Category: Quantitative Methods

Book Review: Nerds on Wall Street

Book Review: Nerds on Wall Street

Posted on by David Merkel

After my last book review, a reader asked how I was able to read so many books, given my other responsibilities.? My answer is this: I keep a book near me at all times.? When I get a break, I read a few pages.? Over a week, that means a book gets read.? That’s how I read so many books.

Onto tonight’s book: I had a number of friends that liked Nerds on Wall Street, and I liked it as well.? The book has a number of strengths.? The author explains complex financial instruments in relatively simple terms.? The same for complex trading techniques.

The author gives history and background as one that was sucked into computerized finance from a technical background that might have had him in a purer technological role.? As I read what he went through, I said to myself, “He was seven years ahead of me.”? I had my own share of innovative things that I did, but the things done in his era were bigger.

He gives reasonable explanations of how computerized trading works, and what factors they look for in designing trading systems.? He talks about the common factors that dominate trading systems, and a few that he knows of but has not published.? (He gives a taste, but does not serve up the full dish.)

Like me, he serves up a full plate of data mining disasters.? There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.? The few significant regularities make sense to seasoned observers, and are not consistent.? They pay off 70% of the time, and kill you 15% of the time.

On Wall Street, if you are really, really smart, they will hand over to you exceptionally advanced tools that you can use to destroy yourself in a unique and memorable way.? So it was for LTCM.


Quibbles

The book is badly edited.? Many elements appear multiple times with little modification.? It sometimes reads like a bunch of articles that was strung together into a book.? The editors should have tried to create something more cohesive.

The last several chapters feel like an afterthought, though many of the ideas presented there are ideas that I have suggested.? I have talked about splitting mortgages into smaller mortgages plus equity appreciation rights.? I have also suggested creating mutual banks, rather than what was done with the TARP.

All that said, the average reader will learn a lot here.? I recommend the book to those that want to dig into how the equity markets became more computerized.? For those that want to understand the same for the debt markets, that book remains to be written.

If you want to buy it, you can find it here: Nerds on Wall Street: Math, Machines and Wired Markets

Full disclosure: If you enter Amazon through my site and buy anything, I get a small commission.? Your price does not go up.? You benefit, I benefit, Amazon benefits.? How could it be better?

On Bond Investing, ETFs, Indexes, and the Current Market Environment

On Bond Investing, ETFs, Indexes, and the Current Market Environment

Posted on by David Merkel

Bond indexes are what they are.? They represent the average dollar invested in the bond markets.? Those that say that the indexes are flawed miss the point.? Indexes represent the average return of an asset class, with all of its warts and wrinkles.? That is the nature of an index; it earns what the asset class as a whole earns.

So what if big issuers dominate the index?? The average dollar in bonds reflects that.? Do you want to take a bet against the average?? You probably do, and I do as well.? But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

I appreciated the book The Fundamental Index ? Arnott did us a favor by writing it.? The book shows how to do enhanced indexing off of fundamental factors.? (A pity that the book went public at the point where most of those factors were overpriced.)

The trouble with enhanced indexing is scalability.? Suppose Arnott?s fund and those like it grew large relative to the market as a whole.? The components of his strategy that are smallest relative to their total market size will get bid up disproportionately.? Eventually they will not be a favored investment of the strategy, and as they move to sell, they will find that they are large holders of something the market is not so ready to buy.? As the price goes down, perhaps it becomes attractive again. Perhaps an equilibrium will be reached.

One thing is certain, though.? The non-enhanced index can be held be everyone.? The enhanced index will run into size limits.

What then for bond ETFs?? Are they chained to inferior indexes? ?No.? By their nature, bond indexes are almost impossible to replicate perfectly because of liquidity constraints. Many institutional bond investors buy and hold, particularly for unique issues.? That?s why indexes are constructed out of liquid issues which will have adequate tradability.? Who issues those bonds?? The big issuers.? It is not possible to create a scalable bond index in any other way, and even then, there will always be some bonds in the index that are impossible to find, and/or, because they are index bonds, they trade artificially rich to similar bonds that are not in the index.

Almost all bond indexers are enhanced indexers, because they don?t have enough liquidity to exactly replicate the index.? Instead, bond indexers try to replicate the factors that drive the index, with better performance if they can manage it.? That?s where choosing non-index bonds that are similar in characteristics, but have better yields comes in.? That is the value of active bond management; it does not mean that the indexes are flawed, but that there are ways for clever investors to systematically do better, that is, until there are too many clever investors.

