An Economics of Single Transactions

I recently read Thomas Sowell's Classical Economics Reconsidered and it struck me that the classical treatment of supply and demand is not adequate when dealing with the real world of price, value, and cost. Consumers don't face a large market of many suppliers. For a real consumer there are many constraints on geography, time, and resources that nearly completely block any kind of decision-making in what might resemble the supply and demand curves of classical microeconomics. 

I'd written on a framework that I put together in 1993 and 1994 that I called "nanoeconomics" ("nano"). I presented a paper on it at a Department of Defense cost analysis symposium in 1994. At the time I was still in need of reading more of the literature, so after working out the basic influences that can be captured in a single transaction framework, I set it aside. I published a blog post in 2011 outlining the basic ideas. Now that I had Sowell's overview in hand, it was clear that the nano framework was not only useful but necessary for understanding decisions in real marketplaces.

If you look back 1000, 2000, or 300 years, or pick almost any point in human history, you will find that humans have traded goods and done so rather enthusiastically. Marketplaces exist because all participants profit from the transaction. However, ever since the dawn of the Industrial Age the rapid growth in production and resources has changed the complexion of the marketplace. It has induced some like Marx and his followers to attempt a reformulation of basic economics, to declare that "cost equals value" or that labor cost equals value. It seems rather drastic to discard the entirety of market economics just because of bruised feelings. The nano framework is necessary to provide a foundational vocabulary and to put the questions of transactions into a robust framework. 

The basic problem is determining a price for a transaction. Note that we've already assumed a medium of exchange (money) in which we can measure costs, marginal utility (opportunity cost), and of course, price. As indicated in the diagram, producer costs must be below the consumer's private value of the good or the net effect of the transaction is to destroy net societal resources. 

Clearly both sides must be motivated to make the trade, or no trade is likely to occur. This is resolved by splitting the profit. In a modern, competitive economy or in a robust town market there will be multiple suppliers. Although the consumer has an "ultimate" value which is the cost of doing without any transaction, the consumer's negotiating value is the price of the next-best deal, or the price of the next higher offer.

The situation is slightly different for unique goods, or those offered by a monopolist or bought by a monopsonist. Now the supplier and customer must exchange information and negotiate, at first just to discover that a trade is possible, then to explore possible trading prices. Often the customer has the information advantage, because their ultimate value is what sets the limit on price and profit, and this ultimate value is usually private information that is costly for the seller to discover (at least until Google and Internet ad tracking systems made it possible to read the minds of internet users): 

One might argue that splitting such profits is "fair" if the price establishes a geometric ratio such that each party's gain is proportional with the same factor. In such cases, consumers still make bigger profits on an absolute basis.

The nano framework gives some rather precise definitions of words that are frequently confused or problematic in debates of classical economics. Cost is the suppliers costs; often this will be private information, except for most government contracting. Value is usually private to the consumer, but since it is subject to rapid change, the consumer may not be fully informed themselves. Consumers have strategies for protecting themselves from this variability, and these mechanisms also contribute to the "buffer" often required by a consumer that tends to increase average realized consumer profit. 

But isn't this just like classical microeconomics? Isn't the single transaction "thermometer" diagram a slice out of the supply and demand diagram?

It turns that it is not. One must make some very large and unusual assumptions to establish a supply/demand analysis. In the real world, consumers very rarely face such efficient markets.

In the real world, people walk through a continually moving "bubble" of opportunity costs. Movement between prospective transactions is costly. If you are at a local corner grocery store, you cannot immediately reach out and take advantage of prices at Costco or a supermarket. Comparison of prices itself involves effort, at finding prices on items, remembering them from elsewhere, and comparing sizes and quality and unit prices. In short, although the supply and demand curve graphic represents the general conceptual landscape faced by the consumer, in practice the demand curve is constantly changing in shape and magnitude, shifting back and forth in response to changes of location, competition for attention, and the immediacy of basic needs.

To fully understand what drives "ultimate" value, we would need to analyze the dynamics of decision-making within the consumer. Some have called this "neuroeconomics", others might put it under the label of behavioral economics.

It's useful to have some background on philosophy of ethics and morals. Goals for comfort, survival, and reproduction come into play. The most fundamental influences are very practical, involving food, water, temperature regulation, social interaction. Although clearly this will invoke most of the human sciences (psychology, anthropology, sociology, cultural evolution) we are getting closer. We at least know now whether the boundaries are, and that certain economic questions can be resolved very directly into organism-level analysis. Furthermore, we have some sense that actual market data, such as the price of a hot dog at a market, supermarket, convenience store, convention, and in the middle of a desert will all be useful in calibrating numerically the effects of organism-level goals and drives.

Monday Quick Takes and a Description of Media Corruption

Energy prices in Europe are shattering records. Trading in German electricity for delivery next year reached prices of over $1.00 per kWh today. 

A month ago I said "I would not be surprised to see housing park itself at current prices for two to five years before the next major move." Perhaps even that was too optimistic. Today Zero Hedge has advanced the idea that the housing FOMO surge has topped out:

The narrative we have a housing shortage is begging to crumble. It is likely many buyers are shifting into a wait-and-see mode. The false housing narrative of shortages is breaking down. The cheap money flowing from Wall Street has stopped flowing in and in some places has begun to retreat. 

Affordability has plummeted with much higher mortgage interest rates and a tightening Fed now grim and determined to kill inflation with higher reserve rates. 10-year Treasuries, seemingly tamed after their surge in June, have resumed their upward march at 3.11% today. 

From CNBC comes a report on a paper that reminds us (again) that inflation is a product of both monetary and fiscal policy, and that the Fed can fail in its mission to lower inflation if Congress continues to spend too rapidly, including spending on student loan forgiveness.

Barron's reports that Berkshire Hathaway, which owns some stocks (KO, AXP) that are highly appreciated and has held for decades, may be subject to paying capital gains under the new tax laws. Speculation: If BRK has to pay tax on KO even without selling it, why wouldn't it then sell it? KO is an extremely mature equity and trades more like a preferred stock or a bond than it does a large cap stock.

Perhaps I've been reading too many books about media (like Bad News and The True Story about Fake News), but the lack of available objective news coverage in the U.S. is not likely to improve any time soon. There is no impending service or mechanism that could diminish the divisiveness one sees in current society. The internet and social media have increased the amount of data people are exposed to, and many of those bits are dedicated to convincing people of what they already believe. I don't say "information" because social media data is often skewed or just cheer-leading, not actual news, and rarely is it objective. This applies to the mainstream media as well. I'm not breaking any ground complaining about the amount of garbage that MSNBC, CNN, ABC, CBS, NBC, NY Times, and Washington Post distribute. I'm skipping Fox, OAN, etc. because liberal readers already think those are garbage. After 2010 and Facebook all media have been engaged in a fight for their lives and they have all devolved by publishing enormous amounts of clickbait. The toxic level of complaints about alt-right is nauseating because most of the material complained about is either never seen or is obviously not believed, but since it fits the outrage generator, the complaints churn along with derogatory labeling, false accusation, and mischaracterization of others.

A couple of years ago I encountered a rather poorly done academic paper (which I will not link to here) that established through a survey the symmetrical result that while the "right" denies evolution, but believes in gender differences, the "left" embraces evolution but denies gender differences. (Another article here, unrelated to the aforementioned paper.) Since my belief system fits neither of these categories, as I think evolution almost certainly generates gender differences, at one time I was willing to attempt to parody the extremists on both sides by labeling myself on social media as inhabiting the "radically polarized center". But since no one seemed either entertained or appreciative of this fine joke, I terminated it.

Of what possible use is this in Vorpal Trade? I'll venture that these distractions slow economic growth, at least a little. Politicians are driven to extreme measures in which they spend excessively in order to grant favors to special interests and damage the economy in ways that the other party cannot undo. Such actions undermine actual economic growth and teach people to hunker down and adopt shorter time horizons (and higher implied interest rates). 

