BLOG.REDHILLCAPITALCO.COM

The Earning Power of Art

Red Hill Capital Corporation — Sun, 23 Oct 2011 09:25:48 GMT

There has been a lot of commotion, in the art markets, these days, about new art investment vehicles. They include art funds, art stocks, and outside guarantors of auction stock. We even recently commented about art funds, in another piece. In the mean time, we keep hearing about more people jumping into the fray. In China, more and more people seem to be getting into the auction business, which has its shady side, and opening art stock funds and exchanges, too. And there is an art stock exchange, in France, and an exchange-traded fund, in Russia.

So, let us step back, first, to look at the basics of finance. Finance is the allocation of funds over time under conditions of risk. The salient feature of financial theory is that an investment is worth the present value of its expected future cash flows, discounted back to the present at the investor’s required rate of return. Ex post, a return can come from some kind of cash flow, like dividends, partnership distribution, and interest, and or capital gains. The focus is on percentage annual return on investment, which is dollar return divided by investment. Returns can be further enhanced with hedging and leverage. The object is to get high return on investment, while minimizing risk.

For traditional investments, like stocks, bonds and commodities, the asset backing the security contract is capable of generating cash from sales of a product at a fairly certain price, in the regular economy. A company makes earnings by making and selling computers and from its net cash flow it can pay interest to bondholders and dividends to stockholders. A stockholder leverages his returns through the bondholders and margin borrowing. He can also make a capital gain or loss when he sells his holdings. A buyer of wheat futures can leverage his holdings and sell his wheat to a miller at delivery time.

Of course, the traditional investment industry has spawned many new products. There are options, real estate investment trusts, securitized mortgages, investment funds, investment advisors, investment analysts, investment consultants, funds of funds, to name a few. From its primary businesses: collecting brokerage fees, investment banking fees, and income from proprietary trading, all low risk or no risk businesses, the investment business has grown with the growth of its products. For the most part, those additional products are simply repackaging of the original traditional products; the ultimate packaging among them, over-the-counter derivatives. The broker-dealers, the sell-side, are the real professionals. In addition, there is a buy-side of investment products, which includes large institutional investors and retail. Indeed, more and more, over the past quarter century, the buy-side has tried to subsume or move more into the businesses of the sell-side with many examples of disastrous results leading to a number of financial crises.

In art, income is mostly in the form of capital gains. The institutional investors are museums, foundations and other large collectors, including corporations. Some of those institutional investors are capable of generating some cash flow from effective rental of art by selling admission to viewings and trading in exhibitions to generate further rental income. Many museums do not do much trading in art but get loans and gifts from collectors. Art dealers are the central professionals, and auction houses act as wholesale exchanges, mostly as brokers, but not as dealers.

Art dealers maintain inventories of art. They also do IPO’s of new art and act as market makers for their artists. They also act as brokers for other dealers and collectors. They can get one hundred percent interest-free leverage with no downside risk, in some of the transactions and services that they perform. They can earn commissions and make capital gains. They might also generate income with charges for exhibitions or other space rental and from art rental.

Thus, art can generate capital gains as well as ordinary income. It can also be highly leveraged. An art dealer can be short against the box, long and short the same thing, which can be done only by broker-dealers in securities, too, with a percentage spread locked in, in his business as a broker-dealer in art. Moreover, dealers offer a display area, both in galleries and online. Art auction houses can also take advantage of some of the same type of leverage. In the case of guarantees, they are giving a put option to the seller. Normally, dealers do not offer puts.

Art derives its value from quality of workmanship, scarcity, and its use for display or interior decoration. In display in museums, it generates ticket income or rental income from rentals to other museums. Museums can also trade in art. However, it seems that the income that many museums generate is insufficient to sustain their display businesses, in that many receive supplemental funding from donations, loans and gifts, and some have even had financial problems or closures, recently. For interior decorating, some antique fixtures, like beds, chairs and couches, serve functional purposes for interior outfitting. Others, like paintings and sculpture, are purely for visual satisfaction and enjoyment but are, by no means, necessary for nest building. Marketing and relative valuation give art its value. First art is valued relative to other art. Then, art is valued relative to other investment assets and necessary items of living. Thus, the value of much of art is tenuous, and there are examples of artists whose art has been in one day and practically worthless, the next. There has also been much volatility in art prices of even established artists.

So, art funds are basically an attempt to leverage art, by using other people’s money, not the manager’s. However, although the fund manager can make fees, the only way that the fund can earn returns for investors is from sales of art. The only way that investors can get money is from distributions of fund proceeds, if any, after sales are made, unless they can sell or cash out their fund investment, which is in most cases restricted. Investors also cannot enjoy the benefits of leverage or hedging. Moreover, how will sales of their art be effected? The choices for these funds are selling privately or through auctions or dealers. Moreover, unlike liquid investments, like stocks, art sales usually cannot be done on demand. Foot leather is required for private sales, sales through dealers can take time, and sales to dealers or through auctions houses are at discounts to retail value. Thus, there are severe limitations on both returns and risk management for investment in art funds. In the end, they provide a source of income for the creator and manager, just like other packaging in the investment business does. They also fit a perceived need or profile, just like other investments designed by the investment community.

Art stocks have popped up in several cities, in China, over the last year. The stocks cover portfolios of an artist’s works. The initial experiences were blowout pricing and closure of trading. An art stock exchange was also opened in France. Now, these vehicles could be used by collectors, art funds and dealers, alike, if there were the ability to sell art stocks short. Then, you could hedge your actual art portfolio. Problems are: the ability to short, liquidity of the markets, limited number of artists and works covered, and mismatch of the portfolio versus a work held by an investor.

In conclusion, art is useful for display, either for earning money from pay-for-view or for personal enjoyment. However, funds take advantage of neither of these aspects of art but only seek to benefit from capital gains. Moreover, like funds of stocks, art funds will stay invested in art, in up markets and in down, and the ability to liquidate in down markets is much more limited than, say, for stocks. After all, liquidity is defined as the ability to quickly sell an asset without much loss in value by the time a sale can be effected. Funds also cannot take advantage of other tactics that are available to professional dealers, like maintaining partial monopolies on art and zero-cost leverage. Although that market does not have dept, at this point in its development, the art stock market could be used by real investors, in art, to hedge their positions. In the absurd limit, however, if all art were held by funds and securitized, it would no longer have any intrinsic value.

