(Malone) Tracking stocks versus spinoffs

Advantages of spinoffs

Spinoffs can hurt bondholders if the debt covenants are weak and allow the company to spin off significant assets backing the debt.  This benefits the equity as the spin-off that is unencumbered with debt can issue debt at lower rates.

Spinoffs make a company easier to understand and allow more institutional investors to own the stock (e.g. sector/industry-specific funds).  This may increase the share price.  This can generate value if the stock is used as acquisition currency in rolling up poorly-managed companies (e.g. LBYTA).

Advantages of tracking stocks

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(LMCA/LBTYA) Malone’s cable strategy

Here’s how I see it.

Some people are superstars at operating a cable company while the majority of people are bad at it.  One way to figure out who the superstars are is to figure out how much money is made per home passed.  Liberty’s investor day presentation uses adjusted EBITDA per home passed, which is a rough proxy for this.  (I would prefer to subtract maintenance capex from adjusted EBITDA.)  Each home passed represents a potential customer.  Good operators will turn a high percentage of its homes passed into customers and sell them as many services as possible (television, premium channels, Internet, voice, video-on-demand, etc.).

Liberty’s investor day presentation (PDF) compares various cable companies:

(KMI) Mispriced long-term options

Here’s the idea:

1. Find options or warrants where the implied volatility (according to the Black-Scholes model) is very low.  I consider implied volatilities slightly above the IV of the S&P 500 index to be low.  Anything under 30 is low.
2. Among that universe of long-term options, find the ones with underlying businesses that are able to compound their intrinsic value at very high rates.

Compounding is very powerful over long periods of time.  Options are generally a leveraged way of playing a stock.  If a stock is mispriced, the options may be even more mispriced.

How the SEC should reform market structure

1. Stop giving broker-dealers (and by extension, market makers) special trading advantages over institutional and retail investors.  There is no reason why broker-dealers should be able to price in sub-penny increments while investors cannot.  It’s bullshit.
2. Tighten spreads.  Historically, this has been the biggest reason why trading costs have gone down for investors.  However, the SEC should be careful not to make spreads too narrow to preempt the “shaving” trading strategy.  Shaving is basically a strategy where you bid one penny more (on 100 shares) to stand in front of the line.  It currently exists as market makers can jump in front of any order by bidding an additional penny on 100 shares (e.g. sub-penny front running).
3. Ban retail brokerages from taking kickbacks via payment for order flow.  Doing this would force retail brokerages to raise their rates to compensate for lost revenue from selling out their customers.  It may put an end to the “free” trades offered by some brokers.  This move might have bad optics politically but it would be the right thing to do.  This move would devastate the order internalization industry, which would have no reason to exist.
4. Ban exchanges from giving special trading advantages to market makers.  (This stuff gets really complicated because there are so many trading advantages and because many of them are subtle.)  Of course the market makers would claim that they provide “liquidity” and are performing a valuable service for the markets.  They will claim that they need incentives to provide liquidity.

While the steps above won’t get rid of all the market abuses, they would dramatically reduce trading costs for investors.

The chance of this happening is almost zero.  The SEC gave special trading advantages to broker-dealers.  It played a role in creating the sub-penny front running game.  Currently, the SEC seems like it wants to confuse and mislead the investing public.  You can read their Twitter feed and the articles on their website (e.g. “research” that totally misses the point and this speech where a staff member pretends that complexity is a good thing).

In the past, I would blindly assume that regulators are the “good guys”.  Nowadays, I am disappointed in myself for being naive.  The reality is that the human beings who work at the SEC sometimes do the right thing and sometimes do not.

The Wolf of Wall Street

This book by Jordan Belfort tells the tale of how his firm used its army of brokers to sell stocks at inflated prices to rich retail investors.  This is secretly one of the best books on short selling.  By understanding the criminal point of view, I started realizing more of the footprints that pump and dump-style frauds leave behind.

The book does have its flaws.  The author isn’t exactly a reliable narrator.  Jordan Belfort is not a “wolf of Wall Street” at all.  The book talks about how he specifically kept his offices and those of his affiliates away from Manhattan.  As well, most of the book does not talk about securities fraud.  Nevertheless, if you want to develop a gimmicky skillset that is only useful for short selling, I highly recommend this book.

The book was also adapted into a Hollywood movie.

China 2.0

Apparently there is a new wave of Chinese stocks hitting US exchanges.  Some of them are Web 2.0 related.  Needless to say, I am extremely skeptical about these Chinese stocks.  Historically, there has been an extreme level of blatant fraud from China.  This is mainly because these Chinese stocks were listed on foreign exchanges around the world and because scumbags gravitate towards reverse mergers.  (To be fair, these China 2.0 stocks are not reverse mergers.)  The underwriting of these China 2.0 stocks seem rather loose.  They do not have to comply with all parts of Sarbanes-Oxley thanks to the JOBS act.  At least 3 of these companies (GOMO, WBAI, WUBA) have identified material weaknesses in their internal controls.

Unbuilt mines with planned expansions

It is a red flag when a development-stage mining company makes plans for a mine with expansion stages.  Why?  There is one mine size that maximizes the net present value (NPV) of the deposit.  Usually this size results in a mine life of 6-15 years.  A bigger mine exploits the resource faster, making the future revenues happen earlier.  Because there is a time value to money, mining faster increases the present value of the future cash flows.  A larger mine also enjoys economies of scale that lower operating costs.  Of course, all of this has to be balanced against the capital costs of a bigger mine.  Underground mines tend to have higher capital costs so they tend to be designed with longer lives.  Open pit mines tend to have low capital costs so they tend to be designed with short lives.

If the estimated mine life is over 20 years, then there is probably something fishy going on.  Usually, it would make more sense to build a bigger mine with a shorter life.