If you're going to value something based on its discounted cash flows, you're going to need a weighted average cost of capital (or an equity cost of capital) to apply to those cash flows. Duff and Phelps recently released a paper discussing the difficulty of determining the cost of capital in today's environment. Some of the problems they address:
Treasury yields (the risk free rate in CAPM) are temporarily low due to liquidity concerns and a flight to quality, understating risk. It is difficult to decompose treasury yields into components of real return, inflation expectations, and reinvestment risk.
The expected equity risk premium (ERP) has increased greatly (as evidenced by the massive decline in stock prices). However, they claim the equity risk premium ranges from 3.5% to 6.0% throughout the business cycle, which seems extremely low to me. We are not in a normal business cycle here, so I think the forward-looking ERP must be higher than 6%.
Declines in financial stocks and companies with high leveraged have outpaced the broader market, leading to a misleading beta calculation that implies risk has actually declined. Beta measures the covariance of a stock's returns with the market's returns. The market had become overweighted with financial stocks that dragged the index down as they declined. So if you compare a non-financial company's stock covariance to the pre-crash market versus its post-crash covariance, it will appear to have decreased, leading to a lower beta. They recommend using a sum beta calculation to correct for this.
Highly levered companies will probably be unable to sustain their debt loads going forward. The cost of capital needs to reflect likely changes to the capital structure over time. Alternately, you could use an approach like adjusted present value (APV) which separates out the value of the tax shields.
Companies operating with substantial losses may not be able to take advantage of the tax shield on interest in the period when it is paid. So the after-tax cost of debt capital may be inappropriate.
Their final recommendation is that any cost of capital calculation must also pass the reasonableness test. Most of these issues stem from the fact that finance theory attempts to use past data to predict future performance. That becomes increasingly hard to justify during times of discontinuous change, such as the one we're experiencing now. For more information, the authors of this paper have published a practitioner's guide to the cost of capital, available at Amazon.
Mar 30, 2009
Regressions everywhere you look
Is there anything more enjoyable than putting your feet up, opening Excel, gathering data, and running regressions? Of course not. Let's take a look at household energy consumption as a function of cooling degree days (CDD). Cooling degree days are calculated by subtracting 65 from a day's average temperature. For example, if the day's high is 90°F and the day's low is 70°F, the day's average is 80°F. Eighty minus 65 is 15 cooling degree days. There's a similar measure for heating degree days. This data is used for a variety of purposes, including weather futures (derivatives tied to temperature allow utilities to hedge exposure to fluctuating weather). Recent data has put Dallas, TX squarely in climate zone five, with around 3200 CDD and 1800 HDD annually. Here's a nice graph of the country by climate zone:
Our gas bill is larger in the winter. This time, a linear regression of heating degree days against gas consumption in thousand cubic feet had the best fit with the data.
- CDD less than 2000, HDD greater than 7000
- CDD less than 2000, HDD between 5500 and 7000
- CDD less than 2000, HDD between 4000 and 5499
- CDD less than 2000, HDD fewer than 4000
- CDD greater than 2000, HDD fewer than 4000
Our gas bill is larger in the winter. This time, a linear regression of heating degree days against gas consumption in thousand cubic feet had the best fit with the data.
Mar 27, 2009
A graphical representation of social security's problems
Takeaway: in 1940, social security offered retirement at age 65 - but the average person didn't even live that long. 60 years later, social security's retirement age was unchanged, but the average person lived 75 years. No wonder the program is perpetually on the brink of insolvency. If a life insurance company operated this way, it would've gone bankrupt long ago. (As an aside, it would be interesting to examine purchasing power of social security benefits from 1940 versus 2000.)
This is from a 2003 paper on Demographics and Capital Market Returns that looks at the coming generational conflict between younger workers and older retirees as a result of the shifting "dependency ratio." This has serious implications for investors, who may see declining demand for stocks as people sell assets in retirement and not enough younger workers willing/able to purchase them. Their (optimistic?) conclusion is that retirement will be unaffordable at age 65 for most baby boomers, and therefore they'll keep working until their early 70s. The potential ameliorating effects of immigration, productivity, global trade, and social security reform are all discussed.
