Look out for the new purple worm

By DAVID MOON, Moon Capital Management, LLC
February 15, 2009

In addition to being Vice-Chairman of Berkshire Hathaway, Charlie Munger is also Warren Buffet's partner and straight man for their annual stand-up comedy routine, otherwise known as the Berkshire Hathaway annual meeting. Munger once told a story of fishing with a friend who owned a fishing lure company.

Good investors are inquisitive. Munger wanted to know if fish really liked purple rubber worms. His friend replied 'Charlie, I don't sell those worms to fish.'

Maybe the fish like purple worms. Maybe not. What matters is if they sell.

Remember that.

The investment industry is notorious for creating purple worms, especially at times of high emotional anxiety. Now is clearly one of those times.

Look out for the purple rubber worms.

They will be disguised as special investments ' things that will protect you from the bad stuff, but let you make money if, by some miracle, the stock market ever goes up again.

Purple worms usually don't have actual track records, since they are typically new investments, created just for the current climate. They will, however, have some charts and projections that will tell you how the investment might react to different types of investment environments.

I first noticed the purple worm phenomenon in the 1980s when brokerage firms organized real estate limited partnerships designed to take advantage of accelerated depreciation allowances.

These investments had nothing to do with undervalued real estate. I realized that when, in a meeting with a salesman, I asked to see the schedule showing the amount of money the partnership planned to borrow and how the cash would be used.

'Don't worry about the numbers,' he assured me. 'Just look at the pictures.'

The pictures were pretty. These folks obviously had a color printer ' which was quite impressive in 1986.

My recollection, however, is that the particular investment didn't work out too well. Tax laws changed. The economics became relevant, as did the details that were printed somewhere in that thick document, behind the color photos.

Auction rate securities were purple worms. These instruments were supposed to almost act like money market funds, but pay interest rates like long-term bonds. These were financially-engineered products that appealed to investors at a time of low interest rates.

They were great investments, until something unexpected happened and people couldn't get their money out of them.

The same people that brought you things like auction rate securities, hedge funds of funds, non-understandable securitized loan pools, private limited partnerships and leveraged illiquid commodities pools are developing the next purple worms.

These worms will appeal to your emotions. They will have comforting names that connote safety, strength or security.

They will have documents with reams of fine print and pretty color pictures.

There are always color pictures.

They are probably also needlessly complicated and expensive.

Before sinking your money into the latest purple worm, however, don't quickly dismiss and old-fashion nightcrawlers. Sometimes simpler is better.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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