Category: Academic Finance

Book Review: Market Indicators

Book Review: Market Indicators

Posted on by David Merkel

Every one one us has limited bandwidth for analysis of data.? We pick and choose a few ideas that seem to work for us, and then stick with them.? That is often best, because good investors settle into investment methods that are consistent with their character.? But every now and then it is good to open things up and try to see whether the investment methods can be improved.

For those that use market indicators, this is the sort of book that will make one say, “What if?? What if I combine this market indicator with what I am doing now in my investing?”? In most cases, the answer will be “Um, that doesn’t seem to fit.”? But one good idea can pay for a book and then some.? All investment strategies have weaknesses, but often the weaknesses of one method can be complemented by another.? My favorite example is that as a value investor, I am almost always early.? I buy and sell too soon, and leave profits on the table.? Adding a momentum overlay can aid the value investor by delaying purchases of seemingly cheap stocks when the price is falling rapidly, and delaying sales of seemingly cheap stocks when the price is rising rapidly.

Looking outside your current circle of competence may yield some useful ideas, then.? But how do you know where you might look if you’re not aware that there might be indicators that you have never heard of?? Market Indicators delivers a bevy of indicators in the following areas:

  • Options-derived (VIX, put/call)
  • Volume and Price driven (Money flow, rate of change, 90% up/down days, and more)
  • Where the fast money invests (money in bull vs bear funds, sector fund sizes, and more)
  • Analyzing the likely motives of other classes of investors (margin balances, short interest, etc.)
  • Price Momentum and Mean-Reversion
  • Measuring asset classes and sectors using fundamental metrics? (Fed model, sector weightings, Q-ratio, etc.)
  • Investor sentiment surveys
  • How to use analyst opinions, if at all?
  • News reporting and reactions of stocks to news
  • Odd bits of news (CEO behavior, little things that indicate a qualitative change in the life of a company)
  • Insider buying and selling
  • Commodity market data (COT, etc.)
  • Bond market behavior (credit cycle, Fed moves, Credit Default Swaps, and more)
  • Changes in the capital structure (M&A, equity/debt issuance, etc.)
  • Monitoring the greats (13F filings)

No one can use all of these indicators.? You can probably only use a fraction of these indicators.? But being aware of how others view the market can widen your perspective, and help to reduce negative surprises on your part.

Quibbles

By its nature, since the book cuts across a wide number of areas in 216 short pages, you only get a taste of everything.? I liked this book, but there is room for a second book in this area — one of additional indicators passed over (I have a bunch!), or going into greater depth on the indicators covered.

Who will benefit from this book?

You have to have a quantitative bent, at least to the level of being willing to go out and collect simple data in order to benefit here.? Now, most serious investors do that, so I would say that serious investors can benefit from the “cook’s tour” of market indicators that this book gives, unless they are so serious that they know all of these indicators.? (Like me.)

If you would like to buy the book, you can buy it here: Market Indicators: The Best-Kept Secret to More Effective Trading and Investing.

Full disclosure: This book is unusual for me in two ways.? First, the author (not the PR flack) sent me a copy, with a nice handwritten letter thanking me for my blog and my assistance.? That is why there is the second reason.? Pages 80-81 summarize the longer argument made in my blog post, The Fed Model, where I take the so-called Fed model, and rederive it using the simple version of the Dividend Discount Model, giving a more robust model with reasonable theoretical underpinnings.

I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.? Your price does not rise from my commission.? Don’t buy anything you don’t want to buy if you want to reward me for my writing.? Only buy what you need if Amazon offers you the best deal.

Toward a New Theory of the Cost of Equity Capital, Part 2

Toward a New Theory of the Cost of Equity Capital, Part 2

Posted on by David Merkel

When I write a piece, and entitle it “Toward…” it means that I don’t have all of the answers.? Typically I think I am getting somewhere, but the speed of progress is open to question.? That said, good questions and constructive criticism aid me on my way.

From Private Equity Beat at the WSJ: Toward a new theory of the cost of equity capital, on the Aleph Blog. We confess to not being entirely up on the benefits of Modern Portfolio Theory versus Modigliani-Miller irrelevance theorems, which is probably why we are journalists and not PE execs. But we nonetheless find this analysis of how to price equity interesting.

