Sao Paulo Value: Global Investment Ideas from Brazil by Arthur O'Keefe

São Paulo Value: “The stock market is a no-

called-strike game.” Reducing Risk.
Try Not to Lose Money: Buffett, Gekko, Goldman and Volcanoes
Sunday, April 18, 2010 Go to home Go to archive

São Paulo Value by Arthur O’Keefe art@spvalue.com http://www.spvalue.com

Warren Buffett has reportedly said that “the stock market is a no-called-strike game.” Keep in
mind that Buffett probably has more in common with Gordon Gekko than with your average
friendly grandfather - i.e. the latter is an image that I would guess he is very careful to
cultivate. So the exact timing of what he says should generally be taken very carefully in the
context of whatever he’s currently up to to make money, but nevertheless in order to maintain
the front that he’s a harmless old man (rather than the ruthless investor that he probably is),
he needs to throw out a decent nugget of truth every once-in-a-while; and the leading quote is
probably one of them. It’s probably time to stop swinging and analyze what’s going on at the
risk of missing a few prime pitches. There are no strikes called in this game.

And besides... at the micro and macro level, at the small and large cap level, in equity and
credit, everything has had a great runs these last couple of months. A few anecdotes:

The above is a graph of Domtar (UFS). I started analyzing the company at 60ish and in short
order it went to $65 and then to $70. The company was cheap, for sure, and after watching
the price action, I sold the April $65 puts for $2.40 near then end of march when the stock
came in again to around $65. They expired worthless on Friday for an annualized return on
capital (assuming 100% capital charge) of over 50%. Whoever owns the stock (actually I
know who owns the stock) saw it rise $10 over the same period for a periodic return of 15%
and an annualized return of over 200%. Not bad.

But this is not a unique story, as likewise, looking at the chart below, we see that since the
middle of February alone until the end of last week, the market has gained something like
know who owns the stock) saw it rise $10 over the same period for a periodic return of 15%
and an annualized return of over 200%. Not bad.

But this is not a unique story, as likewise, looking at the chart below, we see that since the
middle of February alone until the end of last week, the market has gained something like
13% (almost a year’s worth of returns) for an annualized gain of almost 100% (many years of
returns). If one goes back even further, returns have been truly spectacular.

So why am I saying this? Having worked in a levered hedge fund before, and at a quantitative
hedge fund, and at a bank, I have a healthy fear of the flow of the heard. A pack of wildebeest
(aka the market) can easily run you over on their way to running into the mouths of the
hungry lions (aka savvy investors... or worse), which is to say that the market has had quite a
run, and anything that’s performed with or above the market has probably had its run for a bit.
While things cool off, it’s time to cut risk.

Fundamentally the market is still has room to grow in my opinion, but the technicals are pretty
terrible right now. I do (or at least did) think there’s a very decent chance that the market
finishes above 1300 for the year, but that’s only 8% up and there’s 8 months more to run to
get there (and to top it off many people would call 1300 optimistic).... But considering that the
market has returned 13% in 2.5 months, to realize 8% in the remaining 8 months is going to
be extremely difficult as things are probably not going to suddenly taper off to a nice 1% a
month for the remainder of the year without triggering a correction.

Why? The simple act of (1) decelerating prices will cause (2) selling for profit taking which will
then cause (3) selling for de-levering to stem losses which then leads to (4) forced selling
which leads to (5) speculative front-running selling until (6) finally the value funds step in and
stop the process.

I think we have rapidly moved from (1) to (2) and the risk is that we continue into the full
cycle. This is the mechanics of technical trading, and it points to taking a break for a few
weeks.

Throw on top of this the Goldman news and a volcano that is shutting down Europe and an
earnings season that is pretty much already priced into the stock market considering the fast
run up, and the risk-reward is just really not there.

