Academic Finance – Page 5

Leverage Isn’t Free

Posted on 18 August 2011 by David Merkel

I’ve been running across an idea that outperformance is possible with safe assets, so why not take those assets and lever them up until their volatility is equal to common equities, and earn more at the same level of volatility?? That was my only significant disagreement with the book Expected Returns.

I think this is a stupid idea.? (I don’t favor the CAPM either.)? When you borrow money to buy some asset, the distribution of possible returns changes.

Let me give you some analogies.?? First, securitization.? Those that invest in non-senior loan tranches get an enhanced yield, but they face a different risk profile than most corporate bond investors.? Corporate bond investors have a high expectation of full payment, but when default occurs, they lose 60-80%.? Investors in securitized bonds rarely get recoveries.? They usually get paid in full or lose it all.

Second, think of banks or REITs.? They lever up safe assets, and they blow up with a higher frequency than do industrial corporate bonds.

Leverage changes the nature of the distribution of possible returns in three ways:

The cost of borrowing decreases the return.
The returns are levered by the amount of borrowing.
To the degree that others do the same thing, the strategy is no longer undiscovered, and superior returns should not be expected.? In a crisis, the borrowed money leads to overshoots as panicked investors bail out en masse.

Personally. I wish we could get rid of the writings of academic economists and finance writers that don’t actively invest.? They don’t get the dynamics of investing, and assume a simple world that does not resemble our world.

My main point is that trying to buy the asset class with the highest return after equalizing volatilities is a fool’s bargain.? Adding leverage changes the nature of decisionmaking, and what tests in the lab will not likely work in real life.? Paper trading does not always translate to real world profits.

Rationality is Overrated

Posted on 19 July 2011 by David Merkel

When I was in school, I was the “class brain.”? (sigh, I had a hard time with it, but after I became a Christian, I won people over by offering homework help for free) I even have this glow-in-the-dark rubber brain that my senior class awarded me.

But it’s not worth that much.? There are many other character attributes desirable to society aside from being smart.? As a little kid, I was a guinea pig for many of the educational theories they tried to test on me, and I survived them.? Not sure what good they got out of it.

In my adulthood, I learned to appreciate the abilities of others who may be less smart, but they have gifts — empathy, mechanic, insightful into people, technical specialties… everyone has something to give, IF they will give.

Economists have a fixation on rationality, and this article is a partial expression of that.? My answer to the article is the people are limitedly rational.? That’s vague, and won’t fit into mathematical theories, but it is accurate.? It explains why people act rationally in some situations, and why they could be more rational in other situations, assuming that economists really know what is rational.? More goods is better is not an adequate explanation of rational.

A view like mine would make it very difficult for economists to create simple mathematical models of reality.? They would rather live in their fake world, where they can publish nonsense to peers, and keep their cushy jobs.

When I was Young

Posted on 18 April 2011 by David Merkel

I can’t place it, but when I was 5 years old or so, sometime in 1966, my Mom showed me The Milwaukee Journal, and pointed me to an entry for Litton Industries preferred stock.? She told me that I owned some shares of the stock, and that it was good for me if the stock went up, and bad if it went down.? This was repeated two years later with shares of Magnavox common stock.

Both ended up being large losses, and I puzzled about it when I was young.? It did not dent my confidence in the markets because my Mom was such a good investor, looking for? growth at a reasonable price.? And to me, 10-18 years old, watching Wall Street Week with Louis Rukeyser on Friday nights, I gained insights into the markets, and began to appreciate the wisdom of my mother.? The 70s were a tough time to gain a love for the markets, but I played around with paper portfolios until 1982, when I did my last paper portfolio, before heading of to grad school.? (Value Line helped — if you have time, curl up with it and look for neglected companies that offer promise.)

Before that, I took one of my Mom’s former favorite stocks which had dipped, James River, and used it in a class at Johns Hopkins, and made a case that an acquisitive paper company could be a good investment.? My case was good to my professor, Carl Christ, “I never heard of this corporation before, what a great company.”? And my Mom, who had sold out of the company, reconsidered and bought again at a lower price, making money until the firm itself was bought out.? (Hey, gotta help with the tuition.)

