The Aleph Blog » Academic Finance

Archive for the ‘Academic Finance’ Category

A Bond Manager Thinks about the Equity Premium

Saturday, May 31st, 2014

One of the things that annoys me about the concept of the equity premium is that it is an academic creation that does not grasp the structures of the markets.  Send the academics to be bond and equity portfolio managers for a time, and maybe we would get a better theory than Modern Portfolio Theory [MPT].

Here is the first thing that is wrong with MPT — it doesn’t understand the bond market.  The best estimate of what bonds will return over time is the current yield less expected losses from defaults and optionality.  Hold a bond to its maturity, and the standard deviation of returns is low, over the full time horizon.

Thinking about bonds in the current environment, virtually nothing is earned with high-quality short-dated debt.  The yield curve is still relatively steep, as people expect the economy and lending to pick up.

Think for a moment. what is a longer asset, a corporate bond, or the stock of the same company?  The stock is the longer asset, because the cash flows of the business in question potentially stretch far longer than the maturity of the corporate debt, at least in most cases.

Also think, in a bad scenario, where insolvency is possible, who has the better claim: the equity or the unsecured debt?  The unsecured debt, of course.

Longer assets in general possess more risk and should carry higher yields to induce people to take those risks.  Inverted yield curves are exceptions.  Also in general, longer corporate bonds have higher spreads over Treasuries most of the time, than shorter corporate bonds.

The one significant advantage that equities have over corporate bonds is that of control.  Increases in earnings go to the stockholders.  Buyouts go to the stockholders.  Bondholders get paid off at best.

That said, in the losing scenario, bondholders get back 40% of par on average, while stockholders get little if anything.

I believe that the equity of a company needs to be priced to return more than the longest unsecured debt or preferred stock of the company.

Thus when I think about MPT, I think they are positing an asset-liability mismatch, comparing T-bills versus a long asset, common stocks.  The comparison should be broken down into several spreads:

  • T-bills vs T-notes/bonds of the longest maturity issued by companies like them.
  • Corporate bond yields minus Treasury yields at the same maturity.
  • The earnings yield of the stock minus the corporate bond yield.

This takes apart the seemingly simple MPT calculation, revealing the complexity within, helping to explain why beta doesn’t work.  It embeds an asset-liability mismatch.  Stocks are long term, T-bills are not.  There is no reason why their returns should be considered together, without a model of yield curve spreads, corporate spreads, and equity financing spreads.

That’s a sketch of the correct model, now who wants to try to build it out?

An Alternative to the Efficient Markets Hypothesis

Thursday, May 8th, 2014

I read an article today, The Fallibility of the Efficient Market Theory: A New Paradigm  Good article, made me look through a major article cited: An Institutional Theory of Momentum and Reversal.

The former article explains in basic terms what the authors have illustrated.  The latter article, provides all of the complex math.  I get 50%+ of  it, and I think it is right.  This explains value, momentum, and mean-reversion, the largest anomalies that trouble the Efficient Markets Hypothesis.

This article deserves more attention from quants and academics.  The only thing that troubles me about it is that they assume a normal distribution for security returns.

Have a read, and for those that can understand the math, if you disagree with it, let me know.

An Idea for When the Market is High

Tuesday, April 22nd, 2014

Last night I was at the Towson University International Markets Summit.  I’m grateful to the students for inviting me, as it is an honor.  During the presentation, I mentioned the book “Accounting for Value” by Stephen Penman.  I reviewed the book two years ago.  A great book, and one that should lead readers to modify their views on value investing.

But one aspect of the book was easy to implement, he cited his paper that you can read here, Returns to Buying Earnings and Book Value: Accounting for Growth and Risk.  Buy the stocks that are the cheapest as measured by the highest quintiles of book value to price, and trailing twelve month earnings per share to price.

I ran this analysis for all US-traded stocks with over $100 million of market capitalization.  Here are the results:

CompanyTickerIndustryCountryB/PE/P
Petrobras Argentina SA ADRPZE0606 – Oil & Gas – IntegratedArgentina

1.26

7.95

Pampa Energia S.A. (ADR)PAM1203 – Electric UtilitiesArgentina

0.83

11.41

OMV AG (ADR)OMVKY0609 – Oil & Gas OperationsAustria

1.13

11.33

Validus Holdings, Ltd.VR0709 – Insurance (Life)Bermuda

1

13.3

Everest Re Group LtdRE0715 – Insurance (Property & Casualty)Bermuda

0.88

15.35

Maiden Holdings, Ltd.MHLD0715 – Insurance (Property & Casualty)Bermuda

0.93

10.11

Montpelier Re Holdings Ltd.MRH0715 – Insurance (Property & Casualty)Bermuda

0.99

11.83

Axis Capital Holdings LimitedAXS0715 – Insurance (Property & Casualty)Bermuda

1.01

13.2

Platinum Underwriters HoldingsPTP0715 – Insurance (Property & Casualty)Bermuda

1.02

11.25

White Mountains Insurance GrouWTM0715 – Insurance (Property & Casualty)Bermuda

1.07

8.49

Aspen Insurance Holdings LimitAHL0715 – Insurance (Property & Casualty)Bermuda

1.12

9.61

Assured Guaranty Ltd.AGO0715 – Insurance (Property & Casualty)Bermuda

1.18

18.59

Partnerre LtdPRE0715 – Insurance (Property & Casualty)Bermuda

1.23

10.75

Argo Group International HoldiAGII0715 – Insurance (Property & Casualty)Bermuda

1.27

11.55

Endurance Specialty Holdings LENH0715 – Insurance (Property & Casualty)Bermuda

1.31

12.55

Gerdau SA (ADR)GGB0121 – Iron & SteelBrazil

1.32

6.84

Gafisa SA (ADR)GFA0215 – Construction ServicesBrazil

2.04

15.52

Petroleo Brasileiro PetrobrasPBR0606 – Oil & Gas – IntegratedBrazil

1.67

13.2

Telefonica Brasil SA (ADR)VIV0915 – Communications ServicesBrazil

0.85

7.58

Companhia de Saneamento BasicoSBS1209 – Water UtilitiesBrazil

0.89

8.57

Endeavour Silver CorpEXK0118 – Gold & SilverCanada

0.89

9.9

Teck Resources Ltd (USA)TCK0124 – Metal MiningCanada

1.33

6.84

TransGlobe Energy CorporationTGA0609 – Oil & Gas OperationsCanada

0.85

10.03

Granite Real Estate InvestmentGRP.U0933 – Real Estate OperationsCanada

0.87

7.53

Brookfield Office Properties IBPO0933 – Real Estate OperationsCanada

1.08

10.08

Boardwalk REIT (USA)BOWFF0933 – Real Estate OperationsCanada

1.14

11.54

Greenlight Capital Re, Ltd.GLRE0715 – Insurance (Property & Casualty)Cayman Islands

