Tag Archives: behavioural economics

Trinity Meltdown

In May last year I posted on an undisciplined investment, Trinity Biotech (TRIB), which I bought at $21 per share and, after ignoring some basic investing rules, didn’t sell until it hit $16. I had thought that the underlying metrics of TRIB existing business would improve, with a big upside potential with the FDA approval of its Meritas Troponin Point-of-Care test (as outlined in this post). Since last year, I have kept an eye on the firm as their operating results continued to be uninspiring, as per the graph below.

click to enlargetrinity-biotech-2011-to-q22016-revenue-operating-profit

I continued to monitor the firm from afar to see how the FDA approval was progressing, for curiosity sake more than anything else (the investment case was similar a coin toss given the operating results and I have, thankfully, grown out of such gambles). The timing of any final approval was dependent upon FDA queries but Q4 was been talked of as a possible time for a final FDA decision.

It has therefore come as a considerable shock to all stakeholders, and a 50% collapse in the share price, when TRIB announced early on Tuesday that it has withdrawn its FDA application for the Troponin test on the advice of the FDA itself. Analysts representing investors vented their anger at the company’s management on the conference call on the news (worth a listen if you are so inclined).

I genuinely felt sorry for management as they tried to explain the “devastating news” about how they could have got the FDA approval so wrong. Although the FDA would not go into the gritty details on a 30 minute call communicating the news to management behind their “minded to refuse” position, TRIB’s management were restrained in expressing their (obviously very disappointed) view that the FDA had moved the goal posts in their assessment criteria. The FDA will give TRIB more detail on their decision over the coming months (strangely only on the condition that TRIB withdrew their application).

Management expressed their view, based upon the information from the FDA call, that any new application was unlikely given the large R&D expenses needed to address the issues raised and announced they would shutter the programme, reducing their annual capitalised expenses from $9 million to $1.5 million including the closure of their Swedish facility. Given they capitalise most of these expenses, the impact will primarily be on cash-flow rather than on the P&L (they may manage to be cash-flow neutral on a pro-forma basis).  Insight into future operating results and what the balance sheet will look like after the write-offs needed on this withdrawal may come with the Q3 results.

At a share price of approx $6.50, TRIB indicated that their Board would likely instigate a large buy-back programme after the early release of their Q3 results (likely due by mid October). With $85 million of cash left from their $100 million convertible debt, TRIB has the firepower if it can get to positive cash-flow on an operating basis in the near term. Analysts were very blunt in their reaction, stating that management now had a major credibility issue and that a sale of the firm should now be the priority.

All in all, a sad day for TRIB, its employees and its future prospects. And, of course, for its shareholders.

Stuff Happens

Mervyn King is not remembered (by this blogger at least) as a particularly radical or reforming governor of the Bank of England. It is therefore surprising that he has written an acclaimed book, called “The End of Alchemy”, with perhaps some of the most thoughtful ideas on possible reforms we could make to get the global economy out of its current hiatus. One of the central themes in the book is the inability of existing Western economic orthodoxy to adequately consider the impact of radical uncertainty. He quips that “current policies based upon the model of the economics of stuff rather than the economics of stuff happens”.

King defines radical uncertainty as “uncertainty so profound that it is impossible to represent the future in terms of probabilistic outcomes”. A current example could be the Brexit vote this coming Thursday, with commentators struggling to articulate the medium term knock-on impacts of this tightly forecasted vote. This post is not about Brexit as this blogger for one is struggling to understand the reasons and the impacts of the closeness of the vote. I do think the comments from Germany’s finance minister, Frank-Walter Steinmeier, this week that a leave vote would mean “the EU will find itself in a deep crisis” are pertinent and amongst the many issues we will likely face in the medium term if the UK actually disengages from the EU. The current mood of voters in Western economies, such as the UK and the US, does underline the urgent need for radical thinking to be adopted into the way we are addressing global economic and social issues in my view.

