Academic Finance – The Aleph Blog

No es ESG

Posted on 14 November 201914 November 2019 by David Merkel

Picture Credit: David Merkel || E & S are hollow, G is solid

There are fads in investing. They eventually go away. Remember ARM funds? The Americus Trusts? (Neat idea, killed by a legal change). The nifty fifty? Hot industries that produce a lot of IPOs?

I also think cryptocurrencies are a fad, and also factor and volatility investing, at least in terms of the ETFs that are offered to retail investors.

And, I think ESG is a fad, at least in terms of the way it is being deployed today. My main point is that E (environmental) & S (social) are mostly subjective, and not related to investment returns or risk control. G (governance) is mostly objective and related to investment returns and risk control.

Now some will say “But wait, there are all these journal articles showing that ESG produces better volatility-adjusted returns.” Quantitative finance has a laundry list of problems:

We have only one world, one history, one data set. We’ve gone over the data set numerous times, knowing its proclivities. It’s not hard to tease “alpha” out in a study, but it is difficult to realize alpha in real life.
Researchers often take multiple passes over the data set as they do their analyses. Only the ones with results supporting the expected conclusions get a paper published.
Neutral observers don’t exist — their pay and social standing get determined by producing a series of statistically significant results, regardless of whether they tortured the data to get there or not. (Aside: when I read some of the macroeconomic crud out of the Federal Reserve, and I see the abstruse technique employed to get a result, I know the data has been tortured, and of course the model does not predict well.)
And more — you can read this for the rest of the problems. I don’t think I even get all of the issues with academic-style research in that article.

As such, I don’t trust the research on ESG. The limited history that we have for general inquiries is even shorter for ESG analyses. The likelihood of picking up spurious correlation is high. As such, unless I have a good mental model for how environmental or social issues affect long-term growth in value, I can’t use them as a fiduciary. I have those mental models for governance, so I use them — just not the same way as some of the quantitative governance models do.

Governance issues are perennial; they are not a fad. The agency problem, where corporate managements pursue goals that are in their interests, but not in the interests of shareholders never goes away. It can be reduced by a variety of measures, like splitting the CEO and Chairman positions. removing management influence over the audit and compensation committees, end things like that.

That said, there are exceptions to the rules, and certain strong managers running companies with highly focused and ethical cultures might be allowed more running room. Berkshire Hathaway doesn’t fit most of the rules, and in general it has done well. One size fits most, but not all.

It’s similar to the way I view management use of free cash flow. With a talented and honest management team, I want the management to have the freedom to retain all of the cash flow for growth if they see the opportunities. But most managements aren’t that good, and they should pay a dividend. Buybacks should only be done when the stock is notably cheap compared to the private market value of the firm, and the balance sheet remains solid.

That’s why I think many simple governance scores are mistaken. You have to take a look at the management team and culture in order to do a broader evaluation of the governance. I for one a comfortable buying stakes in a company where there is a control investor if the control investor is known for treating the outside passive minority investors fairly, and does not scrape too much off the top.

I expect companies that I own to follow the laws of the countries that they work in, and engage in ethical behavior. My rule is simple: if a company tries to cheat one set of stakeholders, the odds are higher that they will cheat shareholders at some point. Most of my significant losses have stemmed from some sort of fraud issue… this is etched in my mind.

But many of the details of environmental and social factors seem utterly tangential to me — I don’t see how they drive value. Let the government press its claims on corporations to avoid discrimination and limit pollution. That is the proper locus for these issues, particularly if you are a fiduciary. What is in the best financial interests of your clients should be your guiding principle.

Note as well that the implementation of E, S, and G are nowhere near standardized. G is probably the closest. (This also applies to factor investing as well, which is constantly ~~engaging in new specification searches~~ sharpening their statistical analyses.) Even if I wanted to do E & S, how would I know that I have the right figures? How would I know that they weren’t a product of backtest biases?

Also, as Matt Levine points out, many applications of ESG don’t make a lot of sense, even if these were desirable goals. As such, I look at many of the ESG products being put out there are marketing fads to take the attention of retail away from earning returns… after all, it is tough to beat the market, and ESG will give you many ways to have have a built-in excuse.