0.9

19.45

Sinopec Shanghai PetrochemicalSHI0103 – Chemical ManufacturingChina

1.52

11

Yongye International, IncYONG0103 – Chemical ManufacturingChina

1.65

43.36

China XD Plastics Co LtdCXDC0109 – Containters & PackagingChina

1.13

22.71

Lihua International IncLIWA0127 – Misc. Fabricated ProductsChina

2.31

41.21

Xinyuan Real Estate Co., Ltd.XIN0215 – Construction ServicesChina

5.22

42.83

China Automotive Systems, Inc.CAAS0415 – Auto & Truck PartsChina

0.99

11.04

China Petroleum & Chemical CorSNP0609 – Oil & Gas OperationsChina

0.87

10.11

Concord Medical Services HldgCCM0806 – Healthcare FacilitiesChina

3.06

12.45

China Telecom Corporation LimiCHA0915 – Communications ServicesChina

1.17

7.03

Xueda Education Group (ADR)XUE0969 – SchoolsChina

0.84

6.63

Changyou.Com Ltd (ADR)CYOU1018 – Computer ServicesChina

1.23

20.92

Nam Tai Electronics, Inc.NTE1024 – Electronic Instruments & ControlsChina

1.11

21.58

Jinpan International LimitedJST1024 – Electronic Instruments & ControlsChina

1.7

13.36

Semiconductor Manufacturing InSMI1033 – SemiconductorsChina

0.96

8.06

China Eastern Airlines Corp. LCEA1106 – AirlineChina

1.05

12.11

China Southern Airlines Co LtdZNH1106 – AirlineChina

1.7

13.19

Guangshen Railway Co. Ltd (ADRGSH1112 – RailroadsChina

1.34

6.64

Axa SA (ADR)AXAHY0709 – Insurance (Life)France

1.19

9.46

Volkswagen AG (ADR)VLKAY0412 – Auto & Truck ManufacturersGermany

0.94

9.73

Allianz SE (ADR)AZSEY0715 – Insurance (Property & Casualty)Germany

0.92

11.08

E.ON SE (ADR)EONGY1203 – Electric UtilitiesGermany

1.28

8.17

National Bank of Greece (ADR)NBG0727 – Regional BanksGreece

2

131.03

Capital Product Partners L.P.CPLP1118 – Water TransportationGreece

0.83

10.36

Safe Bulkers, Inc.SB1118 – Water TransportationGreece

0.83

11.99

StealthGas Inc.GASS1118 – Water TransportationGreece

1.32

9.08

Navios Maritime Holdings Inc.NM1118 – Water TransportationGreece

1.32

13.4

Sun Hung Kai Properties LimiteSUHJY0215 – Construction ServicesHong Kong

1.44

15.22

Hysan Development Company LimiHYSNY0215 – Construction ServicesHong Kong

1.66

20.18

Tai Cheung Holdings Ltd (ADR)TAICY0215 – Construction ServicesHong Kong

2.11

34.38

Le Gaga Holdings Ltd ADRGAGA0509 – CropsHong Kong

1.55

14.63

Bank of East Asia Ltd. (ADR),BKEAY0727 – Regional BanksHong Kong

0.85

8.78

Iao Kun Group Holding Co LtdIKGH0912 – Casinos & GamingHong Kong

1.36

12.89

Cheung Kong (Holdings) LimitedCHEUY0933 – Real Estate OperationsHong Kong

1.16

11.07

Seaspan CorporationSSW1118 – Water TransportationHong Kong

1.05

15.2

Magyar Telekom Tavkozlesi NyrtMYTAY0915 – Communications ServicesHungary

1.34

6.66

XL Group plcXL0715 – Insurance (Property & Casualty)Ireland

1.12

11.72

Fly Leasing Ltd(ADR)FLY0939 – Rental & LeasingIreland

1.3

17.39

Ellomay Capital Ltd.ELLO1033 – SemiconductorsIsrael

0.93

10.95

FUJIFILM Holdings Corp. (ADR)FUJIY0112 – Fabricated Plastic & RubberJapan

1.55

6.64

Kobe Steel, Ltd. (ADR)KBSTY0121 – Iron & SteelJapan

1.47

14.7

Mitsui & Co Ltd (ADR)MITSY0218 – Misc. Capital GoodsJapan

1.33

13.26

Wacoal Holdings Corporation (AWACLY0403 – Apparel/AccessoriesJapan

1.45

7.14

Toyota Motor Corp (ADR)TM0412 – Auto & Truck ManufacturersJapan

0.82

10.5

Honda Motor Co Ltd (ADR)HMC0412 – Auto & Truck ManufacturersJapan

0.92

7.61

Nissan Motor Co., Ltd. (ADR)NSANY0412 – Auto & Truck ManufacturersJapan

1.11

10.04

Nomura Holdings, Inc. (ADR)NMR0718 – Investment ServicesJapan

1.09

10.18

Mizuho Financial Group Inc. (AMFG0727 – Regional BanksJapan

1.13

14.9

Sumitomo Mitsui Financial Grp,SMFG0727 – Regional BanksJapan

1.28

16.67

Mitsubishi UFJ Financial GroupMTU0727 – Regional BanksJapan

1.53

13.67

Nippon Telegraph & Telephone CNTT0915 – Communications ServicesJapan

1.39

8.93

ORIX Corporation (ADR)IX0939 – Rental & LeasingJapan

0.98

7.59

Ternium S.A. (ADR)TX0121 – Iron & SteelLuxembourg

0.89

7.61

ING Groep NV (ADR)ING0709 – Insurance (Life)Netherlands

1.14

9.46

VimpelCom Ltd (ADR)VIP0915 – Communications ServicesNetherlands

0.93

13.67

ASM International NV (ADR)ASMI1033 – SemiconductorsNetherlands

1.01

74.95

Petroleum Geo-Services ASA (ADPGSVY0612 – Oil Well Services & EquipmentNorway

0.81

9.85

Banco Latinoamericano Comerc EBLX0727 – Regional BanksPanama

0.85

8.39

Compania de Minas BuenaventuraBVN0118 – Gold & SilverPeru

1.18

10.05

OFG BancorpOFG0727 – Regional BanksPuerto Rico

0.93

11.04

Popular IncBPOP0727 – Regional BanksPuerto Rico

1.52

19.77

Triple-S Management Corp.GTS0806 – Healthcare FacilitiesPuerto Rico

1.79

12.52

LUKOIL (ADR)LUKOY0606 – Oil & Gas – IntegratedRussian Federation

1.91

19.08

China Yuchai International LimCYD0218 – Misc. Capital GoodsSingapore

1.2

15.34

Net 1 UEPS Technologies IncUEPS0703 – Consumer Financial ServicesSouth Africa

0.91

6.79

POSCO (ADR)PKX0121 – Iron & SteelSouth Korea

1.72

6.97

Shinhan Financial Group Co., LSHG0727 – Regional BanksSouth Korea

1.24

8.42

Woori Finance Holdings Co., LtWF0727 – Regional BanksSouth Korea

1.91

9.86

SK Telecom Co., Ltd. (ADR)SKM0915 – Communications ServicesSouth Korea

0.89

11.87

Repsol SA (ADR)REPYY0606 – Oil & Gas – IntegratedSpain

1.06

7.93

Transocean LTDRIG0612 – Oil Well Services & EquipmentSwitzerland

1.14

9.54

ACE LimitedACE0715 – Insurance (Property & Casualty)Switzerland

0.84

10.92

Allied World Assurance Co HoldAWH0715 – Insurance (Property & Casualty)Switzerland

