Gambling with financial products 5

Disclosure: Short Plus500.

At root, what illicit online brokerages have in common is the promotion of trading activity as a form of gambling rather than investment.

In my last letter, I mentioned that the Times of Israel has recently drawn attention to abuses within the online brokerage industry in Israel. The Times kindly asked me to provide a perspective on ways to detect potentially abusive firms. My opinion piece has a dual audience: it lists a few quick tips for individuals who may be considering a new brokerage relationship, and it provides a longer list of potential red flags for regulators and the broader industry to consider.

Over the past year, Cable Car has communicated with more than a dozen regulators around the world regarding Plus500 and other abusive online brokerages. It has become clear that, like the online gambling businesses they emulate, many brokerages take advantage of very aggressive regulator shopping, while operating with impunity and little oversight in many jurisdictions.

Operating a broker-dealer generally requires licensing, capital requirements, and strict regulatory supervision. Despite laws on the books prohibiting online brokerages from accepting local clients without registering, many countries defer to a brokerage’s home regulator for enforcement. Scandalously, the home regulators often refuse to supervise conduct that occurs outside their borders. In some cases this confers an artificial air of legitimacy on the worldwide activity of companies that may be conforming to requirements only for clients in regulated jurisdictions.

The Times noted in its initial exposé that some brokerages target customers in impoverished parts of the world with hopes of quick riches. Others seek customers in countries with significant demand for investment but less developed securities markets and regulatory apparatus. When a brokerage based in Israel or Cyprus violates local law in Qatar or Sudan, local authorities have few resources to do anything about it. When a brokerage flaunts regulatory requirements in more established markets like Hong Kong or Singapore, the local authorities may investigate, but to-date they have done little more than warn potential customers.

The United States, ever the world’s policeman, has been relatively effective at bringing enforcement actions against some of the worst offenders who operate within its borders. Hopefully we will see more actions in the future. Yet smart brokerage operators avoid the small handful of countries that have refused to tolerate illegal conduct by overseas firms, such as the United States, Canada, and New Zealand. Even the US has been reluctant to bring enforcement actions against companies that make only indirect use of US means of commerce. In my view, a great deal of responsibility rests with the Israeli Securities Authority to take a more active role in supervising the worldwide actions of its companies.

Below is an excerpt from the op-ed. Please read the whole piece on the Times of Israel website. Comments are welcome.


As the online brokerage industry faces increased regulatory scrutiny in Israel and around the world, it is essential for regulators and prospective customers to understand what separates a legitimate brokerage firm from the “wolves of Tel Aviv.” At root, what illicit online brokerages have in common is the promotion of trading activity as a form of gambling rather than investment. It is no coincidence that many brokerage developers got their start in the online gambling business, and gambling firms have recently diversified into online trading.

Although the bulk of industry criticism has focused on trade in binary options, many binary brokers at least have the virtue of explicitly describing client positions as wagers. Spread betting, a form of contract for difference (CFD) trading popular in the UK, is similarly upfront about what customers are really doing (allowing the results to be taxed as gambling losses rather than capital gains).

Far more insidious, in my view, is the way in which other brokers offering complicated financial products blur the lines between trading for investment purposes and trading for entertainment. Gambling may have its place, but it should not involve financial products. It harms the integrity of capital markets when companies encourage financially unsophisticated individuals to take risks they may not fully understand or have adequate resources to bear.

Complex derivatives like binary options, CFDs, futures, and other leveraged financial instruments were originally developed for professional investors to manage risk and lower tax and transaction costs. They were never intended as gambler’s chits. The risks of binary options, CFDs purchased on margin, and highly leveraged forex trading are wholly unsuitable for all but the most sophisticated individual investors.

Existing laws governing customer suitability, registration requirements, false advertising, and contract fairness already prohibit much of the industry’s conduct, but they have not been adequately enforced across national boundaries. It is not enough for brokerages to simply be registered. There is an urgent need for coordinated international regulatory enforcement to protect the public. Jurisdiction shopping is common, and companies facing sanctions in one country sometimes simply move customer accounts to another.