Within the media world, since there are no easy answers to censorship within corporately-owned social media, the Alphabets, Metas, and Microsofts of the world will continue to have commanding ownership of social communications, which they will use to inculcate, protect, and advance left-leaning information flows. The future of society will look much more like dystopian science fiction novels and 1984 than politicians would like to take credit for. You can buy GOOGL and META, but because of special super-voting classes of stock in each, you cannot ever take them over in order to fix them, even if you have a trillion dollars. 

Perhaps we complain too much? The invention of the printing press caused massive societal disruption. Newspapers and television also caused disruption. We just don't remember or notice it because of desensitization, or we were dazzled by the miracle of those technologies, or (worst) we grew up with them and so think they are absolutely normal. While today we complain about fake news and corrupt media, it really is the case that journalists have always been corrupt, and the print and TV media were always filled with garbage. There is one important difference: the change level of information flow that was brought to use by newspapers and the printing press was very significant. The change of information flow going from old-school newspapers to the internet is not significant. We've gained little new info, but lost a lot of information integrity. The rewards for generating outrage are titanic. This is not a "them" issue. Your side does it too. People who operate within civilized rules are viewed as old-fashioned or clueless. 

One cannot escape the personal data advertising espionage system. It is not only not possible to be truly anonymous within the internet data/advertising system, the system works very hard to manipulate your behavior to force you to categorize yourself. Do you think that by not clicking on the clickbait that you can escape? Well, they have a solution for that. If you fail to click on enough of the hot girl/hot guy, LGBT/cis, leftist/rightist, redneck/urban dweller, racist/anti-racist clickbait stories, then they will assign you a category that is falsely accusative, and then reveal to you via advertising that you have been mislabeled in a way that irritates you. And if necessary, they will use AT&T or Verizon cell phone location data to finish the job. (On second thought, this article is probably more clickbait than news.)

The advertising system doesn't just irritate users, it's also designed to charge extra to advertisers. When you are a good customer of company A, then you see multiple ads for company A just after having bought your year-long supply of their product, when you are no longer interested in buying anything more. Company A has wasted its money. Clearly the internet ad broker knows this, and has manipulated the advertiser into spending more money than they needed to market their product appropriately.

Useful Hunger?

While I'm off topic, I may well pass along this analysis of hunger as an enslavement mechanism. The controversy is over a United Nations article that was published on the internet and remained for 14 years before a sudden stirring on Twitter brought attention to it and it was deleted.

“I never intended it as satire,” Kent said. “I did not hope that it would be read as praise for hunger. My main point was and still is that some people benefit from the existence of hunger in the world. That helps to explain why hunger is so persistent in many places.”

There are numerous ways to interpret this analysis, most constructive or informative. You could be "outraged" too, but that is not how I recommend reading it. Instead, consider that hunger is useful to despots as a mechanism of control over their population, and this phenomenon is very well described in The Dictator's Handbook: Why Bad Behavior is Almost Always Good Politics. Third World hunger relief schemes often run into the problem that the despot and his henchmen need to get a cut of the distributed aid, and they have an incentive to fail to deliver the full measure of the food relief to those who are hungry. So if you provide charitable food aid, be aware that a significant fraction will be lost to extortion or withheld by elites in order to ensure continued political control.

The GOAT of Business Journalism

Once upon a time, business journalism was meaty. It had gusto, dealt with serious topics, and was centered on reality, not social justice. Those days are long gone, and most of the serious journalism went away after social media conquered journalism in the 2010s.

I just want to cite a few memorable articles. This will be very short.

Cabletron the Mighty (Impatient)

First up is Cabletron, and this piece in Inc. magazine from 1991. Some juicy quotes:

Cabletron's turnover is already worrisome. Last year the company fired more than 10% of its white-collar employees. Thirty percent of outside salespeople don't make it through the first 90 days; another 40% are gone within six months. Last summer Benson joined 40 employees for a Sunday boat trip. Afterward he ordered two of them fired immediately. One had not even started yet. "I hated him," says Benson, who was eventually persuaded to give the new hire a chance. At sales meetings, reports Kenneth Levine, it's standard to conduct private polls on who will go next.

I recall reading somewhere that all of their meetings were stand up only, to save money and time. I guess that's how you have to do it if you don't have meeting rooms:

It's a good thing too, because there wouldn't be anyplace for them to congregate. In all 126,000 square feet of Cabletron's headquarters, now in Rochester, N.H., there is not even one meeting room. While that doesn't prevent get-togethers, both Levine and Benson argue that it does keep meetings to an average of 20 minutes or less. Benson once spied an 18-person meeting going on. Storming in, he threatened, "If you people all have the time for this meeting, then I guess I really don't need this many people."

There are stories about tanks, chasing pizza delivery guys, and lots and lots of aggression. The point is not that Cabletron was the acme of computer equipment vendors. The point is that the article was outstanding business journalism. It was something that stood out by itself, even apart from the company that was being covered.

Stewart Brand, Electric Kool-Aid Management Consultant

The author of How Buildings Learn and founder of the WELL and Whole Earth Catalog, later became a management consultant. This Fortune article published October 16, 1995 sort of tells the story:

Says Brand, who often speaks as if he's polishing raw thoughts out loud into his trademark aphorisms: "If I were ever to do an autobiography, which I won't, the title would be Float Upstream. Being a crank is characteristic of my family. Originality on the cheap. You find where the flow is, and go against it. It's a way of feeling alive."

Brand's boredom and curiosity emerged early, propelling him along a life path so nonlinear it seems almost loopy. In 1954-- three years before Jack Kerouac's On the Road was published-- young Stewart, 16, borrowed his parents' car and rambled with high school chums from his hometown of Rockford, Illinois, to northern California to pan for gold. Rockford's nascent beat poet also began wearing a beret around, dismaying his ad-man dad but merely amusing his out-of-the-box mom, a homemaker with a passion for space travel. But he then went preppy, graduating from Phillips Exeter Academy and from Stanford, where he earned a biology degree. Next he plunged into the bohemian New York artist scene, then looped around to join the U.S. Army, where he served at the Pentagon. "It would amuse my New York artist friends no end when I would come in wearing my uniform, take it off, and put on theirs," he says.

Despite having good vibrations about the military, Brand left it after two years to hang out with San Francisco's LSD-popping merrymakers. One night he climbed onto a roof, dropped a restrained half-tab of acid, and saw a stunningly groovy connection between NASA and flower power--an epiphany that moved him to travel coast to coast in a top hat, selling buttons that asked, "Why haven't we seen a photograph of the whole Earth yet?" Millions soon did, via his next visionary move: the Whole Earth Catalog, whose cover picture of earth from outer space at once celebrated the Apollo program's far-out tools and chided us not to mess up the only planet we've got. The title page famously declared: "We are as gods, and might as well get good at it."

The Portrait on my Office Wall

John Rutledge wrote a column for Forbes. After I read this piece in the December 30, 1996 issue, I tore the page out of the magazine and put it in a plastic page protector up near the front of my day planning notebook. I still have it.

We believe that when someone wants to do repeat business with us it is the highest form of praise. Allowing your opponent in a transaction to walk away with his dignity, his humor and his hearing intact, and with a pretty good deal in his pocket, is the right way to do business.

Jerry and I learned this from our first business partner, V.P. Baker, or "Bake," as he preferred to be called, more than 20 years ago. We met when Bake was already 89 years old, with a career behind him that included being a WWI fighter pilot, a wildcat oilman, a borax prospector, a mule dentist, an orange rancher and a real estate developer. He was a wonderfully principled man. We keep a portrait of him in our conference room to remind us how to behave.

The article then lists eight principles to live by.