Pricing Issues

Morningstar prepared this piece on pricing difficulties with bond ETFs and open-ended bond funds.? Yes, it is true that many bonds don?t trade regularly, and that matrix pricing gives estimates for prices on bonds that have not traded near the close, where an asset value must be calculated.

Remember the scandal over mutual fund front-running?? In that case, stale pricing off of last trades enabled clever connected ?investors? to place late trades where the calculated NAV was far away from the theoretically correct NAV (if assets traded continuously).? In order to calculate the theoretically correct NAV (which the late traders did in order to make money), the mutual funds had to engage in a form of matrix pricing, adjusting the last trades to reflect changes in the market since each last trade until the close.? Far from being inaccurate, matrix pricing is far superior to using the last trade.

I will take the opposite side of the trade from the Morningstar piece.? Markets are not rational, especially bond ETF investors.? I trust the NAV more than the current price; matrix pricing is complex, but it is pretty accurate.? Yes, for some really illiquid, unique issues, it will get prices wrong, but that is a tiny fraction of the bond universe.? We can ignore that.

Rationality comes to bond ETFs when sophisticated investors do the arbitrage, and create new ETF units when there is a premium to the NAV, or melt ETF units into their constituent parts when there is a discount to NAV.? That pressure places bounds on how large premiums and discounts can become.

The more specific the bonds must be to create a new unit, the harder it is to do the arbitrage, and the higher the level of premium can become before an arbitrage can occur.? If a less specific group of bonds can be delivered to create a new unit, i.e., the bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option-adjusted spread/yield, etc., then arbitrage can proceed more rapidly, and premiums over NAV should be smaller.

So, when there are large premiums to NAV, it is better to sell.? Large discounts, better to buy.? Of course, take into account that short bond funds should never get large premiums or discounts.? If they do, something weird is going on.? Long bond funds can get larger premiums and discounts because their prices vary more.? It takes a wider price gap versus NAV before arbitrage can occur.

As for cash creations, those that run the ETF could publish a shadow ETF price, which would represent the price that they could create new units themselves, taking into account how they would like to change the ETF?s positions in order to better outperform while matching the underlying characteristics of the index.? That shadow ETF price could not be a fixed percentage of the existing NAV.? It would have to vary based on the cost of sourcing the needed bonds.? This would run in reverse for cash-based redemptions, which would only likely be asked for when the ETF was at a discount.? Better for the fund to do some modified ?in-kind? distribution, agreed to in advance by the sophisticated unit liquidator.

Derivative Issues

Well, if there?s not enough liquidity in the bond market to accommodate our desired investment, why not create it synthetically through credit default swaps?? That might work, but if the bonds are illiquid, often the derivatives are as well, or, the derivatives trade rich to where an identical bond would trade in the cash market.? There is also credit risk from the party buying protection on the default swap; if he goes broke, your extra yield goes away, at least in part.

I don?t see derivatives as being a solution here, though they might be helpful in the short-run while waiting to source a bond that can?t be found.? Derivatives aren?t magic; liquidity comes at a cost, and some of those costs aren?t obvious until a market event hits.

Also, I would argue that the rating agencies are better judges of creditworthiness on average than the prices of credit default swaps.? Though rating agencies should be examined for their conduct in structured securities, their record with corporates is pretty good.? The rating agencies do fundamental research; yields do reflect riskiness, but markets sometimes wander away from their fundamental moorings.? Derivatives can trade rich or cheap to the cash market for their own unique reasons.? Same for bond spreads ? just because one bond has a higher spread than another similar bond, it does not mean that that bond is necessarily more risky.

When I was a corporate bond manager, I would occasionally find bonds that yielded considerably more than others of a given class.? My job, and the job of my analyst was to find out why. ?Often the bond was not well known, or was a better quality name in a bad industry.? On average, spreads reflect riskiness, but in individual situations, I would rather trust the judgments of fundamental analysts, including the rating agencies, though private analysts are better still.

So what should I do in the Current Environment?