1

11.73

United Microelectronics Corp (UMC1033 – SemiconductorsTaiwan

1.3

8.02

Silicon Motion Technology CorpSIMO1033 – SemiconductorsTaiwan

1.96

19.74

BP plc (ADR)BP0606 – Oil & Gas – IntegratedUnited Kingdom

0.85

15.1

Noble Corporation PLCNE0612 – Oil Well Services & EquipmentUnited Kingdom

1.08

10.05

Subsea 7 SA (ADR)SUBCY0612 – Oil Well Services & EquipmentUnited Kingdom

1.09

7.02

ENSCO PLCESV0612 – Oil Well Services & EquipmentUnited Kingdom

1.11

12.2

Rowan Companies PLCRDC0612 – Oil Well Services & EquipmentUnited Kingdom

1.3

6.71

HSBC Holdings plc (ADR)HSBC0727 – Regional BanksUnited Kingdom

0.94

8.09

Vodafone Group Plc (ADR)VOD0915 – Communications ServicesUnited Kingdom

1.47

31.68

J Sainsbury plc (ADR)JSAIY0957 – Retail (Grocery)United Kingdom

0.96

10.57

Global Ship Lease, Inc.GSL1118 – Water TransportationUnited Kingdom

2.11

16.62

Cliffs Natural Resources IncCLF0124 – Metal MiningUnited States

1.87

12.76

M.D.C. Holdings, Inc.MDC0215 – Construction ServicesUnited States

0.91

23.28

M/I Homes IncMHO0215 – Construction ServicesUnited States

0.92

27.21

URS CorpURS0215 – Construction ServicesUnited States

1.16

7.02

Mestek, Inc.MCCK0218 – Misc. Capital GoodsUnited States

0.98

11.53

General Motors CompanyGM0412 – Auto & Truck ManufacturersUnited States

0.83

7.98

Rocky Brands IncRCKY0418 – FootwearUnited States

1.21

6.82

Johnson Outdoors Inc.JOUT0430 – Recreational ProductsUnited States

0.87

7.83

LeapFrog Enterprises, Inc.LF0430 – Recreational ProductsUnited States

0.89

17.58

Yasheng GroupHERB0509 – CropsUnited States

11.77

70.4

Seaboard CorporationSEB0515 – Food ProcessingUnited States

0.82

6.77

John B. Sanfilippo & Son, Inc.JBSS0515 – Food ProcessingUnited States

0.84

8.55

Omega Protein CorporationOME0515 – Food ProcessingUnited States

1.01

12.24

Ennis, Inc.EBF0518 – Office SuppliesUnited States

0.92

8.43

ACCO Brands CorporationACCO0518 – Office SuppliesUnited States

1.01

11.07

Universal CorpUVV0524 – TobaccoUnited States

0.93

10.8

Hess Corp.HES0609 – Oil & Gas OperationsUnited States

0.86

12.86

Approach Resources Inc.AREX0609 – Oil & Gas OperationsUnited States

0.93

9.48

Equal Energy Ltd. (USA)EQU0609 – Oil & Gas OperationsUnited States

0.96

9.38

Sandridge Mississippian TrustSDT0609 – Oil & Gas OperationsUnited States

1.49

63.59

PHI Inc.PHII0612 – Oil Well Services & EquipmentUnited States

0.85

8.96

Medallion Financial CorpTAXI0703 – Consumer Financial ServicesUnited States

0.94

9.13

CIT Group Inc.CIT0703 – Consumer Financial ServicesUnited States

0.96

7.26

Goldman Sachs Group IncGS0703 – Consumer Financial ServicesUnited States

0.97

10.16

Ellington Financial LLCEFC0703 – Consumer Financial ServicesUnited States

1.04

13.7

Walter Investment Management CWAC0703 – Consumer Financial ServicesUnited States

1.11

23.94

Chimera Investment CorporationCIM0703 – Consumer Financial ServicesUnited States

1.12

11.58

PHH CorporationPHH0703 – Consumer Financial ServicesUnited States

1.19

9.68

EZCORP IncEZPW0703 – Consumer Financial ServicesUnited States

1.58

7.55

WellPoint IncWLP0706 – Insurance (Accident & Health)United States

0.89

9.52

Employers Holdings, Inc.EIG0706 – Insurance (Accident & Health)United States

0.93

10.46

Reinsurance Group of America IRGA0706 – Insurance (Accident & Health)United States

1.08

7.49

American Equity Investment LifAEL0709 – Insurance (Life)United States

0.86

16.77

Protective Life Corp.PL0709 – Insurance (Life)United States

0.92

9.76

FBL Financial GroupFFG0709 – Insurance (Life)United States

0.96

9.73

Unum GroupUNM0709 – Insurance (Life)United States

0.98

9.55

Assurant, Inc.AIZ0709 – Insurance (Life)United States

1

9.67

Lincoln National CorporationLNC0709 – Insurance (Life)United States

1.07

9.76

Symetra Financial CorporationSYA0709 – Insurance (Life)United States

1.23

8.64

CNO Financial Group IncCNO0709 – Insurance (Life)United States

1.29

12.39

Imperial Holdings, Inc.IFT0709 – Insurance (Life)United States

1.38

37.03

National Western Life InsurancNWLI0709 – Insurance (Life)United States

1.63

10.85

Genworth Financial IncGNW0709 – Insurance (Life)United States

1.72

6.87

Fortegra Financial CorpFRF0712 – Insurance (Miscellaneous)United States

1.28

8.18

Allstate Corporation, TheALL0715 – Insurance (Property & Casualty)United States

0.82

8.75

HCC Insurance Holdings, Inc.HCC0715 – Insurance (Property & Casualty)United States

0.82

8.92

State Auto Financial CorpSTFC0715 – Insurance (Property & Casualty)United States

0.83

6.92

Stewart Information Services CSTC0715 – Insurance (Property & Casualty)United States

0.83

7.96

Safety Insurance Group, Inc.SAFT0715 – Insurance (Property & Casualty)United States

0.84

7.39

Investors Title CompanyITIC0715 – Insurance (Property & Casualty)United States

0.86

9.85

First American Financial CorpFAF0715 – Insurance (Property & Casualty)United States

0.87

6.75

American Financial Group IncAFG0715 – Insurance (Property & Casualty)United States

0.87

9.15

ProAssurance CorporationPRA0715 – Insurance (Property & Casualty)United States

0.87

10.86

Old Republic International CorORI0715 – Insurance (Property & Casualty)United States

0.88

10.53

Selective Insurance GroupSIGI0715 – Insurance (Property & Casualty)United States

0.9

8.51

Horace Mann Educators CorporatHMN0715 – Insurance (Property & Casualty)United States

0.91

9.6

Kemper CorpKMPR0715 – Insurance (Property & Casualty)United States

0.95

9.64

Baldwin & Lyons IncBWINB0715 – Insurance (Property & Casualty)United States

0.98

9.42

Hanover Insurance Group, Inc.,THG0715 – Insurance (Property & Casualty)United States

0.99

9.44

Alleghany CorporationY0715 – Insurance (Property & Casualty)United States

1.01

9.15

EMC Insurance Group Inc.EMCI0715 – Insurance (Property & Casualty)United States

1.02

9.88

United Fire Group, Inc.UFCS0715 – Insurance (Property & Casualty)United States

1.05

10.3

Navigators Group, Inc, TheNAVG0715 – Insurance (Property & Casualty)United States

1.09

7.68

Cna Financial CorpCNA0715 – Insurance (Property & Casualty)United States

1.1

8.15

American International Group IAIG0715 – Insurance (Property & Casualty)United States

1.34

12

American National Insurance CoANAT0715 – Insurance (Property & Casualty)United States