Boomers vs Everyone vs University Rent Extraction

Many years ago I bought a copy of The Great Boom Ahead by Harry S. Dent Jr. It was published in 1993, and described his predictions for the stock market, inflation, economic growth, and innovation for the upcoming decades. For various reasons, I read only a little of it and put the book aside. I recently picked it up again. Though I have not yet finished it, it has brought to mind some of his ideas about demographics-driven economics that have become relevant in current social media discussion.

One current resentment, one that has the purpose of supporting the call for Federal student loan forgiveness,  says that Baby Boomers had it easy. Although it's questionable whether a generation-wide ad hominem attack is a valid or non-rude debate tactic, it's worth analyzing the idea. In a recent Twitter post one pundit compared inflation-adjusted wages to non-adjusted tuition and housing prices, marking the comparison by saying "Boomer: But why can't the slackers pay for college & pay off their loans like we did?" The stark ratio was falsified by using non-comparable numbers.

If you look at wages, it is clear that current wages (for production and non-supervisory workers) are far higher than they have been for all prior generations (from FRED[1]):

Looked at this way, the current generation is doing extremely well. But this is not the data that was presented. Instead, the pundit used numbers from this FRED graph[2]:

These are inflation-adjusted ("real") wages. Notice the giant dip in the middle? The dip is centered on the Baby Boomer earnings life cycle. So, contrary to current rhetoric, because of their large numbers, when boomers entered into the labor market from 1967 to 1986 they depressed their own real wages. It was only after the labor market digested the new workers that real wages went back up.

This turns out to be highly aligned with Harry Dent's message in The Great Boom Ahead. He forecast a large drop in inflation because of competition in the labor market, which occurred. He forecast a booming economy in the 1990s, which occurred. His predictions don't align as well later on, but this post is not about a review of his book or predictions. I'm referring to the explanatory power of demographics. 

Of course, that is not the whole story. The oil price shock of 1973 caused a long term decline in wages for all production workers. But it was made worse in the 1990s and after, when U.S. workers were forced to compete not only with each other, but with overseas workers in Asia. Though avoiding the macroeconomic mistake of mercantilism (protectionism), the U.S. imposed the cost of its free trade policies on its own production workers.

Of course, in the past 25 years permissive importing policies have come from the "elite", composed primarily of Baby Boomers in managerial, professional, and government positions. So we have a mixed message: though "leaders" are indeed responsible for forcing US workers to compete wage-wise with the Third World (causing low wages), it's not like they skated along in the 1970s and early 1980s. It was rough for them early on too.

Recent Real Wage Gains

It's clear from the rising slope of the CPI-adjusted wage graph that our "story" about labor competition from offshoring of production is questionable. If real wages are depressed because of imports, then why are they actually not depressed, but rising? Unlike the wage declines that Boomers experienced in their 20s and early 30s, new generations are seeing real wage gains after 2000, at least in production roles.

Once again, using the Dent clue, we should probably look at demographics. Recent generations are smaller and the product of much lower fertility rates in the U.S. There is less competition for jobs, fewer people to fill them. Labor is scarcer, so the price of labor has been rising to meet demand. This matches current news about unfilled jobs all across the U.S. economy. It also bodes well for future wages, as the labor supply will continue to be constrained by the low U.S. birth rate.

It's a Tuition Inflation Problem, Right?

So why all the consternation? Is it just a social media conflagration, the outrage machine spinning narratives that are divisive and stupid, for the sake of selling advertising? The rhetoric is, of course, centered on Federal loan forgiveness, and the political message is that tuition inflation has been too high. The populist rhetoric centers on specific categories of goods, especially university tuition and housing, that have increased much faster than the CPI.

What about non-production workers? Were they insulated from real wage declines? It is less clear, because that category is not available on FRED. The closest I could find is this non-CPI adjusted series[3] with a much more limited timescale starting in 2003:

My impression, which likely matches that of many, is that the "elite" did just fine in their professional, managerial, IT, academia, and Government jobs. This caused the "two-tier" economy we have now where the elite are bidding up prices of homes while factory workers struggle to find affordable housing of any sort.

One could think of a college education like a membrane separating the haves from the have-nots. Many high school students and their parents may think that, in which case college tuition has very low price elasticity--any price is worth paying to avoid dropping into the gutter. The moral question (not the kind I usually address here) is whether universities are behaving rationally by charging what the market will bear, or extorting the future earnings of their customers. An ethical university would raise tuition only at the rate of CPI, and keep it affordable. Or, turning the question around, the ethics of the university are revealed by what it chooses to do. If the mission of the university is learning, then it will emphasize student welfare and tuition that matches the CPI. If the mission is profit, it will charge what the market will bear. 

Now we have a result worthy of Vorpal Trade: we have derived the internal goals of the market actor from their economic behavior.

References:

1. Average Hourly Earnings of Production and Nonsupervisory Employees, Total Private (AHETPI)

2. Average Weekly Earnings of Production and Nonsupervisory Employees, Total Private/(Consumer Price Index for All Urban Wage Earners and Clerical Workers: All Items in U.S. City Average/100)

3. Employment Cost Index: Wages and salaries for Private industry workers in Professional, scientific, and technical services (CIS2025400000000I)

MarketVector's MVMORT: A Revealing MREIT Index

You can't think of everything, but sometimes when you finally do find the answer, you feel stupid for not having thought of it earlier. That certainly applies right now to my understanding of long term Mortgage REIT performance. Of course, not being able to think of everything is exactly what the nature of this business is about, so I'm not too discouraged.

Last week I posted my analysis of the MREIT business. Everything I said there is still good, but if I had found this MREIT index sooner then I would have invested less in MREITs, or perhaps invested nothing.

MarketVector's US Mortgage REITs Index

I remember many years ago standing in a book shop in Santa Monica on Wilshire Boulevard reading a book about stock investing. It mentioned the Ibbotson and Sinquefield paper "Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926-1974)", and it greatly impressed me that the returns were so high even though they encompassed the Great Depression and the time period started in the middle of the Roaring 20s. Having this big picture view of the market immediately put a foundation under the idea that stock investing could be not just lucrative, but inevitably so, regardless of short term fluctuations. You are reading part of the fruit resulting from that information.

With this background, you might think that each time I approach a new investment class that I might seek out data on the long term performance of the group as a whole. I will now. I did not do so with MREITs until earlier this week when, on a whim, I wondered if anyone compiled an index or benchmark on the MREITs. Of course they exist, and though there may be others, I'll focus briefly on the MarketVector MVMORT index here.

The index contains 26 U.S. mortgage-based REITs. The usual suspects are here: NLY, STWD, AGNC, BXMT, RITM (formerly NRZ), ABR, TWO, CIM, PMT. You can see from the components page that these are indeed the MREITs we are looking for.

Obviously, there are at least two components to equity return, capital appreciation and dividends. MREITs tend to have poor capital appreciation but excellent dividends. The dividends are, in fact, too good to be true, as is reflected by the terrible performance of MREITs in capital appreciation, as we can see from the Price performance shown in the MVMORT index, which as of 8/26/22 was -80.97% since the inception of the index on 12/30/2004. If you add in dividends, then gross return rises to 77.11%, but remember this is a total return across 17.66 years. Annualized you got 3.29%. The net return (after taxes or withholding, I presume) was -11.91% or -0.72% annualized. 

From the graphs of the indices it's clear that although the 2007-2009 mortgage crisis was a drag on MBS and MREIT returns, the 2020 COVID shock was much worse. You might be charitable and decide that these two events were extraordinary and therefore the index is not representative of the prospects of MREITs. Nevertheless, the index covers 18 years of time, a significant sampling, even if not as compelling as the SBBI period of 1926-1974.