Do I know that I am in a minority for my views here? Yes. But I am often in a minority, and I would argue that the degree of agreement with ESG is paper-thin. It’s good while it brings in assets to manage, but the moment it doesn’t bring home the bacon, it will be jettisoned.

I’m in the minority for now. I expect the majority to come my way, not vice-versa. No illusions — it will take time for that to happen.

We Eat Dollar Weighted Returns ? III (Update)

Posted on 6 November 20196 November 2019 by David Merkel

Photo Credit: Sitoo || No, you can’t eat money. But without money farmers would have a hard time buying what they need to grow crops, and we would have a hard time bartering to buy the crops

Tonight I am going to talk about one of the most underrated concepts in finance — the difference between dollar-weighted and time-weighted returns, and why it matters.

So far on this topic, I have done at least seven articles in this series, and you can find them here. The particular article that I am updating is number 3, which deals with the granddaddy of all ETFs, the SPDR S&P 500 ETF (SPY), which has been around now for almost 27 years. It is the largest ETF in the world, as far as I know.

From the end of January 1993 to the end of March 2019, SPY returned 9.42%/year on a time-weighted or total return basis. What that means is that if you had bought at the beginning and held until the end, you would have received an annualized return of 9.42%. Pretty good I say, and that is an advertisement for buy and hold investing. It is usually one of the top investing strategies, and anyone can do it if they can control their emotions.

Over the same period, SPY returned 7.29%/year on a dollar-weighted basis. What this means is if you took every dollar invested in the fund and calculated what it earned over the timespan being analyzed, they would have received an annualized return of 7.29%.

That’s an annualized difference of 2.13%/year over a 26+ year period. That is a serious difference. Why? Where does the difference come from? It comes partially from greed, but mostly from panic. More shares of SPY get created near market peaks when everyone is bullish, and fewer get created, or more get liquidated near market bottoms. Many investors buy high and sell low — that is where the difference comes from. This also is an advertisement for buy and hold investing, albeit a negative one — “Don’t Let This Happen To You.”

Comparison with the 2012 Article

Now, I know few people actually look at the old articles when I link to them. But for the sharp readers who do, they might ask, “Hey, wait a minute. In the old article, the difference was much larger. Time-weighted was 7.09%/year and dollar-weighted was 0.01%/year. Why did the difference shrink?” Good question.

The differences between time- and dollar-weighted returns stems mostly from behavior at turning points. As I have pointed out in prior articles, typically the size of the difference varies with the overall volatility of the fund. People get greedy and panic more with high-volatility investments, and not with low-volatility investments.

That said, most of the effects of the difference are created at the turning points. During the midst of a big move up or down, the amount of difference between dollar- and time-weight returns is relatively small. The big differences get created near the top (buying) and the bottom (selling).

So, since the article in 2012, the fund has grown from $80 billion to over $260 billion at the end of March 2019. There have been no major pullbacks in that time — it has been a continuous bull market. We will get to see greater divergence after the next bear market starts.

Be Careful what you Read about Dollar-Weighted Returns

I’m not naming names, but there are many out there, even among academics that are doing dollar-weighted returns wrong. They think that differences as cited in my articles are too large and wrong.

The idea behind dollar-weighted return is to run an Internal Rate of Return calculation. To do that you have to have a list of the inflows and outflows by date, together with the market value of the fund at the end as an outflow, and calculate the single rate that discounts the net present value of all the flows to zero. That rate is the dollar-weighted return, and you can use the XIRR function is Excel to help you calculate it. (Note that my calculations use a mid-period assumption for when the cash flows.)

The error I have seen is that they try to make the dollar-weighted calculation like that of the time-weighted, creating period by period values. Now, there is a way to do that, and you can see that in the appendix below. As far as I can tell, they are not doing what I will write in the Appendix. Instead, they treat each year like its own separate investing period and calculate the IRR of that year only, and then daisy-chain them like annual returns for a time-weighted calculation.

Now, the time-weighted calculation does not care at all about investor-driven cash flows, like purchases and sales of fund shares, aside from dividend payments and things like that. It does not care about the size of the fund. It just wants to calculate what return a buy and hold investor gets. [Just remember the rule that an NAV must be calculated any time there is a cash flow of any sort, otherwise some inequity takes place.]

