Tag: learning

Foreword

The Green Transition is the new name given to the idea that human activities are affecting the natural environment negatively, and that effort should be made to transition the economy to a more sustainable and Earth-friendly path.

Over time, it has garnered much discussion both for and against the idea, and right now, is a politically charged topic, when it really shouldn’t be.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Background

It is hard to deny that global temperatures have been rising steadily, on the average, across time. Most of the debate in recent times have centered around whether this is a temporary cyclic phenomenon which will revert by itself, and whether this phenomenon is due to human activities, and thus whether human efforts can pause, halt or even reverse the change.

As with most charged debates where both sides are firmly entrenched, politics have gotten involved, and that has dragged in more polarization based upon one’s political affiliations.

Not helping is the apocalyptic language used by some proponents, especially earlier in the discussion (around the 80’s), in some cases suggesting the Earth may be inhabitable by around this time. Ooops. To make matters worse, it has come to light recently that some of the climate studies supporting the narrative have been doctored, fueling conspiracy theorists on the other side. Of course, that big moneyed interests are involved on both sides (building new green infrastructures vs existing fossil fuel based infrastructures) just makes this into an all out dog-fight.

My personal opinion

Before we go on, just as a disclaimer of sorts, here’s my personal take. I have not personally gone over the climate change data in detail — I am not a researcher in the area so the data will just go over my head anyway. I have, however, read quite a bit on the summaries of studies, as well as various layman oriented articles published by both news and scientific outlets.

While I am not 100% convinced, I lean heavily towards the belief that human activities are affecting global climate, and that the current means by which humans extract energy is unsustainable. I have no idea if changes in human behavior will pause/halt/reverse the effects, but I figure it can’t hurt, and more importantly, we need to find more sustainable sources of energy anyway — at some point we’ll run out of dead dinosaurs.

To the tree huggers

A message to the those who are for the climate change narrative — calm down. Yes, I think the scientific evidence leans heavily towards supporting your views, and some hypotheses floating around suggest that not doing anything, or even doing too little, could be disastrous. But crying your eyes out, screaming at the Earth murderers is not conducive to rational debate, and certainly does nothing more than alienate your audience.

Instead, think of it rationally — there is no point crying over spilled milk. The world and reality is what they are now, and we must make do with what is available to us, instead of crying over what it should have been.

First of all, it is impossible that all fossil fuel programs will stop right now, no matter how much you wish it. For all the advancement in sustainable energy sources, there are severe downsides:

• Solar energy is terrible for base load power supply — there is too much of it during the summer, and way too little during the winter. While batteries can bridge the gap between day and night, even across multiple days to account for rain vs shine, there currently exists no battery technology that can store power across months at a large scale. Do not fret though, this is a well recognized problem, and there is a lot of scientific research into this area (more later!).
• Wind energy works across the seasons and times of day, but is unpredictable because the wind itself is unpredictable. Also, during periods of strong gusts, wind turbines actually have to be shutdown to prevent damage to the turbines, an irony not lost to the other side. Wind turbines are also loud which means they need to be situated further from their use, and the nature of them requires much larger land acreage to deploy. Finally, like solar, wind energy isn’t very reliable in winter as extreme cold can sometimes require the turbines to be shutdown. So while less dependent on battery technology, wind energy still requires battery backup.
• Tidal and hydropower sources tend to involve installing largish installations over rivers/beaches. Tidal energy is not deployed right now due to various issues, mostly to do with concerns about their effects on marine life, the sediment process (i.e. how beaches are formed), and that the turbines tend to need a lot more maintenance/replacement than other forms of green energy. Hydropower similarly affects the natural landscape and thus the wildlife and population centers that depend on it, and while much more durable, breaks in the dams built for hydropower can have devastating consequences for the people that live downstream.

At the same time, the transition is going to cost vast sums of capital, capital which the vast majority of the world simply does not have. Yes, over long periods of time, sustainable energy sources generally pencil out to be more cost effective, but that’s not the problem — the problem is the start up costs. Most countries simply do not have the resources to embark on such large scale transition, especially when there are attendant problems with the technologies (which, again, hopefully will be resolved with time). While it is easy for us in our air conditioned offices to type out articles about how the world should behave, it is important to understand that reality is very much different in other parts of the world. Current fossil fuel energy sources remain the most abundant and easily accessible energy sources for the less affluent countries. Yes, over time, investments in sustainable energy sources are very likely to pay off, but that does not address the very real need these countries need, to survive, now — it is hard to think of a better future when current reality simply demands all your focus.

Finally, and most importantly, it simply doesn’t work to shut off all fossil fuels immediately, not in a “we can’t afford it” way, but in a “it hurts the green transition” way. For the green transition to proceed, there things that we simply cannot do without — steel, fiber glass, copper wiring, etc.

As an extreme example, currently, steel cannot be made without coal — each ton of steel requires about 750kg of metallurgical coal, so if we shut down all coal mines, we’ll also be shutting down all steel production. No steel, no wind turbines, no solar panels (admittedly not a lot of steel is needed in solar panels), etc.

And more importantly, until the transition is over, we actually do need fossil energy to, well, power the transition! How else are we going to transport those gigantic wind turbines to remote parts of the country? How are we going to power the factories that manufacturer the solar panels?

A pet peeve of mine, and to illustrate the counter-productiveness of indiscriminate green protests, is the demand for shutting down of coal mines in some industrial countries. Shutting down a coal mine does not eliminate the fact that some industries (steelmaking!) and power plants need coal still to operate — they can’t simply shutdown overnight and leave entire towns without power. So what happens is that the same amount of coal is mined elsewhere, and then shipped to the original country. Think about it, instead of mining the coal nearby and then using it, we now:

• Mine the coal elsewhere, often in a less regulated part of the world, thereby increasing the amount of environmental disruption (though admittedly out of sight),
• Expend more energy, often in the form of burning fossil fuels, to ship the coal to where it is still needed.

How dumb is that?

To the climate deniers

Hey, I understand — those holier-than-thou, green woke hippies can be annoying. Like, really annoying. But let’s ignore their juvenile tactics for now and think rationally for a bit.

What if, just what if, they are right? Even if it’s a 1% of 1% chance, you have to admit, if they are right, the amount of gloating you’ll have to suffer through will be intolerable. But more than that, the Earth itself may be uninhabitable. Kinda makes the whole point of that Hummer pointless, no?

Now, I get it — you love your gas engines — they’re reliable, refuel in a minute and sound awesome. But the price of gas has been on a tear lately, and that is a bummer right? What if I told you, that there is a way for you to secure more gas for yourself, a way that’ll outright prevent some other folks from buying gas? Less demand, lower prices, I mean, you gotta love that right?

Which is why, I think you should support EVs. Yes, they are terrible — they take forever to charge, they don’t work right when it’s cold, and they simply have no soul. But you don’t have to drive one! Just encourage everyone else around you to buy one. Once they buy an EV, they will stop going to the gas station, and there’ll be less competition for gas, which should, all else equal, reduce the price of gas that you have to pay. Imagine paying for a tank of gas with a $50, and getting change!

Similarly for electricity. The more those climate idiots spend of their money developing new energy sources, the more supply of electricity there will be. And Economics 101 tells us that with increased supply, prices should go down. In parts of Europe, power generation during the daytime is so high due to solar power that energy prices went negative. Negative! Imagine being paid by the power company to blast the A/C at max?

So, don’t do it for them. They are wrong. But do it for your wallet. Smile politely and nod as they make their nonsensical case, and tell them to go about their plans, because it is good for you. It’ll lower the price of a tank of gas, it’ll reduce your monthly electricity bills, and more importantly, you get to gloat about how those idiots are paying you to live your life. What’s not to like?

Supporting the green transition

Now, whether you believe in climate change or not, I hope I have made the point that investment (by others, not necessarily you!) into new green technologies is beneficial.

