Identifying Bernie Madoff Ahead of Time

Benjamin Graham once said that you should never invest in companies that have engaged in malfeasance involving their earnings results, citing the necessity to have accurate numbers in order to make an investment. Since reports of outstanding debt, net profits, and cash flow are necessary prerequisites for determining what a business is worth, unreliable accounting would render business valuation nothing more than a guessing game.

And that brings me back to Benie Madoff’s selection to have a firm called Friehling & Horowitz serve as the auditors for the investment funds held through the Bernard L. Madoff Investment Securities, LLC. And what did Friehling & Horowitz consist of? A small 500-square building previously used for medical billing that consisted of nothing but Jerome Horowitz and David Friehling, who essentially were retirees chilling in Miami.

If you look at the auditing firms for operations that either control or are worth more than … Read the rest of this article!

Bankrupting The Local Fish Store

When I was self-studying the bankruptcy code in preparation for the bar exam, I came across an old Tennessee bankruptcy case in which a pet store that earned almost $150,000 per year with only $85,000 in debt against the building and inventory went bankrupt within the third year of two brothers taking over the business after the death of their father.

In the court filings, one of the brothers claimed that the other one (who managed the day-to-day operations of the store) was responsible for the bankruptcy due to mismanagement. Specifically, he alleged that his brother alienated customers by abandoning the store’s policy of giving new fish to customers who bought some that died shortly after the purchase.

The old policy was highly informal—if you bought some fish and they died, you’d get new ones. The new policy required that you bring in the dead fish, a water sample, and … Read the rest of this article!

Investment Portfolio Diversification In Real Life

I was at an estate sale not that long ago, and I came across a cancelled-stock certificate issued from the Brunswick Company. Back then, it was called the Brunswick-Balke-Collender Company, and derived much of its revenue from developing and selling equipment related to bowling allies. It has actually been a decent investment through the modern area, as it has mitigated against the bowling industry’s collapse by expanding into boating and marine technology services over the years (think of Warren Buffett using the last profit puffs at the Berkshire mills to buy up banks and insurance companies.)

Although the Brunswick Company managed to survive, I was thinking about one of the least-known stock market bubbles in American history—the Great Bowling Alley Bubble of the late 1950s and early 1960s. Between 1956 and 1962, the United States witnessed 125 new bowling alleys enter the market each month. The total bowling alley count … Read the rest of this article!

Justifying Familiarity Bias in Investing

“[Familiarity] bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar (local bias) as well as portfolios titled toward domestic securities (home bias). An implication of familiarity bias is that investors hold suboptimal portfolios. To overcome this bias, investors need to cast a wider net and expand their portfolio allocation decisions to gain wider diversification and risk reduction. Investing internationally helps to avoid familiarity bias.” – H. Kent Baker and Victor Ricciardi, “How Biases Affect Investor Behavior”.

When a family-owned business reinvests its earnings into its own business, it earns a 12% return on book value (this is the historical average for closely-held business according to Ibottson from 1926 through 2012). And yet, when a family-owned business takes its earnings and reinvests the money into the stock market, it underperforms … Read the rest of this article!

Copying David Swensen’s Endowment Model at Yale

At most billion-dollar endowments for American colleges and universities up until the early 2000s or so, the only question was: “What percentage of the portfolio should be invested in stocks, and what percent in bonds?” The scope of being “original” was limited to investing in small-cap stocks, real estate investment trusts, or purchasing debt issued by a governmental entity outside of the United States.

David Swensen, who has earned 12% returns since managing a portion of Yale’s endowment in the early 1980s, gained attention for investing in alternative investments that led to outperformance of average American endowments by almost six percent annually.

In particular, Swensen would invest in highly illiquid investments, capturing a premium that is often believed to exist due to the non-saleability of a particular asset. If you start an LLC whose sole asset is a rental property that earns $1,000 per month, the ownership of that property … Read the rest of this article!