I am not as inclined to be charitable, and see MVMORT as a fair representation of the prospects of the MREIT sector, which I think was fairly characterized by the analysis I posted here on August 16th. More informally, I think of the U.S. mortgage as a strange and amazing artifact that tends to benefit the borrower most. It is at a low interest rate, tax deductible, and allows you to make a highly leveraged investment on a practical and useful capital asset that enjoys special legal protections. The U.S. mortgage is so good a device (for the borrower) that it leads to, and has often led to, overinvestment in homebuilding, leading to excessive real estate prices, homes that are too large, and stranding of capital. By providing special tax advantages for mortgages, the U.S. Government has increased the volatility of the housing sector, which in turn has increased the frequency and severity of financial crises based on mortgages. In that sense, U.S. tax policy caused the 2008 financial crisis.

One might think of MREITs as specialized trading vehicles, to be used like equity options, index options, leveraged or short index closed end funds. If you treat it as toxic waste with zero-sum characteristics, in which staying too long with an MREIT is an indicator of mental illness, then you might have the right approach to dealing with MREITs. Keep in mind, though, that the same quants (or AI-based SAIMS traders) who have mastered MBS will also have the inside track on MREITs.

A Modest Essay on Mortgage REITs

I recently mentioned the Mortgage Real Estate Investment Trust (MREIT) industry while briefly commenting on high NAV-ror companies in the BDC universe. Recently I looked more deeply into several MREITs, and find that they are too complex to be worthwhile. I will pick on Annaly (NLY) primarily because they are the largest market cap MREIT that is publicly traded.

The primary source that convinced me was the Annaly 22Q2 earnings call [1]. You can find a transcript here (NLY earnings call transcript at Motley Fool). This passage in David Finkelstein's prepared remarks especially stood out:

After combining our book value performance at our first quarter dividend of $0.22, our quarterly economic return was negative 9.6%. As noted earlier, the portfolio generated EAD per share of $0.30. Earnings continued to be strong, resulting from high dollar roll income, increasing MSR net servicing income, reduced amortization due to lower CPRs and a benefit from our swaps portfolio as it turned to a net receipt position during the quarter on higher short-term rates. However, EAD was meaningfully aided this quarter by an increase in specialness and dollar rolls, primarily driven by a scarcity of TBA-type collateral and newer higher rate production coupons.

For those of you in the MBS (mortgage backed securities) business, you can stop reading here. This article will be too simplistic. The rest of us need a quick review of what this paragraph implies. 

First, although you can Google the meanings of the specialized terms and acronyms and eventually get a mental picture of what they mean (EAD = exposure at default, MSR = mortgage servicing rights, CPR = conditional prepayment rate, CRT = credit risk transfer [2], TBA = to be announced, specialness = the extent to which implied dollar roll financing rates fall below prevailing market rates, dollar roll = to sell short MBS) as a whole the complexity implied by the jargon is irreducible. Some of these terms originate in the nature of the mortgage contracts. Others refer to typical practices in the MBS trading system. Unless you want to specialize in understanding MBS, it would be difficult to understand how to sort out one MREIT from another based on their business model. 

Could you analyze management, probity, company values? Perhaps, but your analysis would be thin and fragile, with little to count on in difficult times. You would have to be confident that a company with better values could outperform companies without good values, in a commodity market. Thinking back to comments made by Ajit Jain and Warren Buffett about the reinsurance and property and casualty markets, when an commodity business gets crowded, margins thin and often the companies with the thinnest value systems win on price.

The MBS world, although not simple, is a crowded market, as alluded to here by NLY:

This correction will be welcomed for the Agency MBS market as it reduces elevated net supply, which has been the main headwind for the sector in the recent past. 

Although there are many variations in the mortgage market (geographic, % of value, borrower demographics, contractual terms, MSR details, etc.) the primary business of buying and selling mortgage securities is liquid and competitive. The originator may be able to distinguish themselves by service, bundling, and so on, but secondary players like MREITs have little to no moat around their operations.

Monster in the Market: Super Artificial Intelligence

This leads me to speculate about the potential for a very serious difficulty for MREITs, which I will call the Super AI MBS Speculator (SAIMS). The SAIMS entity was constructed sometime around 2013 to 2017, although it is continually upgraded by the MIT quant engineers who developed it for the secretive hedge fund they work for. The goal: to extract value from the MBS market by out-thinking the rest of the MBS players and detecting trends faster than they do. Using deep learning augmented by specialized programming, the SAIMS continually analyzes interest rates, economic indicators, housing markets, consumer behavior, but especially the MBS markets and its players. It does not seek to dominate any one type of trade, but instead seeks to systematically shave an advantage off every type of trade available to it. 

SAIMS is similar to the quant trading done by HFT players, but it seeks advantages in information interpretation more than it does in speed. Because it is automated, it can place trades for small amounts that are statistically consistently profitable without tipping its hand that it has an edge over its competitors. 

In a SAIMS-dominated environment, the players like NLY are continually using very, very sophisticated methods of analysis that show them what just happened and why even though they are not able to anticipate the moves or tactics of the SAIMS. The best MREIT companies at their best are still several steps behind the SAIMS. Although the MREITs may make small amounts of money above trend in quiescent markets, when the SAIMS is paired with an active human-based trading strategy that generates disruptions in the market it can force the market into non-quiescent periods. Naturally, Government actions (or inactions, as when they fail to tighten rates in response to price movements) tend to generate market disruptions, so the SAIMS owners are close friends with Government organizations and politicians.

SAIMS works because it trades against the entire MBS and MREIT marketplace. It goes short and long, offers excellent liquidity and supplies narrow spreads to the market. It takes small amounts of money from all players, but makes up for the small amounts by dealing in volume. To the outside observer, SAIMS's success is mysterious and difficult to explain. Huge profits show up annually on the ledger of the investment bank/hedge fund, but rarely is much attention devoted to explaining the operation to outsiders.

While SAIMS is a speculation and not a prediction, I think that regardless of the actual shape of the risk to MREITs, it is highly useful to think of the MREIT environment as including SAIMS-like opponents. It could be the marketplace itself, a collection of SAIMS programs, or the machinations of a Federal Government that continually collects benefits from the gradual book value loss of the MREITs, even if those "machinations" are not realized in any single mind and are merely the product of bureaucracy plus legislation. If you want a 10% to 12% yield, you need to seriously consider why such a juicy yield is available in the market. Is it a Trojan Horse?

A Low Interest Rate Base Makes All Fixed Income Vulnerable

MBS are bond-like. As I published here before, low long-term interest rates pose problems for those seeking to invest in bonds. Likewise, low interest rates are a problem for MBS and MREITs. 

They are also a problem for target date mutual funds, and for bond funds generally. And this time may be different (for bonds). This blog post at Allocate Smartly[3] says it well:

Importantly, an extended period of rising interest rates could have a more severe impact in today’s market than in the 1960’s and 70’s. Yields rose from a higher base then, and that helped to cushion the impact of rising rates.

Toxic Complexity

While digging through the MREIT acronyms and jargon, I kept encountering ideas that were explained primarily by academic papers. The first, "specialness", with an irony almost too profound to be believed, turns up in a paper you can get via an mit.edu URL [5]. Though maybe I didn't look hard enough, the best explanation for PAA I could find was in another academic paper [4] on obtaining higher yields with near-zero risk of capital loss.

Some years ago while at Hostfest in Minot, SD I met the aunt of a fellow MIT graduate, who put us in touch with one another. We corresponded by email. He mentioned that he was in the MBS business.

I'm in favor of using our intelligence to solve problems and make things better. But it is a problem when simply keeping up with the competition requires either being an MIT graduate or doing your homework just as well as one. If you are in a simple commodity business, then superior teamwork, processes, and a solid corporate culture could make you the low cost provider, and therefore make your business both profitable and stable. In the MBS business, it appears that external players can be leaders just as easily as the publicly-traded MREITs, and for that reason, I'm out.

