Risk versus reward

As an investor, one must always weight risk versus reward. Make a list of all of the risks for a company and then try to think of the worst case scenario for each risk. Next weight these risks against what you think is the potential upside for the company and the effect on future earnings. Next, compare that against the current valuation (stock price versus what you think the stock should be worth). So you do this for each stock and then you compare all the stocks that you could invest in. Next, you allocate your capital appropriate because you know that you will be wrong sometimes…about risk (maybe you missed some), about valuation, about future prospects.

Now let’s think again about BOFI. People will either think that nothing is wrong and short sellers are targeting the company. Or people may think that there are so many red flags that you just want to stay away. Ask yourself how sure you are. Ask yourself what if you are wrong. Next, consider your alternatives. These might include companies like SWKS, SKX, AMBA, and others. You might think that many of these are on sale right now.

If you are in the camp that you think nothing is wrong then try to think about why you believe that. Some people will enter into the following thought process (not my thought process but just an example of how someone might think):

“The evidence indicates that the company is real. Earnings are real. The company is being attacked. It’s really cheap. I expect to make a great return once everything gets cleared up. Short sellers are intentionally driving down the price. I will not let short seller get the best of me so I’ll show them, and I’ll buy a lot or hold my very large position.”

If this is your thought process, be careful. Don’t let your desire to “win” or “beat” short sellers influence you to take on more risk than you would otherwise take on. Don’t think about the short sellers, think about your portfolio and what’s best for you given the appropriate level of risk/return for you. Think about where else you could deploy your capital. Is it better in BOFI or somewhere else. How much is really appropriate given what you really know about BOFI and all the other companies that you could invest.

Chris

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As an investor, one must always weight risk versus reward. Make a list of all of the risks for a company and then try to think of the worst case scenario for each risk. Next weight these risks against what you think is the potential upside for the company and the effect on future earnings. Next, compare that against the current valuation (stock price versus what you think the stock should be worth). So you do this for each stock and then you compare all the stocks that you could invest in. Next, you allocate your capital appropriate because you know that you will be wrong sometimes…about risk (maybe you missed some), about valuation, about future prospects.

I don’t think I could do that even if I had an auto-magic, super-hero spreadsheet. If I had to do it I would just buy an index fund or two. I use shortcuts instead. There are possibly 8 or 10 thousand stocks out there to choose from and I only need about a dozen for my portfolio. One curious lessons I learned from George Gilder is that if there is a superabundance, waste it with glee. There is a superabundance of stocks to pick from! One can dismiss whole sectors in one go. Nassim Nicholas Taleb calls the financial sector “Bad black swan prone” which is almost enough to dismiss BOFI without a second thought. I say almost because there are some financial institutions that don’t have credit risk which is where most of the risk of the financial sector is concentrated. Two examples of low risk financial institutions are VISA and MasterCard, the credit risk is born by the issuing banks. Some of the richest men in the world are bankers which makes it a tempting investment but they have an inside track that you and I don’t have. And plenty bankers have gone bust. Out goes the financial sector.

It’s not my aim to go through the list but one winds up with maybe a dozen or so kinds of businesses that have natural moats, low risk, endurance, and are simple enough that even I can understand them. This wholesale pruning surely must cut out some incredible investments but it has the advantage of simplicity.

One big problem is that once you pick your winners, you’ll have very little to entertain yourself with in the market. You’ll need a second hobby! :wink:

Denny Schlesinger

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I certainly hope you are right Denny about MA and V being low-risk financial institutions. I have large holdings in both. Yet why should the middle-man not be disrupted by, say, Apple or Facebook? It does not seem to be on the cards yet (!) but I wonder if it could happen. Interested if you have a view on the question.

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Yet why should the middle-man not be disrupted by, say, Apple or Facebook? It does not seem to be on the cards yet (!) but I wonder if it could happen. Interested if you have a view on the question.

