Impactful information is not always insider and insider Information is not always impactful!

One of the perils of living in New York is that it is home to two of the highest profile law enforcement officers in the United States, the US attorney for the Southern District of New York (the Justice Department’s lead person in the city) and the New York State Attorney General. Both positions attract smart lawyers, who are politically ambitious, and not surprisingly, they use these positions to maximize their media exposure. While the current position holders, Preet Bharara (as US attorney) and Eric Schneiderman (as NY AG) are either Democrats or appointed by Democrats, my rant is a non-partisan one, since Rudy Guiliani and Chris Christie launched their political careers from the US attorney perches (Christie used the Newark post).

Insider Trading 2.0

While Mr. Bharara has been busy going after hedge fund managers for crossing the insider trading line, it is Mr. Schneiderman who caught my attention last week with two highly publicized actions. He first announced an agreement with 18 investment banks, including JP Morgan and Goldman Sachs, that their equity research analysts would no longer participate in surveys that allowed some of their preferred clients to get advance looks at analyst sentiment changes. A few days later he announced a crackdown on high frequency trading and in particular, the practice of paying data providers to get information milliseconds before the rest of the market. He then wrapped up both actions in a neat little package and came up with a doctrine that he termed Insider Trading 2.0, with his justifications for why it was merited. While Mr. Schneiderman's motives may be noble (or at least they sound good), I don't think that he has thought through either the principles behind this new doctrine or the potential consequences. 

Insider Trading: The evolution of the concept

The US has the most stringent rules and regulations on insider trading and it is worth looking at how the law has evolved since its beginning. The first restrictions on insider trading were included in the Securities Exchange Act (Section 16(b)) of 1934 and were a reaction to the market crash of 1929 and the perception that company insiders had contributed to the market devastation by holding back information from investors and trading for personal profit. The original laws were directed at corporate insiders defined to include managers, directors, employees and large stockholders (owning more than 10% of the shares) and were designed to prevent them from trading on "material, non-public" information ahead of the rest of the market. A side effect of that law was the requirement that insiders, when trading legally on their company stock had to report such trading to the Securities Exchange Commission (SEC) in a filing (Form 4).

In the years, through a series of changes primarily from court interpretations of the law, the law has broadened to include a much larger group of investors.

Mr. Bharara's big wins against hedge funds have come from within the conventional confines of the insider trading law. Thus, in the case against Raj Rajratnam, the government argued and was able to prove that he was the recipient of inside information passed on by Rajat Gupta, then a director at both Goldman Sachs and Proctor and Gamble. In the more recent legal tangle with Mathew Martoma, a trader at Steve Cohen's SAC Capital, the core of the case was that he "seduced" and "corrupted" two doctors to provide him with confidential information about the results of clinical trials, which he then proceeded to use to trade in Elan and Wyeth, two pharmaceutical companies.

I am not a lawyer and the intricacies of some of the legal wrangling in these cases go over my head, but the overall tenor seems to be clear. While the initial focus of the law was on the individuals doing the trading (and whether they were insiders), it has shifted to the information being traded upon (and whether it is material and non-public). In effect, the insider trading laws, as structured now in the US and enforced by the SEC, are more laws that restrict trading ahead of impactful information than insider information.

Impactful information

Rather than use "material information", a legal term, I will start with a broader term that I will title "impactful" information, i.e., information that can be expected to impact the stock price. To make an assessment of whether this information can be legally traded on or should be classified as insider trading, we need to first categorize this information. As I see it, a company's stock price can be impacted by six types of information which I will classify into three sub-groups: fundamental, technical/trading and processed information.

a. Fundamental information

From an intrinsic value standpoint, the value of a company is altered by any information that can affect its cash flows, expected growth and risk, and that covers a lot of potential news. Sub-dividing fundamental information, the information can be about the company, it can be about the entire sector or it can be macro or market-wide information. Within each sub-group, there can be different sources of data.

Company-specific	1. Company: The most obvious source of information is the company itself, with earnings reports being the most frequently used vehicle for delivery of that information. In addition, companies sometimes make public announcements about investments (new projects, JVs and acquisitions) and dividend policy (dividend changes, stock buybacks etc.) 2. Outsiders: Some company-specific information is unearthed by investors and analysts in the course of doing research on the company, without accessing either company insiders or proprietary corporate data.
Sector-wide	1. Other companies in the sector: Earnings and investment announcements by other companies in the sector can be used to reassess investor expectations of market potential and profitability. Thus, the announcement by one auto company of higher-than-expected earnings can lead investors to push up expected earnings (and prices) at other auto companies. 2. Sector research: There are sector experts and consultants whose job it is to collect information about the overall sector and analyze it, with the intent of assessing sector trends and prospects.
Macro economic	1. Government: The biggest source of macroeconomic data (interest rates, inflation, economic growth) is the government through its many institutions. 2. Private entities: There are private entities that also generate macroeconomic data that markets react to. In the US, for instance ADP (a publicly traded company) produces a monthly national employment report and the Conference Board reports a composite index of leading economic indicators.

b. Trading information
In an efficient market, the only news that affects prices is fundamental, but in the markets that we live in, it is an undeniable truth that there is other information that affects prices. Putting my trading hat on,  information on trading volume, trends in trading, the identity of the traders and order flow can all affect prices.

Momentum (Trading volume/details)

1. Stock exchanges: The trading exchanges are the primary suppliers of data on trading volume and order flow (limit order). In addition, they also have data on short sales and bid ask spreads that may affect prices. 2. Private brokers/dealers: There are some private brokers and dealers who keep track of subsets of trading data. In some cases, they trade on this information and in others, they offer them to others (for a price).

