Satyajit Das’s book, Traders, Guns & Money, opens with a great anecdote about a meeting with an Indonesian noodle company. The noodle men were “Indonesians of Chinese extraction,” Das writes. “They were part of the infamous ‘bamboo network’ of ethnic Chinese business interests that crisscrossed South East Asia.” The noodle shop was an old business, playing an ancient and humble trade, the kind you find throughout Asia. Sounds like a nice simple business, right? Yes, but…

The noodle company got itself into some trouble. To simplify the story greatly, it basically lost a lot of money using derivatives to bet on dollar-rupiah movements. The loss suffered was, in fact, more than the capital of the company itself. At one point, Das writes: “What this had to do with producing noodles was a mystery.”

Exactly!

Unfortunately, this kind of story riddles the markets today like worms in an otherwise worthy cut of swordfish. There are so many of these incidences and they are ruining companies and investors across the world. It takes a nasty crisis like the one we are in to expose all these things. And the rot is extensive.

I want to share with you three little-reported events and one historical example that all show how pervasive this mindless risk-taking became during the last few years. They would be almost comical if they weren’t true.

First, consider the sad example of several Mexican and South American companies that made, large, company-jeopardizing currency bets. For example, Mexico’s third largest retailer, Controladora Commercial Mexicana (MXK:COMERCIUBC), recently filed for bankruptcy after losing so much money speculating in the forex markets. What does currency speculating have to do with selling tortillas, milk and eggs? Nothing. That’s the point.

Similarly, Sadia (NYSE:SDA), a poultry producer; Cemex (MXK:CEMEXCPO), a cement outfit; and Gruma in tortillas – all lost huge amounts of money on currency bets. Aracruz Cellulose (NYSE:ARA), the much admired pulp giant of Brazil, owes more than $2 billion to its banks for making bets on currencies that went sour. What was once a great franchise has been brought to its knees. It will take years to pay that back and debt payments now make up 40% of its pre-tax earnings.

The second example of mindless risk-taking is the story of so-called “portable alpha.” Apparently, the brain trusts that run pension funds thought this strategy sounded like a good idea. What is it? I still don’t understand it fully. But it basically amounts to a leveraged bet on the stock market. If you lose, you lose big as many pension funds are finding out. So now the Pennsylvania state employees’ pension fund, for instance, will have to take a multi-billion bath on this exotic investment strategy.

As the Wall Street Journal reports: “The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.” The fund has only $27 billion in total. At least, it had $27 billion.

Several other funds have reported billion dollar losses on portable alpha strategies. I can only imagine how many more institutional investors are in the same boat. The people running these things and advising these people should all find other work.

The third example is so-called “accumulators,” which is another kind of tactic for placing highly leveraged bet on stocks, currencies or commodities. I don’t want to get into the details. It’s so complicated; it would take me a page to explain it. Just know that, like “portable alpha” if you are wrong, you lose big.

And yet all kinds of wealthy individuals and businesses have gotten wrapped up in these things. Accumulator losses are showing up in some unlikely places. For instance, VeraSun Energy Corp. (OTC:VSUNQ), which makes ethanol, filed for bankruptcy in part because of big losses on accumulators tied to the price of corn. Citi Pacific (ASX:CIY), a Chinese conglomerate, lost $2 billion on accumulator contracts linked to currencies.

Billions and billions of dollars lost on nonsense. There was no reason for anybody to buy these things – especially when they clearly did not understand the risks involved. The losses are so bad in Hong Kong that Any Xie, an independent economist, said recently that “Accumulators are ruining Hong Kong.”

I’ll offer one other example of this kind of recklessness that is both a historical and contemporary study: Goldman Sachs.

I just recently finished perusing Charles Ellis’ new history The Partnership: The Making of Goldman Sachs. I was particularly interested in the early history of Goldman Sachs (NYSE:GS). I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and ruined a franchise that had been around since the 1880s.

