Author: Scott Buchanan

Hazards of the Internet of Things 2. Big Brother Is Watching Your Every Breath

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There seems to be something of a generational divide as to how important is your personal privacy. Folks under, say, age 40, have lived such a large fraction of their lives with Facebook and Amazon and Google and Twitter logging and analyzing and reselling information on what they view and listen to and say and buy, that they seem rather numb to the issue of internet privacy. Install an Alexa that ships out every sound in your home and a smart doorbell that transmits every coming and going to some corporate server, fine, what could possibly be the objection?  So what if your automobile, in addition to tracking and reporting your location, feeds all your  personal phone text messages to the vehicle manufacturer?

For us older folks whose brain pathways were largely shaped in a time when communication meant talking in person or on a (presumably untapped) phone, this seems just creepy. Polls show that a majority of Americans are uneasy about the amount of data on them being collected, but “do not think it is possible to go about daily life without corporate and government entities collecting data about them.”

There are substantive concerns that can be raised about the uses to which all this information may be put, and about its security. Per VPNOverview:

Over 1,800 data leaks took place last year in the US alone, according to Statista. These breaches compromised the records of over 420 million people.” . With smartwatches having access to so much sensitive information, here’s what kind of data can fall into the wrong hands in case of a data leak:

  • Your personal information, including name, address, and sometimes even Social Security Number
  • Sensitive health information collected by the smartwatch
  • Login credentials to all the online platforms connected to your smartwatch
  • Credit card and other payment information
  • Digital identifiers like your IP address, device ID, or browser fingerprint
  • Remote access information to smart home devices

Several times a year now, I get notices from a doctor’s office or finance company or on-line business noting blandly that their computer systems have been hacked and bad guys now have my name, address, birthdate, social security number, medical records, etc., etc. (They generously offer me a year of free ID fraud monitoring. )

The Internet of Things (IoT) promises to ramp up the snooping to a whole new level. I took note four years ago when Google acquired Fitbit. At one gulp, the internet giant gained access to a whole world of activity and health data on, well, you. The use of medical and other sensors, routed through the internet, keeps growing. One family member uses a CPAP machine for breathing (avoid sleep apnea) at night; the company wanted the machine to be connected on the internet for them to monitor and presumably profit from tracking your sleep habits and your very breath. And of course when you don a smart watch, your every movement, as well as your heartbeat, are being sent off into the ether. (I wonder if the next sensor to be put into a smart watch will be galvanic skin response, so Big Tech can log when you are lying).

According to a senior systems architect: “The IoT is inevitable, like getting to the Pacific Ocean was inevitable. It’s manifest destiny. Ninety eight percent of the things in the world are not connected. So we’re gonna connect them. It could be a moisture sensor that sits in the ground. It could be your liver. That’s your IoT. The next step is what we do with the data. We’ll visualize it, make sense of it, and monetize it. That’s our IoT.”

When my kids were little, we let them use cassette tape players to play Winnie the Pooh stories. With my grandkids, the comparable device is a Yoto player. This also plays stories (which is good, better than screens), but it only operates in connection with the internet. The default is that the Yoto makers collect and sell personal information on usage by you and your child (which would include time of day as well as choice of stories). You can opt out, if you are willing to take the trouble to write to their legal team (thanks, guys).

There are cities in the world, in China but also some European cities, where there are monitoring cameras (IoT) everywhere. Individuals can be recognized by facial features and even by the way they walk; governmental authorities compile and track this information. These surveillance systems are being sold to the public with the promise of increased “security.” Whether it really makes we the people more secure is heavily dependent on the benevolence and impartiality of the state powers. Supposing a department of the federal government with access to surveillance data became politicized and then harassed members of the opposing party?

I’ll conclude with several slides from  Timothy Wallace’s 2023 presentation on the Internet of things:

The dystopian  novel 1984 by George Orwell was published in 1949.  It describes a repressive totalitarian state, headed by Big Brother, which was characterized by pervasive surveillance. Ubiquitous posters reminded citizens, “Big Brother is watching you.” Presumably the various cameras and microphones used in the mass surveillance there were paid for and installed by the eavesdropping authorities. It is perhaps ironic that so many Americans now purchase and install devices that allow some corporate or governmental entity to snoop them more intimately than Orwell could have imagined.

Hazards of the Internet of Things 1. Hacking of Devices (Baby Monitors, Freezers, Hospital Ventilators) in Homes and Institutions

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For my birthday this year, someone gave me a “smart” plug-in power socket. You plug it into the wall, and then can plug in something, say a lamp, into the smart socket, which you can then control via the internet. Yay, I am now a part of the Internet of Things (IoT). What could possibly go wrong?

However, my Spidey-sense started to tingle, and I chose to give this device away.  At that point, I was thinking mainly of the potential for such devices to get hacked and then recruited to be part of a vast bot-net which can then (under the control of bad actors) conduct massive attacks on crucial internet components. For instance,

Mirai [way back in 2016] infected IoT devices from routers to video cameras and video recorders by successfully attempting to log in using a table of 61 common hard-coded default usernames and passwords.

The malware created a vast botnet. It “enslaved” a string of 400,000 connected devices. In September 2016, Mirai-infected devices (who became “zombies”) were used to launch the world’s first 1Tbps Distributed Denial-of-Service (DDoS) attack on servers at the heart of internet services.  It took down parts of Amazon Web Services and its clients, including GitHub, Netflix, Twitter, and Airbnb.

