We begin this week with a reader's inquiry:
"Could you please explain to your readers how Madoff was able to pull this off for so long. Was he always a crook, or did it develop over time? If anyone can explain this to us in language we can understand, it will be you or one of your analysts. Keep up the good work." – Paid up subscriber "E"
To date, we've said little about Madoff. What we know of the matter isn't likely to help you make money. We don't know the details of how he did it. But we do know a bit about how he got away with it for so long. Unfortunately, what we know isn't very flattering to the people who invested with him. As you well know, we rarely hesitate to call a fool a fool, but even we were uncomfortable about mocking those who lost their fortunes to the talented Mr. Madoff. But now, prompted by a reader, we can't resist...
Let's begin with the obvious: No investment strategy can produce a positive return far in excess of Treasury bonds month after month, without ever producing any losses. Every professional investor in the world knows this. Any professional investor who looked at Madoff's returns must have suspected foul play. Additionally, Madoff's explanation of his strategy never made any sense. Madoff claimed he was buying stocks and selling calls against his positions. This would have left him exposed to the market's downturns, so he claimed he also bought puts as insurance. The combination is known as a "split strike" strategy. But the cost of buying puts every month would have eliminated his gains. In fact, following the strategy he claimed, it would have been very difficult to ever produce a positive monthly return – a fact well understood by professional stock and option traders. Madoff's own traders told Barron's in 2001 they couldn't understand how he was producing his results...
The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff's returns using this strategy. Likewise, three option strategists at major investment banks told Barron's they couldn't understand how Madoff churns out such numbers.
Madoff was clearly doing something wrong... but what?
With such obvious red flags, why were so many knowledgeable investors interested in Madoff? Why did the head of GMAC, Swiss bankers, the most elite hedge funds, etc. all decide to invest with Madoff? The answer is very simple: Everyone knew Madoff was a crook, but they thought he was their crook. It was, apparently, common knowledge on Wall Street Madoff produced his returns because he was using the deal flow of his brokerage firm (which was one of the largest in the world) to front-run mutual funds and other large traders. Everyone assumed Madoff was ripping off his brokerage clients to benefit his managed accounts. Barron's explained all of this in its 2001 article, quoting one of Madoff's own investors to insinuate insider dealing:
Adds a former Madoff investor: "Anybody who's a seasoned hedge-fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve."
When the SEC investigated Madoff, it looked for evidence of this kind of a fraud, not a Ponzi scheme.
My friend Bill Bonner is fond of saying investors often get what they deserve, which is only rarely what they expect. I can't think of a better example of this than Madoff. The Barron's article and the SEC investigation that followed led to more demand for Madoff's managed accounts, not less. Nobody cared about Madoff ripping off his brokerage customers – that's what his money-management clients all thought he was doing on their behalf! Everyone thought Madoff had figured out a new way to front-run his brokerage customers, a way so sophisticated that neither the SEC nor the brokerage customers themselves would ever discover it. These investors thought they were the beneficiaries of Madoff's scam. And as long as they made their 10% a year, they didn't think twice about the ethics of what he was doing.
Now, let's move on to something a bit more useful...
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After making huge returns in 2008, short sellers are taking the other side of the trade. The number of shares borrowed and sold short fell 28% last month from the peak in July, from 18.6 billion to 13.4 billion. Companies in the S&P 500 trade for around 15 times earnings, the lowest multiple in 18 years.
"It'd be easier for me to find five stocks I think are going to go up than five stocks I think are going to go down," said Bill Fleckenstein, who just closed his 13-year-old bear-market hedge fund and bought Extreme Value pick Microsoft.
It's said they don't ring a bell at the top of the market, but we were sure we heard bells ringing in late 2006, when Blackstone announced it would buy Sam Zell's Equity Offices portfolio for $39 billion. (Yes, we said so at the time. See "Too Many Big Deals for Comfort.")
Here you had Wall Street's bankers using other people's money to buy real estate, after a huge bull market, from the shrewdest real estate investor of the last 50 years. You could have shorted any business related to real estate and done very well. Or you might have simply shorted the shares of Blackstone after its initial public offering in mid-2007. You'd be up 86% by now.
But now, I'm almost ready to take the other side of this trade. The crowd has all run into the short side of the market. They don't ring a bell at the bottom either, but take a look at Sears Holdings, the retailer controlled by billionaire Eddie Lampert. Nearly one-third of Sears Holdings' shares are sold short. The struggling company's stock has fallen 58% over the past year, but investors looking to profit from a further demise will pay dearly... Brokers are now charging 30% to 40% interest to lend shares for selling short. Considering the company's healthy cash position (nearly $2 billion) and size ($5 billion market cap), it might be time to go long.
