In Investing, Nobody Knows You’re a Cat

July 7th, 2017 by Potato

I’ve seen multiple versions of the same question chain, which starts easy enough: basically in investing isn’t performance after fees what really matters?

Yes, what you really care about at the end of the day is your performance after fees.

So then isn’t it worth paying a higher MER for Fund X when it out-performed the index last year/over the last 5 years?

And that’s where the arguments start. If you had a time machine, sure, go back and invest in Fund X. Or just buy that one stock that did the best over that time period and do even better. Or see some dinosaurs — it’s your time machine, do what you like. But starting from today and going into the uncertain future there’s no way to say whether Fund X will continue to out-perform net of fees without that time machine. You have to choose where to put your money without the benefit of knowing in advance which fund is going to earn its fees and then some. Then seeing that most actively managed funds don’t beat the benchmark, you can at least control your costs and invest in a low-cost index fund, which is going to do better than most of the other choices you could have made.

But that explanation doesn’t always resonate, so let’s try a different approach.

There’s a clever little expression that I like: on the internet, nobody knows you’re a dog.

And then there’s this interesting little human interest story: a cat won an investing contest. A mash-up of the two gets us this catchier bit of advice: in investing, nobody knows you’re a cat.

Portfolio manager cat reviewing research material.

The manager your favourite mutual fund pays may pick great investments and out-perform the market, even net of fees. And that may be because your manager has great skill and discipline, and is able to continue to beat the market… or it may be because of dumb luck.

It’s extremely difficult for an outsider to tell the difference in a world where cats can beat professionals, a world where even highly paid, ostensibly skilled managers mostly under-perform. So yes, at the end of the day all that really matters is performance after fees, but without a time machine the best chance for getting that is to minimize your fees.

Never Weight — 2nd Quarter Update

July 1st, 2017 by Potato

I started the year off with some goals and made some early progress. In the second quarter though, that momentum was lost and things were bad, as you could probably tell by the fact that I all but disappeared from the internet. Weight backslipped (up a pound over the quarter), sleep was garbage, exercise program completely derailed.

Meaningless excuses: first off, I was sick for a month or month and a half in April/May. Spring allergies, head cold, strep throat, combination thereof, whatever it was I had a hell of a time concentrating and writing. I barely made it through each work day and then had nothing left for side projects/blogging/getting in shape.

Which is a real shame, because Blueberry was going to give me a medal if I managed to check off every cell in my exercise regimen for June. A medal! And I couldn’t do it. So I kind of feel like a failure as a father as well as on my own personal health goals right now.

Then in May I got a device to help my sleep apnea, a special mouthguard from my dentist that repositions my jaw to keep my airway open. It works for the primary outcome: I don’t snore or choke with it in. However, it takes me an extra hour or two to fall asleep with it because it feels weird and my jaw aches sometimes from holding the strange position. So it’s a bit of a catch-22: a small amount of good sleep, or a larger amount of sleep with apnea and snoring (because there aren’t enough hours in the day to just go to bed earlier and get both). Either way, as June comes to a close I’m feeling super sleep deprived, like it’s exam time cramming or a major grant deadline level of dark rings under my eyes. The last few days I have been falling asleep better with it, but it may take the rest of the month to get back to caught up on sleep.

Anyway, for the third quarter of the year I’ve got to get back on track: sleep better, exercise regularly, eat decently (in that order of priority).

Decisions Under Uncertainty and the HCG Example

May 31st, 2017 by Potato

A major problem with human decision-making is that we have to do it with incomplete and conflicting information. It’s hard. And there’s a lot of uncertainty and randomness involved — moreso in some areas than others — so it’s hard to fine-tune our decision-making through trial-and-error. In some cases, we may only get one shot at a decision.

A lot of the time we have to weigh the probabilities of different (often conflicting) opinions and bits of evidence. We can take a sort of Bayesian approach, even without getting into the math: based on what we know already, we think some bits of information informing our opinion are likely to be true and helpful, and others are not likely to be true and helpful. For example, if I’m trying to pick where to go for dinner when I’m out of town for a conference, I could ask a few people for their suggestions. I’m going to put more weight on the advice of my friend Alex who has similar tastes to me than I would on the hotel concierge (a complete unknown who may be getting kickbacks to point guests to a restaurant) or my friend Ahab, who cares more about how food is sourced or presented than how it tastes. I’m also going to have a huge prior probability of choosing a pizza place, so it would take a very strong recommendation to move my decision to say a greasy spoon.

