The first 5 months of 2006 were very easy.  In that span my portfolio appreciated almost 50% as miners soared along with metals prices.  Silver Wheaton (SLW) jumped from 6 to 11.  A gold miner called Desert Sun, which I bought in the high 3s, rose 50% before getting taken over in April by Yamana (AUY).  The latter rose strongly into May.  My biggest gainer was Eurozinc Mining (EZM €“ since acquired by Lundin Mining or LMC).  I bought my initial position below $1 and by May it was close to 3.  Positions in Northern Orion Mining (NTO) and Northgate Mining (NXG) also did well.

The metal’s euphoria peaked in early May. Gold had run up from 525 at the beginning of the year to 725 on May 12th.  Copper was approaching 4, having started the year at 2. With impeccable timing, commentator James Cramer plugged  EZM on May 10th.  The next day it hit an intraday high of 3.25 before closing at 2.91.  Then the metal correction began.  In mid-June gold was back near 560, and copper fell below 3.   EZM had dropped to 2.10 by May 22nd.  That turned out to be its low, but SLW, AUY and others didn’t bottom till mid-June.  SLW bottomed at around 7, while AUY was down 50% from its May peak around 12.

Needless to say, my portfolio took a dive, but it was nothing like the April 2004 subprime debacle.  My yearly gain remained above 9%, and then began to rise again.  While it never regained early May levels, it remained solidly in double digits.  I did a pretty good job of holding through the pain with one exception noted below.  There was another commodities hiccup in September.  I timed well the sales of some covered call  on AUY and NTO, which mitigated the pain.

Japan was an idea which didn’t work out in 2006.  I could have perhaps divined from the oversize gain in late 2005 that it might need to catch its breath.  The decision I regret the most, however, was selling SFL  This had been going sideways for the first half of the year, though during that time it was pumping out an 11% dividend.  I sold the position during the commodities debacle of May and June.  I suspect this was a psychological risk transfer.  I wanted to sell something, but didn’t want to sell the mining stocks which had been so much higher just a little while ago.  So I sold the quiet position.  It started to take off in July, going from around 18 to 28 today.

Despite SFL, I finished the year with a healthy 34% gain.  I had also regained my confidence.  While confidence can be a double-edged sword, I think it was probably a good thing in this case.  When near the end of the year a friend suggested I start blogging, I decided it was worth a try.  The rest of my trading history can now be seen here daily on behavioraltrader.com.

I was shorting because I felt the rally since October 2002 was running out of steam and that the valuations of these stocks were stretched. I was right in the short-term and I profited on trades in RIMM and GOOG. I had shorted EBAY around 95 in October and seen it run up to near 120. It started to reverse in January and when subpar earnings were announced on January 19th, the stock tanked. I closed at 37 (74 pre-split). I also made some money on Ford, but left a lot on the table.

Despite these success, WFMI continued higher. This and large drops in NFI and IMH had me down 20% by the end of February. I closed out IMH in March. I took large gains, these were well below levels at the beginning of the year.

Over the next few months I had some successes, but small in comparison to the many things which went wrong. One of these was non-financial. In April, while playing soccer, I tore my Achilles tendon and spent the next three months in bed or on crutches.

I got back into IMH briefly, but on June 28th after the close they announced they would be lowering the dividend in future quarters. I closed out the position the next morning. I was pretty sure it would continue down. In retrospect, it was so obvious the stock would continue down, but my shock wouldn’t let me see this. I have made a mental note to look at reverses like this as opportunities, but haven’t successfully implemented this technique yet.

The big blows came in the summer. WFMI reported earnings on July 28th and the stock jumped. I jumped out. I had supplemented my short with some puts which I sold for a fraction of my cost. The WFMI debacle was the largest dollar loss I have taken in one position. Too bad since had I held, I’d be profitable now (though not before it went even higher). But with the level of exposure I had, it would have been very difficult psychologically to hold for that long a period. And at that time my psychological state was not so healthy. In addition to the financial losses, my inability to be physically active and general dissatisfaction with my studies and San Diego was throwing me into a state of depression. It took a number of months to recover from this.

The next shoe to drop with NFI, which reported subpar earning the following week. I bailed and my two and a half year love affair came to an abrupt end.

In September Healthsouth (HLSH), which I had bought as a restructuring play announced results below expectations and a small profit turned into a loss. I exited here immediately too. There were a number of other annoyance losses. I took a position in bankrupt United Airlines (UALAQ) as a restructuring play. In September they announced they would be exiting bankruptcy but that the existing common stock would be replaced and was now worthless. I knew that common stockholders are the last one in the queue in cases of bankruptcy, but thought the fact the stock was trading at all meant it would have some value on emergence. Apparently this is not the case. I generally stay away from bankruptcies now because I don’t have a good grasp of the ins and outs (though Calpine has tempted me).