In fact, that’s not what I learned at all. From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been a business that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.

In reading this history, I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?

Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes:

“While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged…became one of the largest, swiftest, and most complete investment disasters of the twentieth century.”

The loss to Goldman Sachs itself was enormous. It basically wiped out thirty years of profits and eliminated the “fruits of all the labors of a generation.”

Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the eighth largest corporation in the country. Again, Ellis writes: “the loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.”

And so it is today, that the company once again finds itself in the middle of yet another big crisis that threatens its very existence. I don’t know about you, but I have to wonder about all the brains at Goldman Sachs and all the people who say what a great firm it is. Seems to me, for such a bunch of supposed geniuses, they routinely shoot themselves in the foot, time and time again. You don’t find Berkshire Hathaway fighting for its life every decade.

All of these anecdotes scream at me to avoid the complex and the leveraged, which often means a potential for a mega-loss if you’re wrong. The problem is these kinds of bets infect many companies, as I’ve shown, even when they have nothing to do with the core business. Even otherwise seemingly simple enterprises, like making tortillas or producing chicken, have been hurt.

The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you don’t understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would’ve saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It’s one thing to lose money. It’s another thing to lose it taking on stupid and pointless risks.

Source: Mindless Risk Taking

I was at an ethanol plant in central Iowa last week. The plant manager let me sniff the ethanol. Then he explained why it smelled of gas. I told him I couldn’t believe someone would actually drink ethanol. He told me he had to fire one of his staff the other day for doing just that. “He was mixing it with Sprite,” he said.

I asked him about taking shots of ethanol. He told me, if you took a shot of ethanol, it would dry out your throat and mouth so fast, you’d asphyxiate and die immediately. “I haven’t tried it myself,” he added. “That’s just what I’ve heard.”

Three years ago, ethanol producers were the darlings of the stock market. They were selling for 100 times earnings and their stock prices were doubling and tripling every few weeks. I remember playing golf with two high school basketball coaches at the time. One of them asked me how to invest in ethanol.

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Now the ethanol industry is struggling. The American public thinks ethanol caused food prices to rise. Politicians are attacking the ethanol industry to win votes. The press hates ethanol. Even Charlie Munger (Warren Buffett’s investment partner) hates ethanol. He says, “Running cars on corn is about the stupidest thing I ever heard of.”

VeraSun Energy, the largest ethanol stock, trades below book value. In other words, you can buy this company for less than the cash invested in it. VeraSun Energy’s stock price is down 68% in the last six months. Pacific Ethanol – another large ethanol stock – has fallen from $45 a share to $3 a share in the last two years.

The manager at the ethanol plant was mad about what has happened. He said the Cattlemen’s Association and Big Oil have used their marketing power to smear the ethanol industry. And the ethanol industry is too small to fight back.

You see, cattlemen hate ethanol because corn is more expensive and they make less profit selling meat. Oil companies hate ethanol because they sell less gasoline with so much ethanol in the system.

The plant manager said the public is wrong about ethanol and food prices. He said oil is probably the biggest factor in the soaring cost of food. And the cheap dollar is probably the second biggest factor. High oil prices make transportation and packaging costs go up. The cheap dollar makes foreigners less sensitive to the rising prices of American crops.

He also said no one realizes ethanol has reduced the cost of gas by 15%. Without ethanol, gas prices would be even higher now.

I’m trying to figure out if ethanol’s a good investment. Frankly, I haven’t made up my mind yet. The fortunes of the ethanol industry depend on the government. Without the government’s support, the ethanol industry wouldn’t exist in America. So to invest in ethanol, you have to know what the government’s going to do.

John McCain hates ethanol. If he wins the election, he’ll remove all the ethanol subsidies and hurt the farm economy. If the Democrats win, they’ll keep the subsidies in place, and ethanol stocks will probably take off…

Good investing,

Tom

Source: John McCain Hates These Stocks