The dollar-weighted calculation cares about all investor cash flows, and ultimately about the size of the fund at the end of the calculation. It doesn’t care about when the returns are earned, but only when the cash flows in and out of the investment.

The odd hybrid method is neither fish nor fowl. Time-weighted corresponds to buy and hold, and dollar-weighted to the returns generated by each dollar in the fund. The hybrid says something like this: “We will calculate the IRR each year, but then normalize the fund size each year to the same starting level so that the fund flows at tops and bottoms do not compound. Then we show them year-by-year so that the returns are comparable to the total returns for each year.

As H. L. Mencken said:

Explanations exist; they have existed for all time;?there is always a well-known solution to every human problem?neat, plausible, and wrong.
Source: Quote Investigator citing Mencken’s book “Prejudices: Second Series”

In an effort to make a simple annual comparison between the two, they eradicate most of the effects of selling low and buying high. More in the Appendix.

Summary

Be aware of the difference between dollar-weighted and time-weighted returns. If you have a strong control on your emotions, this is not as important. If you tend to panic, this is very important. It is more important if you buy highly volatile investments, and less so if you size your volatility to your ability to bear it.

To fund managers I would say this: if you are tired of all of the inflows and outflows, and are tired of getting whipsawed by your clients, maybe you should take a step back and lower the overall risks you are taking. This will benefit both you and your clients.

Appendix

Here’s how to run an annual calculation of dollar weighted returns that be correct. For purposes of simplicity, I will assume a simple annual calculation that has multiple cash flows inside it. (If we are working with a US-based mutual fund, there would be reporting of change in net assets every six months.)

Calculate the first year (dw1) the way the hybrid method does. No difference yet. Then for the second year, run the IRR calculation for the full two-year period (IRR2). Then the second year only dollar-weighted return (dw2) would be:

((1+ IRR2) ^2) / (1+dw1) -1 = dw2

and for each successive period it would be:

(1+IRR[n])^n(1+IRR[n-1])^(n-1) – 1 = dw[n]

That is more complex than what they do, but it would preserve the truths that each entail. It would make the values for the yearly dollar-weighted returns look odd, but hey, you can’t have everything, and the truth sometimes hurts.

Full disclosure: a few of my clients are short SPY as part of a hedged strategy.

The Dead Model

Posted on 21 May 2016 by David Merkel

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Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic,, would not have been a bad decision.

I’m here to write about a related issue this evening. ?To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not. ?Take the “Fed Model” as an example. ?You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole.

Now with interest rates so low, belief in the Fed Model?is tantamount to saying “there is no alternative to stocks.” [TINA] ?That should make everyone take a step back and say, “Wait. ?You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?” ?Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations.

Here’s why: in my?prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model. ?With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital.

Now that’s a basic idea that makes sense, particularly when consider how corporations work. ?If a corporation can issue cheap debt capital to?retire stock with a higher yield on earnings, in the short-run it is a plus for the stock. ?After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards. ?If true for corporations, it should be true for the market as a whole.

The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries — rather, the firm’s cost of capital is the tradeoff. ?My proxy for the cost of capital?for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data. ?It’s not perfect, but here are some reasons why it is a reasonable proxy:

Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity.
The Baa bonds are on the cusp of investment grade. ?The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average. ?You could tranche?off a pseudo-debt interest in a way akin to the old Americus Trusts, and the cash flows would price out much like corporate debt or a preferred stock interest.
The debt ratings of most of the S&P 500 would be strong investment grade. ?Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference.

As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model. ?That’s a better pair to compare against one another.

=-=-=-=-=-=-

That brings up another bad binary comparison that is common — the equity premium. ?What do?stock returns?have to with the returns on T-bills? ?Directly, they have nothing to do with one another. ?Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed — those of maturity risk, credit risk and business risk. ?(And the last of those should be split into a economic earnings ?factor and a valuation change factor.)

This is why I’m not a fan of the concept of the equity premium. ?The concept relies on the idea that equities and T-bills?are a binary choice within the beta calculation, as if only the risky returns trade against one another. ?The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate. ?At certain points lending long is attractive, or taking credit risk, or raising capital to start a business. ?Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere.