The paper portfolio that I created in August of 1982 proved to be fun for my students when I was a TA at UC-Davis in Corporate Financial Management.? I mentioned the portfolio in class, and a subset of students asked to see it.? By the time the class ended, the market was up 20%, but the portfolio was up 40%.? By this time the professor had heard about it, and he said, “Oh, you have a portfolio with a beta of two.”? I tried to explain to him that the beta estimates of the portfolio were much lower than that, and that I had “bought” the names cheaply.? but to no avail… once the religion of efficient markets takes hold, no amount of? facts will prevail.

Then there was the Value Line contest around 1984-1985, where I was in the top 1%, but missed the top 25.? I used the top 100 from Value Line (Timeliness Rank 1), but screened them for value in their volatility buckets, as the contest went.? To this day, I think that stockpicking contest was the best ever designed.? If I ever get wealthy, I want to do a series of such contests, using the same principles.

After that, I married my wonderful wife Ruth, and began investing for real, first with mutual funds, and then with individual stocks.? But I failed to follow through in one way — I bought penny stocks through a “bucket shop” and lost a moderate amount of money, which fortunately was dwarfed by the purchase of a home in Davis, CA at just the right time, such that two years later when we had to leave for a new job (AIG), we had made 4x our capital, net of CA taxes.

Then my Mom gave me a copy of Ben Graham’s “The Intelligent Investor,” and my life changed again.? I spent the next seven years analyzing small company value stocks in the midst of a market that favored large caps, and growth.? Still, my picks were good, and kept up with the S&P 500 (beating the Russell 2000 Value by 5% per year).

I appreciate the past, and use the lessons for growth today.? Mom, she keeps investing well, though she has more of a desire for yield today.

Today I think my best skills are company and industry analysis.? Yes, I am a quant, and can design clever ways to outperform the market with some probability, but prefer my own insights to mathematical likelihoods.

As for what I wrote yesterday, I prefer my own stock investing to moving between equity and debt markets, because my alpha exceeds that of the switching strategy, at least for now.? Volatility is higher, but I am in Buffett’s camp, where I will take a noisy 15% over a calm 12%.

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I did not bump into investing as an adult, but had to wrestle with it as a child.? I got to view it through the lenses of practical people who were bright, rather than academics who have a blunted view of investing.? This will bite the academics, but there is more wisdom outside of academia on investing than there is inside academia on investing.? Far better that you leave the confines of academic research and try to apply your methods to investing, messy as it is.? I dare you.? It takes a while to develop the practical knowledge behind good investing.? I’ve seen it from so many angles; if there is anyone with a more diversified career in financial services, I have not met him yet.

I was never attracted to MPT because I had seen my Mom beat the market regularly.? It was confirmed to me, when I found that I could do it also.

But still, I like MPT, and indexing — it sidelines a lot of the competition.? And for most, buying an index is the right way to go.? They don’t have an edge, so why pay the fees and accept the added volatility?

But to those that think they understand investing in academia, I would simply say, “Join the party.? If your ideas are? good, you will do well.? It is a lot harder to turn theories into hard cash, or gold, if you are so inclined.”

When I was young, I trusted my Mom.? That trust was rewarded.? Today, the game is a lot tougher, but I persevere because I know my principles work on average over time.? I have had a poor last eight months, but I will come back in time, because my methods have worked in the past, and nothing that I can see has changed that environment.

PS — I sometimes say, ” I am a good investor because I learned from my Mom, and I am a good businessman because I learned from my Dad.”? My Dad did excellent work for clients, and was never sued once in 35 years of work.? His reputation of doing quality work at a moderate price preceded him, and allowed him to survive in bad economic environments.? I hope that I can be as good.

On Investment Modeling, Part 4

Posted on 24 November 201024 November 2010 by David Merkel

I thought part 3 would be the end, but I ended up with one huge and good comment from a friend.? A real friend, not a Facebook friend.? I will respond to it in pieces.

Good article and series. A few comments and/or questions for you. First, there is no doubt that both value and momentum work. And while I happen to personally be a big believer in (certain) trend-following approaches, the way in which Covel interacts with people is childish at best. There is room for professional discourse and disagreement, but he has little interest in being professional about anything?at least in the blogosphere/twitterverse world. So, keep at it?be a gentleman and let the other chips fall where they may. Now, a few other areas:

I try to stay polite.? Sometimes I fail, but thankfully, it is not common.