And here comes the controversial part — buying the shares of “green” companies does almost nothing. Yes, maybe it makes you feel better to own shares of “Green Company XYZ”, but you have to understand that when you buy shares on the stock market, you are buying them off someone else, someone who is not “Green Company XYZ”. The company itself sees none of the money that transacted. While there is a case of be made that a higher stock price makes it easier to hold secondary funding rounds, the reality is that most public companies never, ever hold secondary funding rounds — it is generally seen as a sign of weakness, and the stock price tends to get demolished because of it. Also, a high share price does not make it easier for the company to hire better people. Stock/option grants are based on the current price of the share, so for those employees to benefit, the share price doesn’t have to be high, it has to be rising, and it is generally easier for shares with lower prices to rise than for shares with higher prices.

Instead, if you are willing and able to invest to support the green transition, I would recommend that you invest in the debt of green companies, or even better, to invest in green startups. Unlike stock, companies issue debt all the time, and tend to do so on a recurring basis. So the price of their debt is actually important to them, and affects their ability to continue operating. By buying their debt, you are providing another source of demand for that debt, and with higher demand comes higher prices, which directly helps the company during their next debt funding round.

Finally, startups are almost always in need of equity funding. Unlike buying shares from the stock market, investing directly in a startup means the money goes directly into that startup’s treasury, meaning the money is directly available to them to pursue their business needs.

Right now, the areas which I believe are most in need of research are:

• Battery technologies, specifically long term energy storage with minimal leakage. Battery energy density research are good too, as they can help make EVs more palatable by having longer ranges.
• Solar energy efficiencies. Solar power panels typically have an efficiency of under 20%, which is pretty abysmal — 80% of the energy that falls on the solar panel are simply not captured. Increasing that to just a barely passing 60% will decrease the surface area of panels needed to supply the same amount of energy by 67%! Imagine if a solar panels of roughly the size of a dinner table being able to supply all the power needs of a home!
• More efficient/synergistic technologies. Right now, a lot of electricity is wasted simply because existing technologies are terrible at reusing heat. Think about it — we use electricity to remove heat from our fridges, which then dumps that heat in our homes. We then use electricity to turn on the A/C to move that heat outdoors, while at the same time using more electricity to heat up the pool/hot tub (for those who are lucky enough to have one). What if we could just remove the heat from inside the fridge, bypass the rest of the house and dump that heat directly into the pool/hot tub? While we’ll still need A/C to cool down the house during a hot day, the need will be reduced, and even better, that heat can also be pumped into the pool/hot tub! This basic idea of reusing heat can be applied to other areas too — heat generated from cooling of EV batteries can be used to warm up the interior of the car during winter, heat removed from giant datacenters can be used to heat homes, etc.
• Cleaner fossil fuels. Refinement techniques to reduce emissions when burning fuels, while not a long term solution, can buy humanity more time for the green transition. At source carbon capture and sequestration techniques can be developed to reduce and safely store emissions from polluting industries, etc.

Closing

Whether you believe in climate change or not, the fact remains that all of us are stuck on this little rock floating around in space. So maybe let’s stop arguing and let’s start finding commonalities, and where particular efforts can be win-win.

Foreword

Everyone is out to find the next long term compounder — a company with such a strong business model that its earnings compounds steadily over the years. The thinking is that for such a company, if you have a long time horizon, then the price mostly doesn’t matter — simply buy and hold, and eventually, the compounding will make it all worthwhile.

Or will it?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Consistent, long term compounder

Consider the revenue graph of company X, which compounds from $20.22B in 2000 to $58.03B in 2022, a CAGR of about 4.9%:

And its earnings graph, which compounds from -$1.39B in 2000, to $3.74B in 2001, to $16.72B in 2022, a CAGR of about 7% (from 2001 to 2022):

It should be clear, visually, that this company is doing pretty well — even in the depths of the Great Financial Crisis, it was holding up pretty well, and since it first became profitable in 2001, company X has never even flirted with the 0 earnings line at any point in time.

So, if I told you that company X has an all time market cap high of $Y, where do you think its market cap is today?

1. $Y
2. Within 5% of $Y
3. Within 10% of $Y

This is the market cap chart of company X, also known as Cisco (CSCO) from the same source of the graphs above (Companies MarketCap):

23 years after annualized growth of ~5% revenue and ~7% earnings, the company’s market cap is DOWN about 30%. (edit: I was informed that this is misleading — CSCO pays a dividend and has had for years, so if you include the dividends, the performance is much better. That said, the return will still be subpar due to the high entry price.)

How’s that for a consistent, long term compounder?

Relevance

As we come out of what appears to be (at least, temporarily) a downturn in the markets (in 2022), a point to remember, is that by most historical metrics (1), the markets are pretty expensive today. They were, of course, much more insanely expensive in 2021, when the markets had truly gone wild, but Q4 2021 and 2022 brought us back down to Earth just a little bit.

However, even as most of the market, minus the Magnificent 7, appears to be close to fairly priced (again, by historical metrics (1)), it is important to remember that there are still pockets of excessive exuberance, of stocks priced to such ridiculous extremes that the probability of them returning a generous rate of investment returns (2) over the long term seems rather unlikely.

To be clear, while it is possible to make a handsome profit if you are speculating (2) in these stocks in the short term, investment returns (2) requires holding that position for the long term and profiting only off its productive output, i.e. not selling to a greater fool.

And remember — the higher the price you are paying for a share of a company’s future productivity, the more speculative that position generally becomes.

So, short everything!?

And this is where some folks will start pointing fingers and start screaming “perma bear”. The truth is, if you follow me on StockClubs (3), you’ll realize that my portfolio is actually pretty long the market (levered long right now actually), and other than a brief period from early August to early November, it has generally been long.

There is, always, some assets that are overvalued, and some assets that are undervalued. Yes, sometimes, the only undervalued asset is “cash”, but that’s relatively rare.

Rational, long term portfolio management isn’t about putting money on things you like, or things that others like, or even things that are doing well now — it is to weigh the pros and cons of every position, figure out what is likely undervalued, and then overweight your portfolio towards those assets.

Certainly, overvalued assets can become more overvalued — that is how we get bubbles, after all. And certainly, undervalued assets can become more undervalued, which is how we get depressions.

But it is my opinion that if you consistently weigh your portfolio towards (4) what is undervalued, and underweight what is overvalued, then over the long term, reversion to the mean of ridiculously high (or low) valuations will generally work out in your favor.

Footnotes

1. A constant consternation by some is my reference to “historical metrics”. By this, I mean things like trailing P/E, P/S ratios, etc. For an example of what the the S&P500 looks like today relative to its past in terms of P/E ratio, please see https://www.multpl.com/s-p-500-pe-ratio.
2. For a description of investing vs speculating, please see https://jankythoughts.com/2021/04/12/investing-vs-speculating/.
3. Disclaimer: I am an investor in StockClubs, and I’m only sharing one (out of 10+) of my brokerage accounts on the app.
4. To be clear, “weigh your portfolio towards” does NOT mean sell everything else and only buy something or other. It simply means giving something more weight in the portfolio.

Foreword

How should we evaluate a $100 company that pays $10 in dividends a year, every year, vs another $100 company that pays $5 in dividends this year, $5.25 next year, $5.51 the year after, and so on, increasing its dividends by 5% a year?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Perfect world

Let’s say we have a business that scales infinitely at 10% returns — for every $100 you invest in it, it will return $10 every year in perpetuity. Further, let’s say we live in a perfect world, where there are no taxes to worry about and other transactional costs.

This business is, then, the first example from above — the $100 company that pays $10 in dividends every year.