Summary

When looking at investment analyses, ask “What’s the comparison here?” ?By doing that, you will make more intelligent investment decisions. ?Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock. ?(That’s why I prefer swap transactions.) ?People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result.

Simple Stuff: What is Risk?

Posted on 15 May 2016 by David Merkel

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple. ?Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on?how much?it?missed the goals.

There are several good things about this definition:

Note that the word “money” is not mentioned. ?As such, it can cover a wide number of situations.
It is individual. ?The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation. ?The same event may happen for two people — it may be a miss for one, and not for the other one.
It catches both aspects of risk — likelihood of a bad event, and degree of harm from?how badly the goal was missed.
It takes into account the possibility that there are many goals that must be met.
It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus. ?Erudite, but bogus.
It doesn’t specify that there has to be a single time horizon, or any time horizon.
It doesn’t specify a method for analysis. ?That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

You don’t get to retire when you want to, or, your retirement is not as nice as you might like
One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
You can’t buy the home/auto/etc. of your choice.
A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
The firm you work for goes broke, or gets competed into an also-ran.
You lose your job, can’t find another job?as good, and you default on important regular bills as a result. ?The same applies to people who run their own business.
Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them. ?This can be harmful not just to the?banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk. ?I have a series of articles that I have written on the topic based on the idea of the?personal required investment earnings rate [PRIER]. ?PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals. ?From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I?m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There?s a reason for this, and I?ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:

Save more, or,

Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don?t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is ?free.?? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!

Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion?s share coming from the less risky investment grade bonds.? The overshoot of the ?90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are?these:

Spend time estimating your future needs and what resources you can put toward them.
Be conservative in what you think you assets can earn.
Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility. ?Here’s a discussion of when that makes sense, and when it doesn”t.

Book Review: Market Liquidity Risk

Posted on 9 September 2015 by David Merkel

Liquidity is ephemeral, and difficult to define. ?The first real article at my blog was about liquidity, and the three things that liquidity can mean, notably: the ability to:

Enter into large or exit from?commitments to risk assets cheaply (cost)
Borrow at tight credit spreads compared to the safest borrowers
Make large adjustments to their asset allocations rapidly (speed)

Most of these phenomena can be observed without complex models. ?Ask yourself:

Is credit growing rapidly?
Are the exchanges moving turning over stocks more rapidly?
Are credit spreads tight?
Have credit terms and conditions deteriorated?
Do lenders care more about volume of lending than quality of lending?

My bias is that I think most of the academic mathematical models of liquidity risk are overly technical, and tend to obscure liquidity conditions rather than reveal what is going on. ?You may disagree with that view.

But unless you disagree with that view and you like math, this book will not be worth a lot to you. ?Yes, there are qualitative sections, and they are good. ?For example, the beginning of chapter 2 is very good at illustrating the paradoxical nature of liquidity. ?Chapters 1-3 would have made a very good qualitative monograph on liquidity — but it would be so small that you couldn’t charge $80+ for it.

Chapters 4-6 will only be useful to the mathematically inclined. ?I’m dubious that they even be useful then, because much of it is calculus, which does not do well with discontinuous events such as market panics. ?(You would have thought that the quants on Wall Street would have learned by now, but no…) ?Even if the models did work, there are simpler ways to see the same things, as I pointed out above.

As such, I really can’t recommend the book, and at $80+ the price is a lot more expensive than the free Monograph from the CFA Institute “The New Economics of Liquidity and Financial Frictions.” [PDF] ?Read that, not this, and save liquidity.

Quibbles

The book could have used a better editor. ?Too many typos in the introductory chapters.

Summary / Who Would Benefit from this Book

If you are a math nerd, and want to pay a lot of money to buy a book that I think will at least partially mislead you on liquidity risk, then this is the book for you. ?If you want to buy it, you can buy it here: Market Liquidity Risk.

Full disclosure:?I?received a?copy from a friendly?PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Quarterly Financial Reporting is Needed, Productive, and Good

Posted on 21 August 2015 by David Merkel

The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer.

The cause for tonight’s article is a piece from the Wall Street Journal,?Time to End Quarterly Reports, Law Firm Says. ?Here’s the first two sentences:

Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.

Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals.

The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy. ?I disagree. There are at least four?things that are false in the arguments made in the article, and in books like?Saving Capitalism from Short-Termism:

Quarterly earnings don’t produce value in and of themselves
Quarterly earnings cause most corporations to ignore the long-term.
Ending quarterly earnings will end activism, buybacks, and dividends.
Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing.

Why Quarterly Earnings are Valuable

I’ve written a number of articles about quarterly earnings and estimates of those earnings:?Earnings Estimates as a Control Mechanism, Flawed as they are, and?Earnings Estimates as a Control Mechanism, Flawed as they are, Redux. ?The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not. ?As I wrote:

Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.? Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn?t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.? The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

Don’t think of the quarterly earnings in isolation. ?A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. ?A bad earnings number?lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. ?Vice-versa for a good number.

Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” ?That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down.

They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. ?In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings.

In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital. ?When the measurement periods get too long, discipline can be lost.

Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term

Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. ?Even if?the current period’s earnings meet the estimates, the job is not done. ?If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. ?The short-term is just the beginning of the long-term. ?It is not either/or but both/and. ?A company has to try to explain to investors how it is?growing the value of the firm — if present targets aren’t being met, why should there be any confidence that the future will be good?

Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal. ?The quarterly earnings measure?whether the progress toward completing the goal is adequate or not. ?Now, the measure is not perfect, but who can think of a better one?

Ending Quarterly Earnings Would Not?End Activism, Buybacks, and Dividends

I can think of an area in business where earnings estimates don’t play a role — private equity. ?Are the owners long-term oriented? Yes. ?Are they short-term oriented? ?Yes. ?Is?capital managed tightly? ?Very tightly. ?All excess capital is dividended back — it as if activists run the firms permanently.

If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders. ?Activists would still analyze companies to see if they are badly managed, and in need of change. ?If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe. ?Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings.

On the Use of Excess Capital

Investing, particularly for the long-term, is not risk-free. ?In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete. ?In such an environment, it can make a lot of sense to focus on shorter-term?investments that are more certain as to the success of the project. ?It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently. ?Companies that shrink their balance sheets tend to outperform those that grow them.

As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors. ?The same is true of large versus small investments for organic growth away from M&A. ?Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing. ?There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not.

In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. ?That’s how biotech firms work, and it is why so many of them fail. ?The few winners are astounding.

Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity. ?All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted?returns, and not wasted on speculative projects with uncertain returns. ?The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive.

Remember, bad investments are just expenses in fancy garb — it just takes the accounting longer to recognize the losses. ?Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. ?Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. ?Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company.

Conclusion

If quarterly earnings are abolished, intelligent corporations won’t change much. ?Investment won’t go up much, and the time horizon of most management teams will not rise much. ?If you need any proof of that, look at how private equity and large mutual insurers manage their firms — they still analyze quarterly results, and are conservative in how they deploy capital.

The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors. ?Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies.

Other Aleph Blog Articles for Consideration

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.

The Phases of an Investment Idea

Posted on 27 June 201528 June 2015 by David Merkel

Investing ideas come in many forms:

Factors like Valuation, Sentiment, Momentum, Size, Neglect…
New technologies
New financing methods and security types
Changes in government policies will have effects, cultural change, or other top-down macro ideas
New countries to invest in
Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
New asset classes or subclasses
Durable competitive advantage of marketing, technology, cultural, or other corporate practices

Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. ?When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.

For an example, think of Ben Graham in the early days. ?He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. ?As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.

As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. ?Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.

The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. ?Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. ?It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.

Value investing principles, rather than dying there, broadened out to consider?other ways that securities could be undervalued, and the analysis process began again.

My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.

Now think of the technologies that led to the dot-com bubble. ?The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. ?The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.

My second point is that often the price performance of an investment idea overshoots. ?Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. ?It might happen because of expected?demand that does not occur, or too much short-term leverage applied to long-term assets.

Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? ?A new investment factor is discovered:

it earns great returns on a small amount of assets applied to it.
More assets get applied, and more people use the factor.
The factor develops its own price momentum, but few?think about it that way
The factor exceeds the “carrying capacity”?that it should have in the market, overshoots, and burns out or crashes.
It may be downplayed, but it lives on to some degree as an aspect of investing.