 


Luck and Lakshmi 2

Disclosure: Long one Lakshmi coin.

My wife and I recently returned from a visit to India over the holidays. The trip capped a very eventful year for Cable Car and left me in a reflective mood, despite the tumultuous start to 2016 in the markets. Although experiencing a different culture is invariably educational and I had the small thrill of trading from airport lounges on several continents, this was leisure travel. Due to regulatory restrictions, Cable Car is not able to invest in domestic Indian equities, and there are only a few US-listed ADRs available. We elected to watch the popular Bollywood film Bajirao Mastani in theaters rather than meeting with its controversial distributor, Eros International (no position).

Ashtalakshmi

At the risk of relying on what Amartya Sen termed an “exoticist” lens to understand India, I thought I’d share a serendipitous anecdote from the trip not entirely unrelated to investing.

On our second day in Chennai, which has a long coastline on the Bay of Bengal, we asked an auto-rickshaw driver to take us to the beach. The route passed through Besant Negar, a neighborhood that suffered significant damage during last month’s flooding and which I’m pleased to report has rebounded strongly. Many of the street vendors displaced by the floods had returned, and there was a hubbub of rebuilding activity. We arrived at the southern tip of Elliot’s Beach, in front of a large temple we hadn’t planned on visiting.

We had come unexpectedly to the Ashtalakshmi Temple, which is dedicated to the eight incarnations of Lakshmi, goddess of prosperity. The temple is open to all and was uncrowded, so we wandered inside. As we worked our way up the stairs, we passed shrines for each of the eight incarnations, each representing a different form of prosperity in turn. The Dhanya Lakshmi represents the bounty of a good harvest; the Vijaya Lakshmi symbolizes success in the face of adversity; the Vidya Lakshmi stands for the wealth of knowledge. At the very top of the temple, with panoramic views of the Bay to the east, sits the Dhana Lakshmi, bringer of money and gold.

Lakshmi coin

Lakshmi coin from Ashtalakshmi Temple, Chennai

Hindu temples serve an important charitable function in the local community, collecting funds for the temple itself as well as alms for the poor. At each shrine, a priest sought a small donation, but the Dhana Lakshmi’s pandit was different. In keeping with Dhana Lakshmi’s association with money, he had a uniquely convincing pitch. In asking for the donation, the pandit stated that it was not to be viewed as a gift, but as an investment. What you give to the goddess, you shall receive many times over in return. I think the analogy to investing is quite apt. We gave generously, and soon found ourselves garlanded in flowers and given a small coin as a token of good fortune.

 

Fortune

I am not a particularly superstitious or religious person, but I am quite fond of ritual and spirituality. A more cynical type might not have enjoyed the experience, but from my perspective, a shrine on a beautiful beach in Tamil Nadu is as good an avatar of good fortune as any.

Visiting the Ashtalakshmi temple left me contemplating the role of luck in investing. As I look back over a very successful year for Cable Car, I am keenly aware of the importance of luck. 2015 felt at times like a constant parade of potential pitfalls—whole sectors moving suddenly out of favor, precipitous repricing of currencies and commodities, comedowns by investors others look up to—to have avoided some of the year’s worst outcomes was the just reward for healthy skepticism, but in other instances it was a mere case of (not) being in the right place at the right time. Investing provides constant reminders that there are many factors influencing each investment that cannot be hedged and are totally outside an investor’s control.

However, I am firmly of the belief that for investors, the saying “You make your own luck” is a truism. Not by donating to Hindu shrines, although perhaps that will help in some small way, but by creating a universe of attractive potential outcomes. We are fortunate in the investing business to be given the opportunity to specify our preferred probability distribution. The task of portfolio construction is the luxury of assembling a collection of only those investments where research suggests the odds are favorable. I approach investing by trying to minimize the consequences of mistakes and misfortune, while maximizing the likelihood of good luck.

