Beating the Indexes: Investing in Convertible Bonds to Improve Performance and Reduce Risk [1 ed.] 0132885948, 9780132885942

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Beating the Indexes

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Beating the Indexes Investing in Convertible Bonds to Improve Performance and Reduce Risk Bill Feingold

Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jeanne Glasser Editorial Assistant: Pamela Boland Operations Manager: Jodi Kemper Assistant Marketing Manager: Megan Graue Cover Designer: Alan Clements Managing Editor: Kristy Hart Senior Project Editor: Lori Lyons Copy Editor: Karen Annett Proofreader: Debbie Williams Indexer: Lisa Stumpf Senior Compositor: Gloria Schurick Manufacturing Buyer: Dan Uhrig © 2012 by Bill Feingold Pearson Education, Inc. Publishing as FT Press Upper Saddle River, New Jersey 07458 This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book. Opinions expressed are those of the author and do not necessarily reflect those of BTIG LLC, its parent, affiliates, partners, members, officers, or employees. FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, [email protected]. For sales outside the U.S., please contact International Sales at [email protected]. Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing May 2012 ISBN-10: 0-13-288594-8 ISBN-13: 978-0-13-288594-2 Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educación de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data Feingold, Bill. Beating the indexes : investing in convertible bonds to improve performance and reduce risk / Bill Feingold. p. cm. Includes bibliographical references and index. ISBN 978-0-13-288594-2 (hardback : alk. paper) -- ISBN 0-13-288594-8 1. Convertible bonds. I. Title. HG4651.F35 2013 332.63’23--dc23 2012004707

For the three men I admire most: Sky Lucas, Chris Sferruzzo, and Franklin Parlamis

“Just because everybody’s doing it doesn’t make it right, and just because nobody’s doing it doesn’t make it wrong.” —Nicholas Arrigan

Contents Acknowledgments ............................................. ix About the Author ............................................ xiii Foreword .......................................................... xv Preface ..............................................................xix Introduction........................................................1 Part I: Chapter 1 Chapter 2 Chapter 3 Chapter 4 Part II: Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10

Chapter 11

Our Flawed Institutions Indexing and Its Discontents ......................... 7 The Individual’s Edge ................................... 25 Delusions and Illusions: Chasing Performance in Our Lost Decade ................ 43 A Change Is Gonna Come ............................ 51 Convertibles, a Better Solution The Very Basics ............................................. 61 Reminiscences of a Convertible Operator ........................................................ 69 A Quick Review and Quiz ........................... 121 Enough Already...How Do Convertibles Actually Work? ............................................ 145 What to Look for in a Convertible ............. 177 Convertibles For... ...................................... 201 I. Individual Investors .................................... 201 II. Financial Advisors .....................................213 III. Nontraditional Institutional Investors .... 217 IV. Corporate Financial Advisors ...................231 V. Students ......................................................249 Introduction to Advanced Topics ............... 257 Suggestions for Further Reading ............... 285 Glossary ....................................................... 287 Index ............................................................ 291

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Acknowledgments I wouldn’t have been able to write this book without the support of my family—especially my wife Jennifer, who understands how I’m constantly wavering between the worlds of trader and writer and puts up with it. My daughters Abigail and Elizabeth give me daily joy beyond what I ever could have imagined. Any skill I have as a writer comes mostly from what my father, a retired English professor, taught me when I was growing up. His encouragement and praise are priceless because he never hesitates to tell me when he thinks I could and should have done better. I wrote this book while sharing a Westchester office with my close friend George Chuang, whom I first met at Lehman Brothers back in the late nineties. George is one of the best friends and best businessmen I ever hope to know. He’s always graciously made a comfortable desk, complete with a great Internet connection and all the trimmings, available to me during my sojourns away from Wall Street and into writing. Thanks also go out to his team at USB Media Company, especially Maggie Dobbins and Cristina Herrera. Also in Westchester, my good friend Dan Riseman, the hardest working man in education, has encouraged me by example and with humor. Dan’s not only a uniquely capable teacher and businessman, he’s also a fine writer, as his first novel, Dancing in Puddles, proves. Don’t miss it. To my horse-racing friends who have given me airtime on their investing programs, Gary Greco, Ron Olinsky, and Derek Simon, I say it’s always a pleasure to work with you. When it comes to friends I’ve met through racing who also know a thing or two about the markets, no one rivals Cary Fotias, the best handicapper I know, and a friend of 25 years who’s always supported my writing efforts. I also thank Mike Tolaney, another terrific handicapper and market student, for his good words and encouragement. I send out a special thanks to Tatyana Hube, who worked as a convertible research analyst at Merrill Lynch for more than 12 years, and graciously assisted with historical data. Other convertible pros who have aided and encouraged me at various stages throughout my career include Bart Baum, Brian Bentley, Sabina Bhatia, Frank Bianco, Tom Birkett, Mike Brailov, Doug Burke, Kevin Cadden, Joe

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Castro, Mike Chizmar, Richard Cunningham, Scott DeCanio, Scott Dillinger, Brian Donahue, Mark Edgar, Tom Felgner, Ron Fertig, Doug Fincher, Eddie Finkelstein, Howard Fischer, Abby Flamholz, Jeff Fox, Tony Frascella, Greg Freihofner, Richard Gatward, Salma Gaya, Ryan Goldman, Eric Grant Jr., Darren Haines, Bob Hamecs, David Harris, Rick Hochman, Steve Hodulik, John Idone, Alireza Javaheri, Chris Keller, Jim Kenney, Asad Khan, Catharina Kusuma, Rob Langer, J.P. Latrille, Bill Lee, Eric Lovelace, Steve McCormick, Tom McCusker, Larry McDonald, Donough McDonough, Walt McNulty, Greg Miller, David Muccia, Sri Nadesan, Howard Needle, Charles Ng, Van Nguyen, Mike O’Brien, Scott Parrot, Curt Peters, Jason Pinkernell, Adam Posnack, Pat Prendergast, Dave Puritz, Tim Reilly, Sean Reynolds, Marc Rice, Mike Rinaldi, Pat Rossi, Jeff Sawyer, Bennett Schachter, Erich Shigley, Abe Shulman, Mark Steele, Adam Stein, Mike Stewart, Scott Subeck, Ravi Suria, Mark Vanacore, Tom van Buskirk, Joe Venn, Bob Wagner, Livia Wei, Dan White, and last but certainly not least, Eric Xia, Rich Yakomin, and Pete Yeranossian. I thank Bernie Schaeffer, my fellow horseplayer and horse owner, for giving me the chance to start writing about convertibles at his Web site, Schaeffer’s Investment Research, back in 2006. I also give thanks to Todd Harrison of Minyanville. You will not meet a better trader or student of the market. But as good as he is in those areas, Todd’s even better as a person. It’s a cliché, I know, but Todd is one of those guys worthy of it. Todd gave me a forum at Minyanville, and his vision of positive social change through financial education underlies this book. Todd’s willingness to take risks other people wouldn’t touch led to Minyanville’s alliance with Pearson and, by extension, this book. At Pearson, I thank Jeanne Glasser, my wonderful editor, whose encouragement and constructive, pointed criticism have made this book far better than it would have been without her. We’ve had our disagreements but her arguments have always been well reasoned. For the book’s possible shortcomings, I take full responsibility. Others to whom I owe gratitude include, but are not limited to, Ravi Arcot, Robert Arnott, Joel Greenblatt, Mark Mitchell, Lasse Pedersen, Antti Petajisto, Todd Pulvino, and John Succo. And thanks to Scott Raab, my new friend and the author of the best sports book I’ve ever read, The Whore of Akron. Scott has encouraged me to push

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for getting this book to the widest possible audience and to give myself the benefit of the doubt, and then some, in taking on new challenges. My lifelong buddies from Berkeley, Robert Sasaki and Serge Wilson, have done the same. My friendship with Emile Westergaard, an exceptionally talented manager of health-care investments, a fine musician, and a remarkable outside-the-box thinker, has helped both focus my thinking and expand my horizons. I thank John Seo, by a considerable margin the smartest person I’ve met in the past 48 years, for his continued time and support and his contribution of a foreword. Some friends and I used to joke about the ego-to-accomplishment ratios of the people for whom we worked. For some of our colleagues, the number seemed to approach infinity, not a good thing. John’s ratio is as close to zero as can be calculated. I particularly want to thank Lou Satenstein, Jon Stern, and Mike Vacca. They stood by me during my first, most tentative baby steps as a convertible trader back in 1994, and showed faith in me even as I made every mistake conceivable. Not surprisingly, through ups and downs, they continue to be among my best friends in the business. A special thank-you goes out to my one-time colleague Elliot Stiefel. In the world of convertibles, Elliot is one of the best stock pickers and pure traders I’ve met. We were a great tandem—I taught him about options while he introduced me to charts. I like to think it was a trade that helped both teams. Elliot has continued to be a terrific friend and a great resource. Without his guidance and insight, this book would be a far poorer effort. I thank my colleagues on the BTIG convertibles team, Omar Brown, Jake Creem, Bill Freihofner, Will Frohnhoefer (believe it or not, the two of them are not related), Jeff Gould, Shannon Hsu (the Asian guy with an Irish girl’s name who likes to speak with a German accent), Dave Kallenberg, Mike Kirsh, Kevin McGuire, Mayank Patel, and Donny Pizzutello, for all their assistance and encouragement. I also thank the management team at BTIG, led by cofounders Steven Starker and Scott Kovalik, as well as Anton LeRoy, Rick Blank, and Jim Aniello, along with countless other employees of a great place to work, for giving me the firm’s terrific stock platform from which to preach the convertible gospel. To wit: As I write this, we are making

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plans for me to end my sabbatical by returning to BTIG as a convertible strategist, helping translate the firm’s liquidity in convertible-related equities into better prices for its convertible customers, and bringing opportunities in convertibles to accounts traditionally focused on stocks. I’ve had many good friends in the convertible market over the years, but three stand out, and this book is for them. I begin with Sky Lucas, my mentor, boss, and friend. Sky is the best trader I’ve ever known because he refuses to define the game and the market in the penny-ante, shortsighted manner of the benchmark chasers. Nobody has a better vision of where things are going, and nobody understands better the shortcomings of most professional investors and how to take advantage of them. I never make a major decision without asking myself “what would Sky do?” Of course, only he knows for sure. Sky has always had confidence in me, even when I’ve felt it was misplaced, and has encouraged me to keep sharing my ideas in print. Nobody will ever affirm my pride in spotting talent, teaching, and mentoring more than Chris Sferruzzo. Chris was my clerk at my first hedge fund. He displayed a blend of curiosity, street smarts, and work ethic that you just don’t find. It became clear to me early on that Chris had the goods to be a great trader—certainly a far better trader than I was. Chris didn’t believe me when I told him he would be a huge success, but fast-forward a handful of years, and he is now one of the most important convertible managers on Wall Street. As with Sky, Chris’ friendship is priceless to me. Finally, much of my inspiration for pursuing a multifaceted career comes from the example set by Franklin Parlamis. Trained as an attorney, Franklin lightened the tedium of law school by writing the underappreciated satire “The Passive Man’s Guide to Seduction,” a hilarious send-up of pickup guides for nerds. Franklin went on to work in Russia for a while before entering the world of convertibles, almost on a whim, and going on to become one of the market’s most successful managers. No part of a benchmark chaser, Franklin invests when he sees value and sells—whether he owns the thing or not— when he doesn’t. He trusts his own opinion and really doesn’t care what anyone else says. We need more people in the business who operate the way Franklin does. But there’s only one of him.

About the Author Bill Feingold began his Wall Street career in 1985 as a corporate-finance analyst with Dillon Read after graduating from Yale, summa cum laude, Phi Beta Kappa in economics. Bill received Yale’s Hadley Prize for being the top graduating social sciences major. He earned his M.B.A. in 1991 with distinction in finance from the Wharton School. Currently, Bill is Managing Director and Convertible Strategist at BTIG LLC in New York, having traded convertibles for the firm before taking a leave to write this book. Bill was previously responsible for managing a portfolio of convertible securities at Goldman Sachs. Between Goldman Sachs and BTIG, Bill contributed regularly to the financial education Web site Minyanville and published his first book, 2009’s The Undoing of Cowardice. Before that, he was the senior partner and comanager of the FrontPoint Convertible Arbitrage Fund from 2003 to 2005. From 2000 to 2003, Bill comanaged the Clinton Riverside Convertible Fund, during most of which time the Fund grew substantially and was one of the top performers in its strategy. Between FrontPoint and Goldman Sachs, Bill served as a consultant to Schaeffer’s Investment Research, a firm founded in 1981 and dedicated to the individual investor, with a focus on option-based strategies. Bill created the Advanced Trading Center at Schaeffer’s, designed for clients looking to expand their investment toolkits with advanced option strategies, convertible bonds, and other techniques. In the fall of 1999 and 2000, Bill cotaught the acclaimed Yale seminar “Market Psychology and the Truth About Derivatives.” Bill’s objective with the seminar was to provide liberal-arts students likely headed for policy-making careers the skills necessary to get behind the financial headlines and understand the real issues for themselves. A native of New York City, Bill was raised in Berkeley, California. He lives in Westchester County, New York, with his wife, two daughters, and two cats.

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Foreword Some of the smartest money in the world makes a lot of its money in convertible bonds by not telling you what Bill Feingold tells you in the book you now hold in your hands. I do not know how to put it more directly than that. Convertible bonds have a marvelous history of making serious money for those who understand their unique potential. And you don’t need supercomputers or a staff of elite analysts to succeed in convertible bonds. Sure, that kind of firepower helps if you are trying to raise, or continue to hold on to, big money and impress folks who are charged with doling out billions of dollars to the fanciest investment managers they can find. By the way, I’m not putting those managers down because I’m supposed to be one of those fancy managers myself, but having just read Beating the Indexes, Bill’s second book, I think he makes a compelling case that getting started in convertible bonds is easy—certainly much easier than you might think. Consider the case of a college student, who started trading convertible bonds out of his dorm room and turned himself into a multibillionaire and head of one of the most famous hedge funds in the world. Of course, many of you already know that I’m talking about Ken Griffin. Here, I note a small, incidental connection between Mr. Griffin and me, as shameless name-dropping—which normally makes me cringe—is one of the most efficient ways to establish one’s credibility within the brief space of a foreword. With all the gravitas of simultaneous appointments at Harvard, Oxford, and Stanford Universities, the superhistorian Niall Ferguson in his The Ascent of Money mentions prominently only two hedge funds, as far as I can recall from my reading, in his sweeping, global history of the financial world: Mr. Griffin’s and mine. Mr. Griffin’s mention is easy to explain because his career in convertible bonds has been amazing, but I have no idea how a relatively smaller firm that trades hurricane and earthquake bonds (we lose money when they occur) also caught the attention of one of the most respected historians of our day. Yet, I will make a wild guess: Maybe the point of singling out Mr. Griffin’s firm, and the firm I cofounded with my brother ten years ago, was perhaps that one of the most innovative and truly profitable functions that hedge funds perform is making investments that bridge previously unconnected worlds.