On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. ?By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. ?On a dollar-weighted basis, the verdict on the factor might not be so hot.

So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? ?Not very useful. ?Dollar weighted? ?Better, but still of limited use, because the discovery era will likely never be repeated.

What should we do then to make decisions about any factor/idea for purposes of future decisions? ?We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. ?That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.

It leaves us with a mess, and few?firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”

That’s all for now. ?As always, be careful with your statistics, and use sound business judgment to analyze their validity in?the present situation.

There’s a Reason for Risk Premiums

Posted on 3 June 2015 by David Merkel

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. ?In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? ?I don’t have the article in front of me but I’ll toss out a few.

Many were Credit-oriented. ?Lend and make money.
Some were volatility-oriented. ?Sell options on high volatility assets and make money.
Some were currency-oriented. ?Buy government bonds where they yield more, and short those that yield less.
Some had you act like a bank. ?Borrow short, lend long.
Some were like value investors. ?Buy cheap assets and hold.
Some were akin to arbitrage. ?Take illiquidity risk or deal/credit risk.
Others were akin to momentum investing. ?Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

Someone will start a hedge fund off this.
Many of these are correlated; with enough leverage behind it, the hedge fund?could leave a very large hole when it blows up.
Yes, who wouldn’t want to be a bank without regulations?
What an exercise in data-mining and overfitting. ?The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. ?(Even those are not truly free; animals have to be fed and cared for.) ?They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that?pays all of its interest and principal. ?Usage: “Is it ‘money good?'” ?”Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. ?There are a few problems though:

Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. ?What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? ?What insurance company wouldn’t want to sell off its junk bonds at that time as well? ?And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. ?Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. ?Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

We Don’t Need To Be Able To Short Private Companies

Posted on 29 April 2015 by David Merkel

Photo Credit: Matthias Ripp?|| Some bad ideas should be locked away…

Dan Primack of Fortune wrote in his daily email:

Saving unicorns from themselves? There was an interesting piece last week from Martin Peers in The Information?(sub req), arguing that the private markets need some sort of shorting mechanism so that there is a check on unreasonable valuation inflation. It would make the market more efficient, Peers argues, even though implementation would require several structural changes (particularly to stock transfer rules). He writes:

“Private companies will probably resist the development of a short-selling market, given it would hurt valuations, which in turn can undermine the value of employee option programs, and give them less control over their shareholder group. But those risks are likely to be outweighed by the long term benefits of bringing more buyers into the market and ensuring the company’s valuation can be sustained outside of the constraints of the private market.”

Leaving out the technical difficulties — including?the lack of ongoing price discovery — one big counter could be that shorts didn’t so much to stop the earlier dotcom bubble (which largely took place in the public markets).

Adam D’Augelli of True Ventures pointed me to a 2002 academic paper (Princeton/London Biz School) that found “hedge funds during the time of the technology bubble on the Nasdaq… were heavily tilted towards overpriced technology stocks.” They add that “arbitrageurs are concerned about attacking the bubble too early without support from their peers,” and that they’re more likely to ride the bubble until just a few months before the end.

That would seem to be?too late to impose price discipline in private markets, but I’m curious in your thoughts. Does some sort of private shorting system make sense? And, if so, how would it be structured?

I’m going to take a stab at answering the final questions. ?There is often a reason why the financial world is set up the way it is, and why truly helpful financial innovations are rare. ?The answer is “no, we should not have any way of shorting private companies, and it is not a flaw in the system that we don’t have any easy way to do it.”

Two notes before I start: 1) I haven’t read the paper at The Information, because it is behind a paywall, but I don’t think I need to do so. ?I think the answer is obvious. ?2) I ran into this question answered at Quora. ?The answers are pretty good in aggregate, but what exists here are my own thoughts to present the answer in what I hope is a simple manner.

What is required to have an effective means of shorting assets

An asset must be capable of being easily transferred from one entity to another.
Entities willing to lend the asset in exchange for some compensation over a given lending term.
Entities willing to borrow the asset, put up collateral adequate to secure the asset, and then sell the asset to another entity.
An entity or entities to oversee the transaction, provide custody of the collateral, transmit payments, assure return of the asset at the end of the lending term, and gauge the adequacy of collateral relative to the value of the asset.