1.4

8.99

MBIA Inc.MBI0715 – Insurance (Property & Casualty)United States

1.45

10.86

FBR & CoFBRC0718 – Investment ServicesUnited States

1.03

29.21

KKR Financial Holdings LLCKFN0718 – Investment ServicesUnited States

1.05

11.24

NASDAQ OMX Group, Inc.NDAQ0718 – Investment ServicesUnited States

1.13

6.66

Piper Jaffray CompaniesPJC0718 – Investment ServicesUnited States

1.17

7.42

Primus Guaranty, Ltd.PRSG0718 – Investment ServicesUnited States

1.25

50.12

Arlington Asset Investment CorAI0718 – Investment ServicesUnited States

1.28

11.6

Oppenheimer Holdings Inc. (USAOPY0718 – Investment ServicesUnited States

1.34

6.71

CIFC CorpCIFC0718 – Investment ServicesUnited States

1.73

9.51

JPMorgan Chase & Co.JPM0724 – Money Center BanksUnited States

0.98

7.39

First National Bank AlaskaFBAK0727 – Regional BanksUnited States

0.81

6.61

Old National BancorpONB0727 – Regional BanksUnited States

0.81

7

Sandy Spring Bancorp Inc.SASR0727 – Regional BanksUnited States

0.81

7.28

TowneBankTOWN0727 – Regional BanksUnited States

0.81

7.52

Fidelity Southern CorporationLION0727 – Regional BanksUnited States

0.81

10.35

Central Pacific Financial CorpCPF0727 – Regional BanksUnited States

0.81

21.18

Cascade BancorpCACB0727 – Regional BanksUnited States

0.81

22.18

LCNB Corp.LCNB0727 – Regional BanksUnited States

0.82

6.69

S & T Bancorp IncSTBA0727 – Regional BanksUnited States

0.83

7.38

Great Southern Bancorp, Inc.GSBC0727 – Regional BanksUnited States

0.83

8.55

ESB Financial CorporationESBF0727 – Regional BanksUnited States

0.84

6.88

WesBanco, Inc.WSBC0727 – Regional BanksUnited States

0.84

7.15

Trustmark CorpTRMK0727 – Regional BanksUnited States

0.84

7.28

KeyCorpKEY0727 – Regional BanksUnited States

0.84

7.3

MidWestOne Financial Group, InMOFG0727 – Regional BanksUnited States

0.84

8.77

Bar Harbor BanksharesBHB0727 – Regional BanksUnited States

0.84

9.1

Seacoast Banking Corporation oSBCF0727 – Regional BanksUnited States

0.84

21.31

First Bancorp IncFNLC0727 – Regional BanksUnited States

0.85

7.39

Mercantile Bank Corp.MBWM0727 – Regional BanksUnited States

0.85

9.45

Heritage Financial Group IncHBOS0727 – Regional BanksUnited States

0.86

7.23

MainSource Financial Group IncMSFG0727 – Regional BanksUnited States

0.86

7.33

Norwood Financial CorporationNWFL0727 – Regional BanksUnited States

0.86

7.9

Fulton Financial CorpFULT0727 – Regional BanksUnited States

0.87

6.82

Pulaski Financial CorpPULB0727 – Regional BanksUnited States

0.88

6.85

Washington Federal Inc.WAFD0727 – Regional BanksUnited States

0.88

6.87

International Bancshares CorpIBOC0727 – Regional BanksUnited States

0.89

7.93

Lakeland Bancorp, Inc.LBAI0727 – Regional BanksUnited States

0.9

6.84

Northrim BanCorp, Inc.NRIM0727 – Regional BanksUnited States

0.9

7.67

BCB Bancorp, Inc.BCBP0727 – Regional BanksUnited States

0.9

7.91

ACNB CorporationACNB0727 – Regional BanksUnited States

0.9

8.14

Intermountain Community BancorIMCB0727 – Regional BanksUnited States

0.9

9.74

First Financial CorpTHFF0727 – Regional BanksUnited States

0.91

7.44

Farmers & Merchants Bancorp InFMAO0727 – Regional BanksUnited States

0.91

7.8

Southeastern Bank Financial CoSBFC0727 – Regional BanksUnited States

0.91

11.29

Isabella Bank CorpISBA0727 – Regional BanksUnited States

0.92

6.95

First Merchants CorporationFRME0727 – Regional BanksUnited States

0.93

6.76

Wintrust Financial CorpWTFC0727 – Regional BanksUnited States

0.93

7.12

First Citizens BancShares Inc.FCNCA0727 – Regional BanksUnited States

0.94

7.57

Firstbank CorporationFBMI0727 – Regional BanksUnited States

0.94

8.03

Century Bancorp, Inc.CNBKA0727 – Regional BanksUnited States

0.95

10.72

Central Valley Community BancoCVCY0727 – Regional BanksUnited States

0.96

6.62

PNC Financial Services Group IPNC0727 – Regional BanksUnited States

0.96

8.94

American National BankShares IAMNB0727 – Regional BanksUnited States

0.96

9.01

Capital One Financial Corp.COF0727 – Regional BanksUnited States

0.97

9.95

Provident Financial Services,PFS0727 – Regional BanksUnited States

0.99

6.92

NASB Financial, Inc.NASB0727 – Regional BanksUnited States

0.99

11

Flagstar Bancorp IncFBC0727 – Regional BanksUnited States

1.01

21.87

First Defiance FinancialFDEF0727 – Regional BanksUnited States

1.02

8.35

MidSouth Bancorp, Inc.MSL0727 – Regional BanksUnited States

1.03

6.96

C&F Financial CorpCFFI0727 – Regional BanksUnited States

1.04

13.4

First Community Bancshares IncFCBC0727 – Regional BanksUnited States

1.05

7.25

Provident Financial Holdings,PROV0727 – Regional BanksUnited States

1.05

8.78

Chemung Financial Corp.CHMG0727 – Regional BanksUnited States

1.06

6.7

Territorial Bancorp IncTBNK0727 – Regional BanksUnited States

1.08

7.23

Berkshire Hills Bancorp, Inc.BHLB0727 – Regional BanksUnited States

1.09

6.61

Regions Financial CorporationRF0727 – Regional BanksUnited States

1.09

7.73

Old Second Bancorp Inc.OSBC0727 – Regional BanksUnited States

1.1

113.32

Farmers Capital Bank CorpFFKT0727 – Regional BanksUnited States

1.14

7.7

Premier Financial Bancorp, IncPFBI0727 – Regional BanksUnited States

1.18

10.46

FIRST FINANCIAL NORTHWEST, INCFFNW0727 – Regional BanksUnited States

1.18

14.46

Intervest Bancshares CorpIBCA0727 – Regional BanksUnited States

1.19

8.37

MBT Financial Corp.MBTF0727 – Regional BanksUnited States

1.23

28.89

New Hampshire Thrift BancshareNHTB0727 – Regional BanksUnited States

1.26

7.66

MVB Financial CorpMVBF0727 – Regional BanksUnited States

1.29

10.03

Citigroup IncC0727 – Regional BanksUnited States

1.3

8.73

Susquehanna Bancshares IncSUSQ0727 – Regional BanksUnited States

1.31

8.42

QCR Holdings, Inc.QCRH0727 – Regional BanksUnited States

1.44

12.41

First Niagara Financial GroupFNFG0727 – Regional BanksUnited States

1.45

8.28

First Citizens Bancorporation,FCBN0727 – Regional BanksUnited States

1.5

9.95

Farmers & Merchants Bank (LongFMBL0909 – Business ServicesUnited States

0.98

8.05

Kelly Services, Inc.KELYA0909 – Business ServicesUnited States

1.02

7.21

Lakes Entertainment, Inc.LACO0912 – Casinos & GamingUnited States

1.01

14.29

Black Box CorporationBBOX0915 – Communications ServicesUnited States

1.38

7.36

Iridium Communications Inc.IRDM0915 – Communications ServicesUnited States

1.72

10.16

Courier CorporationCRRC0927 – Printing & PublishingUnited States

0.86

6.72

CSS Industries IncCSS0927 – Printing & PublishingUnited States

1.08

7.53

Blackstone Mortgage Trust IncBXMT0933 – Real Estate OperationsUnited States

0.87

145.18

New York Mortgage Trust IncNYMT0933 – Real Estate OperationsUnited States