In investing, I might put some high probability on the likelihood that the income statement and balance sheet are right, and some low probability that someone ranting on Twitter or on a blog is right, then come to a decision as to whether or not to invest in a company.

The next trick then in your probabilistic model of the world is when do you shift your decision? There’s a lot of good stuff to read out there on the foibles of human decision-making, how we’ll stick to a decision far longer than we should, etc. So try to consciously consider from time to time what new evidence would make you change your mind or your weightings of the probabilities. Granted, most of what comes out in the investing world is non-actionable noise: some analyst somewhere changing a price target or opinion on a stock is not necessarily a reason to change your mind on what the balance sheet is telling you or to sell — and I fully encourage you to get into the habit of ignoring most of that. But maybe something else might come along to outweigh your prior decision: firing the CEO (especially if your thesis revolves around betting the jockey not the horse), or missing targets, or the ascendance of a competitor.

Allegations of fraud, for example, can (and should!) shake your faith in a decision based on book value (because if the financial statements are fraudulent anyway, then any information you got from reading them is worthless for making an investment decision).

I think the Home Capital (HCG) case and the OSC disclosure is a timely example of this in action. For years I have been biased to the short side: I’m a real estate bear to begin with, I’ve heard of some shady lending practices (and conversely, have trouble finding evidence of people who likely shouldn’t ever get a mortgage not being able to find some way to close a deal), but HCG kept making money and writing more mortgages and going up.

Then in 2015 the company disclosed its problems with fraud in their mortgage channel, and the disclosure was quite late, with insider selling associated, and heavily spun to be dismissive (for example, the company framed the number of loans as being less than 5%, but that was comparing the flow in 2014 to the total stock – of that year’s originations, the loans in question were something more like 10%, which really does sound material). Those were red flags to me, and though I wasn’t brave enough to short at the time, I certainly wasn’t going to buy the dip.

But I could see the holding long case being potentially forgivable: maybe you saw real estate continuing on its tear (which it did), which washes away many sins of underwriting; maybe you figured it was a contained, one-time issue that was fully in the open and priced in to the stock.

Short sellers like Marc Cohodes were, however, alleging that management had still not fully disclosed the problems — that the focus on the 2014 originations was missing that the problem could have been bigger (what were those brokers doing in 2012 and 2013?), or that the problems in the company were larger than a few third-party mortgage brokers. Cohodes likes to use clever names: “the Queen Street Cowboys” for the OSC, or “the Potato Chip Queen” for Bonita Then. So in his tweets you may have seen “Project Trillium” referenced and figured that it was just another cute name he made up — after all, I tried several times to find out what the heck it was and there was nothing indexed in Google on it (other than Cohode’s tweets). Last fall was the first time I saw anything more than a tweet in this BNN piece.

But then the OSC statement of allegations came out, and there it was: a reference to Project Trillium, confirming that that was the name of the Home Capital internal investigation into the mortgage fraud issue. And not just that, but that there were “serious systemic underwriting control deficiencies” (which had not yet been disclosed by management). In all the ink spilled over the bank run and collapse in Home Capital’s share price, not many (props to Macleans) picked up on that tidbit. Yet that’s the kind of new evidence that should make an investor immediately re-assess their probability weightings of the evidence – clearly the shorts did know something more than the longs. Sure, it’s not as big a deal as if the allegations were that the books were being cooked, but there are concerns when management is not being forthcoming and transparent about issues — and repeatedly hiding behind their freedom to interpret what is “material”.

With the short lens on, you can start to find things that aren’t total red flags on their own, but look a bit suspicious in light of a company that’s not being transparent (or even actively hiding things wherever possible): like the “other operating expenses” line. Before the issues in 2014, that was broken into subcategories; in 2015 it’s all consolidated and increases from $70M to $90M, then to $123M in 2016. Or the news that HCG partners with a company started owned by the founder’s kids (without disclosing it as a related party transaction, again using the shield of a “not material” interpretation) to do 1st & 2nd mortgage package deals, seen as a way to side-step mortgage rules around borrowed down payments.