This is a whole new level of lunacy... William Ackman, a well-known "activist" investor who runs Pershing Square (a hedge fund), raised $2 billion simply by promising investors he'd invest in one, single, blue-chip, iconic American company. Ackman is charging 2% up front and then 20% of whatever capital gains accrue. So... in effect... Ackman is getting $40 million for a single stock tip, plus 20% of whatever money it makes. – S&A Digest, June 7, 2007
The single stock in question turned out to be Target (we told Ackman he should have bought Budweiser). Last October, with Target down 40%, Ackman urged the company to spin off its real estate into a REIT, thereby unlocking inherent value. Target refused. Last week, news leaked that Ackman's Target fund is down 90%. Ackman actually amplified his losses by buying call options. The fund lost 40% in January on top of a 68% drop in 2008. Target stock is only down 38% over the same period. To ease angry investors, Ackman announced he would put $25 million of his own money into the fund. He's also considering waiving the performance fee... which won't cost him anything, will it? Ha, ha, ha...
More layoffs: Nissan, Japan's third-largest carmaker, announced it will cut 20,000 jobs (9%) and post its first loss in nine years. Nissan's U.S. sales dropped 31% in January.
Last week, Retirement Millionaire editor David Eifrig gave DailyWealth readers a free taste of his new research. He shared secrets like how to eat at top restaurants for 60% off, how to take a cross-country vacation at one-tenth the normal cost, how to cash in early on your 401(k), and how to get paid to own gold (an especially useful secret considering the government's current money-printing binge). And he's got much more in store for his newsletter...
Eifrig's new advisory will focus on all sorts of loopholes that guarantee you a happier and wealthier retirement. As we've said, Eifrig has already retired twice... once from a job as a bond trader at Goldman Sachs, and next as an eye doctor. He's spent a lifetime gathering money-saving secrets and tips ... And we recently hired him to tell our readers about all of them. We've sent him all over the world to find ideas for his letter... He's on an idea-gathering trip as I write.
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New highs: none.
In the mailbag, the hard part of shorting stocks – volatility. Questions? Send them here: feedback@stansberryresearch.com.
"If the large homebuilders are such a sure bet to go bankrupt, as Brian and Porter contend, why was CTX up 31% and DHI up 53% last week? Either you guys are way off base or this is a great opportunity to short the heck out of them, for someone who hasn't already lost their shirt following your advice to short sell them at much lower levels." – Paid-up subscriber David
Porter comment: If you look back at our track record of predicting bankruptcy, I'm pretty sure we've been right more than 90% of the time. We only say a stock is worth "zero" when we see a company whose debts far exceed its assets, which cannot afford the interest on those debts, and whose business has very unattractive economics. There are no easy ways out of these circumstances, and none of the options are good for common shareholders. We see these elements in most of the major homebuilders, whose assets have been wiped out by the fall in real estate prices, whose sales have been decimated by the decline in housing demand, and whose businesses (like the airlines) have historically not earned their cost of capital.
With respect to DHI, I recommended shorting the stock in my newsletter in early December at around $7.50 for these reasons. Using a 25% trailing stop loss, you would have gotten out of this trade last week at breakeven. (The closing low price was $5.96 on January 30.) Shorting stocks is difficult, especially when the shares trade for less than $10. Short sellers get spooked out of the trade from time to time, causing huge swings in price.
In this case, DHI rallied because the company received more than $600 million in tax refunds during the fourth-quarter 2008. This substantially enhanced the company's balance sheet and seemed to put off the risk of bankruptcy for at least another year. Here's what the company didn't mention in its press release: It has already spent most of the money. On January 15, DHI paid $155.2 million to repay senior notes, and it spent $304 million on February 1 to repay another tranche of maturing senior debt. DHI has another $700 million worth of obligations maturing in the next two years. Even more importantly, its existing line of credit prevents the company from borrowing more money and makes it impossible for the firm to continue generating cash flow by selling assets, because of a tangible-asset-to-debt ratio covenant. Here's the relevant section of the company's latest 10Q filing with the SEC:
However, the margin by which we have complied with the tangible net worth covenant of our revolving credit facility has declined. If our operating results and inventory impairments continue at levels experienced in recent quarters, our tangible net worth may decline below the minimum level required by the revolving credit facility during fiscal 2009.
Eventually DHI's creditors will wind up owning its assets, which they will liquidate. Why not restructure? Who wants a bankrupt company that mostly sells homes to people who can't actually afford them? In 2008, 25% of the people who bought homes from DHI required seller-financed down payment assistance. What do you think the value of these communities will be like in a few years?
"I am just beginning to dabble in some of the covered calls your various publications have been recommending. What amount of brokers' commissions should I expect to pay or writing a covered call, e.g. on 100 shares of ExxonMobil?" – Anonymous
Porter comment: It varies widely depending on the firm you use and the kind of account you have. I would begin by calling around to discount brokerages like Ameritrade, E*Trade, TradeKing, and OptionsExpress.
Regards,
Porter Stansberry
Baltimore, Maryland
February 9, 2009