The China Moon Cake Arbitrage

Red Hill Capital Corporation — Sat, 17 Sep 2011 09:25:02 GMT

Each year, China celebrates one of its most important holidays: Mid-Autumn Day. It occurs in September, on the night of the full moon, and represents the beginning of the Fall. Celebration includes, family gatherings, walks to look at the moon, and moon cake, a cake created just for that day, like fruit cake during the Western Christmas-Chanukah-New Year season.

Moon cake is a big part of the celebration, and stands at department stores begin to pop up several weeks before the day. Another more subtle activity is moon cake arbitrage, It begins with moon cake makers selling gift certificates to Chinese companies, many of which are government agencies or companies, who give them to employees. Just about everyone in the country gets a moon cake from their work, it seems.

The moon cake manufacturer sells the gift certificates, en masse, to a company for, say a 30% discount, on Y200 cakes. Then, moon cake arbitrageurs stand around the vicinity of the ,moon cake stands and offer to buy the certificates for Y80. And they sell them back to the company for Y120.

Thus, the arbitrageur makes a 50% return on his capital, and the moon cake company, who is effectively short moon cake certificates, covers its short at a return of about 20%. Almost all of the parties, the original short seller, the moon cake maker, the receiver of the free gift certificate, and the moon cake arbitrageur, make money. All funded by the companies who buy moon cake gift certificates for their employees.

Craig Mattoli of Red Hill Capital Writes about the Chinese Art Market in China Economic Review

Red Hill Capital Corporation — Fri, 02 Sep 2011 18:12:07 GMT

We were recently asked to write an article about the Chinese art market for China Economic Review. The final edited version to fit space is in the September 2011 issue. You can read it at
Painting by Numbers.

Craig Mattoli: Art Authority - article in July's Tianjin Plus magazine

Red Hill Capital Corporation — Sun, 10 Jul 2011 17:23:46 GMT

Tianjin Plus Magazine recently interviewed Craig Mattoli about the art market. The interview can be seen on page 23 of the July 2011 issue, which you can download at Tianjin Plus July 2011.

The New Venues in Art Investment: Will They Make a Difference?

Red Hill Capital Corporation — Sat, 04 Jun 2011 13:01:43 GMT

We put the English language version of an article that we have just written for Beijing Collector and Investor Magazine about art funds and art stocks on our Leona Craig Blog.

Craig Mattoli
Leona Craig Art
Guangzhou, China: 86 136 3241 0877
Website: http://www.leonacraig.com
11 Gui Gang Three Road, Dongshan Kou, Yuexiu district,
Guangzhou, China 510080
广州市越秀区东山口龟岗三马路11号
086 020 37625069

Investment is not a Fair Game

Red Hill Capital Corporation — Wed, 05 Jan 2011 08:37:00 GMT

Modern economics and investment analysis had their beginnings with the theories of the mathematical physicist, John Von Neumann, in the early 1900’s. The early work in these fields assumed that the actors were rational, something which more modern finance has finally scrapped. Along with that axiom, it was also assumed that games, including investment, were fair games.

A fair game is one in which a player has an equal chance of winning and losing. This concept also led to the introduction of Gaussian Normal probability distributions (the famous bell-shaped curves), into finance, as they are symmetrical, conforming with equal probability of winning or losing. Another convenience of Gaussian distributions is that they can be completely described by two parameters: the mean and the variance of the distribution.

There is an a priori reason to expect that the distributions of investment would not be Gaussian: technically, one can win an unlimited amount, so, positive returns could be unlimited, while losses (at least for unlevered investment) are limited to 100 percent of your investment.

The fair game theme also leads to assumptions of efficient markets, which are markets in which you cannot earn abnormal returns because that would not conform to fairness. Fairness in the sense of efficient markets means beating the general market. In that sense, the zero of the game is recalibrated to return on the market, and you have an equal chance of doing better or worse than the market.

In truth, people are not rational, markets are not really efficient, and investment is not a fair game. We should already have a clue for that in looking at all of the people who get paid money to be in the investment business. Of course, many of the people who are in the investment business are actually paid for marketing, not investing, so, we should already realize that people in the investment business make use of psychology, in marketing, to take advantage of the fact that people are not rational. For those who are truly professional investors, barriers to entry, in terms of ability, capital, knowledge, etcetera, serve to create market inefficiencies, which professionals take advantage of. Connecting with the efficient market theories, professionals have or develop information and process it more quickly than the man-on-the-street, which gives them an advantage and which turns investment into an unfair game. They also use other tactics, like stop loss orders, portfolio diversification, limiting capital committed to one position, to also make the game unfair by biasing their aversion to loss. They also primarily deal in arbitrages, many of which are completely riskless.

More rigorous mathematical financial analysis began in the 1950’s, when the Von Neumann methods were applied to find minimal variance (the measure of risk) portfolios. Then, in the 1970’s, the capital asset pricing model was developed, and, in the mid-1970’s, stochastic processes, which are, basically, the calculus of Gaussian distributions, were applied to develop the Black-Scholes options model, and the pursuit of that line of investigation continues into today. Another school of investigation, behavioral finance, began in the 1980’s, and its focus has been on the irrationality of people in games.

A final aspect of the Gaussian distribution, which finally led the rational the mathematical school to realize that distributions in investment are not Gaussian, is that 99.9% of all possibilities lie within three standard deviations of the mean. After the stock market crash of 1987, it was pointed out that a crash of that magnitude, under perfect Gaussian statistics, could only happen once in 3 billion years. And, thus, began the search for better fit distributions, skewed to one side, and the fair game hypothesis was finally dethroned.