King’s book is not only full of interesting ideas but he also has a cutting turn of phrase. Amongst my favourites are:  “economists mistrust trust”, “liquidity is an illusion”, and “any central bank that allows itself to be described as the only game in town would be well advised to get out of town”. Before I go over some of King’s ideas, I think it would be useful to recap on the conclusions from other recent books from UK authors on policy measures needed to address the current stagnation, in particular “The Shifts and the Shocks” by the highly regarded Financial Times commentator Martin Wolf and (to a lesser extent) “Between Debt and the Devil” by the former UK financial regulator Adair Turner. Wolf’s book was previously reviewed in this post and Turner’s book was referenced in this post.

Wolf articulated the causes of the financial crisis as “a savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable financial system, and naive if not captured regulation”.  Wolf argues for practical policy measures such as much higher and more resilient capital requirements in banking (he rejects the 100% reserve banking envisaged by proponents of the so-called Chicago Plan as too radical), resolution plans for global systemic financial institutions, more bail-inable debt in banking capital structures and similar alignment changes to the terms of other financial contracts, proper funding of regulatory bodies and investigators of criminal misbehaviour, tax reform with a bias towards equity and away from leverage, tax on generational transfers of land, measures to address income inequality (due to the resulting dilution of demand stimulus measures as a result of the rich’s higher propensity to save) and measures to encourage business and infrastructure investment, education and R&D.

Wolf also highlights the need for new thinking at global institutions, such as IMF and those (unelected) bodies governing the Eurozone, particularly the urgent need (although he is pessimistic on the possibility) for global co-operation and radical action to address the imbalances in the global economy. The need for deeper co-ordination, irrespective of narrow short term nationalistic interests, is nowhere more obvious than in the Eurozone with the alternative being financial disintegration. The Brexit vote is an illustration of the UK electorate’s preference for disintegration (as is the popularity of Trump in the US), presented by shady politicians as a return to the good ole days (!??!), and is perhaps a precursor to a more general disintegration preference by voters across the globe. Wolf observes that “financial integration has proved highly destabilizing” and that “the world maybe no more than one to at most two crises away from such a radical deconstruction of globalized finance”.

Turner’s book is more focused on the failure of free markets to “ensure a socially optimal quantity of private credit creation or its efficient allocation” and the need for policy makers to constrain private credit growth, particularly excessive debt backed by real estate, and the creation of less credit intensive economies. Turner argues that “the pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (interest rate) produced an economic disaster”. In common with Wolf, Turner also advocates structural changes to tax and financial contracts to incentivize credit away from land and towards productive investment and policies to address income inequality. Turner also rejects 100% reserve banking as too radical in today’s world and favours much higher capital requirements and restrictions on the shadow banking sector. On the need for China and Germany to take responsibility for the impact of their policies on global imbalances, he repeats the pious lecturing of current elites (without the negativity of Wolf on the reality of such policies actually happening). Similarly he repeats the (now) consensus view on the need for the Eurozone to either federalise or dissolve.

As to real solutions, Turner states that “our challenge is to find a policy mix that gets us out of the debt overhang created by past excessive credit creation without relying on new credit growth” and favours the uses of further monetary measures such as Bernanke’s helicopter money, once-off debt write off and radical bank recapitalisation. Although he highlights the danger of opening the genie of money finance, his arguments on containing such dangers in the guise of once-off special measures are not convincing.

King highlights many of the same issues as Wolf and Turner as to how we got to where we are. The difference is in his reasoning of the causes. He points to significant deficiencies in the academic thinking behind the policies that govern Western economies. As such, his suggestions for solutions are more fundamental and require a change in consensus thinking as well as changes in policy responses. As King puts it – “I came to believe that fundamental changes are needed in the way we think about macroeconomics as well as in the way central banks manage their economics”.  According to King, theories upon which policies are based need to accommodate the reality of radical uncertainty, a model based upon the economics of stuff happens rather than the current purest (and unrealistic) models of the economics of stuff. King states that “we need an alternative to both optimising behaviour and behavioural economics”.

One of King’s most interesting and radical ideas is for a compromise between the current fractional banking model and the 100% reserve narrow bank model proposed under the so-called Chicago Plan. As King observes “to leave the production of money solely to the private sector is to create a hostage to fortune” and “for a society to base its financial system on alchemy is a poor advertisement for its rationality”. The alchemy King refers to here (and in the title of his book) is the trust required in the current “borrow short-lend long” model we employ in our fractional banking system. Such trust is inherently variable due to radical uncertainty and the changes in the level of trust as events unfold are at the heart of the reason for financial crises in King’s view.