But it turns out the hazards with smart devices are widespread indeed. IoT devices are so useful for bad guys that that they are attacked more than either mobile devices or computers. One layer of hazard is the hacking of specific, poorly-secured devices in a home or institution, with subsequent control of devices and infiltration of broader computing systems. This will be the focus of today’s blog post. Another layer of hazard is the use to which masses of (sometimes private and personal) data snooped from “unhacked” smart devices are put by large corporations and state actors; that will be considered in a part 2 post.

Here are results from one study from nearly three years ago:

https://www.thalesgroup.com/en/markets/digital-identity-and-security/iot/magazine/internet-threats

A study published in July 2020 analyzed over 5 million IoT, IoMT (Internet of Medical Things), and unmanaged connected devices in healthcare, retail, manufacturing, and life sciences. It reveals an astonishing number of vulnerabilities and risks across a stunningly diverse set of connected objects….

The report brings to light disturbing facts and trends:

  • Up to 15% of devices were unknown or unauthorized.
  • 5 to 19% were using unsupported legacy operating systems.
  • 49% of IT teams were guessing or had tinkered with their existing IT solutions to get visibility.
  • 51% of them were unaware of what types of smart objects were active in their network.
  • 75% of deployments had VLAN violations
  • 86% of healthcare deployments included more than ten FDA-recalled devices.
  • 95% of healthcare networks integrated Amazon Alexa and Echo devices alongside hospital surveillance equipment.

…Ransomware gangs specifically target healthcare more than any other domain in the United States. It’s now, by far, the #1 healthcare breach root cause in the country. …The mix of old legacy systems and connected devices like patient monitors, ventilators, infusion pumps, lights, and thermostats with very poor security features are sometimes especially prone to attacks.

So, these criminals understand that stopping critical applications and holding patient data can put lives at risk and that these organizations are more likely to pay a ransom.

I know people in organizations which have been brought to their knees by ransomware attacks. And I have read of the dilemma of the guy who was on vacation in the Caribbean or whatever, and got a text from a hacker instructing him to deposit several hundred dollars in a Bitcoin account, or else his “smart” refrigerator/freezer would be turned off and he would come home to a spoiled, moldy mess.

What brought all this IoT stuff to my attention this week was a talk I ran across from retired MIT researcher Timothy Wallace, titled “Effects, Side Effects and Risks of the Internet of Things”, presented at the 2023 American Scientific Affiliation meeting. The slides for his talk are here. I will paste in a few snipped excerpts from his talk, that are fairly self-explanatory:

(My comment: 10 billion is a really, really big number…)

(My comment: this type of catastrophic compromise of computer systems being enabled by hacking some piddling little IoT device that happens to be in the home or institution local network is not uncommon. Which is why I am reluctant to put IoT devices, especially from no-name foreign manufacturers, on my home wireless network).

Many of these vulnerabilities could in theory be addressed by better practices like always resetting factory passwords on your smart devices, but it is easy for forget to do that.

And just to end on a light note (this cartoon also lifted from Wallace’s slides):

San Francisco Fed Says Pandemic Surplus Is Gone; Boston Fed Demurs

Scott Buchanan2 Comments

Is it the best of times or the worst of times? This question I asked myself as I saw the following three headlines juxtaposed last week:

“US consumers are in the best shape ever” is sandwiched between two downers. The American consumer’s ongoing spending has staved off the long-predicted recession, quarter after quarter after quarter. Can we keep those plates spinning?

We noted earlier that the huge windfall of pandemic benefits (direct stimulus plus enhanced unemployment benefits) put trillions of dollars into our bank accounts, and the spending down of that surplus seems to have powered the overall economy and hence employment (and inflation). How the economy does going forward is still largely determined by that ongoing spend-down. Thus, the size of the remaining hoard is critically important.

Unfortunately, it seems to be difficult to come up with an agreed-on answer here. The San Francisco Fed maintains a web page dedicated to tracking “Pandemic-Era Excess Savings.” Here is a key chart, tracking the ups and downs of “Aggregate Personal Savings”:

This is compared to a linear projection of pre-pandemic savings, which is the dotted line. (Which dotted line you choose is crucial, see below) . The next chart plots the cumulative savings relative to that line, showing a steady spend-down, and that this excess savings is just about exhausted:

If this represents reality, then we might expect an imminent slowdown in consumer spending and in GDP growth, and presumably a lessening in inflationary pressures, which may in turn justify more rate cuts by the Fed.

But the Boston Fed says, “Maybe not.”  A study by Omar Barbiero and Dhiren Patki published in November titled Have US Households Depleted All the Excess Savings They Accumulated during the Pandemic? showed that it makes a huge difference which savings rate trend you choose for a baseline.

The following chart shows two versions of the first plot shown above, with (on the left) a linear, increasing projection of 2018-2019 savings trends, versus a flat savings rate baseline:

Two significant differences between these plots and the San Francisco Fed plot shown above are that these plots only run through the end of 2022, and that they display per cent savings rate rather than dollar amounts. However, they demonstrate the difference that the baseline makes. Using an increasing savings rate baseline (2018-2019 trend projection), the surplus was nearly exhausted at the end of 2022. Using a flat rate average of 2016-2019 for the baseline, the surplus was barely dented.

