Niederhoffering the Investors

In economics, signaling is the idea that one party credibly conveys some information about itself to another party.  A good example of this is education.  If you have a degree for Harvard, it wouldn’t be beyond my imagination to presume that you have some semblance of intelligence (I could be wrong).  Signaling is a heuristic, a shortcut, a prejudice that is typically useful in life.

However, savvy operators understand that signaling can be gamed…I will quote the following story as told by Charlie Munger:

“There was a wonderful example of gaming a human system in the career of Victor Niederhoffer in the Economics Department of Harvard. Victor Niederhoffer was the son of a police lieutenant, and he needed to get A’s at Harvard. But he didn’t want to do any serious work at Harvard, because what he really liked doing was, one, playing world-class checkers; two, gambling in high-stakes card games, at which he was very good, all hours of the day and night; three, being the squash champion of the United States, which he was for years; and, four, being about as good a tennis player as a part-time tennis player could be.

This did not leave much time for getting A’s at Harvard so he went into the Economics Department. You’d think he would have chosen French poetry. But remember, this was a guy who could play championship checkers. He thought he was up to outsmarting the Harvard Economics Department. And he was. He noticed that the graduate students did most of the boring work that would otherwise go to the professors, and he noticed that because it was so hard to get to be a graduate student at Harvard, they were all very brilliant and organized and hard working, as well as much needed by grateful professors.

And therefore, by custom, and as would be predicted from the psychological force called reciprocity tendency, in a really advanced graduate course, the professors always gave an A. So Victor Niederhoffer signed up for nothing but the most advanced graduate courses in the Harvard Economics Department, and of course, he got A, after A, after A, after A, and was hardly ever near a class. And for a while, some people at Harvard may have thought it had a new prodigy on its hands. That’s a ridiculous story, but the scheme will work still. And Niederhoffer is famous: they call his style Niederhoffering the curriculum.”

Although Munger says this is reciprocity tendency, I think he means signaling because Niederhoffer was not a graduate assistant and therefore did nothing for the professors to receive the reciprocity from them.  Instead, the professors assumed that Niederhoffer was smart because he signed up for the hardest classes and therefore gave him an A based on that signal.

A public company example of signaling gone wrong is Insider Purchases.  There has been a significant amount of documented evidence that companies whose Insiders purchase shares will outperform.  Insiders have the most knowledge of the current situation and therefore when they put their own cash on the barrel to purchase shares of their companies in the open market (as opposed to options being exercised), investors should follow the Insiders.

However, given this historical evidence, Insiders can selectively game the system to restore confidence in their companies through deliberate and coordinated share purchases at times when confidence may be slipping away (i.e. accounting misstatements, insurance reserve increases, potential acquisition being called off, risky technology IP).

I can name 3 companies that have currently experienced the above-mentioned “issues” and whose executives have made coordinated share purchases (by coordinated, when 4-5 executives all purchase stock within 2 days of each other).

1. Barrett Business Services–Insurance Reserve Increase

2. American Realty Capital Partners/RCS Corp–Accounting Misstatements

3. Globalstar–Risky Technology IP

Numbers 2 and 3, I only follow from far away for pure entertainment value, but number 1, I have followed closely and it will be interesting to see if the executives are trying to Niederhoffer the investors or they truly believe in the long-term prospects of the company.

To illustrate a little math on why it makes sense for executives to attempt to Niederhoffer the investors, below are the compensation and stock ownership numbers for the CEO of Barrett Business Services:

1. Executive Compensation for 2013: $2.0m

2. Value of Unvested Stock and Restricted Stock Units: $4.8m

3. Current Stock Ownership: 82,000 shares @ $22 per share = $1.8m

Total: $8.6m

If the company is underserved to the point that it cannot fill the hole of the reserve charge (it has publicly acknowledged that the reserve charge is roughly $40m after tax) the company is essentially insolvent and total compensation and equity values for the CEO would be $0.

The CEO made an open market purchase  of 6,200 shares at $24.06 for a grand total of $149,215.

In other words, if the CEO is Niederhoffering the investors, he spent roughly $150k to keep his $8.6m in compensation safe.  In my book, that’s a fairly good investment.

Time will tell….





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