There were a couple of might have beens. In June I bought a small position at under $2 in American-Oriental Biotech (AOB), a Chinese nutraceuticals company. A poster had recommended it, and I liked the fact that they were growing and already making money. But I got skittish as everything else seemed to be going wrong. I sold for a small profit after holding for two weeks. The stock closed around 6 by the end of the year and is around 11 now.

Another almost was FDG. A friend (and broker) had recommended it to me early in the year, but I was late getting on board. Still, it jumped after I bought it in July only to fall back in October. I handled this pretty well, as it was clear the fundamentals were deteriorating. I avoided the subsequent tumble it took and collected some dividends, but felt I could have done better.

The end of 2005 saw a vastly different portfolio than the beginning. Despite the setbacks, I had begun to lay the foundation for a good year in 2006. Specifically, I started to invest in some metal mining companies which were heavily recommended on my investment board and by my broker. These included Southern Peru Copper (PCU), Silver Wheaton SLW, and Eurozinc Mining (since acquired by LUM). I also had some dividend plays including SFL and a few Canadian royalty trusts such as Enerplus (ERF). Finally, I was building a position in Japan through JEQ. The Canadian royalty trusts and Japan didn’t help in 2006, but the miners led me on a wild ride up.

I had just finished my math of finance program and was preparing for a big move to San Diego to study in UCSD’s economics PhD program.  In the meantime I took a bike trip to Slovenia which let me escape my portfolio for a while (though not completely in this era of ubiquitous Internet).  I returned home in the midst of earnings season with some time on my hands.  It seemed a lot of tech/Internet stocks were reporting their expected numbers and getting pummelled.  I shorted RedHat before earnings and booked a quick profit when the pattern repeated.  After Priceline.com got pounded, I shorted competitor Interactive Corp (IACI) and profited when it tanked on earnings the next day.  Does each earning’s season have a pattern?  That one certainly seemed to.  I did well on those two trades, but it could have just been luck.

The rest of the year was, by comparison, fairly sedate.  I took on two major shorts: EBAY and Whole Foods (WFMI).  The first worked out, the latter would turn out to be an even bigger debacle than Amazon on a dollar basis (though much smaller as a percentage of wealth).

 By December 20^th, NFI had made it back to the high 50s.  I was in Mexico at the time and resolved to sell some when I got back to the States, but by that time it had fallen to 50.  It would have been a swing trade anyway because I still was bullish on the stock.  It never reached those levels again and its fall in recent days has been chronicled in this blog’s daily wrap entries. 

But at the end of 2005 I was worried about my shorts of EBAY, which hadn’t worked out yet, and WFMI, which ultimately wouldn’t.

The market, however, doesn’t always abide by our mental reference points. On April 2^nd the employment report came in well above expectation and suddenly everyone was worried about rate hikes and a collapse in the mortgage market. After the big run-up in subprime lenders, this was all that needed to knock them down. Both NFI and IMH fell by about 7%. They took another hit on Monday as NFI fell 13% before stabilizing for the rest of the week.

Despite the drop, the stocks were still above their March 1 levels, and I thought I had weathered the storm yet again. I was wrong. On April 8, the Wall Street Journal published a story on non-compliance of some of NFI’s branches with lending requirements in some states. This had been reported in local newspapers and on the Web, but when it hit the WSJ the stock plummeted 31%! With over half my portfolio in NFI, it was a challenging session. My total portfolio was down 25% for the day.

Suspicion grew on the NFI message boards that the fall was a concerted attempt by short-sellers to push down the stock (allegedly by some of the same Sith lords later referred to Byrne Overstock.com CEO Patrick Byrne). The next day NFI recovered by 10% to the low 40s. Sensing a recover, I bought some June 45 calls. They didn’t pay off. NFI continued down, hitting an intraday low in the high 20s on April 29^th. When it fell early the next morning, I couldn’t take it anymore and sold about 20% of the position. These were the shares I had got from exercising options earlier in the year and they were sold for a loss. My wealth was back to the same level it had been the previous September (though I had paid tuition and living expenses since then).

The sudden drop in my wealth was jarring, though was cushioned by the fact that even at these levels, my investment in NFI not counting dividends had about doubled. My gains in IMH were less, but still substantial.