Happy New Year from Red Hill Capital and Leona Craig Art

Red Hill Capital Corporation — Sat, 01 Jan 2011 09:52:00 GMT

Pomegranates, in Chinese Culture, represent wealth (technically, if you go back further, it is many sons). Wishing you all prosperity in the new year.

From Craig, Ayu, Fanny, Carrie, Yiling, and Longlong

About Market Indexes

Red Hill Capital Corporation — Wed, 17 Nov 2010 10:47:00 GMT

While there are many securities and commodities markets, there are even more market indexes, including for art markets, these days. Market indexes are meant to represent some sort of all-in-one measure of market prices for a particular market. There are composite indexes of the various exchanges, like the NYSE composite index. Often, indexes are weighted averages of the individual stocks (or other assets) that they include, with the weighting depending on the relative market capitalizations or on the relative prices of the components. Other indexes include stocks from various exchanges, not just one. The Dow Jones 30 Industrial Averages, the DJIA, includes 30 so-called blue chip stocks, the icons of industry, from both the NYSE and the NASDAQ. There are also the Dow Transports and the Dow Utilities indices composed of stocks of companies in the transportation and the utility industries, respectively. There is a basic difference in computations of indexes, like the NYSE and the DJIA. The former is an example of a capitalization weighted index, while the latter is a price weighted index.

The index business, itself, has become big business, and index compositions have become more effective. Simple price weighting, as that used in the Dow Jones 30 stocks, might not be appropriate when considering a large set of diverse stocks of divergent total market capitalizations. Other adjustments have also become part of the index constructions mainstream, as we shall discuss, subsequently. Indeed, even the NYSE Index has recently redefined itself; in the figure, we show the differences in its old and new definitions.

NYSE Index Computation
Security class inclusion	Old Method	New Method
Common stocks	Yes	Yes
ADR’s	Yes	Yes
Tracking Stocks	Yes	Yes
REIT's	Yes	Yes
Closed-end funds	Yes	No
ETF's	Yes	No
Preferred stocks	No	No
Derivatives	Yes	No
Shares of beneficial interest	Yes	No
Trust units	Yes	No
Limited partnerships	Yes	No
Other Information
Weighting	Full market cap	Float-adjusted market cap
Base Date	December 31, 1965	December 31, 2002
Base Value	50	5,000
Maintained/Calculated by	SIAC	Dow Jones Indexes
Reconstitution/Rebalancing	Ongoing	Ongoing
Share Updates (<10%)	Daily	Quarterly
Return Calculation	Price return index	Price & total return indexes

To summarize the differences in the old and the new NYSE index, exchange-traded funds and derivative instruments have been eliminated in the new construction. In that regard, index funds and other exchange traded funds, which are, themselves, portfolios of stocks, not pure stocks, have been taken out of the index, as have other derivatives products, which also are not true stocks. The change to a float-adjusted market capitalization basis means that the market floats of all of the component companies are adjusted to reflect the true amount of shares that are available for public trading, eliminating certain shares that are effectively out of the public domain. That can make a large difference, especially in many of the newer foreign markets. For example, when the Russian Trading System (RTS) changed reporting of its market capitalization to a float-adjusted basis in 2004, the capitalization decreased by about two-thirds.

Also new was the creation of a total return index, in order to account for dividend returns, which is useful for making comparisons of real stock and portfolio returns to the index. In total return indexes, such as those that have been created recently for the NYSE and the NASDAQ, the index is calculated in a manner that assumes that all dividends are reinvested as they are received. In that regard, whereas traditional price indexes can provide a measure of capital gains on stocks, in the aggregate, the total return index gives a broad measure of return, including dividends and capital gains. It is especially difficult for an investor to get a handle on total return, on her own. On the one hand, the dividend yield for all stocks on the NYSE is around 1.5 percent per year, but it is quite useful to have the higher precision of a company-calculated total return index. Again, such an index will have different meanings and significances to, for example, a tax-free institutional investor and a tax paying individual. We shall discover other types of weightings and adjustments when we discuss international stock market indexes and investing.

It will be instructive to take some time to look at example computations of the two more common types of indexes. In computing a price weighted index, the prices are all added together, and the result is divided by the number of stocks, like in the case of the DJIA, 30. In that regard, a percentage change in the average summed index is equal to the sum of the percentage changes of each member of the average.

Example Index Construction

Price weighted index

For example, we can compose a price weighted index of two stocks, A, price $50, and B, price $30,

the AB index, as AB Index = ($50+$30)/2 =$40

Thus, the “portfolio” of stocks, included in the index, weights the stocks by their dollar prices.

Capitalization based index

The index is formed by weighting each member of the index by its total market capitalization, i.e., the total stock market value, shares outstanding times price per share. To compute a capitalization weighted index for A and B, assume that the total capitalization of A is $1 million, and that of B is $2 million. Then, the capitalization weighted

AB Index is computed as [$50x$1 million +$30x$2 million]/$3 million = $36.66.

For a capitalization based index, percentage changes in the larger capitalized component will have a greater affect on the index. For example a 10% change in the smaller component of the AB index would correspond to a 3.3% change in the index, while a 10% change in the larger component results in a 6.6% change for the index. Therefore, understanding the construction of an index is necessary for understanding the information that it conveys.

There are other well-known capitalization weighted indexes for the U.S. stock markets. One is the Standard and Poor’s (S&P) indices: including the S&P 500, the top 500 stocks as rated by S&P, the S&P 100, and even composites of certain sub-class stocks. Other indices, like the Wilshire 5000, include over 6000 stocks from the NYSE, the AMEX, and the NASDAQ. Some of the Russel indexes include securities on an international scale. Morgan Stanley Capital International (MSCI) maintains and publishes index for a large number of international investment portfolios. Therefore, care must be taken in garnering information from such indexes. The DJIA tells us only what is happening with prices of 30 better stocks, which information might not apply to all stocks. The S&P index gives a better view of stocks, but the more general course of stock prices, like in the NYSE or the Wilshire 5000, may be different from even the broader S&P 500 view. There are also bond, commodity, investment fund, and art market indexes.