Transmogrify

Now, imagine if at the end of year 1, instead of pocketing the $10 in dividends, you pocket $5, and invest $5 into the company. Now you have $105 invested in the company, so your next dividend will be $10.5. Again, you do the same thing, pocket half, and put the rest back into the company — in year 2, you’ll then pocket $5.25, and reinvest $5.25 for a total of $110.25 invested. In year 3, you’ll get $11.02 in dividends, of which you’ll pocket $5.51, and reinvest $5.51, and so on.

If you look at the numbers closely, you’ll realize that we’ve transformed our 10% dividend paying company, into a 5% dividend paying company, but with a 5% increase in dividends every year.

In general, absent frictional costs (like taxes, transaction costs, etc.), an asset that yields X% a year every year, is equivalent to an asset that yields Y% a year, but which grows the dividends at (X-Y)% a year — The difference (X-Y)% in yearly yield can be considered as being re-invested to grow the next year’s yield at an additional (X-Y)%.

Welcome to Earth

Of course, in real life, there are taxes and there are transactional costs — in the prior example, your $10 per year in dividends will be taxed, leaving you less than the desired amount to reinvest so that you cannot achieve the 5% increase in dividends for the next year — one way of thinking of it, is if the money was directly reinvested instead of first being passed to you as dividends, the taxes on that reinvested part will not be due yet, and so will compound for you instead of the government.

But even though so, in many cases, it is useful as a rule of thumb to think of the two companies as essentially equivalent. There are many ways around the frictional costs conundrum:

• You could invest using a tax-advantaged account such as an IRA or a 401(k), in which case, there are no tax consequences right now either way.
• If you didn’t intend to reinvest anyway, the tax drag is irrelevant.
• When you pay taxes, and then reinvest in a smaller piece of the company with after tax money, your cost basis for that smaller piece of the company is higher, which reduces future taxes.
• Reinvesting involves increasing your stake, which involves additional risks. The taxes paid now can be considered a counterbalancing force for not taking on those additional risks.

In practice, since tax rates can differ dramatically between different investors, many financial decisions are evaluated without taking taxes into consideration, with tax considerations being worked in later at the edges. So while a single person investing their own money may prefer one company or the other (depending on their personal tax situation), a fund manager (who services multiple clients with different tax situations) may actually treat the two companies as essentially the same.

Risks

One thing we only briefly touched on, is the idea of risk. If you take the $10 in dividends now, that’s a $10 profit there and then. But if you reinvest $5, then you are betting that the increased 5% of investment will result in 5% (or higher!) increase in yield going forward.

That may not be true!

Unlike our toy example, most businesses in practice do not scale forever. Whether you are selling cars, TVs, or services, at some point, you simply run out of customers to sell to. Also, as companies get bigger and bigger, bureaucratic overheads tend to grow and at some point, the marginal rate of return simply diminishes to 0 or even negative.

Which is to say, cash now is certain, while future growth is uncertain, and most investors will generally demand that an increase in investment of X% results in more than X% increase in yield going forward. Otherwise, it may not make sense from a risk/reward perspective.

Foreword

We’ve discuss the capital stack of a company before — basically how the company funds its initial creation and ongoing concerns. But why are there so many classes of funding? Why not just fund the entire company with equity? Or with debt?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Perfect business

Let’s say we have found a magical business — it scales perfectly from $0 to infinity amount of money we invest in the business, and for every $1 invested, it will return 10c every single year. So, if we invest $100 into the business today, it’ll return $10 at the end of 1 year, another $10 at the end of the 2nd year, and so on.

A naïve view would say that this business returns 10%. But can we do better?

Terminologies

Before we go further, let’s get some terminologies out of the way:

Term	Definition
Returns on invested capital (ROIC)	A measure of the efficiency of a business, it is defined by NOPAT divided by invested capital: NOPAT / Invested capital
Cash returns on invested capital (CROIC)	A measure of the efficiency of a business, it is defined by free cash flow divided by invested capital: Free cash flow / Invested capital
Cash returns on capital invested (CROCI)	Not to be confused with CROIC, CROCI is another measure of the efficiency of a business and is more commonly used for enterprise purposes (i.e. when a company is trying to buy another company). It is defined by EBITDA divided by total equity: EBITDA / Equity
Invested capital	The total amount of capital invested into a business, generally defined as total equity + total debt: Equity + Debt
Net operating profit after tax (NOPAT)	A measure of how profitable a business is, it is defined by net operating profit – taxes: Net operating profits – taxes
Net operating profit	A measure of how profitable a business is, it is defined by free cash flow – depreciation – amortization: Free cash flow – depreciation – amortization (1)
Free cash flow	Another measure of how profitable a business is, it is defined by: Total sales – COGS – Operating expenses – Capex
Costs of goods sold (COGS)	The cost of making each unit of product sold by the business
Operating expenses	All costs related to a company’s primary business, other than COGS, such as sales and general administrative costs, etc.

For the purposes of this discussion, we’ll focus on ROIC.

ROIC

In our little toy example, the ROIC of the business is simply 10% — for every $1 invested, we get 10c back per year.

Does this mean that the owner of the company, i.e. the shareholders must settle for a 10% return on their money? Is there anything they can do to improve those returns?

Financial alchemy

Let’s say we want to invest $10,000 in the company, giving us a return of $1,000 per year.

We could put up that $10,000 ourselves and settle for a return of 10% a year, or we could borrow $5,000 at 5% interest rates, and only put up $5,000 of our own money:

Debt funding	Equity funding	Invested capital	Total return	Return to debt holders	Return to equity holders	% Return on equity
$0	$10,000	$10,000	$1,000	$0	$1,000	$1,000 / $10,000 = 10%
$5,000	$5,000	$10,000	$1,000	$5,000 x 5%= $250	$750	$750 / $5,000 = 15%

By funding half the business with debt at 5% interest rate, we’ve created an additional 5% of return for our equity holder!

In fact, if you think about it, as long as the interest rate paid for debt is below the ROIC, it always makes sense, in this example, to fund the business with debt — Since the debt holders demand a return less than the ROIC, the difference (ROIC – interest rate) effectively accrues to the equity holder.

ROIC vs CROIC

In our little toy example of a perfect business, ROIC = CROIC, as there are no taxes and the business is perfectly scalable with no drag (i.e. no depreciation nor amortization). In the real world, this is generally not true, and the difference between ROIC and CROIC is important!

ROIC measures how profitable a company is overall, while CROIC measures how good a company is at generating cash. Because debt interest payments are tax deductible, and because depreciation and amortization are tax deductible too, a company has some leeway to manipulate its funding sources (invested capital) to try and reduce its total taxes paid. For example, the more a company funds itself with debt, the higher ROIC it will generally be able to report, all else equal, as we’ve seen from above.

Furthermore, some businesses do not pay corporate taxes — REITs are a famous example, and instead, their shareholders pay taxes for profits directly on their own tax returns.

Finally, some businesses have depreciation and amortization costs that are far higher than what it actually costs the businesses — REITs again are a famous example, with proper maintenance, buildings tend to depreciate less than the accounting depreciation suggests.

For these reasons, generally speaking, most businesses should be valued on their ROIC, while real estate heavy businesses are generally better evaluated on their CROIC.

ROIC vs risk

In our perfect business example, because there is no risk, it is always preferable for the equity shareholders to fund the company with debt as long as the interest rate is below the ROIC. That is not always true in the real world — often, businesses tend to get less efficient after they reach a certain size, so infinite growth is impossible (edit: prior version had a typo saying infinite growth was possible — it’s not). Also, companies tend to get more risky as they take on more debt, as debt payments are mandatory, while equity dividends can generally be skipped without much financial repercussions — if a company falls on hard times, it can conserve cash by reducing or even skipping dividends, but it generally cannot reduce nor skip debt payments without an event of default.

Debt buyers understand that the more debt a business takes on, the more risky the debt becomes as there is less of an equity cushion if something goes wrong. As such, they’ll demand higher interest rates as the debt to equity ratio goes up.