The main lesson I’ve taken away from this episode: don’t fall in love. When things started to go south after such a big run-up, I should have taken some profits. The eery feeling I had that if I didn’t hold NFI I’d never get to certain wealth levels was just silly. There are thousands of opportunities in the market every day. Where to find them? I could have looked in my own portfolio. One position I held, Knightbridge Tankers (VLCCF) doubled in the year from April 1^st. Another, Asia-Pacific Fund (APB) went up 50% in the 2 years from the same date. These were positions I wasn’t very excited about at the time. Finding something that did excite me would have helped. Its much easier to escape an infatuation when you have an another apple for your eye (or several as the markets go).

In theory investors should note the added debt and lower the price they are willing to pay for the IPO. Do they do this? Its hard to tell since we don’t know what the offering prices would have been without the debt. If investors are only looking at multiples such as P/E ratio, then the reduction in share value will be a function of how much the added interest expense affects earnings.

Should private equity ownership before an IPO be a reason per se for selling short a company? No. The company should be viewed on its fundamentals: valuation, riskiness of its indebtedness, sales prospects, likelihood of insider sales, etc. All things equal, private equity investors may be a good thing for a company if they provide management expertise or are especially vigilant about their investments. Some private equity investors are adamant that they look after their portfolio companies in ways mutual funds and other institutional investors can’t. On the other hand, private equity firms are getting larger and larger and their attention span may becoming stretched. They also generally retain large stakes even after the IPO, and these get unloaded in future secondary offerings. This supply overhang could in theory keep the stock price down.

Acting on this theory, I have recently shorted both Burger King (BKC) and J Crew Group (JCG). They have high valuations (P/Es of 45 and 77 though falling), high debt, recent secondary offerings and large stakes still held by private equity firms. I’m near break-even so far. We shall see what happens.

For more info on private equity see:

Special Report of Private Equity (The Economist)
Private Equity Public Offerings (MarketWatch)
This Dog Was Fixed (SD Reader story on Petco)

Still 2003 turned out to be my best year ever as I increased my NFI and IMH positions. NFI went from the low 30s to 70, splitting and ending the year near 40 (post-split). Along the way it had paid almost $5 in (split-adjusted) dividends. I held through a nasty decline in July which turned out to be a speed bump. Low interest rates and the continued housing boom were the perfect environment for these companies. Dividends kept rising and the stock prices followed.

In September I entered Columbia’s Math of Finance program. We mainly studied options and I began buying them. I bought some calls on the usual suspects €“ NFI and IMH €“ and sold these for a large profit. I also bought some SEBL puts with mixed results.

I started 2004 in a bit of a daze from an intense semester at school. This was partially mitigated by the run-up in my wealth. I started the year HIGHLY concentrated in NFI and IMH. By the end of January, these two position, including calls, equaled about 90% of my account’s net worth, or about 65% of total long positions held as I was leveraged by about 20%. If you add New Century Financial (NCEN and later NEW), another subprime lender, and Friedman Billing Ramsey (FBR), an MREIT/investment bank, I had over 100% of my net worth in positions related to the housing market.

While it lasted, it was a quite profitable strategy (and crazy). NFI and IMH went parabolic and by the end of March my portfolio was approaching $1 million. Since quitting work, my total net worth (on an unrealized basis) was up almost 60% even after New York City living expenses, a couple of bike trips, tuition and taxes on realized gains. And I had also just been accepted to several good economics PhD programs, proving that I wasn’t simply some money-grubbing narrow-minded simpleton . I was feeling pretty smug.

My mood had subtlety changed though. The run-up in NFI’s stock was actually causing me some anxiety. Of course I wanted it to go up, but a little more slowly and steadily. I didn’t want to have to say goodbye too soon — in short, I had fallen in love. I had this feeling like once this was gone I’d never have another such opportunity. I was also getting used to my new net worth quickly. I decided I wanted to maintain my not quite attained 7-figures of wealth and on an after-tax basis of course which meant I needed NFI to reach an even higher level. When my very profitable NFI calls came due in March, instead of selling as previously, I exercised.

I wasn’t completely blind. Near the end of March I sold some FBR and IMH. But I bought the IMH back at higher prices over the next couple days as I felt my wealth fantasy slipping away. I also wasn’t completely oblivious to the need to have some target selling price. I told myself I’d sell when the yield reached 8%. Where did I get this number? It seemed reasonable for a solid company which was spinning money, and conveniently it fit in with my wealth fantasy requirements.