Mar 26, 2009
Personal investment preferences by country
Much has been said about Americans' low savings rate, usually less than 1% in recent years. As with most numbers that get a lot of press time because they sound impressive ($60 trillion in credit default swaps? Excuse me, but that's a notional value, not the actual value of the contracts), it's a misleading statistic. It doesn't count saving in 401(k)s and IRAs. It also gives too much weight to retirees who spend more than their income by selling assets in their portfolio. It doesn't account for the amortization of durable goods - if you buy a car, the entire cost is counted as spending in the year of purchase when in fact, you will likely use that car for several years. Depreciation on houses is also counted as spending and this "expense" increased substantially as house values rose. However, no credit was given to households for the appreciation of their real estate. Granted, a lot of that appreciation was phantom wealth, but even so, over the long term we should expect house values to increase roughly in line with inflation. If you're going to count non-cash expenses like depreciation then you should also count unrealized capital gains as income. Once you correct for all of these factors, Americans' savings rate is actually several points higher than the reported number.
So how do Americans invest their savings compared to citizens of other countries? Here's a graph from a slightly dated report on household investments by country. Not surprisingly, we have the highest proportion of our wealth tied up in equities.
More detailed statistics on US household investment preferences is available from the Census:
So how do Americans invest their savings compared to citizens of other countries? Here's a graph from a slightly dated report on household investments by country. Not surprisingly, we have the highest proportion of our wealth tied up in equities.
More detailed statistics on US household investment preferences is available from the Census:
Mar 25, 2009
Spending in retirement: The 4% rule
Bill Sharpe et. al. prepared an interesting analysis of The 4% Rule (At What Price?) that examines the traditional advice given to retirees: plan on spending 4% of your initial 60% stock/40% bond portfolio every year in retirement to acheive a >90% success rate (confidence interval) of having enough money for the rest of your life. The 4% rule is parroted by many retail investment advisers - and therefore, "it behooves us to be familiar with the rule’s approach, features, and flaws." They find that this strategy, while popular, is suboptimal in terms of overpayments and surpluses (i.e. you are paying more than you need to or spending less than you could). Common modifications to the plan, such as adjusting spending depending on market returns (also known as the glide-path strategy), don't do much to remedy the situation. Part of the problem lies in the fundamental mismatch between the cash flows - the investor seeks a constant stream of payments while the portfolio's returns are variable.
The authors make an interesting comparison between the risky investor that buys stocks and bonds versus one that guarantees his retirement spending by buying zero-coupon inflation-index government bonds (TIPS). For the very risk averse investors, this 100% TIPS portfolio provides the highest utility and dominates other investment strategies. This is an application of financial economics. Investors that are willing to take on more risk with a stock/bond portfolio can still achieve a higher utility by moving away from the 4% rule. But the riskless portfolio provides a minimum cost option that all other investment/spending plans should be judged against.
What does all this mean? Basically, that blind adherence to the 4% rule is inefficient. Unfortunately the paper stops short of developing a new framework that takes into account investors' preferences. However, it does conclude that once surpluses or overpayments are identified, they can be appropriately valued, which is the first step towards improving the spending and investing decisions.
This graph plots the static 4% rule at point A for an investor that has $100 to pay for a retirement plan. You can clearly see that an individual would prefer other points under the curve. Depending on their risk tolerance, they might move up and obtain a higher utility for the same cost, or move to the left and get the same benefits for less cost.
The authors make an interesting comparison between the risky investor that buys stocks and bonds versus one that guarantees his retirement spending by buying zero-coupon inflation-index government bonds (TIPS). For the very risk averse investors, this 100% TIPS portfolio provides the highest utility and dominates other investment strategies. This is an application of financial economics. Investors that are willing to take on more risk with a stock/bond portfolio can still achieve a higher utility by moving away from the 4% rule. But the riskless portfolio provides a minimum cost option that all other investment/spending plans should be judged against.
What does all this mean? Basically, that blind adherence to the 4% rule is inefficient. Unfortunately the paper stops short of developing a new framework that takes into account investors' preferences. However, it does conclude that once surpluses or overpayments are identified, they can be appropriately valued, which is the first step towards improving the spending and investing decisions.
This graph plots the static 4% rule at point A for an investor that has $100 to pay for a retirement plan. You can clearly see that an individual would prefer other points under the curve. Depending on their risk tolerance, they might move up and obtain a higher utility for the same cost, or move to the left and get the same benefits for less cost.