1. First, I?d be interested to have you elaborate a bit further (or point me to a different post) on your views of the Carhart factors. In my mind, there is no doubt that they are betas?but at the same time, there is also no doubt that those betas can and should be used (carefully) as alpha factors as well. Much as my brain has been trained to think about them as simply betas, I?m more than willing to think about them in both ways. They aren?t mutually exclusive, are they?

I have no other post on this.? This series was meant to bring this idea buried in me to the surface.

I think the thing that set me off here is the value factor.? Value is regarded as a risk factor, when if you own enough stocks with the value factor, you will outperform over the intermediate term.? The same applies to momentum, it is a risk factor, but it tends to outperform.? The same can be said for size, small is usually a winner because of neglect.? Beta tends to be negatively correlated with outperformance.

If the factors were neutral, having zero expectation of future performance, they would be betas.? But that is not true even of “beta.”? Thus, most of the time one can make money by tilting to the moneymaking sides of these factors.

Recently, there was an analysis of Berkshire Hathaway for the last decade, showing Buffett had no alpha.? But if you looked at Berky versus the index, Berky beat it by 6%/year.? Buffett asks whether companies are cheap.? If he buys a company because it is specially cheap, or because its associated “risk” factors are cheap, that should be measured as skill, not taking risk.

If we add enough “risk” factors to the analysis, most alphas disappear.? But the ability of managers to buy when a risk factor is cheap does not go away, as does their ability to be “late followers” and lose money as so many retail investors do.

2. Second, and importantly, I don?t believe that every investment strategy can be boiled down to a fairly simple mathematical/quantitative approximation. Therefore, not every strategy can be tested in a purely academic sort of fashion. Take Covel?s trend-following, for instance. There are obviously many ways to do trend-following, but few are so simple as to easily do an historical test. It?s NOT simply momentum (as you well know!), and while momentum and trend-following certainly have some correlation, it would be a disservice to the TF crowd to view one as a proxy for the other. The buy and sell rules, timing of entry points, level of stop loss, etc. are hugely crucial to the success of the strategy.

You are right here, mostly.? What we test are only the quantifiable aspects of the strategy.? We don’t test, we cant test nuances.? Nuances will get lost in the noise.? We are out to test the first approximation of a strategy, not the strategy itself.

Most managers have an initial screen that winnows down the universe of stocks that they will then use their abilities to analyze.? Managers think that only a subset of stocks are worth their time, because that pool is likely to outperform, now let’s get the best of those.

In this sense, we are not testing the fullness of a manager’s processes, but only his initial quantitative screen.? Processes beyond that are alpha, whether positive or negative.

As one who has sat through many dog-and-pony shows (and you, friend, more than me), most managers fall into buckets off of their screens.? What is their investable universe?? We test that.? We can’t test the fine gradations beyond that — the law of small numbers interferes.

But what I will argue regarding trend following is that there is some measure of momentum that explains over 70% of the results of a wide number of trend followers, much as Buffett could point to the “Superinvestors” and claim that they were all one tribe, though the details differed considerably, much as Covel has done with trend following.? The first approximation of the group element is the important part tested.? Maybe we need to use principal component analysis to tease it out, but we do need to simplify the broad parts of the strategy for testing.? We can test the broad stuff.? Beyond that we are stuck.

3. So with #2 as an assumption, the only way to analyze TF is as a group of investors. Is there survivorship bias? Yes, but you have that with value guys, too. Is it enormously dependent on sticking with the system, even when it?s not working? Yes. Is there a good sample of auditable accounts out there? No?not so far as I?m aware. I think the issue that Covel has is that the majority of the best investment returns people have ever put up are from the momentum/TF crowd. However, one should very clearly separate investing from trading. The trading crowd has the ability to put up ginormous returns, but at what cost? Huge volatility, gigantic turnover, etc. that most people are not willing to live with.

Let Covel and his friends try to raise money from the institutional investment community.? We may admit that momentum works, but not the ability to consistently make money off of price/volume action when managing a large amount of money.? If they do have that skill, we need to explore it, and let the behavioral investors analyze it so that we get a first approximation, a factor, to explain it.