Perhaps surprising for an ex-governor of the Bank of England, King highlights the dangers of overtly complex regulations (the UK PRA rule-book runs to 10,000 pages for banks) with the statement that “by encouraging a culture in which compliance with detailed regulations is a defence against a charge of wrong-doing, bankers and regulators have colluded in a self-defeating spiral of complexity”.  He warns that “such complexity feeds on itself and brings the system into disrepute” and that “arbitrary regulatory judgements impose what is effectively a high tax on all investments and savings”. This is a sentiment that I strongly agree with based upon recent experiences. All of the authors mentioned in this post are disparaging on the current attempts to fix banking capital requirements, particularly the discredited practise of applying capital ratios to risk weighted assets (RWA). A recent report from the Bank of International Settlements (BIS) illustrates the dark art behind bank’s RWA calculations, as per the graph below.

click to enlargeAverage Risk Weighted Assets

King’s idea is to replace the lender of last resort (LOLR) role of Central Banks in the current system to that of a pawnbroker for all seasons (PFAS). In non-stress times, Central Banks would assess haircuts against bank assets, equivalent to an insurance premium for access to liquidity, which reflect the ability of the Central Bank to hold collateral through a crisis and dispose of the assets in normal times (much as they currently do under QE). These assets would serve as pre-positioned collateral which could be submitted to the Central Bank in exchange for liquidity, net of the haircut, in times of stress who would act as a pawnbroker does. The current regulatory rules would then (over a transition period of 10-20 years) be replaced by two simply rules. The first would be a simple limit on leverage ratio (equity to total nominal assets). The second rule would be that effective liquid assets or ELA (pre-positioned collateral plus existing Central Bank reserves) would be at least equal to effective liquid liabilities or ELL (total deposits plus short term unsecured debt). The graphic below represents King’s proposal compared to the existing structure.

click to enlargeFractional Banking Pawnbroker Seasons Banking

King states that “the idea of the PFAS is a coping strategy in the face of radical uncertainty” and that it is “akin to a requirement on private institutions to take out compulsory insurance”. He highlights its simplicity as a workable solution to the current moral hazard of the LOLR which recognises that in a crisis the only real source of liquidity is the Central Bank and it structurally provides for such liquidity on a pre-determined basis. Although it is not a full narrow bank proposal, it does go some way towards one. As such, and as the graphic illustrates, it will require a significant increase in equity for private banks (similar to that espoused by Wolf and Turner, amongst others) which will have an impact upon overall levels of credit. Turner in particular argues strongly that it is the type of credit, and its social usefulness, that is important for long term sustainable economic growth rather than the overall level of credit growth. Notwithstanding these arguments, the PFAS is an elegant if indeed radical proposal from King.

Another gap in modern economic theory and thinking, according to King, is the failure to follow policies which address the problem of the prisoner’s dilemma, defined as the difficulty of achieving the best outcome when there are obstacles to co-operation. King gives the pre-crisis failure to recognise that each private bank faced a prisoner’s dilemma in running down its holdings of liquid assets, and financing itself as cheaply as possible by short-term debt, as the only means of competing with its peers on the profit expectations of the free market. The global economy currently faces a prisoner’s dilemma as the current (tired) orthodoxy of trying to stimulate demand is failing across developed economies as people are reluctant to consume due to fears about the future. In his own acerbic way, King quips that we cannot expect the US “to continue as the consumer of last resort”.

Current policy measures of providing short-term stimulus through low interest rates are diametrically opposite to those needed in the long run in King’s view. People, in effect, do not believe the con that Central Bank’s artificial reduction in risk premia is trying to sell, resulting in a paradox of policy. King believes that “further monetary stimulus is likely to achieve little more than taking us further down the dead-end road of the paradox of policy“. This means that Central Banks are currently in a prisoner’s dilemma – if any of them were to unilaterally raise interest rates, they would risk a slowing of growth and possibly another downturn in their jurisdiction. A co-ordinated move to a new equilibrium is what is needed and institutions like the IMF, who’s role is to “speak truth to power”, can hypnotise all they like about what is needed but the prisoner’s dilemma restricts real action. Unfortunately, King does not have any real solution to this issue besides those hopeful courses of action offered by others such as Wolf and Turner.