I don?t think we are being paid to take credit risk at present, so stay conservative in bonds for now.? Specifically:

  • Underweight credit risk.
  • With equities, stress high-quality balance sheets, and stable industries.
  • Underweight financials, particularly banks and names that are related to commercial real estate.
  • GSE-related residential mortgages look okay.
  • TIPS don?t look good on the short end, but look okay on the long end.
  • Be wary of paying premiums on bond ETFs? and maybe look at some closed-end funds that trade at discounts.
  • The yield curve is steep, but that is ahead of a lot of long supply coming from the US Treasury.? Stick to short-to-intermediate debt, and wait for supply to be digested.? After that, maybe some long maturity positions can be taken as rentals, so long as inflation does not take off.
  • Diversify into foreign bonds, but don?t go crazy here. ?The Dollar has run down hard, and opportunities are fewer.? (I will have a deeper piece on this in time, I hope.)

This is a time to preserve capital, not reach for gains.? Don?t grasp for yields that cannot be maintained.

PS — Thanks to the guys at Index Universe and Morningstar for the articles; they stimulated my thinking.? I like both sites a lot, and recommend them to my readers.? The articles that I cited had many good things in them, I just wanted to take issue with some of their points.

Book Review: The Predictioneer’s Game

Book Review: The Predictioneer’s Game

Posted on by David Merkel

Most of us were kids once.? I think I was a kid once, but my memory is fuzzy.? I do remember playing the card game “War.” Nice game, but suppose if you were dealt a weak deck you had the option to look at the opponent’s deck, and stack yours to meet the challenge.? That would be a sharp example of how game theory could be used to defeat a stronger player.

This book is a little further afield than I usually go, because this is not an economics or finance book in the traditional sense.? The Predictioneer’s Game describes using game theory to solve complex problems, and possibly, affect the results in your favor, or, the favor of your client.

The author, Bruce Bueno de Mesquita is a professor of political science at NYU, and a senior fellow at the Hoover Institution.? Though he uses game theory in his academic work, on the side, he uses game theory in his own firm to analyze tough policy, business, and legal questions.

His methods are simple and complex.? Simple, because the math at first glance isn’t that difficult, but complex, because many different iterations of the simple model must be considered using a computer.? Often the answer that the computer spits out is a surprise that reveals that there is a clever strategy to achieve an unusual result.

There are many elements that go into building such a model.? It begins with designing the question in a way that facilitates sharp opinions from experts.? The experts name all of the parties that have an interest in the outcome, and:

  • What their desired outcome is.
  • How motivated they are to achieve their desired outcome.
  • How influential can they be with other parties in the dispute.
  • How much they want an agreement, even if it is not their favored outcome.

The experts rate all of the parties on those variables on a scale of 0 to 100.? Then the math starts, analyzing what sorts of coalitions can develop to come to an outcome that satisfies those with the most influence and motivation.

Now, I don’t buy in entire his view that everyone is strictly motivated by self-interest.? I have adopted five children, in addition to having three with my wife.? Yes, we wanted a large family, but we would have been happy with fewer.? We saw this as something good for society on the whole, as well as the church, which made us more willing to adopt.? If we are going to argue that a person having love for their culture or for their church is an expression of self-interest, then please tell me what would be self-disinterest.? To use an example from the book, I have mixed feelings about “Mother Teresa,” but I have little doubt that she did what she did out of devotion to the Catholic Church, and not out of self-interest.

That said, until proven otherwise, assuming any party is entirely self-interested is probably correct to a first approximation, which is why game theory is so applicable to complex problems.

Bruno de Mesquita has quite a track record according to the CIA:

Since the early 1980s, C.I.A. officials have hired him to perform more than a thousand predictions; a study by the C.I.A., now declassified, found that Bueno de Mesquita?s predictions ?hit the bull?s-eye? twice as often as its own analysts did.

As a result, I tend to believe his claims as he goes through the book.? He has helped solve some tough political and business problems. Most of the examples in the book fall into legal or political categories, though there are a number of examples for the business world: CEO succession (funny), merger negotiations, and how to buy a new car.

The last will pay for the book on its own.? I have used the technique twice before, and it works.? That said, that I have used it twice before means it is not unique to the author.? (For those buying used cars, I have another approach.)

Now, the author offers the opinions of his models on:

  • What will happen in the global warming negotiations?
  • Will Iran develop a nuclear bomb?
  • Will Iraq and Iran develop an alliance?? (Note: there is no explicit mention of the Saudis in this discussion, which I think is a major miss.)
  • Will Pakistan continue to cooperate with the US in the “war on terror?”

Good questions all, but I would ask the following questions:

  • How will the various nations of the world fare through the coming demographic crises?
  • Will the US Government pay off its debts in real terms, or will they inflate the debts away?
  • Will the US Dollar remain the global reserve currency?? If not, then for how long?
  • When will the Communist Party lose control in China?