0.88

14.44

PennyMac Mortgage Investment TPMT0933 – Real Estate OperationsUnited States

0.89

13.15

Starwood Property Trust, Inc.STWD0933 – Real Estate OperationsUnited States

0.94

7.84

Capstead Mortgage CorporationCMO0933 – Real Estate OperationsUnited States

0.99

7.31

Dynex Capital IncDX0933 – Real Estate OperationsUnited States

1.02

12.82

Two Harbors Investment CorpTWO0933 – Real Estate OperationsUnited States

1.04

16.24

American Capital Agency Corp.AGNC0933 – Real Estate OperationsUnited States

1.05

14.81

Apollo Commercial Real Est. FiARI0933 – Real Estate OperationsUnited States

1.09

7.4

MFA Financial, Inc.MFA0933 – Real Estate OperationsUnited States

1.09

9.89

Anworth Mortgage Asset CorporaANH0933 – Real Estate OperationsUnited States

1.1

9.07

Resource Capital Corp.RSO0933 – Real Estate OperationsUnited States

1.16

9.91

Rent-A-Center IncRCII0939 – Rental & LeasingUnited States

0.97

8.84

Willis Lease Finance CorporatiWLFC0939 – Rental & LeasingUnited States

1.31

9.51

Biglari Holdings IncBH0942 – RestaurantsUnited States

0.83

23.81

Rick’s Cabaret Int’l, IncRICK0942 – RestaurantsUnited States

0.92

8.66

PCM IncPCMI0948 – Retail (Catalog & Mail Order)United States

1.09

7.11

Trans World Entertainment CorpTWMC0963 – Retail (Specialty Non-Apparel)United States

1.68

7.37

TravelCenters of America LLCTA0963 – Retail (Specialty Non-Apparel)United States

1.76

7.55

Tech Data CorpTECD0966 – Retail (Technology)United States

0.87

7.43

hhgregg, Inc.HGG0966 – Retail (Technology)United States

1.32

6.67

Ingram Micro Inc.IM1015 – Computer PeripheralsUnited States

0.84

6.68

Key Tronic CorporationKTCC1015 – Computer PeripheralsUnited States

0.93

9.42

Xerox CorpXRX1018 – Computer ServicesUnited States

0.89

8.31

VOXX International CorpVOXX1024 – Electronic Instruments & ControlsUnited States

1.57

10.96

OmniVision Technologies, Inc.OVTI1033 – SemiconductorsUnited States

0.91

8.46

Benchmark Electronics, Inc.BHE1033 – SemiconductorsUnited States

1

9

JetBlue Airways CorporationJBLU1106 – AirlineUnited States

0.85

6.84

Republic Airways Holdings Inc.RJET1106 – AirlineUnited States

1.42

12.1

SkyWest, Inc.SKYW1106 – AirlineUnited States

2.19

8.93

Atlas Air Worldwide Holdings,AAWW1109 – Misc. TransportationUnited States

1.49

10.44

International Shipholding CorpISH1118 – Water TransportationUnited States

1.67

7.41

Gas Natural IncEGAS1206 – Natural Gas UtilitiesUnited States

0.89

6.75

What are my surprises here?

  • My but there are a lot of foreign companies in this list, far more as a percentage than the 3575 total companies I started with.  It seems that foreign companies are cheap.
  • Now, that said, accounting standards are tighter in the US than elsewhere, and particularly, be careful on Chinese companies.  Many of them are scams.
  • There are a lot of financial companies listed.  I would note that earnings quality for financial companies is often poor, so don’t go “hog wild” buying financial companies.

All that said, this could be a good list for starting due diligence, and I will use at least some of this in my next selection of companies for my clients.

What’s that, you say?  Do I and my clients own any of these firms?  Yes we do.  Of the 38 stocks in my portfolio, 11 of them pass this screen, and here is the summary:

Full Disclosure: Long ENH, SNP, GTS, LUKOY, BP, ESV, RGA, AIZ, NWLI, IM, XRX

On Approximate Valuation Methods

Thursday, April 17th, 2014

The growth of corporations is always constrained by something.  The trick is figuring out what the “something” is.  Tonight, I am here to simplify it for you.

Financial businesses that are regulated

We value these via book value or tangible book value.  Capital levels constrain business growth, so look at the return on equity to help modify what the proper valuation level should be.  Book value and return on equity are what govern.

Non-financial businesses that are regulated, such as utilities 

Look to the rate base that the regulators use.  Book value might be a good substitute, but look to see how companies might invest to increase their “rate base.”  Market Cap as a ratio to what the regulators allow profits on would be ideal.

Unregulated businesses that are mature

These are governed by sales per share, calculating the price-to-sales ratio.  In general, it is wise to buy these when the P/S ratios are low, and sell them when they are high.

Unregulated businesses that are not mature

This is the complex part of valuation, but in this case the PEG Ratio makes sense.  Companies that grow their earnings rapidly can justify high P/E multiples, but in general they need to grow earnings more rapidly than their P/E ratio expressed in percentage terms.

I don’t invest in many immature businesses, so this is not so relevant to me.  I look for places where businesses are neglected, and I buy, while selling businesses that are more then fully valued.

Summary

Think about compounding.   Ask what will best compound the growth of your capital.  I suspect that it will resemble what I have written here.  Focus on compounding and ignore Modern Portfolio Theory.  Compounding is real business.  MPT is fakery from men who could not build a business.

I’m Not in This for Love

Friday, April 11th, 2014

Much as I appreciate those who like what I write at this blog, I don’t write to be loved.  I don’t write to be hated, either.  I am sensitive to what people think of me, but not to the degree that it changes what I write.

I may have nonconsensus views on:

  • The Federal Reserve
  • Gold
  • Social Security & Medicare (and their cousins around the globe)
  • The current Bull Market in Stocks and Corporate Bonds
  • Long Treasuries
  • and more…..

But I write what I write to disclose the truth.  I am an active equity manager, but I encourage people to use passive investing via index funds, unless they can find a manager who can reliably obtain outperformance.

I don’t blog for economic advantage.  If I wanted to do that, I could channel a wide variety of ideas on investing that are popular, but I know are marginal at best in terms of effectiveness.

Some friends of mine have told me, “Why don’t you write about companies that you own, or companies that look attractive to you?”

I’ve been burned by doing that.  For every ten that you get right, you get the same response from every one you get wrong.  As with most of the web, the complainers dominate.  That’s why I don’t trot out many individual stock ideas.  It’s not that I don’t have them, but I only share them as a group, not as a single idea, most of the time.