Moreover, you will find that all stock markets around the world have several indexes associated with them. For example, there are the Nikkei 225 and the TOPIX indexes for the Tokyo Stock Exchange, the FTSE All Share and the FTSE 100 for the London Stock Exchange, the WIG and the WIG 50 for the Warsaw Poland Stock Exchange, the TASI in Saudi Arabia, the CASE 30 on the Cairo and Alexandria Exchange, the LuSE index for Lusaka, Zambia, and the TEPIX in Tehran. Often, there are indexes for a particular exchange created by the exchange, itself, and by outside companies, like FTSE, S&P, MSCI, and Dow Jones. To be sure, a great demand for indexes has come from institutional investors and investment fund managers who will use indexes as benchmarks for portfolio construction and performance evaluation.

We point out that the specific stocks that are included in these indexes can change over the years. For market composite indexes, like the NYSE Composite index or the NASDAQ Composite, the indexes naturally change as new stocks get listed and old stocks get delisted. Even, indexes that maintain a set number of stocks change their composition, periodically. For example, before the 1929 stock market crash, the DJIA included such names as International Nickel and Victor Talking Machines, which you would not even recognize, today. Indeed, at this point in time, knowledge of stocks that will be removed from or added to an index has risen to the level of inside information.

In order to get information from market indexes, you have to understand how the index is composed and what information it gives you. When we recently asked Artron, an art market information service, in China, how their various Chinese art market indexes were constructed, no one could actually tell us, and they said that we were the first to ever ask. Investment advisors even play games with indexes. For example, fund of fund managers and brokers have indexes of their funds, but as old ones leave the index and new ones are added, there is a natural bias to the upside, as losers are eliminated and winners are put in.

© Craig L. Mattoli 2004-2010 All rights reserved. No part of this monograph may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior express written permission from Craig L. Mattoli, RedHill Capital Corp., Delaware, U.S.A.: clm@clmattioli.com.

Inside Caixin's Overvalued Yuan: a Variation on the Index Game

Red Hill Capital Corporation — Wed, 17 Nov 2010 07:56:00 GMT

Caixin Magazine, in Guangzhou recently published an article called the overvalued Yuan. We wrote our own commentary on our Red Hill China Blog, which you can link to http://bit.ly/b2TxbF .

The Maximum Profits Theorem from Economics

Red Hill Capital Corporation — Tue, 27 Jul 2010 05:11:00 GMT

Especially, now, since I have been living in China where people are desperate to get ahead in the modern capitalistic Chinese world I have seen many people who believe that, if they charge a high price, they will be able to get rich quick and retire early. As a former member of the Wall Street proprietary trading community, in arbitrage, I have always been taught that greed is not good. The Wall Street expression goes: bulls make money, bears make money, and pigs end up broke or in jail.

A basic law of economics, based on psychology and logic, is that the demand curve is downward sloping: people are more willing to buy a [product, if the price decreases; less willing, if the price increases. Then, equilibrium will occur at the intersection of the upward sloping supply curve and the downward sloping demand. To fill in a few more details, total revenue can be found as the rectangle on such a supply-demand graph touching the intersection and going to the origin of the graph: it is simply Revenue = PxQ where P is the sales price per unit and Q is the quantity sold.

Profit is defined as revenue - cost, which can be put into equation form as: I = R - C = PxQ - ATCxQ, where ATC is the average unit cost and I stands for income or profit. From calculus, we know that a maximum (technically, an extremum, which could be a max, min, or turning point) is found by taking the first derivative of something and setting it equal to zero. Thus, in the case of profits, we have the condition for maximum ΔI/ΔQ = QxΔP/ΔQ + P - QxΔATC/ΔQ - ATC = 0. Other standard concepts, in economics are marginal variables, which are just first derivatives of quantities. Specifically, marginal revenue = MR = ΔR/ΔQ = P + QxΔP/ΔQ, which is always less than P with downward sloping demand, and marginal cost = MC = QxΔATC/ΔQ + ATC. In the latter case, we also, note that since cost curves are U-shaped, MC will be under ATC for sometime, and it will cross over at minimum ATC, then, move above it.

Looking back at our profit maximization condition, we see that we can rewrite it as ΔI/ΔQ = 0 = MR - MC. Thus, without going into the proper secondary condition for actual maximization, which requires that the second derivative is less than 0, we arrive at the profit maximization condition MR = MC, which simply says that we should sell units up to the point where marginal revenue is just equal to marginal cost.

That condition, in turn, gives us a price and quantity for sales. If we sell less than that maximal quantity at higher prices, our profits will be less than maximal; if we sell more than that quantity at a lower price, the same is true. That this theorem is valid, even in the case of a pure monopoly, tells us that we should abide by it because even a pure monopolist, much less a lowly competitor in any other business, cannot get away with charging any price they desire.

For more analysis and information about finance and investment, please visit our website http://www.redhillcapitalco.com .

Craig L. Mattoli, CEO
Red Hill Capital Corporation, Delaware, USA
© Red Hill Capital Corp. 2010, all worldwide rights reserved

The Art of Xu Zhao Qian: Good Investment Value

Red Hill Capital Corporation — Sun, 25 Jul 2010 06:44:00 GMT

At Red Hill Capital, our focus is on investment in inefficient market, and the art market is one of the most inefficient. Of course that is not true about the part of the art market that is always in the news. What is already all over the news never presents good investment opportunity. That is why we prefer to invest in relatively undiscovered artists, not the ones who capture headlines with their stunts or gimmicks.

We discovered the art of Zhao Qian Xu (Xu Zhao Qian) when we first began to invest in contemporary oil paintings, in China, and we liked his art. We recently paid a visit to him, and we like the new art that he has been creating, and we like his attitude, too. We believe his art presents good investment value, and we wrote about him on our Leona Craig Art Blog, recently, so, we thought that we should provide the readers of our Red Hill Capital Blog with a link to that article http://blog.leonacraig.com/2010/07/23/zhao-qian-xu-an-artist-who-understands-art.aspx

Comments on the Chinese Teapot Art & Other Art Markets, in China, on Leona Craig Art Blog

Red Hill Capital Corporation — Sun, 04 Oct 2009 07:24:00 GMT

We recently made some comments about the state of the art markets, in China. While the comment centered on the Chinese Yixing teapot art market, on both the buy and sell sides, we also made some general comments about the art markets, in China.

