the decision by some to naked short is simply a “trading strategy,” and it is not the SEC's place to reveal a firm's proprietary trading strategy.

The thing is, there is a technical term for trading strategies that rely on selling something that you don't own, don't borrow, and don't deliver. That term is, “illegal.” It is “illegal” to collect money for selling something that you own, borrow, or deliver. Selling the Brooklyn Bridge when you don't really own it, for example, would be, “illegal.” And because some hedge funds have made doing something that is “illegal” the core of their “trading strategies,” the SEC is refusing to reveal the size of the hole that those funds have dug in any particular stock because that might reveal something about their illegal trading strategies, because that would be “improper.” They even give an example of one way it might be improper: in the case of stocks that had seen this kind of heavy manipulation downwards, releasing the size of the naked shorts would let some people see how the stock had been artificially watered down, which would perhaps lead some to buy the stock believing that there was an artificial misprice, and this would create a situation where the stock…. went up. In the eyes of the SEC this would be “improper”: after all, we know that hedge funds who use illegal trading strategies to generate high levels of naked shorts can count on not even the size of those naked short positions being disclosed, because that might allow others to reverse engineer their proprietary illegal trading strategies. And it might even make some to recognize that a stock had been manipulated downwards, leading them to buy it at what they would perceive as an artificially low price, thus creating the risk that stock would go up. Which is, as we all know, improper. How could it be proper? The hedge funds' illegal trading strategy demands that the stocks go down: how could the SEC possibly allow a situation where they go up?

Everyone got that?

Can anyone say, “captured regulator”?

I knew before I launched that I would be going down a few rabbit-holes, and that some would call me a nut-job for doing so. But can anyone read this Alice-in-Wonderland stuff from the SEC and not begin to wonder which way is up? I know I am coloring outside the lines at times (going on TV and calling the SEC “captured regulators” is not a strategy often recommended by securities lawyers as one designed to curry favor, for example). But as far as I can tell, there are no lines for the bad guys, at least as far as the SEC is concerned: forcing the bad guys to respect lines would create “volatility,” and revealing the degree by which they were ignoring the lines would reveal their proprietary illegal trading strategies, and might even let the stocks they were shorting go up, which would be “improper,” naturally.
And they call me “nuts.”

So, take heart, Heartofthematter: these guys keep asking for proof, but at this point I am not sure what they really mean. It is out in the open: in the SEC website, in a FOIA response, in the footnotes to the Refco story, in the daily Reg SHO list itself. Our opponents will always pretend not to see how these all add up, and instead blindly parrot a party line that is getting more hackneyed with each passing week.

To the unthinking repetition of their mantra, “where's the proof?” you should simply rejoin, “Settle the trades.”

Patrick

Here's a good story of manipulation ...

2005-11-22T20:36:00.000-08:00

http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2003/11/09/MNGO92TRV71.DTL

Thanks, Tom Gardner for the link.

The best way to build an investment partnership

2005-08-11T19:27:00.000-07:00

It seems the best way to build an investment partnership is to attract the right people and do it with the way Buffett did it.

Getting Innoculated through Berkshire's Annual Meeting

2005-08-11T07:47:00.000-07:00

The meetings with Buffett's Berkshire Hathaway Annual Meetings truly turned me into a self-actualizing, value investor. Now, I can honestly say I am innoculated. I can say "no" to all investment ideas, if I have to. I don't feel I miss out on a winner. My mistakes will be mistakes of ommission, not commission. "When I read, I know. When I study, I remember. When I do, I understand. When I went to Buffett's Meetings, I self-actualized."

Incentive Structure

2005-08-11T07:34:00.000-07:00

I still think the management fee of a hedge fund should not be a profit center. I know a lot of funds that have billions of dollars under management and they won't put it to work so they don't risk any money and they just live off the management fees.

Rogue Traders

2005-08-11T05:44:00.000-07:00

The Trader in somebody's fund just lost 2% for the fund in one day! Geez, nice! It makes me think that Buffett is right. You only need one person to run money. If you have somebody who is not value inoculated, watch out!

Pabrai's 2 year holding rule ... helpful or fatal?

2005-08-10T17:48:00.000-07:00

Mohnish Pabrai stated that one of his rules is to never take a loss if the position is held within two years. Most behavioral investing finance books say that never taking a loss is the path to investing destruction. Could this be fatal? Or could this be helpful?

If a person has a longer-term holding period, it makes sense to ignore the stock price movement for the next couple of years because value investing ideas, being contrarian that they are, share near-term outlook that that sucks anyway. In this case, this rule is helpful.

On the other hand, if a person is too stubborn to admit a mistake within a two year period, this could be a fatal flaw.

What do you think?

Trading Vs. Investing

2005-08-08T08:01:00.000-07:00

With trading, you monitor stock quotes frequently. You do not build insights and cumulative knowledge about business. I have a passion for understanding economics and businesses. To me, it is a lot more fun to know that beer consumption is at the lowest in 20 years rather than knowing if a stock is breaking out of a base.

I do believe that for account sizes of under 1 Million dollars, you can do very well with a proven trading system, provided you are psychologically wired to be able to cut losses automatically and avoid many of the behavioral mistakes that affect 99% of the human population. When your account size goes above $5 Million, the after-tax returns between trading and investing favor the disciplined investor.

Sell Side Research

2005-02-17T08:23:00.000-08:00

The worst thing one can do is accomodate a sell-side broker. Today, I dealt with this. I emailed my answer, avoided a phone conversation and rejected the idea. I just could not get comfortable after speaking with management.

Investing and Physics

2005-02-17T08:22:00.000-08:00

Thinking about an investing decision is like trying to solve a difficult physics problem. You constantly think and might sleep on it. And then all of a sudden, you know the answer. That's what it is when you decide to get in bed with a stock.

My investing philosophy

2004-10-25T13:53:00.000-07:00

My investing philosophy is an amalgamation of my five great inspirations and direct teachers: Graham&Dodd, Buffett and Munger's Latticework of Mental Models, Phil Fisher, and of course, my two direct teachers, Marty Whitman, and Joel Greenblatt.

Numerous studies (See Fama-French, Lakonishok, Piotroski) have been made confirming that a value strategy beats a growth strategy in U.S. and international markets. I hope to beat the performance of these studies by actively searching through stocks that have gone through "these" filters. I apply value investing principles to businesses that have a sustainable competitive advantage. I look for investment ideas that fall into 4 baskets: excellent businesses( high returns on capital, that can deploy retained earnings and yield higher than the cost of capital) at fair prices, stocks selling for below liquidation values (the cigar butts), stocks selling for below net ascertainable values (Marty Whitman), and special situations (Joel Greenblatt -- spinoffs, post-bankruptcies, and liquidations).

I help run a fund using these principles here in the U.S. Beginning in 2006, I will also run a fund with a satellite office in Asia. The focus will be investing in companies that will enjoy benefits of the growth opportunities in Asia.

I don't guarantee anything but one: we will underperform for as much as up to three years (all great value investors do, so why should we be an exception?), but we hope to beat all the indices handily over the long term.

Why I like Investing

2004-10-13T14:32:00.000-07:00

Two reasons I like investing very much.

1. Sloth is necessary but not enough.
2. You get better when you get older.