Mar 20, 2009
What is the purpose of the capital markets?
- To allow for the efficient allocation of capital across industries, and by extension, society as a whole.
- To enable income smoothing over time by letting some borrow from future earnings for consumption today and others lend today in the hopes of higher consumption in the future.
Mar 19, 2009
Objective 401k ratings
BrightScope has a website where you can search for evaluations of employer's 401k plans. They provide an overall rating as well as a comparison to the peer group on dimensions such as employer match, investment options, and participation rate. Perhaps the most interesting number is the average account balance by employee, which ranges from a few thousand dollars to close to a million.
Mar 18, 2009
Personal Finance with Zvi Bodie: The Conventional Wisdom is Wrong
Here's a nice set of videos from my favorite finance professor, Zvi Bodie, where he challenges the conventional wisdom about stock market investing. For a more thorough discussion of his safe investment philosophy, I recommend his book: Worry Free Investing. It's written for a non-academic audience and is fairly accessible even if you're not familiar with CAPM. The first chapter is available as a sample from Bodie's website here.
Mar 17, 2009
The next bubble to burst: higher education
Bloomberg and the New York Times recently confirmed what I have believed for several months now: higher education is the next bubble to burst. Applications at non-Ivy League schools are declining. Private college expenses have increased at a rate far above inflation for too long, and households are no longer willing nor able to tap an inexhaustible supply of home equity to pay $150,000 for a bachelors degree that will not even guarantee a decent wage. Meanwhile, colleges felt the wealth effect as endowments rose and they embarked on grandiose construction plans, often building dorms that would fit in better at the country club than an educational institution. A recent study of university salaries found over 200 presidents making more than $500,000 per year.
As with most things in our economy over the last few years, all of this growth was fueled by cheap debt. An investment in education became one of the most highly leveraged investments you could make (100% financing implies an infinite debt-to-equity ratio). Just as people believed house prices could never go down, they felt that any college degree was worth its price. Obviously, not everyone should be an accountant - but you can justify the $150,000 price tag for an accounting degree much easier than you can justify $150,000 for an art history major. The long-term trend will be massive trading-down in the market for education: those considering private schools will switch to quality in-state public universities, and those who formerly considered state schools will move down to community colleges. Ivy League schools will always be in demand, but they'll have a harder time affording the financial aid they have committed to maintain an economically diverse student body. State universities that have unnecessarily committed to becoming a research institution will also have to scale back their plans.
Ultimately, a return to rational pricing is a good thing. Higher education was becoming unaffordable for an increasing percentage of households. State universities need to focus on their core mission of providing affordable high quality undergraduate education.
As with most things in our economy over the last few years, all of this growth was fueled by cheap debt. An investment in education became one of the most highly leveraged investments you could make (100% financing implies an infinite debt-to-equity ratio). Just as people believed house prices could never go down, they felt that any college degree was worth its price. Obviously, not everyone should be an accountant - but you can justify the $150,000 price tag for an accounting degree much easier than you can justify $150,000 for an art history major. The long-term trend will be massive trading-down in the market for education: those considering private schools will switch to quality in-state public universities, and those who formerly considered state schools will move down to community colleges. Ivy League schools will always be in demand, but they'll have a harder time affording the financial aid they have committed to maintain an economically diverse student body. State universities that have unnecessarily committed to becoming a research institution will also have to scale back their plans.
Ultimately, a return to rational pricing is a good thing. Higher education was becoming unaffordable for an increasing percentage of households. State universities need to focus on their core mission of providing affordable high quality undergraduate education.
Mar 16, 2009
A review of Wal-Mart's $2.97 wine: Oak Leaf Cabernet Sauvignon
Is it possible to produce and distribute a quality bottle of wine for under $3? California residents are probably familiar with Trader Joe's "Two Buck Chuck" but those of us further east were out of luck until recently. I spotted several varieties of Oak Leaf vineyards wine at my local Wal-Mart all selling for $2.97: Cabernet Sauvignon, Merlot, Chardonnay, Pinot Grigio, and Zinfandel. These wines sell for $2.00 in CA; supposedly the extra dollar covers added transportation costs. The economics of this wine are indisputable; consider how it compares to some other common beverages:
All three preferred the Blackstone to the Oak Leaf. They commented that it had more fruit flavor, a darker color, and possessed a more substantial mouthfeel. The Oak Leaf's bouquet had a slightly earthy tone that not everyone was fond of. One person gave Oak Leaf a point for its lower alcohol content. Another felt that it was just a little too watered down. However, no one would object if they were served the Oak Leaf; everyone regarded it as a perfectly drinkable wine, especially when served with a meal (that is to say, Oak Leaf would probably not be a great choice for a cocktail party). The Oak Leaf would also be a fine choice for cooking or any kind of mixed wine like Sangria. Ultimately, while this wine delivers some value given its price point, it's not one I would regularly purchase.