Art, in China, is one of our biggest investment business at Red Hill Capital, currently, and the prices of many types of art, including paintings and teapots, are misaligned with each other and with world art markets, in some cases, because of the mispricing of the Yuan and because people, in China, have not caught onto the idea of home decoration, the way that we have, in the West.

You can link to the blog at:
http://blog.leonacraig.com/2009/09/26/chinese-teapot-art-and-other-art-at-leona-craig-art.aspx

The Importance of Design & Marketing in the Investment Business

Red Hill Capital Corporation — Sun, 04 Oct 2009 05:13:00 GMT

We resently wrot a paper about phsychology, design, and marketing, in investing and the investment business. As a professional investor and arbitrageur, I have always focused on the psychology of invetment, and the recent trend in finacial studies ove the past few decades has also focused on the. The paper looks at how much design and marketing, which I have also been aware of since beginning my career on Wall Street three decades, ago, goes into the finance and investment businesses. It also examines the psychology of investment that causes people to get suckered into all the get-rich-quick schemes and the resulting "crises" that causes.

Since it was 8000 words, we felt that it was too long to put on the blogs, so, we added it as a downloadable paper on the In Country Analysis page of our website. you can find it by going, there; it's at the top of the list:
http://www.leonacraig.com/In_Country_Analysis.htm

Testing Networks

Red Hill Capital Corporation — Sun, 20 Sep 2009 11:44:00 GMT

Detecting different information or return potentials and combining that information, differently, and before others do is crucial to investing. Rumors are rife, and there has so much competition to fill twenty-four hour business news services with feed that the media has become prone to be duped into publishing unverified information that, often, is not quite accurate, complete or true. In that regard, we must not only collect information but we must also continually monitor the source for accuracy and the information for corroboration.

After working on a PhD in mathematical physics, my first career on Wall Street was, naturally, to compile industry, financial, and economic data and to make predictive models for key variables, like GDP or computer sales. To do that, I had to develop sources of information, in government departments, industry groups, companies, and other investment firms. I also majored in linguistics with an emphasis on psycho-linguistics, in college. I took graduate level courses, studied a lot on my own, and worked as a research assistant, in psychology, while working on my graduate physics degree. I am a student of the behavior of living things, and I realize the importance of psychology, in markets. Thus, my next career on Wall Street was as a merger arbitrageur.

Merger arbitrage involves business and market psychology, valuation, legal understanding of securities and contracts laws. There is much information to collect and many types of analyses to perform. There are also many rumors, flying about, in this very secretive and proprietary investment business. Moreover, because buying and selling move market prices, you do not want your private information to be distributed to the general community or he public. So, in addition to testing sources for accuracy, one must also test those with whom one trades proprietary. The testing is for fidelity or to induce their networks by observing where your information pops up at other sources.

Finance was born from warfare, having arisen in response to the need for funding wars among Italian city-states, in the 13^th century. It was beneficial for business men to buy war bonds to help fund the side that would do best by their interests. Having grown up together, finance has taken many of its strategies and tactics from warfare, including from the espionage and counterespionage parts of that business. After all, finance and investing must be secretive businesses by their nature. Especially where money is concerned, I have found, in my three decades, in the business that you can only surround yourself with those who you can completely trust and rely on. A useful lesson from counterespionage is the additional importance of not only misinformation but also disinformation. You might consider using untrustworthy contacts for disseminating that.

In deciding, a priori, which fits into which category, you can test the source, the information, and the network by disseminating information or misinformation, one bit at a time. After you dole out the information, you can observe where trading activity or return of the information , subsequently, occurs. If you give out information with the caveat that it cannot be redistributed, and you see results of the knowledge, elsewhere, you know how far you can trust that particular contact. It is truly something that is done by proprietary traders on Wall Street.

Thus, we can surmise that there is, in use, the strategy of compartmentalization of information from espionage, in the business of investment. We form investment spy rings, and we also are aware and participate in making the information spread among some of the ring. Furthermore, we set up a network of misinformation, including trading accounts at a number of discreet brokers, so that even our trading will make tiny tracks, not those of an elephant.

Indeed, most of the time one can only compile a fraction of even specific information. For example, I might take a survey of business at selected Holiday Inns to try to predict profitability of the whole company. I would never have the time, and it would not be worth the resources employed to survey all of their branches in the world. However, I might have several associates who also take similar surveys from different branches, and it would be very useful to share our information for comparison. It might even help us build a more accurate prediction (model) of the future.

A more elaborate part of merger arbitrage was that we hired lawyers to sit at courts waiting for any filings, to immediately forward papers and analyze. Those types of services cost several hundred thousand dollar per year, and both their cost and understanding the legal arguments and issues are out of the reach of the ordinary person. It is an example of both economies of scale on investment funds and barriers to entry based on expert knowledge. Even so, we all had different lawyers, so there might still be usefulness in comparing note.

In the end, professional investing is very hard and technical work, involving elements of psychology, warfare, and espionage. It is neither possible nor economically feasible to collect and properly process all of the information. Thus, admitting that no man or woman is an island, we begin to develop contacts and networks for the collecting, testing, synthesizing, and disguising relevant and irrelevant information. Testing sources and information networks is necessary to develop the amount of precision, in this business where large losses are lurking, awaiting the more careless. It is the reason that I advise my students in finance at the universities where I teach and my assistants at Red Hill Capital to, first, read both Machiavelli’s The Prince and Sun Tsu’s Art of War. After that, I also advise them to read both physics and psychology books, on their own: physics, not because investment is about math, but, instead, to develop good general analytical skills. Moreover, in psychology, I would especially encourage them to study concepts in psycholinguistics and behavioral finance. Then, the comparative tools that they have learned can be combined and compared with others. After all, the fundamental basis of investing is comparison, whether it is interest rates, PE’s, or imagination, ability, and technical skills of artists. Comparison needs points of comparison in sets of information. Indeed, the latest craze in investment modeling is neural networks, which, I assume, is just a precise abstract version of the points that we have been discussing.