Sources

1. NLY earnings call transcript at Motley Fool

2. PMT earnings call transcript at Motley Fool

3. https://allocatesmartly.com/government-bonds-have-failed-to-deliver-when-needed/

4. Keller, Wouter J. and Keuning, Jan Willem, Protective Asset Allocation (PAA): A Simple Momentum-Based Alternative for Term Deposits (April 5, 2016). Available at SSRN: https://ssrn.com/abstract=2759734 or http://dx.doi.org/10.2139/ssrn.2759734

5. Song, Zhaogang and Zhu, Haoxiang, Mortgage Dollar Roll (July 2, 2018). Review of Financial Studies (Forthcoming), Available at SSRN: https://ssrn.com/abstract=2401319 or http://dx.doi.org/10.2139/ssrn.2401319

Problems with Reality? Let's Virtually Go All the Way

Following up the Meta article and the data posting from the next day, I'm adding one more post before moving on to other topics. May as well pile on some more links and get this over with. First: Mark Cuban says virtual real estate is stupid. For a known heavy cyber cash investor to see it like that, ouch. And further ouch:

Trading for land on six platforms, including the Sandbox and Decrentraland, is down 97 percent from its November peak, according to WeMeta. Trading volume was $229 million that month, but only $8 million in June.

If you are looking for advice on buying (but not selling) VR stocks, it seems everyone has a bunch of opinions. It's a crowded market, so Vorpal Trade will skip making any suggestions. You could try The Impact Investor, which will tell you how to "choose the best VR stocks." You can choose from 13, including DIS, META, and Sony. Yahoo! Finance also has a list of 10 VR stocks to buy, or maybe the 5 best. This May 2021 article might be a little dated. Or try the long-standing Motley Fool, which is more selective, with only 7 VR stocks. These are not small companies with potential, though, they are mostly "giganticaps" like Google, Meta, and Apple. Or you can just go to Google or DuckDuckGo (preferred, because it doesn't "bubble you in") and search for "virtual reality stocks".

(This is a link collecting and commentary article and may be updated occasionally in the next week.)

Data for META Post: Pew Research Center Report Link and Comments

Additional data on teen use of social media apps. This is a follow up to yesterday's post on Meta.

The pdf of the Pew Research Center report "Teens, Social Media and Technology 2022" released on 8/10/22 is available here. 

My notes:

1. I believe the predecessor of TikTok was musical.ly. I didn't see that mentioned in the Pew study. 

2. Only those ages 13-17 were polled, not those who reached the age of majority.

3. Several services that were in the prior 2014-15 poll no longer exist. These include Vine and Google+.

4. The number of teens who use Facebook "almost constantly" is 2%. Not having seen the report yesterday before my post, this subtlety obviously was not considered. You might see this as a possible source of expansion for Facebook (from 2% to 100% is a 50x multiple!). But I think it is a clear sign that Facebook is on the way out.

5. The number of teens who use any one service "almost constantly" is 19% or less, with YouTube most popular. If we assume that usage "almost constantly" is mutually exclusive, then we can add the amounts for each service:

YouTube  19%
TikTok  16%
Instagram  10%
Snapchat  15% 
Facebook  2%
total  62%

This leaves at most a 50% gain in teen use from current levels. 

6. It's probably the case that perceptions of what teens use lags, as it certainly does for this writer. I had not tracked that Facebook use among teens had fallen so far, or that Instagram was poised for further retreat among teens.

7. It's useful to notice just how much turbulence there is in social media choices overall. The only platform that shows long term stability is YouTube. DCF modeling of income from social media should use shortened durations of earnings.

8. Only 32% of teens "ever use" Facebook. This is a significant decline. It matches what has been said about Facebook before in other places, and it's old news that adults crowded into Facebook to such an extent that it became uncool. I'm in danger of being seriously uncool just mentioning such horribly stale information.

Meta's Reality Problem

Mark Zuckerberg is convinced that ordinary message-based communications using text and images will be largely replaced and supplanted by virtual reality in the future. He believes it so hard that he has pivoted his entire company towards delivering the hardware and software needed to create virtual worlds that people might inhabit and interact in. He changed the company's famous name, and its two-letter stock symbol.

It's sometimes amusing, and sometimes appalling, to watch how companies that succeeded at a ground-breaking new technology or product attempt to make lightning strike again in other fields. You've seen it too. Lotus created 1-2-3, then squandered most of its lead in spreadsheet software by attempting to reshape other markets. Google became Alphabet, because even though it controls search, it thinks it is smart enough to re-shape humanity in a half-dozen other ways too, from AI to self-driving cars to desktop software, none of which make any money, since the only lightning strike that Google actually has is search. In contrast, companies that stayed in their lane last longer. Ford Motor Company is still here and still a leader 120 years after it was founded. 

Facebook, having conquered most of the social media world, has decided that it is not good enough for the 21st century? This seems like a mistake. After all, what is wrong with text? It's concise, easily constructed and consumed, and occupies very little storage space. Though slightly less efficient, the same remains true of images, even if they are electronic.

Perhaps I am too old to understand the appeal. But then, I've experienced virtual reality, many years ago. A friend in Los Angeles who is well known in the VFX business showed me his state-of-the-art VR rig in 2016. It was good enough to give you a heart-stopping fear of falling off of virtual "cliffs". It was immersive, high resolution, smooth, without any flaws. It was a very effective demo, one that should have been impossible to dismiss.

And yet, there are problems, all centering on our humanity. If you watch someone in VR with a headset on, you see someone who is disconnected and completely divorced from the world around them. They haven't been enhanced, they have been removed. 

It reminds of me of a time in the 1990s when I looked through all of the industry categories that Investor's Business Daily maintained. Along with lists of companies, I recall seeing the industries' collective stock rates of return over a long period. It might have been only 10 years, but it was long enough that I felt I was comparing the fundamental prospects of entire industries side-by-side. What emerged was the sense that companies that deal with products that have fundamental human benefits do well. One industry that hadn't? Alcoholic beverages. Over the short run users may derive from enjoyment from the product, but over consumption is detrimental and so the alcoholic beverage industry's best customers tend to curtail their own productivity, and therefore ability to pay.

One could argue that Facebook is also such a product. Studies have shown that self-esteem declines among those who are heavy users of Facebook. Teenage suicide rates have increased markedly since the introduction of the smart phone and wide adoption of Facebook and Instagram[1]. The META officers like their products because they can make them addictive while sucking highly personal information from users, and that means higher advertising revenues for META. Perhaps Zuckerberg sees VR as an even more addictive social media. If so, I would worry that it is more like an alcoholic beverage than it is a medicine.

I actually own a few shares of META. It's not much, and so far I'm losing money. I don't see META-based VR as improving the fortunes of its users or of META, and for that reason I have little interest in adding to my position. Normally I would do a discounted cash flow (DCF) analysis of a company in figuring out its long term potential. Unfortunately, tech companies tend to have volatile, short, hard to predict life spans. Will META last five more years before seeing revenues decline? Will they spend all of their profits on VR capex for the next 10 years? At what point would they give up, or would they ride it all the way down to zero? Will it turn out like AOL?

META is already trading at a non-unicorn price. PE of 13.97, at today's price of $178.78. That's not bad, until you see ALLY at PE of 4.6, INTC at 7.4, WBA at 6.6, C at 6.6. Can META grow? Don't they already have 2 billion users? Does the bull case for META involve rooting for people to have more sex and more babies, and a higher total fertility rate (TFR) worldwide?

Teens already spend too much time on Facebook. Just today WSJ published "More Than a Third of U.S. Teens Are on Social Media Almost Constantly, Survey Says". What is the growth rate over "almost constantly"? Is it "constantly" (!!), "while sleeping too", or do we need to rely on increasing Facebook use among prison inmates and finding more undiscovered African and South American tribes?