Survivorship bias? You bet that is there.? That is why we test mechanized first approximations to a strategy, not the strategy itself.? We test tribes, we don’t test families, much less individuals.

So in the end, as you?ve said before, it comes down to finding a system/approach that has shown the ability to work well for others and sticking with it through the tough times. No approach to investing/trading will be absolutely perfect every month, and most people lack the discipline to actually make it work over time. They switch from system to system, at the most inopportune times.

Thanks for the good work?keep it up!

You would know better than most that though I am generally a value investor, my own strategies are different because I use industries as my primary screen in investing.? And it is nonlinear — I look at those that are running, and those that are dying, but not the middle.? I consider macro factors that many do not, whether I am right or not.

I am one of those managers that would be hard to measure, if one wanted to measure things precisely; I don’t screen, as most managers do.? But I consider value, momentum, and mean-reversion effects to be givens, while I try to analyze what industries and companies will do well.

And that is a reason why I have not fared well with fund management consultants.? Like Covel, I do not fit their paradigm.? Unlike Covel, I would like to fit their paradigm.

But no, I am happy for the present to attract individual investors who want to outperform on a risk adjusted basis over a 5-year? period.? That is my forte, and I will pursue it with investors as my firm goes live at the beginning of 2011.

On Investment Modeling, Part 3

Posted on 20 November 201022 November 2010 by David Merkel

This is the last piece intended in this series, but I know that I will get a some abuse for it.? One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.? Thanks.

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Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.? Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.? Another win for value investing.? I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.? No envy here.? I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.? I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.? I write this as a convinced value investor.

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Far better to try to do a general study.? The trouble is that it is difficult to segment the market into value investors, and everyone else.? The category is squishy.? Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.

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So, what are we left with?? We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.? The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.? Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.? For value investing, it has worked.? Value factors have outperformed.? I love being a value investor, and I have been better than most of my competitors.

But that is not enough.? Price momentum factors have also outperformed.? Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.? He had more freedom to pick trend investors than Buffett did to pick value investors.? I give Michael Covel a choice:

Are you willing to recognize that value investing works, even as momentum investing works?
Or, do you end up a narrow-minded man who only sees one way to make? money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.? I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.? On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.? Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.? I hate that.? A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.

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Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

Segment investors, and analyze their performance
Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.? I agree with those, and let Michael Covel agree with me.? I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.? Why not incorporate both value and momentum into your investing?

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Update: here is a transcript of the discussion with @Covel:

Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.? There are five parts, and you would do well to read them carefully.? My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.? But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.? I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.? If you get to Baltimore, lunch is on me.

On Investment Modeling, Part 2

Posted on 18 November 2010 by David Merkel

Before I begin tonight’s piece, one small thing that I want to point out from my last piece was that though my models were a few years ahead of the life insurance industry, the two most important things that I did were:

Not optimize for best return, even if risk adjusted.? I gave extra weight to avoiding the downside.
Added in the details.? My models were entirely home-grown, and took advantage of my programming abilities to come to a sharper result.? I am not a good theoretical mathematician, but I am good at using math to solve practical problems.

The idea is model completely, and don’t ignore scenarios that could not happen.? My interest rate model had scenarios that mimicked what we actually got, though what we got was not a high probability.

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One of the themes that I came away with from the Denver conference last week was look through the windshield, not the rearview mirror.? But much of the investment industry, and retail investors are destined to? look through the rearview mirror.? I, as an actuary, have been unfairly accused of driving life insurance companies through the rearview mirror, look at this and say that we can look through the windshield, but we have to be more than the common shlubs who are the majority of the market.

To do that we have to adopt an independent disposition, and not care about raising funds, but only earning returns for clients.? If we build it, they will come.? In one sense, it is like someone who has a beautiful singing voice, but who avoids pride, and admires his voice as if it were someone else’s voice. (Apologies/Credit to C. S. Lewis)

The main point here is to look through the windshield, and exercise intelligent independent judgment.? Analyze the situation, and figure out where there is an advantage as a businessman.? The tools of modern portfolio theory will be useless here, so ignore them.? They only sharpen/obscure our understanding of the past/present by calculating parameters that are not stable or predictive.