The unfortunate reality is that we seem to be on a road towards more disintegration rather than greater co-operation in the world economy. King does highlight the similarities of such a multi-polar world with the unstable position prior to the First World War, which is a cheery thought. Any future move towards disintegration across developed economies doesn’t bode well for the future, particularly when the scary issue of climate change is viewed in such a context. I hope we wouldn’t get more illustrations of the impact of radical uncertainty on our existing systems in the near future, nor indeed of our policymaker’s inability to address such uncertainty in a coherent and timely way.

I do however strongly recommend King’s book as a thought provoking read, for those who are so inclined.

Pimping the Peers (Part 1)

Fintech is a much hyped term currently that covers an array of new financial technologies. It includes technology providers of financial services, new payment technologies, mobile money and currencies like bitcoin, robo-advisers, crowd funding and peer to peer (P2P) lending. Blockchain is another technology that is being hyped with multiple potential uses. I posted briefly on the growth in P2P lending and crowd-funding before (here and here) and it’s the former that is primarily the focus of this post.

Citigroup recently released an interesting report on the digital disruption impact of fintech on banking which covers many of the topics above. The report claims that $19 billion has been invested in fintech firms in 2015, with the majority focussed in the payments area. In terms of the new entrants into the provision of credit space, the report highlights that over 70% of fintech investments to date have being in the personal and SME business segments.

In the US, Lending Club and Prosper are two of the oldest and more established firms in the marketplace lending sector with a focus on consumer lending. Although each are growing rapidly and have originated loans in the multiple of billions in 2015, the firms have been having a rough time of late with rates being increased to counter poor credit trends. Public firms have suffered from the overall negative sentiment on banks in this low/negative interest rate environment. Lending Club, which went public in late 2014, is down about 70% since then whilst Prosper went for institutional investment instead of an IPO last year. In fact, the P2P element of the model has been usurped as most of the investors are now institutional yield seekers such as hedge funds, insurers and increasingly traditional banks. JP Morgan invested heavily in another US firm called OnDeck, an online lending platform for small businesses, late in 2015. As a result, marketplace lending is now the preferred term for the P2P lenders as the “peer” element has faded.

Just like other disruptive models in the technology age, eBay and Airbnb are examples, initially these models promised a future different from the past, the so called democratization of technology impact, but have now started to resemble new technology enabled distribution platforms with capital provided by already established players in their sectors. Time and time again, digital disruption has eroded distribution costs across many industries. The graphic from the Citi report below on digital disruption impact of different industries is interesting.

click to enlargeDigital Disruption

Marketplace lending is still small relative to traditional banking and only accounts for less than 1% of loans outstanding in the UK and the US (and even in China where its growth has been the most impressive at approx 3% of retail loans). Despite its tiny size, as with any new financial innovation, concerns are ever-present about the consequences of change for traditional markets.

Prosper had to radically change its underwriting process after a shaky start. One of their executives is recently quoted as saying that they “will soon be on our sixth risk model”. Marrying new technology with quality credit underwriting expertise (ignoring the differing cultures of each discipline) is a key challenge for these fledging upstarts. An executive in Kreditech, a German start-up, claimed that they are “a tech company who happens to be doing lending”. Critics point to the development of the sector in a benign default environment with low interest rates where borrowers can easily refinance and the churning of loans is prevalent. Adair Turner, the ex FSA regulator, recently stirred up the new industry with the widely reported comment that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”. A split of the 2014 loan portfolio of Lending Club in the Citi report as below illustrates the concern.

click to enlargeLending Club Loan By Type

Another executive from the US firm SoFi, focused on student loans, claims that the industry is well aware of the limitations that credit underwriting solely driven by technology imbues with the comment that “my daughter could come up with an underwriting model based upon which band you like and it would work fine right now”.  Some of the newer technology firms make grand claims involving superior analytics which, combined with technologies like behavioural economics and machine learning, they contend will be able to sniff out superior credit risks.

