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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor. Previous Columns
8:30 AM EST Tuesday, September 26, 2006: Don't be suckered in by great past performance. It has nothing to do with the future. Great performance (and fortunes) can (and do) turn on a dime -- especially with a leveraged gamble on volatile, illiquid markets, like natural gas futures.

Sadly (at least for them), investors in Amaranth, who have now lost 65% of their money, may not be able to get out for years and years. Meanwhile, because Amaranth never had a high water mark in its contracts with its investors, those investors will keep paying Amaranth fees -- annual fees and performance fees -- and even BEFORE Amaranth makes up the losses -- if they ever can.

+ Don’t invest in hedge funds WITHOUT a high water mark.

+ Don't invest in hedge funds who borrow money and make leveraged bets with your money.

+ Don't invest in funds of funds.

+ Don't invest in hedge funds whose trading strategy is a mystery.

According to one report, investors in Amaranth may have to wait as long as four years to retrieve what is left of their money. Amaranth, which managed $9.5 billion at the end of last month, had placed stringent restrictions on investors redeeming their capital.. Investors, of which 60% are funds of hedge funds, had to commit to keeping their money in place for at least a year. The company also has the right to restrict the amount of any redemptions it pays out in any quarter to 7.5% of total funds, the consultant said.

Investors who cannot get out of Amaranth’s funds will be forced to pay performance fees as soon as its funds start making money again, because the firm does not use a “high water mark.” Other hedge funds, which use a high water mark, do not charge performance fees until the fund has made up any losses to investors. Amaranth earns its performance fees every quarter. If its positions recover in the last three months of the year, Amaranth will earn an estimated 20% of any performance despite the losses of $6 billion last week.

The high water mark in scandals. Bernard Ebbers heads to prison today to start a 25-year term for his role in the WorldCom accounting fraud. Bernie will be out when he's 91 -- if he serves all his time or doesn't die. I never thought Bernie was a serious crook, just a very stupid one.

The backdating of stock options: The FBI is now conducting 52 inquiries into alleged cases of companies backdating options. But over 100 cases have been reported. The FBI is one of half a dozen state and federal agencies looking into the H-P matter, on top of what the FBI says are 486 investigations into corporate fraud so far this fiscal year, up from 423 in 2005, according to Bloomberg. Twenty of these involved alleged fraud of more than $1 billion, and the FBI has also opened 1,160 securities-fraud cases, up from 1,139 last year. See below.

Cablevision gave backdated options to a dead exec.
Cablevision Systems Corp. awarded options to an executive after his 1999 death, backdating them so that they appeared to have been granted while he was still alive. The executive's estate benefitted. Why? To motivate a reincarnation? Who knows. I don't make this stuff up.

The huge jump in bond prices: Or a huge fall in interest rates -- same thing. Look at the yield on 10-year treasury notes:

This chart means that 10-year treasury notes are now paying 4.56%. Prices have risen as investment money has flocked into "Cash is King" vehicles -- away from the market. How high might bond prices go from here? Your guess is as good as mine. It seems to depend on how bad investors feel the economy will become in coming months. If the slump in real estate causes a hard landing for the economy, bonds could go even higher. I can't (and won't) make that call.

Thank you for all the good wishes: You have all assured me that I'll stop crying, settle into smiling and anticipation of grandchildren. It seems other people have had daughters get married, have children and live happily ever after. And I thought I was the first! Damn, now I'm crying again...

What does the press know?

* Fortune, 2/19/1996: "By the time you read this story, the quirky cult company...will end its wild ride as an independent enterprise."

* Time Magazine, 2/5/96: "One day Apple was a major technology company with assets to make any self respecting techno-conglomerate salivate. The next day Apple was a chaotic mess without a strategic vision and certainly no future."

* BusinessWeek, 10/16/95: "Having underforecast demand, the company has a $1 billion-plus order backlog....The only alternative: to merge with a company with the marketing and financial clout to help Apple survive the switch to a software-based company. The most likely candidate, many think, is IBM Corp."

* Wired, "101 Ways to Save Apple," 6/97: "1. Admit it. You're out of the hardware game."

* Fortune, 2/19/1996: "Apple's erratic performance has given it the reputation on Wall Street of a stock a long-term investor would probably avoid."

* The Economist, 2/23/95: "Apple could hang on for years, gamely trying to slow the decline, but few expect it to make such a mistake. Instead it seems to have two options. The first is to break itself up, selling the hardware side. The second is to sell the company outright."

Curiosity has its merits and and its profits: This piece appeared in Saturday's New York Times. It's totally engrossing. Joe Nocera wrote it:

“I think we’re people who are just curious about things,” said Andrew J. Redleaf, with a tone of mock innocence.