The only positive thing about Modern Portfolio Theory is that it sidelines a bunch of bright guys who would otherwise be competitors in the markets.? Sun Tzu would admire this tactic — getting a large portion of the opposition to become peaceniks because the expected value of the war is zero or negative.? It’s as if an economic Tokyo Rose is broadcasting that competition in financial markets is futile — in aggregate, everyone will get average performance, so why fight to get better performance?? It’s futile; give up; go home.

I would simply say there is always a decent amount of lazy investors in the market. Smart investors can get better returns through paying careful attention to what seems to offer the best returns on a forward-looking basis.

Part of looking through the windshield is avoiding noneconomic constraints.

1) Do I care where a company is located? Yes. I want a place where the rule of law is honored.? As many have commented at my blog, does that include the US?? Yes, for now.? Global diversification is important.? That said, it will be interesting to see what will happen to investments should we see tariffs, foreign exchange controls, and expropriation.? At least in you own home country you only have to deal with the “devil you know.”

2) Do I care whether a company has a large or small market capitalization?? Not now.? Even if my asset management firm grows, I will adjust my strategy to include attractive small caps at lower target percentages.? If my buying begins to affect the stock price, I will take smaller positions.

3) Do I care if a stock is “a growth stock” or a “value stock?”? No, I care more about industry and firm prospects relative to price.? I will pay up on occasion.? Still, mostly I try to buy them cheap, and it biases me toward “value stocks.”

4) Do I care about whether a stock is volatile or not?? Yes.? Stock price volatility is a sign of low creditworthiness, and usually I only buy higher quality stocks.

5) Do I care about price momentum?? Yes.? Typically, I buy companies that have strong current momentum, or poor momentum over 3-5 years.? Is it what I focus on?? No.

6) Do I care if I have an “undiversified” portfolio?? No.? I want to be in the right place at the right time on average.? Mimicking the index is a recipe for mediocrity.

7) Do I care if I am holding cash?? Yes.? I’d rather be in stocks, but will build up cash if I have to.? Cash moderates volatility in a concentrated portfolio, and allows for opportunistic purchases.

8 ) Do I care if I underperform?? You bet.? It burns a hole in my gut.? But it doesn’t make me change my methods.? It will make me sharpen my analyses.

A large part of the idea is to focus on risks, not risk.? Academics focus on univariate risk, with its simplistic math — beta, standard deviation, skewness, and all of the half-measures and ratios that stem from them.? I can’t model my methods in full, but I look at the risks in particular for each of my investments.? Every investment has to justify its existence in my portfolio independently.? I don’t do correlations; they are not reliable.

I also don’t go in for the four Carhart risk factors — beta, size, value/growth, and price momentum.? I don’t think of them as “betas,” but as “alphas.”? These are factors that can be taken advantage of when they are cheap or rich.? They are not risk factors, they are simply factors.

In closing, there has been a shift in the environment from inflation to deflation.? How does that affect investment choices?? My guess: buy well-financed companies with a low price to tangible book.? Stagflation?? In the ’70s the answer was low P/E with pricing power.

The closing segment of this series will focus on how to do statistically valid studies of investment performance.? I know at least one person who may be annoyed by what I say, but it is important to try to be fair in investment analysis, lest we lead others astray.

On Investment Modeling, Part 1

Posted on 16 November 2010 by David Merkel

Investing is a battle between the past, present, and future.

The past tempts all to look and see what has happened, and extrapolate, or assume mean-reversion.? It tempts academics to use simplistic math, and calculate alphas, betas, standard deviations, R-squareds, and more.? They consider the past to be prologue.? They estimate assumptions for asset allocation off of averages of past returns, sometimes even making the error of arithmetic averages, rather than geometric averages.

But the past is the past.? It happened, and it usually has little bearing on the future, aside from momentum effects when few are following momentum.? Those who calculate models off of historical data describe the past in a stylized way.? The past is a historical accident; generalizing from it in precise terms is difficult.? In some ways I think that analogies from the more distant past have more validity, partly because they are less known by the average market participants.

Those who use the past for asset allocation are doomed for failure.? The past is the past.? Bonds returned well in the past, but the best estimate of a bond’s return over its maturity is the YTM now.