From Eddy Elfenbein at Crossing Wall Street: I like the logic, but my question is?what if a firm has little or no debt?

Good question.? The total volatility of a firm can be broken up into three pieces: financial leverage, operating leverage, and sales volatility.? Saturday’s piece dealt with financial leverage and its costs.? An unlevered firm in the financial sense still possesses operating leverage and volatility of sales.? Different unlevered firms have different costs of equity capital because they have different levels of sales volatility, and different degrees of operating leverage.

That will manifest itself in option implied volatility, which is a crude measure of what people would pay to gain and lose exposure to the equity of the company.? The cost of equity should be positively related to that.? More volatile companies should have a higher cost of equity.

Another way to look at it is to ask what is the effect on the firm if the company issues or buys back equity.? How much does the generation of free cash flow change relative to the price paid or received for equity?

Another question:

Doug Says:

October 19th, 20098:25 am

?As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.?

How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising ?coupons? and get back value much greater than ?par? at the end of his/her investment.

I realize that models such as gordon growth take this into account, but you don?t address it in your ?debt plus a premium? calculation.

Doug, good point.? The FCF yield, unlike a dividend yield, as used by the Gordon and other DCF models, reflects the ability of the company to reinvest the FCF that is not paid out as dividends.? It reflects growth already in a crude way.? If the ability to grow via reinvestment is below the FCF yield, then the company may as well just sit around and buy back stock.? If the ability to grow earnings is higher (unusual), then the FCF yield will understate prospects.

That’s a crude way of phrasing it, but the FCF yield is a good place to start.

Finally, regarding my thoughts on M-M:? Take Falkenstein?s recent book ? high yield tends to underperform with both debt and equity. Or consider that less levered companies tend to return better over the long haul (Megginson, Corporate Finance Theory, page 307.)

M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms.

Summary

The idea here is to try to view the cost of equity capital as a businessman would, rather than an academic who has little exposure to the world as it operates.? Look to the degree of certainty in obtaining cashflows; the yields on various assets should rise as certainty declines.

Toward a New Theory of the Cost of Equity Capital

Toward a New Theory of the Cost of Equity Capital

Posted on by David Merkel

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

  • Beta is not a stable parameter; also, it does not measure risk well.
  • Company-specific risk is significant, and varies a great deal.? The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.? If less scientific, it was probably more accurate than MPT.? Science is often ill-applied to what may be an art.? Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I?ve also never been a fan of the Modigliani-Miller irrelevance theorems.? They are true in fair weather, but not in foul weather.? The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.? The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.? The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.? If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.? If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.? I will use a securitization of commercial mortgages [CMBS], to serve as my example here.? There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is ? the party that gets the leftovers after all of the more senior capital interests get paid.? In many securitizations, that equity tranche is small, because the underlying assets are high quality.? The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.? That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton?s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.? But for average investors, what does that mean?? How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.? The driving rule should be that riskier instruments deserve higher yields.? Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.? As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.? Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody?s ? the part that bought KMV).? If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.? This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.? The answer varies with the assets financed, and the degree of leverage already employed.? Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

I?ve wanted to write this for a while.? Though this is an outline of how to replace MPT in estimating the cost of capital, it has broader ramifications, and could become a much larger business, much like the rating agencies started with a simple business, and branched out from there.

Maybe someone is doing this already.? If you are aware of that, let me know in the comments.

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PS — Sorry that I have been gone for the last few days.? Church business took me away. I’m back now, and will be posting on Monday.

Book Review: Expectations Investing

Book Review: Expectations Investing

Posted on by David Merkel

Why don’t average investors use discounted cash flow analyses?? Typically, they don’t use them for several reasons.