Which is to say, the more debt a company takes on, the more levered it is, the more risky it tends to be. Though if everything works out, the more profitable for the equity shareholders it will be as well.

Footnotes

1. This isn’t exactly correct — certain non-cash expenditures such as stock based compensation, changes in inventory levels, etc. are taking out as well. For the purposes of this discussion, this is close enough.

Foreword

While hedging is mentioned in finance a lot, it is, surprisingly, not very well defined. Despite its frequent use in finance literature, it seems that most people have a rather hazy mental model of what hedging is, or how it works.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

What is hedging

To try and make the discussion more concrete, I’m going to provide my own mental model of what hedging is. To put it simply, a hedge is simply an auxiliary position that reduces the risk of your main position, where “risk” is defined as the variability (i.e. variance) of the combined positions performance.

Types of hedging

In my framework, there are 2 main types of hedging:

Mechanical hedges

Mechanical hedges are positions which “mechanically” go down (or up) in value as your main position goes up (or down) in value. For example, buying a put to hedge your stock exposure is a mechanical hedge — the value of the put mechanically goes up or down as the value of the stock goes down or up.

Similarly, TIPS are a form of mechanical inflation hedge — as inflation (as measured by the CPI) goes up or down, the value of the bond mechanically goes up or down.

The key thing to note, is that the value of the hedge moves inversely to the main position, regardless of market conditions. This generally happens because there is arbitrage between the main position and the hedge, such that any spreads will be swiftly closed by market makers, and/or there is an authority (such as a regulator, a government, an exchange, etc.) that enforces that the hedge moves inversely with the main position.

Statistical hedges

Statistical hedges are positions which are known to generally go down (or up) in value as the main position goes up (or down) in value, though there is no guarantee for them to always do so.

For example, in the classic 60/40 portfolio, the 40% of the portfolio in bonds can be thought of as a hedge for the 60% of the portfolio in stocks. Over the short/medium term, the value of bonds tend to move inversely with the value of stocks.

Other types of statistical hedges generally involve what is colloquially known as “pair trades”. For example, the value of the Australian dollar tends to move with high correlation to the value of the Canadian dollar, as both countries are commodities exporters with fairly similar exports, so changes in commodity prices tend to affect both. Thus, AUDUSD (Australian dollar valued in US dollars) and USDCAD (US dollar valued in Canadian dollars) tend to move inversely with each other — it used to be profitable to trade these 2 in a pair trade that bets that any gaps in performance will eventually close.

Observations

• Assuming you do not rebalance, your total position (main position + hedge position) cannot perform better or worse than your main position. The performance of your total position, absent rebalancing, is always of a smaller amplitude of your main position.
  • If you find that your total position actually went up in value despite your main position going down in value (i.e. your hedge position went up in value more than your main position went down), then you’ve made a mistake — your main position is actually the hedge and vice versa.

• If you rebalance smartly, then it is possible for your total position to perform better than your main position, and with lesser risk (i.e. smaller variance).
  • This is a result of the Modern Portfolio Theory. In simple terms, when your main position goes down in value (and your hedge goes up in value), you’ll sell some of the hedge position to buy the main position, and vice versa. Assuming the main position generally increases in value over time (i.e. your main thesis is correct), then this essentially forces you to buy low and sell high, and over time, should outperform the main position, but with smaller variance.
• If the value of the hedge consistently or generally goes down when the value of the main position goes down, then you’ve made a mistake — the “hedge” is simply not a hedge for the main position.
• If the value of the hedge moves essentially randomly with regards to the value of the main position, then it can still be used as a hedge, but only if you rebalance diligently and size the positions properly.
  • This is a result of the Modern Portfolio Theory.

My personal hedging

If you follow my positions on StockClubs (Disclaimer: I am an investor in the app, and only show 1 [of 10+] brokerage accounts in that app), then you’ll see that I very often sell calls against my stock positions. In a hand-wavy kind of way, these can be considered as hedges as well — the short call goes up in value (less negative) if the stock goes down in value.

One way of thinking about this, is that I’m giving up some upside for the stock position, to reduce some downside (if the stock goes down in value, the premium from selling the calls “absorbs” some of that loss).

Foreword

What are you actually getting yourself into, when you buy shares of a company? Or the bonds of a company?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

History lesson

The first known business corporations were formed in 16th century England. These were mainly linked to the crown and were given monopolistic powers over certain sectors of the economy by the crown. At around the same time, partnerships between private individuals were also being developed, mostly by merchant guilds and other large private organizations(1). With time, these two models took ideas from each other and the culmination resulted eventually in the modern day corporations that we know today.

Originally, corporations were joint ventures, where every shareholder signs up for the venture by entering into a contract with each other. The contract dictates the rules of incorporation, what responsibilities each member has, and also how profits are to be split, forming the basis for the modern capital stack.

Around the early 17th century, the modern joint ventures with limited liability partners signing on via buying shares was invented(2) and that eventually evolved into the stocks and shares that we know today. Each share effectively represents a pre-negotiated fractional share of the company, and within each share class, every share was identical. This treatment allows for shares to be easily sold and traded by removing the friction of having to individually negotiate the ownership with each new investor.

Partners

When you buy shares or bonds of a company, you are, literally, entering into a financial arrangement (bonds are contracts, but shares are not quite contracts, though close) with the company — its management, other shareholders and debtholders. These 3 groups of people (management, shareholders and debtholders) have gotten together to collectively fund and run the company and its businesses, hopefully to the benefits of all parties, according to the articles of incorporation.

In fact, from a legal perspective, as a shareholder, you are literally part of the group that hires the management to run the company on your behalf.

Think about that for a minute.

While buying shares on your brokerage account feels abstract and impersonal, from legal and financial perspectives, it is not really very different from buying a part of a private company, where the contract can be negotiated in a bespoke manner. Now ask yourself these questions:

• Would you go into business with a known fraudster?
• Or someone who has a history of promising grandiosity, but delivering mediocrity?
• Or someone who sells large portions of their shares while encouraging others to hold on to their shares?
• Or people with a known history of fickle relationships with the truth?
• Would you hire someone with the above traits to run your company for you?

And if your answer is no to any of the above, then consider if you should or would buy shares in companies that have majority shareholders or managements (collectively, “insiders”) with similar traits?

Shenanigans

While the law set by Congress and rules set by the SEC/FINRA bound what insiders of companies can do, laws and rules are, by their nature, static while human creativity is dynamic and always changing. So, while the laws and rules prevent insiders from outright defrauding other shareholders, there are still many loopholes and legal grey areas that the less scrupulous insider can exploit, often with the result of enriching themself at the expense of others.

As investors, it is paramount that we look out for such behaviors, identify the perpetrators, and refuse to enter into partnerships with them ever again. Because while in the short term we may benefit from their unethical ways, there is no telling when they may turn on us — after all, a series of spectacular returns is still 0 after an eventual 100% drop.

Footnotes

1. Additional reading: https://www.britannica.com/topic/corporation
2. Additional reading: https://www.britannica.com/topic/joint-stock-company

Foreword

In this blog, we talk a lot about “value” — intrinsic value, extrinsic value, productive value, etc. What does it mean exactly, though, what is value? In this post, I try to put a definition on what I mean by “value”.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

My values

We’ve discussed in multiple prior posts about this amorphous thing called “value”, and at times, I’ve adorned it with a prefix like “intrinsic value” or “extrinsic value”, but I’ve never really defined what these mean.

The idea of “value” is ill-defined in finance, and in many cases, is simply synonymous to “price” — for example, in some states, the value of your home on which your property taxes are based, is simply the price you bought the home at, and the value of your stocks portfolio is generally defined to be the sum of the last traded price of each asset.

But in economics and finance, sometimes there is a distinction made between price and value, yet value is very often not clearly defined — certainly, if you ask 10 different economists/financial observers, you’ll likely get 11 different definitions of “value”.