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Convertible bonds fuse together the worlds of stocks and bonds; and the securities my firm trades link the worlds of natural catastrophe insurance and bonds (catastrophe bonds). You may think stocks and bonds are not so obviously disconnected as earthquakes and bonds, but I will tell you that other than the common usage of the phrase “stocks and bonds,” stocks and bonds are the proverbial “dogs” and “cats” of the financial world—respectively, of course. The two markets are polar opposites, starting with the fact that they are often at each others’ throats in the corporate finance structure: What is good for stockholders is often bad for bondholders and vice versa. Although some alignment of interest holds, there’s still a lot of bad blood there, trust me. Stocks and bonds, as you probably know, are a few tens of trillions of dollars in market size each. Currently, at a relatively much smaller few hundred billion dollars in market size, the convertible bond market is a kind of love child that only the nanny, its private tutors, and a handful of trustees seem to know about (remember that the parents are absolutely loaded). These days especially, stocks are wild and bonds have impotently low yields. As such and after reading this book, I find it credible to believe that opportunities for investors in convertibles, particularly individual investors, may be just about as high as they were 25 years ago, when trading convertible bonds out of a college dorm room might have struck most casual observers as a pretty innocuous, if also odd, activity. Bill Feingold and I first met in 2006 at a Wharton Hedge Fund Network event in New York. I did not attend Wharton, as did Bill; I was just a guest speaker at the event. We hit it off instantly. His father was a university professor; so was mine. As a consequence, we both had the same kind of value-oriented, market-aware approach to investments that you might expect from a couple of...well, there’s no good way to say it...a couple of nerds. Bill and I each had traded billions in nontraditional bonds over the years before we met, so we eagerly got down to comparing notes. I’m afraid I’ve learned much more from him than he from me. Bill’s first book, The Undoing of Cowardice, had a significant impact on my approach to investing. To use a sports analogy, another Bill influence, Bill’s first book helped me hit more home runs while striking out less in my own work, so naturally I was excited when he told me he was writing another book that took his ideas even further. Having just read this newest book, I

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can tell you that Bill has outdone himself and that this is the best book of its kind I have ever read. Books on finance typically come in two flavors: One kind is a collection of stories; the other, a collection of equations. Some elite trading firms will mandate that new employees read a particular book, but to my knowledge and in my experience, such mandatory reading comes from only the first category, not the second. Perhaps this is because, to modify an Edison quote, “Market genius is one percent mathematics, ninety-nine percent experience.” Most smart money traders are not born, but are mentored by seasoned traders. I believe Bill’s second book represents a potentially new form of finance textbook because he fuses stories and math together in a natural way that comes close to replicating the experience of spending time on the desk of a patient and talkative trader. For those of you who have experienced this already in another market, you will recognize what I am talking about as you make your way through this book. You will note, too, how you are even given instructions on proper broker etiquette and how to work an order in a constructive manner. You have to admit, that’s impressive. Before closing, my one reading tip for you is to go back eventually to all the subsections of Chapter 10 that you may have skipped because they were not directly addressed to your intended role in the market. This is your chance to understand more fully how different players approach the convertible bond market from different angles. Ultimately, this notion of complementing needs among a variety of players in the convertible bond market actually pervades the whole book if you read closely for it. This is a refreshing departure from the traditional “beat the market at its own game” mentality, which is tiresome and not long sustainable by even traders armed with supercomputers. I can’t explain this better than Bill has, so read Part I to understand to how to beat ’em by not joining ’em. And speaking of supercomputers, mine are calling out to me now, reminding me of my duty to be a fancy investment manager, so I will be brief: If you are looking to enhance your related business opportunities by reading this book, I think this is a good way to go because you’ll be conversant in convertible bondspeak in no time, which should get you quickly on your way. If you are reading this book

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as your first introduction to markets and trading, I envy you. Not that I’ve got anything to complain about, but I wish this book were around when I got started in markets 20 years ago. Dr. John Seo Cofounder & Managing Principal Fermat Capital Management, LLC Westport, Connecticut

Preface

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I’ve been caught between worlds and professions for as long as I can remember. As the son of a Berkeley English professor, I’ve long been connected with teaching and writing. But as someone who bet his first horse at age ten and was immediately hooked, I’ve also been drawn to anything that involves estimating value and odds and dealing with risk. My father’s struggles with academic politics—approved for tenure by his colleagues, he had to win a year-long struggle with a university budget committee to make it official—convinced me not to leave my future to such whims. Instead, I headed for Wall Street, hardly known for job security. I figured I would make some money, or try to, and then go into teaching. Knowing nothing about my new field, I took a job as a junior investment-banking analyst. It seemed like that was what the “smart” kids did out of school. But grinding out endless spreadsheets in the days of sharing primitive personal computers was not my thing. Instead, I was fascinated by how excited my roommate, who was trading convertible bonds, seemed to be about his job. Convertibles—securities

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combining the protection and income of bonds with the upside of stocks—were gaining in popularity and starting to emerge from the recesses of Wall Street. So when I went to business school, after a detour as a semiprofessional horseplayer, I positioned myself as a trader. After an internship at Goldman Sachs and a stint doing options research, I got my shot as an options trader with PaineWebber, which led naturally enough to convertible bonds. Convertibles, you’ll find, are a fascinating hybrid investment with a little bit of everything, including options. And I loved options. Even then, though, I still had the writing bug. At PaineWebber, I wrote a piece comparing option trading with stages of a basketball game. It nearly got me fired because I knew my boss wouldn’t approve and thus distributed it without his permission. But it was worth it. It set me on a path of writing about finance in a manner that the intelligent, but unfamiliar, reader will find accessible and fun. After a handful of years as a convertible trader, the writing bug came back to me. I found a way—for a short time, anyway—to have it double as my livelihood. The convertibles analyst at Lehman Brothers decided he wanted to be a trader. Some former colleagues of mine were running the convertibles effort at Lehman, and after some politicking and doubts, they gave me a shot at moving into research and writing about convertibles. It was fun for a little while. I tried to change the nature of convertibles research. Up until that point, most convertibles research involved saying, “We like this stock—and by the way, the company has a convertible, so you should buy it.” I tried to make the research more about the convertible itself, and how its price moved after adjusting for the stock. In short, I was trying to write research for the more quantitative, hedge-fund types. Over time, after running a couple of convertible hedge funds and spending many more years in the field, I came to believe that convertibles are actually far better when used more simply than the way hedge funds do. It struck me that expecting convertibles to hold up to the requirements of hedge funds—needing them to perform every day according to the complex models the funds used—was unrealistic and a recipe for trouble. At the same time, for investors not so worried

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about day-by-day, tick-by-tick price changes, the value of convertibles became clearer and more persuasive than ever. My stint at Lehman doing convertibles research didn’t last long, mostly because trading was still too much in my blood. But after my hedge-fund stints and a short period as a proprietary trader at Goldman Sachs (just in time for the financial crisis), I went back to writing. I began a column for Minyanville, for Todd Harrison, whom I’d met through a mutual friend. I realized that I had the makings of my first book, The Undoing of Cowardice, which was published in 2009. In Undoing, I voiced my opinion that the popular impression of Wall Street—as a world of unchecked, wildly aggressive risk takers—was at odds with the way the business really works. As Wall Street was collapsing, I wanted people to understand that a lot of the volatility comes not because professional investors take too much risk, but because they tend to take the same risks—and they do this because it’s the logical course of action given their incentives. Most of them— with notable and critical exceptions—don’t want to stand out. They want to keep their jobs. Losing money is okay as long as everyone else is doing it, too. In Undoing, I introduced readers to the world of convertible bonds. I was writing columns on convertibles for Minyanville, trying to show readers that the risk/reward trade-offs in that market were remarkable and available only because of the forced selling by hedge funds. But it wasn’t the primary theme of the book. After I published Undoing, I went back to trading convertibles at a terrific little firm called BTIG. I was happily minding my business there when Todd called me. He told me that Minyanville had formed a joint venture with Pearson, the big British publishing outfit responsible for one of my favorite publications, the Financial Times. Would it be okay, Todd asked, if Pearson got in touch with me? They liked some of the stuff I’d written for his site. I agreed, and soon I heard from Jeanne Glasser, who would become my editor. I was impressed to learn that Jeanne had worked with Mohamed el-Erian of PIMCO, whom I subsequently had the pleasure of meeting, and whom I consider one of the two smartest people in the world of finance. I gave Jeanne a copy of Undoing. After reading it, she asked me to submit a proposal for another book, and

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I began to get excited. After a bit of give-and-take, we agreed that I would write a book focused on bringing convertible bonds to a new audience, while also touching on some of the themes of institutional paralysis driven by an excessive focus on benchmarks and sameness that I began in Undoing. They teach you in business school that having the greatest product in the world won’t do you any good if you don’t market it properly. And convertibles, as an investment, have been singularly mismarketed. First, most of the people who should be selling them barely understand what they are. You shouldn’t be allowed to sell securities if you don’t understand the basics of stocks, bonds, and options. That’s why brokers are required to pass the Series 7 licensing examination. And if you understand these things, you should be able to understand convertibles well enough to explain them to your customers. But because they require a bit more effort than stocks or traditional bonds, convertibles fall by the wayside. Second, the securities industry has failed to make the effort to show its customers that convertibles provide all the attributes they seek: upside, income, and protection. It really doesn’t need to be a whole lot more complicated than that. I’m trying to change this. I think the time for a change has come. The wildness of the equity markets is scaring people away, people who know they need the benefits of stocks but understandably can’t stomach the downturns. One of the best solutions is out there for them—convertibles. A problem some people have with convertibles is that in the shortterm they often misbehave. Even though they have built-in defenses making them far safer than stocks, you sometimes wouldn’t know it during the downdrafts. But this problem, as I hope to illustrate, is not with the convertibles themselves but with the investors who buy them. This difference may seem too subtle. And if you’re an institutional investor judged by short-term performance measures, the distinction may be effectively nonexistent. But if you have a legitimate multiyear time horizon, it is absolutely critical.

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In fact, I think it’s so important to understand this distinction that I’ve dedicated the first part of this book to understanding the motivations of institutional investors. Although most of them are intelligent, capable people, the infrastructure of their professional lives forces all but the best and bravest to run in packs. It forces talented athletes to play like scrubs. For this reason, I think you can get the most out of convertibles by learning to buy them individually instead of through a fund. Having said that, there’s nothing wrong with buying a professionally managed convertible fund. Some are quite good. But even if you do, as the saying goes, you’re likely to be a far more satisfied customer as an educated consumer. That’s where this book comes in.

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Introduction If you’re accustomed to books that follow traditional categorizations, you’ll need to bend your expectations a little. I am taking a new approach with this book, one that I refer to as the “narrative textbook.” If you like the markets, are reasonably comfortable with numbers, and enjoy solving problems, you not only can make good money in convertible bonds, but you can also have a lot of fun with them. I think they are the most fascinating of all investments because of their versatility. But, let’s face it—convertible bonds, as a subject matter, is probably not going to rival your basic Stephen King thriller. Most books about convertibles do a respectable job of delivering the material, but they do it in such a way as to lose the interest of all but the most devoted students. Let’s call it what it is—they are dry. For introducing new readers and new investors to a valuable investment option, then, they are essentially dead on arrival. Although I think you will find convertibles intriguing, there are some basic concepts you need to learn. I’m trying to help the medicine go down with a spoonful of sugar. This book mixes the necessary details of understanding convertibles with a collection of stories from my career. I hope that you’ll find the narrative aspect of the book sufficiently engaging to inform you painlessly about what you need to know about convertibles. In fact, I suggest you think of the book as a story with plenty of teaching woven in, rather than the other way around. And if you approach the material with an open mind, I think you’ll be surprised how intriguing and enjoyable you’ll find it. The book has two distinct but related parts. The first and shorter section, Part I, “Our Flawed Institutions,” addresses and expands upon the core of my first book, The Undoing of Cowardice. I lay out the argument that the professional investment world is largely 1

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designed for mediocrity and job preservation at the expense of the creative, forward-looking asset allocation it is supposed to provide. I think there are a lot of competent people out there who want to do a good job, but we are giving them all the wrong incentives. I explain why and how this actually creates more opportunities for you. I hope that as you come to understand the structure of markets, you will feel more confident about taking control of your investments, especially as an individual investor. If you do, you will find that the time invested in learning about convertible bonds—the second and larger part of the book—will repay you many times over. Within Part II, “Convertibles, a Better Solution,” I begin by laying out the basic facts you need to understand convertibles. For investors focused largely on stocks—and this means most investors—you will find this part highly useful. You’ll come away with knowledge of traditional bonds and options that you knew you should have had, but probably never got around to. Then I’ll take you through the journey of my career so that you have immediate contexts for those facts. I hope that you’ll experience a bit of the thrills, pitfalls, and unintended humor that have all befallen me in my own convertible journey. After we finish the tour, we dig deeper into convertibles, learning how to compare them as investments with the stocks that underlie them. There’s a brief quiz midway through this section to make sure you’re learning to speak the language. By the end, although you might not quite be a convertible guru, you’ll have a pretty good comfort level with an investment a lot more people would use if they only knew about it. I need you to keep a few things in mind. This book does not teach you how to pick stocks. I am not a stock picker. My skill, such as it is, involves starting with an idea about where a stock is heading, how long it might take to get there, and what might happen if the idea turns out to be wrong. For most people, the set of possible investments begins and ends with the stock itself. After you’ve finished this book, you’ll be way ahead of them. You’ll understand not only stocks, but also options, bonds, and, of course, convertibles. You’ll begin, as a matter of course, examining your own thought process and matching your investment to your opinion—because it’s not a one-size-fits-all world.

INTRODUCTION

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As such, this book is probably best for people—individual investors and professionals alike—who like to pick their own stocks but want help in finding the best way of structuring their investments. I know there are a lot of you out there. After we’ve learned how convertibles work—including the actual nuts and bolts of the trading process—and how to identify attractive ones, we’ll look at the securities from the perspectives of different constituencies. Individual investors, financial advisors, institutions, corporate treasurers, and students will all find a subsection dedicated to their area of interest. Before we finish, we’ll take a quick overview of the more advanced topics convertible professionals follow. Those of you eager to learn more about convertibles will find this last section a good starting point for further study. Congratulations on taking your first steps toward making one of Wall Street’s best trades part of your portfolio!