Mood/Sentiment

1. Private entities: Many charting services collect data on investor sentiment on companies (bullish/bearish), primarily from surveys and provide this to subscribers. 2. Option exchanges: There are sentiment measures based on option prices and volume, especially by relating call option to put option values. The data is held by the option exchanges.

c. Processed information
In the final grouping, I would include processed information, i.e., analyst/investor reports and statistics based upon the processing of raw information from any of the sources listed above. Again, while this should have little or no impact on stock prices in an efficient market, these reports sometimes do affect stock prices.  For instance, sell side equity research analysts use an aggregation of all of the data listed above, in conjunction with their own views, to generate earnings estimates and recommendations (buy/sell/hold) on the companies they track. That information is often picked up by the press and made public, affecting stock prices.

The trade off
Breaking down impactful information into its component parts provides us with a framework for assessing insider trading laws and restrictions. In fact, there are some who adhere to the ends of the spectrum. A subset of free-market economists, led by Milton Friedman, has argued that investors should be allowed to trade on all types of impactful information and that there should be no insider trading laws. This case is best made in Henry Manne's numerous writings on the topic, including his book on insider trading. At the other end of the spectrum are those who believe that all impactful information is essentially insider information and trading on it should be restricted or banned.

To provide a template for assessing the different views of insider trading, I propose five guiding principles (some of which you may view as hopelessly utopian) that should guide our choices:

Guiding Principle 1: Information revealed by companies about their prospects should be unbiased, complete and be provided to markets in a timely fashion. 

Guiding Principle 2: There should exist a strong external information market (outside investors and analysts), investing resources to collect additional information and process it, with the intent of supplementing, complimenting and challenging corporate news releases.

Guiding Principle 3: The market reaction to the information should be appropriate (reflecting what that information reveals about the future prospects of the company) and immediate (with the price change, if any, happening instantaneously).

Guiding Principle 4: At any point in time, the market price should reflect all of the information, private or public, about a company.

Guiding Principle 5: Investors should perceive the information/pricing/market processes as fair. If investors perceive the trading game to be fixed in favor of some investors over other, they will withdraw from the market.

Using these principles, you can see why the limiting arguments are both problematic.

• The Manne/Friedman argument is built on the presumption of an efficient market and with the implicit assumption that guiding principle 4 (that the price reflect all available information) is the dominant one. However, it has its costs. Company insiders may hold back information so that they can trade on it (undercutting proposition 1), there is no incentive to develop a strong external information market (since insiders capture the rents) and investors may stop participating in the market if they perceive the game to be fixed. Over time, there will both less information and liquidity in this market.
• Classifying all impactful information as insider information, and banning trading on it, may improve investor perceptions of a fair market, advancing proposition 5, there be no incentive for outsiders to invest resources in collecting new information. Even if they do, there will be a black market for illegal (but impactful) information, which in turn will also undercut market efficiency both in terms of having the information being reflected in the market price and the speed with which it is reflected. That will also allow "illegal" insiders to capture more rent from their information.

A good insider trading law walks the fine line between fair and free markets and that has to come from a sensible break down of impactful information into the clearly illegal (insider information), the gray middle (where you have to look at the facts of the case to make the judgment) to the legal (impactful information).  As I see it, here is the breakdown:

Clearly Insider (should be regulated)	Gray area	Not insider (should be left to market forces)
1. Company news releases, including earnings reports and investment announcements. 2. Macroeconomic data from government and quasi-government entities.	1. Exchange data on trading volume, short sales and order flow. 2. Premium news, where news services provide preferred customers with information earlier than others.	1. Analyst earnings revisions and recommendations. 2. Investment newsletters 3. Survey-based data/indicators 4. Sector research/reports 5. Privately generated macroeconomic indicators

I think that insider trading rules should clearly apply to company-generated information and that governments should not play favorites, with macroeconomic data. I also believe that anyone (analysts, investment advisors, data services) who expends time and resources to collect their own data or do their own research should be free to reap the benefits of that data, either by trading on it themselves or selling it to others, to trade on. I have mixed feelings about exchanges selling privileged access to trading data (volume, order flow, short sales). While exchanges, at least in the US, are private entities, the trading data is a by-product of their primary business, which is to facilitate market trading. Offering preferential access to this data to their best or biggest traders strikes me as not only unfair but also not merited, since there was no investment made in collecting this data. In the same vein, news services that offer premium data feeds (for a price) to preferred customers are trying to exploit information that they had no role in gathering or processing and should be held accountable. In either case, I don't it is insider trading laws that they are guilty of breaking, but they are violating their fiduciary responsibilities (to traders, on the part of exchanges, and to the data collecting entities and  customers, for news service).

Impactful Information 1.0: The Analyst Case

To see why Schneiderman’s attempts to constrain equity research analysts really neither fits the definition of insider trading nor is merited, let’s look at the business of sell side equity research. Investment banks hire and pay equity research analysts who are given subsets of stocks (sectors and subsectors) to follow and analyze. Analysts have to estimate the earnings that these companies will be reporting in the near term and make judgments on their relative pricing (not valuation). In making these judgments, they are already barred from getting "material, non-public" information from the companies that they analyze, under both insider trading laws and SEC rules. (See Regulation FD) While you may be cynical about analysts actually following these rules, recognize that if they break these rules, you don’t need Insider Trading 2.0 to crack down on them. Insider Trading 1.0 will do. 

