Does Value Investing Lead to Fraud?

Jason Zweig’s latest article in the WSJ piqued my interest.  The subject du jour is J. Ezra Merkin, a name I first encountered during my recent study of the new edition of the absolute investment classic, Security Analysis, 6th ed.

Regular readers are aware of my recent interest in bonds (a topic I plan to discuss in an imminent post) and Merkin contributes a very good essay on distressed debt and junk bond investing. Thus, I share Zweig’s surprise that a professed Dodd-&-Grahamite could be caught up in the torrid Madoff scandal.  What could account for a value investor’s abrupt transformation from genius to fraud?

Zweig generously attributes Merkin’s fault to success and money going to his head which led to declining attention to detail.  He closes his article with some fortune-cookie investing sage:

“Of all the seductions that can lead a value investor to stray from the true path, perhaps the worst is simply making too much money.”

Honestly, what the hell is Zweig talking about? A value investor’s biggest danger is making too much money?!?  WTF.  Is Zweig implying that if value investors get too good, they may engage in unethical and possibly criminal behavior?

From my vantage point (which is very far away, thank goodness), the best I can say about Merkin is maybe he simply got lazy. Value investing is hard work. You have to read hundreds of pages of annual/quarterly reports, filings, conference calls, investor presentations, etc. for a given company.  Then you have to research its competitors and the industry. For the supposed professionals who manage money and need to impress their clients, you’ve got to do field research, the proverbial “scuttlebutt” made famous by Phil Fisher. Take it from me, this stuff can really hurt your head.

Merkins’ area of specialty, distressed debt, is even more taxing as you have to grasp the legal intricacies surrounding corporate structures and bankruptcy proceedings.  Then you’ve got to wrestle with various constituent committees, court appointees, management and an endless batallion of lawyers to arrive at a settlement.  It seems a long, arduous process suited primarily for hardcore masochists  (Hilary Rosenberg’s The Vulture Investors is a great introduction to this world).  Perhaps Merkin simply got tired of doing all this work and decided to just delegate to Madoff’s magic 12% money-making machine.

However, saying Merkin just got lazy is giving him the benefit of the doubt. The activities described in Zweig’s article sound a lot like fraud to me. You open a hedge fund with 2/20 fees and put all the money into Madoff? What is that, like a fund of a fund? Did Merkin tell investors his fees were simply an access charge to Madoff? If he didn’t, that sounds like fraud. I don’t know what Zweig is talking about with money going to Merkin’s head. And Merkin’s conduct on the various boards he served on, funneling those organizations’ funds into his partnership (and thus Madoff) while collecting his fees, strikes me as criminal.

Zweig also has his own curious transformation.  To compare the arrogant, almost pompous commentary that peppered the revised edition of Ben Graham’sThe Intelligent Investor to his very pedestrian advice found in his latest book, Your Money and Your Brain, I get the impression Zweig is a failed value investor. Maybe he decided to devote his time to other pursuits as value investing is a time-suck. His Intelligent Investor column in the WSJ is closer to Larry Swedroe than Warren Buffett. In fact, that statement is a disservice to Swedroe. Swedroe has given much more thought to asset allocation and diversification to go along with his efficient-market driven approach than anything I’ve read in Zweig’s recent, cookie-cutter ETF advice in his book or his weekly WSJ column.

However, his latest book, Your Money and Your Brain, is a must-read.  If he had simply stuck to the physiological aspects of behavioral economics instead of trying to weave in investment advice, it would have been near perfect. I will probably post a review in the upcoming weeks (ok, months).

And finally, I know I’ve written some negative remarks about Ben Graham’s writing style as found in The Intelligent Investor (maybe the absence of Dodd?) but the 6th edition of Security Analysis is absolutely must-have (which is stronger than must-read). If nothing else, the essays by Seth Klarman, Howard Marks and yes, J Ezra Merkin are worth the price of the book (discounted, of course — value always!). For any value investor interested in bonds, Security Analysis is absolutely essential.  The new edition also comes with a CD containing the unabridged 1940 text as the book is abridged to make room for the essays.

I don’t think I would have gotten the most out of this book if I had read it a few years ago so if you’re new to value investing, this wouldn’t be the first book I put on your list unless you already have extensive financial experience. But highly recommended for those who have progressed past beginning value investing.


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4 Responses to “Does Value Investing Lead to Fraud?”

  1. George Says:

    Great post! I’m glad you spotted Zweig’s article, because I totally missed it. I too get the impression from Zweig recently that he is dissapointed in value investing.

  2. Davy Bui Says:

    George, I’m glad I’m not the only one who noticed! Who knows, maybe he’s so rich, he figures it’s better use of his time to index everything and write articles.

    “I didn’t leave value investing. Value investing left me.” — Ronald Rea … err.. Jason Zweig

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