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Part I Our Flawed Institutions

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1 Indexing and Its Discontents Don’t get me wrong. Most people who manage money on Wall Street are honest, reasonably intelligent, and hardworking. And a few are really, really good at it, year after year. But only a few. If you can invest with them, you should. Chances are, they’re not accepting new investors. If you can’t, then either invest on your own— the odds are far better than you think—or give a shot to a creative manager who isn’t afraid to underperform a benchmark. If neither of these appeals to you, then just throw in the towel and stay middle of the road with a low-cost approach. Whatever you do, don’t pay a star’s salary for a scrub’s performance. The industry is filled with scrubs wanting to be paid like stars even as they try to copy each other’s ordinary results, and in many cases, they’re succeeding. This book will help you understand why these people actively seek mediocrity in their work and excess in their pay, and help you make sure that these people will no longer profit at your expense. And what if that exceptional investor you want to get in with still is taking new money? I’d like to relay a brief story. Recently I was speaking with a good friend, an entrepreneur who’s worked on Wall Street and knows his way around investing. He was telling me of a disheartening conversation he’d had with a friend from graduate school, a senior executive at a large money-management firm. My friend has invested a significant portion of his wealth with that firm, being originally drawn to it by the firm’s discipline of buying deeply undervalued companies and avoiding trendy, fully priced stocks. That approach has led the firm to grow its assets by a factor of 50 or so over the past 15 years. 7

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Why was the conversation disheartening? Because during the conversation, my friend realized that his money manager had departed radically from the firm’s original approach. “I get the sense they don’t think fundamentals matter any more, at least in the time frame they care about,” he told me. “Now what interests them is if something is down 30% from its 52-week high. It used to be they didn’t care about that stuff. Now it seems like they are just looking at technical analysis.” His friend defended the change in emphasis, saying, “You don’t understand the pressure we have to outperform our benchmark.” Essentially he was saying, “It’s not worth it for us to do the kind of intensive research we used to do. Maybe we’ll be right, maybe not. All we know is that if we fall behind our benchmark, investors will leave us.” This story is just one example of why Warren Buffett is thought to have said “size is the enemy of investment performance.”1 Clearly, the organization in question has become preoccupied with maintaining the size it has achieved because of the tremendous economies of scale in the investment business. If you’re collecting 1% of the assets you manage in annual fees, and your assets have gone from $200 million to $5 billion, you’ve gone from $2 million to $50 million in revenues. You’ve gone from a very nice little business to a seriously major one. Although your costs will surely go up, a certain way to keep them in check—and keep most of the revenue growth for yourself—is to simplify your investment process. You might have achieved your growth from exceptional performance. But now that you’ve got the money in the door, you probably won’t lose it if you can convince people it’s not worth their while to leave—that they probably can’t do much better elsewhere. My friend is, indeed, considering taking his money out, but not because of any short-term performance concerns. He’s thinking about leaving because the firm he originally invested with has changed, and not for the better. He invested with them because he thought they had the resources and skill to discover investments he would never find on his own. Now they are telling him they are just trying to buy the same stocks everyone else is buying—they’re just hoping to get in at a slightly better price.



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In a nutshell, this is the behavior I’m trying to push you away from. There’s little argument that over the long term, you need a significant part of your portfolio in stocks or stocklike investments. But in the short term that sometimes seems interminably long, stocks bounce around like pinballs as professional managers try to align themselves with today’s trend. Buying your own convertible bonds accomplishes the dual purpose of giving you a known target. You get this target—a promised return of capital in all but the very worst scenarios (and a stream of income to boot), free from the daily madness of stock moves—while still keeping you in the game for big long-term gains in the market and the economy. It also frees you from dependence on managers more focused on daily performance than deep value—sadly, you might be even more likely to find this behavior with professional convertible managers than their stock counterparts, which should help convince you it’s worth trying on your own. Indeed, one of the recurring themes of the convertible market is the periodic meltdown. It seems to happen every four years or so and rarely has much, if anything, to do with the convertibles themselves or the companies that issue them. It’s because of the narrow holder base—hedge funds and a small number of big traditional investors. The hedge funds get most of their money from asset allocators focused on, and perhaps even mesmerized by, benchmarks. This naturally leads to a regular boom-and-bust cycle of overinvesting after good performance, using borrowed money, and pulling out just when things are getting cheap and attractive. But that’s what happens when you’re more driven by matching the averages than by purchasing dollars for 80 cents. As an individual or a nontraditional institution who understands the convertible market, you’ll be in position to capitalize on these regular meltdowns. But to understand why convertibles are so prone to these collapses, you first need to recognize the flaws in the institutional process.

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How a Closet Index Investor Is Born Index investing was a great idea, a brilliant idea, as long as not too many people were doing it. The basic thought was simple: Harness the power of consensus and make it work for you without paying for it. Think back to our example a moment ago of the money manager going from $2 million to $50 million in annual revenues. If that manager recognizes that running more assets means needing many more portfolio holdings, and thus a lot more research and maintenance, even the intrinsically beneficial economics of the asset-management business have their limitations. You could probably manage $200 million, the asset base needed to generate $2 million annual fees at 1%, with a fairly small team. Let’s say you decide you want to invest the money equally in 25 companies that have an average market value of $800 million apiece. You’d own on average 1% of each company—enough to get the attention of management when you had a question, but not so much that if you needed to adjust your holdings, you’d wreck your own price (either getting out or adding meaningfully more). This is the outline for a concentrated yet disciplined portfolio. Let’s further add that as part of your investment process, on average, you need to study ten companies for every one you decide to buy. To come up with your 25 best ideas, you need to follow 250 different possibilities. Many people would argue this is aggressive—some might say you need to follow 20 or 30 companies to come up with one legitimate investment.2 But we’ll stick with the 10:1 ratio for now. Okay, now how many companies can one analyst effectively follow? Well, most Wall Street analysts are responsible for somewhere around 10 to 20 names. Some do considerably more, some fewer, but this is a good ballpark number. Meanwhile, analysts at investment managers like mutual funds usually follow at least two to three times this many companies. They can do more because, unlike so-called “sell side” analysts, they are not responsible for regularly publishing for and marketing to a large number of clients, leaving them more time to focus on actual analysis. So let’s say an analyst at an investment manager follows somewhere around 40–50 companies.



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If the manager is looking to make 25 investments and needs to study 250 candidates and each analyst can follow 50 names, that means you need five analysts. In reality, five analysts is a lot for a fund managing $200 million, unless the analysts are pretty junior. If the analysts are being paid $250,000 apiece annually, which is pretty good money by most standards but not a whole lot in the market for experienced analysts, you just spent more than half your revenues. A couple of points central to my argument become clear from this example. One is that a salary that sounds pretty good to most people is not a lot on Wall Street, even in today’s downsized world. So if you get a job in the industry, you’re going to do your best to hang on to it. Sometimes this means doing original, creative work. But as your employer gets bigger and more focused on hanging on to the assets it already has, your emphasis is going to migrate from winning to not losing. The other point? Put yourself in the shoes of the owner of the money-management firm. You’ve done well and the money has come rushing in, faster than you imagined. All of a sudden, you’re managing $5 billion. Your specialty is small companies, and your approach has been to take stakes of about 1% in a manageable number of firms. But now, if you’re running $5 billion and you only want positions in 25 firms, you’ll have $200 million on average in each. Keep in mind that the average size of the companies you’re good at is only four times that much. Are you going to own a quarter of each of these companies? That puts you in an entirely different position than you were before. The short answer is, no, you’re not going to do that. No way. So what do you do instead? You could change your universe to include much larger companies. After all, if the average market value of your targets went from $800 million to $20 billion, you could still take a 1% stake in 25 companies and be done with it. So why don’t you just do that? Some managers might. The problem is, your investors chose you because of a specific expertise—small-capitalization companies. If you tell them that you’re switching to much larger firms, they’ll get nervous that you are no longer sticking to your knitting—that you’re experimenting with their money. And they’ll be right.

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So you can’t go that route. You have to stick, at least for now, with the small-capitalization universe. But you’ll need to hire a lot more analysts. If you are 25 times bigger, you might not need 25 times more analysts, but you’ll need a lot more. Also, and perhaps more important, your analysts might no longer be satisfied with getting paid $250,000 annually, at least not the ones who have contributed the most to your growth. They’re going to want a lot more money, and to some extent, that will ratchet up the cost of all the other analysts you hire. But we still haven’t addressed the biggest problem. If you’re using your old approach, you’re going to need to invest in 25 times more companies than before! That’s 625 companies. And what does a fund that owns 625 companies look an awful lot like? That’s right. An index fund. In reality, not many funds would be likely to own 625 different positions—although some may own more. Still, you see the point. Even if you own, say, 200 stocks, it’s going to be very hard for your best ideas to have a meaningful impact. But if you’re managing $5 billion and you own 200 names, that’s an average of $25 million apiece. These can be pretty unwieldy holdings of smaller companies if your investor base could be demanding its money back at any moment. So there’s a very strong incentive to spread out your holdings. What does this mean? Funds that succeed can become the victims of their own success— remarkably quickly, in fact. The path they are likely to take is unfortunately clear. Grow quickly with skill, and then switch to autopilot. A fund like our mythical one could never come out and say, “We’ve grown too big to make doing our homework pay, so we’re just going to become an indexer.” By doing so, the fund would almost force most of its noncomatose investors to switch either into a smaller, actively managed fund or to a lower-cost index fund. But its only real choices are to adopt a closet-indexing approach while maintaining the appearance of staying true to its roots, or to take a relatively small number of very large, concentrated holdings, thus moving away from its initial discipline. If it follows the latter course, it’s just a matter of



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time before one of those holdings blows up and takes the fund down with it. Sometimes you see asset managers handle their growth another way—by expanding into areas rather far afield from their original specialization. Back in the late 1990s, the infamous Long-Term Capital Management, run by a bunch of brilliant, mathematically inclined bond arbitrageurs, managed its growth both by increasing the sizes of its core trades and by getting into such new areas as betting on stock takeovers. It didn’t turn out well. More recently, John Paulson, the biggest winner in the subprime mortgage blowup, has deployed some of his resources in investments like Sino-Forest, the Chinese timber company accused of fraudulent accounting. How do you avoid these blowups? You become a closet indexer. You’ll never make the kind of returns you did when you were smaller, but you’ll also probably never make the headlines. And for institutional investors paid on a percentage of the assets they manage, that’s usually good enough.

How Big a Deal Is Closet Indexing? Professor Antti Petajisto of New York University has focused his research on this question, and he thinks it’s huge—to the tune of roughly one-third of all mutual-fund assets.3 At the same time, Petajisto estimates 20% of mutual-fund money resides in index funds. In other words, of all the dollars being invested in mutual funds, less than half is going into the hard, time-consuming process of figuring out what the stocks are really worth. The rest is going along for the ride—and the lion’s share of that money is trying to get paid the same as the funds doing the dirty work. So we have two real problems here: Not enough of the market is doing its homework, and too much of the market is trying to get overpaid. I’m not sure what an “acceptable” percentage of closet indexers is, but I think one-third is way too high, and this is just from the perspective of how much analysis is going into valuations. From an investor’s perspective, paying for active management and getting automated performance should never be acceptable.

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How About the Implications for Individual Investors? If you choose to invest with an actively managed mutual fund, you should try to make sure the fund is small enough to make its decisions count. But then you have to keep tabs on its development. If the fund does well, good for you. But you’ll need to keep an eye on how it handles its growth. It will be forced to become a closet indexer, take highly concentrated bets, or drift away from its original specialty. None of these options is particularly good news for the investor. So you may have to be prepared to switch your funds more often than you’d like. Either that, or accept the fact that the fund you bought may not be the fund you own. What are your main alternatives to this? Either just go with index funds, or, perhaps with some help from an advisor, go on your own, at least with some of your assets. Even if you stick largely with the professionals—which certainly still makes sense for many people—the more you know, the better you can judge how they operate, and the more informed you can be as you choose your partners. The basic math of diversification should give you a certain confidence that you don’t need 500—or even 30—stocks to be comfortably immunized against an unforeseen drop in one of your holdings. Figure 1.1 shows how even a relatively small number of holdings—assuming they are meaningfully different from one another—quickly cuts your exposure to any single name. Moreover, the benefits to diversifying drop off rapidly once your portfolio holds more than a dozen or so different securities. So you shouldn’t feel daunted by the need to own many different investments, be they stocks or convertibles.

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1XPEHURI(TXDOO\:HLJKWHG +ROGLQJV



15

3HUFHQWDJHSHU+ROGLQJ          













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Figure 1.1 How a little bit of diversification goes a long way

Why Indexing Used to Be a Good Idea As we’ve seen, picking stocks is expensive—and that’s assuming you are good at it! Because stocks tend to move collectively, why not just buy all of them, or at least a lot of them, instead of going through the painstaking process of buying them one at a time? Why not let other people do the hard work, the heavy lifting of figuring out what companies are worth, for you? If you believe in the power of consensus, this argument is quite compelling. The intellectual force behind indexing comes from Harry Markowitz, a Chicago grocer’s son who in the 1950s developed what came to be known as modern portfolio theory. In his youth, Markowitz was more interested in philosophy than finance. He was fascinated by the concept of uncertainty and how (from the work of the great Scottish philosopher David Hume) the mere fact that something had happened repeatedly in the past offered no assurance that it would repeat in the future.4 Markowitz’ interest in how investors manage uncertainty led him to develop sophisticated calculations around an elemental concept— don’t put all your eggs in one basket. He recognized that investors buy

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multiple stocks even though they surely like some more than others. They don’t put everything into their single favorite holding because they understand that such a concentration exposes their wealth to far greater variability than a more diversified portfolio. Interestingly, Markowitz settled on variance—essentially day-today volatility—as the best measure of risk. The implications of this decision, which his biography suggests was more of a mathematically convenient hunch than anything else, have been profound. For individual investors, concern over day-to-day variability of their wealth is probably a secondary concern: Trying to grow wealth over time while controlling losses in down periods would seem to be the watchword. For institutions, however, risk management has focused largely on minimizing so-called tracking error, the daily difference between a portfolio’s benchmark and its actual results. Make no mistake: A highly concentrated portfolio that regularly deviates significantly from the benchmark it’s “supposed” to track is probably more susceptible to big losses than a widely diversified one. But it ain’t necessarily so.