The real disruptive impact that may occur is that these newer technology driven firms will, as Antony Jenkins the former CEO of Barclays commented, “compel banks to significantly automate their business”. The Citigroup report has interesting statistics on the traditional banking model, as per the graphs below. 60% to 70% of employees in retail banking, the largest profit segment for European and US banks, are supposedly doing manual processing which can be replaced by automation.

click to enlargeBanking Sector Forecasts Citi GPS

Another factor driving the need to automate the banks is the cyber security weaknesses in patching multiple legacy systems together. According to the Citigroup report, “the US banks on average appear to be about 5 years behind Europe who are in turn about a decade behind Nordic banks”. Within Europe, it is interesting to look at the trends in bank employee figures in the largest markets, as per the graph below. France in particular looks to be out of step with other countries.

click to enlargeEuropean Bank Employees

Regulators are also starting to pay attention. Just this week, after a number of scams involving online lenders, the Chinese central bank has instigated a crack down and constituted a multi-agency task force. In the US, there could be a case heard by the Supreme Court which may create significant issues for many online lenders. The Office of the Comptroller of the Currency recently issued a white paper to solicit industry views on how such new business models should be regulated. John Williams of the San Francisco Federal Reserve recently gave a speech at a recent marketplace lending conference which included the lucid point that “as a matter of principle, if it walks like a duck and quacks like a duck, it should be regulated like a duck”.

In the UK, regulators have taken a gentler approach whereby the new lending business models apply for Financial Conduct Authority authorisation under the 36H regulations, which are less stringent than the regimes which apply to more established activities, such as collective investment schemes. The FCA also launched “Project Innovate” last year where new businesses work together with the FCA on their products in a sandbox environment.

Back in 2013, I asked the question whether financial innovation always ended in lower risk premia in this post. In the reinsurance sector, the answer to that question is yes in relation to insurance linked securities (ILS) as this recent post on current pricing shows. It has occurred to me that the new collateralised ILS structures are not dissimilar in methodology to the 100% reserve banks, under the so-called Chicago plan, which economists such as Irving Fisher, Henry Simons and Milton Friedman proposed in the 1930s and 1940s. I have previously posted on my difficulty in understanding how the fully collaterised insurance model can possibly accept lower risk premia than the traditional “fractional” business models of traditional insurers (as per this post). The reduced costs of the ILS model or the uncorrelated diversification for investors cannot fully compensate for the higher capital required, in my view. I suspect that the reason is hiding behind a dilution of underwriting standards and/or leverage being used by investors to juice their returns. ILS capital is now estimated to make up 12% of overall reinsurance capital and its influence on pricing across the sector has been considerable. In Part 2 of this post, I will look into some of the newer marketplace insurance models being developed (it also needs a slick acronym – InsurTech).

Marketplace lending is based upon the same fully capitalized idea as ILS and 100% reserve banks. As can be seen by the Citigroup exhibits, there is plenty of room to compete with the existing banks on costs although nobody, not yet anyway, is claiming that such models have a lower cost of capital than the fractional reserve banks. It is important not to over exaggerate the impact of new models like marketplace lending on the banking sector given its current immaterial size. The impact of technology on distribution channels and on credit underwriting is likely to be of greater significance.

The indirect impact of financial innovation on underwriting standards prior to the crisis is a lesson that we must learn. To paraphrase an old underwriting adage, we should not let the sweet smell of shiny new technology distract us from the stink of risk, particularly where such risk involves irrational human behaviour. The now infamous IMF report in 2006 which stated that financial innovation had “increased the resilience of the financial system” cannot be forgotten.

I am currently reading a book called “Between Debt and the Devil” by the aforementioned Adair Turner where he argues that private credit creation, if left solely to the free market under our existing frameworks, will overfund secured lending on existing real estate (which my its nature is finite), creating unproductive volatility and financial instability as oversupply meets physical constraints. Turner’s book covers many of the same topics and themes as Martin Wolf’s book (see this post). Turner concludes that we need to embrace policies which actively encourage a less credit intensive economy.