Analysts expend resources collecting data, processing it and converting it with varying degrees of skill into earnings estimates and stock recommendations. If their work has any merit, these estimates and recommendations, when made, should have an effect on stock prices (thus making it impactful information). It is at this stage that they outrage Mr. Schneiderman by making these estimates and recommendations available only to preferred clients, i.e., the clients who can be expected to deliver trading commissions to the investment bank. The NY attorney general seems to view analysts as public service providers, whose job it is to collect and process information for the market. It is not. The investment banks that hire them and pay for their research are not charitable institutions and are entitled to be selective about who gets to see the information first. In fact, if analyst revisions/recommendations are insider information, because they have price impact and thus cannot be offered to clients, where exactly do you draw the line on active investing and trading? If my skill is valuing companies and it is perceived to be good enough that my recommendations affect stock prices, am I barred from starting a paid newsletter? After all, my information is impactful and my clients will therefore be getting that information ahead of the market.

Impactful Information 1.0: The High Frequency Trading (HFT) Case

High frequency trading has become a catch all for high volume, computer-based trading. Stories such as these feed into the presumption that HFT is an immensely profitable enterprise, where the purveyors make huge profits by trading ahead of the rest of us. In his broadside against HFT, Mr. Schneiderman seems a little confused about what aspect of high frequency trading he finds more unfair, the fact that computers can trade faster than rest of us or that the HFT systems get information (and pay to get it) milliseconds ahead of the rest of us.

While I do have some sympathy for Schneiderman on the advance information being procured by HFT traders, to make a judgment on whether Insider Trading 2.0 is, in fact, merited, I would like to know what information is being acquired, and from whom. If the data is coming from a government agency (the Fed, Labor Department), I agree that information should be made available to all investors at the same time (though our legislators seem to have no qualms about trading on that information ahead of time). If it is a private entity, I find it hard to believe that insider trading laws actually apply. For instance, one of the examples provided by Schneiderman was of Reuters letting HFT clients buy Consumer Confidence survey (conducted by the University of Michigan) numbers a few milliseconds ahead of the rest of the market. Without entering the debate about whether this information has a market impact, it would seem to me that the problem here is that Reuters is not sharing that revenue with the University of Michigan. If the University of Michigan had chosen to offer this advance peek data for a price to customers willing to pay the price, how can that be considered insider trading?

The Greater Good?

Elliot Spitzer, in his high profile assault on sell-side equity research, a decade ago, and Eric Schneiderman in recent days have framed their actions as being in the interests of fair markets and protective of small investors. You can put me in the skeptical camp because the only group that does not seem to come out ahead from these actions is small investors. In spite of all of the ink that was spilt and the legal costs that were created by Spitzer’s crackdown on conflicted equity research, I don’t believe that sell side equity research is any less conflicted than it was (though the bias is hidden deeper and is more subtle) or of higher quality. After Schneiderman’s forays into Insider Trading 2.0, I remain convinced that small investors will have gained nothing from his crusade and will perhaps have lost access to information that used to be available. 

If it is a strategic growth investment in China, the numbers don't matter! Or do they?

If I were asked to characterize my investment philosophy, I would describe myself an investor who believes in value, but I would be lying if I told you that it has always come easily or naturally. My faith in value is tested constantly, not only by the recognition that there is far more that I don't know about value than I do, but also by the market, which seems to have an uncanny ability to sense my doubts and find ways to probe them.

The Market Test

To see if we share some of the same weaknesses, let's try an experiment. Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don't buy the stock, or perhaps, sell it short! Now let's say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don't. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take. 

1. Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
2. Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor. 
3. Preserve the value illusion and look for "intrinsic" ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.

If you choose the first path, I respect you for your principles. If you pick the second one, I understand your pragmatism. If you pick the third path, I think that you are on dangerous ground, as you wander the netherworld between trading and investing. Unfortunately, though, it seems to be the path most often taken and in this post, I would like to shine a spotlight on the buzzwords that are most frequently used by investors to distract and delude themselves and others.

The deadliest buzzwords

As someone who teaches at a business school, I am aware of both the ubiquity of buzzwords and their power in decision making. The most powerful buzzwords can still discussion, stifle dissent and overwhelm common sense and they share three characteristics. The first is that at their core, they are built around undeniable truths, even though those truths might get stretched in practice. The second is that they come with highbrow backing from academics and/or well-known practitioners, skilled at packaging and presenting these concepts to broad audiences. (An academic paper is nice, a book is better and an appearance on national TV show cements the deal). The third is that they tie into the world views of many investors and thus provide an intellectual rationale for anecdotal evidence and story telling. So, with no further ado, here are my five deadliest buzzwords, ranked from least to most potent (based upon my subjective judgment). I would hasten to add that I have been guilty of using some of these buzzwords myself and promise to be more careful in the future in both when and how I use them.

5. Optionality

What it really means: Success in a particular product or market may give a company the option to enter a different market (product-wise or geographically). Thus, Apple's success with the iPod allowed it to enter the music retailing market (with iTunes) and led eventually to the iPhone and the iPad.  From a valuation perspective, these possibilities could not have been foreseen (explicitly) in 1999, but the optionality could have been incorporated into the value.

In Buzzword form: You use the existence of a large market as a rationale for giving a company an option premium, often subjectively determined to be whatever you need it to be to justify buying the stock. In the late 1990s, some analysts used the potential of a large e-commerce market as justification for attaching option premiums to dot-com company valuations, just as many analysts are using the online advertising market as a reason for attaching option premiums to social media companies. 