So, here to make things clearer (or murkier?), I’m putting forth my own definitions of value, of which there are 4. Yes — ask 1 single JB, you’ll likely get 4 different definitions of “value”.

Intrinsic value

Intrinsic value is the value something has, because someone wants it for the thing itself. For example, a piece of bread has intrinsic value — it sustains life and affords temporary reprieve from hunger.

Extrinsic value

Extrinsic value is the value something has, because others prescribe it value beyond its intrinsic value. For example, a dollar note has very little intrinsic value — if you are desperate, you can burn it for a few seconds of heat, but that’s about it. However, a dollar has exactly one dollar of extrinsic value, because others are willing to trade you things of value for your dollar.

Productive value

Productive value is the value something has because it is able to produce other things of value. For example, a well run, profitable business has productive value — it produces goods and/or services that are valuable and which can be exchanged or sold for other things of value.

Speculative value

Speculative value is the value something has that is above and beyond all the values above. It is generally the value someone, including yourself, may ascribe to something, simply because that someone think yet another someone else may value the thing at some value beyond the values above.

Breakfast at the beach

Let’s say you are on a deserted island with no food. For whatever reasons, you have infinite dollars with you. What would you pay for a slice of bread at that very moment?

Given that the island has no other sources of food, the amount you would be willing to pay, would be somewhat commensurate with how hungry you are (time difference between now and the last time you bought bread) and how long you think rescue will come. Therefore, the intrinsic value of that slice of bread increases with time, until you buy it, at which point, it’ll drop slightly as you are sated, but start growing in value again until the next time you are hungry. It would be entirely conceivable, for you to pay $1m or even more for that slice of bread in this situation.

If, however, you are in the middle of Manhattan, with all its wonderful choices attending to all kinds of appetites, a slice of bread would very properly drop in value, to almost nothing.

So, on the deserted island, the extrinsic value of money dropped significantly, because there simply isn’t any other merchants for you to spend your money. But in Manhattan, the extrinsic value of money grew comparatively, because you are spoiled for choice.

In the opposite way, the intrinsic value of bread increases to almost infinity as you are starved for food on a deserted island, but drops to almost nothing when you are in Manhattan, surrounded by much more choices of food.

As with intrinsic value, productive value, being a derivative of the other types of value, will, too change based on the circumstances. Back on that deserted island, a magic machine that produces a slice of bread a day would be worth fortunes — you may even be tempted to give up your entire infinite wealth. But in Manhattan, most would barely pay a few hundred dollars for it.

Buffett value

Warren Buffett is often cited as having said

Price is what you pay. Value is what you get.

Warren Buffett

To put that in our value framework, “price” would be the money you hand over, i.e. the extrinsic value you give up, and “value” would be the things you get in return, the sum of the intrinsic, productive and speculative values.

While we’ve said that the exchange rates between intrinsic, productive and extrinsic values can change, the value of speculative value is entirely in the difference — If you paid $10 for something with $1 intrinsic value and $2 productive value, then you must have paid 10 – 1 – 2 = $7 speculative value for it.

Unlike the changes in intrinsic and productive values under different circumstances as we’ve discussed above, changes in speculative value are almost entirely based on changes in mindset and sentiments. It is changes in speculative value, when a stock trades $100 one moment, and $101 the next, absent any relevant news.

And that difference is key. While intrinsic, extrinsic and productive values rarely change dramatically from minute to minute or even day to day, speculative value can and do change almost continuously. If someone bought a stock at $100, someone else may see the trade and think “what do they know? I should buy at $101!”, and yet someone else may see the trade and think “what does the seller know? I should sell at $99!”.

This uncertainty, this second guessing, this random flights of fancy and random depths of despair, they are what drives speculative value, and because the reasons for changes in speculative value is so fickle and the results so extreme, it is rarely a good thing to rely solely on speculative value when you are trading assets.

Net worth

It is with this in mind that a well thought out financial plan should include some cash buffer and sources of cash flow (dividend stocks, bonds, etc.). Because while it is generally true that non-dividend paying stocks tend to increase in value faster over time, if your entire portfolio is in non-cash and non-cashflowing assets, then you will always be subject to the whims of speculative value — to the whims of how much others feel they should pay you for your assets.

And remember, you cannot eat net worth. Especially if it is ephemeral, and the market simply ascribes lower (or even negative!) speculative value to your assets right now.

StockClubs

As you may have heard from prior posts, I am an investor in StockClubs, an app which lets you share your portfolio (or part of it) with others. While it is still in heavy development, the team would greatly appreciate any feedback!

Foreword

AML, KYC, MIFID, RegNMS, RegT, SEC, CFTC, FinCEN! Regulations and regulators! If you’ve ever worked in finance, you’ll know that the alphabet soup of regulations and regulators that need to be followed is long and overwhelming. Do we really need all of these?!

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Cost of regulations

If you’ve ever worked in a financial company, you’ll know that other than legal, there is a compliance department, whose job, it seems, is solely to make your life miserable. “Can I do this?”, “No”. “How about this?”, “Hell, no”. “What can I do?”, “I’ll get back to you in a month. Or year.”

And to rub salt into the wound, compliance folks do not come cheap. Every large bank spends millions to possibly even billions every single year for compliance related reasons, or, in cases where there is a compliance lapse, for fines. All of these costs are directly the result of regulations mandated by regulators. And like all costs to a business, all these are directly or indirectly paid for by clients.

Which means, yes, you are getting a lower interest rate from your savings account, in part, because some of the gains are taken by the bank to pay for compliance. You are paying a higher fee (either directly or via spreads) when you trade stocks, because the broker needs to take part of your profits to pay for their compliance. You are paying a higher mortgage rate, because, you guessed it! The mortgage company needs to pay for compliance.

Is it really worth it? What about a world without regulations?

Road to Alabama

Let’s say you are driving in a car, on the way to Alabama (1). This is the new world, a freer world, a world where there are no rules. Street signs? Nope. Traffic laws? No, siree. Speed limits? LOL. You get the idea.

How would you drive? On the right side of the road? Is the right side still the right side? There are no rules!

How fast would you drive? What if you drive too slowly for someone in a fancy car and they decide to just bump you off the road? Again, no rules!

How do you navigate a roundabout? Go straight through over the middle? Turn left? Or right? NO RULES!

Would you even dare to drive?

Confidence

Let’s say you have $100k, and you need to stick it somewhere. Somewhere safe, so not your mattress. What would you do?

Would you give the money to your next door neighbor Blair, and ask them (nicely) to take real good care of it and leave it at that?

Would you give the money to your local loan shark? After all, Cameron seems to be really good with money!

Would you put the money in the bank?

I’m guessing most people would say the bank, and the next question is… why?

Insurance

One of the reasons why folks tend to choose the bank for largish sums of money, is because of the FDIC insurance. If the bank goes under, or there is fraud and the money is lost, or pretty much anything else, the FDIC, an agency backed by the full might of the US Government, will make you whole. It may take a few days or even weeks for them to sort out the mess, but you can be sure that you’ll get your money back. In full.

Are you confident of getting your money back from your Blair? Or Cameron the loan shark? What if they just laugh in your face when you ask nicely to get your money back? Who you gonna call (2)?

Now, how does FDIC insurance works? Why would the FDIC subject itself to this? What if the banks just collectively decide to defraud the entire nation, take all the money and go live in the Bahamas with their slightly scandalous college room mates?

Well, that’s where regulations come in. The FDIC is playing a statistics game. They know that regulators regularly conduct checks on the balance sheets of banks, and that if anything goes wrong, certain folks at the banks are personally liable and may very well spend the rest of their days in jail. Now, bankers make a lot of money, especially if you are at the top of the food chain in a big bank. Like, a lot, a lot. But a lot of money is really only useful if you actually get to spend it freely — it’s really no fun spending money whilst in jail. So there is just that amount of incentives for bankers, and thus banks, to toe the line.

