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Why is this an equity?

June 12, 2012

The regulators, such as the Securities and Exchange Commission (SEC) or the Ontario Securities Commission (OSC), cannot possibly anticipate or stay ahead of “bad behaviour” – every new rule inevitably creates some new way (or ways) in which promoters can “game” the system and, often, we, as investors, are left “holding the bag”. For example,

Market Watch, June 7, 2012 – Canada’s securities regulations too weak [Market Watch] Is the Sino-Forest scandal a watershed moment for Canada’s securities industry? Or will it just be another glaring example of the impotence of its enforcement mechanisms?

To which we might add that no one has ever been convicted in the multi-billion dollar Bre-X Minerals gold-mining fiasco and fraud of the late 1990s. And what about the hedge fund, Amaranth Advisors LLC – from hero ($9 billion) to zero in thirty days (September 2006) – or the abuse of programs such as TARP and the draconian Dodd-Frank Wall Street Reform and Consumer Protection Act (please see my Letter, Banks 1 Congress 0, June 2012).

Would it be fair to say that the repeal of the Glass-Steagall Act in 1999 had a lot to do with a “renaissance” in banking and new “gorillas” in the room that caused a decade of turbulence and uncertainty relieved (but not exterminated) by TARP and the policies of “quantatative easing”?

Or that the Sarbanes–Oxley Act of 2002 has created news, heat, fire and smoke but no benefits to investors despite a roughly four-fold increase in the cost of corporate reporting?

Since none of us, as investors, really have the time to debate the finer points of law, order and the markets, let’s just go to the bottom line and ask the question,

How soon did we know that Sino-Forest was not “investment grade” and, in fact, nothing more than a speculation?

How soon did we know that Sino-Forest was an equity that we were not interested in buying and holding?

Or, to put it yet another way, how soon did we know (please see our previous Letter, The Perpetual Bond, June 2012) that Sino-Forest was an (N) and not a (B)?

The answer is, almost right away. We didn’t have to wait five years and lose $5 billion to find that out – nor is that just luck or a “one trick pony”. We do it every day and routinely among the thousands of companies that trade in the global equities markets and notable examples that we have discussed in timely client letters during the past several years include huge and well-heeled and well-regarded companies such as ConocoPhillips, American International Group (AIG), General Motors, Manulife Financial, Research in Motion, and Hewlett-Packard (and many more) which lingered in investment portfolios long after a significant part of the market, but not all, had decided that these companies were not what they were.

In the case of Sino-Forest, we note that the stock price increased steadily for six months after the IPO in 2007, and then began to retreat until it entered what is best described as a “trading range” below the “price of risk” (below the dark, solid line in Exhibit 1 below).

Notwithstanding that there was a lot of money to be made between $10 in early 2009 and $25 in early 2011 – would that they remembered to take some profits in time and not just trust to their continuing and unfounded good fortune – the stock price (SP) remained firmly below the risk price (SF) and, therefore, the company was never in our portfolio during all of that time because our policy of risk aversion trumps mere opportunism, all of the time as long as we are confident that the price of risk is reasonably correct and demonstrates that relationship.

Exhibit 1: Sino-Forest and the Price of Risk (SF) 2007 through 2011


The regulators can now wonder what it is that some people knew, or suspected, and others didn’t or simply ignored because in order for the stock price to increase there needs to be a greater buying interest than selling interest among the remaining enthusiasts.

Market Watch suggests that Sino-Forest may be  “just another glaring example of the impotence of its enforcement mechanisms”.  We disagree and would suggest that the enforcement and research mechanisms of the regulators are perfectly ordinary, and powerful, and all that they can do within the precepts of a free but sensibly regulated market – it is just too late for a substantial contingent of the investors who were, in fact, “playing the odds” and left “holding the bag” because they didn’t know the price of risk.

If you don’t know the price of risk, then you don’t know anything about the price of the stock.  (Goetze 2009)

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  “price of risk”, “risk price”, and the symbols “(B)” , “(N)” and N*.

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