Mr. Redleaf, 48, runs Whitebox Advisors, a $1.8 billion Minneapolis hedge fund that has had sparkling returns since he started it in 2000. Mr. Redleaf is one of those hedge fund guys who write letters to investors that are filled with big ideas about the market. He’s also funny, cynical, cranky and unabashedly opportunistic.

“Could that professor really be right?” he continued. The professor he was referring to was Erik Lie of the University of Iowa, who published a study last year that essentially set off the options backdating scandal. Although Mr. Lie did not name names, his work showed, indisputably, that there were simply too many cases where options were granted to top executives just before a nice run-up for it to be happening randomly. He suggested that companies had to be backdating option grants to enrich executives.

That study, in turn, piqued the interest of the Securities and Exchange Commission and The Wall Street Journal, which began looking at individual companies. At this point, 115 companies have been identified as being under some sort of investigation, either by the S.E.C., the Justice Department or an internal investigation. So far, executives from two companies that backdated options, Converse and Brocade, have been indicted. This week, Cablevision revealed that it gave backdated options to a deceased executive — making it appear as though he had received the options while still among the living.

A few months ago, Mr. Redleaf and several of his Whitebox colleagues decided to do their own options backdating study. They ran 6,000 companies — and 60,000 options grants — through their computers. They looked at a 40-day window: 20 days before the options were granted and 20 days after. And sure enough they discovered several hundred companies whose pattern of granting options at the precise moment the stock was about to jump was eyebrow-raising, to say the least. And while Whitebox Advisors does not have absolute proof that options backdating took place, neither did Mr. Lie. It was statistical detective work.

Mr. Redleaf is quick to express outrage at executives who backdated options. Of the series of recent Wall Street scandals, Mr. Redleaf told me: “This is by far the worst. It is a direct transfer of wealth from stockholders to insiders.”

But let’s be honest here. Hedge funds don’t do deep dives into options backdating just to satisfy their curiosity or to gain justice. Rather, they do it to find an edge — and to use that edge to get richer than they already are. What Mr. Redleaf has begun to do with this options backdating information raises a question that is being asked a lot these days about hedge fund operators. Is he an activist, helping to make the market a better place? Is he a holdup artist? Or is he both?

When you ask the folks at Whitebox Advisors how they make money, they have a hard time explaining it in layman’s terms. “Relative value arbitrage,” Mr. Redleaf replied when I asked him to describe his fund. “Generally,” he continued, “we focus on mispriced securities that have a relationship to each other” like a company’s stock and bonds. “That,” he added, “tends to cause us to skew towards distressed companies.”

Often, for instance, a company’s bonds will send up an early warning signal that there may be internal problems, even as its stock remains buoyant. In that mispricing is an opportunity for a smart hedge fund guy who sniffs it out. Sometimes, though, the hedge fund guy won’t be willing to just sit on his hands while waiting for the market to catch up with his insight. That’s when he becomes an “activist.”

Earlier this year, for instance, Whitebox was among a number of hedge funds that were holding General Motors bonds. “We were betting that they would cut the dividend because we thought it was inevitable,” Mr. Redleaf said. He also felt, though, that cutting the dividend was the right move for G.M. to make — so he went to Detroit and met with members of G.M.’s finance team to press that case. Sure enough, in February, when General Motors cut its dividend in half, the bond market applauded, and Whitebox’s G.M. bonds were suddenly more valuable.

Mr. Redleaf became interested in options backdating because of another, more controversial bond play that Whitebox and a number of hedge funds began using a few years ago. When a company fails to file its financial documents on time, its bonds are technically in default. For decades, though, bondholders have generally looked the other way when that happened.

But Whitebox did not. Instead, it took to buying up bonds “below par” — that is, bonds trading below their face value — of companies that had failed to deliver their financial documents on time, usually because of an accounting problem.

Then, Whitebox and other activist bondholders would tell the company that since it was in default on its bonds it was liable for the full face amount — immediately. Sometimes, the company would wind up paying off the bonds. Other times, it would negotiate an agreement, usually a one-time payment to the bondholders in return for a waiver. Either way, Whitebox won.

Mr. Redleaf argues that what he is doing is “being vigilant in asserting our rights,” unlike mutual funds and other big institutional investors that have ill-served their investors by not fighting for everything they are entitled to. Of course, most companies don’t see it quite that way. They view Whitebox as taking advantage of a technicality to make a quick buck.

Companies that are caught backdating options, of course, have huge accounting problems. Options that have been backdated require a different accounting treatment, and companies usually have to restate their financials for the years during which they were backdating. This almost inevitably means that they will also not be able to file their current quarterly or annual report on time. Which therefore means their bonds will technically be in default. Which therefore means the bondholders can squeeze them.