The present intrudes on the past that way. With stocks, the same thing happens measuring current P/Es, P/Bs, P/Ss, versus long term average returns.? It is far better to be a buyer when a stock is out of favor, but not dying.

In the present we can estimate implied volatilities from options, and even implied correlations in certain cases.? Real-time as those are, they give the knife-edge of the estimate of how things react presently.

But as for the future?

We have precious little in the way of clues.

Yes, value and momentum may give us some guidance when they are underfollowed, but they are poor and weak guides to the future.

The truth is that we just don’t know.? Our models are often regime-dependent, because data has been collected over a limited period of time.? I smiled at the Denver conference that I recently attended, as models were trotted out that were based on 20 years of data or fewer.

Now, I don’t blame the researchers, including myself, much.? We all look for the biggest, longest set of clean data we can find.? We realize there are things that we aren’t testing.? We should know that there are hidden variables that haven’t varied much during a regime, that might our results quite different when the regime shifts, but for the most part those are Rumsfeldian “unknown unknowns.”

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Excursus: I once did a seemingly hopeless project to try to estimate withdrawal sensitivity to interest rate movements on deferred annuities.? I completed it in 1998, with 16 years of data, on hundreds of thousands of policies.? Big known problem: interest rates had fallen over the whole period.? But the need for the project was evident, because interest rates had nowhere to go but up, right?? With a little clever modeling, though, I teased out the statistically significant result that a one percent rise in the difference between competing and our deferred annuity yields would lead to additional withdrawal of 2%/yr.

At first, I thought 2% was too small, but then I realized it was an option not efficiently exercised.? So I left padding? in my analysis, assuming that if the market ran away and we couldn’t keep up, that withdrawal levels would be far higher than a ratio of 2.? I built my asset-liability model, which had the capacity of running multiple scenarios developed from my multivariate mean-reverting lognormal interest rate model, built from my homegrown quasi-monte carlo multivariate random number generator.

I did not set the model to optimize investment policy.? Instead, I set it to do well on two criteria that I weighted: minimize losses in the lowest 5% of the tail, and best average result.? When I got the results, they looked wrong; but the more I looked at them, I realized they were right.? I did two versions, one that allowed for the use of interest rate options, and one that didn’t.? Knowing? that my investment department had no quants, I realized the options would be a tough sell — indeed, they chose the option without them.? But then they asked me, “Dave, these are deferred annuities; crediting rates vary annually.? You’re telling us to invest three years longer than we are currently in duration terms — that’s huge.? And why 20% in 30 year bonds?”

My answer was a simple one.? We were all concerned about rates rising and withdrawals that would occur from that.? We missed the other issue, because interest rates can only go up from here, right?? Floor guarantees.? If rates continued to fall, we would have no ability to lower rates further on an increasing amount of the policies; those policies also would have low lapse rates.? When I explained how close we were to the floor we were they caught on, and realized that we had a rare “free lunch.”? Limit risk and improve returns all at once.

Actually, it meant we had mismanaged the business previously, because it was the first withdrawal study in the history of that line of business, but at that point it increased the profits of the company significantly.? What’s more — rates didn’t rise as we all knew they would.? The change in investment policy saved the insurer that merged/acquired the company a lot of headaches.

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So, with whatever our results seem to be, we have to take caution and not overdo what our results seem to prove.? Risk control should be the order of the day.? Buffett said that all he wanted in life was an unfair advantage, but with our limited knowledge of how markets work, we have to realize that we probably have less advantage than we think.

I have more to say here, but I have to hit the publish button — too long already; more coming in part 2.

Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Posted on 6 November 20109 November 2010 by David Merkel

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.? The CFA Society of Colorado is co-sponsoring it.? As a guide, they have asked my panel to comment on this piece? by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.? I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren?t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python?s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.? The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.? Market prices reveal the current expectations of the market as a knife edge — sharp but thin.? They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.? Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.? Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.? The main thing to remember is that human nature never changes.? In aggregate, we don’t learn from market behavior.? We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.? That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.? Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.? Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.? The truth is: it’s never different, or, it’s always different.? Human nature in individual and aggregate, does not change.? Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.? One thing that I have focused on in my money management ideas, is to avoid thinking short-term.? There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.? Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.? If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.? If I find a more? attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.? I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.? Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.? Think of Fannie and Freddie.? They ran on thin capital bases for years, thinking that they could never lose.? So long as housing prices continued to rise, they were right.? And for many, the idea of housing prices falling in aggregate was ridiculous.? Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.? The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.? Scientists are biased? like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.? Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.? Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.? That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.? Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”? Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.? But, how well can we predict that?? I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.? I would like an infinite stream of patsies to soften the blow if I make bad decisions.? In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

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So, after all that, aside from point one, I agree with Montier almost entirely.? What a great article he wrote, and what a great article to stimulate the panel that I am on.