The key test: Exclusivity. In its generic form, a call (put) option gives its holder the right to buy (sell) an asset. In the same vein, any optionality argument has to be built around exclusivity, where the company in question has the exclusive or close-to-exclusive right to expand into new markets. This exclusivity can come from owning a proprietary technology or possessing an exclusive license to operate in a market. The e-commerce companies of the late 1990s had no such exclusivity, and while the social media companies of today use their large user bases to stake out exclusivity, it is on shaky ground, since these users are fickle and quick to move to the "next big thing". With Apple, the exclusivity derived from the company's control of the operating system, making it very difficult for competitors to enter their very profitable ecosystem.

If you really mean it: If you are going to use an optionality argument, you have to be comfortable with both option pricing fundamentals and models. However, option valuation is not an alternative to traditional valuation, but an addendum. Thus, to value the optionality in a company, you have to do a discounted cash flow valuation first, make judgments on the size and uncertainty in potential markets next and then value the option. 

Links (perhaps helpful, perhaps not): (1) My paper on real options (2) A spreadsheet to value the option to expand.

4. Growth potential

What is really means: There is a large potential market for the firm's goods and services, which will allow the company to to scale up revenues and profits over time, without running into market capacity constraints. This argument has resonance when valuing small companies that operate in large markets, since high growth can be accommodated with ease. In my valuation of Tesla in September 2013, it was the magnitude of the automobile market that allowed me to make generous assumptions about revenue growth in the future.

In Buzzword form: You argue that a company has high value because it has growth potential, but you refuse  to be specific about the market that your company is operating in, how big the market is today and how much of that market your company will capture over time. (This is my bone of contention with analysts who use the online advertising market to justify high growth in social media companies, without clarifying their assumptions about the overall market.)

The key test: Excess returns. I may be beating a dead horse here, but growth, by itself, has no value. To create value, you need to earn excess returns while growing, and to earn those excess returns, you need barriers to entry and competition. Thus, if you are going to make an argument for growth potential, you have to twin that argument with one that explains what the company's competitive advantages will be that will allow it to create value from that growth.

If you really mean it: To value growth potential, you have to do the grunt work of defining the market, determining your company's competive advantages and forecasting how much you will have to reinvest to deliver that growth.

Links (perhaps helpful, perhaps not): (1) A spreadsheet to value growth

3. Strategic considerations

What it really means: Taking the action (investment, acquisition) is critical to the company's long term growth and profitability, though the short term effects may be negative.

In Buzzword form: You use strategic as prefix for any action where the numbers don't add up but you want to take anyway. Thus, a strategic acquisition is one where you pay too much for a sought-after target company, a strategic investment is one where you know you will never make money but is indispensable (at least to you) and in its most cringe-inducing form, you are a strategic buyer, i.e., one who will pay any price to buy something. 

The key test: Show me the money. You cannot pay dividends with strategic victories or nice sounding stories. All decisions, no matter how strategic and long term they might be, are ultimately financial decisions. Consequently, if you make the strategic argument, the onus is on you to then convert the qualitative benefits into earnings and cash flows. If you cannot show me the money, I am afraid that there is nothing strategic about this decision, other that the prefix.

If you really mean it: Start converting stories to numbers, dreams into plans and deal makers into managers. No matter how much uncertainty you face or how far in the future the benefits may lie, you need to put your best estimates down on paper, before you take action. Not only will that put some discipline into the process but it will also become the basis for organizing and planning to deliver those benefits and holding someone (perhaps you, since you pushed for it so hard) accountable.

Links (perhaps helpful, perhaps not): (1) My paper on valuing synergy (2) A spreadsheet to value synergy.

2. Disruptive

What it really means: A new entrant in an existing business uses a new or unorthodox business model to lower the costs of production (Southwest) or the delivery/distribution system (Amazon) or even the product/service (Apple). In the process of doing so, the disruptor finds way to be profitable at the expense of the status quo.

In buzzword form: You view any new entrant in a business as a disruptor, even if that entrant brings little of value to the process, no cost savings innovations or no game changing products, and is unlikely to change the way the business is run.

The key test: Status Quo. While disruption takes many forms and has happened in different markets, the common feature that allows it to succeed is dissatisfaction with the status quo, either on the consumer side (because consumers are not getting the products and services they want or are getting them at prices that they believe are too high) or on the producer side (because producers are unable to generate the economic profits they need to make to stay in business).

If you really mean it: You have to complete the story of disruption by fleshing out the details. In particular, you have to map out a pathway for the disruptor to grow in the disrupted business, with realistic estimates of the challenges and costs that will be faced along the way. It is worth noting that most disruptors fail to change the status quo, and that the few that succeed often have setbacks along the way. It is easy to point to Amazon and Apple as successful disruptors, but these companies are the exceptions, not the rule.

1. China
What it really means:  A billion plus people, with rising incomes, is a very large market and any company that succeeds in this market should be able to generate large revenues and perhaps large profits.

In buzzword form: For many people, especially those not from Asia, the notion of a billion plus people in a market addles the brain. Thus, investors are quick to give a company that is China-based, one that has entered China or one that is even thinking about China a boost in market value. Companies, recognizing this impulse, are quick to play the China card, slipping it into investment announcements and earnings reports.

The key test: Preferred Competitor The Chinese economy is neither free nor open. The game is tilted towards one competitor over others, and that tilt does not necessarily reflect product quality. If you are the competitor preferred by the Chinese government, you will be a big winner. If not, you are just an also-ran, destined to invest large amounts of money in the Chinese market, with little benefit to show for it. For instance, in the contest between Google and Baidu to be the search engine for the Chinese market, Baidu starts off with a decided advantage as the preferred competitor and that translates into significant market share and large profits.