You can read more of the things that we have written about in this and our other blogs and on the In Country Analysis page of our website.

© 2009 Red Hill Capital Corporation, Delaware, USA; all rights reserved.

Mythical Trading Systems, Pyramid Schemes, Greed, and Arbitrage

Red Hill Capital Corporation — Sat, 27 Jun 2009 03:19:00 GMT

As someone who understands some things about models, psychology, mathematical physics, theoretical finance, arbitrage, and trading in real markets, I will admit that beat-the-market trading systems can be invented. Even the hardliners in financial theory have softened their stance on the efficiency of modern investment markets, as one after another so-called anomaly was discovered by the academic world (professional investors had know it all along). However, I will further state that any so-called trading system that can consistently garner excess profits, if shared with the public or any larger number of other actors in the market, will lose its ability to earn excesses.

If the academics focus on the sterility of rational financial theory in application to real markets, the average man on the street is still convinced that get-rich-quick schemes really exist. The truth lies somewhere in the middle ground. Indeed, over the past thirty years, just after the Efficient Market Hypothesis and around the time of Black Scholes, another branch of finance began to develop. In Behavioral Finance, the focus is on the fact that people are not actually the rational machines on which financial theory, as begun by the mathematical physicist, John VonNeumann, in the early part of the twentieth century. That new hypothesis, alone, means that there will be overreaction and underreaction, leading to mispricing. Of course, a corollary of that implication is that, if you understand how people will act irrationally and under what conditions, then, you will be able to take advantage of those situations and, again, make excess returns.

However, the continued effectiveness of such excess-profit strategies depends on their being kept secret, which may not be an easy task. Even though you might never tell anyone about your system, at the least, the people who execute your orders to buy and sell will see your order flow and might realize that you continually take on winning positions. That can be an especially salient problem, if, for example, you manage a large quantity of money. When I traded in merger arbitrage, we, in the business, often used multiple brokers to execute our orders, so that it would take people a longer time to figure out that one entity was accumulating a large position.

In the end, anyone who knows about your system will replicate your actions, and, therein, lies the rub. Market prices are affected by buying and selling. There will always be only a limited supply of an investment asset, like stock or gold. Thus, there will be only a limited amount being either bid for or offered at various prices. For example, there might be 10,000 shares of ABC offered at $50; 15,000 offered at $50.25; 25,000 offered at $50.30; 30,000 offered at $51. If you are the only one who knows your trading system, and the proper place to buy is at $50, you can execute your strategy, if you want 10,000 shares or less. However, if other people know your system, they may all put in orders to buy and push the stock up to $51, which is 2% higher and may represent a price that no longer offers an excess return.

There are two more truths of the investment business that go hand in hand with what was demonstrated in the above example. First, arbitrage is a general trading strategy to find misaligned prices among even disparate instruments and markets and initiate simultaneous buying and (short) selling to take advantage of the misalignments. An easy example is in the foreign exchange markets and is called covered interest arbitrage (CIA). In that regard, if you can earn 7% in six-month riskless bonds, in country X but only 3% in country Y, you could exchange currency Y for X, in the spot market, invest the money in X-bonds, and enter a six month forward contract to buy currency Y for X. The key to the viability of that strategy is the price of the forward contract. In reality, the forward contracts, in this situation, will eventually, if not immediately, be priced so that there will be no interest rate advantage. If they were not, arbitrageurs would take on the chain of positions, described above, and reap a riskless profit. In fact, the number and description of possible arbitrages, like this, are as numerous as the imagination can come up with, and the point is that as people recognize these riskless opportunities to profit, there buying and selling of the various components will eventually wipe out the excess benefit.

The second factor that we alluded to, above, is that as more and more non-professionals become aware of an excess-profits trading strategy, their inexperience will make matters even worse. In that they do not fully understand all of the technicalities involved in a particular trading strategy, it has been observed that they tend to overpay and undersell, taking the original results of the strategy past the point that a professional arbitrageur would, making the eventual results even less than normal profits. I have seen that happen, for example, in my old business, merger arbitrage, over the last several decades, and the business has become so unprofitable, in general, that, by now, all of my friends and I have exited the business.

Another type of trading “system” that I have observed over the last decade plus is not a system at all but is closer to a pyramid scheme. In that regard, since the advent of on-line trading and message boarding, there are many self-styled investment “gurus” who post buy and sell recommendations on message boards or, now, on twitter. Even back as far as the 1980’s, there were people who would spread rumors about certain stocks. Their underlying motives were that they already had a position, long or short, in a stock, and as the rumors spread, the stock price would move in a direction that made profits for them, and they would unload their positions at a profit. For the past decade plus, this type of thing has been made even easier with on-line message boards and trading. If they can get enough people to believe that what they are saying is true, the actions of those followers will create momentum in the stock (or other investment instruments) and make their musing reality. Moreover, they will gain credibility with their followers because what they recommend seems to always come to pass. In my opinion, it is that type of pyramiding, rumor-mongering that has been responsible, at least in part, for the incredible bubbles in the NASDAQ, in the late 1990’s, and, more recently, in the Chinese stock markets. Moreover, in my opinion, it is tantamount to forming an unregistered group, which is illegal under the securities laws, and I hope that, someday, the SEC and other securities commissions will act to do something about it.

That people fall into these traps, in the first place, is that they believe that get-rich-quick schemes do exist, while I believe that they do not: hard work and creative ideas will make you rich. The people who offer such systems, in my opinion, are preying on hopelessness, desperation and greed. It is what has always made con games possible. You might make money for a while, but, if you look at what happened to all of those people who “played” the hot NASDAQ, in the 1990’s, or the Chinese stock market, in the last few years, you may begin to realize that it can also leave you much worse off when the party is over: the NASDAQ lost 80%, and the Chinese stock market lost around 70%, in the end. I advised people to get out of the Chinese stock market over two years ago; those who did, thanked me; those who didn't, lamented.