We will see how this plays out. My guess is that at the first whiff of actual recession and job losses, the administration will gush out the maximum amount of largesse; while we may have ongoing inflation and high interest rates due to the deficit spending, we will not have a hard landing. I think.

Stock Options Tutorial 2. How Options Are Priced

Scott Buchanan5 Comments

This continues our occasional series on stock options for amateurs.

I find options to be a nice tool in my investing arsenal. The previous post in this series was Stock Options Tutorial 1. Options Fundamentals.  That post dealt with buying options, to provide simple examples. For reasons to explained in a future post, I usually prefer to sell options. Anyway, here we will look briefly at how options are priced. It is important to get an intuitive understanding of this, in order to be comfortable actually using options in your account.

The current price of an option, if you wanted to buy or sell it, is called the premium. There are two components that go into the premium, the intrinsic value and the extrinsic (or “time”) value:

Source: OptionAlpha

Intrinsic Value of Options

The intrinsic value is easy to figure out, once you understand it. It is simply how much you would profit if you owned the option, and decided to exercise it right now. For instance, if you owned a call with a strike price of $50, but the stock price is $55, you could exercise the call and force whoever sold you the call to sell you the stock at a price of $50/share; you could turn around and immediately sell that share for $55, pocketing $5/share. We say that the option in this case is $5 in the money, and the intrinsic value is $5.

If the stock price were $60, it would be $10 in the money; you could pocket $10/share for exercising it. If the stock price were say $90, the option would be $40 in the money, and so on.

However, if the stock price were $50 (the $50 option is “at the money”) or lower (option is “out of the money”), you would get no benefit from being able to purchase this stock for $50, and so the intrinsic value of the option would be zero.

With a put (which is an option to sell a stock at a particular price), this is all reversed. If the stock is $5 lower than the option strike price, the option is $5 in the money and has a $5 intrinsic value, since if you own it, you could say buy the stock at $45, and force the put option seller to buy it from you at $50/share:

Source: OptionAlpha

Extrinsic (Time) Value of Options

Suppose the current price of a stock is $50. And suppose you suspect its price may be above $50, say $60 sometime in the next month, so you would like to have the option of buying it at $50 sometime in the future, and then selling it into the market at (say) $60, for a quick, guaranteed profit of $10. Sounds great, yes?

Since a $50 call is right at the money (since the stock price is also $50), the intrinsic value of a $50 call is zero. Does this mean you could go out and buy a $50 call option for nothing? No, because the seller of the option is taking a risk by providing you that option. If the stock really does go to $60, he could be out the $10. Therefore, he will demand a higher price than the intrinsic price, to make it worth his while. This extra premium over the intrinsic premium is the extrinsic premium, which varies greatly with the time till expiration of the option.

If you wanted the option of buying the stock at $50 sometime in the next week, the option seller would charge only a small amount; after all, what are the odds that the stock will rise a lot in one week? However, if you wanted to extend that option period out to one year, he will charge you a high extrinsic premium, since there is a bigger chance that the stock could soar will over $50 sometime in that long timeframe.

Another way of framing this is, if you buy a $50 call option today with an expiration date a year from now, you will pay a high extrinsic value. But as the months roll by, and it gets closer to the expiration date, this extrinsic value or time premium will shrink down ever more quickly towards zero:

Source: QuantStackExchange, on Seeking Alpha

Now, computing the actual amount of the extrinsic value is really gnarly. The Black-Scholes model provides a theoretical value under idealized conditions, but for us amateurs, we pretty much have to just take what the market gives us. In deciding whether to buy or sell an option, I look at what the current market pricing is for it.

It turns out that an option which is priced at the money has the highest extrinsic value. As you get further into or out of the money, the extrinsic component of the total premium for the option diminishes. Below is one final graphic which pulls all this together:

Source: OptionTradingTips

The call option strike price is $25. The blue line shows the intrinsic value (labeled as “payoff at expiration”) at each stock price – this is zero at or below $25, and increases 1:1 as the stock price climbs above $25. The red curve shows the full market price of the option, including the extrinsic (time) premium. The spacing between the red and the blue lines shows the amount of the extrinsic premium. That spacing is greatest when the stock price is equal to the $25 strike price. The shaded areas specify the intrinsic and extrinsic values at a stock price of $27.

And (not shown here) as time passed and the option got closer to expiry, the extrinsic value would shrink (decay), and the red curve would creep closer and closer to the blue curve.

Saba Closed-End Funds ETF (CEFS): Have Finance Legend Boaz Weinstein Manage Your Closed End Fund Investments

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Boaz Weinstein and the London Whale

Boaz Weinstein is a really smart guy. At age 16 the US Chess Federation conferred on him the second highest (“Life Master”) of the eight master ratings. As a junior in high school, he won a stock-picking contest sponsored by Newsday, beating out a field of about 5000 students. He started interning with Merrill Lynch at age 15, during summer breaks. He has the honor of being blacklisted at casinos for his ability to count cards. 

He entered into heavy duty financial trading right out of college, and quickly became a rock star. He joined international investment bank Deutsche Bank in 1998, and led their trading of then-esoteric credit default swaps (securities that payout when borrowers default). Within a few years his group was managing some $30 billion in positions, and typically netting hundreds of millions in profits per year. In 2001, Weinstein was named a managing director of the company, at the tender age of 27.