Summary

I’m here to tell the truth, even if it cuts against my own short-term economic interests.  Most of the time, I adjust my portfolio so that it is ready for everything, but sometimes I delay, because I know that changes in the market usually happen slowly.

I do not write to be popular.  I write to change the consensus, unlikely as that will be.  Finance is a perverse area of life where fear and greed take over.  And with academics, they have these lame models that are fit for Vulcans (maybe) but not humans (and certainly not Ferengi).

We need new models that reflect the fear-greed cycle, and make valuation a significant input in risk assessments.

I’m not in this for love; I only want to change the way that we view investment decisions.

On Fat Tails

Wednesday, October 30th, 2013

I’m reading an investment book that is arguing for market timing.  I’m not impressed with the line of argumentation so far.  I just finished a chapter where the authors pointed out that security price movements are more volatile that the normal distribution would admit.

This is a well known result, or at least it should be well-known.  What I hope to contribute to the discussion is why the tails are fat, and skewed negatively.  There is a famous saying in investments:

Cut your losses, and let your winners run

I regard this saying as vapid, because I have had so many investments where the price action was bad initially, but ended up being incredible investments.  I have also had companies stumble after prior gains, and persevere for greater gains.  Intelligent asset management does not react to the past, but analyzes future prospects, and looks at current margin of safety.

But imagine a situation where many parties have their plans, and they are all similar.  I’ll give a few examples:

  • Institutional investors decide in 1986 to follow the momentum, but be ready to sell if the momentum breaks.  They want upside, but want to protect the downside.
  • Japan was a total momentum market up through 1989, and the reverse thereafter.  Loose monetary policy was an aspect of that, as was a loss of fear, warrant speculation, etc.
  • Those investing in hot emerging markets in the mid-90s did not recognize valuations getting stretched, and the inability of the countries to maintain stimulative policies amid falling currencies.
  • The guys at LTCM were geniuses until they weren’t.  They had no idea of the risks they were taking.  They did not have an ecological view of investing.  Essentially, they thought liquidity was free, until the jaws of the trap snapped shut, and they died.  Taking a concentrated position is a risk, because the investing typically pushes up the price.  When you are so big in a position that you are affecting the market price, that is a bad place to be for two reasons: 1) if you sell, you drive down the price for future sales, and 2) you no longer know what the fair price would be if you weren’t there.
  • Aside from that with LTCM, their brokers mimicked their trades, accentuating the boom-bust, but the brokers had risk control desks that forced them to sell out losing trades, which further hurt LTCM.
  • Think about residential mortgage bonds in 1994.  So many players thought that they had mastered the modeling of prepayment risk only to find amid a Fed tightening cycle that many wanted to limit their interest rate risk as rates skyrocketed, fueling a self-reinforcing panic.
  • Consider tech stocks 1998-2000.  Momentum ran until the sheer weight of valuations, together with insolvencies, crushed the market as a whole, and tech stocks more.  Think of European financial institutions getting forced by regulators to kick out US stocks in September 2002, putting in the bottom.  Regulators almost always act too late, and exacerbate crises, but they should do that, because worse things would happen if they didn’t.  (Later = bigger crisis, Earlier = Some Type II errors, regulating where it was not needed).
  • Finally, consider the housing/banking crisis in the US 2005-2009.  People bought homes with a lot of debt financing, and short-dated debt financing.  Banks levered up to provide the financing.  Shallow credit analysis allowed banks to take on far more risk than they imagined.  It all ended in a trail of tears, with many personal, and not enough corporate bankruptcies, with the taxpayers footing the bill.

In each of these cases, you have correlated human behavior.  The greed of investors gives way to fear.

Now if you are thinking about Modern Portfolio Theory, where market players have perfect knowledge, this doesn’t make sense.  These crises should not happen.  But they happen all too regularly, and I will explain why.

Men are not greedy as much as they are envious.  This leads to mimicking behavior when things are going well.  Those not currently playing want a piece of the action, and so they imitate.

Modern Portfolio Theory implicitly assumes that market players don’t react to the actions of other market players, but that is false.  Most market players don’t think; they mimic.

That is what leads to fat tails, because when people move as a herd, you get dramatic price moves.  Because fear is a greater motivator than envy, that is why the big downward moves are almost always greater than the big upward moves.

Add into that the credit cycle, because gains on credit-sensitive bonds are small, but losses are huge when they occur.  The distribution of outcomes has a long left tail.

The main point here is that price movements are non-normal because market players act as a group.  Their behavior is correlated  on the downside, and to a lesser extent on the upside.

Among other things, this means Modern Portfolio Theory is wrong, and needs to be severely modified, or abandoned.  It also means that we need to watch the credit cycle, and speculative activity to get a sense of how committed the hot money is to risk assets.  Hot money follows trends.  Cold money estimates likely returns over a market cycle, and invests in the best ideas when they are out of favor.

I don’t think timing the market is easy.  I do think that fundamental investors have to look at whether they have a lot of opportunities, or few, and vary their safe assets opposite to opportunities.

So beware the fat tails — we haven’t had a lot of volatility recently.  Maybe we are due.

Traveling with David

Friday, October 25th, 2013

Sometimes I over-commit my time.  That’s been the last few days.  Recently I went to visit a friend who had lost his job at a large company, to look over his severance papers, and advise him.  He is older, a “minority,” and only been with the firm 5-6 years.

Severance agreements have gotten a lot tighter since the two that I have personally experienced.  Corporations dangle some compensation to eliminate possible future legal costs.  I pointed out to my friend the most likely reasons he might sue, but added two things:

  • The company has a large number of sharp lawyers, so you had better have an open-and-shut case.
  • We’re Christians, so we don’t go to court over small matters.

But what impressed me in reading the agreement was how airtight it was — can’t sue over Federal, State, Local, or common law offenses, or anything else.  Which made me think about another thing… the connection between entrance and exit doors.

In investing, people are more wiling to invest if they can have their money back at any time.  With employment, it is the same — employers are more willing to employ if they can fire people for any reason.

Every protection for those employed makes it harder for those without work to be employed.  This also forces jobs to go underground — if advertising them publicly subjects them to regulation, then the good jobs will be filled via “word-of-mouth.”

This takes me back to the early days of the Reagan Administration.  They deregulated a lot of things, and the economy grew far more rapidly.  We could do the same now, starting with labor and healthcare.

My friend may do fine, but the things that “protected” him at his last job now hinder him in seeking another job.  Better to eliminate the protections, and let people compete based on skill and assiduousness.

Part Two

Then I was a judge in a financial analysis competition at a local college.  The analysis involved a stock that faced a large investment decision, larger than the current enterprise value of the junk-rated company.  Should the hedge fund buy, sell short, or do nothing with the stock?  The simple part of the case study was working through the intricacies of the discounted cash flow model, together with changes to the assumptions about cash flows and the weighted average cost of capital.

What I found interesting was the lack of attention to:

  • Details of the case study — did you even read it?
  • Common sense — we are sorry, but a stock can’t lose 113%.  Perhaps you would like to tell us to short the bonds?
  • Limitations of complex techniques in finance.  Yes, there’s many nifty formulas available to you, but do you understand what they really mean, and what limitations they imply?  When are they not valid?
  • What markets can and can’t do.  No, you can’t do an public issuance of junk debt at the level of current debt.  You can’t do an issuance longer than ten years.  You can’t do one that is really big without changing market pricing (and the answers from the case study had this wrong as well).  Same applies to large secondary IPOs for equity.