Where Markowitz Erred: Is Risk Volatility, or Fear of Losing? Indeed, the options market, where people essentially buy and sell insurance on stocks every day, proves that variability per se is not the paramount concern that Markowitz’ pioneering work suggests. Thanks to the formula published in the early 1970s by Fischer Black and Myron Scholes, option prices are now routinely described in terms of “implied volatility,” with higher prices, all other things equal, implying higher anticipated day-to-day variability in the underlying stock price. But one regularly observes considerably higher implied volatilities in lower “strike” or exercise prices than higher ones, even though the measure of volatility implies a fairly uniform distribution of prices. Why are options with lower exercise prices—essentially representing the cost of insuring a stock against sharp downward moves—more expensive than high-strike options? There are two reasons, closely related to one another. One is that stocks typically move down more



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violently than they move up, with the general exceptions of takeovers and unexpected good news in biotechnology stocks. The second is that far more investors own stocks than are short them, so the natural demand for protection is strongly biased toward the downside. In other words, the option market shows that investors collectively are more worried about losses than just plain variability. This is an important concept, and I’m going to take the next few paragraphs to explain it. Don’t worry if you find it a bit hazy— although it’s worth learning and even kind of fun. If you’re confused, take heart. To be clear, when I say one option is more expensive than another in this context, I am using the previously mentioned “implied volatility” as a measuring stick, not the actual dollar price. For example, let’s say you were looking at two different “put” options on stock XYZ, with XYZ currently trading at $50. Consider XYZ put options expiring in three months, one with a strike price of $45 and another struck at $40. We’ll get more into options later, but just in case, a put option gives its owner the right, but not the obligation, to sell the underlying stock at the strike price, typically at any time up until the option expires. It should be reasonably apparent that the put struck at $45 should always be worth more than the one struck at $40—after all, if the stock should drop to a point where it pays to exercise both, you get $5 more when you exercise the higher-strike put. But in thinking about how expensive the options are, you have to go beyond just the raw price. Let’s say with the stock trading at $50, as we already stipulated, the $45 put option is trading at $1.20, and the $40 put is going for 50 cents. Now, the $45 put costs more in absolute terms, 70 cents more to be precise. But we’ll see that in all meaningful senses, the $40 put is the more expensive of the two. You save only 70 cents by buying it vis-à-vis the $45 strike, but you give up $5 (so $4.30 net) of potential upside in case the stock collapses. How much more expensive is the $40 strike? We use implied volatility to tell us. In this example, the $45 put has an implied volatility of about 33%, whereas the $40 put’s implied volatility is about 38%. If both options were trading at 33% implied volatility, the $40 put would be going for only around 28 cents, or just over half as much as with a

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fairly typical “premium” for disaster insurance! You can think of the extra 22 cents—a huge amount on something that costs only half a buck—as the price people will pay to avoid catastrophe because such investors typically buy protective put options with low dollar prices but high implied volatilities. Why do they do this? Why do people pay 50 cents for options that one could logically argue are worth only about half that? Because they are afraid of taking huge losses. If you own the stock at $50, buying the $40 put means that at least through the option’s expiration, you won’t lose more than $10 (plus what you paid for the option). Also, it seems psychologically easier to buy a protective option that has a lower dollar cost, even if you’re only getting what you pay for, and not really even that. The point here is that people are not just worried about variability—the essential risk measure of the Markowitz model. If they were, those $40 puts would cost a lot less than 50 cents, given where the $45 puts are trading. No, they’re worried about catastrophic loss, and they’re willing to pay what seems like too much to make sure it doesn’t happen.

A Great Idea When Nobody Was Doing It Putting the difference between variance and loss aversion aside for now, Markowitz’ work still has had tremendous implications. From his efforts came the notion—again, a high-level take on keeping your eggs in multiple baskets—that investors will not be rewarded for taking risks that diversification can eliminate. This is the concept of “beta,” or the degree to which an individual stock (or a portfolio) moves in the same direction as the broad market. High-beta stocks theoretically have a sort of built-in leverage: They go up and down a lot faster than a broad index. From Markowitz’ work, it followed that the market as a whole, by definition, had a beta of one (the market moves with the market, a tautology) along with a certain expected return. If you buy a small number of high-beta stocks, you might expect to do better than the market in good times, but you would also expect to pay for it with exaggerated downside losses. No real



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edge there. Moreover, even if you put all your money in a single stock that historically showed a beta of one, perfect market correlation, you were still exposed to the natural idiosyncratic risk of any individual holding—risk that could theoretically be removed by diversifying. It logically followed that trying to pick individual stocks, however enticing the prospect, had some rather severe built-in deficiencies. We’ve already seen how expensive it is. So building an investment strategy around simply “buying the market” made a lot of sense. This is what Princeton student Jack Bogle started thinking as he worked on his undergraduate thesis at about the same time Markowitz was coming up with his groundbreaking theories. After working his way up at mutual-fund firm Wellington upon leaving Princeton, Bogle ended up founding the Vanguard Group in 1974 and introduced the first index mutual fund, based on the Standard & Poor’s 500, about two years later. His argument, which has held up remarkably well over time, has been that it’s extraordinarily difficult to beat the market, and the best one can do is buy the market while keeping costs to an absolute minimum.

Groupthink: The Seeds of Indexing’s Flaws Our little intellectual exercise in the rapidly growing fund, I hope, makes it easy to see why Bogle’s creation has done so well. Launched as the market was recovering from the depths of a vicious downturn, the Vanguard 500 fund family has become the standard by which other indexers are measured. But one can reasonably ask whether the success of even this kind of investing carries the seeds of its own, if not destruction, then at least rather severe limitations. Why? As I mentioned earlier, indexing is all about the power of consensus. Let knowledgeable people do the research and the pricing and ride their coattails. So it’s worth a few minutes to explore what consensus requires to be effective. A quirky business-school professor of mine used to have his students predict where various markets would be at the end of the

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semester. He would then calculate the average prediction and make some moderate investments accordingly. He claims to have done quite well. His one requirement of the students was that they not confer about their predictions, but promise instead to submit them independently. Independence is one of the two keys to consensus’ value. If the individuals who constitute the consensus talk to one another, compare notes, and then submit their answers, you might think you’d get a better prediction. But you’d be wrong. Instead, you get the phenomenon known as “groupthink,” a term coined by Yale psychologist Irving Janis to describe “a mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members’ strivings for unanimity override their motivation to realistically appraise alternative courses of action.”5 In other words, peer pressure and the unfortunate human desire to conform overrides independent analytical thinking. The other key is that the members of the group have reasonable knowledge of the subject matter. It doesn’t do much good to take a poll of independent-minded first graders about where Microsoft stock will be next year, even if they attended some kind of miniature version of the stock-market day camps that seem to be popping up everywhere.

An Indexing Parable So let’s take a look at these two requirements in two worlds: one where indexing is a comparatively new phenomenon and another where indexing’s powers are well known and active managers are relentlessly compared against well-defined benchmarks. In the first world, indexing is pretty much the Holy Grail. Pat Indexer (as I will call him or her, with a nod to Saturday Night Live’s character of ill-defined gender) stands apart, watching lots of intelligent, well-trained, presumably independent-minded stock-market operators spending all their time doing homework and making prices. Pat then swoops in, benefiting from the whole process without paying its costs. If thousands upon thousands of money managers are setting



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prices and a few anonymous indexers are coming in to trade at those prices, Pat would seem to have a pretty good deal, and a pretty clear advantage. But what happens after indexing has taken hold? Now the indexers are growing in number. Chris, Alex, Whitney, and countless others have joined the party. Not only are the indexers starting to hurt their own prices, moving the markets as they flock in and out of stocks, but they are benefiting less from the collected wisdom of a relatively smaller consensus. Bit by bit, the Indians are becoming the chiefs, with an accompanying loss of quality in the process. Moreover, there’s a major problem built into the index-construction process. This problem, the effects of capitalization weighting, has been well-documented by Robert Arnott6 and Joel Greenblatt,7 among others. Essentially, the better a stock does, the bigger its weighting becomes in a standard index. Because indexes are designed to match the overall market, this is the natural way to build them— you wouldn’t want to have Microsoft and Nike equally weighted— although both are iconic American brand names, Microsoft is a far larger company by every reasonable measure. By putting essentially all the weighting power in a company’s market capitalization (the aggregate value of all its shares), however, you turn index funds into a dangerous, runaway perpetual motion machine. Buying begets more mechanical buying—a process that rarely ends well. Index investing, which sounds like it ought to be an intrinsically disciplined approach, starts looking more and more like momentum investing, the “it works until it doesn’t work” style that had its heyday in the late 1990s but, with occasional exceptions, has never quite recovered.

The Happy Recap To be sure, there are clear benefits to index investing. Taking the human element largely out of the equation has much to recommend it, given how prone we humans can be to all manner of emotionally inspired errors. You know you will “own” the market with minimal cost, so you don’t have to worry about making bad judgments of your

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own in choosing stocks or managers. As long as you’ve decided to be in the market, you’ll never really have to second-guess yourself, and there’s much to be said for the peace of mind that can bring. But you have to remember that as indexing has become more popular, a smaller percentage of the market is spending its time deciding what stocks are worth, and a bigger part—the part you join as an index investor—is blindly accepting that decision. You’re buying things because they’re going up. Are you sure you want to do that? After all, unless you’re the type of shopper who clicks on “most popular” and then buys, you don’t purchase anything else that way. Why your investments? Indeed, the growth of index investing reveals a delicious irony. Do you see it? We have an approach whose logical underpinnings came largely from Harry Markowitz’ fascination with David Hume’s skepticism that the past would necessarily resemble the future. What does this strategy do? It puts its money into the stocks that recently have been performing the best. I wonder what Hume would have said.

Endnotes 1. Interestingly, one thing Mr. Buffett did say at his 2005 shareholder meeting is that “The enemy of investment performance is activity.” This would seem to argue in favor of the kind of buy-and-hold approach that works with convertible securities. It’s worth noting that Mr. Buffett frequently structures his investments as convertibles. 2. See Julie Steinberg, “So You Want to Be an Equity Research Analyst,” in fins.com, March 17, 2011. 3. Antti Petajisto, “Active Share and Mutual Fund Performance,” December 15, 2010, p.12. Working paper, New York University (NYU), Department of Finance, Yale School of Management. 4. In the biography he submitted upon receiving the Nobel Prize in Economics in 1990, Markowitz cited his fascination with the work of Hume, the eighteenthcentury empiricist. “I was particularly struck by David Hume’s argument that, though we release a ball a thousand times, and each time, it falls to the floor, we do not have a necessary proof that it will fall the thousand-and-first time,” Markowitz wrote (from nobelprize.org).



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5. Irving L. Janis, Victims of Groupthink (Boston: Houghton-Mifflin, 1972), p. 9. 6. In The Fundamental Index: A Better Way to Invest (Hoboken: John Wiley & Sons, 2008), Arnott et al. make a compelling argument that an index fund with holdings weighted by their fundamental attributes such as earnings and cash flow should, and does, outperform a capitalization-weighted index. 7. The Big Secret for the Small Investor: A New Route to Long-Term Investment Success (New York: Crown Publishing, 2011) recommends value-weighted funds among various techniques available to small investors. Greenblatt also describes how attractive opportunities in smaller companies favor individuals over institutions that are simply too big to participate.

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2 The Individual’s Edge We’ve already seen that as a fund grows, it becomes far more difficult to manage. The easy way out is to stop trying to pick individual stocks and just buy what’s out there, proportionate to the aggregate market value of the companies. For managers of large mutual funds, which by default are compared with the S&P 500, it is indeed difficult to beat the market. Part of this comes from expenses, as we’ve seen. Another part is that most mutual funds keep at least a small portion of their assets in cash to make it easier to handle redemptions, for the times when investor demands for cash exceed contemporaneous inflows. This “drag” tends to reduce performance in up markets, although it has the opposite effect when stocks are going lower. Smaller funds have an easier time of it, but good funds don’t stay small very long, and because of that they often stop being so good.

Stop Worrying about the Big Boy Market But part of the problem is the near-universal acceptance of the S&P 500 as “the market.” It really isn’t. There are narrower indices, such as the Dow Jones Industrial Average, and broader ones, including the Russell 2000 (for smaller companies) and even broader ones, such as the Wilshire 5000. Even these indices, though, are still pretty narrow in conception. For one thing, they are limited to American stocks. As overseas investing has become more popular, indices and related products on international stocks have gained in acceptance, particularly funds dedicated to so-called emerging markets. Although investing in these 25

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markets carries many risks domestic funds don’t have—including political, currency, regulatory, and accounting issues—it’s certainly true that investors willing to allocate some of their resources to these markets stand a good chance of doing better than by sticking with a purely local approach. Of course, some of the benefits from international diversification can be illusory. Quantitative market types like to say, “In a crisis, all correlations go to one.” In English, this means that when people panic, they sell everything. Fund managers typically sell what they can at these times—their most liquid holdings—because there may be no bid for their other positions. But all of the above simply covers a basic approach—just buying stocks. Remember that for all the headlines they get, stocks are still the dregs of the investment world. Martin Whitman, who as one of America’s leading “value” investors is known for his success in buying distressed debt, wrote, “the amount of money invested in credit instruments of all types in our economy dwarfs the amount of funds invested in equities.”1 So if you’re going to focus on big American companies and you consider the market to be the S&P 500, it’s probably true that you can’t hope to beat the market. As sports announcers often say, “You can’t stop him; you just try to contain him.” Using index funds makes a lot of sense in that case, acknowledging an unstoppable power and trying to keep up with it by minimizing expenses. But there are plenty of other ways to go. If some of our best investors make their money focusing on credit instruments, shouldn’t it be worth your while to look into a kind of credit instrument—the convertible bond—that still has the potential to give you considerable participation in the upside of stocks? To be sure, convertibles tend to be among the lower-ranking credit securities, though this is not always the case. Still, you regularly encounter situations where a convertible bond is the company’s only debt outstanding. In those cases, should the issuer’s ability to repay the convertible be jeopardized, it will frequently issue new shares to raise the necessary funds. Stock goes down, convertible bond goes up. Talk about beating the market!



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Even if you decide you want to focus on stocks, you’re not bound to the big indices. Remember that the benchmarks are there largely to measure how institutional investors are doing. It’s certainly wise to have some of your money in large-capitalization stocks—they are, after all, highly representative of the overall economy—and doing so via index funds is inherently reasonable. But never forget that there are many smaller companies out there, underfollowed by the broad investment community because they can only meaningfully add to the performance of relatively tiny funds. That doesn’t mean they don’t have a lot of value. The example I’m about to provide should give you a taste of what’s out there—and why it can be so worthwhile to do a bit of your own homework.

Making Size Your Best Friend In the summer of 2009, shortly after I completed my first book, I was looking for new ideas to write about and perhaps invest in. I came across a company called Facet Biotech. It had been spun off the previous year from a larger biotech company called PDL BioPharma (for Protein Design Labs). If you’re not familiar with spin-offs, you should learn a bit about them because they are one of the best ways to “beat the market.”2 They are typically divisions of larger “parent” companies. For a variety of reasons, the parent may decide it no longer makes sense for the child to live at home, so to speak. Perhaps there are cultural clashes. Maybe management believes the investment community cannot properly value the child’s business because the parent’s aggregate size dwarfs it. In any event, in a spin-off, shareholders of the parent company receive stock in the child when it moves out of the house. Because the spun-off company is typically fairly small, it is more of a nuisance than anything else to many of its initial, institutional shareholders. These investors decide it isn’t worth the time and effort to follow such a small company, so they put in market orders to dispose of it as soon as they can. Their need for size and liquidity translates readily into opportunity for small funds and individuals.