Weinstein left Deutsche Bank in 2009 and started his own credit-focused hedge fund, Saba Capital Management. One of its many coups was to identify some massive, seemingly irrational trades in 2012 that were skewing the credit default markets. Weinstein pounced early, and made bank by taking the opposite sides of these trades. He let other traders in on the secret, and they also took opposing positions.

(It turned out these huge trades were made by a trader in J. P. Morgan’s London trading office, Bruno Iksil, who was nick-named the London Whale. Morgan’s losses from Iksil’s trades mounted to some $6.2 billion.)

For what it’s worth, Weinstein is by all accounts a really nice guy. This is not necessarily typical for many high-powered Wall Street traders who have been as successful as he.

Weinstein and the Sprawling World of Closed End Funds

If you have a brokerage account, you can buy individual securities, like Microsoft common stock shares, or bonds issued by General Motors. Many investors would prefer not to have to do the work of screening and buying and holding hundreds of stocks or bonds. No problem, there exist many funds, which do all the work for you. For instance, the SPY fund holds shares of all 500 large-cap American companies that are in the S&P 500 index, so you can simply buy shares of the one fund, SPY. 

Without going too deeply into all this, there are three main types of funds held by retail investors. These are traditional open-end mutual funds, the more common exchange-traded funds (ETFs), and closed end funds (CEFs). CEFs come in many flavors, with some holding plain stocks, and others holding high-yield bonds or loans, or less-common assets like spicy CLO securities. A distinctive feature of CEFs is that the market price per share often differs from the net asset value (NAV) per share. A CEF may trade at a premium or a discount to NAV, and that premium or discount can vary widely with time and among otherwise-similar funds. This makes optimal investing in CEFs very complex, but potentially-rewarding: if you can keep rotating among CEF’s, buying ones that are heavily discounted, then selling them when the discount closes, you can in theory do much better than a simple buy and hold investor.

I played around in this area, but did not want to devote the time and attention to doing it well, considering I only wanted to devote 3-4% of my personal portfolio to CEFs. There are over 400 closed end funds out there. So, I looked into funds whose managers would (for a small fee) do that optimized buying and selling of CEFs for me.

It turns out that there are several such funds-of-CEF-funds. These include ETFs with the symbols YYY and PCEF, CEFS, and also the closed end funds FOF and RIV. YYY and PCEF tend to operate passively, using fairly mechanical rules. PCEF aims to simply replicate a broad-based index of the CEF universe, while YYY rebalances periodically to replicate an “intelligent” index which ranks CEFs by yield, discount to net asset value and liquidity. FOF holds and adjusts a basket of undervalued CEFs chosen by active managers, while RIV holds a diverse pot of high-yield securities, including CEFs. The consensus among most advisers I follow is that FOF is a decent buy when it is trading at a significant discount, but it makes no sense to buy it now, when it is at a relatively high premium; you would be better off just buying a basket of CEFs yourself.

I settled on using CEFS (Saba Closed-End Funds ETF)  for my closed end fund exposure. It is very actively co-managed by Saba Capital Management, which is headed by none other than Boaz Weinstein. I trust whatever team he puts together. Among other things, Saba will buy shares in a CEF that trades at a discount, then pressure that fund’s management to take actions to close the discount.

The results speak for themselves. Here is a plot of CEFS (orange line) versus SP500 index (blue), and two passively-managed ETFs that hold CEFs, PCEF (purple) and YYY (green) over the past three years:

The Y axis is total return (price action plus reinvestment of dividends). CEFS smoked the other two funds-of-funds, and even edged out the S&P in this time period.  It currently pays out a juicy 9% annualized distribution. Thank you, Mr. Weinstein, and Merry Christmas to all my fellow investors.

Boilerplate disclaimer: Nothing in this article should be regarded as advice to buy or sell any security.

Former Treasury Official Defends Decision to Issue Short Term Debt for Pandemic;  I’m Not Buying It

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We noted earlier (see “The Biggest Blunder in The History of The Treasury”: Yellen’s Failure to Issue Longer-Term Treasury Debt When Rates Were Low ), along with many other observers, that it seemed like a mistake for the Treasure to have issued lots of short-term (e.g. 1-2 year) bonds to finance the sudden multi-trillion dollar budget deficit from the pandemic-related spending surge in 2020-2021. Rates were near-zero (thanks to the almighty Fed) back then.

Now, driven by that spending surge, inflation has also surged, and thus the Fed has been obliged to raise interest rates. And so now, in addition to the enormous current deficit spending,  that tsunami of short-term debt from 2020-2021 is coming due, to be refinanced at much higher rates. This high interest expense will contribute further to the growing government debt.

Hedge fund manager Stanley Druckenmiller  commented in an interview:

When rates were practically zero, every Tom, Dick and Harry in the U.S. refinanced their mortgage… corporations extended [their debt],” he said. “Unfortunately, we had one entity that did not: the U.S. Treasury….

Janet Yellen, I guess because political myopia or whatever, was issuing 2-years at 15 basis points[0.15%]   when she could have issued 10-years at 70 basis points [0.70 %] or 30-years at 180 basis points [1.80%],” he said. “I literally think if you go back to Alexander Hamilton, it is the biggest blunder in the history of the Treasury. I have no idea why she has not been called out on this. She has no right to still be in that job.