Yes, not all bankers and banks will toe the line. Some will think they can get away with it, and maybe they can! And some other banks are just unlucky and make bad bets. Like, who would have thought calls on AMC would go to 0? So some banks go under, and the FDIC pays out for those banks. But because the vast majority of banks don’t go under, collectively, the FDIC manages to stay afloat by collecting a small premium from every bank, and directing those premiums to bail out customers of the banks that do go under. Insurance, at work.

And the thing that gives the FDIC that confidence? The thing that allows this statistics game they play? Regulations. Regulations which detail what banks can and cannot do with your money. Regulations which mandate banks keep a minimum amount of liquidity (float), and regulators which conducts checks to make sure the banks are following the rules.

Confidence, again

Other than insurance (and also for insurance, because this is something FDIC, SIPC, other insurance companies depends on), is the fact that by putting down regulations, and setting out what a bank and broker can or cannot do with customer money, it dramatically reduces the surface area of shenanigans that bankers and brokers can do.

Yes, some of the more creative ones will still do stupid things. And some of the less scrupulous ones will just laugh at the regulations and do whatever anyway. But the vast majority of them will know where the line is, and while they will push ever so hard against the line, they will likely not actually cross it (by too much).

Because of that self policing, confidence in the economy and the financial system blooms. Businesses can operate, because they know that when they are approved for a loan, their interest rates won’t magically jump 20% tomorrow. Savers can bank, because they know the banks won’t bet it all on red in Vegas. Investors can leave their cash in their brokerage accounts, because they can be sure that the money is likely there, as opposed to being used to buy magic beans or to fund the CEO’s lavish lifestyle (3), and even if the money is lost, the SIPC will make them whole (4).

And this confidence in the system, this ability to know how others will act, and what to expect, these regulations, they allow the modern world to work.

All regulations are equal, but some regulations are more equal than others

That’s not to say that all regulations are good. While most of them come from a good place, a lot of regulations are reasonable, and many regulations are simply needed for the world to even work, there are, clearly, some regulations which were either poorly thought out, or designed with less than altruistic concerns.

Which is not great, certainly, but welcome to Earth, population 8billion (5), where humans fail, and there’s a lot of us around to fail. Get used to it.

The whole point of having ongoing lawmakers is because we know that laws and the rules borne of those laws are not always good or right, and very often become obsolete over time. And the whole point of democracy is so that lil’ ol’ us get at least a bit of a say in how and what the lawmakers do and legislate. If every law and rule was perfect and will always remain perfect, then there’s really no point to having an ongoing government, is there?

So yes, things break sometimes, but hopefully, over time the bad bits will get replaced with somewhat better bits.

But claiming that we should do away with all regulations, because of 1 or 2 bad ones, is simply naïve.

Footnotes

1. To bring granny a basket of fruits and cakes. In your red car. What else could it be?
2. Ghostbusters! The answer is, always, Ghostbusters! With the exclamation mark.
3. OK, fine, bank/brokerage CEOs get paid a lot of money. So maybe some of that. But not all of it.
4. Currently up to a maximum of $500k, of which at most $250k can be in cash.
5. Yea, that just happened, in the Philippines, apparently.

Foreword

What is money? What is debt? How are they related?

Some people get all twisted out of shape calling fiat money “debt”, and that only gold or bitcoin or silver or whatever is real “money”. But is that really right?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Debt

Let’s start with the easy one. What is debt?

The Cambridge dictionary defines debt as “something, especially money, that is owed to someone else, or the state of owing something“. That’s fairly clear, ain’nit?

Island adventure

Let’s do a little thought experiment. Let’s say a bunch of people, including you, are on a remote island. None of you know each other, none of you have reasons to trust each other. But for your little society to work, and for everyone’s lives to improve, you need to work together, because it simply isn’t feasible for one person to do everything well — division of labor generally tends to yield much better results for everyone.

One day, one of the strangers, Alex, did a favor for you — they built a little fire pit for you, out of rocks they carried down from a nearby mountain. Your specialty is foraging berries, but Alex already had their meals today, and berries don’t keep long. How can you repay Alex?

One way, is for you to give Alex a token, a symbol of the value you owe them, for their work in constructing the fire pit. This token can be a cowrie shell, a pretty rock, a piece of leaf you scribble a mathematical puzzle that only you can solve, etc., pretty much anything — Anything that both you and Alex agree to recognize as an accounting measure of what you owe Alex.

Now, let’s say you and Alex settle on using cowrie shells — they are hard enough to find that neither of you are concerned about the other using newly found cowrie shells to deceive the other, and the shells are pretty enough that you wouldn’t mind keeping them just for their own sake. Further, let’s say that the rest of the group of strangers feel the same — that cowrie shells are rare enough, and valuable enough in their own right, so that everyone starts offering, and accepting, cowrie shells for goods and services bought and rendered.

Well, congratulations, you’ve just invented money — the cowrie shells are, essentially, money.

As you can see, money is, at least in this case, just a means to measure how much each person is owed by the collective body — the rest of the island (world). It is a physical manifestation of the debt that the rest of the world owes you. Nothing more, nothing less.

Intrinsic value

“Hold on there!” someone will be shouting right about… now, “Cowrie shells have intrinsic value as you’ve said, that’s why they are money”. Yes, I did say that cowrie shells, at least on that island, has some intrinsic value — they are pretty enough that everybody wouldn’t mind keeping them around just to look at them.

But you see, that doesn’t make cowrie shells money. It just makes cowrie shells pretty. There are a lot of things that are pretty, yet are not used as money — a medium of exchange, a scoreboard for tracking how much you owe the world, or how much the world owes you.

Part of the reason why cowrie shells is money on your remote island, is because everyone agrees they are money, and everyone agrees to accept or offer them as representations of value transferred. The fact that they are pretty is mostly irrelevant — the prettiness is a useful property for bootstrapping the economy, but beyond that has no real relevance to the day to day use of cowrie shells.

Similarly, a fiat currency can be bootstrapped into money by, well, fiat — a government can decree that within the borders under its control, some currency needs to be accepted and offered as legal tender for goods and services offered or rendered. The currency need not be pretty in this case for the bootstrapping — the credibility of the government, and how much people believe the government is able to enforce its legal tender laws, is the criteria for bootstrapping the currency. And once the currency is in wide circulation, and everyone agrees to use it as money, then it will be money, and it will, as before, track debt owed to (or by) each individual person.

Hyperinflation

Now, let’s say that for whatever reason a large portion of the population of the island decide not to use cowrie shells anymore at any point in time. They stop accepting cowrie shells, and start using their existing cowrie shells to quickly buy up goods or services from those who still use cowrie shells.

In time, more and more people will recognize that cowrie shells cannot be used to buy certain goods and services, and even though the shells are just as pretty, their “value”, how much each cowrie shell can buy, will start to drop. As more and more people recognize this, they will be more and more willing to exchange cowrie shells for less and less, resulting, eventually, in hyperinflation — the value of money essentially drops to, or close to, 0.

Now, I want to be clear here — hyperinflation and inflation are not the same thing. Inflation is just the regular ebb and flow of the value of money vs goods and services. Hyperinflation, on the other hand, is a loss in confidence in the value of money by a large portion of the populace, which then feeds on itself, becoming a death spiral for the value of money (1). The former is a measure of relative supply and relative demand, while the latter is a loss in confidence of money — two very different things.

You can have very, very high inflation (say 10-20% a year), without actually getting hyperinflation. There are countries with poorly managed currencies with such high inflation numbers for prolonged periods of time, but because enough people still believe in the currency (even if that belief means mentally adjusting by 10-20% a year), that hyperinflation simply does not set in.

In short, high inflation is a crisis of relative supply vs relative demand. Hyperinflation is a crisis of confidence in money.

Another way of looking at it, is that hyperinflation is one way how money stops being money.