  • Most people don’t want to use an algebraic formula to estimate anything.? As some legendary trader reputedly yelled at a quant, “No formulas!? You can make me add, subtract, multiply, and divide!…? And don’t make me to divide too often!”
  • It is not intuitive to most.? It takes a bond-like or actuarial approach to analyzing stocks — forecasting future free cash flows and discounting them at the firm’s cost of capital.
  • It is highly sensitive to assumptions one employs.? Small changes in growth rates or discount rates can make a big difference in the estimate of value.? It lends itself easily to garbage in, garbage out.? (I remember a Dilbert cartoon where an analyst told Dogbert that scientific decision analysis required forecasting future free cash flows and discounting them.? He added that the discount rate had to be right or the analysis would be garbage.? Dogbert’s comment was to the point: “Go away.”)
  • It takes a lot of work, and shortcuts are easier, providing most of the analysis with less effort.

Now, most professional investors don’t use DCF either, for many of the above reasons.? But there are a number that do, among them Buffett.? Morningstar uses DCF for its stock recommendations.? It’s not a bad system after one makes the effort as an organization to standardize your free cash flow estimates and discount rates.? Most professionals invert the process, and rather than trying estimate what a stock is worth, they estimate what they think the company will return at the current market price.

Expectations Investing is one way to formalize DCF, and a rather comprehensive one.? It would be a good way for an investment organization to formalize its investment process, but is way too complex for one person implement, unless one is following some type of simplifying system like Morningstar, ValuEngine or any of the other purveyors of DCF analyses out there.

In the process of formalizing DCF, the book explains the problems with traditional P/E analysis, and how a focus on free cash flow can remedy the problems.? A weak spot in the book is their discussion of cost of capital.? Their cost of equity capital analysis relies on beta, which is not a stable parameter, nor does it really capture what risk is.? That said, inverted DCF can work without discount rates.? The book takes the approach that the discount rates are the less critical factor, because when they change for one firm, they typically change for all firms.? The book’s solution is to use current prices to drive DCF backwards and determine market free cash flow expectations for a stock.

The analyst can then look at those expectations, and try to determine whether they are too high or too low.? The analyst can also look at whether there might be changes due to unit growth, product price changes, operating leverage, economies of scale, cost efficiencies, and changes in the marginal efficiency of capital.? After the analysis, usually one or two factors will stand out capturing a large portion of the variability.? The analyst then focuses on those, and what drives them.? Unexpected changes lead to revisions to the analyst’s model, and the game continues.

Beyond that, the analyst needs to understand how the company in question fits into its industry.? The book discusses Michael Porter’s five forces, the value chain, disruptive technologies, and the economics of information.? Beyond that, the book touches on:

  • Real Options — the ability of a company to pursue value enhancing projects or not.
  • Buybacks — do them when the company has no better opportunity, and the shares are undervalued.
  • Mergers and Acquisitions — how to tell when are they good or bad ideas.
  • Reflexivity — Are there situations where a higher or lower stock price affects the business?? High/low valuation makes financing easy/difficult.
  • Understanding management incentives — how will they affect financial results and management behavior over the short and long runs.

At 195 pages in the body of the book, Expectations Investing is not a long book for what it covers.? The flip side of that is that is breezes over much of the complexity inherent in what they propose.? One other shortcoming is that little time is spent on financials, which are a large part of the market, and for which it is intensely difficult to calculate free cash flow.? After reading the book, I would have no idea on how to apply their DCF model to valuing a bank or an insurance company.

Aside from financials, if someone were to ask me, “Is this how valuation should be done?” I would say, yes, ideally so.? But it brings up one more critique: though I hinted at it above, most of the shortcuts that investors use are special adaptations and first approximations of the DCF model.? That is why shortcuts have validity — if you know the critical factors that drive profitability for a given company or industry, why waste your time on a big model with many inputs?? Cut to the chase, and use simpler models industry by industry.

Who would benefit from this book: someone who either wants a detailed means of calculating a DCF model, or a taste of the issues that an analyst/investor has to consider as he evaluates the worth of a company’s stock.

This is a neutral review from me.? I neither encourage or discourage the purchase of the book.? It has its good and bad points.? But if you want to purchase it, you can find it here: Expectations Investing: Reading Stock Prices for Better Returns.? I have a copy of Damodaran’s The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd Edition), weighing in at 575 pages, as well as his book Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Second Edition (similar size, with a quarter inch of dust on my shelf.? Guess I don’t use it that much).