Unsurprisingly, Yellen pushed back on this charge (unconvincingly). More recently, former Treasury official Amar Reganti has issued a more detailed defense. Here are some excerpts of his points:

( 1 ) …The Treasury’s functions are intimately tied to the dollar’s role as a reserve currency. It is simply not possible to have a reserve currency without a massive supply of short-duration fixed income securities that carry no credit risk.

( 2 ) …For the Treasury to transition the bulk of its issuance primarily to the long end of the yield curve would be self-defeating since it would most likely destabilise fixed income markets. Why? The demand for long end duration simply does not amount to trillions of dollars each year. This is a key reason why the Treasury decided not to issue ultralong bonds at the 50-year or 100-year maturities. Simply put, it did not expect deep continued investor demand at these points on the curve.

( 3 ) …The Treasury has well over $23tn of marketable debt. Typically, in a given year, anywhere from 28% to 40% of that debt comes due…so as not to disturb broader market functioning, it would take the Treasury years to noticeably shift its weighted average maturity even longer.

( 4 ) …The Treasury does not face rollover risk like private sector issuers.

Here is my reaction:

What Reganti says would be generally valid if the trillions of excess T-bond issuance in 2020-2021 were sold into the general public credit market. In that case, yes, it would have been bad to overwhelm the market with more long-term bonds than were desired.  But that is simply not what happened. It was the Fed that vacuumed up nearly all those Treasuries, not the markets. The markets were desperate for cash, and hence the Fed was madly buying any and every kind of fixed income security, public and corporate and mortgage (even junk bonds that probably violated the Fed’s bylaws), and exchanging them mainly for cash.  Sure, the markets wanted some short-term Treasuries as liquid, safe collateral, but again, most of what the Treasury issued ended up housed in the Fed’s digital vaults.

So, I remain unconvinced that the issuance of mainly long-term (say 10-year and some 30-year; no need to muddy the waters like Reganti did with harping on 50–100-year bonds) debt would have been a problem. So much fixed-income debt was vomited forth from the Treasury that even making a minor portion of it short-term would, I believe, have satisfied market needs. The Fed could have concentrated on buying and holding the longer-term bonds, and rolling them over eventually as needed, without disturbing the markets. That would have bought the country a decade or so of respite before the real interest rate effects of the pandemic debt issuance began to bite.

But nobody asked my opinion at the time.

Charlie Munger’s Rule for a Happy Life

Scott Buchanan1 Comment

A big piece of news in the investment world has been the passing of Charlie Munger on Nov 28 at age 99. He was vice chair of Berkshire Hathaway, and Warren Buffett’s right-hand man there.

Munger grew up in Omaha, Nebraska, which is Warren Buffett’s hometown as well. They met at a dinner party there in 1959, and hit it off with one another personally.  Munger was a really smart guy. After joining the US Army Air Corps in1943, he scored highly on an intelligence test and was sent to study meteorology at Caltech. After the war he was accepted into Harvard Law School despite lacking a formal undergraduate degree, and graduated summa cum laude.

In his 50s, Munger lost his left eye after cataract surgery failed. A doctor warned he could lose his right eye too, so he began learning braille, but the condition improved.

He entered law practice, and eventually started his own firm, but he became more interested in investing. He racked up 19.8% annual returns investing on his own, between 1962 and 1975. Buffett convince Munger to give up law and join him as vice-chairman of Berkshire Hathaway in 1978.

Perhaps Buffett’s most famous investing saying is “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. He credits this approach to Munger: “Charlie understood this early – I was a slow learner.”  Before being influenced here by Munger, Buffett had been more inclined to buy very low-priced shares in mediocre companies.  

Munger was heavily involved with Buffett’s decisions. “Berkshire Hathaway could not have been built to its present status without Charlie’s inspiration, wisdom and participation,” Buffett said following Munger’s death. That tribute is no overstatement: from the time Munger joined Berkshire Hathaway in 1978 till now, shares of the company soared 396,182% (i.e.,  $100 invested in Berkshire Hathaway in 1978 is worth $396,282 today). This performance dwarfs the 16,427% appreciation of the S&P 500 over the same time period. When he died, Munger was personally worth $2.6 billion.

(See more on Berkshire Hathaway’s formula for success at: Warren Buffett’s Secret Sauce: Investing the Insurance “Float” )

Quotations From Vice-Chairman Charlie

The internet is rife with sites displaying memorable or useful quotes from Charlie Munger. For example, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do”;   and three rules for a career: “1) Don’t sell anything [to others] you wouldn’t buy yourself; 2) Don’t work for anyone you don’t respect and admire; and 3) Work only with people you enjoy.”

Some of these quote lists focus on sayings which provide guidance to individual investors, such as this from CNBC:

“I think you would understand any presentation using the word EBITDA, if every time you saw that word you just substituted the phrase,  ‘bull—- earnings.’ ″

The 2003 Berkshire shareholder meeting was one of the many occasions Munger called out what he saw as shady accounting practices, in this case EBITDA — a measure of corporate profitability short for earnings before interest, taxes, depreciation and amortization.

In short, Munger felt that companies often highlighted convoluted profitability metrics to obscure the fact that they were severely indebted or producing very little cash.

“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash,” Munger said at the same meeting. “It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”

To invest like Munger and Buffett, don’t fall for the flashiest numbers in the firms’ investor presentations. Instead, dig into a company’s fundamentals in their totality. The more a company or an investment advisor tries to win you over with esoteric terms, the more skeptical you should likely be.