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For these reasons alone, spin-offs are worth some attention. Sometimes you will find specific, compelling reasons, as I did with Facet. PDL (which, by the way, has been a regular issuer of convertible bonds) spun off Facet because it (PDL) decided that it owned two distinct businesses that, unlike Paul McCartney’s words for his belle Michelle, did not go together well. PDL owned significant royalty-generating assets, which it used to pay large dividends to its shareholders. It also had a drug-development business, Facet. PDL’s press release announcing the spin-off included the following: The spin-off of our biotechnology operations from our royalty assets will enable investors to invest in and realize the benefits of each asset fully and independently,” said Brad Goodwin, PDL’s chairperson of the board. “The spin-off will better allow PDL to return the value of the royalty assets to its stockholders, and enable Facet, the new biotechnology company, to create value by investing in disciplined R&D activities to improve patients’ lives and create value for stockholders.3 One thing the press release didn’t mention was probably the most important. When kids move out of the house, parents sometimes set them up with a little cash to tide them over. PDL was most generous in this regard. It gave Facet a little more than $400 million. The liabilities Facet had to assume were relatively minor, leaving it with the equivalent of about $15 per share in unencumbered cash. Meanwhile, the stock, once free to trade, quickly dropped from the high teens to the high single digits. That put a market value of around $200 million on all of Facet’s assets, including the cash. A persuasive case could have been made that you were buying a dollar for not much more than fifty cents, largely because of the way institutions dispose of spin-offs—and you were getting all the noncash assets for free as an extra bonus. This was by no means a sure thing. Facet could have frittered away the cash over time, or, even worse, it might have made an acquisition—thereby either using up much of the cash, or by paying with stock, which would have diluted existing shareholders’ claim on the money. I decided to get involved when I read that Seth Klarman’s Baupost Group, which had owned PDL, was selling its PDL stock but keeping Facet. Klarman is as good as investors get. I doubted he



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would sit idly by and watch his money get wasted. You don’t become a billionaire that way. PDL’s relatively tiny size meant this trade would never show up on most institutional radar screens. The fact that Klarman had already taken a big stake meant there was even less stock to go around. But for a small investor, it was there for the taking. If size is indeed the enemy of investment performance, there should be plenty of trades like this where, for the alert smaller investor, it becomes your best friend. The payoff came faster than I expected. A major pharmaceutical firm, Biogen Idec, bid $14.50 per share for the company a few weeks after I’d bought in at around $8. The stock traded above $15 after the announcement (in expectation of a higher bid, either from Biogen or a rival) and I sold, figuring that my fifty-cent dollars were now trading at full value. The stock subsequently traded up a couple of points, then fell back below $15. For old times’ sake I took a new position, maybe 10% the size of the old one, and got lucky again, as Abbott Labs ended up buying Facet for $27 per share. The point of this story is not that it’s easy to buy companies for not much more than half their cash balances (although in depressed markets, opportunities like this come along more than you might think). It’s simply to show that often the best trades are way below the radar screens of most institutional investors. Many of them can’t buy companies with capitalizations of $200 million, and many more can but are afraid to. They follow the logic of the professor who believes in perfectly efficient markets who tells his student not to bother picking up the $20 bill he sees on the ground. “If that were a real $20 bill, someone would have picked it up by now.” You have the choice—after all, sometimes the bill is a counterfeit. But sometimes it isn’t. You need to decide what kind of investor you want to be—one who thinks the market must be right, or one who thinks independently. Don’t assume your fund manager will do it for you.

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Catalysts Are for Wimps Just as the big institutions crave liquidity, so they demand an obvious and defensible flow of information. As one client of mine describes it, too many of them manage their portfolios according to the 5 o’clock news. I imagine that most of them are smart enough to know that this is not good investing practice. But it offers them something else—cover. If you own a stock in which the news flow has been favorable, you are largely immune to second-guessing from those whose main source is the general media. How much you pay for this comfort is immaterial—you make yourself part of the crowd, and you can’t be singled out when the inevitable reversal occurs. Nowhere is this more evident than in the hackneyed expression favored by many stock analysts, “I don’t see the catalyst.” Analysts commonly say this when they’ve been recommending a stock that does poorly and their bosses pressure them to either defend their opinion or cut bait, with a strong preference for downgrading the opinion. The trouble is, if you were arguing for buying a stock when it was at $50, it’s hard to make a compelling argument to sell it at $25 unless the fundamentals have deteriorated horribly. A modest, nearterm shortfall should not justify this change in opinion when the price is already so much lower. So what is an analyst to do when his boss comes angrily into his office and says, “I’m getting a lot of angry calls from clients. You have to do something. Your recommendation is embarrassing the franchise.” The usual result is a downgrade. Something to the effect of “while we think the stock is cheap, it could get cheaper, and we don’t see the catalyst to drive it to a fuller valuation.” This takes the immediate pressure off. It stops the nasty phone calls. But it has nothing to do with making money. Indeed, you will rarely get better information from Wall Street than an analyst comment such as this. Invariably you will profit from buying upon reading words like these. See, once an analyst, especially an influential one, writes a comment like this, it takes some of the decision-making burden off the large portfolio managers struggling with how to handle this losing



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position. Now they can point to the analyst downgrade as a defense for having sold, in case the stock is substantially higher down the road. The problem with using “I don’t see the catalyst” as a justification for a downgrade at a depressed price gets to the heart of investing— and also makes a powerful argument for convertibles, whose holders, as industry people love to say, “get paid to wait.” Embedded in the comment is the fantasy that even after the positive catalyst has manifested itself—after the news flow has shifted from negative to positive—the stock will still be available at a price not meaningfully higher than today’s level. You don’t need to be a market wizard to see the poverty of this logic. So the purpose of a comment like that cannot be to help investors make money. It can only be to cloak the body of professionals that, while supposedly competing for undervalued assets, is often instead looking to hide in agreed-upon decisions protected from later scrutiny. When the institutions get their signal from an analyst, and the signal is filled with the perverse logic of “I don’t see the catalyst,” the wise individual, contrarian to his core, goes the other way. Nor is such logic solely the province of traditional analysts. In the Internet era, bloggers can play, too. Some years back, one blogger identified a retailing stock that appeared far too cheap, but cautioned that its operating margins were far worse than the industry averages. He argued that until management began improving the retailer’s performance, there were “no catalysts in play” to drive the stock higher. Several months later, after the company’s next earnings report, the stock had risen by better than 25%. Why? The company had beaten depressed earnings estimates by cutting costs. The blogger identified the correct issue but drew precisely the wrong conclusion.

Smart Trades, Bad Investments, and the Unknown Wall Street and technology have long been the ultimate power couple. Software and hardware improvements let traders slice and

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aggregate orders more easily than ever. Many trading algorithms are designed to approximate, and perhaps beat, the volume-weighted average price of a stock, the execution benchmark to which traders are often compared. Much has been made of high-frequency trading,4 dark pools,5 and various other technological innovations designed to empower institutions with computerized market access that would have been unimaginable not long ago. Academics have varying opinions on whether these resources, in the aggregate, make the markets better or worse for the average investor. But all of this stuff only targets the “known unknowns,” a concept popularized by Donald Rumsfeld. As a buyer of a stock trying to get the best price, you don’t know exactly what the sellers out there have, but you know you don’t know that. So you invest heavily in technology in an attempt to decipher what the sellers’ actions suggest they have, and to minimize your exposure in case you’re wrong. All these efforts can gather savings, perhaps relatively modest ones, but also ones that can add up meaningfully over time. Nevertheless, they are trivial in comparison to the impact of Rumsfeld’s “unknown unknowns.” And it is the unknown unknowns that deserve more attention than they get. They are the things that send a stock down 30% in a day, offsetting by orders of magnitude all the halfpennies and nickels saved through the high-powered trading technology. Of course, firms that specialize in using high-frequency trading don’t typically expose themselves to those 30% moves. They rarely have major positions overnight when the news comes out. But the point is, most of the firepower you read about Wall Street having doesn’t really make much difference to anyone with a meaningful horizon. Moore’s law (the theory of one of Intel’s founders that computing power doubles every 18 months) has a great deal to do with the known unknowns, and essentially nothing to do with the unknown ones. The failure to prepare for unknown unknowns, perhaps better known as “black swans” nowadays thanks to the pioneering work of Nassim Taleb, has defined Wall Street in recent years. That’s because when a mind-set of hitting benchmarks prevails, black swans don’t seem to matter. If “nobody” saw an event coming, and everyone takes



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essentially the same loss as a result, then it’s easy for any given manager to argue he should not be held accountable. What are these unknown unknowns? Take Netflix. Perhaps one of the great momentum stocks of the past decade, Netflix lost nearly two thirds of its value in a couple of months, with much of the damage coming after a brutally mismanaged change in marketing strategy. The company, whose stock had been priced in the summer of 2011 to reflect seemingly perpetual growth of 25% to 30% annually or more, slipped and slipped badly. Could anyone have known that management would commit an awful unforced error, announcing that it would split one good business into two bad ones, and forcing its customers—for whom convenience was the primary appeal—to spend twice as much time ordering entertainment? Probably not. But one certainly could have known that Netflix was being priced as if it would make nothing but smart moves, in a business where a single bad move could wipe billions from its valuation. You might not see the mistake coming—but you want to limit your downside if it happens. But most institutions can’t afford to think this way, even though they should. They care too much about relative performance—being part of the pack that’s buying or selling at any given point in time— and not enough about absolute.

The Real Cause of Volatility This is why we get so many bouts of wild volatility. It’s conventional for market pundits to blame individual investors for panicking to buy at tops and sell at bottoms. No doubt many are guilty. But they are far, far from alone. I’ll never forget one time when I was fairly new to convertible trading. We had a situation in a bond trading around 98. One of our salesmen called a large account, who said he liked the company and was intrigued by the bond but was looking for a lower entry point. He said if the bonds got to 95 we should call him.

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A few days later, the bonds were indeed at 95. The stock was lower, of course, but the relationship between the two gave the bonds a meaningfully better risk/reward profile than at the higher price. This should have been the opportunity the customer was waiting for. So we called him. “You asked us to give you a heads-up in XYZ bonds if they got down to 95. Well, they’re there now. We can offer you three million, maybe as many as five, at that price.” “I don’t care.” “Really? We thought this was where you wanted to buy them. That’s what you told us the other day.” “Yeah, well, that was a different market.” Click. That’s the kind of behavior typically blamed on retail investors. But this guy was one of the biggest unhedged convertible managers out there. Now, he is entirely within his rights to reevaluate previous comments in light of new market conditions. Perhaps a number of similar bonds he was also considering had cheapened even more. But if that were the case, he shouldn’t have simply dismissed our offer. He should have said something like, “Everything I own has cheapened two points since we spoke about these bonds. I’m sorry, but the best I can pay you now is 93 for the bonds. You’re welcome to work the order. Maybe the seller is desperate.” He didn’t say that, though. He didn’t come in and put a floor under the bonds. His attitude, essentially, was, “I wanted to buy them when I knew I couldn’t. Now that I can, now that one of my competitors is a seller, I have no interest.” And this, my friends, this is the real source of volatility. It’s a lack of conviction in one’s own analysis, spurred by the knowledge among institutional investors that short-term underperformance can kill a career. This is why the real edge in the market belongs to those not with the biggest computers, or the most up-to-date information, but the most patient capital. This can mean an endowment or a hedge fund with money tied up for a number of years. But it can also mean a calm, rational individual. It can mean someone whose investment thesis depends more on what’s really happening than what the guy across the street is selling today.



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The Buyers’ Pact It’s no secret that institutional investors and hedge funds like to travel in packs. They attend the same investor meetings and, in recent years, have started to congregate at “idea events” more regularly. In these events—typically dinners attended by a fairly small number of influential money managers—these investors share the theses behind various trades. They hope their sharp, educated, savvy peers will poke holes in the ideas, forcing them to go back and reexamine them. If the criticisms can be satisfactorily addressed, the investment thesis is still valid, though perhaps at a different price or with a less-aggressive targeted exit. This is a great idea in theory. Moreover, some of the participants in these events have probably made themselves more money in a good month than I’ve earned in my whole career. So what I’m about to say is intended respectfully. The structure of investment-manager compensation creates troubling potential for collusion. You see, money managers typically get paid on annual performance. But performance means marking to market. It does not have to mean realized, completed performance. It does not have to mean buying and then selling an asset—or selling short and then covering, for that matter. Although no two institutional investors use identical procedures, most of them are highly linked to the calendar year. They report their performance, marking their positions to the official year-end closing prices. In general, their performance is calculated as if the positions were closed out at those prices. There’s nothing even remotely illegal or unethical about this, per se. Indeed, the mutual-fund industry could not exist without this type of practice—otherwise, the notion of a net asset value, the price at which mutual funds change hands daily based on closing prices, could not exist. But if individual employees of an investment manager receive their compensation based on year-end marks, as opposed to actual completed trades, the implications require some thought. Suppose in the process of the investment-manager meetings, a consensus is formed on a given trade. “As long as the company

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earns x per share, the stock should go to y.” At the same time, conversations between these influential investors and company management impress upon management the importance of achieving those earnings. Now, as a company reaches its goals, and the consortium—tacit or otherwise—continues to buy the stock, a sort of perpetual motion machine comes into being. Performance begets performance. As long as the stock keeps getting marked higher, investors—professional asset allocators and individuals—keep funneling cash in, making it easier and easier to drive the stock to its goal. Meanwhile, analysts who find their price targets reached must decide—pull the plug or raise the target. And when the direction seems so clear, the path of least resistance is to raise the target, shooting even more adrenaline into the trade. I call these arrangements “buyers’ pacts.” Such pacts—implicit understandings among investment managers to keep buying, or at least not sell, holdings as long as the company stays “on message”— are healthy for the employees of these firms, but potentially devastating for their ultimate investors. A buyers’ pact requires a triad of investors, analysts, and willing company management. The company publicly tells of unexpectedly high revenues and growth, the analysts applaud the company while sparing it the difficult questions of the quality and sustainability of the growth, and the investors keep buying with impunity because there is no public “red flag” that might hit major news services. The trouble is, although any given investor can leave a buyers’ pact, they cannot do it as a whole. It becomes a sort of “roach motel”—easy to enter, almost impossible to exit. But as long as the right year-end mark is achieved, the individuals in the pact get paid. If you’re skeptical about the presence and importance of buyers’ pacts, consider the unfortunate analyst at a boutique research firm who downgraded a large, well-known financial services company in the final weeks of 2010.6 Evidently a number of clients of the boutique, large money managers, threatened to pull their business from the firm because of the downgrade, because of its timing so close to year-end.