A note on the SEC’s Goldman case. The charges against Goldman can be read here and
below (as the SEC’s website is a bit spotty on downloads). This is bad news for Goldman and
bad news for banks and a serious potential disruption to valuations of the financial sector.
earnings season that is pretty much already priced into the stock market considering the fast
run up, and the risk-reward is just really not there.

A note on the SEC’s Goldman case. The charges against Goldman can be read here and
below (as the SEC’s website is a bit spotty on downloads). This is bad news for Goldman and
bad news for banks and a serious potential disruption to valuations of the financial sector.
Where to start....

Undoubtedly charges against Goldman will get all kinds of analysis, but I suspect most of it
will be on judging Goldman and Paulson. So let’s sidestep those issues and look at the
human elements of this case to understand the SEC’s strategy and see if that could be
predictive of an outcome.

The most interesting is the naming of Tourre as the only natural person defendant (with the
only other defendant being Goldman as a company). From the allegations we see that Tourre
is 31 years old and a director at Goldman London, and at the time of the alleged fraud he was
a 27 year old VP on the correlation trading desk. We also see that the deal netted Goldman
$15mm and the gratitude of a high profile client that eventually made $1bb and paid who-
knows-how-many other fees elsewhere in the firm.

Well, anyone who’s worked on Wall Street can tell you that a VP is a great title with limited
authority. It basically means that you made it out of the training program and survived a
couple of years as an associate and were deemed to be stable enough to put on a career
track at the bank. Tourre was probably ultimately promoted to director some time after the
deal for being a good coverage of an important account (Paulson) and getting a very decent
P/L ($15mm on one deal), but it’s extremely unlikely he was calling any shots while he was a
VP.

So why name him and no others? It’s pretty clear that the SEC is going for blood on this suit.
They likely have named Tourre to dangle in front of him huge fines and a lifetime bar from the
industry unless he coughs up a bunch of incriminating evidence... and names.

If the SEC were just looking for a nice headline fine to impose, they would’t be going after the
then 27 year old VP. Goldman, not being stupid, gets this as well which is why they haven’t
shown Tourre the door. But it’s not clear that they have figured out how to counter this looking
at their press releases.

A second interesting point is the brilliance (or luck) of picking a product where the wronged
parties were Europeans - namely the Germans through IKB, and the Brits through ABN via
ACA. This creates a multi-front war for Goldman and also makes it almost impossible to settle
the suit cheaply with any remote admission of wrong doing. If Goldman settles with the SEC,
it’s going to have to pay back the Germans and the British.

Next, is that by starting in a civil matter, the SEC is basically given a fishing license to look for
other civil, and worse - criminal, offenses. What else will they find?

Finally, a must read is Sam Antar’s analysis of the prosecutor in an article called “The Kiss of
Death” here. Richard Simpson sounds like their worst nightmare. For Tourre, he’s going to be
even worse.

Then there’s the question of who’s next in line.... The Magnatar trade has been getting tons of
press recently and doesn’t sound so different. Who knows where this goes?

Finally, if all of this wasn’t enough, we have the Volcano in Iceland.... I haven’t had a chance
to do in depth research on this, but surely the airlines are bleeding money and many forms of
commerce in Europe are slowing, which translates to GDP reduction in an already fragile
region. This can’t be good.
press recently and doesn’t sound so different. Who knows where this goes?

Finally, if all of this wasn’t enough, we have the Volcano in Iceland.... I haven’t had a chance
to do in depth research on this, but surely the airlines are bleeding money and many forms of
commerce in Europe are slowing, which translates to GDP reduction in an already fragile
region. This can’t be good.

Put everything together and why not take a break? I don’t see the potential upside paying for
the risk in downside. For me, it seems clear that if it hasn’t already been done, this is a decent
time to lock in some profits, cut some risk, and reassess the situation in a few weeks.

Arthur O’Keefe, São Paulo Value

Below: http://www.scribd.com/doc/30152414/Goldman-Sachs-SEC-Complaint
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