You can read some more of the things that we have written about investment, on this blog and, also, at:
The In-Country Analysis page of our website http://www.leonacraig.com/In_Country_Analysis.htm
Red Hill China Blog http://blog.redhillchina.com
Ezine Articles http://ezinearticles.com/?expert=Craig_Mattoli
Buzzle http://www.buzzle.com/articles/china-exports-purchasing-power-arbitrage.html
Article Base http://www.articlesbase.com/investing-articles/contrarian-investment-strategy-as-pe-arbitrage-845377.html

Craig Mattoli, CEO Red Hill Capital Corporation, Delaware © 2009

Art Market Update at Leona Craig Art Blog

Red Hill Capital Corporation — Tue, 23 Jun 2009 11:57:00 GMT

We did a blog entry on the current state of the art markets, as seen through the eyes of our Leona Craig Art arm. In the blog we also give references to other recent articles and commentaries. Bottom line is that the market seems to be firming up and picking up. See the entry at http://blog.leonacraig.com/2009/06/14/state-of-the-art-markets-june-2009.aspx

Barking Dogs: China's Misplaced Bid for Recognition in Finance

Red Hill Capital Corporation — Sat, 06 Jun 2009 01:22:00 GMT

Since the fall of 2008, China has been trying to get attention and recognition as a financial power. Indeed, several authors and analysts have been drawn in by their saber rattling. We, on the other hand, believe in thoughtful analysis of any topic. So, we wrote a blog entry on our Red Hill China blog about China's financial recognition aspirations, called Barking Dogs, which you can read at: http://blog.redhillchina.com/2009/06/05/barking-dogs-chinas-aspirations-to-be-a-financial-powerhouse.aspx

Initial Investment Considerations: Business Startup Costs

Red Hill Capital Corporation — Tue, 05 May 2009 11:00:00 GMT

In the course I teach about introductory business finance, one of the topics is evaluating business projects, either stand alone or additions to an existing business portfolio. The framework is to compare initial investment in a project with the discounted future cash flows that we expect from the project. For example, we buy a new piece of machinery to make noodles. Then, we project net cash inflows from making noodles over the life of the machine, and we discount the projected after tax cash flows, using the rate of return that we want or need to earn on our initial investment.

One of the things that my students often have trouble with is what constitutes the initial investment, and I realize that not only my students have trouble with this but also many people who start a business, which I am made even more aware of as I watch literally hundreds of people go in and out of business, in my neighborhood, in China. It is easy for most to understand that some sort of capital investment is necessary, for example, buying a noodle making machine to be in the noodle making business or remodeling a space for a store or restaurant. However, some do not even figure out, properly, how much that part of the investment will be. For example, there was a space being built out, in my neighborhood for a hamburger bar, and the person did not even have the money to finish building out the space, so, a new person took over and turned it into an Indian Restaurant, which was in business only for a few months. Lately, it is being ripped apart and built out again (why did they even have to do that?) for its third potential business in about a year. Indeed, there are quite a few tall office and apartment buildings, in Guangzhou, which have been only partially finished for as much as ten years or more.

If some people do not even plan for the obvious long-term capital investment that is required for business startup, many totally miss the short-term, working capital part of the equation. Working capital (WC) is the short-term, less than one year, part of the balance sheet: current assets (CA) and current liabilities (CL; NWC = net working capital = CA - CL). In that regard, if you are going to start a dress shop, you will need to make a long-term capital investment, consisting of: fitting out a space and buying fixtures. However, you will also need to make an initial invest in inventory ( a CA in WC) as part of startup costs, or you will have nothing to sell. If you plan on selling partly on credit, you will also have to set aside seed-money for accounts receivable (A/R), which will also need to be part of your initial investment. For example, if you expect to sell $100,000 per month in dresses (ignoring profits to make it simple), and you will sell 25% on credit (due in one month), then, you will need, not only $100,000 initial investment, in inventory, but also $25,000 initial investment for future A/R. Otherwise, after one month, you will have sold $100,000 in dresses, but your cash inflow will be only $75,000, so you could only buy $75,000 in dresses to sell in the second month. By thinking to put aside the extra $25,000 for initial investment startup costs for A/R, you will be able to buy $100,000 in dresses the second month. By the end of the second month, your credit customers from month one will have paid you, and for the third month and thereafter, you will have $100,000 to buy dress inventory.

Those are the things that people must think about when they are starting a business. Those are the broad strokes. The fine points of startup include considering all of the components of the larger classes of short-term and long-term asset startup costs. For example, purchase of equipment will include purchase, transportation, insurance and installation of equipment. If you expect sales to grow each year, you might also have to plan for further investments in WC, in future years. You can also subtract from initial investment, if you expect to be able to buy materials for the business on credit (A/P). Then, you could make a subtraction from the funds that you will need for your total initial startup costs.

After that, you can toy with the future side of the equation. First, for a new small business, you might also want to set aside some extra money as a cushion to pay expenses for 6 months or more until you get discovered. You might look at the future cash flows using different required rates of return (called a present value profile. You could look at sales and costs under various good and bad future scenarios.

I realize that it is the dream of many a person to have their own business, but don't romanticize and fantasize, understand the game, and then play. The theoretical idea in finance for this problem is to look at the discounted value of the future cash flows, which means that the money you get from the investment, totaled and accounting for an annual return on investment as percent per year on initial investment. Then, that amount should be larger than your initial investment total. In other words, you pay less, in terms of what you initially pay for the investment project, than it is worth in expected discounted future after tax cash flows from the business investment project. If it works out as predicted and you included all of the money you really need to start the business, in the first place, you will make the return on investment that you used to value the business.