Great question! Anything can be disrupted, the question is what are the chances of being disrupted. Exactly what GauchoChris was talking about!

If you examine business from the point of view of the Science of Complexity, you get your answers. There are several factors at work, one is the law of increasing returns: “The more you sell, the more you sell” which is what allows products like Windows, the X86, VISA, MasterCard and some time ago IBM’s S/360 and S/370 to dominate over half the market as opposed to commodities which work under the law of decreasing returns which subjects them to price pressure and fragmented markets. This is the moat which can be described in more detail under headings like “switching costs,” high in knowledge based products, “network effect,” the increasing benefit of large numbers of users, “cost of entry,” self explanatory.

One important point to note is that it’s not necessarily the best product that wins which makes lots of technical discussion by investors moot. With commodities, with the law of decreasing returns, the law of supply and demand rules. Not so with the law of increasing returns. Several brands or competing ideas go head to head and the market picks one at random. To explain, with decreasing returns there is only one point of equilibrium that clears markets. With increasing returns there are multiple possible points of equilibrium, like a roulette wheel has lots of pockets. The ball lands in one at random. When it does, “path dependence” keeps it in that winning place.

Despite these safeguards businesses and products do get disrupted and it’s good to know how disruption comes about. Intel, for example, won the race for microprocessors with the technically inferior X86 and it has ruled the roost for decades moving upscale as technology progressed. You might have heard about IBM and the Seven Dwarfs except some of the Dwarfs were pretty big. GE, the King of the Dwarfs!

http://www.dvorak.org/blog/ibm-and-the-seven-dwarfs-dwarf-fi…

The head on assault on Intel and IBM didn’t work. Steve Jobs tried it in 1984 and Apple almost became the dead dwarf number eight. Disruption has to come from below, serving new, underserved markets, with cheaper and less powerful products that the market leaders ignore as unimportant until it is too late. A classic example is ARM Holdings vs. Intel. ARM went after the underserved embedded market with low power, low capacity chips that were no match for Intel, a market where Intel had some business but little interest. By now Intel has lost the increasingly important 64 bit mobile market. But ARM didn’t mount a frontal attack, like Steve Jobs (Apple) tried against IBM and Scott McNealy (Sun Micro) against Microsoft.

Don’t worry about Apple disrupting VISA and MasterCard, worry about some unknown entity, one which you never heard of, doing so.

In conclusion, the chances of disrupting VISA and MasterCard are pretty slim – not that it can’t happen.

Denny Schlesinger

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Yet why should the middle-man not be disrupted by, say, Apple or Facebook? It does not seem to be on the cards yet (!) but I wonder if it could happen.

I think it could definitely happen at some point Strelna. Here’s a list of competitors/disruptions to MasterCard’s business model I listed in a recent post on the company:

PayPal: Likewise, Paypal is another worthy competitor in the payment processing, mobile wallet and global remittance markets. It has developed a nice niche in e-commerce and, with the advent of mobile wallets, could soon become a real player in point-of-sale (POS) transactions as well. With a lower transaction fee, many merchants would prefer Paypal transactions which might mean future incentives from retailers to use this platform. More realistically, I would expect this to just further cut the margins of MasterCard. Because of this, I don’t see Paypal or other similar platforms as an existential threat to MasterCard.

MCX’s CurrentC: Merchant Exchange, better known as MCX, is a loose alliance of several big name, brick-and-mortar retail giants including: 7-11, Best Buy, CVS, Darden Restaurants, Dunkin Donuts, Exxon, Kohls, Lowe’s, Rite Aid, Shell, Target, and Walmart. MCX’s first major effort was to try to form its own mobile payment processing app, CurrentC.

The system is intended to work similar to other mobile wallets with one major difference: Instead of linking the smartphone app to the consumers’ own credit cards, the customer can only use store gift cards, private store cards (e.g. Target’s REDcard), or link the app directly to their own checking account.