It is interesting to see that the contribution of the financial sector has not reduced significantly since the crisis, as the graph on US GDP mix below illustrates. The financialization of modern society does not seem to have abated much since the crisis. Indeed, the contribution to the value of the S&P500 from the financials has not decreased materially since the crisis either (as can be seen in the graph in this post).

click to enlargeUS GDP Breakdown 1947 to 2014

Innovation which makes business more efficient is a feature of the creative destruction capitalist system which has increased productivity and wealth across generations. However, financial innovation which results in changes to the structure of markets, particularly concerning banking and credit creation, has to be carefully considered and monitored. John Kay in a recent FT piece articulated the dangers of our interconnected financial world elegantly, as follow:

Vertical chains of intermediation, which channel funds directly from savers to the uses of capital, can break without inflicting much collateral damage. When intermediation is predominantly horizontal, with intermediaries mostly trading with each other, any failure cascades through the system.

When trying to understand the potential impacts of innovations like new technology driven underwriting, I like to go back to an exhibit I created a few years ago trying to illustrate how  financial systems have been impacted at times of supposed innovation in the past.

click to enlargeQuote Money Train

Change is inevitable and advances in technology cannot, nor should they, be restrained. Human behaviour, unfortunately, doesn’t change all that much and therefore how technological advances in the financial sector could impact stability needs to be ever present in our thoughts. That is particularly important today where global economies face such transformational questions over the future of the credit creation and money.

Disappointing TRIB

Every investor knows the feeling of wondering what to do when a stock they have invested in falls unexpectedly in value. Although some may not be aware of the term “disposition effect” in behavioural economics, it reflects the widely observed tendency of investors to ride losses and lock in gains (a previous post touched on more behaviour economic concepts). I have been guilty in the past of just such a tendency, all too often I’m afraid! Bitter experience, maturity and the advice of many successful professional investors has caused me to now try to proactively act against such instincts. [On the latter point, the books of Jack Schwager and Steven Drobny with wide ranging professional investor interviews are must reads.]

Averaging down when a stock you hold falls, particularly when there is no obvious explanation, is another strategy that rarely ends well. Instead of looking at the situation as an opportunity to buy more of a stock at a reduced price, I now question why I would invest more in a situation that I have clearly misread. I only allow myself to consider averaging down where I clearly understand the reason behind any decrease and where the market itself has reduced (for the sector or as a whole). Experience has taught me that focusing on reducing the losers is critical to longer term success. Paul Tudor Jones put it well when he said: “I am always thinking about losing money as opposed to making money”.

This brings me to the case in point of my investment in Trinity Biotech (TRIB). I first posted about TRIB in September 2013 (here) where I looked at the history of the firm and concluded that “TRIB is a quality company with hard won experiences and an exciting product pipeline” but “it’s a pity about the frothy valuation” (the stock was trading around $19 at the time). The exciting pipeline included autoimmune products from the Immco acquisition, the launch of the new Premier diabetes instruments from the Primus acquisition, and the blockbuster potential of Troponin point-of-care cardiac tests going through FDA trials from the Fiomi deal.

Almost immediately after the September 2013 post, the stock climbed to a high of over $27 in Q1 2014, amidst some volatility. Fidelity built its position to over 12% during this time (I don’t know if that was on its own behalf or for an investor) before proceeding to dump its position over the remainder of 2014. This may simply have been a build up and a subsequent unwinding of an inverse tax play which was in, and then out, of vogue at the time. The rise of the stock after my over-valued call may have had a subconscious impact on my future actions.

By August 2014, the stock traded around the low $20s after results showed a slightly reduced EPS on lower Lyme sales and reduced gross margins on higher Premier instrument sales and lagging higher margin reagent sales. Thinking that the selling pressure had stopped after a drop by TRIB from the high $20 level to the low $20s, I revised my assessment (here) and established an initial position in TRIB around $21 on the basis of a pick-up in operating results from the acquisitions in future quarters plus the $8-$10 a share embedded option estimated by analysts on a successful outcome of the Troponin trials. As a follow-on post in October admitted, my timing in August was way off as the stock continued its downward path through September and October.