- 2 liter Coke: $0.02/oz
- Ocean Spray cranberry juice: $0.05/oz
- Oak Leaf wine: $0.12/oz
- Starbucks drip coffee: $0.17/oz
All three preferred the Blackstone to the Oak Leaf. They commented that it had more fruit flavor, a darker color, and possessed a more substantial mouthfeel. The Oak Leaf's bouquet had a slightly earthy tone that not everyone was fond of. One person gave Oak Leaf a point for its lower alcohol content. Another felt that it was just a little too watered down. However, no one would object if they were served the Oak Leaf; everyone regarded it as a perfectly drinkable wine, especially when served with a meal (that is to say, Oak Leaf would probably not be a great choice for a cocktail party). The Oak Leaf would also be a fine choice for cooking or any kind of mixed wine like Sangria. Ultimately, while this wine delivers some value given its price point, it's not one I would regularly purchase.
Mar 14, 2009
Texas: A very sticky state
A new study from the Pew Research Center ranks Texas as the country's stickiest state, meaning that it has the highest percentage population of native born citizens who are still here (75.8%). Texas doesn't rank as high on the magnet scale, which measures how strongly it attracts transplants from other states, but this metric is somewhat distorted because the organic population growth and retention rate is so high, on a relative basis it dwarfs the immigration we do have.
Mar 13, 2009
A Week on Wall Street: Day 5
New York Federal Reserve
Truly staggering to see the Fed's balance sheet balloon up from ~$800 billion to +$2.5 trillion over the last few months. And I don't think that includes many of the loan guarantees (e.g. the government backstop of $300B of Citigroup debt) that have taken the form of off-balance sheet contingent liabilities. The Fed is still serving up hot steaming bowls of "alphabet soup" - more acronyms for funding programs than we know what to do with. Another frightening comment from our speaker: when the time comes to reign in all that liquidity, its going to be very difficult to do it in an orderly manner. Many of the outstanding commitments are tied to short term obligations, which will run off in due course. But what about mortgages that could take +10 years to amortize? If those securities are unmarketable, the Fed will have no choice but to hold them to maturity, leaving the money supply inflated for quite a while. Our speaker was also light on details about the Fed's exit strategy.
We toured the gold vault which holds the largest cache of gold in the US (larger than the US Bullion Depository at Ft. Knox). 80 feet below street level, the vault has a massive rotating door that forms a watertight seal at night to protect all the sovereign gold that we hold for other countries. This is a free service of the government. The vault looks nothing like what was pictured in Die Hard.
CNBC
Driving out to New Jersey, we tour the studio and meet with one of the on-air commentators from the news network that everyone loves to hate. Our host is one of the more reasonable talking heads and he comments on how a dedicated financial press is a relatively recent innovation (occurring the last 25 years).
Returning home, the flight was only at 75-80% capacity. Surprising, given the capacity cuts that have already taken place.
Truly staggering to see the Fed's balance sheet balloon up from ~$800 billion to +$2.5 trillion over the last few months. And I don't think that includes many of the loan guarantees (e.g. the government backstop of $300B of Citigroup debt) that have taken the form of off-balance sheet contingent liabilities. The Fed is still serving up hot steaming bowls of "alphabet soup" - more acronyms for funding programs than we know what to do with. Another frightening comment from our speaker: when the time comes to reign in all that liquidity, its going to be very difficult to do it in an orderly manner. Many of the outstanding commitments are tied to short term obligations, which will run off in due course. But what about mortgages that could take +10 years to amortize? If those securities are unmarketable, the Fed will have no choice but to hold them to maturity, leaving the money supply inflated for quite a while. Our speaker was also light on details about the Fed's exit strategy.