At this time the venture has been met with nothing but delays, defections and minor controversies. Establishing a payment processing network is hard! But there are significant resources behind this venture and too much has probably been invested in it for these retailers to just abandon the project at this juncture. It is conceivable that one day CurrentC will be a viable competitor to MasterCard.

For further thoughts on MCX’s CurrentC, you can see my post here: http://discussion.fool.com/the-problems-with-mcxs-currentc-31882…

Bitcoin: Much ink has been spilled about Bitcoin and I’ve read a great deal of that ink but still am not confident in my ability to explain what Bitcoin is or how it works. But it is a whole new way of thinking about money and currency and, if it ever took hold, could radically alter the payment processing arena so that players like MasterCard would no longer be necessary.

While I am vastly underqualified to even to attempt to make this statement, I personally don’t believe Bitcoin, as we know it right now, will ever replace US currency or our current monetary system. Some of Bitcoin’s features, like its block chain technology, is truly innovative and can add much needed security to monetary transactions. I do believe this technology, whether still a part of Bitcoin or not, will be integrated into a number of different type of transactions in the future.

Possible Future Upstarts

Here is where this conversation gets interesting. I have long pondered how tech companies like Facebook, Apple, and Google could disrupt the payment processing industry if they really wanted to. I do not believe we will have to wait too long to find out. Both companies have already taken the first steps necessary to do so.

Facebook: In March, Facebook announced you could now send money to your friends via Facebook Messenger by linking your Facebook account to an existing debit card.

http://newsroom.fb.com/news/2015/03/send-money-to-friends-in…

Facebook is currently working hard to build Messenger into the most holistic customer experience that exists in e-commerce. Soon you will be able to make your order, track your package, immediately talk to a customer representative, and probably post reviews - all through FB Messenger. Oh, and of course, you’ll be able to pay for everything with Messenger as well. Right now, this will all be done through a pre-existing credit or debit card. But what if Facebook ever considers eliminating the middle man?

They definitely have the firepower, resources and expertise to pull off such a move. Last year, they even hired former PayPal President David Marcus. Facebook’s network is so ubiquitous that the hardest part – getting people to sign up to the service – is already done. In countries with developed economies it is hard to find a person or company that does not already have an account.

Even the Washington Post believes Facebook could be the “future of money”:

http://www.washingtonpost.com/news/innovations/wp/2015/08/18…

Apple and Google: The thought process is similar for these two companies. Both already have hardware used for making payments but, as of now, both use pre-existing cards. If either ever decided to eliminate the middle man and establish their own payment processing network, both might be able to make a serious play into the payment processing industry. Both of these companies would have even more resources to use in either acquiring a company in the industry already or building its own network than Facebook.

Making all three (Apple, Facebook, and Google) of these threats even more dangerous to MasterCard, is that merchants would probably welcome these competitors as it would drive down fees and rates.

Regulation and Litigation Risks

There are always several risks and areas of concern investors need to watch while investing in a company and MasterCard is no different. The two chief areas of concerns for MasterCard shareholders though are, I believe, regulatory actions and litigation threats.

Being a major financial company, one that must interact with nearly all merchants and banks in each country it operates within, means MasterCard is subject to a number of different laws and regulations across the globe. This past summer, for instance, the European Union filed antitrust charge against MasterCard because the EU believes MasterCard is “artificially increasing the costs of credit card payments”.

http://www.forbes.com/sites/nickclements/2015/07/09/credit-c…

MasterCard has also been the subject of a number of lawsuits over the years alleging a variety of anti-consumer behavior that can potentially cost the company billions of dollars going forward.

If you’re interested, you can see the entire post at http://discussion.fool.com/mastercard-ma-report-31909029.aspx

Hope this helps. Obviously these are just my thoughts. To be clear, I do think MasterCard will provide market-beating returns going forward. I just think investors should be fully aware of all the risks going forward.

  • Matt
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Matt, thank you for taking the time to write that very comprehensive and interesting reply.

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