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Now, for the average individual who puts money into mutual funds, the timing shouldn’t matter. Such an individual is in for the long haul. If there’s new analysis or information out there, though, the people charged with fiduciary responsibility for that individual’s money must take it into account in the asset-allocation process. You see, in the absence of the downgrade, the institutional investors could blithely hold their positions in the stock to year-end. With the tacit agreement of large holders to refrain from selling—and perhaps put spare cash to work buying more, thus driving the year-end mark even higher—they can act in their own best interests. If these holders get their way and the analyst holds off on his downgrade until the New Year, the employees of the manager keep the year-end performance mark, while the trusting individual is left with a stock trading lower to reflect the new research. It isn’t fair, and it isn’t right. Once the analyst’s call is in the public domain, members of the buyers’ pact have a dilemma. If they hold on while others sell, they potentially underperform their competition. They also subject themselves to external criticism—“how could you not sell after what that analyst said?”—should the stock go appreciably lower. The cat’s out of the bag. High-growth, mid-to-large-capitalization stocks (valued at, say, $10 billion to $20 billion, more or less) are particularly fertile ground for buyers’ pacts, especially when the company succeeds in convincing analysts and investors that it should be valued by nontraditional measures, and especially when management is particularly adept at developing a near-cult following from the analyst community. While the valuations of these stocks invariably lead to unhappy endings, the individuals involved—the portfolio managers, analysts, and especially the corporate executives—have usually cashed in rather fully by the time of comeuppance. In the Wall Street vernacular, you hear not of buyers’ pacts, as I think they should be known, but “momentum stories.” Momentum investing—arguably an oxymoron—is the game of seeing how far a trend can continue, with the implicit faith that the player can get out, not necessarily at the top, but before most of the gains are relinquished. It has some surprisingly robust theoretical underpinnings, largely because it goes against the natural, and often wrong, human

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instinct to cut winners short and let losers ride. But it’s basically a style of mutual agreement to stay in the game as long as the company “beats” its numbers, announcing regularly better-than-expected results. So a company that cleverly keeps expectations low can get its stock price substantially higher, thanks to the momentum crowd, than one that puts its cards on the table. The simple dichotomy, buy more on “beats” and sell everything on “misses,” is the core of the buyers’ pact. Buyers’ pacts are, indeed, one of the main reasons why the savvy individual investor should strongly consider managing at least some of his or her own money. Explicit, coordinated collusion—while not unimaginable—is not necessary for a buyers’ pact to work. It only takes the participation of the players I described.

The Myth of the Natural Other Side Hand in hand with the notion of buyers’ pacts goes the myth of the natural other side. You see, if the major accounts involved in a stock have an implicit understanding that the stock should be bought (or sold) at a given point in time, particularly when a piece of news that furthers that understanding has come to light, there is a problem. If they need to buy, who will sell? And if they need to sell, who will buy? When a major institution decides to buy a stock, the portfolio manager or managers send the order to the firm’s trading desk. Some orders have price indications or limits; others simply seek to get done as quickly as possible, or “at the market.” These institutions are so large that the orders pile up quickly. Traders at these firms are judged on the executions they obtain, frequently using the “volume-weighted average” of the day’s trades. But the one absolute is that market orders must get filled. A buy-side trader,7 as such individuals are known, will not keep his job long if he tells his portfolio manager that an order did not get done, especially if other competing institutions are getting their orders filled in the stock. After all, that’s the recipe for underperformance and missing benchmarks.



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Wall Street firms generate major revenues from the commissions large institutions pay to trade. Although commission rates are far lower than they were in the white-shoe era that ended decades ago, volumes are orders of magnitude higher. Still, there’s only so much business to go around. So firms try to distinguish themselves in one of two ways to get it. The larger dealers use their own capital—their own balance sheets—to win business. They announce regularly throughout the trading day which stocks they will buy and sell, sometimes representing customers, often for their own accounts. Meanwhile, smaller dealers, lacking much capital, must offer greater skill and discretion in matching buyers and sellers. These dealers typically specialize in smaller, less-liquid stocks, where trades must be negotiated carefully. The term trade by appointment comes to mind. Institutional customers typically say that they prefer firms not to “commit capital,” or use their own money to take the other side of what the customer is trying to do. They have two reasons for saying this. One is that dealers, when committing capital, need to price trades to minimize risk. Because of this, in general, a client will get a better price when the other side of the trade is “natural,” meaning another money manager, instead of a dealer. The other is that when a dealer commits capital and loses money in the process, the dealer’s representative will usually go back to the customer whose order caused the loss and ask for business to help offset it. But wanting a “natural other side” means being willing to be wrong, at least on this particular trade, with respect to a competitor’s trade. Suppose you are a large institution and you execute a big buy order, only to find that the other side, a competitor, now has more for sale, at a lower price. One of the most common questions salesmen get in such an instance is “who’s on the other side?” Accounts know that salesmen cannot disclose this—it’s a betrayal of trust that usually leads to immediate dismissal. And accounts understand this. But they are afraid, in a world of relative performance, that someone else knows something they don’t. When a salesman receives this question, there’s really only one permissible answer: “another smart customer, just like you, who

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receives the same confidentiality we give you.” But this doesn’t ease the fear that the account might be going the wrong way on this trade. After all, somebody else is doing the opposite. And most portfolio managers prefer to think they’re going the same way as the major competition. Either they’ll all make money together, or misery will love company and blame will be spread throughout the community. But when a dealer takes the other side of a trade, there’s the possibility that the account really got it right—being able, say, to sell at a price higher than any competitor would pay, or than any other competitor sells for later in the day. And when a dealer commits capital, the client doesn’t need to worry, at least for the moment, that a smart adversary was going the other way. When an account leaves a “working order”—an order that gets filled only when the other side of the trade is found—with a dealer, it can be seen as a no-win situation. Either the trade doesn’t get done at all, or the account is providing liquidity to a potentially better informed rival. Getting a trade done under these circumstances brings on a form of “buyer’s regret,” the concept by which someone willing to pay the best price, and thus obtaining the asset in question, immediately begins the self-doubting associated with the knowledge that nobody else would pay as much. So whether they say so publicly or not, accounts want a “natural other side” far less than they claim. Most of them want dealers to use capital at least in certain circumstances. Some demand it. This desire comes partially from the speed and ease of execution of having a dealer assume the risk of the position, of hearing “you’re done” on the wire. But it is also a direct result of benchmarking and the fear of underperformance. As Washington seeks to limit the risks big dealers take, in the hope of avoiding another financial crisis, it must come to grips with this reality. Limiting the risk of the institutions whose wheels spin the economy is certainly a good idea. It would be an even better idea if policy could discourage an investment mind-set geared toward benchmarks, indexing, and short-term measures. Although lower tax rates for long-term capital gains have problematic social implications, they are healthy to this extent: They tend to discourage a financial machine that needs dealers to take risks better suited to more patient money.



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The myth of the natural other side also helps to explain the popularity of new issues, where the seller is not a competing investor, but a company. On these trades and these trades alone, the investment community is in it together. Everyone’s in at the same price, and this is a huge benefit if you’re being benchmarked.

Summary: The One Reliable Natural Other Side Individual investors, whose livelihoods do not depend on hitting benchmarks, need not worry about this phenomenon. They can afford to look at price in a much healthier, more absolute sense. And by choosing well-priced convertibles as alternatives to stocks, they can maintain the long-term benefits stocks offer, while minimizing some of the risk of needing to raise cash selling stocks when there is no natural other side. For as long as a company doesn’t go bankrupt, if you own a convertible, the issuer plays that role for you.

Endnotes 1. M.J. Whitman, Third Avenue Fund Newsletter, July 31, 2004, p. 6. 2. For an excellent discussion of spin-offs and the opportunities they present, see Greenblatt, The Big Secret for the Small Investor: A New Route to Long-Term Investment Success (New York: Crown Publishing, 2011) pp. 63–65. 3. Press release of PDL BioPharma, November 19, 2008. 4. Using computers to make very large quantities of trades, rapidly in and out of stocks, based on perceived short-term supply/demand imbalances. 5. Trading environments not directly available to the average investor. 6. Noted industry site TheStreet.com had the following summary of an analyst downgrade: Well, money managers who’ve had a good 12 months aren’t about to let someone else mess it up at the end. So they will put their cash to work, bidding for stocks just under the share price. This creates a floor of sorts that prevents big sellers from breaking through. The defense can be so powerful, (host Jim) Cramer said, that the shorts unload their positions lightly so as to prevent the counter-buying from cutting into their profits.

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Another reason this trend plays out every year is because of the relationship between analysts and mutual funds. It’s a symbiotic one where analysts tend to hold back any significant downgrades until the New Year so they don’t hurt the annual performance of mutual funds. Cramer pointed to the downgrade last week of American Express by Stifel Nicolaus as an example of how this relationship can go wrong. Plenty of money managers were angry at the downgrade, he said, enough to threaten pulling some of their business from Stifel. That’s why Cramer doubts that any other analysts will make the same mistake as the year comes to a close. Lastly, the companies themselves go quiet at year-end, and for much the same reason that analysts won’t upset mutual funds—they, along with hedge funds, are clients. These funds own huge pieces of companies, and the companies don’t want to risk hurting the funds’ performance. So any bad news will most likely wait until after January 1 (from TheStreet.com, December 23, 2010). 7. Buy-side traders work for money-management firms and are responsible for getting actual trades executed, whether the order involved buying or selling securities.

3 Delusions and Illusions: Chasing Performance in Our Lost Decade It’s no secret that individual investors did a lot to promote the dotcom bubble. The unique mix of point-and-click Internet ease in buying stocks and a brave new economy of stocks with funny names was too irresistible for many. Short sellers, who usually play a critical role in maintaining valuations, could not provide much help. Many of the stocks were difficult to borrow for the very reason they soared—an extremely limited “float,” or number of shares outstanding. Even for the names that could be borrowed, however, shorting was dangerous to the point of making it unworkable. When something’s valuation already makes no sense, it’s difficult to make a compelling argument that it couldn’t just as easily make twice as little sense. This unalterable truth powered dot-com stocks for longer than many could believe. More important, the dot-com blastoff infected the validity of index investing and corrupted asset allocators who were paid to know and do better.

Cisco—Not What You Signed Up For The case of Cisco Systems has been widely documented. Cisco was not one of the dot-com fluff jobs—it was, and continues to be, one of the world’s most important and profitable technology companies. But Cisco, maker of the networking equipment at the Internet’s core, basked in too much reflected glory of the small, speculative firms. At its peak, Cisco was valued at about half a trillion dollars. As I write this, Cisco trades well below a quarter of its peak valuation. And 43

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yet the company has generated steady, growing earnings throughout the decade. Still, I know of more than one investor permanently alienated from stocks as a direct result of having bought Cisco near the top. It’s one thing for a tiny, growing company to trade at a silly valuation. It’s another for a firm whose very size makes the kind of growth such valuations imply almost mathematically impossible. And the idea that you can buy a good company without worrying about how its stock is valued is nonsense. Cisco, more than any other stock, corrupted the benefits of index investing in the dot-com era. The trouble with standard index investing is capitalization weighting. The bigger a company gets, the more heavily weighted it becomes in an index constructed this way. This is classic procyclicality: Buy more of what’s done the best. It’s a perpetual motion machine, not unlike a buyers’ pact, and it works until it doesn’t work. But its value for responsible money management is dubious. And I find it hard to believe that most people who invested in major index funds—no matter how much they might have enjoyed watching the funds rise in the late 1990s—were really thinking they wanted to go along for this ride. I think they believed they were buying the most solid, stable participants in the long-term growth of the economy. Although the companies themselves, for the most part, might have lived up to this, the stocks certainly did not. Now, saying that perpetual-motion-machine investing should be avoided is not to say that it’s good to buy things just because they used to be higher. That’s a fallacy and an awful trap. Many things go up, and down, for good reasons. But few continue indefinitely in either direction. The dot-com era was lethal to investors in that it combined the forces of individual trading ease, index procyclicality, and asset allocators’ performance chasing. The latter can be seen most clearly not in where the allocators were putting money but where they were taking it away. Professional managers who had served their clients well for many years found themselves bereft of capital because they stuck with their traditional valuation principles and refused to buy—or worse, sold short—the dot-com universe. I heard story after story of money managers with solid long-term records and disciplined approaches whose investors deserted them for not drinking the dot-com juice.

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Noteworthy among these was Julian Robertson, whose venerable Tiger Management tried unsuccessfully to go against the tide and ended up shutting down just as the dot-coms peaked. We’ll see later how the dot-com boom and bust created opportunities in convertibles, particularly for the hedge funds that successfully identified companies whose stocks were grossly overvalued but whose underlying businesses were solid enough to keep them fully creditworthy. If you follow the discipline I recommend with convertibles, which I call protected stock picking, you can participate in much of the upside of booming periods while minimizing your exposure to the inevitable falls. Much of the strategy comes to a straightforward discipline of finding companies you like with convertibles trading in the vicinity of 100—the price you are assured if you hold to maturity and the company doesn’t go under—and selling with defined targets usually 30% to 50% higher. This strategy, while reasonably simple, goes a long way to making market volatility your friend. You won’t get it from an index fund. Indeed, if you invest solely in capitalization-weighted index funds, you’re always at the mercy of a system that forces you into high-flying stocks. Whenever indexes rebalance, you will buy high and sell low. Although there’s much to be said for the simplicity and diversification of index investing, it strips you of the ability to make the bobs and weaves of the market work for you. This is reason enough in itself to consider managing at least part of your money on your own.

The Big Boys Make Bubbles, Too Even if you believe that the dot-com boom and bust was solely the fault of unsophisticated small investors—which I don’t—it led to another suspension of disbelief, which, in its own way, made even less sense. I’m talking about the credit bubble formed by the aggregate reactions to the dot-com mess and the Federal Reserve’s steps to keep the economy going after the awful events of September 11, 2001.

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Think of the markets as giant rubber bands that periodically get stretched and then released. They might have natural steady-state levels and trends, but disturb them and they will overextend one way and then the other. A fair question would be why markets, after recovering from negative disruptions, do not simply get back to their original levels. More often, they overshoot positively. And it’s this excessive positive snapback that often does most of the damage. This is where capital is most poorly allocated, leading to the greatest economic destruction. Consider the history of the credit markets during our lost decade of the 2000s. At the beginning of the decade, even as the market was enthralled by the dot-coms, credit markets were (as markets go) stable and reasonable. True, they had not fully recovered to the levels that preceded the Russian debt crisis of 1998—indeed, my snapback theory did not hold in this case. But, it could be argued powerfully that corporate credit was dangerously overvalued in the late 1990s before the Russian default. In the later stages of a prolonged economic expansion, investors had simply become too willing to take credit risk without being rewarded. Excessively rich credit markets are, I think, a phenomenon of the institutional mind-set I aim to criticize. Does it make sense to accept a, say, 6% annual return on a less-than-pristine credit without the possibility of substantially greater upside? I say, in most cases, no, and you would probably agree. But if you’re an institutional corporate bond manager, you’re not really paid to make this call. And you can lose your job for thinking this way. Think back to the case of Jeff Vinik, the former block trader1 who went on to run perhaps America’s best-known mutual fund, Fidelity Magellan. After a successful bet on technology stocks in the mid1990s, Vinik decided the market had come too far, too fast, and moved largely out of stocks and into bonds. Trouble was, the market didn’t cooperate and continued higher. In the bigger scheme of things, for one of the country’s most successful investors, Vinik’s underperformance was not really disgraceful: In his final six months at Magellan, the fund returned about 5% versus nearly 14% for the market. He had been wrong in the near term to be conservative, but he was still making money, though investors expecting marketlike performance had a right to be disappointed. Still, his well-timed and independent

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previous emphasis on technology stocks had kept him well ahead of most of his peers over a more meaningful time frame. Vinik eventually left Fidelity to run money on his own, which he did with great success. But as long as he was in charge of Magellan, no matter what his previous success, he was essentially not permitted to underperform the broad stock averages by any noticeable amount. To some degree, this is understandable. Regardless of the fine print in Magellan’s prospectus, which gave Vinik the latitude (and more) to take the kind of stand he did, it’s reasonable to assume that virtually everyone who had invested in that fund wanted fullbore exposure to stocks. The upshot was that it’s not really the manager’s choice to deviate from the investors’ presumed intentions. Put another way, if you deviate, you had better be right, because there’s essentially no tolerance for being different and being wrong. Unfortunately, this mind-set—for the Vinik story has served as a warning for managers skeptical of the value of their chosen asset class—is conducive to the kind of volatility most would argue harms the economy. Since then, most professional money managers have feared underperforming an up market at least as much as sustaining absolute losses, even when their best professional judgment tells them they are paying full valuations or worse.