I could do a review of one or both of those, but if Expectations Investing is overkill for the average investor, and light for the professional, then either of Damodaran’s books are for the professional only.? At best I think it would only produce a review on the weaknesses of DCF analysis.

Full disclosure: If you enter Amazon through my site, if you buy something there, I get a small commission.? Your price does not change.? I review old and new books, and I don’t like them all; my goal is to direct readers to the books that can best help them.

Book Review: Think Twice

Book Review: Think Twice

Posted on by David Merkel

Since I met him at a Baltimore CFA Society meeting in 2001, I have? appreciated the intelligence of Mike Mauboussin.? (My old boss was his roommate in college, so I was told, the name is pronounced “MOE-bus-son.”)? He was early to pick up on the value of behavioral economics and nonlinear dynamics (“chaos theory”).

Think Twice is an effort to get all decisionmakers to take a step back and ask whether they are making decisions from shorthand rules, or from carefully analyzed data.? The book is full of examples of how people are easily fooled by irrelevant data.? Most of the examples I was aware of, becauseI have studied this stuff intensively.? There were a few surprises for me, though.

Did you know that at the craps tables in Las Vegas, on average, when someone wants a higher number, they throw the dice hard, and when they want a low number, they give it a gentle toss?? I found that to be an amusing example of the illusion of control in? a case where humans have no control.

This book helps answer a number of tough questions:

  • When are crowds better than experts, and vice-versa?
  • Why don’t we go get data, rather than listening to anecdotes?
  • Why does an initial estimate play such a large role in estimating the final value?? (Why don’t people ignore the estimates, and start from scratch?? It’s too much work!? Never underestimate the power of laziness.)
  • Can subliminal cues lead people to make different decisions?
  • Do I have to understand the whole system to understand the piece of the system that I am interested in?
  • When can you outsource production, and when does it not make sense?
  • When do catastrophic events occur, and why?
  • How does one sort out happenstance (so-called “luck”) versus skill?

The clear message of the book is don’t be lazy; do your homework on any task.? Try to be objective as possible, ignoring the opinions of others, and using as much data and cold logic as one possesses to confront the problem.? Be aware of the mental shortcuts that hinder good decisonmaking.

I recommend this book, but with a quibble.? It is not written in a truly user-friendly way.? There are technical terms used and not defined that many average people will blink at, and maybe get part of the meaning through context, but not get it in full.? If we Flesch-tested the book, it would come up at “college level” for reading.? (As for me, I am to be understood at a high school level.)

Who can benefit from this book?? Anyone who makes economic decisions could benefit.? It would help them be more self aware of the pitfalls involved in decisionmaking.? I found it to be a breezy read at 143 pages of main text, and the writing style is entertaining.

You can buy the book here: Think Twice: Harnessing the Power of Counterintuition.

Full Disclosure: Anyone entering Amazon through a link on my site, and buying something — I get a small commission.? Your costs remain the same.

To my readers, if you want me to review Mauboussin’s other book, Expectations Investing, I would be more than happy to, because I read it five years ago.? If you have other books you would like me to review, let me know… my time is limited, but if I get a lot of people asking for the same book, I will give it a shot.

PS — look at the book cover — what is the hidden message? (which never gets mentioned once in the book…)

Ten Notes on Current Market Risks

Ten Notes on Current Market Risks

Posted on by David Merkel

1)? You hear me talk about this more than most, but liquidity risk needs more emphasis.? This is true whether you are a retail or institutional investor.? As the old saying goes, “Only invest what you can afford to lose.”? The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance.? The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets.? I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research.? Once markets do not trade continuously, the math gets tough.

2)? Insiders are selling, should you worry?? Perhaps a little, but I would wait until the price momentum starts to fail.? Like value investors, insiders tend to be early.

3)? What works in a time of rising leverage will not work well when leverage is decreasing.? Or, a strategy that requires liquid markets does not so well in a time of deleveraging.? Consider Citadel, then.? The period from 1991-2007 was pretty care-free.? What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap.? In 2008, the trap was sprung and Citadel had a lousy year.? Amid the carnage, they were forced to sell into? falling market.? Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4)? Average retail investors don’t understand regulated investments well enough to invest in them.? It would be stupid to allow them to invest in hedge funds, then.? If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime.? The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much.? (The culture abhors little investors being fleeced by bigger institutions.)