As Buffett put it in his 2008 letter to shareholders: “Beware of geeks bearing formulas.”

Munger’s Secret to Happiness

Out of all these witty and helpful quotes, I’ll conclude by zeroing in on what Charlie Munger thought was the single most important factor in achieving personal happiness. He said it a number of different ways:

The secret to happiness is to lower your expectations. …that is what you compare your experience with. If your expectations and standards are very high and only allow yourself to be happy when things are exquisite, you’ll never be happy and grateful. There will always be some flaw. But compare your experience with lower expectations, especially something not as good, and you’ll find much in your experience of the world to love, cherish and enjoy, every single moment.

and

The world is not going to give you extra return just because you want it. You have to be very shrewd and hard working to get a little extra. It’s so much easier to reduce your wants. There are a lot of smart people and a lot of them cheat, so it’s not easy to win.

and finally:

A happy life is very simple. The first rule of a happy life is low expectations. That’s one you can easily arrange. And if you have unrealistic expectations, you’re going to be miserable all your life. I was good at having low expectations and that helped me. And also, when you [experience] reversals, if you just suck it in and cope, that helps if you don’t just stew yourself into a lot of misery.

Stock Options Tutorial 1. Options Fundamentals

Scott Buchanan4 Comments

Put simply, a stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date.

Example: Buying Apple Call Option Instead of the Stock


In a little more detail: if you buy a call option on a stock, that gives you the right to buy that stock at the strike price (“call” the stock away from some current stockholder).
For most American stocks the option holder can exercise this right at any time, up till the end of the expiration day. (For so-called European options, you can only exercise the option on the expiration date itself.)
Let’s jump into an example. As of late morning 11/27/2023 when I am writing this, the price of Apple stock is $190 per share.  Suppose I have a strong conviction that within the next month or so, Apple will go up by 10 dollars (5%) to $200/share.

One thing I can do is plunk down 100 x $190= $19,000 to buy 100 shares of Apple, and wait. If Apple does indeed reach my target price of $200 in some reasonable timeframe, and I sell it there, I will make a profit of 100 shares x $10 / share = $1000 on my initial investment of $19,000. That represents a 5.3% return on my investment.


But suppose because of some unexpected factor (Taiwan invasion?), that the price of Apple plunges by say 30% to $133/share, and remains there for the indefinite future. If I want to get my money out of this affair and move on, I would face a huge loss of 100 shares x (190-133)= $5,700 dollars on my large $19,000 investment.

Instead of buying the stock outright, I could buy a call option. There are a number of specific strategies and choices here, but to keep it simple, I could buy an Apple call option with a strike price of 190 (the current price of Apple) and an expiration date of say December 29, 2023. At the moment, that call option would cost me $3.80 per share, or $380 dollars for a standard options contract that involves 100 shares.


If Apple stock hits my price target of $200 sometime in the next month, I could exercise this option and purchase 100 Apple shares for $19,000 dollars, (100 x $ 190 strike price) and immediately sell them into the market 100 x $200/share = $20,000 dollars. That would give me a net profit of: (profit on stock buy & sell) minus (cost of call option) =  100 x ( ($200 – $190 ) – $3.80 ) = $620. That is a return of 163% on my $380 investment. Woo hoo!
(If I did not want to actually exercise the call, I could have sold it back into the options marketplace; the value of the call would have risen by somewhat less than $10 dollars since the time I bought it, so I could take my profit that way, without going through the cycle of actually buying the shares and immediately selling them.)

If Apple stock fails to rise by more than the $3.80 dollars a share that I paid for the call option, I will lose money on this trade. If Apple stays at or below 190, this call option expires valueless, and I will have lost 100% of my option purchase price. (If say two weeks goes by and the share price is hovering just below 190, this call option might still be worth something like $1.90/share, and I might choose to sell it and bail on this trade, to recover half of my $3.80 instead of risking the loss of all of it; there are many, many ways to trade options).

Now, in the event that Apple shares plunge by 30% and stay low indefinitely, I would only lose the $380 that the options cost me, instead of the $5,700 dollars I would lose if I had bought the stock outright.

This example demonstrates some of the benefits of buying stock options: You can make a huge return on your invested/risked capital if your stock price thesis plays out, and you can be shielded from any losses other than the cost of the option. The big weakness of this approach is that your hoped-for stock move must occur within a limited timeframe, before the expiration date, or else you can lose 100% of your investment. Folks who trade options for a living make lots and lots of small trades, knowing that they will lose on a significant percentage of these trades, hoping that their wins will outweigh their losses.

Buying Put Options for Hedging and Speculation

This has been a somewhat long-winded explanation of one way of utilizing options, namely, buying calls. Buying a put option, on the other hand, gives you the right to require that someone will buy a stock from you at the strike price (here, you are “putting” the stock to the person who sold you the option).

Puts are often used as for protective hedging. Suppose I own 100 shares of Apple stock that is currently valued at 190 dollars a share, and I want to protect against the effects of a possible plunging share price. As an example, I might buy a March 15, 2024 put with a strike price of 175, for $2.80. If Apple price falls, I would absorb the first 15 dollars per share of the losses, from 190 to the strike price of 175. However, that put would protect me against any further losses, since no matter how low the share price goes, I could sell my shares at $175. (Again, instead of actually selling my shares, I might sell the puts back into the market, since their value would have increased as Apple share price fell).
Buying puts in this manner is like buying insurance on your portfolio: it costs you a little bit per month, but prevents catastrophic losses.