Forgeries

Let’s say instead of losing confidence in the cowrie shells, someone stumbled upon a little cove on a remote part of the remote island, where cowrie shells are just all over. They secretly take these cowrie shells and start using them to buy things, and entirely stop working. If they do this at a small scale, most people may not notice, and while inflation may set in (prices will go up a bit to reflect the relative value of money vs goods and services has shifted), confidence in cowrie shells won’t be loss, and life goes on without hyperinflation. If, however, they do it on a large enough scale, effectively introducing a level of supply of money that’s so large that society (the rest of the island) can never repay the debt as symbolized by the new supply cowrie shells, then things will likely go haywire and hyperinflation will likely set in.

To counter the demise of cowrie shells, you found something else, a shiny yellow rock, that is, again, very rare, but because it wasn’t money, nobody has been really collecting it, and so you are the only person with a lot of it. Can you just unilaterally demand everyone use the yellow rock as money? Maybe! Obviously everyone else will be at a severe disadvantage to you, and clearly they won’t like that very much. Some other people can probably find other things, maybe a leaf scribbled with an arcane math problem only they managed to solve, or a series of auditable numbers carved on a giant stone, things that are also hard to forge, but that they themselves have a lot more of than the rest of the island. Those people will also make the same demand that their thing is the new money.

So why yours and not theirs?

Ultimately, the choice of what to use as money depends on the interplay of 2 things:

1. Who has the clout, the ability (by persuasion or by force) to convince more people to accept their choice
2. What is the thing most people agree to use

Essentially, being hard to forge, even impossible to forge, does not automatically make something money. Humanity has known for decades about cryptography and how to make essentially unforgeable artifacts. Yet none of these have become money in and of themselves — instead, they are used to secure existing money, by encrypting transactions made in USD, EUR, GBP, etc.

Summary

To become money, having the properties that are necessary for being money is not enough. You also need that bootstrap, and you need that bootstrap to morph into popular support by the populace. Finally, to prevent your money from stopping being money, you also need to maintain the people’s confidence in your money, essentially in perpetuity.

But underlying all of these, is the basic premise, that money is, simply, debt. Money represents debt owed, and is the unit of accounting so that society can decouple the 2 parts of a barter trade — instead of you and Alex trading a fire pit for berries, you get the fire pit now, and Alex gets the berries later, with money acting as a measurement of the debt you owe Alex in between.

Edit:

The key, then, to remember, is that the value of money does not come from within — it comes from without. Money is money not because it has intrinsic value. Instead, money is money because it has extrinsic value — its value is entirely bestowed by the willingness of others to take that money as payment for their goods and services. Claiming something is hard to forge or highly divisible is necessary, but not sufficient. Claiming something has intrinsic value because it can be used in industries, or looks pretty, is mostly irrelevant. Claiming something is backed by something else, is irrelevant, unless that backing is either a form of widely accepted money, or that backing involves the ability to persuade others (again, either by persuasion or force) to accept the backed asset as money.

Footnotes

1. Wikipedia defines hyperinflation here, which includes a mathematical definition of hyperinflation, which is basically 50% increase in prices of general goods and services on a month over month basis, over a prolonged period of time, essentially the death spiral mentioned above. On a year over year basis, 50% month over month translates to roughly 129x increase in prices per year.

Foreword

I’ve received, over time, numerous requests from various people inquiring about real estate syndication. Here is a quick summary of the space, and the things I look out for when evaluating a new deal.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Real Estate Syndication

As way of a quick introduction, real estate syndication is a fancy way of saying a “real estate fund”, or, in some cases, “real estate private equity fund”. The former (real estate fund) is more general, and encompasses various real estate strategies (explained below), while “real estate private equity fund” refers specifically to funds which buy properties, improve them somehow, and then sell them again — Similar to how generic private equity funds buy companies, improve their operations, and then sell the companies again either on the private or public markets.

Terminologies

Before we dive in, here are some common terms which will come up over and over again in this space.

Sponsor, General Partner, GP	The people who found the deal and are marketing it are generally called the sponsor. The people who actually run the day to day operations as well as make major decisions on behalf of all the other investors are called the general partner (or GP for short). In general, the sponsor will usually be the GP, so the terms are used interchangeably in most cases.
Broker	The people/entity which is purely marketing the deal on behalf of the sponsor. The broker typically takes a cut of the profits, either in the form of a front load (a fee up front as a percentage of committed dollars they bring in) and/or an equity stake (usually a percentage of the profits). While brokers are common for really large deals (hundreds of millions to billions of dollars), they are uncommon for smaller deals (under $100m). Personally, if a smaller deal has a broker (or worse, many brokers), I would consider it a sign that the sponsor is new to the game and simply doesn’t have a large enough rolodex of investors to call upon. Some common brokers are FundRise, CrowdStreet, YieldStreet, etc.
Investor, limited partner, LP	The people who actually put money into the deal. While the GP earns their profits from sweat labor, the LP earns their profits from equity labor, i.e. actual return on actual cash put into the deal. In particular, the LP is also limited in that they have no say in the day to day running of the deal. This is important! A key determination of who has limited liability (and thus can walk away from a failed deal by “only” losing their investment) vs who has unlimited liability (and thus may be personally liable for any losses/debts) is who is responsible for making decisions and who actually made decisions. Before you take part in any deal, make sure that you are joining as an LP, unless you are comfortable making decisions for the deal, and taking responsibilities for the consequences of your decisions.
Capitalization rate, cap rate	The capitalization rate of the deal. At the start of the deal, this is obviously estimated, but when a deal exits (sells of its assets), the “exit cap rate” is also of interest and is typically actual (instead of estimated). Cap rate is simply the “net operating income” divided by the value of the asset. In a hand-wavy sort of way, you can think of it as the inverse of the P/E ratio that is so common for stocks.
Internal rate of return, IRR	The imputed return of the deal (either estimated or actual, depending on context) over a period of time, annualized to one year. The IRR is more complicated than simply the return of the deal divided by the amount invested — the timing of the return of capital and profits is important! A deal that takes in $100, and then immediately returns $100 the next day, while also returning another $100 over the next year, is a much better deal than one that takes in $100 and returns $200 at the end of the next year. Both deals return $200 over a one year period, but the former returns your capital almost immediately, letting you put that capital to further use. Think of it this way — assuming you can and do put all cash thrown off by the deal back into the deal and compounding at the same rate, then 2 deals with the same IRR and same period of compounding will return exactly the same amount of money at the end of both deals.
Levered returns, levered IRR	Almost all real estate funds use leverage, because without leverage (and the associated risks!), most real estate deals simply do not make sense — you can get much better returns with much lower risks by just investing in the stock markets passively. Levered returns or levered IRR is simply the actual (or estimated, depending on context) return or IRR after including the multiplicative effects of leverage and taking out the costs of leverage (i.e. interest fees).
Gross return, gross IRR, fund level return, fund level IRR	“Gross” basically just means “fund level” in this context, which means whatever number listed, is for the fund before the GP takes their cut, but after all other applicable fees, such as property management, expenses reimbursements, legal fees, etc. While these numbers are interesting, the more important numbers are the “net” ones. Always be sure to ask the GP for the net numbers, and if you have both net and gross numbers, then you can get a sense of how much the GP is getting paid.
Net return, net IRR, investor level return, LP level return, investor level IRR, LP level IRR	“Net” basically just means “LP level” in this context, so the number listed is the actual (or estimated, depending on the context) return that you, as the LP, will get. These are the numbers you want to use when comparing two otherwise equal deals.