Perhaps the author could favor us with some answers, but regardless, I recommend the book to all that have interest in predicting the outcomes of complex situations.

Who will benefit from the book?? This is a book that many will benefit from, because the subject area is broad, and the ability to turn the windmills of the mind are considerable.? For those who want to buy it, they can buy it here: The Predictioneer’s Game: Using the Logic of Brazen Self-Interest to See and Shape the Future

Full disclosure: my goal is to have alignment of interests between me and my readers.? I don’t want any of my readers buying something only to benefit me.? But if you want to buy something at Amazon, please enter it through my site — you buy at the prices that you like, and I get a commission.? I like the fact that my readers get what they want at no additional cost as they aid me.? I look for win-win situations, and this is one of them.

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.

On Dual Share Classes

On Dual Share Classes

Posted on by David Merkel

My research sometimes takes me into the nooks and crannies of finance.? I know it is wonky, but I actually enjoy tearing into complex prospectuses in order get a sense of where value is.

One of my current projects is on large companies that have more than one share class.? Some easy questions:

  • How many companies are there in the US with more than $1.5 billion in market cap? 1,045.
  • How many of them have have more than one common share class?? 103, or roughly 10%.
  • How many of the 103 companies extra share classes trade more than one thousand dollars worth of volume per day?? 28.
  • How many of the 103 companies extra share classes trade more than one million dollars worth of volume per day?? 11.

Why are there dual share classes?? Usually, it is because a founder that prized control had a financing need for which equity was the right choice, but he decided that he did not want to give up control.? So, he issued equity with lesser voting rights at a discount to the shares with greater voting rights.

In most cases, there are covenants that protect dividend rights and liquidation rights of the lesser voting shares.? The difference in the share prices of different classes of stock often boils down to the value of what a vote is worth.

Now what of those 11 companies where liquidity is adequate in the dual shares?? There is the opportunity for arbitrage in synthetically buying votes cheap and selling them dear.

Now, this is not a large trade.? Indeed, this is not big enough to begin a hedge fund around.? But it could be of value to enhanced indexers that are trying to outperform their benchmarks by a small amount.? The lesser voting shares, particularly at an extreme discount offer higher yields, and a better return in a change of control.? The loss is a lesser degree of control — you are on the back of the bus and other investors

This presumes that there are covenants on the various share classes for equal treatment in a change of control, and/or that there are rules to govern dividend policy, giving the same or superior treatment to those with a lesser voice.? That is normally the case, but when I was younger, I ran into a case with a micro-cap stock (Cerbco, aptly named for the mythic three-headed dog of hell) where the supervoting share class received a higher price in an asset sale.

This isn’t going to be too much use to the average investor, except to say when you look at buying a company with dual share classes, do this:

  • Review the EDGAR filings to see the benefits of each share class.? Be wary of situations where lesser voting shares lack protection.
  • See whether the classes trade adequate volume (or at all) for the size of the position you want to have.
  • Review the price series for each share class, and review how wide or narrow the differential can be.? When near extremes in the values, shift to the class that is undervalued.? Sell votes dear, buy them cheap.? This works better in a tax sheltered account.

Where this has the most punch is for tax-sheltered index investors that want to enhance their indexing.? It won’t shoot the lights out, but using this on the 11 companies with decent volume, it would likely offer 5 basis points of outperformance versus a pure index portfolio, and more, if your trader is good.? My clients do/will get more specific advice on the eleven companies, but I put this out to my blog readers to give them a general idea of what to do as small investors when faced with multiple share classes.

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One final note: Berkshire Hathaway was an exception (isn’t it always?) with respect to why it has a second share class.? Buffett didn’t need more financing when he created the “B” shares.? He noticed that a small cottage industry grew up to allow investors to buy fractional shares of Berky.? What annoyed him was that the providers were taking a significant annual cut off of the fractional shares.? So, Buffett outcompeted them by creating a second class with lesser voting rights than the “A” shares, and 1/30th of the economic value of an “A” share.

This also allowed Berky investors to be able to gift shares under the gift tax limit.? (Thanks Dr. Bob, I did not know that, but it makes perfect sense.)

Now, for index investors, that doesn’t help, because Berky is not in any of the indexes (though I think it should be), aside from the NYSE Composite (no one follows that).? There’s still a smallish noisy arb there for those who want to play it.? Thanks, Climateer.