If you really mean it: Quantify the preferred competitor status, which will require you to understand political reality on the ground. You can start off with few presumptions. A Chinese company will be preferred over a non-Chinese one, and a Chinese company with good political connections will beat one without those connections. Analyzing the value of expanding into China requires you to be as much political analyst as valuation assessor.

Closing Thoughts

There are sensible uses for all of the terms that I have listed above, but unfortunately, the buzzword versions are the ones that I see more often in practice. In fact, I find that the people who are quickest to bring up a buzzword or use it to justify a premium often are the ones who have the shakiest understanding of it, leading me to put forth two propositions about buzzwords:

1. The Buzzword Count Proposition: My exposure to both equity research and buzzwords leads me to conclude that there is a negative correlation between buzzword usage and valuation quality. In other words, the more an analyst uses words like real options, disruption and China in talking about a company, the less substance there seems to be the actual research.
2. The Buzzword Swarm Proposition: The most dangerous challenge that you will face as investor will be when multiple buzzwords come together in the same news story. We have two IPOs coming up in the near future, Alibaba and Weibo, which will qualify under multiple buzzwords (strategic, growth potential and China at the minimum) and will undoubtedly be priced to deliver multiple premiums.

My resolutions for the near future are that I will use buzzwords sparingly, that I will not them use as a substitute for analysis, and that when I do use them, I will go the extra distance and try to work through the consequences.

Bitcoin Q & A: Bubble or Breakthrough? Both! Cult or Currency? Both!

As I have talked about or written on topics, I have learned that there are hot-button issues that almost always attract firestorms. Thus, when I write about Tesla, Apple or Facebook, I am guaranteed to provoke reactions, some strongly supportive and some strongly opposed, some rational and some emotional, but these reactions, for the most part, are determined by the pre-dispositions of the readers, rather than my views. In fact, my posting acts like a Rohrsbach test, with readers taking a portion of the post that is in line with or opposed to their positions, and either ignoring or discarding the rest of what I have to say. That, in part, is why I have stayed away from posting on Bitcoins, even as news stories about it, good and bad, have hit the headlines, since the world seems to be divided among the true believers in Bitcoins (who will brook no disagreement) and the cynics (who consider anything positive that is said about it to be a sign of gullibility). Since I live in a world filled with shades of grey, rather than black and white, I am going to try to look at the middle ground, though I undoubtedly will make neither side happy.

Bitcoin is a currency! And it cannot be valued!

Warren Buffet is already on record as saying that Bitcoin is "not a currency, because it does not meet the criteria of a currency, including being a store of value".  I guess I must have a lower standard than Mr. Buffett, because my criterion to classify something as a currency is that it be accepted in transactions. It is true that by my definition, shells and beads would have once been considered to be currencies and that is true. Perhaps, Buffett's point is that Bitcoin is not a good currency or that it is one that will not stand the test of time, and those are certainly relevant and debatable questions,

Unlike an asset or a business which generates cash flows, a currency is a measurement unit that cannot be intrinsically valued. You cannot construct a DCF model to conclude that the US dollar is cheap or that the Chinese Yuan is expensive. However, it can be priced, at least relative to other currencies. With paper or fiat currencies, that pricing of course takes the form of exchange rates and the question about a paper currency's pricing becomes one of determining whether the prevailing exchange rate is a fair one. However, not all currencies are paper and some non-paper currencies have been in use for centuries. The most obvious of these non-fiat currencies is gold and in a prior post, I argued that gold cannot be valued but that it can be priced, relative to paper currencies and that the pricing can be traced to fundamentals.  Using the same logic, I will argue that while it is impossible to value Bitcoin, it is possible to view its price as an exchange rate into paper currencies and make judgments about whether the pricing is fair, again on a relative basis.

The determinants of a currency's price
To make judgments on both the efficacy of Bitcoin as a currency, and indirectly, its staying power and pricing, I looked at three determinants of a currency's price/power: the trust you have in its issuing entity, its acceptance in transactions and how securely you can store and save it, while generating a fair rate of return while doing so.

1. Trust in the issuing authority
The first factor that determines a currency's price is the trust that users of the currency have in the issuing authority to keep its supply in check, with greater trust going with greater willingness to use and hold on to that currency. With paper currencies issued by governments, the authorities are usually the central banks in question: the Federal Reserve for the US dollar, the European Central Bank (ECB) for the Euro and so on. With gold or physical currencies, the constraint is usually a physical one, insofar as the supply of these physical currencies is limited by nature. Since anything that releases that physical constraint will render that physical asset useless as currency, it is ironic that alchemists have, for centuries, tried to make gold in laboratories, because their success would have undermined the use of gold as a currency.

So, what is the issuing authority for Bitcoin? There is none! While that may seem like a fatal weakness, the innovative aspect of Bitcoin is that while  the power is spread across the network of users of the currency, the supply is set by a computer algorithm, which, in turn, cannot be changed by  any user or even a group of users.  If this sounds too complex, and it was for me, you may want to go back to the source, which is the paper that gave birth to the idea (by Satoshi Nakamoto). If the name sounds familiar, it is because it is back in the news again, with the controversial story in Newsweek last week, claiming to have unmasked the real Satoshi Nakamoto, with that person claiming in response that he was not the inventor of the Bitcoin. I must confess that the technicalities in the paper went over my head and I found this YouTube description of how it works to be a good one, though it is from the perspective of someone who is a Bitcoin believer. 

