Aug

3

To my knowledge, there has NEVER before been a case (except in war or natural disaster) when a legitimate business has been destroyed so quickly — as what Knight Capital Group (KCG) experienced.

Every business takes risks. Every business can experience disasters. But in screening businesses, what are the idiosyncratic risks that can (permanently) destroy a legitimate enterprise in a time frame so short that long-term investors have almost their entire investment vaporized before they even bring in the morning paper? Does Mr. Market correctly value these low-probability risks? If one isn't Mr. Nassim Taleb, how does an investor calculate the probability of such an event (and still be a profitable long-term investor)? Are certain business more prone to (as the Discovery Channel TV show is called) "Destroyed in Seconds" ?

Here are some examples:

1. Single factory. In 2008, Imperial Sugar had their only mill explode and burn down. They had business interruption insurance, but never fully recovered and were eventually acquired by Louis Dreyfus corporation.

2. Concentrated Customer. Businesses that have more than 50% of revenues associated with a single customer can have a virtual firestorm. There are numerous examples of this, but the implosion is usually associated with a credit/liquidity event.


3. Concentrated Lender. Businesses that are dependent on a single source of funding (e.g. Bear Stearns) can implode when that liquidity disappears.

4. Supplier. Businesses are vulnerable to the "weakest link." If a supplier that makes a tiny, but critical, widget fails to deliver — it can bring an elephant to its knees. This is an insidious risk, since investors know about the largest customers, but they probably don't know about the tiny providers on the supply chain.

5. Fraud. Employee/Executive fraud and embezzlement can go on for years with only very subtle warning signs. Unless the CEO/CFO is involved, it's rare that the fraud is sufficiently large to bring down the entire company. And I'm sure there are dozens of others. What is the theme and lesson here? Interestingly, it's the same lesson for successful investors: Diversification reduces risk of disaster. Insurance reduces risk of disaster. Multiple sources of liquidity and reasonable leverage reduce risk of disaster. Reasoned human judgement reduces the risk of disaster. But in the case of Knight Capital (in which I am not an investor), I'm left scratching my head. How is it even possible that any business could burn through their entire balance sheet before the grownups pull the plug out of the wall outlet? The only answer is stupidity. And that they did blow up is bittersweet — because it means capitalism is working. (And if you are an investor in Interactive Brokers, you should probably hope that Mr. Peterffy is a bit smarter than that.)


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3 Comments so far

  1. Harry Balzer on August 3, 2012 1:55 pm

    Event driven programs create looping problems. The bid ask spread in a market is a nickel wide: penny the bid. When your program reanalyzes, if it doesn’t know the best bid is your’s, it loops to the offer.

    Knight’s error likely resided in the order management component of their software. When an order was submitted that missed, they received (or misinterpreted) no fill acknowledgement, then looped and resubmitted (again, no confirm or position increment).

    Most automated systems (especially at Interactivebrokers) take for granted the risk management systems of the broker. That’s a recipe for future disaster.

  2. steve on August 4, 2012 8:09 am

    Look at the companies that should have been transparent that fell into oblivion. Drexel Burnham Lambert. The fiefdom that was created by the very great man, Michael Milkin. I mean here is a man who was always the smartest in the room. Pride goeth before the fall.

    Lehman Brothers. Wow what a catastrophe this was this was similar to the LTCM group debacle that sought to undermine the whole financial system.

    Look at some of the names from the 80’s who disappeared from the face of the earth fro corruption and fraud. Ivan Boesky, Dan Dorfman

    In the end the most important latin phrase that every serious business person and trader should have tattoed ontheir bodies:

    Sic Transit Gloria Mundi. All fame is fleeting. or literally Thus passes the glory of the world.

  3. Craig on August 10, 2012 10:29 am

    I used to work for a financial web site that had some sort of relation with Knight. We weren’t allowed to report any negative news on the company.

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