Yet ultimately we cannot control outcomes, only the research process, and the best investors will retain their focus on research irrespective of the market’s gyrations. I’m not immune to Schadenfreude, but I do not enjoy seeing famous investors in the headlines for a tough year. There but for the grace of Lakshmi, perhaps, go I. It is far too soon to count out some of the boldface names who had a difficult go of it in 2015.

Often, I feel that the timing of returns is the most significant element of randomness. When taking the view that the market has mispriced a security, it is difficult to predict when and if that will change. We can try to influence market perceptions and corporate actions through activism, but there is an element of uncertainty to every investment. Returns are path dependent—the opportunity to redeploy capital from a positive outcome can be a powerful contributor to future performance. I consider myself fortunate both when the market agrees with my positioning and when volatility provides an opportunity to adjust exposures.

Just as it can feel like a stroke of luck to have avoided pitfalls in the marketplace, it can feel like a blessing to be able to obtain borrow on an obviously overvalued stock, or to be unable to obtain it on a stock that later squeezes higher. I have had occasions to be fortunate to be at my desk during breaking news, and fortunate to be away during moments when others have acted rashly.

Most of all, I feel fortunate to be entrusted by my clients with their capital in a role that I love. Whatever your personal Dhana Lakshmi, I wish you good fortune and many happy returns in the year ahead!


Yes, your capital is still at risk 5

Disclosure: Short PLUS. This content is not directed toward persons with residence or place of business in the United Kingdom. By accessing, transmitting, or reviewing this material, you acknowledge that the author has represented his honest opinion and made statements of fact believed to be true at the time of publication. No content herein should be construed as a recommendation to take action with respect to any security.

Playtech and Plus500 terminated their agreement today after FCA scrutiny. Cable Car’s questions remain unanswered.

I’m visiting with family for the Thanksgiving holiday this week so will offer only a brief comment on Plus500. There are ample grounds for the observance this year after a truly remarkable 2015.

The FCA raised confidential, unspecified objections to Playtech’s proposed acquisition of Plus500. I do not know whether it was Playtech’s shareholders’ personal histories, its gambling business, its acquisition of Epsilon Finance, its connections to unlicensed trading firms, Plus500′s unlicensed activities, its ongoing regulatory issues, its business conduct, or the characteristics of the business itself that led the FCA to block the transaction.

MiFID II

In any case, who is allowed to operate Plus500 in Europe may shortly become irrelevant. As made clear by Playtech’s attempted expansion into financial products, highly leveraged CFD speculation is a tacitly acknowledged form of gambling. CFDs are not suitable as an investment product for the vast majority of retail investors. Under MiFID II regulations expected to take effect in 2017, European brokerages will be required to attest that complex financial products, including CFDs, are “appropriate” for clients. Guidelines remain in flux, but much of Plus500′s product offering as currently constructed appears designed for its activities in “unregulated” jurisdictions. How much revenue does Plus500 currently generate in regions where it operates without a license?

UK clients seeking to open a Plus500 account today are directed to Plus500′s Cyprus subsidiary, and it is unclear if Plus500 will ever again be allowed to onboard new clients under its FCA approval. Despite the change in control objection, the FCA has not historically shown itself to be a terribly toothsome regulator. I do not expect dramatic fines and regulatory sanctions of Plus500′s conduct, although the outright withdrawal of the FCA license remains a plausible outcome. However, the scandal of passporting the Cyprus authorization remains.

Valuation

For the time being, I therefore assess Plus500 as a going concern. The company now proposes to repurchase shares and resume its dividend. Assuming completion of the full US$20 million buyback at today’s closing price of GBp 329, Plus500 would have approximately 110.9 million shares and GBp 45/share in cash. Added to this, the customer lifetime value approach described in Part 3 remains the only reasonable method of calculating the company’s franchise value.