Is it any wonder Mr. Redleaf suddenly became interested in options backdating?

Once he had his list of potential options abusers, Mr. Redleaf and his team shorted about 80 of them. But Whitebox also went into the marketplace and bought bonds of some of the companies in question. (In other cases, it already owned the bonds.) And then the firm got to work.

Consider the case of Affiliated Computer Services, a Texas-based technology outsourcing company with over $4 billion in 2005 revenue and 50,000 employees. It was one of the first companies to be fingered as a possible options backdater, and instigated an internal investigation in March. In July, when the company released its quarterly results, it also said that while the investigation wasn’t complete, it didn’t think it would have to restate results. “We do not believe that any director or officer of the company has engaged in the intentional backdating of stock options grants,” it added.

Mr. Redleaf shot back in a letter he sent to the company in early August. “There were 14 grants between November 1995 and March 2005,” he wrote to Darwin Deason, the chairman of the board. “Every single grant was better than a random day for the period, a 1-in-16,384 occurrence.” He added, “if we look at the stock return for the 20 days after the grant, the award days were in the 91st percentile, a result very consistent with backdating but hard to square with legitimate methods.”

Within days of receiving the letter, A.C.S. announced that its previous statement about options backdating “can no longer be relied upon” — strongly implying that things were worse than it had claimed a few weeks earlier. A few days later, a lawyer working for the company’s audit committee contacted Whitebox to see what the firm had found. Last week, A.C.S. announced that it had missed the deadline for filing its annual report — the exact event Whitebox was hoping would result from its letter.

The company also reported that because of that missed deadline it “may face covenant compliance issues,” meaning that it may be in default of some $2 billion worth of loans. The company said it would seek a waiver. You know what that means: money in the pockets of Whitebox Advisors.

A spokeswoman for Affiliated Computer Services wouldn’t comment on its option backdating investigation except to say that it was a coincidence that the company made its tougher announcement so soon after getting the letter from Mr. Redleaf. She also wouldn’t comment on Mr. Redleaf’s tactics.

Indeed, of the half-dozen companies I called for this column — all of whom received similar letters from Whitebox, and several of whom face the prospect of having to pay off their bonds at full value because they missed filing deadlines — only one spokesman was willing to say what they undoubtedly all feel. That was Jeff Luth of Amkor, a company whose options problems caused it to fail to file its quarterly report last June —and is now dealing with the consequences.

“We don’t think opportunistic hedge funds should hold Amkor hostage for a financial windfall,” he said. “We believe it siphons off corporate assets to the detriment of our shareholders.”

But doesn’t that also describe options backdating? As Mr. Redleaf pointed out: “By cheating on options grants these companies filed phony financial statements and they used those phony financials to borrow money from bondholders. Shareholders have the right to fire management. All bondholders can do is try to get their money back.”

The punishment Mr. Redleaf is meting out may be harsh. And it may be a hold up. But it’s hardly undeserved. “Eventually,” he said, “the market punishes the wicked.”

Marriage is a relationship in which one person is always right, and the other is a husband.

One day, a man came home and was greeted by his wife dressed in a very Sexy nightie. "Tie me up," she purred, "and you can do anything you want."

So he tied her up and went golfing.

Let's be super literal:
Boudreaux tries out for the tigers....

Boudreaux, a college freshman at LSU fresh from the swamp tries for the football team.

Can you tackle?" asked the coach the first day of practice.

"Watch dis," Boudreaux told him, and proceeded to run smack into a telephone pole, shattering it to splinters.

"Wow," said the coach. "I'm impressed. Can you run?"

"Mais, sure I can run," said Boudreaux. He was off like a shot, and, in just over nine seconds, he had run a hundred yard dash!

"Great!" exclaimed the excited coach. "But can you pass a football?"

Boudreaux rolled his eyes, hesitated for a few seconds and replied,"Mais, Coach", he said, "if I can swallow it, I can probably pass it."

Informing next of kin:
Father O'Malley rose from his bed. It was a fine spring day in his new Texas mission parish. He walked to the window of his bedroom to get a deep breath of the beautiful day outside. He then noticed there was a jackass lying dead in the middle of his front lawn. He promptly called the local police station.

"Good morning. This is Sergeant Jones. How might I help you?"

"And the best of the day te yerself. This is Father O'Malley at St. Brigid's. There's a jackass lying dead in me front lawn. Would ye be so kind as to send a couple o' yer lads to take care of the matter?"

Sergeant Jones replied, "Well now father, it was always my impression that you people took care of last rites!"

There was dead silence on the line.

Father O'Malley then replied: "Aye, tis certainly true, but we are also obliged to notify the next of kin."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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