With the announcement of a suspension of the FDA Troponin trials in late October due to unreliable chemical agent supplied by a 3rd party, the stock headed towards $16 at the end of October. Despite my public admission of mistiming on TRIB in the October post and my proclamations of discipline in the introduction to this post, I made a classic investing mistake at this point: I did nothing. As the trading psychologist Dr Van Tharp put it: “a common decision that people make under stress is not to decide”. After a period of indecision, some positive news on a CLIA waiver of rapid syphilis test in December combined with the strength of the dollar cut my losses on paper so I eventually sold half my position at a small loss at the end of January. I would like to claim this was due to my disciplined approach but, in reality, it was primarily due to luck given the dollar move.

Further positive news on the resumption of the Troponin trials in February, despite pushing out the timing of any FDA approval, was damped by disappointing Q4 results with lacklustre operating results (GM reduction, revenue pressures on legacy products). The continued rise in the dollar again cushioned my paper loss.  It wasn’t until TRIB announced and closed a $115 million exchangeable debt offering in April that I started to get really concerned (my thoughts on convertible debt are in this post) about the impact such debt can have on shareholder value. I decided to wait until the Q1 call at the end of April to see what TRIB’s rationale was for the debt issuance (both the timing and the debt type). I was dissatisfied with the firm’s explanation on the use of funds (no M&A target has been yet identified) and when TRIB traded sharply down last week, I eventually acted and sold all of my remaining position around $16 per share, an approximate 15% loss in € terms after the benefits on the dollar strength. The graph below illustrates the events of the recent past.

click to enlargeTRIB Share Price + Short Interest

My experience with TRIB only re-enforces the need to be disciplined in cutting losses early. On the positive side, I did scale into the position (I only initially invested a third of my allocation) and avoided the pitfall of averaging down. Joe Vidich of Manalapan Oracle Capital Management puts it well by highlighting the need for strong risk management in relation to the importance of position sizing and scaling into and out of positions when he said “the idea is don’t try to be 100% right”. Although my inaction was tempered by the dollar strength, the reality is that I should have cut my losses at the time of the October post. Eventually, I forced myself into action by strict portfolio management when faced with a market currently stretched valuation wise, as my previous post hightlights.

As for TRIB, I can now look at its development from a detached perspective without the emotional baggage of trying to justify an investment mistake. The analysts have being progressively downgrading their EPS estimates over recent months with the average EPS estimates now at $0.16 and $0.69 for Q2 and FY2015 respectively. My estimates (excluding and including the P&L cost of the new debt of $6.3 million per year, as per the management estimate on the Q1 call) are in the graph below.

click to enlargeTRIB Quarterly Revenue+EPS 2011 to Q42015

In terms of the prospects for TRIB in the short term, I am concerned about the lack of progress on the operational results from the acquisitions of recent years and the risks (timing and costs) associated with the Troponin approval. I also do not believe management should be looking at further M&A until they address the current issues (unless they have a compelling target). The cost of the debt will negatively impact EPS in 2015. One cynical explanation for the timing on the debt issuance is that management need to find new revenues to counter weakness in legacy products that can no longer be ignored. Longer term TRIB may have a positive future, it may even climb from last week’s low over the coming weeks. That’s not my concern anymore, I am much happier to take my loss and watch it from the side-lines for now.

Ray Dalio of Brightwater has consistently stressed the need to learn from investing mistakes: “whilst most others seem to believe that mistakes are bad things, I believe mistakes are good things because I believe that most learning comes via making mistakes and reflecting on them”. This post is my reflection on my timing on TRIB, my inaction in the face of a falling position, and my current perspective on TRIB as an investment (now hopefully free of any emotive bias!).

One must look at one’s own behaviour….

That markets often behave irrationally, particularly over the short to medium term, is generally widely accepted today. Many examples can be cited to show that human behaviour does not restrict itself to the neo-classical view of rational player’s expected utility maximisation. The subject of the behavioural impact of humans in economics and finance is a vast and developing one which has and is the subject of many academic papers.

As a result of a recent side project, I have had cause to dig a little bit deeper into some of the principles behind behavioural economics and finance. In particular my attention has been caught by prospect theory, so named from the 1979 paper “Prospect theory decision making under risk” by Amos Tversky and Daniel Kahneman (who received a Nobel Prize in 2002 for his work on the subject), largely seen as the pioneers of behavioural economics and finance. In essence, prospect theory asserts that humans derive utility differently for losses and gains relative to a reference point.