5)? Auction rate preferred securities — when I was younger, I wondered how they worked.? By the time I figured that out, the market failed.? Now the lawsuits fly.? Yes, they were marketed as money market equivalents, but none of them made it into money market funds.? Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance.? Few believed them because it had worked so well for so long.? My view is this — investors needed to read the “risk factors,” and did not.? ARPS were designed to be investment vehicles that could survive a storm, but not a tornado.? Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6)? My, but the high yield market and lower investment-grade corporate markets have moved higher.? What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog.? Systemic risk is still high.

7)? Spreads have fallen for high yield; I have previous suggested to lose the overweight in credit.? I now suggest that credit be underweighted.? This is not a time to stretch for yield.

8 )? After many other crises, junior debt gets grabbed when seniors have rallied a great deal.? The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield.? When does the rally end? Now?? Typically near a market peak, there is confusion, and a diminution in volume.? I think we are close to the end, but as I usually say, honor the momentum.? If it is still going up, hold it.

10)? This article is a little unusual for me, but it points out something that I often talk about in different terms.? Trees don’t grow to the sky.? In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless.? Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve.? So it is with business, and much of finance.

Book Review: Finding Alpha

Book Review: Finding Alpha

Posted on by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Avoid Risk; Make Money.

Avoid Risk; Make Money.

Posted on by David Merkel

Sometimes a single article can change my direction for publishing for an evening.? So it was for this article, Hedge Fund Keeps Reins on Risk.? I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.? I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.? Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

  • How creditworthy are my counterparties?
  • How readily can I convert my portfolio to cash if I had to?
  • What are my competitors doing?? Are my positions in strong hands or weak hands?? How many are making the same bet that I am?
  • Have the fundamentals of my positions changed?? Have the views of other major players in the market changed?
  • Has the time horizon of other investors alongside of me changed?
  • What cash flow yield am I likely to get, and how might that vary?
  • What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
  • Am I implicitly taking the same bet through seemingly different? areas of my portfolio?

Limit the downside, and the upside will provide for you.? I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.? I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.? I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.? Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.? This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.? The university endowments have stumbled here; they needed more liquidity than they thought.?? So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.? Good move, I think.? Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.? As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.? Even investment banks are getting into the act.? Add to the leverage and let’s take some sweet bets!? Devil take the hindmost!

I get it, and I don’t get it.? This is a time to decrease risk, even though I might be early.? The troubles of our financial sector are not solved.? Our consumers are still overleveraged.? I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.? Avoid risk; make money.

Earnings, Analyst Estimates, and Estimating Future Prospects

Earnings, Analyst Estimates, and Estimating Future Prospects

Posted on by David Merkel

This has been an interesting earnings season.? Many companies have been beating earnings estimates once certain one-time items are excluded.? This has led to criticism by market commentators alleging that earnings estimates and/or adjusted earnings are not a reliable guide for individual stocks or the market as a whole.? There’s some truth there, but let me try to give a more nuanced view.

What are we really trying to estimate?

Earnings estimates do not primarily exist for the purpose of estimating the next few quarters’ or years’ earnings.? They exist for estimating the future path of free cash flows.? Wait, what is free cash flow?? Free cash flow is the amount of money that you can take away from a business at the end of an accounting period and leave the company as well off as it was at the beginning of the accounting period.? How does that compare to earnings?? Typically, non-cash charges like depreciation and amortization get added back to earnings, and maintenance capital expenditures get deducted — what remains is free cash flow, which can be used for dividends, buybacks, and investments to build the business.? Free cash flow is similar to what I will call “run rate” earnings, though there are some differences.

In that sense, analysts are trying to estimate “run rate” earnings when they adjust for “one time” events.? Absent these abnormal occurrences which won’t happen next quarter, what would the earnings have been?? Surprises above and below the consensus estimates of the analysts provide information to investors.? Positive surprises indicate that the future run rate for earnings might be higher, and vice-versa for negative surprises.