In that manner, business, itself, becomes a sort of long-term arbitrage, albeit not riskless. Consider borrowing all of the initial startup costs for interest rate, B, and having the implied annual rate of return on investment (formally, called the internal rate of return of the investment, which is analogous to the yield-to-maturity, YTM, on a bond), ROI, greater than B. Then, with an initial capital outlay of zero dollars, you make a return, equal to ROI - B. An analogy from bond investment is convertible arbitrage, wherein one buys convertible bonds (convertible at a certain number of shares of stock per bond after or on a given future date in the bond indenture), and short sells stock against the long bond position. Moreover, for a broker dealer, the required capital outlay on the position is only 10% of the value of the bonds (note quite zero, but close).

In the end, whatever you invest in, invest thoughtfully and wisely. By doing only that much, you will already be light years ahead of the pack.

Note: Discounted cash flow is a technique from finance that talks about the time value of money. A dollar that you get a year from now is not worth the same as a dollar, now, because, if you had a dollar, now, you could invest it, in a bank account or elsewhere, and have more that a dollar, a year from now.

Real Estate Pricing: Rent-Purchase Arbitrage Considerations

Red Hill Capital Corporation — Sat, 02 May 2009 14:15:00 GMT

The real estate markets in China have been red hot for years, and we do not consider that to be a recommendation. The rising prices have come from several motivations. First, since China changed to a more market economy, several decades ago, people have been striving to own and invest. In addition, everyone sees that some people have accumulated wealth, and they want a piece of it, too.

For the man (or woman) on the street, the most common and accessible object for ownership and investment is real assets, like housing. In fact, by investing in housing, they also take care of another basic need: shelter, so it is a quite natural first investment for people all over the world. In China, the novelty of business operation and wealth, combined with the ever increasing number of people who are earning enough to afford to buy a house had already set the stage for a pyramid scheme in housing prices. The additional ingredients that have allowed the pyramid to build is envy and greed, as described in an earlier post on our redhillchinablog, entitled “Fear, Envy and Greed: the Chinese Business Model”. In that regard, people are so envious of those who have accumulated wealth, and they believe that they can do the same just by starting a business or making an investment, that they give no forethought to the mechanics and realities of the situation. Thus, people hear about how other people have made large returns on housing, then, later, in stocks, and they follow, blindly, into the market, expecting the same.However, as an arbitrageur.

I understand that all markets must, ultimately, be connected. I even have experience in arbitrage, in the real estate markets. In the late 1980’s, I bought an 18th century estate, in chic Bucks County, Pennsylvania. A similar bubble had come into real estate markets, in the U.S., at that time, but the air was coming out of the bubble. Indeed, the original price tag on the property had bee over $800,000, but I eventually bought it for $500,000. My mortgage payments were over $4,000 per month, and, in the U.S., mortgage interest is tax deductible. So, with the tax shield, my net payments were about $3,000 per month. I had been involved in merger arbitrage, but that market, also, was having its own difficulties. Thus, I had to find a way to make the real estate investment pay for itself. I had a separate apartment, in an outbuilding, which I could rent out, and I had stables in the barn, which I could also rent out. Still, my income from those rentals was only about half of my after tax mortgage payment, which was lessened slightly by depreciation deductions for the parts of the property that I could rent out. Perhaps, I could have rented out the remainder of the property to break even. Instead, though, I turned the property into a country inn, which had potential revenues from weekend-only rental of $8,000. What I did, therefore, was to enhance my return by doing an arbitrage between the monthly and daily room rental markets, and I was able to, not only live on the property, but also to earn a profit from owning it.

In fact, we would always expect there to be a break even arbitrage between rental and purchase of residential or commercial real estate. However, a simple example will reveal the state of the real estate market, in our home city, Guangzhou. First, we must point out that there are no deductions for real estate, like those, in the U.S. Our apartment costs Y3,000 per month for us to rent. On the other hand, the owner of the apartment must pay mortgage payments of around Y8,000 per month on a purchase price in excess of one million Yuan. That means that each year, the owner will make a loss of Y60,000, and without accounting for either the time value of money or increasing real estate prices, that is a loss of over half a million Yuan in ten years. In fact, we have not had an increase in rent for over two years, and we even have a perpetual lease at the same price, if we choose to stay, and we see larger apartments, in our building, now, offered at even lower prices than we are paying for this one.Other people are also beginning to lift their heads above the frenzy to get rich, quick, in China. The stock market bubble was partly fueled by the real estate bubble, both directly and indirectly. Directly, because people who made money, in real estate, moved on th “play” the stock market. Indirectly, because the envious who could not afford the buy-in price for the housing market saw an opportunity for a lower buy-in to “play” stocks. After the bubble in stocks burst, and the stock market has come down two-thirds from its highs, real estate prices have also been backing off. In Guangzhou, prices have declined by about ten percent in the last half year and forty percent, in parts of Shenzhen, for example.

The point is, real estate prices, in China, cannot continue with their current upward march, and even the downturn in prices over the last half year, still leave a huge gap between the rental market and the market for ownership, which must ultimately be connected, in the manner that we have described. It is the reason that we continue to stay away from the real estate market as an area for investment, in China.

Recent Analysis and Articles by Red Hill Capital

Red Hill Capital Corporation — Sat, 02 May 2009 11:30:00 GMT

Since we just recently began the official Red Hill Capital blog, we wanted to provide our readers with links to recent articles and blog entries that are part of the business of Red Hill. Below, we list links to some of those analyses.

Contrarian Investment Strategy as P/E Arbitrage http://www.articlesbase.com/investing-articles/contrarian-investment-strategy-as-pe-arbitrage-845377.html
Information: The Most Important Thing in Investing http://ezinearticles.com/?Information---The-Most-Important-Thing-in-Investing&id=2233807
China Exports: Purchasing Power Arbitrage http://www.buzzle.com/articles/china-exports-purchasing-power-arbitrage.html
The Art of China: Opportunities for Superior Investment Returns http://www.leonacraig.com/In_Country_Analysis/The_Art_of_China.doc
Investment Aspects of Art http://www.articlesbase.com/investing-articles/investment-aspects-of-art-788446.html

See the In Country Analysis page of our website for more research and analysis and the Red Hill Capital portion for free financial models and excerpts from the investment textbook that we are readying for publication..
Also, visit our other blogs for analysis and commentary on investment, China, and art.