Buying puts can also be used for speculative trading. Suppose I was convinced that Apple stock might fall well below $175 in the next three months. Without owning Apple shares, I might buy that March 2024 175 put for $2.80 per share, or $280 for a 100-share contract. If Apple share price went anywhere below (175 – 2.80 = 172.20), I would make money on this trade. If the price went back down to its recent low of 167, my net profit would be around 100 x (172.2 – 167) = $520. This would be nearly doubling the $280 I put into buying the puts. But again, if Apple price failed to fall as hoped, I might lose all of my $280 option purchase price.

Where to Find Options Prices

There are lots of YouTube tutorials on trading stock options. Here is quick ten-minute intro: Stock Options Explained, by The Plain Bagel. If you want to check out the prices of options, they are shown on websites like Yahoo Finance, Seeking Alpha (need to give email to sign in; you can ignore all the ads to make you purchase premium), and your own broker’s software.

I usually prefer to sell options, rather than buy them, but that is another post for another time. As usual, this discussion does not constitute advice to buy or sell any security.

Mutiny in Silicon Valley:  OpenAI Workforce May Quit and Join Microsoft If Board Does Not Resign and Bring Back Former CEO Sam Altman

Scott Buchanan1 Comment

The bombshell news in the tech world as of late Friday was that, in a sudden coup, the board of OpenAI fired CEO and tech entrepreneur Sam Altman, and demoted company cofounder and former president Greg Brockman. The exact grounds for their decision remain somewhat murky, but apparently Altman wanted to move faster with AI deployment and monetization than some board members were comfortable with.

The OpenAI organization burst on the scene in the past year with the release of advanced versions of ChatGPT. This “generative” AI technology can crank out computer code and human-like text articles and reports and images. Naturally, students have taken to employing ChatGPT to write their essays for them. And so, professors now use AI to detect whether their students’ essays were machine written or not.

Fellow blogger Joy Buchanan has addressed the rising problem of erroneous information (“hallucinations”) that can appear in AI generated material. There is a movement to slow down the development of AI, for fear it will lead to The End Of The World As We Know It (TEOTWAWKI).  (Interestingly, all of the business commentators I listened to today dismissed the alleged world-ending dangers of generative AI as largely deliberate hype on the part of AI developers, to create a buzz – which it has.)

Having hitched itself technically to OpenAI technology, and having poured something like $13 billion into funding OpenAI, giving it a 49% ownership stake in part of the business, Microsoft was obviously concerned about the effect of Altman’s dismissal on its own AI plans.  As it became clear that the board action would lead to substantial dysfunction at OpenAI, Microsoft carried out its own coup, by hiring Altman and Brockman to run a big in-house AI research initiative, and making it clear that anyone else who wanted to resign from open AI could have their old jobs back, under their old leaders, in Seattle.  And indeed, as of late Monday, nearly all of OpenAI’s employees had signed an open letter stating that unless the OpenAI board quits, they “may choose to resign from OpenAI and join the newly announced Microsoft subsidiary.”

Investors are still trying to figure out what all this means for Microsoft. A pessimistic take is that the corporation has to take a big write down on a $13 billion investment, if the OpenAI organization  (valued a month ago at $90 billion) loses its momentum. An optimistic take is that Microsoft may get the human capital crown jewels of this leading tech outfit for simply the cost of salaries (and signing bonuses), instead of shelling out to buy the enterprise as such. Also, having the technology all in-house would remove the vulnerability of Microsoft currently faces with having a key piece of its future in the hands of a separate organization. There is debate on how much the intellectual property held by OpenAI would inhibit Microsoft from forging ahead with its own version of ChatGPT.

According to Wikipedia:

Shares in Microsoft fell nearly three percent following the announcement.   According to CoinDesk, the value of Worldcoin, an iris biometric cryptocurrency co-founded by Altman, decreased twelve percent.   After hiring Altman, Microsoft’s stock price rose over two percent to an all-time high.  

According to The Information, Altman’s removal risks a share sale led by Thrive Capital valuing the company at US$86 billion.   A potential second tender offer for early-stage investors is also at risk.   Altman’s removal could benefit OpenAI’s competitors, such as Anthropic, Quora, Hugging Face, Meta Platforms, and Google.  The Economist wrote that the removal could slow down the artificial intelligence industry as a whole.  Google DeepMind received an increase in applicants, according to The Information. Several investors considered writing down their OpenAI investments to zero, impacting the company’s ability to raise capital. Over one hundred companies using OpenAI contacted competing startup Anthropic according to The Information; others reached out to Google Cloud, Cohere, and Microsoft Azure.

There is a slight possibility that the open AI board could take a big hit for the team, and bring back Altman and Brockman and then resign in order to keep the organization intact. If that happens, the deployment of generative AI would accelerate – – which might destroy the world.