So it goes.? On to review some deal arbitrage…. enhanced indexing can be fun. 😉

Full disclosure: no positions in companies mentioned.

The Good ETF

The Good ETF

Posted on by David Merkel

What makes a good ETF in the long term?? My, what a question, driven by the ETFs challenging the limits of what is prudent.? Maybe it is easier to start with what makes a bad ETF, then:

  • Headline risk can be eclipsed by credit risk.? All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk.? Did you know you were taking credit risk?
  • Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so.? The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make.? (For storable commodities, better to take delivery and store.)
  • Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
  • Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index.? I ran into this personally in 2002, when I ask ed why a certain bond traded rich.? The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index.? Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds.? I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them.? For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares.? That is one reason whey NAVs get stretched versus market prices.
  • Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs.? But away from structural risks is the faddish investment risk.? The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets.? In the same way, the market can punish those that become too large for the pond that they swim in.? Growth will be limited or negative.? Even the efforts to create more capacity, create it at the cost of credit risk.

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Seasonally Adjusting the Google Real Estate Index

Seasonally Adjusting the Google Real Estate Index

Posted on by David Merkel

Barry did an interesting and short post on the Google Real Estate Index.? It measures the amount of search going on over real estate.? My question was: okay, are we over or under the trend at present, on a seasonally adjusted basis?

I decided to run a regression where each month would have a similar effect across years, and each year would have its own effect.? December 2009 was the baseline.? Here are the results:

Wow.? Very significant results.? As Barry said, “Go figure: Even the search pattern for Real Estate is highly seasonal;”? It’s not that surprising.? People don’t search in the fourth quarter, because they know the inflexibility derived from children and schools.? (Only 2% of the population homeschools and can act like turtles, taking their homes with them as they walk.? That said, homeschoolers don’t typically use that flexibility.)? But at the start of each calendar year, people look forward to the new year, and make new plans on real estate.

From the annual coefficients, there is also no surprise — 2005-2007 were great, 2008 was worse, and 2009 was horrible.

It should not them be surprising that with a 94% R-squared, that the following graph would be tight, actual versus expected:

But looking at the bottom, the purple line indicates when people have been more willing than normal to search for housing.? This is such a time — on the low end, from what I am seeing, many people are more interested in housing given the current lower prices.? Should we jump up and down about this?? Not sure, but it does point out what I have said recently, that housing on the low end has reached equilibrium with foreclosures.

Don’t get too excited by this, 2009 is still a bad year for real estate, but maybe a few things are starting to turn up.

PS — all of this assumes that search on Google has some correlation with actual intent to buy or sell real estate.? I think that is a reasonable assumption.

In Defense of the Rating Agencies — IV

In Defense of the Rating Agencies — IV

Posted on by David Merkel

I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies.? Those who want historical context can read my earlier three pieces:

And let me repeat my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

First, please understand that institutions own most of the bonds out there.? Second, the big institutions do their own independent due diligence on the bonds that they buy.? We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.”? The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.? They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.? They know that ratings are just opinions, except to the extent that they affect investment policies (“We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).? Now, sophisticated investors knew that AAA did not always mean AAA.? How did they know this?? Because the various AAA bonds traded at decidedly different interest rates.? The more dodgy the collateral, the higher the yield, even if it had a AAA rating.? My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.? Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.? Early in the 2000s, sophisticated investors got burned, and learned.? That is why few insurers have gotten burned badly in the current crisis.? Few insurers bought any subprime residential securitizations after 2004.? But, unsophisticated investors and regulators trust the ratings and buy.

Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made is that ratings are free speech has been shot down.? I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter).? People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech.? Fraud, and implied fraud from speech is prosecutable.

But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?? Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.? A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.? Instead, they do some qualitative comparisons to similar? but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.? Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.? As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.? Gaussian copula?? Using default rates for loans on balance sheet for those that are sold to third parties?? Ugh.

But think of something even more pervasive.? For almost 20 years there were almost no losses on non-GSE mortgage debt.? How would you rate the situation?? Before the losses became obvious the ratings were high.? Historical statistics vetted that out.? No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.? In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:

I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits.? If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.

As for solutions, I would say the following are useful:

  • Competition (yes, more rating agencies)
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).

In economics, where there are more than two players, easy solutions are tough.? I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems.? Ratings have their benefits as well as problems.

No economic interest

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