Now, I know these are students.  They can’t know what an experienced market professional does.  To their credit, they dug up many bits of useful data that the case study did not contemplate.  But the case study itself should have noted these things, and to that degree I fault Darden for writing up a subpar case study.

The main thing I would say again to the students is to ignore the academic models with their false certainty, and try to understand the qualitative aspects of the business, out of which the quantitative modeling will grow.

When we were done, each of the judges gave comments to the students.  I started off with, “Sorry for being such a hard-nose.”  I got a decent laugh from the students, and then explained to them what I have said to you.

Part Three

That evening I went to a talk by CareFirst on the PPACA/Obamacare.  It was a genuinely useful 20-minute presentation, with one annoying thing: all of the pictures in the slide deck were of healthy smiling people.  If you are healthy, you will pay more, unless you are really poor.  A realistic presentation would have had people that are stoic, sad, or crying, if they are healthy and not poor.

The best part of what CareFirst gave me was premium rates for PPACA.  The lowest level plan would increase my premiums by 50%, and would increase the areas in which I would have to pay.  More expensive in every way.

It is only an affordable care act to those who were previously uninsurable; to those who were insurable it is a tax on your health and income.  In 2016, we will rip it out by its roots, and have people pay for healthcare directly, with no tax deduction for employer-provided healthcare.  That will reduce healthcare spending, and shrink healthcare to a more reasonable part of the economy.

If you want healthcare to be affordable, get the government out of it in entire.

Part Four

Dr. Kathryn Crecelius spoke to the Baltimore CFA Society on Thursday.  She is the Chief Investment Officer of my alma mater, The Johns Hopkins University.  She talked to us about endowment investing.  Very common sense stuff, very well said, and much like you would hear from me.  I found myself nodding through the whole talk.  It was all very much like my last piece on endowment investing.  I learned a lot, which makes me happy, because I always like to learn.

My travels are done for a while.  I like that too, because being home is a happy place.

 

A New Look at Endowment Investing

Saturday, October 5th, 2013

I’ve written at least two significant pieces on endowment investing:

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.  This was partially in response to Matthew Klein’s excellent article, Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.  If you are interested, it is worth a read.  The remainder of this piece expresses ways that I think their views could be sharpened.  Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.  The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.  I like 10 years, but that might be too long for many.   As I said in Managing Illiquid Assets:

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

I include all risk assets in illiquid assets here.  The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.  There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.  They are just limited partnerships that invest.  Look through the LPs to the actual investments.  It is those actual investments that will drive value, not the form in which they are held.  Get as granular as you can.  Ask: what is the margin of safety in these endeavors?  What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.  Correlation coefficients on returns are not generally stable.  Do not assume any correlation benefits from risky investments.  Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.  Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.  The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.  As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.  Unless you are the first on the scene, themes are expensive.  Rather, look at margin of safety.  Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.  Look at he likely internal rate of return on all of your investments, and the worst case scenario.  Buy cheap assets with a margin of safety, and don’t look further than that.  Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.  I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

Advice to Two Readers

Saturday, August 3rd, 2013

I get a lot of requests for advice.  Here are two of them.

David,

 I really appreciate you discussing your trading/haggling strategies in the Education of a Corporate Bond Manager.  It’s definitely given me new ideas and helped me get better pricing in my purchases the last couple of years.  I still refer to them every few months or so.

I have a question about changing jobs in the fixed income industry – I work in a treasury division, managing my company’s cash and short-term investments.  I’ve done well, but we use yield-based benchmarks, as part of the portfolio is used to immunize short term liabilities.  When I interview with asset management shops, they want previous total return portfolio management experience.    

Do you know any particular types of firms or sub-industries that use yield-based benchmarks?  Does managing to a yield benchmark stunt my learning growth compared to a total return mandate?

 

Yield-based benchmarks exist when:

  • The liability structure being invested against is short (We could need this cash at any moment for business use!)
  • The liability structure is long, but well-defined, such as a bank or insurer that wants predictable income versus their liabilities, and so the game becomes maximize spread net of default costs, subject to matching asset and liability durations (and maybe partial durations if the liability stream is long).

You are doing the first of these.  Truth, what you are doing could be measured on a total return basis, but it wouldn’t make a lot of difference.

The second one applies to banks and insurers, and can be done on either basis as well.  The difficulty comes with trying to calculate the total return of the liabilities.   If that it too hard to do, they create a bond benchmark that they think represents when they think the liabilities may pay out.  If the liabilities possess some degree of optionality, like that of residential mortgage prepayment, the benchmark could include bond options (long or short).

The yield on the bond benchmark is easy to calculate, as is the total return.   Thus relative performance can be calculated either way.  I had to do this for an insurance client once who insisted that our performance was poor when we had returned more than 0.70% year more than single-A corporate, which was quite good.

Thus, one place you could try working is for is an insurer, bank, or other financial intermediary.  But what of those that manage funds for retail.  What then?

Aside from unconstrained funds, even a mutual fund has a liability to invest against – the expectations of the client.  In that sense, most mutual fund managers aren’t doing full total return either – they have to stay within a certain range for interest rate sensitivity. They also could be evaluated on the basis of yield realized versus that of a generic portfolio meeting their interest rate sensitivity targets.  More commonly, they would be ranked against their competitors on a total return basis.

In closing, it you don’t want to manage money for a bank or insurer, you’ll have to try to wedge your way into work in a total return environment – taking a junior level position, and showing competence.  Believe me, most firms would love to promote from inside, if possible.

Sincerely,

David

Dear Mr. David Merkel,

I really appreciate your hard work you are putting in your site and I am an avid reader of it. I would like to seek your advice regarding a decision I am facing. My goal is become a value investor and establish my own asset management firm to manage my own money and other people’s money. Right now, I have the opportunity to pursue partnership in my family business and be able to run it along with my father. I am 23 years old, and I am a freshman student at the _+_+_+_+_.  If I am to be a partner in my family business, I have to drop out from the university and travel to +_+_+_+_+_+_+_, where the business is. I am still a freshman student because when I was 19 years old, I dropped out to establish my own business in the same industry as my family in +_+_+_+_+_. I had an experience running a business and I had the opportunity to sell my business after two years of operation to my cousins, and, thankfully, it was a profitable venture.

My family business is somehow facing sales shrinkage and cash flow problem due to low capital (my family made terrible mistakes in managing it) and economic downturn. They are specialty contractors and manufacturers of fenestration products (windows, doors, kitchens, curtain walls, and rolling shutters). If I am to work with them, I can be able to help them in reorganizing the company. It might be risky for me, but if everything worked out well enough, I will have earnings that I believe is better than being an employee.

I am facing a decision that I need to make. You might not be able to advice me, but whatever advice you give me, I appreciate it. If my goal is to manage my own money and other people’s money by establishing my own asset management firm, is it helpful to have a university degree or the experience of having ran a business? Shall I drop out and pursue my family business opportunity? If I am to continue studying, I will incur student loan debt which I won’t prefer. But, alas, I will do it if it need be to accomplish my goal. Thank you a lot.