On the other hand, Facebook and Instagram do seem to addict a lot of people. Look at how that worked for the tobacco companies. All these years later, despite huge price increases and taxes, and the fact that federal, state, and local governments make more money from cigarettes than shareholders do[2], PM, MO, and BTI are still around. Unfortunately for META shareholders, there haven't been enough academic studies that show people dying from use of social media for the liberal hue and cry to go out about shutting down or heavily taxing social media. Fortunately for META shareholders, it is unlikely that such things will come to pass, as liberal sociology academics have normative principles that align with the heaviest user base of social media, which is liberal. It is unlikely that those who lean left will shut down an addictive product most heavily used by the left.

And that bookends the META reality problem quite nicely. Here I will define a "social world" as being one that is held collectively in the minds of a large number of participants. META's infrastructure supports social worlds of this type. The maintenance of a larger, more connected and involved social world is what social media is all about. We've had social worlds since the first clans. Any polity has some aspect of a social world to it. Until 2010, most of our social worlds had to live within physical worlds, and if there was a conflict, usually the physical world won. And in cases where the social world won completely, the precarious physical existence of the polity supporting the social world (e.g., U.S.S.R., East Germany, Mao's China) forced the death or rapid reconfiguration of the "victorious" social world.

Zuckerberg's political style is clearly of this stripe. Perhaps in his mind, collectives can provide better support to a social world when the technology is enhanced. To make something up, he might believe that socialist systems don't fail because of their physical world problems, but because the social worlds built on top of the physical layer wasn't compelling enough.

Said this way, it's obvious that he is constructing a fantasy that is unlikely to hold up. Even when social worlds were held together by single page newspapers, Jane Austen novels, and town marketplaces, they were still vibrant and worthwhile, even though thinly spread. We're richer now by far, but just because we have surplus resources to commit to commentary, outrage, and Like buttons doesn't mean that we make our social worlds richer because of excess.

I think that eventually META will build a virtual world, it will have inhabitants, there will be news articles, and some exciting things will happen there. But it will be like Second Life. It will be like the other Corporate experiments with virtual worlds and virtual meeting spaces, many of which have been attempted and discarded or written off. It will be far less compelling as part of a full life. It will be easily bypassed, too expensive in all sorts of non-monetary ways. There will be injuries, repercussions, and lack of revenue. It will muddle along and be disappointing, but not when you look closely. It will also be exciting when viewed at the small scale, but a distraction when viewed at the scale of civilization.

References

1. The CDC data on teen suicide I found only goes to 2015, but the graph is certainly cheerier than the ones Jon Haidt uses, in part because it doesn't go out to 2017, and the 1990s were evidently a very dark period for teen males, who committed suicide five times more often female teens.
2. Federal cigarette tax is $1.01 per pack. State taxes vary, with DC, NY, and CT having the highest rates at $5.01, $4.35, and $4.35 per pack respectively. 

A Small Cap-Based Disproof of the Efficient Market Theory (EMT)

I have a puzzle to pose to those of you who have slightly more training than the common investor. 

I found this graph at a Fundrise page for an innovation venture fund.

I am contending that the data on this graph effectively disproves EMT. Can you explain why I am making this claim?

If it is not evident, I can give you a hint. It is: What if you consider the Stocks, Bonds, Bills, and Inflation results versus this graph?

If the answer is still not at hand, then let me give you a second clue: consider the material presented on this Fundrise page about private equity. 

The EMT Problem

The first important clue to the puzzle is that the small cap ROR shown above is below that of mid cap and large cap equities. We should generally expect that riskier investments have higher rates of return, but somehow that has not been the case from 1984 to 2015. The volatility is in the right direction, but not ROR. Mid cap equities have both higher return and higher volatility, as we would expect. 

A parallel problem is that non-U.S. equities have much higher volatility, but lower ROR than any of the U.S. equity categories. 

Another important clue: Buyout funds have higher ROR and lower volatility than any of the equity classes. 

A Thesis about Why Small Caps have Under-performed

An important point made in the Fundrise page is that tech companies have been remaining private longer. Some of them emerge from their IPOs as mid caps or large caps. Private capital is capturing more of the gains of early stage companies. That leads us to the conclusion:

Private equity is skimming off the best small cap companies from the public markets.

But if the market were efficient, then their attempts to "skim" would for naught, as any attempt to buy the "best" small cap stocks would be countered by higher small cap prices in the public markets prior to acquisition. The way to get a reduction of the small cap ROR from the SBBI results (which include 1926 to 1984 as well as the more recent years) is for private equity to have a "stock picker's edge" in selecting small cap stocks.

This edge can also be seen in the high ROR for buyout funds.

Not all small caps were bought by private equity funds. Some were bought by other public companies, including public companies that had an edge in buying their small cap competitors. The FAANGM have bought and eaten hundreds of small cap companies over the last 20 years, and it wouldn't surprise anyone if the people running those companies had an inside edge on which public (or non-public) small cap companies were worth buying. Or you could think of the FAANGM as being venture or mutual funds in themselves. Then the excess return one would typically associate with a small cap instead would show up as enhanced return of the tech large cap stocks. This certainly feels plausible, as the FAANGM cluster has done inordinately well over the past 10 to 12 years.

Entanglements with SBBI

This presents problems for those who rely (such as we did in our advice on outperforming professional investors) on SBBI results to prospect for future returns. If the future small cap candidate pool will have been cherry-picked by private equity, then what does that say about the future of SBBI and small cap index funds?

What could account for this outcome? SBBI only dates back to the early 1970s. As the SBBI results became more widely believed (perhaps in the mid-1980s?), private equity became an increasingly large force in the overall marketplace for equity. We might think that there were forces tending to make the market efficient, and this is reflected in how private equity has been scooping superior small caps from the market. If there had not been a small cap premium, there wouldn't be opportunities for capturing the excess that fed private equity.

One piece is missing: Many would argue that a strong component of private equity performance is the additional management expertise, aligned with capital, that can be brought to a deal. Then a small cap equity returning 12% in the public market could in theory return perhaps 13% or 14% or more under alternate ownership. This in turn means that public small cap stocks that would "naturally" return less than 12% could also be bought out and it would be more efficient for private equity to buy them and manage them than if they were publicly owned. An 11% stock with a 2% gain due to private ownership then becomes a 13% return; better than public ROR, and better than if the private acquirer were to only hold a partial stake in the company as publicly owned. This in turn would then explain the gap in the graph above. Only below average small caps would remain in the market after private equity had cherry-picked the better performers.

Other Theories About Small Business Formation

If business formation is substandard to past eras, then the supply of small business could be less than the long term historical norms. I have not made a systematic study of this, but this chart seems to show that U.S. business formation has been declining.

We also have anecdotes like the "flying cars" comment by Peter Thiel that expresses this sentiment. Government regulation has increased over the last 30+ years as well. The economy has shifted from rewarding physical work to intellectual work, starting in the early 1970s, which raises both the entrance requirements for building the average new business and the stakes involved.

If we assume that the efficient market theory applies to privately owned small businesses all the way down to sole proprietorships and companies employing less than 15 people, then this graph is not something that can be overcome by "boosting" small businesses via Small Business Development Centers, government programs, special grants to disadvantaged entrepreneurs, and similar interventions. Special programs that favor women-owned, minority-owned, and Native American-owned businesses in Federal Government contracting are rampant and have been in place for a long time, so there are more opportunities for entrepreneurs, not fewer.

It could also be that the costs of being a public company are higher than before. Increased regulation would also cause this to happen. If so, then the founder of a private company would tend to hold onto it longer before selling shares to the public, and therefore could potentially collect more of the superior returns available inherently in the business while it is growing rapidly. This also matches what Fundrise's second chart shows:

(Considering the current moral climate of the country, I feel it worth mentioning that having the founder "skim" from his own company by delaying when he takes his company public is completely fair. It is ridiculous to suggest otherwise; no owner "owes" it to others to take a company public sooner. Before 2020 I would not have written those sentences; now I feel that such needs to be said because there are many people who will automatically assume that founders have a duty to work harder than everyone else, take the risks on themselves, and then deliver the resulting profits to the public for free.)