We toured the gold vault which holds the largest cache of gold in the US (larger than the US Bullion Depository at Ft. Knox). 80 feet below street level, the vault has a massive rotating door that forms a watertight seal at night to protect all the sovereign gold that we hold for other countries. This is a free service of the government. The vault looks nothing like what was pictured in Die Hard.
CNBC
Driving out to New Jersey, we tour the studio and meet with one of the on-air commentators from the news network that everyone loves to hate. Our host is one of the more reasonable talking heads and he comments on how a dedicated financial press is a relatively recent innovation (occurring the last 25 years).
Returning home, the flight was only at 75-80% capacity. Surprising, given the capacity cuts that have already taken place.
Mar 12, 2009
A Week on Wall Street: Day 4
Dynamic Credit Partners
This firm is an expert in dealing with CDOs, toxic or otherwise. Our host took us through the process of creating such an investment and explained how a bank could take $100 of bonds, repackage them to appeal to investors' different maturity/credit preferences, and create securities worth $102 (the $2 was kept as profit for the bank). We examined a pitchbook for one deal that went south rather quickly, the collateral in the CDO was 95% subprime residential mortgage backed securities (RMBS). Whoops! Although the pitchbook had several pages of boilerplate on the various risks of the investment, there was no real analysis of which risks were the most important. A possible justification for lawsuits - investors in the subordinated classes (e.g. below the A tranche) were not informed that their cash flows could be diverted to the senior tranches if the collateral was downgraded by the ratings agencies. This was surprising to me, because why should the lower tranches suffer as long as the collateral was still performing? But that's what the waterfall of cash flows called for. The CDO we looked at had 6 tranches, and currently 5 of those tranches were non-performing and completely worthless. The top-rated A tranche was trading for 7 cents on the dollar.
Barron's
It would be hard to mistake Barron's offices for the well-appointed accommodations of any of the investment firms we visited - it had the appearance of a threadbare newsroom. Tough times for the print media in general, and the financial press is no exception. Demographic shifts - the average age of a Barron's reader is over 50. There is no doubt that investors will keep getting older, but eventually they'll consume content in electronic form only. Bad news for Barron's (and the rest) - rates for online ads have always been less than print ads, but it was hoped the two prices would converge around the average of the two. Instead, they're converging at the substantially lower online rate. Maybe they can clawback some of this differential with better targeted ads?
Cowen and Company
Although business was holding up better than many other firms here, the outlook here was quite pessimistic. Expenses are being cut to the bone - as is prudent - but if everyone cuts expenses until "things start to turn around" it seems the entire economy could easily get trapped in a deflationary spiral.
Completely unsubstantiated rumor of the day: Madoff will plead guilty to everything - the only thing he wants in return is protective custody in jail for the rest of his live, because many of the billions of dollars he is alleged to have lost belonged to organized crime syndicates/drug cartels in South America and Europe. It is an understatement to say they are unhappy with his investment performance and would likely seek to have him killed in prison.
Random observation: under normal circumstances, labor is a cheaper input than capital. In recent history, capital became cheaper than labor, which led to rampant inflation of investment bankers' salaries. The huge profits recorded in good years were actually returns to capital, not labor, but bonuses were paid out anyway.
Overall mood: approaching maximum bearishness.
This firm is an expert in dealing with CDOs, toxic or otherwise. Our host took us through the process of creating such an investment and explained how a bank could take $100 of bonds, repackage them to appeal to investors' different maturity/credit preferences, and create securities worth $102 (the $2 was kept as profit for the bank). We examined a pitchbook for one deal that went south rather quickly, the collateral in the CDO was 95% subprime residential mortgage backed securities (RMBS). Whoops! Although the pitchbook had several pages of boilerplate on the various risks of the investment, there was no real analysis of which risks were the most important. A possible justification for lawsuits - investors in the subordinated classes (e.g. below the A tranche) were not informed that their cash flows could be diverted to the senior tranches if the collateral was downgraded by the ratings agencies. This was surprising to me, because why should the lower tranches suffer as long as the collateral was still performing? But that's what the waterfall of cash flows called for. The CDO we looked at had 6 tranches, and currently 5 of those tranches were non-performing and completely worthless. The top-rated A tranche was trading for 7 cents on the dollar.