The Rules, Part XIX

Posted on 23 October 201023 October 2010 by David Merkel

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

After doing my talk for the Society of Actuaries last Wednesday, I got inspired to write something about modern portfolio theory, the capital asset pricing model, the efficient markets hypothesis, etc.? This particular rule deals with two things:

The same event can have different risk for different individuals.? Risk is unique to each individual.? It cannot be summarized by a single statistic for comparative purposes across individuals.
In general, with a few exceptions, risk is inverse to price.? As the price gets higher, so does risk.? As the price gets lower, so does risk.? The major exception to this rule is when trends are underdiscounted, because estimates of intrinsic value are flawed.

Let’s deal with these issues one at a time.? Start with a simple question.? Why do academics want to have a single measure for risk?? It allows them to write papers, and it keeps the math simple.? That’s why we have concepts like beta and standard deviation of total return.? It’s why we have concepts like the Sharpe ratio and other ratios that purport to measure return versus risk.

If our total planning horizon was similar to the periods that these figures are calculated over, they might have some validity.? But most of the time are planning horizons are longer than the periods that these figures are calculated over.? Even worse, most of these statistics are not stable.? The value calculated today may likely have a statistically significant difference from the value calculated a year ago.

But what is worse still is the idea that by taking more risk you will get more return.? If anything, the empirical research that I’ve been reading, and the value investors that I have talked to, indicate that the less risk you take, the more you’ll make.? A good example of that would be Eric Falkenstein and his book Finding Alpha.? Minimum beta and minimum standard deviation portfolios tend to outperform the market.? Junk grade bonds tend to underperform investment-grade bonds.

If it hurts too much, don’t do what I’m about to say.? Think about Lenny Dykstra.? When he and I were writing at RealMoney.com at the same time, I would often ask him about what his method would be to control risk.? He never gave me a good answer; actually he never ever gave me an answer at all.

My concern was for small investors, dazzled by the celebrity, and the simple approach that he would take that seemingly yielded huge profits, would adopt the approach, and not know what to do when things went wrong.? For Dykstra, who seemingly had a lot of money, losing a little on a deep in the money call trade would not hurt him much.? But to an unfortunate average guy reading Dykstra’s work, a similar sized loss could be very painful.

That said, that greatest risk was in plain view, which Steve Smith, I, and a few others went after — Larry didn’t know what he was talking about.

Risk varies by differences in wealth; risk varies with age.? Risk varies with the level of fixed commitments you have in life.? To give you an example there, when I went to work for a hedge fund, the first thing I did was pay off my mortgage so that I would feel free to take big risks for the hedge fund.? It is far harder to take risk, the higher the level of fixed obligations that one must pay month after month.

To make it more practical, think of all the malarkey that has been spilled talking about ?animal spirits.?? I don’t believe that businessmen are irrational; many Keynesian economists are irrational, but no, not businessmen.? Businessmen will not take risks when they are overleveraged, or, when a broad base of their customers is overleveraged.

Risk is unique to everyone’s individual situation.? Any time you hear someone bring up risk factors that are generic, you can either ignore them, or, more charitably think that they have a proxy that might have something to do with risk, maybe.

Go back to Buffett’s dictum: far better to have a bumpy 15% return than a smooth 12% return.

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The second part of the rule says that risk models should reflect higher risk as prices rise and lower risks as prices fall.? The implicit idea behind this is that it is possible to calculate the intrinsic value of an asset.? Can I disagree with one of my own rules?? Well, since I do the writing here, I guess I get to make up the rules about the rules.

There are many assets that it is difficult calculate the intrinsic value thereof.? Examples would include commodities, growth stocks, and anything that is highly volatile.