If there is a shortage of small caps, then the value generated by a good new small business will be captured faster than it was before. So, from the perspective of an investor who is also willing to be an active investor, this era calls for angel investments and personal entrepreneurship as active and increasing percentages of the total investment portfolio. It is certainly the case that a great business will reward the owner far beyond the SBBI averages. If you can maintain a 20% to 30% ROE, then your money is better placed on the liabilities side of the general ledger of a small business you run yourself, because that's your return, 20% to 30%.

In some circles it might be common to write poetic lamentations about how people have lost their fire, their passion for new ventures. I scarcely think that is relevant; it is just emoting. If we believe America's SBDC and their 8/2/2022 blog entry, business formation is not suffering from any lack of enthusiasm:

"2021 broke a record year for entrepreneurship with five million new businesses started."

Where to Put Your Mind

It is a never-ending quandary in investing that you can never know enough to create an optimal investment portfolio. If you broaden your search and knowledge, then your expertise in a particular sector will be thin compared to those who specialize in that sector. If you specialize in a sector, then you may outperform others in that sector while completely missing out on other sectors that outperform yours. With enough hubris and in-borne talent you might attempt to know a lot about everything, but even if you succeed, by the time you learn it the knowledge will be obsolete or you will have allowed too much of your life to pass by to enjoy the fruits of your information advantage. 

It gets worse. With respect to knowledge about a particular sector or stock, understanding your position in a skill hierarchy is costly. Even when you act within your circle of competence, you must decide either to act with your current level of superior knowledge, or invest more time in refining it further, to beat the competition. Among specialists with which you compete some may have greater talent than you, but in order to know when you are at the top of the game you would need to invest time in learning how much the other experts know and how much they are investing in sharpening their skills. Such an effort would then compete with the time you have to invest in sharpening your skills.

When understanding the broader landscape, the more you search, the more time expended. You can attempt to locate the best performing sector, but at the start there is no guarantee that you will find it within an appropriate level of effort, or that the differentials among sectors will be worth the investment in cataloging their relative performance. Even if you locate an outperforming sector, you must then engage in extracting value from that knowledge, which may involve understanding that sector in at least some degree of detail. You might make the assumption that indexing across the sector would be sufficient, but in order to be sure that the assumption was correct, you would need to expend further effort understanding your selected sector.

Supposing that you were lucky or informed so as to have good breadth of knowledge of sector performance and depth within a chosen sector, you would still have the problem of evaluating the degree to which your knowledge would decay over time. That would control whether the advantage gained from the time invested would actually pay off in greater rates of return for long enough to pay back your time investment.

Systematic Methods

Those in quantitative professions are likely to answer these doubts with a systematic approach. The answer, at least to start, might be to survey, index, and gather numeric data on potential investments. This is certainly preferable to having no information, and in my personal experience, quantitative objective data is far superior to hunches and qualitative, subjective judgment. Still, as described above, there are limits to how much quantitative methods will advance your cause, and it can be costly. 

Perhaps the worst quantitative problem was a quip I heard many years ago that I'll loosely paraphrase: "The trouble with quantitative investing is that it finds the biggest flaw in your data and puts all of your money there." This was in the context of automated quantitative investing, which "quants" do.

When I say "quantitative" (vs. "quant") I mean any sort of numeric analysis and comparison method, starting with analyzing the balance sheet, income statement, and cash flow statements, and including fundamental ratios (PE, P/S, margins, ROE), revenue and earnings histories, and more tactical data like same store sales, customer account retention, employee turnover, and market share. It also means comparison of a large number of stocks side-by-side in some fashion, valuation, and comparison to historical values. Though quantitative methods have a tendency to consume lots of resources before they produce results, the large majority of such data is nearly impossible for the human brain to grasp at once. Such data figuratively makes the difference between being blind and seeing trends.

Notice that although I am not including any form of technical analysis in my definition of "quantitative", some aspects nevertheless qualify as objective, numeric, and potentially automated, so as to eliminate bias. In this sense, although I will claim that I make little to no use of technical price and volume analysis, it at least has some advantage over purely subjective methods because of its numeric nature.

Focusing Methods: Theory

Where do you put your attention? Do you even have control of it? This is a deep question of psychology and philosophy, and will lead you to considerations of free will if you carry it too far. If you've read to this point it is probably fair to say at least that you are attracted to the idea of improving investment results by paying attention to something, including the subject of focus.

The focus problem is another quandary, an aspect of the "optimal information gathering" problem described above. For the sake of discussion, I will confine this analysis to what to focus on once you have already allocated attention to the problem of inspecting your investments. There isn't much to be gained in looking at why you don't have time for investments, or can't even start thinking about them. You likely aren't reading this post if you fall into those categories.

To begin, although some prominent people have declared that focus was helpful to their success, it's not clear that a concentrated focus is a critical activity. Too much concentration might lead one to overlook obvious dangers or obvious gains. Too little might lead to inaction. What is the optimal level? What gets the job done? Aside from homespun bromides, I'm not aware of any scientific research, success stories, or compelling common sense that declares that "this level of focus is the right one," whatever that might be. Some clearly non-optimal levels of focus are none and too much. 

Nevertheless, focus strongly affects your investments. You can't buy something you aren't aware of, and if you are too aware of your own holdings, you won't have the adverse information and perspective you need to sell them when it is objectively required. There are many, many opportunities for regret, some leading to "analysis paralysis" in which you become so aware of the many things you don't know, and compelled to find out before acting, that the information search prohibits you from taking any action until it is too late.

Though I've come nowhere close to "proving" that there is no optimal focusing method, it seems that this line of investigation is showing that there might not be anything close to an "optimal" focusing method, so instead we turn to smaller measures. We shall be inspired by folklore and common sense here.

Practical Focusing Methods

This section will use a brainstormed list of ideas for maintaining focus, obtaining or re-obtaining focus, or changing focus. Since these are practical and not theoretical methods, the proof of their performance will be in whether they work for the reader.

• making a checklist once, for today, at the beginning of the day, and going through it
• using a canned checklist that contains items that historically have been useful to review, or which at least we think might be useful to review
• looking around to see what catches your attention right now (requires that looking around be slightly more than just doing nothing)
• asking people near you what's new
• looking at an internet-based website that has a feed based on (something)
• meditating
• reflecting on what is more important, perhaps as amplified by a Franklin-Covey planner or similar time-tracking system, and using critical long term goals that can be fed through near term actions
• reading psychology papers, such as Kahneman and Tversky's psychology papers on non-rational thinking, or the behavioral economics literature, and reflecting on how those principles impact whatever it is that you are supposed to be doing today
• just doing it

Is this list satisfying? I would not be surprised if it leaves you cold. Perhaps you are thinking that I didn't really do my homework today, that this list really ought to be different, better, more complete, or more informed by research. If so, please comment. 

Using The Force to Jump Outside the Box

This article originally started as the introduction to the BDC survey I published earlier this week. It grew beyond that mission and so became its own article. The focus section was started on twice, resisted being written at least once, and perhaps changed shape overnight after the first attempt. At this moment, as I write this, my own impression is that the topic of focus is probably very misunderstood among practitioners. Nearly every industry business standard or development standard (CMM, CMMI, ISO, Kanban, DevOps, Six Sigma, etc.) involves some of the steps in the list above, with very strong emphasis on doing something, a business practice, over and over again in repeatable ways. What's missing is any sort of approach when you have a problem that is not repeatable.

The first bit of folklore to use to illustrate the problem is "the Force" in Star Wars. Is this a focus trick? It certainly seems to be. The Jedi advice is, roughly, do not plan or worry too much about the future, that rather than have your mind elsewhere, one should focus on being where they are.

"Always remember, your focus determines your reality." 