Here’s the best diagram I saw on the internet to help describe it (credit to this Latvian website):

I’m leaving aside the concept of naked shorting, because there are a lot of bad implications to allowing a third party to create ownership interests in a firm, a power which is reserved for?the firm itself.

The Troubles Associated with Shorting Private Assets

I can think of four?troubles. ?Here they are:

The ability to sell, lend, or buy shares in a private company are limited by the private company.
Lending over long terms with no continuous?price mechanism to aid in the gradual adjustment of collateral could lead to losses for the lender if the borrower can’t put up additional capital.
The asset lender can decide only to lend over lending?terms that will likely be disadvantageous to the borrower. ?Getting the asset returned at the end of the lending term could be problematic.
It is difficult enough shorting relatively illiquid publicly traded assets. ?Liquidity is required for any regular?shorting to happen.

The first one is the killer. ?There are no advantages to a private company to allow for the?mechanisms needed to allow for shorting. That is one of the advantages of being private. ?Information is not shared openly, and you can use the secrecy to aid your competitive edge. ?Skeptical short-sellers would not be welcome.

The second problem is tough, because sometimes?successive capital rounds are at considerably higher prices. ?The borrower will likely not have enough slack assets to increase his collateral, and he will be forced to buy shares in the round to cover his short because of that. ?The lender could find that the borrower cannot make good on the loan, and so the lender loses a portion of the value his ownership stake.

But imagining the first two problems away, problem three would still be significant. ?If the term for lending were not all the way to the IPO, next capital round or dissolution/sale, at the end of the term, the borrower would have to look for someone to sell shares to him. ?It is quite possible that no one would sell them at any reasonable price. ?They know they have a forced buyer on their hands, and there could be informal collusion on the price of a sale.

Perhaps another way to put it is don’t play in a game where the other team has significant control over the rules of the game. ?One of the reasons I say this is from my days of a bond manager. ?There were a lot of games played in securities lending, and bonds?are?not the most liquid place to short assets. ?I remember it being very difficult to get a bond back from an entity that borrowed it, and the custodian and trustee did not help much. ?I also remember how we used to gauge the liquidity of bonds we lent out, and if one was particularly illiquid, we would always recall the bond before selling it, which would often make the price of the bond rise. ?Games, games, games…

What Might Be Better

Perhaps using collateralized options or another type of derivative could allow bets to be taken, if the term extended all the way to the IPO, the next capital round, or dissolution/sale of the company. ?The options would have to be limited to the posted collateral being the most the seller of the option could lose. ?Some of the above four issues would still be in play at various points, but aside from issue one, this would minimize the troubles.

What Might Be Better Still

The value of the shorts is that they share information with the rest of the market that there is a bearish opinion on an asset. ?Short-sellers are nice to have around, but not necessary for the asset pricing function. ?It is not unreasonable to live with the problem that some assets will be overvalued in the intermediate-term, rather than set up a complex method to try to enable shorting. ?As Ben Graham said:

?In the short run, the market is a voting machine but in the long run, it is a weighing machine.?

The weighing machine will do its job soon enough, showing that the overvalued asset will never produce free cash adequate to justify its current high price. ?Is it a trouble?to wait for that to happen? ?If you don’t own it, you shouldn’t care much.

If you want to short it, I’m not sure that will hasten the price adjustment process that much, unless you can convince the existing owners of the asset that it isn’t worth even the current price. ?Given that buyers have convinced themselves to own the asset, because they think it will be worth more in the future, intellectually, convincing them that it is worth less?is a tough sell.

In the end, only asset and liability cash flows count, regardless of what secondary buyers and sellers do. ?Secondary trading does not affect the value of assets, though it may affect the perception of value in the short run. ?Thus, you don’t need short sellers to aid in setting secondary market prices, but they are an aid there. ?In the primary markets, where whole companies are bought and sold, the perceived cash return is all that matters.

Conclusion

Ergo, live with short run overvaluation in private markets. ?It is a high quality problem. ?Sell overvalued assets?if you own them. ?Watch if you don’t own them. ?Shorting, even if possible, is not worth the bother.