On March 23^rd, NFI hit an intraday high of 70. I remember remarking to a school friend that maybe I should buy some puts. But near the money prices seemed €œhigh€?. I briefly considered spending the small amounts for 1 to 2 month out puts at 50, but figured it would never go that low. NFI closed that day at 62.06, well down from the intraday high and the open, but a couple of cents above the new high it had set three days earlier. It would meander up to an all-time closing high of 66.05 on April Fool’s Day. Then all hell would break loose.

I was feeling very smart and when I closed many of my shorts in early October and the market jumped up I was feeling smarter still. I was still long-term bearish. One pearl of wisdom wisdom I was operating under (forgot the source) was that when markets overshoot in one direction they often overshoot in the other and that we could probably expect post-Bubble PE ratios to go to 10 before things turned up (the PE on the S&P 500 was still above 25). I was willing to concede 15, but didn’t want to leave money on the table. When the markets took a big jump on October 10^th, I started to dive back in on the short side.

As Mark Twain noted, €œHistory doesn’t repeat itself, at best it rhymes.€? The market didn’t cooperate with my PE target and October 2002 turned out to be low of the post-Internet bust for both the major averages and particularly the tech stocks I was shorting. By mid-December I was in full retreat from my shorts with major losses. In addition, AXM managed to blow up as they had locked-in to fixed rate funding and short-term rates continued to fall. The writing had been on the wall and the knowledgeable poster I had first learned about AXM from had been giving warnings. I sold AXM for a big loss, but it was an easy decision as it was obvious the game was over. AXM struggled along for the next year until getting taken over.

Another big mistake I made was something I’d like to call conjunctivitis €“ selling another position when one goes bad. The shaking my shorts and AXM had given me caused me to close my most of my IMH position. I bought most of it back several months later when I recovered my nerve €“ at higher prices. I’ll do a dedicated column on conjunctivitis some time in the future.

2002 wasn’t as good as it could have been, but +37% in a year when the major averages were down is probably more than most (including me) can expect on average. At the end of the year I also entered into a position which would be one of my best performers ever: another mortgage originator called NFI which was heavily recommended on the message boards. They were trading near 15, their PE was below 10 and they had just declared a $1.60 dividend (up from .47 earlier in the year). Another attraction was that short interest was reported by Yahoo to be at 70% of the float (though probably a miscalculation, it was still probably above 30%). When short interest is high, eventually short sellers must cover. If prices rise quickly, short covering can accentuate the rally, as I had discovered to my peril with Amazon. I hoped to be on the other side this time.

Risks include a slowdown in reform under the new prime minister Shinzo Abe and possible defeat by the ruling party in summer elections. The Japanese population is aging and this will put strains on a government which is already financially stretched. Interest rates will probably have to rise soon €“ not good for the government, but probably a good sign for an economy where deflation was a big problem until recently.

I do all my Japan investing through closed-end funds and ETFs. I currently hold JEQ and JSC. I recently sold JOF because of the large premium. A list of Japanese ETFs and closed-end funds can be found here. Many mutual fund companies also offer Japan funds.

In Depth
In the late 1980s in looked like it was only a matter of time before Japan overtook the United States as the #1 economy in the world. Japan combined high growth and low inflation and was running huge trade surpluses. Downtown Tokyo was supposedly worth several times the value of all the real estate in the United States, and Japanese investors were buying up American icons such as Rockefeller Center and Pebble Beach. The Japanese economic model, which featured consensus between government and industry, and allowed for long-term planning horizons unattainable by quarterly-profit driven American executives, was widely studied and lauded.

In December of 1989, the Nikkei hit an all-time high of 38,957, having risen from 11,993 at the beginning of 1985. Then things changed. By Sept 1990, the Nikkei had fallen to 26000, and remained in a downtrend until April 2003 when it hit 7824. As it turned out, much of the huge rise in asset prices was fueled by companies using excess cash and borrowing to set up €œspecial financial€? subsidiaries which invested in shares and real estate. More money was wasted paying top dollar for foreign assets, of which Rockefeller Center and Pebble Beach were only two examples. The coziness between business, banks and government meant that bloated companies with connection were kept on life support, while more efficient up and comers were deprived of resources. The result was over 15 years of economic stagnation and mountains of bad debt.

It looks like the stagnation is finally coming to an end. The last 15 years have brought large changes to the Japanese economy including increased labor market flexibility, tougher financial standards, and a breakdown of the cosy relations between companies, banks and government. Foreigners have played a big role, including the turnaround of Nissan by Renault, and a number of takeovers of financial institutions. Signs of change were evident in July 2000, when a plan to rescue Sogo, a venerable and troubled department store chain, was torpedoed by creditor Shinsei Bank, formerly Long-term Credit Bank of Japan and now owned by US-based Ripplewood Holdings. Though the government initially agreed to buy out the Shinsei stake, public, outrage forced it to back down and Sogo went bust.