THIS JUST IN: ALTMAN BACK IN CHARGE AT OPENAI

If there was a prize for “worst board decision of the year” it would have to go to the move late last week to fire Sam Altman. But just when you thought there was no more drama to be milked out of this scene, the news Wednesday is that the OpenAI board is out, and Altman is back in as CEO at OpenAI. Microsoft is presumably happy to have the organization intact, and it seems that those pesky timid souls who were trying to go slow on AI proliferation have been swept aside. TEOTWAWKI here we come…

“The Biggest Blunder in The History of The Treasury”: Yellen’s Failure to Issue Longer-Term Treasury Debt When Rates Were Low

Scott Buchanan3 Comments

That extra $4 trillion or so that the feds dumped into our collective checking accounts in 2020-2021 – -where did it come from? Certainly not from taxes. It was created out of thin air, via a multi-step alchemy. The government does not have the authority to simply run the printing presses and crank out benjamins. The  U.S. Treasury sells bonds to Somebody(ies), and that Somebody in turn gives the Treasury cash, which the Treasury then uses to fund government operations and giveaways. In 2020-2021, the Somebody who bought all those bonds was mainly the Federal Reserve, which does have the power to create unlimited amounts of cash, in exchange for government bonds or certain other investment-grade fixed income securities.

What is causing a bit of a kerfuffle recently is public assessment of what sorts of bonds that Janet Yellen’s Treasury issued back then. Interest rates were driven down to historic lows in that period, thanks to the Fed’s monster “quantitative easing” (QE) operations. The Fed was buying up fixed income hand over fist: government bonds, mortgage securities, even corporate junk bonds (which was probably illegal under the Fed’s charter, but desperate times…). This buying frenzy drove bond prices up and rates down.

All corporate CFOs with functioning neurons and with BB+ credit ratings refinanced their company debt in that timeframe: they called in as much of their old bonds as they could, and re-issued long-term debt at near-zero interest rates. Or they just issued 5, 10, 20 year low-interest bonds for the heck of it, raising big war-chests of essentially free cash to tide them through any potential hard times ahead. And of course, millions of American homeowners likewise refinanced their mortgages to take advantage of low rates.

What about the federal government? Was the Treasury, under Secretary  Yellen, similarly clever? No, not really. Because there is little serious doubt that the U.S. government will be able to pay its debts (grandstanding government shutdowns aside), the government can always find takers for 20- and 30-year bonds, as well as shorter maturity securities. A mainstay of government financing is the 10-year bond. And in 2020-2021, the Fed would have consumed whatever kinds of bonds the Treasury wanted to sell, so the Treasury could have issued a boatload of long-term bonds.

It seems that the Treasury issued a lot of 2-year bonds, rather than longer-term bonds. If they had issued say ten-year bonds, the government would have had a decade of enjoying very low interest payments on that huge slug of pandemic-related debt. But now, all those 2-year bonds are being rolled over at much higher rates and thus much greater expense to the government. (Since the federal debt only grows, almost never shrinks, maturing earlier bonds are not simply paid down, but are paid by issuing yet more bonds).

Veteran hedge fund manager Stanley Druckenmiller (reported net worth: $6 billion) commented in an interview:

When rates were practically zero, every Tom, Dick and Harry in the U.S. refinanced their mortgage… corporations extended [their debt],” he said. “Unfortunately, we had one entity that did not: the U.S. Treasury….

Janet Yellen, I guess because political myopia or whatever, was issuing 2-years at 15 basis points[0.15%]   when she could have issued 10-years at 70 basis points [0.70 %] or 30-years at 180 basis points [1.80%],” he said. “I literally think if you go back to Alexander Hamilton, it is the biggest blunder in the history of the Treasury. I have no idea why she has not been called out on this. She has no right to still be in that job.

Ouch.

Druckenmiller went on:

When the debt rolls over by 2033, interest expense is going to be 4.5% of GDP if rates are where they are now,” he warned. “By 2043—it sounds like a long time, but it is really not—interest expense as a percentage of GDP will be 7%. That is 144% of all current discretionary spending.

Unsurprisingly, Yellen demurs:

 “Well, I disagree with that assessment,” Yellen said when asked to respond to the accusation during an interview on CNN Thursday night. She said the agency has been lengthening the average maturity of its bond portfolio and “in fact, at present, the duration of the portfolio is about the longest it has been in decades.”

According to Druckenmiller, this is not quite true. It does seem that of the federal bonds held by the public (including banks), the average maturity (recently as long as 74 months) has indeed been a bit longer than usual in the past several years. However, this ignores the huge amount of government bonds held at the Fed:

“The only debt that is relevant to the US taxpayer is consolidated US government debt,” Druckenmiller said. “I am surprised that the Treasury secretary has chosen to exclude $8 trillion on the Fed balance sheet that is paying overnight rates in the repo market. In determining policy, it makes no sense for Treasury to exclude it from their calculations.”

Druckenmiller makes an important point. However, how this plays out depends on how the Fed treats these bonds going forward. If the Fed keeps these bonds on its balance sheet, and buys the replacement bonds, there will be actually very little interest expense to the government going forward. The reason is that the Fed is required to remit 90% of its profits back to the Treasury, so the gazillions of interest payments on those bonds and their replacements will largely flow right back to Treasury. However, if the Fed continues with reducing its balance sheet, forcing the Treasury to go the open market to roll these bonds over, Druckenmiller’s dire warnings will prove correct.

Because of this enormous debt overhang and the ongoing need for the government to sell bonds, I do not expect interest rates to go down as low as 2021 or even 2019 levels, unless there is a financial catastrophe requiring the Fed to become a gigantic net buyer of bonds once again.