“Your eyes can deceive you. Don’t trust them.”

“Mind tricks don’t work on me.”

“Don't center on your anxieties, Obi-Wan. Keep your concentration here and now, where it belongs.”

Many years ago I spent a day playing a business game called Gold of the Desert Kings. Each team's task was to travel (virtually, via a game board with markers and other game accessories) across the desert, mine gold, and bring it back. Although at first you were given part of the goal of the game, you were not told much about anything else. Rules, options, potential events, and other details were omitted at the beginning. Turns were timed, with hard deadlines. Lots of information was unknown, but you were allowed to ask some types of questions. 

After it was over, during the debriefing, we were told a story. Who was the highest scoring team ever and how did they achieve it? The answer, was that the team asked early in the game what was possible, what was the previous highest score? Having obtained that answer, they could then work backwards and deduce other unknown aspects of the game. The lesson seems to have been: Find out what is possible before deciding what to do. 

The meta lesson: Jump outside the box before establishing a focus. 

This lesson too will be unsatisfying and inapplicable to some circumstances. If we have no free will the question of where to put focus and this answer are meaningless. But perhaps we do have free will, and making an effort to consider the problem is part of the art of obtaining "optimal focus", if there is such a thing. In the process of journeying briefly through the problem of where to put your attention, perhaps we have improved our chances at putting it in places of most utility.

Pizzarias: A Forgotten Favorite with Unusual Comeback Potential?

Some snack foods develop very loyal followings. One I learned about today, but I never tasted myself, is Keebler's Pizzarias. They were introduced in 1991 and were supposedly an instant hit:

Pizzarias were made in a novel process from fresh pizza dough and were available in three flavors: Cheese Pizza, Pizza Supreme, and Zesty Pepperoni. Launched in 1991, Pizzarias were reported to be the most successful snack food launch in Keebler's history, earning wholesale revenue of $75 million in their first year. Due to the success of the Pizzarias launch, Keebler was named "New Product Marketer of the Year" in 1992 by the American Marketing Association. Pizzarias also earned a Gold Edison award from the AMA for marketing excellence.

How loyal? Although discontinued in the 1990s (?), the brand has two Facebook groups and its own Wikipedia page. A Reddit posting to r/nostalgia mentioned Pizzarias 4 days ago.

Why would a successful brand be discontinued? Perhaps because management overlooked it. Actually, many managements (plural).

At the time of Pizzarias' introduction, it looks like Keebler was owned by United Biscuits. United Biscuits sold Keebler to Flowers Industries and Artal Luxembourg, a private equity firm in 1997. In 2001 Keebler was bought by Kellogg Company. In 2019 Kellogg sold Keebler to Ferrero SpA. 

At some point, the right to the Pizzarias brand changed hands separately from Keebler. According to this Wikipedia article on Pizzarias, Utz Brands now owns the Pizzarias brand.

Assuming a unit wholesale price of 80 cents, Keebler might have sold 94 million units in 1991. If Utz were to reintroduce the product today, assuming a 50% reduction in unit sales (because of health consciousness) but an increase of, say, 25% due to higher population and faster social contagion, and 50% higher unit price, then a re-introduction could be worth $88 million in revenue in the first year. Or, social media could cause it to go viral, at double the 1991 unit sales, and then the first year would produce $352 million in revenue. Perhaps a vegetable topping-based flavor variant with onion, bell pepper, and celery? Or maybe a healthy homemade dip could go viral for being famous as the perfect complement to pizza flavor (but especially cheese pizza) chips, where the home-made diced vegetable dip is based on the Cajun "holy trinity" vegetables plus tomato?

A Quick Survey of Business Development Companies (BDCs)

A so far unremarked misadventure of my own the last few years has been making several investment mistakes in mortgage real estate investment trusts (MREITs). Perhaps 10 years ago a friend of mine mentioned that he had invested in Annaly Capital Management Inc (NLY). At that time, I was leery of investing in high-yield financial securities, having observed several equity REITs with high yields crash about a dozen years before. The basic idea of an MREIT is simple enough. The problem I worried about was the conflict of interest management has with shareholders, and the intense competition among companies in the same industry trying to outdo each other in leveraging up their assets. The other problem is that I've never found interest rates to be predictable over the short term, and over the long term the error is more likely to be in holding long-dated bonds as interest rates rise.

Sure enough, my experiments in that sector resulted in mostly setbacks. At the moment I'm not convinced that I have the expertise to pick winners in the MREIT industry, and so I am currently avoiding it.

Still, MREITs are not the only high-yield sector. Another category in the Business Development Company sector. Last week I spent some time exploring it, and I liked what I found much, much more than MREITs. This article will report on my findings.

BDC Structure and Legal Background

The BDC structure originates in a 1980 amendment to the Investment Company Act of 1940. Taxation is pass-through, like a REIT or MREIT. The BDC Wikipedia article and Investopedia have good explanations, so I will say nothing more here. I found the external links section of the Wikipedia article to be a great resource.

Use as a VC-Style Investment

Suppose you've had some success at investing in publicly-traded equities, have watched Shark Tank, and want to go further and get closer to the founding and running of new enterprises? You could start your own business, be an angel investor in friends and acquaintances' businesses, or take other risks like bungee jumping with frayed cords. BDCs offer a way to get the flavor of this style of investing, with smaller initial outlays, liquidity, and diversification. You can choose to pay little attention and just collect dividends, or inspect the portfolios to see the small businesses who are clients. In my short investigation of one BDC's portfolio I found arborists, a cosmetics company, an HVAC services company, several small manufacturers, and a construction company.

Function 

The purpose of BDCs is to provide increased borrowing options for small and medium-sized businesses. The public supplies the capital, a management team (typically fairly small with respect to the investments, of course) supplies concentrated business expertise at judging the riskiness of the client firms, and small business gets credit and expansion opportunities they might not have had otherwise. In my quick view of the business I saw multiple important functions addressed for all parties. The usual business risks are present, as they always are, but there is a fundamental purpose that is quite valuable.

The BDC purpose is not flawed like MREITs. MREITs exist to provide capital to the housing market. Unfortunately, this purpose accidentally provides all of the benefits to the public and real estate brokers. Since mortgage funds then become a commodity, mortgage rates are driven to levels that are unprofitable for the lender, and which also then drive risky behavior by management, who scramble for survival. (Or at least are scrambling for the survival of the enterprise's book value.) Though I have not yet written enough for a full article on the topic of U.S. housing finance, I think there is some reason to believe that the tax-advantaged nature of mortgage debt makes the U.S. housing market inherently unstable, and that instability is reflected in the volatile and generally poor results of the MREITs. 

Selections and Rationale

Closed End Fund Advisors maintains an outstanding database of BDC data. They maintain an extensive database and provide reports on most (all?) closed-end funds. It is well worth your time to go to their excellent, well-presented site and review what they have to offer. (No, I am not affiliated with them and this is not a paid advertisement. I doubt they even know that Vorpal Trade exists.)

I reviewed all 49 BDCs in the database, noting NAV growth especially. My method of sorting for quality using the data was to weight annualized NAV rate of return most highly, and to discount NAV ROR for length of tenure. I was also less interested in BDCs trading at a large premium to their NAV. With those criteria in mind, I found these nine BDCs worth investment: ARCC, CSWC, FDUS, GAIN, NEWT, PNNT, PSEC, SAR, TSLX.

This year's turbulence has driven down prices of most BDCs, so although some have recovered in price over the month of July, you are getting better prices than were available in 2021. Also keep the premium or discount to NAV in mind. The market clearly favors BDCs that generate above average NAV gains, so you might have to pay a premium to get quality.

The vast majority of BDCs are debt-focused, making secured loans. Many will still have some equity or warrants in their portfolio. I saw only two equity-focused BDCs, though I may have missed some others. The past performance of the equity-focused BDCs was not impressive, so none are in my list of nine.