Strategies

There are 4 main strategies for real estate funds:

Development	This is where the fund takes in capital to build a new property. There are two exits: a) The property is sold to buy/hold investors. b) The property is converted into a buy/hold investment for long term holding. In some cases, a fund may even opt for both — the property is sold to an affiliated buy/hold fund, and existing investors can opt to collect cash of the proceeds, or to roll over their investment into the new buy/hold fund. If too many investors opt to collect cash, then investors rolling over may be given the opportunity of putting in more cash, or the GP may find new investors or even put in their own money to make up the shortfall. In general, development funds are the most risky, as a lot of things can go wrong during construction, and delays, additional costs, etc. are common. Also, during the period of construction, there is no cash flow — the property is not in a rentable state! As a result, a successful development deal tends to have the highest returns.
BRRR(R)R – Buy, Rehab, Rent, (Refinance), Repeat	This is a strategy popularized by some influencers, such as the founder of BiggerPockets.com. The basic idea is to a) Buy a piece of property that is somehow mismanaged, either because management has let it fall into disrepair, the property isn’t positioning it properly for the local market, etc., b) Rehab the property by fixing the issues identified, either by fixing whatever’s broken, or renovating the property to position it as more upscale, etc., c) Rent out the property with the fixes in place for higher than what it was previously rented for, d) (Optionally) Refinance the property at the new, higher, valuation to take cash out of the deal, e) Repeat the entire process. Generally speaking, if the goal is to sell off the property to recapture capital invested, then the refinance step may be skipped and instead the property is sold off. This is the “real estate private equity” strategy. If the goal is to keep the property as a long term profit generating asset, then refinancing may be a good way to get some (or in some cases all) of the invested capital back so that it can be put to use in a new deal. In general, this strategy is less risky than development, but more risky than buy/hold. As a result, it tends to have returns in between the other 2 strategies.
Buy/hold	This is the simplest strategy where the deal is to simply buy some property at some perceived fair price, and the GP is in charge of handling the day to day operations of the property, while returning a portion of the rental income to LPs as dividends. In general, this strategy is the least risky of the 3, but as a result, also has the lowest returns.
Opportunistic	This is a catch all phrase for “everything else”. In these types of funds, the sponsor has a lot more leeway to do whatever they deem is appropriate, which can be good (if the sponsor is good) or bad (if the sponsor is not). Be sure to read the incorporation documents to know exactly what the sponsor is allowed or not allowed to do, and make sure you are comfortable with everything listed before you sign your name!

Evaluating a deal

When I evaluate a deal, I look at 2 main things:

• The sponsor
• The deal itself

Sponsor

In the case of the sponsor, the things I look out for are:

Is the sponsor trustworthy?

Anyone can put up a website and ask for money. Anyone can claim 10, 20, 30% IRR.

Doesn’t mean they mean it or that they can do it.

There are lots of unscrupulous sponsors who put up misleading and/or outright faked information to get investors, and I’m not particularly interested in investing with them.

Does the sponsor have the experience to bring the deal full cycle?

Even if the sponsor is acting in good faith, they may simply be too inexperienced to handle the deal and the stresses involved. If everything goes well, this may not matter, but if something breaks, I’d like to know that the sponsor has seen similar situations before, and/or at least have a vague idea how to handle the setback, instead of just throwing their hands up in the air and possibly sobbing in the corner.

Evaluating the sponsor

One of the best ways to evaluate if the sponsor meets both criteria, is to see what their track record is — if they have been running the company behind the fund for at least 8-10 years (roughly the time it takes to bring a fund full cycle, or at least 4-5 individual deals), and they’ve done so without changing their name (personal and company), then that’s a good sign that:

• They have been successful enough that they aren’t sleeping on the streets.
• They have built up enough of a reputation/goodwill that they are unlikely to throw it all away just to scam lil’ ol’ me.
• They have been doing this for a while, so they are at least somewhat experienced and are not flying in the dark.

Now, this isn’t a hard and fast rule — some sponsors worked for other funds, and are just starting out on their own.  If they were reasonably successful before, and they are just starting out because of ambitions (as opposed to, say, embezzling from the prior fund), then that’s a good sign too — while the fund itself doesn’t carry much reputation/goodwill, the sponsor themselves might.

I’m also not entirely opposed to working with new teams, as long as they show they know what they are doing — I’ll have to talk to them more.  But the point is that new teams tend to make mistakes, and I’m not particularly inclined to foot their tuition bill.

The absolute worst case is the “serial founder”, who creates new companies (not deals) every 5-6 years, and completely leaving out mentions of their prior endeavors.  This suggests that their prior attempts were less than stellar, and I’m not a fan of the deception, even if by omission.

There are other ways for sponsors to prove their mettle, such as being able to conduct a Q&A with ease and confidence, having a large social media presence for a long time (reputational risk if they mess up, also, if they did mess up, someone would have probably pointed it out, so you should look for those bad reviews), etc.

Another thing about sponsors — it’s usually about the team.  The more things that the sponsor does inhouse, the more likely they have control over their own destinies (and thus your investment).

If a sponsor is just a broker (i.e.: they seek investors, put the money in the fund, take a cut, then give the rest to another sponsor to do the actual deal), then understand that you are paying fees twice.  Once to the broker, and another time to the actual sponsor doing the work, whom you may never meet — because if you’ve met them, you may get the crazy idea that maybe, just maybe, you should cut out the middleman and make more for yourself.

Now, there are benefits to this arrangement — if you are deploying huge sums of money (say O($10m+)), then maybe it’s too much work to find all the deals yourself, and a broker is useful.  But if not…

BTW, and I may be wrong on this, but I believe that all such brokers need to be licensed (For example, https://dos.ny.gov/real-estate-broker for single deals. For funds, see SEC/FINRA rules).  If someone is clearly brokering a deal, and does not clearly list their licenses, then you should worry.

Deal

As for the fund, usually just understanding what the fund is doing will give you a good idea of what to expect. As discussed above there are generally a few types of funds:

• Buy/hold, sometimes called core/core+
• Buy and flip, sometimes called value add, or BRRR(R)R
• Build new, sometimes called development
• Whatever crazy scheme the sponsor can dream of, sometimes called opportunistic

Note: All numbers below are approximate for the period just before Covid19. For the 2 years after Covid19, real estate generally returned significantly higher numbers (a few multiples of the below in some cases) due to all the upheaval as people moved around. We’ll have to wait and see what post-Covid19 brings…

Now, if a fund is a buy/hold, then you’d expect levered net IRR to be in the 6-10% range, with cash flow generally steady from day 1.

For a buy/flip, you should generally see net IRR in the 12-15% range, though I’ve seen as high as 20-25% when the fund gets lucky. Cash flow in the first year is probably close to 0.  Cash flow in the 2nd year may be half of preferred (~4%), and then 8% in 3rd year, before 8-12% in the next 2-3 years.

Development funds can see net levered IRR be as high as 15-20%. Cash flow in the first 2-3 years will be 0.  No renter’s gonna pay you rent for an apartment that does not exist yet. So, if you come across a development fund, that promises 6% cash flow starting from the first year, you’ve gotta ask yourself this:

Where the hell are they getting the money in the first 1-3 years, while the property is being built, to pay me?

And the answer is, probably, they just took in more money than they really need, and are paying you with your own money. Which generally means:

• It’s a marketing gimmick.
• Actual net IRR is likely to suffer, since this additional money is non-productive, and just a paperwork transfer.

Location, location, location

Finally, for a deal to make sense, the strategy must fit the location.

• It doesn’t make sense to build class A+ buildings in a depressed neighborhood with median income in the $30k’s.
• It doesn’t make sense to do heavy renovations on a fund with many single family homes.
• It doesn’t make sense to build large apartment complexes in a city with heavy net outflow of households.
• It doesn’t make sense to value add a property that just recently underwent renovations.
• Etc.

Also, note that there are some states which are just extremely hostile for real estate investments, and a fund that tries too hard to make it work there, probably can make substantially more returns by just focusing their attention elsewhere. These states tend to have laws which make it hard to turn a profit on an investment, by severely restricting the landlord’s abilities to manage their property the way they see fit. For a discussion on this, see Affordable Housing.