In 2015 you may have put a low weight on the opinions of a short-seller like Marc Cohodes in your decision about what to do with HCG. As Marc’s track record as a short of Canadian names has become quite impressive over the past few years (Valeant, Concordia, Home Capital Group to name a few), and as it became clear that he likely knows more about this company than many of the longs speaking on TV, you should probably have increased your weighting of his opinion in your decision of whether or not to own the stock (especially if you were relying on the opinion of talking heads on TV who were on the long side).

This was an interesting case for me to think about, because it was not as cut and dry as Enron or Sino-Forest, where the companies themselves were broken. AFAIK, no one has said that HCG is a complete sham, but the weakness of their controls could be a big issue if the housing market turns, and the number of fraudulent loans (or the slowdown in future business to prevent it from happening again) could be larger than previously indicated. Their lack of transparency is another issue, which IMHO is what underlies the bank run — banks are built on trust and HCG lost that. It’s also likely why they haven’t solved their liquidity issue by just selling loans: they had to massively over-collateralize the HOOPP loan, which on top of the other issues suggests that no one should be paying anywhere near par for mortgages they’ve written (and it only takes about an 8% discount to wipe out the equity thanks to the power of leverage).

So whether your decision is to buy an investment or something totally different, what evidence and opinion did you consider when making the decision? How did you decide how much weight to give one piece of evidence over another? What new evidence would it take for you to change your mind?

Full disclosure: I did purchase a small number of puts on HCG (i.e., I am effectively short).

Footnote: This decision under uncertainty stuff helps show why active investing is so hard. For 99.9% of investors out there, you should probably use a passive index investing strategy rather than messing around with individual stocks — and I just so happen to have an online course that will help teach you how to do that! While I did eventually take a position here, it is very small and could more properly be considered entertainment/gambling money rather than part of my long-term portfolio, which is mostly passive ETFs.

Presto and the TTC

May 29th, 2017 by Potato

At my local subway stop they’ve replaced all the old token/metropass gates with Presto ones. So it made sense to get a Presto card and start using that. In just one month of using it, I’ve twice been completely unable to board the subway with my brand-new and fully loaded Presto card at that entrance — yet I got charged for the tap anyway. Then when I walk an extra block to the other entrance, it would still be hit-or-miss, with up to 15 tap attempts needed to get in. I’ve seen many other people at the station having to tap multiple times or seeing declined messages on these new gates.

The good news is that Presto has refunded the extra money they charged me.

But I figure if I have to walk an extra block anyway, with the possibility of having to phone in to initiate an investigation to possibly get a refund of the extra charges, I may as well just go back to using tokens (which are now only accepted by the collector at the other entrance a block further away).

I’m amazed at how many problems the system seems to have. In addition to my personal failure rate of about 10%, I took the King streetcar the other day and watched many people try to tap their cards for transfers when it intersected north/south bus lines, only to have the machines give errors (I couldn’t see the screen, but could see people’s puzzled expressions and multiple attempts to tap). I’ve looked around online, and there are many reports of issues with Presto, from transfers not working correctly to others getting declined at fare gates and getting charged, as well as general equipment failures that are more common than they should be for a system that’s nearly fully rolled out (indeed, the TTC has indicated that in 2017 — just 7 months left now — all other forms of payment will be eliminated).

And that is hard to believe, especially as Presto really isn’t set up for the occasional TTC rider. In the terms and conditions, I was surprised to see that it takes 24 hours for a new balance to load — but that it will expire in 30 days if not used! So if you maybe sometimes take the bus or subway, for the past few decades you could pick up a few tokens and keep them just in case. But now you’ll have to know at least 24 hours in advance when you’ll be using transit, but not more than 30 days. Fortunately, I cleared up with Presto that when they say the scary word “expire” they actually meant “automatically refunded”. Phew — though that also suggests a lack of real-world testing. But still, there’s such a long way to go for all the TTC use cases, plus the reliability issues, that I find it hard to believe that in a few short months that will be the only option.

On Rent Control

April 6th, 2017 by Potato

An important principle in our society when it comes to rentals is striking a balance between a landlord’s ability to make money and a tenant’s security of tenancy. A tenant will call whatever place they are renting home, and deserves to have some reasonable modicum of security that they will get to continue to call that place home.

They should not be kicked out because they got a non-destructive pet, because of their skin colour or religion, or that of their significant other (or the very fact that they may have started dating since the place was first rented). A tenant shouldn’t get kicked out because it would just be more convenient for the landlord to flip the place if it was vacant, or because the tenant didn’t welcome the landlord’s sexual advances – we as a society have said that the laws are going to protect against that.