If you are still confused, let's cut to the brass tacks. The supply of Bitcoins is constrained by the computer algorithm, which, as constructed, is (supposedly) very difficult to hack or change, because it requires collusion or agreement across the entire network.  If the algorithm remains untouched, the increase in the number of bitcoins is therefore on autopilot (with about 25 created every ten minutes), as evidenced by looking at its history:

There were 12.4 million bitcoins in circulation in March 2014 and that number will rise, on the preset path, to reach a cap of 21 million bitcoins in 2140.  The way in which people can acquire one of the new bitcoins is by mining for them, running powerful computers, as described in this article in the New York Times. As more and more people try to mine for these bitcoins, though, the difficulty of finding bitcoins has become greater over time. 

The first key question with Bitcoin or any digital currency is whether people will trust a computer algorithm. While your first reaction may be "Hell, No!", it may be worth asking yourself a different set of questions:

(a) Do you trust central bankers? 

(b) If so, do you trust some central bankers more than others? 

(c) Are these some computer algorithms that you would trust more than some central bankers? 

My answers to these questions would be (a) not really, (b) of course and (c) yes. The rise of Bitcoin in the last four years has coincided with the Age of Hubris in central banking, where central bankers have donned Supermen capes and viewed their mission as saving economies, rather than protecting their currencies. It is also worth speculating whether money that would have normally flowed to gold, historically the prime beneficiary of loss of trust in central banks, has flowed instead into Bitcoin, explaining both the anemic price behavior of the former and the heady price action in the latter.

Bitcoin's staying power will ultimately depend upon how impervious its source algorithm is to mischief. While Bitcoin's defenders are quick to argue that its computer fortress is impossible to breach, this article seems to suggest that there are potential flaws that may be exploited by a collusive group. I am an absolute novice when it comes to computer technology of this type and I don't know how much weight to attach to the claims in the article, but if you are a Bitcoin promoter, you want to make sure that even the slightest doubts that the algorithm can be fudged or modified are dealt with quickly and openly, since those doubts will undo its effectiveness as a currency.

2. Acceptance in Transactions

Since the defining role for a currency is that it can be used in transactions, the price of a currency will depend upon how widely it is accepted in transactions for goods and services. Promoters of digital currencies, in general, and Bitcoins, in particular, argue that they have two advantages over paper currencies: lower transactions costs and anonymity. However, the proof is in the pudding, and the chart below looks at the growth in the volume of Bitcoin transactions since inception:

Clearly, there are more Bitcoin transactions now, than ever before. Having never used Bitcoins in transactions, I was curious about how it worked and this link was pretty useful to get started, as I proceeded to build my bitcoin identity. I first created a digital wallet  on my computer, which generated my first and subsequent bitcoin addresses.  I then went to coinbase, one of many vendors of Bitcoins, to acquire my first Bitcoin, and after realizing that it would cost me $640, decided to check on where I would spend that Bitcoin by visiting this site that lists vendors that accept bitcoins in transactions.  The good news is that transacting with Bitcoins is a breeze: you create an address for the transaction that you swap with a vendor who accepts it, and it is recorded in a  transaction log called a block chain. The bad news is that vendor list is still limited, even in the US, and non-existent in many other parts of the world.

So, who are the primary users of Bitcoins? At the risk of over generalizing, the charitable view is that it is the young and technically savvy, the cynical view is that it is the paranoid and the secretive and the darkest view is that it is those who operate on the wrong side of the law. Fairly or unfairly, stories such as this one about Bitcoins being used in the drug trade feed into the perception, leading to legislative hearings  and bans by some countries. (It is revealing that the countries that have cracked down on Bitcoins first are China and Russia. Perhaps, they feel more threatened by their inability to track what their citizens do and where they spend their money than other countries do.)

In summary, Bitcoin is a currency, but one that is currently accepted only in a small subset of transactions and used by only a few. Whether it or any other digital currency will be widely accepted will depend in large part on how its advocates package and market it. If the emphasis is on convenience, low cost and transaction speed, it has the potential for much wider acceptance, especially if it is made simpler to understand and not oversold. If the focus is on privacy, security and anonymity, I am afraid that the dark side will win out and it will become the currency of the paranoid and illegal, with all of the associated costs and benefits.

3. Security, Conversion, Storage and Rate of Return

The final measure of a currency's strength and durability is how easily you can convert it into other currencies, how securely you can store and save it and and whether you are compensated while you hold it. The global currencies of trading, such as the US dollar or Euro, offer these benefits, since they can be converted at minimal cost into other currencies and can be invested in banks or securities to generate a market-determined rate of return, while idle. Emerging market currencies are more constrained, sometimes because they are restrictions on conversion into other currencies and often because they cannot be used or invested outside their local economies. Gold offers an interesting anomaly. While it can be converted into other currencies in most parts of the world, there are restrictions on trading gold in some countries, and holding gold does not offer any explicit returns other than potential price appreciation.

You can save your bitcoins  on computers, but can you do so securely? It is possible that the stories about bitcoins being stolen from supposedly secure servers are overblown and that the recent collapse of Mt. Gox (one of Bitcoin's biggest exchanges) was an aberration, but it seems to me that if these servers/exchanges are the equivalent of banks in the Bitcoin economy, these banks are unregulated and depositors have neither protection nor insurance against either bank runs or bank robberies. While it may conflict with the vision of some Bitcoin revolutionaries, the Bitcoin economy may need a banking system of its own that is regulated and perhaps even insured by a centralized entity. 

A Comparison of Currencies

To get a measure of Bitcoin as a currency, I decided to do a comparison with three paper currencies (the US $, the Chinese Yuan and the Argentine Peso), a real currency (gold) and a digital currency (Bitcoin).  Note that these are my subjective judgments and that you should free to substitute your own to come to your own conclusions.

So, what do I get out of this table? Given my perceptions of how these currencies measure up on three three dimensions of currency quality, I would choose to be paid in US dollars over being paid in Chinese Yuan, and in Chinese Yan over Argentine Pesos. While I trust Nature more than any central bank when it comes to self-restraint, the lack of market-determined returns from holding gold would tilt me towards holding US dollars over holding Gold, but it is a closer call than it was five years ago. I would rather be paid in gold than in Yuan, though I would still be more comfortable with Yuan than Bitcoins. Finally, and I apologize in advance to my Argentine friends if they are insulted by this statement, but I am afraid that I would rather be paid in Bitcoins than Argentine Pesos today.

Bitcoin: To Buy or Not to Buy?

Now, for the $640 question! Would I buy Bitcoin at today's price? No, and not because I am a Luddite that is convinced that digital currencies will not work. It is because I have never been good at calling currency movements and consequently have never bet on them. Since I would not bet on the dollar strengthening relative to the Euro or on the future price of gold, why would I try to do so with Bitcoin?

I believe that there will be a digital currency in wide use a decade or two from now. The question, of course, is whether that digital currency will be Bitcoin or a competitor. If you are a Bitcoin enthusiast, the pathway to its success requires three developments: the computer algorithm underlying the currency has to stay transparent, robust and protected, the usage of Bitcoins has to spread beyond the narrow band of enthusiasts to the broader marketplace and the infrastructure for securing, transporting and saving Bitcoins has to be strengthened. That will require true believers to accept compromises to both their vision (of a truly decentralized currency with no regulatory authorities or power) and their practices (anonymity, for instance, might become a casualty to commerce). Anarchy is a great disruptor of the status quo, but long-lasting currencies require order and predictability, and Bitcoin's biggest promoters seem to have little fondness for either.

If Tim Cook does not care about the "bloody ROI", does he care about the "bloody stock price"?

Tim Cook has got a lot of favorable press for confronting an investor group at the last Apple stockholder meeting and telling them that he does not check the “bloody IRR” when he has to do the "right thing". In fact, he went further and suggested that any investor that does not believe in Apple's social mission should sell Apple stock. Since everyone else seems to have been selling Apple stock ever since Cook became CEO, I guess adding one more group to the mix will not make much of a difference. At the risk of sounding like a moral reprobate, I take issue with both what Cook said at the meeting, and how he said it.

The Incident at the Annual Meeting

The incredible success that Apple had in the first decade of this century is the stuff of legend, converting Steve Jobs into a cultural icon and changing the landscape of the market. Filling Job’s shoes was always going to be a difficult task, but it was made doubly so by Apple’s size (in market cap terms) and increased competition. The fall from grace was quick and painful, as Apple went from a company that could do no wrong to one that could do nothing right. 

Tim Cook was, in some ways, in a no-win situation, catering to investing groups with wildly different visions of what the company should do, a development that I found troubling in April 2012 and one that eventually led to the tension that you see today. In the last year or so, you have seen at least two activist investors make noises at Apple. The first was David Einhorn, who argued that the market was undervaluing Apple’s cash balance and cash generating capacity and that the way to unlock this was to issue preferred stock. While I disagreed with Mr. Einhorn on his recommendation, I agreed with his theme that the company would have to find ways to unlock the value as a cash cow. In the last few months, Carl Icahn has been active at the company, arguing that stock buybacks were the key to pushing up the stock price, a sales pitch that he abandoned just a few weeks ago, but only because the company had bought into his prescription.

It is interesting that Tim Cook’s caustic response was to neither of these “big” activist investors but to a rather obscure investor group called the National Center for Public Policy Research (NCPPR). While this group describes itself as a conservative think tank, it does not own much stock in the company (at least not enough to make the list of top stockholders) and it pushed a shareholder proposal to “disclose the costs of its sustainability programs and to be more transparent about its participation in "certain trade associations and business organizations promoting the amorphous concept of environmental sustainability." While this resolution seemed to get under Cook’s skin, note two things about it. First, all it required was disclosure of the costs and not a cessation of any worth programs that Apple was promotion to improve the environment. Second, the proposal was rejected by Apple shareholders, with only 3% voting in favor.

In the question and answer session that followed, Tim Cook was asked two questions by the NCPPR representative. The first of the two questions was whether these “green actions” that the company had adopted were good for the bottom line and the second was whether the company would commit to only taking actions that were good for that bottom line. Cook, according to press reports, was visibly angry and is reported to have said that “there are many things Apple does because they are right and just, and that a return on investment (ROI) was not the primary consideration on such issues” and he reportedly followed up by also saying that "when we work on making our devices accessible by the blind," he said, "I don't consider the bloody ROI." 

Why Tim Cook is missing the point

Well, Mr. Cook, I am an Apple stockholder, am not a member of the NCPPR, am supportive of good environmental policies and find your response to be troubling, because it reveals a mindset that I would not want in the CEO of a company that I own stock in, for four reasons:

1. Social responsibility comes with a  price tag: I know that corporate social responsibility (CSR) is a big deal in classrooms, board rooms and executive offices today. In fact, given how many pages companies devote in annual reports to showing us how socially responsible they have been, I am actually surprised that they actually have the time or the resources to run businesses. Assuming that this is not just empty talk (and I have a sneaking suspicion that it often is), it is important that they recognize that this social responsibility goes with costs (which may lower profits at least in the near term). At the same time, these costs have to come out of profits, which means that they have to be reasonable (given the profits) and that the companies that are most profitable are the ones that can afford to be most socially responsible. The reason that Apple can afford to spend money on environmental causes is precisely because it has earned a “bloody high ROI” on its iMacs, iPhones and iPads. 
2.  If you choose to be socially responsible, as a publicly traded company, you have to be transparent.: If you accept the proposition that being socially responsible has costs, and you are a publicly traded company, you have an obligation to be open about those costs. Hiding behind the cloak of virtuosity or “access for the blind”, as Tim Cook is, is an act of cowardice. In fact, I am curious as to why Time Cook refused to tell investors how much Apple spends on being environmentally conscious. Is it because they spend too much or is it because they spend too little (but talk about it a lot)?
3. If you are transparent, and you truly respect your stockholders, you have to give them a say.: CEOs seem to believe the worst about their stockholders, i.e., that they are craven, short term and amoral people who would never assent to socially responsible actions, because it costs them money. Otherwise, what is lost by being transparent about the costs of social responsibility and giving Apple shareholders a say in whether they are okay with Apple being environmentally friendly and the costs associated with that mission? After all, it is their money that is being spent, not Tim Cook’s, and it is the height of arrogance for him to assume that he owns the moral high ground here.
4. If you give stockholders a say in CSR spreading, and they tell you no, you have to listen: It is true that there will be cases where shareholders decide not to go along with top management and will vote to curtail or eliminate costs associated with being socially responsible. Given the history of corporate governance, I will argue that it will happen very infrequently, and if it does, it will be at companies where the managers are not trusted on doing a good job. For instance, if I were an HP stockholder, I would definitely not take the word of HP’s management on environmental consciousness. Given the company's perverse track record on acquisitions in the last few years, any spending they do to stop global warming will probably blow a bigger hole in the ozone layer. At Apple, stockholders clearly were not especially troubled by the presence or magnitude of these costs and 97% of them voted against the resolution.

In summary, I want publicly traded companies to be socially responsible, but not at the expense of becoming basket cases, to bear costs being good corporate citizens, while being transparent about these costs, to trust their stockholders by giving them a say on whether they are okay with that mission, while taking no for an answer. I don't want sanctimonious CEOs to define social responsibility for me, to be generous with my money and then refuse to let me know how much they have spent (let alone give me a say).

What should Tim Cook have said?

So, what should Tim Cook have done in response to the questions from the NCPPR reps? First, he should have responded with respect. After all, he is an employee, albeit a very highly paid and elevated one, and these are the owners of the business that he works at. Second, he should have conceded that Apple spends money doing the right thing and being socially responsible; in fact, if he had the facts on hand, he should have mentioned how much of the cost of an iPhone or iPad goes to it being environmental consciousness. Perhaps, the reason he did not do so is that it may be just pennies, not dollars. Third, he should have zeroed in on the definition of the bottom line and argued that the bottom line, as he sees it, is to make Apple a more valuable company, not necessarily one that earns the highest profits this year. I think he could have and should have made the point that being socially responsible will make the company more valuable by making its products more attractive to consumers and its profits higher over time. 

Of course, to make this argument, the lazy rationale for CSR, i.e., that being a virtuous company is its own reward, has to be replaced with a more rigorous foundation, where CSR is connected to the drivers of value: cash flows, growth and risk. I personally believe that if we want companies to be socially responsible, we need to stop treating this as a morality play and make it in their economic best interests to be socially responsible. For that to happen, of course, we, as investors and consumers, have to put our money behind our mouths and actually be willing to pay higher prices for products for socially responsible businesses and pay more for their shares. In fact, I would glad to help Apple with building this valuation model and I would do it on a pro bono basis, and treat it as my contribution to a green cause this year.

As an Apple investor, this is what this incident tells me about Tim Cook

I may be over reacting to this incident. Who knows? Perhaps, Tim Cook was having a bad day or there is a history here with the NCPPR representative that I do not know about. However, I am troubled by the reaction because it reveals three troubling things about what Tim Cook thinks about Apple’s mission and its stockholders. 

1. The first is Tim Cook's response to the “bottom line” question from the stockholder group, where he reacted with his “bloody ROI” comment. If Cook believes that the ROI, which is a near-term accounting earnings-focused number, is the bottom line for Apple, that may explain the absence of any “major” new products since very few innovations generate high near-term earnings.  Value is driven by cash flows over time, not earnings in the near term, and it is definitely not maximized by maximizing ROI.
2. The second is his suggestion that stockholders who are unhappy with Apple’s social mission, at least as defined by Tim Cook, should feel free to sell their stock. It is never a good idea for an employee to suggest that an unhappy owner of a business sell the business, since the owner is on much more solid ground suggesting that an employee who does not like the owner find another job. 
3. Third, there is a hint of a Messiah complex in Tim Cook's answer, a mix of hubris and elitism that he not only knows what’s best for society and how Apple can deliver that benefit, but that he can do so, without letting Apple stockholders be privy to the details.

As a parting thought, Mr. Cook should realize that while he may have fought off Mr. Einhorn and neutralized Mr. Icahn, there are Apple stockholders who care about the “bloody stock price” and they will only get more restive over time, no matter how green, virtuous and socially responsible Apple may be perceived to be as a company. If Mr. Cook feels that he cannot reconcile his green mission with delivering higher value for stockholders, he should give up the pay package that he got from Apple last year and become head of Greenpeace instead.