My limited knowledge on the topic has been tweaked by a paper from Nicholas Barberis in 2012 entitled “Thirty Years of Prospect Theory in Economics: A Review and Assessment”. Although Barberis states that “while prospect theory contains many remarkable insights, it is not ready made for economic applications”, he highlights some recent research that may “eventually find a permanent and significant place in mainstream economic analysis.

Tversky and Kahneman updated the 1979 original prospect theory in 1992 to overcome initial limitations, so called cumulative prospect theory, based upon four elements:

1)    Reference Dependence – people derive utility from gains and losses relative to a reference point (rather than from absolute levels).

2)    Loss Aversion – people are much more sensitive to losses rather than gains of the same magnitude.

3)    Diminishing Sensitivity – people are risk averse in relation to gains (e.g. prefer certainty) but risk seeking in relation to losses.

4)    Probability Weighting – people weight probabilities not by objective probabilities but rather by decision weightings (e.g. objective weightings transformed by their risk appetite).

Graphically cumulative prospect theory is represented below.

click to enlargeProbability Weighting

Barberis highlights a number of sectors where prospect theory, as a model of decision making under risk, has applications. I will only comment on areas of interest to me, namely finance and insurance.

Probability weighting highlights that investors overweight the tail of distributions and numerous studies confirm that positively skewed stocks have lower average returns than would otherwise be suggested by expected utility investors. In other words, investors overestimate the probability of finding the next Google. This explains the lower average return of classes such as distressed stocks, OTC stocks, and out of the money options.

Loss aversion has also been used to explain the equity premium compared to bonds (i.e. returns have to be higher to compensate investors for volatility). Using an assumption called “narrow framing” investors evaluate separate risks according to their characteristics. This has also been used to explain why many people don’t invest in the stock market.

Prospect theory is also used to explain one long standing failure of investor behaviour, namely selling winners too early and holding on to losers too long. This is something that I have learned from experience to my determent and one piece of advice that many professional investors emphasis again and again. This characteristic was highlighted in research as far back as 1985 in a paper by Shefin and Statman. Further research to formalise this “disposition effect” is on-going and much debated. Other research focuses on the impact of “realisation” utility when it comes time to sell a stock (e.g. we derive more utility in selling a winner).

In the insurance area, prospect theory has been used to explain consumers purchasing behaviour. For example, if we overweight tail events then we likely
purchase too much insurance, at too low a deductible! Purchasing of a product such as an annuity is also impacted by our mentality of being risk adverse on gains/risk seeker on losses. The consumer is therefore more sensitive to a potential “loss” on an annuity by dying earlier than expected as opposed to a “gain” by living longer. One area that has proven difficult in using prospect theory is to understand what reference point people use in making decisions such as the purchase of an annuity.

There have been recent criticisms on the use of behaviour theories in finance and economics. Daniel Kahneman himself, whilst promoting the paperback launch of his 2011 bestselling book “Thinking, Fast and Slow” expressed his frustration at the blasé labelling of a divergence of social science as behavioural economics – “When it comes to policy making, applications of social or cognitive psychology are now routinely labeled behavioral economics”.

Another recent report entitled “How Behavioural Economics Trims Its Sails and Why” by Ryan Bubb and Richard Pildes claims that some policymakers naive embrace of the new field may actually be doing more harm than good. The report states that “fuller, simpler, and more effective disclosure, one of the main options in behavioural economic’s arsenal, is not a realistic way, in many contexts, to rectify adequately the problems in individual capacity to make accurate, informed judgments with the appropriate time horizons.” The report cites examples such as opt-out options in automatic enrolment of retirement savings and disclosure on teaser rates in credit products that claimed to offer reasoned choices to consumers but ultimately led to unintended economic impacts.

It is ironic (and probably inevitable) that some features designed to modify behaviour backfire given that, in the words of behavioural economist Dan Ariely, the premise of the theory is that “we are fallible, easily confused, not that smart, and often irrational.