I recently updated the cumulative new accounts chart to reflect customer additions and churn from Plus500′s Q2 and Q3 trading updates. In both quarters, despite additional customer acquisition costs, the number of newly inactive accounts increased more than the number of newly active accounts. The total number of inactive customer accounts reached further record highs.

Cumulative new accounts through Q3 2015

At 30 September, I estimate Plus500 had 103,146 “potentially active” accounts using the methodology described in Part 3, which will generate potential net income of no more than $83 million before churning, or GBp 50/share after buybacks under the assumptions described in the original report.

In other words, the market continues to place a significant premium on future customer acquisitions in 2017 and beyond, despite the major upcoming regulatory change in what is purportedly Plus500′s largest market. At current margins, the price is ~5x the value of the current customer base.

How much unsegregated cash does Plus500 actually have?

The company continues to have remarkably lax internal controls and financial reporting. Despite additional scrutiny of its financial statements, Plus500 has managed to reference three different cash balances (excluding customer funds) as of 30 June 2015. Does Plus500 properly segregate its customer funds? Which of the three mysteriously dwindling balances is correct?

  • “Net cash stood at $97.5m as at 30 June 2015″ (9 July Trading Update)
  • “Net cash stood at $95.5m as at 30 June 2015″ (27 August Interim Results)
  • “The amount of cash held at 30 June 2015, excluding client balances which are held is segregated accounts, was $95m” (23 November RNS)

The interim report put cash and equivalents at $95.533 million, so the third amount isn’t even a rounding error.

Unanswered questions

Finally, Plus500 still has yet to address the host of disclosure inconsistencies and misrepresentations documented in the original report and reiterated in Part 11. As I wrote there:

Notwithstanding PwC’s unqualified audit opinion, I question how the Board could possibly be comfortable with the 15 inconsistent disclosures identified in part 4, which have been forwarded to the FRC for review. Presumably, PwC did not also audit Geostrading, the mysterious Belize-based subsidiary the company has yet to acknowledge. Are the directors also comfortable with the historical operations of that entity? With respect to revenue generated from unlicensed jurisdictions, perhaps the Company could clarify how its purported European revenue in 2010-13 exceeded the gross revenue recorded at Plus500UK, the only licensed subsidiary at the time. Are any members of Plus500′s affiliate program related parties?

Failing to address material historical omissions and misstatements could perhaps be forgiven in the context of a pending acquisition and delisting.

Now that Plus500 intends to continue trading as a standalone public company, the Board of Directors and Nominated Adviser must meet their legal obligation to ensure that public disclosures accurately reflect the company’s true operations and financial position as soon as possible. I call on the company to respond directly to the outstanding questions raised in this series. Plus500 should immediately restate its disclosures and address its omissions regarding historical and ongoing unlicensed activity.


Final Public Comment on Cologuard 1

Disclosure: No position in EXAS.

This month’s draft recommendation by the United States Preventative Services Task Force on colorectal cancer screening was deeply validating. The task force highlighted the specificity reduction introduced by combining FIT with a diagnostic DNA assay, a point emphasized by many market participants and independent observers over the years. Cable Car submitted comments supporting the task force’s recommendation.

I will have more to say about the impact on Exact Sciences and Cable Car’s positioning in the forthcoming third quarter investor letter.

In the meantime, I had one more public comment to research and submit first. Cable Car’s final public comment on the reconsideration request, which was preliminarily denied in August, is now available. The comment is styled as a compromise and follows an enlightening conversation with the staff at CMS regarding their constraints.