And none of them mean a damn thing without rent control, because all the landlord has to do is jack the rent to a level no one can afford, and the tenant gets forced out (“economic eviction”). They don’t even have to show that that’s actually the new market rent or find a new tenant at the new price. They could jack the rent from $1000/mo to $100,000/mo, evict the tenant they don’t like (for any reason whatsoever), then rent it to the next tenant they do like at the original $1000/mo and nobody in power blinks an eye.

So in Ontario it’s a big deal that we don’t have rent control on properties built after October 1991. All those new condos built in the boom, many of which are serving as rental stock, are uncontrolled and there are essentially no protections for tenants. This is especially important in the midst of a housing bubble, as people feel there’s no option but to buy (no matter the price) if they don’t have the security to raise kids as tenants. We’ve been seeing that in the news recently in Toronto, with the Premiere picking it up this week when the rent doubled on a few people for an economic eviction.

Now, I think the existing pre-1991 rent control is a very good compromise between security and economics: the landlord can charge whatever the market will bear when the tenant leaves, and they get to put through increases in line with inflation (set by the government) while the tenant stays there. So the tenant gets protection, but not the unit. And to a large extent, the government rate is actually about what rent inflation is. I spent a decade in London, Ontario, and watching the rental market* there, market rent inflation if anything lagged the allowed increases. I know the approximate rent a few people were paying in downtown Toronto near UofT, and running those through the increases to today gets to within 5% of the current asking rent in those areas. Other than the last few years, rent inflation has been really low. And when costs legitimately spike (like when our apartment replaced the boiler or property taxes increased), the landlord can apply for an above-guideline increase, which goes before a third-party arbiter.

But, it doesn’t have to be that exact system: we could add enough rent control to prevent economic eviction, but allow double the rent increases for places built after 1991, or have regional inflation rates, or permit any increase to market rent, with the burden of proof on the landlord to apply to a board or ombudsman that that’s actually the new market rent and not a ploy for economic eviction.

Some people on Twitter and elsewhere have railed against rent control for buildings after 1991 – including Ben Rabidoux, who I usually agree with – as it would dis-incentivize building rentals. But I simply do not see it here.

First, there was hardly any building of rentals after the exemption was put in, and we’ve had almost three decades for that to do something. So evidence suggests it was not effective as an incentive, and taking it away isn’t going to change that.

Second, deciding whether to build a rental building depends on a number of factors: how much it costs to build and operate versus how much you can bring in in rent. The current market conditions and base case projections on inflation and financing costs are massively more important to that decision than rent control rules. Having free reign to increase rents only helps you in the scenario where rent inflation increases rapidly and where tenants do not turn over very often and where the government doesn’t recognize the inflation in the guideline increases. For more normal scenarios, the lack of rent control is a nice option (mostly to skirt eviction rules) but otherwise doesn’t really affect the economics of your building — doesn’t sound like the make-or-break incentive to me. Indeed, for most cities over most of the last few decades, the provincial guidelines (and occasional above-guideline requests and vacancy de-controls) have been plenty to keep your units at market levels. So yes, putting in rent control will be a dis-incentive, but a relatively minor one compared to the other costs of building and operating, and is nowhere near something that should out-weigh the social need for some measure of rent control (without which all other tenant protections are toothless).

And the fact is, cap rates are garbage right now. Rent control or not, we’re going to get hardly any serious purpose-built rentals in the GTA simply because people are willing to pay far more for a condo for consumption than a rational investor would for a rental (driving up land and construction costs). There are many other incentives to condo building (including that you get to crowd-source your funding and punt the risk to individual saps), and disincentives to purpose-built rentals (including the property tax regime). Despite the fact that at the moment there is no rent control on the books for future rental units, I’m amazed that there are any being planned in this environment, and I’m sure that there is a story about back-room dealing with the city to have made that happen anyway.

So I say bring on rent control for buildings after 1991: as it is for others, or a weaker compromise form if necessary, but something to provide more security of tenancy than the current economic eviction free-for-all.

* – note, there are no good data sources on market rents that I know of. Everyone complains about CMHC’s because it only tracks large apartment buildings, which tend to be older. Many rentals don’t show up on MLS so the realtors don’t have a good picture, either.