The political will to increase the pace of reform was displayed with the election of Junichiro Koizumi as prime minister in April 2000. His appointment of Heizo Takenaka as head of the Financial Services Agency did much to end the non-performing loan problem. Koizumi’s reforms included a measure to privatize the Japanese postal system, one of the largest financial institutions in the world.

More Info:

Japan: From Long, Slow Decline to Long, Slow Recovery (Wharton – Mar. 1, 2006)
Walking on Eggshells (The Economist – Dec. 19, 2006)

As Y2K approached, I felt fairly comfortable that the coming rout, which had spooked me so much before, would not in fact occur.  It didn’t.  But Internet stocks still appeared way overvalued, and I was beginning to recover my nerve.  I began to short in earnest in late February 2000.  Among the biggest positions were SCMR and ICGE.  I shorted ICGE after reading that the lock-up expiration (after which insiders could sell shares) was approaching, and that insider holdings were large compared to the float.

Though the Internet crash would begin in April, it was not an easy month.  I shorted Sycamore (SCMR) in the low 100s only to see it go to 199.5.  I shorted ICGE in the 100-110 range only to see it jump 50 points in a week.  Luckily my positions weren’t large enough to sink me and I held on for dear life.  I took a small loss on SCMR, but more than made up for it with robust profits on ICGE.  Still, I was shaken and stirred.  I closed all my shorts after the first week of April downdraft, glad to have escaped and waiting  for the next upturn to re-engage.  It never came.  I got a taste of victory, but left a lot on the table.  I got another chance in the fall when B2B, Internet equipment makers and telecoms peaked.  I was a little early on ARBA and JNPR, but booked solid profits on JDSU, BRCM, and VRTS.

Amidst the Internet excitement it was hard to foretell that impact that a completely unrelated stock would have on my portfolio.  This was a company called Athracite Capital, a so-called mortgage REIT, which a friend of mine had recommended.  Unlike equity REITs, which own buildings and collect rents, mortgage REITs invest in mortgages or mortgage-backed paper.  They had gotten killed during the LTCM debacle, and now had some pretty heady yields.  When I first bought in May, AHR was trading in the high 6s with a quarterly dividend of .29 for an annual yield of about 17%.  Investing in AHR would introduce me to a sector and a community that would greatly impact my future wealth.

I was living in New York City at the time and had just bought a co-op on the Upper West Side. Its hard to believe now how soft the market was. In 1996 I bought my co-op for a little more than half of what it had sold for before the 1987 crash. I was working as a systems developer using the newly introduced Java programming language and had just incorporated (subcontracting to another Java consulting firm). As the tech boom deepened, cash flow was good and rising.

The LTCM crisis and Russian default in summer of 1998 again hit my emerging markets positions, but by late in the year these were recovering and my tech holding were doing well. By then the big story was the Internet. Amazon, Yahoo and EBay began to take off, but I felt sure they were overvalued. The other story was the looming Y2K crisis and I was looking for ways to hedge myself against the impending crash. Strangely enough, selling my tech holdings didn’t occur to me. Well I suppose it did, but for whatever reason shorting Internet hi-fliers seemed an even better idea. Part of my motivation was seeing a corporate finance friend of mine in la-la land about how great the price run-ups were. He was speaking in this dreamy voice which struck me as willful self-delusion. I really wanted to pop his bubble, but refrained from saying anything.  Instead I put a short on YHOO,my first short ever. Arriving at my mother’s house the day before Thanksgiving, I saw YHOO falling 15 points and felt completely confirmed in my intellectual and moral superiority.  The next week I shorted Amazon and then doubled my position on Dec. 11^th at around 200.

I remember shortly thereafter having a particularly easy time buying a Christmas present on Amazon and thinking about closing the short. It was at 190 and I could have taken a small profit. I didn’t though and AMZN started to run. I took a gain on YHOO and again could have closed Amazon and netted a profit on my shorts, but I was still laboring under my €œhedging€? fantasy. AMZN continued to run and then on Dec. 15^th Blodgett made his famous call of 400 which AMZN reached within three weeks.  Ouch.

How does our hero recover from this debacle?  Does he decide to stop fighting the tape, go long and reap a fortune?  Or at least escape with only a flesh wound? If only. The not so happy ending to this trade in my next installment.