Cable Car has advanced a new crosswalk proposal: 82274 (FIT) + 81275 (KRAS) + 81288 (MLH1 methylation). As a diagnostic assay that is explicitly excluded from reimbursement for screening purposes, KRAS still has no business in the crosswalk, in my opinion. However, it appears Exact Sciences is going to get away with its clever exploitation of policy, which makes it virtually impossible to argue on methodological grounds that a KRAS assay is not a KRAS assay. This is no different from the old abuses of “code stacking” and is one of the many shortcomings of the current process the new PAMA procedure will seek to address. 81288 is a far better comparator for the methylation assay than any previous proposal, but it was only recently priced through the gapfill process.

I am hopeful that at this point in the process CMS will still be able to give the compromise crosswalk its full consideration.

PDF iconRead the comment letter.


Fun with FOIA 1

Disclosure: Short WRLD.

I don’t often write about World Acceptance Corporation, a position that was the subject of a detailed report last year but has since become relatively difficult to borrow. With potential CFPB enforcement action expected within the next few months, the stock is discounting uncertainty around the scope, severity, and consequences of the Bureau’s oversight. It remains a modest position, and I anticipate that an eventual wind-down/dissolution of the business remains probable, with varying potential equity recovery depending on the nature of the enforcement action.

I have little to add on the exact nature of the CFPB’s theories of legal liability, although I have previously speculated that credit insurance, repeated refinancing, fee disclosures, and collection practices represent potential sources of concern. However, as an illustration of what is becoming an increasingly popular step in the investment process, I thought I would share a recent response from the CFPB regarding inquiries into that very question.

Under the Freedom of Information Act (FOIA), government agencies are required to provide a wide variety of information generated by their operations, subject to several limitations. In particular, there is an exemption allowing agencies to withhold records compiled for law enforcement purposes. Investors and analysts have cleverly used this exemption as a way to confirm the existence of undisclosed SEC investigations.

Cable Car submitted a FOIA request to the CFPB requesting copies of the NORA letter and response from WRLD. Under the law enforcement exemption, the agency must demonstrate that disclosing material would reasonably be expected to impair the enforcement process. Cable Car argued unsuccessfully that disclosing the CFPB’s theories of legal liability would not negatively impact an enforcement proceeding and sought redacted copies of the documents in the alternative. The latter request was unfortunately denied on the amusing basis that “release of any non-exempt information would produce only incomplete, fragmented, unintelligible sentences composed of isolated, meaningless words.” The semiotics of such a document might still be interesting, but I digress.

PDF iconRead the CFPB response to Cable Car’s FOIA request.

Even when a FOIA request is denied, the response can be illuminating. Over the past few weeks, there have been unfounded rumors floated in the marketplace that World’s CFPB review was nearing an imminent resolution without material consequences to the company. On the contrary, the CFPB’s response indicates that an enforcement action remains reasonably anticipated. The FOIA response stated:

“Premature disclosure of the Bureau’s theories of liability, as well as the recipient’s responses to those theories, could reasonably be expected to interfere with reasonably anticipated enforcement proceeding.”

Precedent enforcement proceedings have been initiated several months after a NORA response, so the rumor never made much sense to begin with. I believe a reasonably negative outcome for World Acceptance remains reasonably likely.


Healthcare Cost Inflation

Disclosure: Short EXAS.

CMS has preliminarily determined not to change the reimbursement rate for Cologuard.

Turing Pharmaceutical’s decision to dramatically increase the price of Daraprim in order to achieve investment returns and fund incremental research drew widespread condemnation this week. Turing became emblematic of wider biotechnology industry practices that collectively contribute to healthcare cost inflation. Optimal drug pricing is a more nuanced question than the immediate outrage suggests, but the systemic problem is not limited to pharmaceuticals.

Even government payors do not always feel empowered to consider cost-effectiveness when establishing reimbursement rates. Unlike the niche commercial toxoplasmosis market served by Daraprim, CRC screening is in large part a publicly financed benefit recommended for almost everybody over the age of 50. Americans are now being asked to pay more for non-invasive screening.