Bubbles: Bonds Versus Stocks Anyway, corporate credit markets began deteriorating around the dot-com peak in early 2000 and continued a fairly steady decline, with occasional sharp bouncebacks, into late 2002. The convertible hedge fund I comanaged was one of the best performers over that period because we’d kept hedges against general credit deterioration in place. High-yield bonds took a beating, with defaults rising sharply amidst a tottering economy. The collapse in technology stocks, more than a few of which had issued convertibles during the bull market, dragged those converts down to busted, pure yield status. Many stocks were trading at less than 25% of their bonds’ conversion prices, thus effectively saturating the high-yield market with more paper at precisely the time of greatest pain.

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But in October 2002, the high-yield market bottomed. And while high yield’s decline had been surprisingly calm and orderly, its return to health in early 2003 can only be described as vicious. So desperate to keep up were the professionals who found themselves with excess cash, even as their peers were marking positions higher day after day, that Wall Street quickly manufactured a huge pipeline of yield for these lagging managers. It wasn’t enough to stop the rally—cautiously managed funds returned 20% to 30%, and aggressive ones did far better, in 2003. But this fierce momentum trade did set the stage for continued accumulations of corporate debt at prices not reflective of the risk/reward trade-offs involved. A bull market in corporate debt, though, has rather different properties than one in equities. Remember, as you always must, that straight debt’s upside is capped. Because of this, even as debt can be priced unappetizingly, it cannot reach the lunatic fringes sometimes tested by equities. Moreover, to a large extent, debt’s strength is selfreinforcing, at least to a point, in ways that equity’s can never be. You rarely see straight debt trade above, say, 120 cents on the dollar, and bonds that do reach those levels are frequently refinanced with the issuer repurchasing bonds at those levels to replace them with lowercoupon debt. The bond market can largely be thought of as a bank that keeps rolling over loans to its creditworthy customers. Equities are different. Without built-in floors, they can be driven far above reliable support levels by momentum buyers, only to fall brutally when the pacts implicitly formed by those buyers go the way of mice and men’s best-laid plans. Moreover, bonds have finite lives, and the investors who own them need new supply to replace maturing paper. Stocks, though, can go on essentially forever and do not need to be replaced. New issues, thus, must eventually depress the value of existing stocks as investors look to reallocate their capital. The point here is that bond bubbles—particularly in corporate credit—can not only exist, but can go on for years. The trouble with them is that the debt market is so huge that the sheer weight of its decline can be an accelerating force. Think of a stock collapse as a small stone from a forty-story building and a bond crash as a boulder from a ten-story one. They both do great damage, but while the stock collapse tends to hurt only the unfortunates who have invested too

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much in the exposed overvaluation, the bond fall wipes out everything in its wake. But it takes a lot longer to push the boulder off than the little stone—the buildup can take quite a few years. A good way to check whether corporate bonds may be due for a plunge is by watching the controversial VIX, or volatility index of the S&P 500. Remember that when you buy straight corporate bonds, you’re effectively selling volatility. The VIX tends to scream above 40 during periods of market duress—it briefly pierced 80 in the worst stretch of 2008—but most typically resides in the teens and twenties.

The VIX: Markowitz’ Error and the Best Contrary Indicator Out There From late 2002, when the high-yield market’s sustained decline ended, to the 2007 beginnings of the financial crisis, the VIX did its best impression of Benjamin Button, the man who aged in reverse. It steadily fell from around 40 to a preteen-ager. A decline like this in the VIX means that investors who have been selling volatility have been cleaning up, whether through the actual sale of options or through a related trade like the ownership of high-yield bonds. When you see VIX in the teens—or lower—be wary of committing significant funds to the high-yield market. Chances are you’re not getting sufficiently paid for the risk you’re taking. Although a VIX reading this low does not necessarily portend the kind of high-yield collapse we saw in 2008, it does mean it’s time to be especially careful. It means that performance chasing and fear of missing benchmarks has likely supplanted far more basic risk/reward considerations. Remember our discussion of the flaws in Harry Markowitz’ line of reasoning, that investors worry primarily about variability as the key measure of risk? The way VIX moves largely disproves it. Without fail, it goes up in falling markets and down in rising ones. Although it might be true that investors who manage money for others are worried about relative performance, those whose actual fortunes are on the line think differently. They usually get especially nervous about losing after the worst losses have already happened.

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Endnotes 1. One who handles large stock trades, not someone who buys and sells children’s building toys.

4 A Change Is Gonna Come Good ideas have a way of turning bad when they start being applied in manners beyond their original intent. Consider our educational reforms. In the name of “No Child Left Behind,” we are having an outbreak of a phenomenon known as “teaching to the test,” wherein curricula are designed to ensure that students pass specific examinations. Now, passing the test is great, but it’s supposed to happen organically. Students are supposed to pass key examinations by drawing from the body of knowledge they’ve acquired, not by an unsatisfying, targeted set of lessons quickly forgotten. The test is supposed to be a means, not an end. But in a culture that cheapens its standards to deaden the pain of decay, it has become the be-all and end-all but ends up signifying next to nothing. The best test I ever took was in a sophomore honors microeconomics course in college. The professor designed an exam such that memorization of formulas and theorems would be almost completely useless. The smooth curves assumed by all the theoretical constructs were replaced by unusual functions we’d never seen in any of the problem sets. Only by thinking about the core ideas we’d learned could we attack the questions. I came out of the exam feeling that I probably hadn’t scored well, but exhilarated by the exercise my mind had been through. I was right on both counts—I only scored 75 out of a possible 120, but it proved to be good enough for an A. The professor saw no purpose in writing an exam a robot could pass. He wanted to see how we would think, how we would adapt to problems demanding creativity. In other words, he was trying to prepare us for whatever might lie ahead, at least within the context of the course.

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Teaching to the test is the polar opposite. It assumes that life will offer a static group of challenges. It promotes the fiction that we know what lies ahead. It sends a horribly misleading message to our students that being spoon-fed a set of mechanical rules prepares them well. And it closes the mind to other avenues of thought. Although it’s certainly good to make sure our students have the basic tools they need, teaching to the test sends all the wrong signals. A real test tells you not only that the students learned the material, but also that they understand when it doesn’t apply, and that they are prepared to handle related, but meaningfully different, problems, not just the ones they’ve already seen.

Indexing: Wall Street’s Teaching to the Test So it goes with index investing. Once upon a time, the idea behind indexing was that a great body of sophisticated work was being done to evaluate and price stocks. So much work, in fact, that adding a little more was virtually pointless, almost like reinventing the proverbial wheel. Why not take advantage of the labors of others? But, just as with teaching to the test, index investing takes a premise with bits of validity and extends it past the point of workability. The logical result of hard work becomes a goal in and of itself. Once the conventional wisdom has become that the index cannot be beaten, trying to do so looks like a foolish waste. And much of the rich, nuanced work that went into figuring out what businesses are worth—and what would be a smart price to pay for them—gradually deteriorates into more cost-effective ways of buying or approximating the index however it’s constructed. Penny-wise and pound-foolish. The potential social costs of an indexing culture are rather frightening. When the government stepped into the depths of the financial crisis to rescue the automobile industry, we heard cries of “we can’t have the government picking winners.” But apparently it’s acceptable to have index makers—sometime affiliates of the rating agencies that abetted the housing crisis—pick them. It’s quite ironic that a business culture so focused on trumpeting the benefits of a pure, unfettered



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capitalistic free-for-all willingly accepts being measured by the standards of a few statistical bureaucrats. If we tell people they should just buy index funds, we’re allocating billions of hard-earned dollars on the basis of some fairly narrowly based decisions. It doesn’t seem right to me. It seems kind of dangerous. And it’s especially dangerous when there’s so much closet indexing going on. But that’s what happens when we teach to the test, when we think we already know the answer. We don’t, and we never will. The sooner we admit that we don’t know—and that we need to encourage creative, open-minded thinking that challenges orthodoxy—the better off we will be. My older daughter loves to ask questions. Some of her best have been:

• Is infinity really a number? • Is there really a middle of nowhere? • If there are no dinosaurs now, does that make stories about dinosaurs fiction?

I always tell her that I never want her to stop asking questions. I hope I’m not raising her to go into a world that thinks it knows the answers.

A Modest Proposal...Taxing the Closet Indexers If you believe that figuring out what companies are worth has value, and that there’s social good in allocating scarce capital to the businesses best situated to use it, you’ll want to read this part. Remember that the idea behind indexing was that markets are efficient. Enough work has already been done in setting prices so that additional research is unlikely to produce any added value. The market, essentially, already has it right. Don’t waste any more time or money trying to figure it out. Add closet indexing to the equation, and the theory, even if you believed it in the first place, starts to break down. More and more

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people charged with analyzing securities are instead taking someone else’s word for it. The decisions on where society’s capital goes are falling to fewer and fewer active participants. So we’d all better cross our fingers and hope they are right. But what if you think we’ve gone too far in the other direction? Think of the market as a multilane highway, or as we Californians call it, a freeway. Some of the lanes are reserved for those following the indexes, while others are open to those who—either through well-chosen professionals or their own work—make independent investment choices. Meanwhile, the closet indexers, their numbers growing, are trying to force their way into the indexer lanes to avoid the tolls (namely, the price of research) charged by the independent paths. As more and more drivers crowd into the indexer lanes, the possibility for accidents increases. Too many cars are driving too fast, unable to see where they are going. The road wasn’t built to accommodate so many of them. People are sending money to them, thinking it’s being professionally managed, only to learn it’s blindly following someone else’s choices. What is to be done? Here’s what I propose. Just as toll roads charge users, so should the markets charge closet indexers. The true indexers shouldn’t have to pay—they are providing a legitimate service by keeping costs at a minimum for investors who make the conscious choice to go along with the selections of a statistical bureaucracy. Some might feel it’s a wise choice, others not, but at least it’s an honest one. But the closet indexers are a different story. They’re trying to run portfolios that track the indexes while getting paid as if they are doing the painstaking, dirty work that unlocks hidden values. It’s deceitful, it’s wrong, and it’s causing markets to careen this way and that when they don’t have to. We should require all mutual funds to declare themselves as either indexers or nonindexers. At the end of each year, the daily performance data for each fund will be compared against the major stock indices. I’m not a statistician, so I don’t know exactly what criteria



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should be used, but if a fund not declared as an indexer should be found to have indistinguishable day-to-day performance from a wellknown index, it would have to pay a fine. The fine would equal a portion of the difference between the fees charged by the fund and the average fees charged by indexers. The closer the performance to the benchmark, the greater the fine. Funds declaring themselves as indexers would be exempt from this procedure. But they would have to notify shareholders of their status and post the declaration publicly on all marketing and related materials, Web sites, and so on. Investors would thus have no reason to pay for active management while receiving the work of an indexer.

Educated Investors Make Resilient Markets How would the fines on the closet indexers be used? They would support the establishment of an independent research body. This research would be posted on the Internet, available for a nominal charge to all investors. Retired analysts would supervise up-and-comers, with an emphasis on the smaller companies often ignored by Wall Street firms but responsible for much of the growth in our economy. Analysts would be responsible for industry overviews and for identifying potentially undervalued and overvalued situations. Users willing to pay slightly higher fees would be able to address specific questions to analysts. The objective would be to make the general public more conversant with the investment process—something we badly need after the events of recent years. I would also recommend that part of this public-interest research effort be dedicated to educating investors of the world beyond pure common stocks. Focal points would be corporate bonds, options, and, yes, convertible securities. Do I expect my proposal to be implemented? Unlikely. But I hope that it will raise some questions about the ground rules under which our markets operate. Again, the events of recent years have damaged investors’ trust, and the force of too much money rushing in and out of the same trades one day to the next does little to help. The

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answer, I think, is education: teaching people that with a reasonable amount of attention and diligence, the markets offer them tremendous opportunities. The benefits of being small and nimble, with no bosses or fiduciaries peering over the shoulder, are far greater than most individuals realize. The institutions that are trying to think for themselves, ferreting out value in poorly understood situations, absolutely deserve to charge investors for the work they do. Good research is difficult, expensive, and worth it. And although nobody goes into Wall Street to help people, the fact is that a well-functioning and transparent capital market is one of our nation’s greatest assets. When I returned to my office in downtown Manhattan on September 17, 2001, the day the markets reopened, I felt a sense of pride in my occupation like never before or since. By doing my part to keep our markets going, helping them serve their functions of valuing assets, allocating capital and pricing risk, I was doing what I could as an American to prove that the terrorists had not won. When our markets collapsed in the fall of 2008, I began writing for Minyanville, trying to show investors who wanted to take advantage of depressed prices but were afraid of stepping in that convertibles offered the best way of doing it. We need to make our policies, and our customs, reward those investors who look beyond the comfort of indexes and the cover of what someone else is doing. We need to make independent thinking attractive while discouraging the false security of buying the same thing the other guy buys.

On to Convertibles... Speaking of convertibles, the rest of this book will be about them. There are many good reasons to add convertibles to your investing arsenal. But perhaps the best comes from the crowding and herding that comes from a market dominated by indexers and closet indexers. You see, when you invest in convertibles, as long as you buy them properly, the selling largely takes care of itself.



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When you buy stocks—and there’s often very good reason for owning them—you have to commit to a fairly indeterminate time horizon. You can be right, but the market might not agree with you, for months, quarters, and even years. Guessing what will turn the market’s opinion your way, and how long it will take, is often a fool’s errand. But if you buy convertibles right, you take most of this pressure off. As long as you don’t pay too high a price getting in (something you fully control), as long as you don’t make catastrophically bad choices, and as long as you match your time horizon to the bonds you buy, you put the risk/reward calculus entirely in your favor. Exuberant and buoyant markets will bring you substantial returns—bleak ones will leave you intact. The day-to-day gyrations of risk-on, risk-off, and the rush of the indexers into the biggest and most expensive stocks, will all be a source of amusement to you. Your own investments will be made of sterner stuff.

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5 The Very Basics We’re about to go on a brief tour of my experiences as a convertible trader. I hope this little journey will help bring convertibles alive for you and prepare you to learn more about this fascinating, often superior investment. Before we start the tour, I’m going to give you the most basic measures convertible professionals use to define the essence of the product. We’ll dig deeper once the tour is done, but a couple of minutes now will take you a long way.