I say “might be,” rather than “will be,” because of randomness in profitability, or, an inability to truly figure out all of the abnormalities and timing differences in a given quarter.? Typically, several positive earnings surprises must take place before estimates of the run rate begin to rise.? One is normal randomness, two is happenstance, three is a pattern, four is a change in trend.

Guiding up, guiding down

Of course, corporate management can make life easier by giving earnings guidance to analysts, and then guiding the estimates up or down as they see best.? They can also break out their estimates of operating or adjusted earnings in order that analysts can decide for themselves which adjustments are “one time,” and which aren’t.? (In my opinion, Allstate does a particularly good job with this, as does Assurant.)

But changing guidance is powerful, particularly for companies with a reputation for UPOD (underpromise, overdeliver), as opposed to companies with a reputation for OPUD (overpromise, underdeliver).? When analyzing guidance changes, one must adjust for prior earnings surprises to figure out whether th raise in guidance reflects only past successes, or forecasts greater successes in the future.

That’s a lot of “one time” events!? Why do so many of them raise operating earnings?? Shouldn’t the difference net to zero over a long enough timespan?

Alas, once we start adjusting earnings to create operating earnings, we enter a new world with a new accounting basis that superficially resembles “run rate earnings” but with a fault.? Almost every quarter has its parade of “one time” events.? On average, the adjustments raise operating earnings over ordinary GAAP earnings.? Managements are more incented to find the positive adjustments to earnings in the short run.? Obvious negative adjustments get accounted for, but non-obvious ones don’t get searched for.

But clever investors eventually adjust for this.? Here’s a way to do it.? Analyze a long period of time, say five years, or the CEO tenure, whichever is shorter.? Look at the growth in book value, and add back dividends.? Compare that to cumulative diluted earnings over the same time period.? If cumulative diluted earnings are higher, then earnings are inflated.? Here’s another way: if you have a long enough data series, add up operating and diluted earnings over a long period of time, say five years, or the CEO tenure, whichever is shorter.? If operating earnings are significantly larger, there is a company that is using operating earnings to make itself look more profitable than it actually is.

If nothing else, over a long enough period of time, this is a means of measuring the honesty of management teams where it comes to financial reporting.? In my book, honest/conservative management teams deserve higher multiples than less scrupulous management teams.? These measures document the games that management teams play in order to make their results look better than they should appear.

How are we doing versus the expectations of the market?

The investment game is one where profitability performance versus expectations determines price performance.? Prices don’t ordinarily react to backward-looking data, unless there is a big one-time charge that adds a lot to book value, or takes a lot away, perhaps impairing the future prospects of the firm.? Prices do react to the signals given through earnings relative to expectations, as it leads investors to update their views of potential future run rate earnings, or, free cash flow.

Can we make a lot of money off of this effect?

Not so much any more.? There are many investors following earnings momentum, earnings surprises, analyst estimate revisions, and price momentum, that the average investor can’t make a lot of money off of this effect.? But ordinarily it does help an investor understand what is going on when stock prices move after earnings are released.? Expectations of the future change, and that drives current stock prices.

Full disclosure: long ALL AIZ

Book Review: The Myth of the Rational Market

Book Review: The Myth of the Rational Market

Posted on by David Merkel

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.? The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.? I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.? Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.? My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).? I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).? Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.? I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.? As I read Justin Fox’s work, I admired its ambition.? This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.? It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.? This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.? Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.? Many of them came to my view that the market is pretty efficient, but not perfectly so.? Efforts at finding inefficiency promote market efficiency.? Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.? It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.? More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.? That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

  • Those who are too certain about their positions on market efficiency.
  • Those that assume that the market is always or rarely right.
  • Those that select asset managers, because there is a lot of volatility around investment returns.? What is luck? What is skill?? We know less here than we imagine.
  • Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.

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When I do book reviews, I actually read the books.? In the few cases where I scan a book, I reveal that in the review.? I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:? The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Full disclosure: if you buy anything through Amazon after entering through my site, I get a small commission, but your costs do not go up.

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