The transformation of Exact Sciences from a heavily promoted penny stock with a failed DNA-based CRC detection technology at the end of the last decade to the multi-billion dollar company of today was premised on what now appears to have been a remarkably foresighted decision:

The company took a decades-old screening test, licensed expensive diagnostic biomarkers not reimbursable for screening on their own, and then spent millions demonstrating that, predictably, administering diagnostic assays to screening populations catches a few incremental early-stage cancers at a very high cost with a large number of false positives.

They then successfully lobbied a government agency to increase the price for the combination by 23x over the predecessor test.

It seems that decision will stand.

Last night, CMS released its preliminary 2016 payment determinations. The rationale for new code 81528 was thin:

CMS Recommendation: Crosswalk to codes 81315 PLUS 81275 PLUS 82274.
Rationale: We believe that the 2015 pricing of code G0464 is the correct reimbursement rate, and this molecular pathology test is replacing that code. Commenters recommended other formulas. While we appreciate the comments that payment of this test should be based on various mathematical equations, it is our belief that the crosswalk to the current 3 codes best represent this test. The Clinical Laboratory Diagnostic Test Panel also agreed.

While there is another comment period before the rates are finalized later this year, there is very little else to say about how much the reimbursement rate exceeds both the unit cost of the test and the cost of gaining equivalent life-years through more efficient screening modalities.

I stand by Cable Car’s analysis and thank the staff at CMS for their consideration.


Reconsideration Update 10

Disclosure: Short EXAS

As promised in my previous post, you may now download Cable Car’s public comment in response to statements made at the Public Meeting in July. Comments are normally available only through a FOIA request, but in the interest of transparency I wanted to share my views more broadly. I believe Kevin Conroy made several statements at the Public Meeting that are not accurate and deserve a public accounting. The comment letter discusses the legal basis for the reconsideration request, claims regarding compliance and cost-effectiveness, and additional cost analyses. Exact Sciences shareholders can take comfort in the fact that the company has impressive operating leverage, irrespective of the Medicare payment rate. The incremental cost per test in recent months appears to be less than $100.

Following the preliminary determination on the reconsideration request expected sometime in September, there will be an additional 30-day comment period before the 2016 fee schedule is finalized.

CMS Panel

This morning, CMS convened the first meeting of an advisory panel on Clinical Laboratory Diagnostic Tests. Steve Phurrough, the CMS Medical Officer who asked Conroy several questions at the Public Meeting that are addressed in my letter, chairs the panel but is not a voting member.

The panel was established under the Protecting Access to Medicare Act (PAMA), which is also changing the rate-setting process for the clinical lab fee schedule beginning in 2017. Since the PAMA rulemaking is not yet complete, the purpose of this initial meeting was to provide input into the new codes for 2016 that were discussed at the Public Meeting in July. The panel’s recommendations are advisory and non-binding.

The bulk of today’s debate involved highly technical, controversial determinations regarding the most comparable tests, from a methodological standpoint, to use for several new test codes. Cost-effectiveness concerns were not mentioned at all.

Disappointingly, the panel’s brief discussion (starts at 1:26:30) of code G0464 resulted in an 11-0 vote, with 1 abstention (likely the representative from the Mayo clinic) from the 12 panel members present, in favor of maintaining the current crosswalk. More accurately, there was no discussion. The panel did not discuss their reasoning at all; the only comment was from one individual who questioned why code 81315 had no connection to colon cancer and such a high reimbursement level before voting to include it in the crosswalk anyway.

The panel members are all very well-respected scientific experts, but it does not appear that they devoted much, if any, deliberation to the substance of the reconsideration request. In particular, despite asking many clarifying questions regarding the most appropriate factors to consider for other tests, in the case of G0464 there was no debate whatsoever about the appropriateness of considering a test’s purpose, rather than its methodology, in assigning a crosswalk.

It is unclear whether or not the panel had the opportunity to review the reconsideration request in full or the further comment letter. As the panel’s recommendation is non-binding, I strongly urge CMS to take all available information into account in reaching its determination.