How to Speak Convertible-Ese Convertibles, as you know by now, are part-bond, part-stock instruments. Industry shorthand for convertibles involves summarizing these attributes with a quick two-number description, such as “3s (pronounced “threes”) up 30.” What does this mean? The “3s” is the bond part, meaning the bond’s yield. Yield is supposed to imply the annual income a bond generates, or a reasonable facsimile. The easiest way to calculate yield is to figure current yield, obtained by dividing a bond’s annual income by its price. A bond trading at 100 and carrying a 3% annual coupon would have, naturally enough, a yield of 3%. In more technical terms, bonds are typically sold in denominations of $1,000. If you buy $1,000 face amount of a bond with a 3% coupon, you’re supposed to get $30 in annual income. $30 divided by $1,000 is, of course, 3%. Just to make things confusing, even though bonds are typically traded in $1,000 increments, they are quoted in percentage terms. So 61

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if you pay $1,000 for $1,000 face amount of bonds, for quoting purposes, you are paying 100% of par, or just 100. It’s not really as muddled as it sounds. For actual dollars-andcents trading amounts, think in terms of 1,000. For price quoting, think in terms of 100. We’re going to go with the price-quoting convention in this book. If it seems silly, have a chuckle and think of the Monty Python skit about a furniture store with a quirky staff. One of the salesmen, Mr. Lambert, puts a bag over his head whenever he hears the word “mattress.” Another, Mr. Verity, overstates all numbers by a factor of 10. So when you need to go from the way a bond is quoted by a broker to the way it’s technically calculated, pretend you’re Mr. Verity. A bond quoted at 90 is really a bond trading at $900 per $1,000 face amount.

Right of Way: Understanding Yield But as far as calculating and quoting yield, we need to get just a bit more involved. Current yield—the yield you get when you divide the annual income by the bond price—can be very misleading. It overstates what you’re really getting when the bond is trading above 100 and understates it below 100. For example, let’s say a convertible bond with a 5% coupon is trading at 125. This could happen if the underlying stock performs well after the bond is issued. If you just do the current yield calculation, you’ll obtain 5/125, or 4%. So if you’re not careful, you might be deluded into thinking the purchase of this bond promises a 4% annual return. Very little could be further from the truth. If you buy a convertible at 125 and the stock doesn’t perform well subsequently, you’re probably looking at a money-losing performance, even after giving effect to the coupons you collect. Let’s say that when you buy the convertible, the bonds mature in three years—meaning that you’ll collect 5% per year, or 15 “points” of coupon income over that period. If when the bonds mature you cannot convert them into stock worth more than 100 per bond, you’ll end up losing 25 points, more than offsetting your coupon income. You actually, in receiving 100 upon your



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bond’s maturity, lost 10 points on balance: getting back 25 less than you paid, but easing the pain with the 15 points of coupon income. Losing 10 points on an investment of 125—that doesn’t sound like a 4% return to me. It’s actually a negative return of almost 3% per year. The lesson: Never use current yield when looking at bonds trading above 100. Flipping this over, when you buy bonds below 100, current yield only tells you a part—sometimes a pretty small part—of what you’re hoping to make. Consider now a bond with a 3% coupon trading at 75 cents on the dollar. Your current yield is (3/75) or 4%, the same as in the previous example. But what happens now if you get 100 back for your bond in three years? Not only did you collect the annual income, you also picked up 25 points of capital appreciation. Your annual return ended up being better than 13%! Current yield was a horrible measure of the bond again, but this time in the opposite direction. In short: When you hear someone talk about yield, unless the bond is very, very close to 100, make sure it’s not current yield they’re talking. The better measure is the yield for the planned holding period, typically the bond’s maturity or the equivalent. Most spreadsheets have easy-to-use yield calculation functions, so that if you know a bond’s price, coupon, and maturity, you can quickly obtain the yield. A lot of handheld calculators also offer yield functionality, although I’ve always found it annoying to use them for this purpose because several inputs are required and it can be tricky to keep track of what you already entered.

Premium: A Convertible’s Defining Trait Now to the second part of the convertible shorthand quote. Whereas the yield number was designed to capture the convertible’s bondlike properties, the second number, known rather clumsily as “conversion premium,” is supposed to give you a feel for how sensitive the convertible is to the underlying stock price. The lower the premium, the more stock sensitivity. A “high-premium” convertible, on the other hand, tends to trade primarily like a traditional, nonconvertible bond.

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To calculate a convertible’s premium, all you need are the bond’s market price, the price of the underlying stock, and the conversion ratio. People with a passing knowledge of convertibles more commonly refer to the conversion price rather than the ratio, but it’s the ratio, not the price, that’s actually specified in a convertible’s documentation. No matter—you simply get one by dividing the other into $1,000, except in very unusual cases. For instance, a convertible bond with a conversion ratio of 50 ($1,000 face amount can be converted into 50 shares) can also be said to have a conversion price of $20.1 After we finish our tour, we’ll spend some time talking about what constitutes a reasonable conversion premium. For equity-sensitive convertibles, this is the Holy Grail. It doesn’t do you much good to buy a convertible, seeking to participate in an upward stock price move, if you pay too much premium up front. At the same time, a convertible that might have a little too much premium to appeal to a purely quantitative trader might make total sense for you, depending on your time horizon, outlook, and risk tolerance. To understand conversion premium, it’s probably helpful to think of the kind of premium you’re most used to, insurance. You can think of paying conversion premium as buying insurance in the form of the right to turn in your bond at maturity and get its face value, instead of converting it into stock. When you’re very likely to exercise this option—not to convert—and take par value instead of stock, conversion premiums are very high, as if you’re buying insurance on a house you think is almost certain to burn down. This describes the typical “busted” convertible, which trades essentially like a straight bond, where the market price is a multiple of the bond’s conversion value. A convertible trading at a price of 80 that can be converted into stock worth 40 (i.e., a conversion premium of 100%) would be a good example—the expectation is that you are more likely to redeem the bonds at 100 than convert them. On the other hand, a convertible trading at a price of 250 is unlikely to have a conversion premium more than several percent because you’re very unlikely to end up taking 100 for your bonds—that price, after all, would imply a 60% loss. So just get used to this mantra with convertibles: High price means low premium, and vice versa.



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Back to our example. The bond is convertible into 50 shares per $1,000 face. If you prefer to think in terms of 100, the way bonds get quoted, just divide by 10 and think of the math as 5 shares per bond. This is actually easier. So let’s say the stock is trading at $21 per share. This makes its conversion value 50×21, or $1,050. You can do a reverse Mr. Verity to get the conversion value into the form people actually discuss, 105. If the market price quoted by your broker is 125, you can calculate the bond’s conversion premium as follows: (125–105)÷105. You take the difference between the market price and the conversion value, and divide that difference by the conversion value itself. In this case, you’d get 20÷105 or 19%. Again, you will typically see a mix of low yields and premiums for equity-sensitive convertibles and higher measures for bondlike ones. “1s up 20” might characterize a convertible expected to move considerably with the underlying stock, while “8s up 150” would represent a bond more sensitive to interest rates and the credit markets. Let’s get to the story. There will be plenty of time to learn more about yields and premiums later. As a quick reference, please use the following summaries (see Figures 5.1 through 5.5) of the different convertible profiles.

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Figure 5.1 Key Features of Hybrid Convertibles

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BEATING THE INDEXES

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Figure 5.2 Key Features of Busted Convertibles

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Figure 5.3 Key Features of Equity Substitute Convertibles

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Figure 5.4 Key Features of Distressed Convertibles



Chapter 5 • the very basICs

67

 

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Figure 5.5 Price Points for Different Types of Convertibles

Endnotes 1. One unfortunate aspect of people talking about conversion prices is that it leads to a natural, but entirely incorrect, assumption that if you own a convertible bond and the underlying stock goes above the conversion price, you should immediately convert the bond. Not so. You only convert at the very end, when you’re forced to choose between stock (or its cash equivalent) or the face value of the bonds. Until that time, for reasons we’ll get into later, the convertible’s value exceeds that of the pure stock, and the latter is all you get by converting. If you want to take advantage of a rising stock price and lock in some profits, don’t convert, just sell the bonds in the market.

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6 Reminiscences of a Convertible Operator I think a good way to learn many of the key ideas behind convertibles is in narrative form. Too often, teaching is done with textbooks that talk at you, not with you. I thought I would tell some of the stories of my own experiences with convertibles and convertible-like things. We’ll go back later to focus on the concepts you need to understand in more detail. In the meantime, I hope you enjoy the tour.

Bond Basics and Learning to Play the Game I started trading convertible bonds at the end of 1993. I had been an options trader for about a year and a half, working for PaineWebber, the old-line wirehouse firm that ultimately was taken over by the big Swiss bank UBS in 1999. I’d been fascinated by options when I studied them in business school and was thrilled when PaineWebber offered me a job in 1991 doing options research. It was a tough time to be coming out of business school. The economy was still in recession and Wall Street was not hiring. We were only a year or so removed from the collapse of Drexel Burnham Lambert, the banker that popularized junk bonds as a way of paying for hostile takeovers. With Drexel went sentiment on the Street, at least for a while. I had been fortunate to get a summer internship in 1990 in Goldman Sachs’ fixed-income division. I’ve never been particularly good at interviews, but for whatever reason, I had my “A” game the day Goldman brought me into New York. I sat down with one of the heads of the division. He quizzed me on where a number of key market indices were—kid stuff if you wanted 69

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an entry-level job on the Street. He acknowledged my answers, nodded, looked away for a moment, and then stared right at me. “Thousands of people want this job. Why should I hire you?” I’m still not sure how I did it—if I’d rehearsed this line, it would have sounded tinny and wrong. But, whatever the reason, I was precise, confident, authoritative. “I’m smarter, I’m quicker, and I want it more.” They called me with the job offer a couple of weeks later. Every morning I got in early, read the Wall Street Journal, the New York Times’ front and business sections, and, as often as possible, the Financial Times. I moved from week to week between different parts of Goldman’s bond business, picking up phones to relay information and learning the lingo. I had thought I wanted to be a trader and everything I was experiencing seemed to confirm it. I knew I was lucky to have the job—I was one of four MBA students hired as summer fixed-income associates, down from 40 the year before, before Drexel. The first thing we learned was the value of an “01,” also known as a basis point, or one one-hundredth of a percentage point. To a bond trader, this is everything. A small change in interest rates doesn’t mean much to short-term interest-bearing securities, but to longerdated ones, it’s huge. If you buy a one-year Treasury bill, and interest rates suddenly jump by one percentage point, it’s not that big a deal. The bill you bought at 98 is now worth 97. Why? If you bought the bill at 98, you were expecting to make slightly more than 2% on your investment. Treasury bills don’t pay interest—you make your money on the difference between what you initially pay and what you ultimately receive. Paying 98 today to get 100 in a year means a return of 2.04%—the 0.04% comes because 100÷98 is actually 1.0204, not 1.02. But 2% is a good enough approximation for government work. If rates go from 2% to 3%, a one-year bill is now only worth about 97 because paying 97 today to get 100 in a year means a return of 3.09%. Now consider a ten-year Treasury bond that, like a Treasury bill, doesn’t pay interest but provides all its return on the difference between what you pay and what you get at the end.1 If you buy such a ten-year security when the relevant annual interest rate is 2%, you pay a price of 82.2



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The Best Calculator Is in Your Head If you like to approximate—and I think the ability to approximate is critical, especially for students getting started in finance and business—you can see that the order of magnitude makes sense. If you’re buying something at 80 and getting 100 for it in ten years, that means you’re making a 25% return over the period. A straight-line approximation would be 2.5% a year. But this ignores two things—first of all, you’re paying 82, not 80, so the return is going to be somewhat less than 2.5%. Also, the straight-line approximation ignores the effect of compounding, which adds up over longer periods even at low interest rates. OK, so you’ve bought this ten-year quasi-bill for 82, yielding 2%. Now let’s say rates for this kind of paper spike to 3%. When we were looking at one-year bills, the rate move meant a loss of about one point, 1%. What about on the ten-year? Well, it turns out that to give a new buyer of this security an annual yield of the now-prevailing 3%, the price has to drop all the way to 74. That’s a decline of approximately 10%. Ouch. You should use your approximation talents to convince yourself that this makes sense. (Just to make sure—making 26 on an investment of 74 is 35%, which straight-lined over ten years is 3.5% annually, but that’s before compounding.) In case you’re wondering what the big deal is about approximation, talk to anyone who’s made a big, embarrassing, expensive mistake by mispunching a number into a calculator or spreadsheet. Lose a potential client by looking foolish getting something wrong by a factor of 10 and not immediately correcting yourself. Trust me on this.

Duration: Longer Bonds, Bigger Moves OK, so we’ve seen that on a one-year instrument, a one-percentage point rise in rates means a 1% or so drop in value. On a ten-year piece of paper, the same interest-rate move means a 10% decline. Remember that these securities did not pay coupons.

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This is telling you what you probably already knew—having your money tied up for a long time, when the market moves against you, is a lot more painful than having it in something that comes due pretty soon. With the short-term paper, you take a little loss, but then you get to reinvest pretty soon at the new, more favorable rate. Not so with the longer-dated stuff. Did you notice that the percentage move in the notes bore a striking resemblance to their maturities? This was no coincidence. But it’s also the main concept they wanted us to learn that summer at Goldman. It’s called duration, and it measures a bond’s sensitivity to changes in interest rates. It seems like a strange word because it’s supposed to measure price changes, and it sounds like it measures time instead. But as we’ve seen, the two are very closely related. In fact, when the bond doesn’t pay periodic interest (as in our examples), the two are pretty much identical. So if bonds didn’t pay coupons, but just paid off at maturity, their durations would always be essentially the same as their maturities. A five-year bond would thus move about 5% with a one-percentagepoint move in interest rates, and so on. Of course, most bonds do pay periodic interest. How does this affect duration? Think about it. The longer it takes you to get your money back, the higher duration is, and the more sensitive your bond is to changes in interest rates. We’ve already seen this. When you buy a bond that pays regular interest, it’s effectively returning some of your money sooner than a bond of the same maturity where you get everything back at the end. So your money isn’t tied up quite as long and, thus, the duration is somewhat lower. For a ten-year coupon-paying bond in a low-rate environment, the duration is about 8. For a five-year bond, it’s about 4.5. You should be starting to get the idea. In a higher-rate environment, durations are lower, which should make sense. When rates are high, you tend to get a higher proportion of money in coupons instead of your final principal, and you get to reinvest it at higher rates. Figure 6.1 shows that duration rises nearly as fast as maturity in an environment of very low interest rates. But when rates are high, the duration of a very longdated bond is not much higher than that of a substantially shorterdated one. This is really telling you that when rates are high, the value



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of principal repayment at maturity is relatively small compared with the coupon stream. Of course, as I write this, we find ourselves in an extremely low-rate environment.

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