Though I believe my rule is correct most the time, markets are subject to momentum effects.? Often when a stock is at its 52-week high, that’s a good time to buy, because people are slow to react to changes in information.? And, when stock is falling hard, and is at a 52-week low, that is often a good time to not buy the stock, because there are maybe bits of information about the stock, or its holders, that you don’t know.

In general, though, higher prices are more likely to be overpayment and lower prices are more likely to indicate bargains.? Why?? Because returns on equity tend to mean revert.? Companies with poor returns on equity tend to find ways to improve business.? Companies with high returns on equity tend to find increased competition.

Thus, as always, I counsel caution.? Don?t ignore momentum, but also don?t ignore valuation.? Ask yourself how much upside there could reasonably be, and how much downside.? Play where the downside is limited relative to the upside, because the key to investing is margin of safety.? Play to win, yes, but even more, play to survive, so that you can play longer.

Earnings Estimates as a Control Mechanism, Flawed as they are

Posted on 6 October 2010 by David Merkel

Why does the stock market pay so much attention to earnings estimates?? Don’t earnings estimates embody the worst type of analysis of stocks on Wall Street?

There is some truth to the thought above.? After all, earnings estimates eliminate all one-time charges.? Now, that makes sense in the short run, but not in the long run.? In the short run we want to estimate the growth in value of the business on a continuing basis.? Thus, we eliminate one-time events.? In the long run we must see how a management team has grown the total value of the Corporation.? To do that, we must factor in all of the one-time events as well as the regular earnings in order to see how they have managed Corporation over time.? Would that one-time events were really one-time events.? And, would that one-time events averaged out to zero.? But truth, one-time events are on average highly negative.? And so, companies with a lot of one-time events typically have lousy earnings quality, and deserve a lower price earnings multiple as a result.

So if there is that much trouble with how we measure earnings as far as earnings estimates go, why do we use earnings estimates?? 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.

So long as the earnings estimates are relied on a fair measure of likely future earnings of the company, they become an influence on the current price stock.? For example:

If earnings estimates rise rapidly, so will stock prices.
If actual earnings comes in above estimates the stock price will have one-time rise.
And vice versa for when estimates fall , and when actual earnings are less than the estimate.

Now if earnings estimates were done right, together with growth estimates, by angels did not men, they would serve as cornerstones for estimating the value of corporations.? But our ability to see the future even collectively is poor.? Many things happen that we do not expect, whether from the government or the central bank or wars, you name it.

But even with all those flaws, earnings estimates provided useful function in being a feedback mechanism so that the market knows how to react in general, when earnings are released.

New Problem

But when beating earnings estimates become the be all and end all of the corporate management, we run into trouble.? Knowing that the estimate drives the stock price, makes some corporations fuddle the accounting.? They adjust revenue recognition, they differ recognition of expenses, enter into useless mergers and acquisitions, etc. Most accounting chicanery problems would not exist if beating the earnings estimates was not so important.

So what do we as investors do?? We look at the release of actual earnings with skepticism.? We carefully consider the adjustment of net earnings to operating earnings and asked whether the adjustments are truly reasonable or not.? We also don’t give full credibility to earnings estimates as if they were a sure thing.? Further, we review revenue recognition policies, and all other means to easily adjust operating earnings so we are not deceived by corporate managements.

And, if I can be so radical, we begin ignoring earnings and focus on growth tangible book value per share.? We look at growth cash flow per share net of maintenance capital expenditure.? We do all we can estimate free cash flow, and yet, take a step back and ask how the free cash flow is being used.

Free cash flow is not valuable if it’s being used to buy back stock at a high multiple.? It’s not valuable if it’s being used to do a scale acquisition.? Both of these are forms of dilution to common shareholders.

The key question is this: is the management building the net worth per share of the company?? That’s a lot harder question asking if the current earnings beat the estimate, but if this were easy, they would’ve brought someone else in to do it, not you or me.

PS ? I leave aside the issue of intangibles here.? Usually intangibles are worthless.? But some are quite valuable, like the name Coca-Cola, or distribution network that is not easily replicated, or research and development is unique to the Corporation has not yet developed into a product.? All that said, for an intangible to have value, it must produce additional cash flow in the cash flow statement under operations, that do not reflect in the earnings statement.