You have my sympathies on two fronts:

1) Choosing between family obligations and personal goals is never easy.  I have had to face that in deciding what jobs I could take while raising my family.  I was recruited for a managing director position in an investment bank in the mid-90s, but passed it up because I could not peel away that much time from my family and church.  It took a lot of time for me to become an institutional investor as a result.  I became an investment actuary at the age of 31, started working in an investment department at age 37, started work at a hedge fund at age 42, and started my own firm at age 49.  By 49, I had more than enough assets to care for my family if my business failed, at least to put the kids through college.   After that, I could be stretched.

2) Good operational businessmen can be very good investors.  There are synergies between the ability to operate a business, and the ability to make good investment decisions.  Don’t think that building another business is a waste of your time.  It will sharpen you in ways that most institutional investors never grasp.  I benefited a great deal from building profitable business within insurance companies, and it sharpened my knowledge on how to invest.

Now, all that said, if you take time out to rebuild your family’s business, don’t neglect your education.  Read good books on value investing, and study those who have been great.  I’m not saying that college is useless, but I am saying that much of the knowledge that academics teach on economics is deficient.  In some ways, it is better to be a clever businessman than an academically trained man.  The latter will not gain much insight into how to invest.  The businessman has a better chance.

Perhaps a good compromise would be to study for the CFA credential in your spare time.  I did that.  Along with that, invest some of your money in ideas that you think are worthy.  I did that from 1992-2003, before I began investing in stocks professionally, and I did very well.

You need to find out whether you have significant insights versus the rest of the markets.  Academic learning will not help that.  Operational business experience *might* help that.

Don’t give up your goal of managing your own value investing firm, but realize that there are many paths to getting there, and the most important thing is trying to develop insight into the markets that others don’t have.  Typically, academic study does not develop that.

I hope things work out for you.  Let me know how you do.

Sincerely,

David

On Stock Splits

Saturday, May 25th, 2013

Mark Hulbert had a recent piece in the Wall Street Journal called How to Use Stock Splits to Build a Winning Portfolio.  I find it curious, because 31 years ago I wrote my Master’s Thesis called, “Predicting Stock Splits: An Exercise in Market Efficiency.”  As far as I know, aside from the unbound copy sitting next to me, the only other copy is in some obscure part of the Johns Hopkins Library System.  If a number of people are really curious about this, I could try OCR and see if that would adequately read the typewritten text.

But anyway, I find it amusing that some are still trying to use stock splits to try to make money.  Quoting from Hulbert’s piece:

But try telling that to Neil Macneale, editor of an investment-advisory service called “2 for 1,” whose model portfolio contains only those stocks that have recently split their shares, holding them for 30 months. Over the past decade, according to the Hulbert Financial Digest, that portfolio has produced a 14% annualized return, far outpacing the 8% gain of the Standard & Poor’s 500-stock index, including dividends.

Mr. Macneale’s track record isn’t a fluke. Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company’s announcement of that split. Indeed, Mr. Macneale said in an interview, he got the idea for his advisory service in the 1990s from one of the first such studies, conducted by David Ikenberry, now dean of the Leeds School of Business at the University of Colorado, Boulder.

Research on stock splits goes back to the ’30s.  In the ’50s & ’60s before MPT got into full swing, a few researchers began trying analyze why there were abnormal rises in stock prices two months before a stock split.  Could it be that other factors affecting future value were somehow associated with stock splits?  Many factors pointed toward that, notably prior price increases, prior earnings increases, and increases in the dividend associated with the stock split.  Little did they know that they were anticipating momentum investing.

The consensus by the end of the ’70s was that there was no excess return after the stock split announcement, and few ways if any to capture the pre-announcement excess returns.  If in the present stock splits are providing excess returns for 2.5 years afterward, well, this is something new.

One of the leading stock-split theories—supported by the work of professors Alon Kalay of Columbia University and Mathias Kronlund of the University of Illinois, Urbana-Champaign—is that companies implicitly have a target range for where they would like their shares to trade.

If a firm’s shares are trading well above that range, and management believes that this high price is more than temporary, it is likely to initiate a split in order to bring its share price back to within that range.

This isn’t a new theory — it goes back to the ’50s, if not earlier.  One of the oldest theories was that it improved liquidity, but back in a time of fixed tick sizes, where everything traded in eighths, and higher commissions, that made little sense to a number of economists.  Splits made trading costs rise in aggregate for the same amount of dollar volume traded.

In the present though, there are many venues for execution of trades, commissions are much smaller, and negotiable.  Perhaps today more shares at lower prices does add liquidity, and the way to test might compare the bid-ask spread and sizes pre- and post-split.

The professors late last year completed a study of all U.S. stocks that split their shares by a factor of at least 1.25-to-1 between January 1988 and December 2007. They say the evidence their study uncovered suggests that splits are an “indication of sustained strong earnings going forward.” It therefore shouldn’t be a big surprise that split stocks outperform other high-price stocks that don’t undertake a split.

What this might mean is that stocks that split are examples of price and/or earnings momentum.  A management team splits the stock as a signal that corporate profit growth has been good, and will continue to be so.  If not, the management team runs the risk that if the stock price falls, it looks bad to a management to have a low stock price.  There are some investors who won’t buy stocks below $10, $5, etc.  Why run the risk of lowering your stock price if you think the odds are decent that the price will fall from there?  Low stock prices affect the confidence of many.

Investors looking to profit from the stock-split phenomenon should shun stocks that have undergone a reverse split and focus instead on those that have split their shares. You will have to invest in such stocks directly because there is no mutual fund or exchange-traded fund that bases its stock selection on stock splits.

Fortunately, constructing a portfolio of such stocks needn’t be particularly time-consuming.

For example, there is no need to guess in advance which companies are likely to split their shares—which in any case would be difficult, if not impossible, to do. There even appears to be no need to buy a company’s stock immediately after it announces a split, since research shows that it is likely to outperform the overall market for up to three years following that announcement.

Still, Mr. Macneale recommends that investors be choosy when deciding which post-split stocks to purchase. He cites several studies suggesting that the post-split stocks that perform the best tend to be those that, at the time of their splits, are trading at relatively low price/earnings or price/book ratios. Both are commonly used measures of a stock’s valuation, with lower readings indicating greater value.

I’m going to have to find the papers that say that post-split stocks outperform for the next 30 months.  Doesn’t sound right — a result like that would have been found from the research pre-1980, and no one suggested that; in fact, the evidence contradicted that consistently.

Note that the investment manager in question uses cheap valuation to filter opportunities.  That the stock has split usually indicates strong price momentum.  Value plus momentum is usually a winner, so why should we be surprised that stock splits often do well?

But I know of three papers that focused on predicting stock splits — two in 1973, and mine in 1982.  It’s not that hard.  Most of it is price momentum, and with a balanced set of stocks that would and would not split, the models predict 70% of the companies that would split.

What’s better, is that the formulas to predict stock splits pick good stocks in their own right — they end up being value and momentum, and maybe a few other factors.  I remember my thesis adviser being surprised at how good my models were at picking stocks.

This brings me to my conclusion: stock splits are a momentum effect, but it is larger when companies are still have a cheap valuation.  Perhaps splits have no effect on stock performance — it is all momentum and valuation.  To me, that is the most likely conclusion, and my thesis anticipated quantitative money management by 10+ years.

In one sense it is a pity I didn’t do anything with it, but if I hadn’t become an actuary, I would never have gained many other insights into the ways that the market works.  I’m happy with the way things worked out.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin