FRMO Annual Shareholder Letter Posted

 One of the most important letters, and one that is not well followed, the FRMO Corporation Annual Shareholder Letter has posted.  It has some very interesting details on some of the activities happening in FRMO / Horizon Kinetics operations.  The creation of a tradable diamond security as a crypto token.

The annual report is also available here.

Growth in book value has been impressive and many small private equity and angel style investments are starting to compound into more significant operations.

Core Molding Technologies (CMT) New Investor Deck is out and its Fantastic

 Definitely worth a read.

You can download it here.   PowerPoint Presentation (coremt.com)

I believe this company is worth $30/sh and not less than $24 and it trades at $15.  That value gap could close rapidly.

Earnings "Consensus" - and value

 Short post today - but a pet peeve - why do financial reporters refer to averages as "consensus"?  A consensus is a thing - it is when there is broad agreement, that is, it is a statement of FREQUENCY of observation, or a mode - an average of widely disparate values is not a "consensus", it is an average.  

If you, know, 20 people come to roughly the same estimate of something, then there is consensus - it expresses a statement about the level of confidence of the crowd; they all agree with each other at least.  Too often, though, analyst estimates are far apart, as when someone thinks they will earn $1 a share, someone else $2 and someone else $0.21.  The average of their estimates is $1.07, but there is no "consensus" that this is true.

I think the root cause of this is that the journalists are relying on a service that claims to produce "consensus" values, so they quote that like sports commentators talking about the NFL.

But even that, I think, is derivative of an economic concept that market prices represent the "consensus" view of the value of something.  Since price discrimination happens frequently, how much consensus their really is in markets is tough to say.  Auctions, like stocks, perhaps, settle at prices that reflect the aggregate willingness of buyers and sellers to transact business, but even that is not a "consensus" really.  This can be useful for understanding a solitary quoted market price, if that is your academic purpose, but in fact, there are still a range of values (most bids and asks go unfilled, but does that mean that their is broad agreement about the true "value" of the thing, or just that that is a place where at a moment in time a buyer and a seller were able to agree to do business, doesn't make it a consensus.  The assumption that what we are doing is just a stochastic and iterative pricing exercise is wrong, just as claiming that wildly divergent views represent consensus is wrong.  

Price discovery may be the goal of the AUCTIONEER or the student of auctions, but it is not necessarily the goal of the participant and quite frankly, the exact same asset can have quite different value depending on the circumstances of the buyer and seller.

ELLH - the worst security on the market?

 Elah holdings - ELLH - is an NOL cashbox that has a valuation that makes no sense, but which demonstrates how illiquidity can work to keep a price from finding a level in any way commensurate with fair value.

This is a company that has $15m in assets, 735k shares, and a $99 price tag, as of 2 May 2021.  How this can be is a mystery, since it has no meaningful operations - it generated $179,000 in revenue (no, this is not in thousands), but experienced $2m in SGA costs as management set about looking for an operating company to purchase.  It DOES have $1bn in NOLs, which, when you think about it, is a pretty impressive achievement.  It's hard to make $1bn, but in some ways, it might be harder to lose that much, inasmuch as you have to find investors to provide the capital that was incinerated with such aplomb.

That means that the business, at one time, and likely for some time, had to be a success, growing funds internally and possibly through additions of outside capital.  Also, that such a business was so spectacularly mismanaged that management could neither see the hopelessness of the situation (and therefore unload the business) or solve the competitive problem.  One would expect that such management would be jettisoned in favor of new owners and leadership that can pick up the pieces.  In the case of ELLH, incredibly, the stunning collapse did not result in a wholesale change of management, with the present CEO serving as a holdover; indeed the CFO who presided over the final immolation of the previous incarnation of the business.

But really, what are those NOLs worth?  Alas, NOLs are among the lowest quality assets around.  Sure, if you have a generally profitable business that has a bad year - like an insurance company hit with a major cat loss, or a cyclical company hit with cyclical weakness - then yes, you are likely to be able to recover or offset taxes from future profits and these are good assets.  But what if you have a poor operation that loses money regularly?  What if you no longer have any operations at all?  Now you have a real problem: you have to find a means of earning a reliable income in order to use those NOLs.

The IRS makes that difficult - you cannot sell the company or simply merge it with another entity.  The tax laws are set up to prevent NOL shells from simply selling themselves as tax shelters.  No, they have to maintain a pretty stable ownership structure AND acquire assets or operations that generate profits.  Since they cannot recapitalize themselves without having the NOLs largely disallowed (the dreaded section 382), the resources that are going to be available in this effort are largely going to be internally financed, which means, they have to bootstrap their own capital.  And there are only so many years (about 20) in which to achieve this feat.

Now, if businesses were cheap and inflation were raging - think 1973-1981 or so, this might work out; you could have purchased a dollar of earnings for just a few dollars and then watched as revenues and profits grew in nominal terms without having to expand the business all that much, helping you to consume tax losses generated in earlier years.  Of course, the real value of those recoveries would have declined, but you might subsequently enjoy a boost to valuation if inflation declined significantly thereafter.

Today, however, is a different environment.  A dollar of earnings is quite expensive.  And buying control of a business in present market conditions is very expensive, especially if you cannot use appreciated securities of your own as currency.  $15m might buy you just $1 of earnings, but more likely will buy you even less.  Yes, there are businesses that have lower multiples, but many of those, like professional services, need to be owner operated to be effective and simply cannot be sold effectively to passive capital because there isn't enough return available to future partners.

There just aren't great incentives, in a world where corporate tax rates are 21% (or 25 or 28%) for someone to cut you in on their good business in order to save those tax costs for a few years.  Instead you have to look at buying and fixing a crappy business.  That takes time and often generates more losses in the meantime.  Moreover, how probable is it that the management that lost $1bn is going to be the fix-it people for the new operation?

Daunting as this task is, one of the biggest factors is the starting position of the firms capital, which represents the major constraint on the size of the business that can be acquired and also sets something of a "lead" on the running room available to fix a business needing some help.  The larger the capital, the wider the potential target list can be and larger the scope of a turnaround can be.

So there is nothing worse than seeing a moderate amount of capital in an NOL shell being siphoned off by "management" in it's search for a new asset to acquire, but this is exactly what we see at ELLH.  Management - by which I mean officers of the firm; they don't manage operations - takes some $2m a year in SGA in spite of the negligible revenues, while they look for a deal to do.  The odds of them finding one have become much much longer in the past year as SPAC-mania has set hold.  The amount of capital with no operations in search of a deal to complete (with incentives structured to get deals done even if a high price be paid) means that potential targets are being courted and schmoozed in an auction-like environment.

Meanwhile, the scope of potential investments is being narrowed every year for ELLH.  Ok, it is true that in 2020, tax benefits associated with the CARES act offered ELLH a one time benefit of a one-time extended carryback on the losses that provided an extra tax recovery (from a higher tax period) and which generated about $4m in 2020.  That has increased the cash balance of the company by about $2m, after management helped itself to half of this one time bounty.

Now, it is true that higher taxes in the future, which seem likely, could both tank asset prices and increase the value of NOLs; so the case is not entirely hopeless, but if the only upside is macro, you can find NOL shells that have similar setups, better management and lower prices.  RCBN, to name one.

ELLH is in a strategic dead end with dwindling resources, suspect leadership and is trading for a premium, not a discount, so even a liquidation - likely the best option - would result in a significant capital loss.

Things that happen in manias

 This is a funny story.  When we have this sort of buoyancy in markets all sorts of securities trade at absurd valuations.  David Einhorn apparently featured, in his letter, a business with $35k in revenue and no real assets, that has $100m valuation.

Hometown International, NJ deli owner, worth millions in stock (cnbc.com)

I recognize that sometimes this sort of valuation is possible in markets that trade infrequently and in which a few shareholders control most of the shares, ensuring that funny bids or asks or unusual trades of de minims shares can then be extrapolated over a large, but illiquid share count to arrive at confusing valuations.

A better, albeit perhaps less extreme examples is ELLH, which deserves a longer discussion.  I believe it might be the worst equity security I have found, certainly in the diversified holdco space.  You deserve a full accounting of this one, not because you will want to invest, but because it is a poster child for what really happens with many of these "triumph of hope over experience" firms; the holdco with small tangible asset base, but laden with huge NOLs from an operating business - often discontinued - operations, leaving management with the challenge of lacking an operating base that can actually earn the profits that enable those assets to be used before they expire, and few strategic options for doing so.  Indeed, I believe that the NOLs may cause management to behave in foolish ways because of the endowment effect of wanting to preseve those assets, sometimes at the expense of feeding the new or remaining business (raising external capital can limit the NOL recovery and so management may force the company to internally finance growth).

Anyway, this is a larger topic for another day, but it is a counter-example, I think, to the Klarman view that there are no bad assets, just bad prices. I get his point - free options are just that.  But the endowment effects on the free option holder; the desire to make something of that option, can warp the perception of how to grow the greatest aggregate value.

In any case, everywhere I look, I see high prices and low returns.  I suppose there is a real possibility that we will see huge inflation and that operations of firms will be able to grow to justify today's valuations, but today's valuations won't have moved much and the purchasing power of those assets will be greatly diminished, so the "richness" will be nominal only.  More likely, we will get a period of pricing weakness, though not so long as we are in "lockdown"; imprisoned but working upper middle class types are experiencing incredible savings rates that are fueling this market surge.  The end of lockdown might actually see a decline in transfers into brokerage accounts, so ironically, economic growth might actually hurt equity prices.

It's a very tough time for someone to have a consistent strategy, in part because the strategies that have worked pretty consistently since the 1940s, are not set up for what we are about to experience.  The "normative" experience of US equity markets might be much more of an outlier than we think.  Japan, mid-century Germany, revolutionary Russia, revolutionary China; all of these places have experienced really catastrophic results where buying the dip didn't put you on a glide path.

But in a speculative mania, where money and profits seem pretty effortless (and I will admit that nearly all of my investments have been working but I have been raising cash) it is very hard to take money off the table.  Also, if we truly do get inflation, short duration assets will struggle; especially if we have policymakers engaging in financial repression on yields of short term instruments, as seems likely.

On Coinbase and Bitcoin 60,000

 Below is a letter I wrote to some investor friends.  The backstory is that I attended an annual meeting of FRMO Corp in 2016 or so, where Murray Stahl, the CEO, advised everyone to invest in Bitcoin.  Actually, since there is a transcript of the meeting available here you can look up his story, yourself, the example is on page six.  Murray has returned to the subject at length in later meetings.  2017, 2018, and 2019.  2020 has yet to be published.  I attended those to.  In spite of this, I never actually purchased bitcoin, though I could have taken his "vacation" example just to see.  Instead, I told myself, FRMO can make the investments for me, and I will instead invest in FRMO.  Not as much upside, perhaps, but less downside.  Also, that FRMO could make investments in the space that simply would not be available to retail investors.

Hindsight is 20/20 and of course, I would have made alot of money had I listened to him.  But I don't know if I could stay with it, because a) this whole market feels like a mania - driven by a cult of performative "newness" that is deeply Millennial and therefore encourages action over reflection(1), and b) I still don't really know how to think about it, and therefore I don't by any of the valuation methods.  This includes the PQ = MV argument that Murray makes.  The circulation of gold doesn't have to equal the circulation of dollars (or of all currencies), any more than the number of Swiss francs does.  I get the idea, but it seems to me that if it has utility in this way, it is as a reserve unit, not as a currency, really. 

Even so, I question whether something that is so inherently reliant on large systems - the need for electricity and internet connectivity to function - can really serve as a base unit.  We financialized and digitized money because of the impracticality of lugging around physical money.  Bank of America spends something on the scale of $1bn a year to move coin and cash around.

But the normal pattern of abstraction and financialization is to start with an asset that exists in the real world, but which, for various reasons; weight and cost, risk of theft, or lack of divisibility (e.g. a business operation) lead to a development of a convention, a contractual relationship around that thing which makes transacting with it much easier and more practical (and expands the range of potential investors).  In this case, it feels that what is happening is the opposite - that someone has constructed a completely synthetic digital construct and is now trying to make the real world reflect the digital one.  It has a man-bites-dog sort of quality (and mystery) that make it perfect catnip for financial journalism.

It seems to me that "new ways to trade" have alot to do with this more than the asset classes themselves.  Tulipmania, after all, was really about the intersection of three things: first, some new techniques developed by florists for grafting bulbs of different colored tulips to create new color patterns, second - and far more important - financialization of the bulbs by the creation of a futures market for the bulbs (that had to stay in the ground over winter), bored florists waiting for spring and finally, the pressures of a war. In 1637 the Thirty Years War was entering its final and most brutal decade, dramatically shortening duration preferences among pretty much everyone.  So, some new technology, coupled with new trading platforms (Amazon-like Robinhood stock recommendations? or new "disintermediated" trading platforms, boredom and lockdown - the mania was most intense during winter - and the pressures of an existential threat heightened willingness to take risk for short term gains.

Bitcoin and crypto have remained surprisingly resilient even as the narrative has changed (quick quiz - what was the Byzantine General's Problem?), in some cases many times.  That might mean that there really is something there; major investors are getting on board, after rejecting the early justifications for its utility.  So I am totally open to the fact that it is I who am missing the thread here.  If any reader wants to help me understand it; I am particularly interested in the economics of mining and how it can be that the most efficient miner doesn't manage to beat everyone else to the solutions to the validation problems.  I understand why it is necessary to keep as many nodes operating as possible, but not how this is addressed; unless, Harrison Bergeron, there is a Handicapper General?

Anyway, here is my note. The Luddite's voice rings strongly:

So, sometimes I feel like an idiot not listening to Murray when he said: buy bitcoin.  Being a skeptical type, had I done so, I no doubt would have exited my position by about $20k certainly by $25.  If I say that figure in retrospect, then in the moment, I would likely have been exiting above $10k and certainly above $15k, with at most only a small position retained, and I would have been sure that 20 to 25k was all that was realistically possible at least at the present time.

I just don't see what these coins really offer.  So much of what they are selling is the opportunity to speculate.  At least in the 1990s the use cases were understandable if implausible.  Viewed the other way, it seemed clear that they couldn't work.  (It cannot be that $1 of fiber optic cable laid by anyone anywhere was worth $7 and allowed the company laying said cable to borrow $2.  I mean, on some level, perhaps, but honestly not possible at scale.  There was real value there tho.  In that case, it was a case of finance people overplaying the capitalization of new income streams to book profits and benefits up front - "revenues" followed the capital investments, rather than the other way around.  But with crypto? I just can't see it.  Maybe I am too old or too dumb.  I observe that the use cases and the narrative have changed multiple times and yet none of the cases have proven out.

It was going to be a bank-less payments system.  Or a store of value (digital gold) or a supercomputer, or access to a currency trading platform or or or.  A bit like the 90s, when everyhting was goign to be digitized.  Eventually that happened, tho it was the people who were legacy firms in those industries that found it easiest to transition the customer experience to digital, since there were still offline processes that had to function and be managed and such.  Grafting the new tech onto the legacy firm turned out to be easier than taking the tech and building a de novo competitor in an industry.  I feel the same here.  The capital assumptions - that all of these firms can be asset light digital properties once they adopt this tech, doesn't seem sensible either.  In a sense, I think the goal is to build new social networks, but honestly, how many of those can society possibly need?  The ones we have seem to be making us miserable.  I get that if you could create a Mutual of Facebook, with the users owning the platform, that might be very valuable, except that the value will of necessity be very widely distributed.  Is Facebook's trillion dollar valuation all that valuable if roughtly evenly distributed among hte 2bn users it claims?  I guess if the most active users get a disproportionate amount of the profits, it's worth more to them, but then you also have to be constantly trying to use facebook; the usage becomes an end in itself instead of as a tool.  That strikes me as literally the proof that Seth Klarman's dictum: that there are no bad assets only bad prices, is false - an asset that requires you to spend all your time investing activity on it to make it work, seems to be a truly bad asset, even though it's paying you.  Its basically a job (as many "assets" are).

Or perhaps its specific activities that matter - like validation / mining.  There, tho, the business seems to be that he who supplies the computing power to run the network gets the money.  At some point, mining will likely stop, right?  I mean with Bitcoin that will happen - then how do you get people to supply power to the network?  Do they just get the assets transferred to themselves.  Essentially demanding Satoshis as fees, right?  Eventually these large pools of digital assets might loan them to people, or they might serve as a reserve currency backstopping some other payments system.  Ok.  but then the big aggregators simply become a form of reserve banks.  How is that so different from what we have today?  It's sort of anti-statist (assuming that the government or the FRB don't offer computing power to the network at rates that enable them to make this money.

Dunno.  Maybe I am just making no sense.  But I can't see what problem these things solve better than the system we already have.

To me, we live in an era that is again obsessed with "new era" thinking - this is applying to all sorts of things beyond the financial markets.  We are questioning liberalism, the nation state, representative government, rule of law (favoring instead attainder by twitter mob) and the dignity of the individual, let alone things like economics.  Alot of firms seem to be surfing the "new era" thinking; that like celebrity, famous for being famous, new era firms are investable for their newness.  Of course, that can be a way to get very very rich.  But - and this is where I see a real problem with the decentralized approach - commerce is generally best managed when it is headed by an individual of exceptional energy and talent.  Crowdsourcing business decisions is not a winning strategy so far as I know.  But maybe there are a few good examples?  Economies, yes.  Institutions, no, because the larger the institution gets, the more crowdsourcing is a vote for incumbency and to protect insiders, which is why external competition is so crucial to disciplining them.

Again, maybe I am just missing it.  I really would like someone to explain to me what "digital trust", or whatever the latest use case is, is, so I can understand what this is really all about.

(1) this is more broadly an attitude about the culture generally and about upper middle class Millennials in particular.  There is a very strong attitude of Jacobin "Year Zero" thinking in which the expectation is that we can simply dump overboard everything that came before them, including the culture itself.  You can hear it in the way their shortcut for "ancient history" is to refer to something old-fashioned as being "circa [insert year between 1965 and 1980 or so].  This is unwise and arrogant.

On Gamestop

In the story of Gamestop, the media has been pushing a classic David and Goliath story for the past several weeks as a few hedge funds (out of something like 10,000 funds, tho the precise number is unknown) got caught in a most amusing short squeeze.

It does seem likely that online fora were the germ of the squeeze idea; clearly some relatively small investors were able to acquire decent numbers of shares in the early goings, when shares are $5, even a speculative-minded retail investor with $10 or $100k can start acquiring a solid amount of daily trading volume, reducing float and shares available to borrow or to buy to cover.

But I wonder how much of this squeeze was ultimately orchestrated by some other big funds or players; it is possible, indeed, even probable, that other funds smelled blood and also purchased?  Might it have been a case of professionals gaming other professionals with a few retail investors just making out like bandits?

One theory would be - no, since if that were true, someone would be talking about it - and the media hasn't said anything. But a second view might be, what incentive does the media have to tell the story? So long as anonymous day traders with fabulous but unverifiable human interest stories can claim to be "winning one for dad" clicks rain down on the articles.  If the story was, hedge fund A crushed hedge fund B, it would get some play among the financial literati, but would likely not seep out into the wider culture.

So no journalist is going to be assigned to get to investigate and the funds that made the money probably don't want to share, since it paints a target on their own backs.

But honestly, when the shares were at $300 and $400, how many retail investors could be buying in any volume?  $10k nets 33 shares, against a trading volume in the millions.  If the retail investor was buying and selling (day trading) then ok, he could round trip many times, but then he wasn't "holding the line" as a hero, but rather just a guy exploiting volatility.

No, it seems to me, that the most likely story is that some hedge funds saw movement and started buying with the intent of generating the squeeze.  They would be best positioned to negotiate the private market transaction to deliver the shares the funds needed to cover once things really got going.

Moreover, one has to ask why management didn't avail themselves of the opportunity to issue additional shares; these are authorized and management could have registered more shares for sale with the SEC, EXCEPT that management wanted to sell their own shares and if there was a new round of shares sold by the company, management would be barred by insider trading rules for six months from dumping their shares.  So they prioritzed themselves over increasing the financial strength of the company with insanely cheap capital.  No one is telling that story, either.  Note that management telling people that they would issue additional shares would have broken much of the speculative bubble.

And quite frankly, reading some of these stories of these small investors, one really has to wonder if they aren't all fabulists - a class of people increasingly taken in by a media desperate for narrative stories that play to subscriber bias.

I have owned small businesses and have worked for them, too.  I have never known small business owners to be as reckless with their financing as the people described in these bios.  Every one of these children of small business owners who had the company "implode in a week" with nothing to show for it?  How many small business owners are so illiquid?  It's perhaps easy to believe this if you are an employee living paycheck to paycheck, but most small business owners I know keep large amounts of liquidity on hand.  In fact, one of the primary differences between founder led firms and management led ones is a demonstrable liquidity preference among founders; where managers worry about hitting all of their financial metrics to earn the largest bonus and push financial ratios, founder led firms are usually more motivated by institutional preservation and capitalized themseves much more conservative.

I understand that it was tough to get financing in late 2008 and early 2009.  If you had to roll over financing of anything, it was tough.  If you didn't have months of expenses in cash, you could get crushed; but I simply don't believe that we have dozens of children of small business owners using day trading to effect World Socialist Revolution.

Alas, we also don't have a media environment interested in questioning this stuff, either.  The stories are "too good" to check.