Barron's
It would be hard to mistake Barron's offices for the well-appointed accommodations of any of the investment firms we visited - it had the appearance of a threadbare newsroom. Tough times for the print media in general, and the financial press is no exception. Demographic shifts - the average age of a Barron's reader is over 50. There is no doubt that investors will keep getting older, but eventually they'll consume content in electronic form only. Bad news for Barron's (and the rest) - rates for online ads have always been less than print ads, but it was hoped the two prices would converge around the average of the two. Instead, they're converging at the substantially lower online rate. Maybe they can clawback some of this differential with better targeted ads?
Cowen and Company
Although business was holding up better than many other firms here, the outlook here was quite pessimistic. Expenses are being cut to the bone - as is prudent - but if everyone cuts expenses until "things start to turn around" it seems the entire economy could easily get trapped in a deflationary spiral.
Completely unsubstantiated rumor of the day: Madoff will plead guilty to everything - the only thing he wants in return is protective custody in jail for the rest of his live, because many of the billions of dollars he is alleged to have lost belonged to organized crime syndicates/drug cartels in South America and Europe. It is an understatement to say they are unhappy with his investment performance and would likely seek to have him killed in prison.
Random observation: under normal circumstances, labor is a cheaper input than capital. In recent history, capital became cheaper than labor, which led to rampant inflation of investment bankers' salaries. The huge profits recorded in good years were actually returns to capital, not labor, but bonuses were paid out anyway.
Overall mood: approaching maximum bearishness.
Mar 11, 2009
A Week on Wall Street: Day 3
New York Stock Exchange
It was a rare treat to go down to the trading floor of the NYSE for the opening bell. Although the vast majority of trading has gone electronic, they still have specialists for many stocks that manually open and close the trading day. The specialist we talked to seemed to base trading decisions on split second gut reactions and news events - there was no time for any kind of fundamental analysis or even technical analysis (one screen had a chart on it, but he didn't seem to rely on it much). Interestingly, these market makers get paid by the exchange for providing liquidity. There were also mad swarms of people running around writing down the expected opening price from the specialists, which was then sent upstairs. There is an electronic feed that provides similar information, but apparently this manual one is more accurate (one of the advantages of having a seat on the exchange is that you can get better pre-market information). Sadly, I learned that the funny looking colored jackets used to be used to identify different positions on the floor, but have since been made unnecessary (though many still wear theirs).
The NYSE gave us a sales pitch on how companies list on their exchange because they want to co-brand themselves. I'm skeptical that this is a prominent consideration when a company lists itself today - the increases competition with Nasdaq over fees has certainly had an impact on the NYSE. In the next 10 years, it would not surprise me if the trading floor was gone all together. Or, the room will be filled with actors hired by CNBC so they can still claim to be reporting from the middle of the action - a live shot of a room full of servers is less glamorous, but more likely where the real trading action is taking place.
WL Ross
It's not everyday that you get to meet a legend in the industry, so we were understandably impressed by Wilbur Ross and one of his managers. These guys were sharp. It is not an exaggeration to claim that before they make an investment, they know more about the company than its own CFO. They have the patience to wait and not bid up deals when dumb money is rushing in. They are also prudent about leverage - if a deal needs a ton of leverage to work, then you're probably paying too much for it. If they think it's an attractive opportunity, they'll consider restructuring an entire industry (such as the entire US steel market). If I could invest with anyone we met this week, it would be this firm.
Oppenheimer Funds
A quantitative fund manager and his team spoke to us about their fund. They have a multi-factor model with almost 100 inputs. They do a lot of back testing. They revise their model periodically. Overall, they seemed like intelligent guys. You'd think that all this fancy math would remove human emotion and mistakes from the investment process - but all of this quantitative analysis eventually came down to which factors they thought would best predict future performance. Given that their fund has been lagging its benchmark, I find it hard to believe that these guys have any edge in factor selection (despite their overall level of intelligence and sophistication). They were unwilling to engage in a discussion of active versus passive management, although they did mention that one of their small cap funds had about 1200 holdings in it (that sounds a lot like a closet index fund, with a higher expense ratio). A cynical observer might note that active management fees do provide for well appointed office space.
The old debate about active versus passive management really fascinates me. Generally, I believe that the market for public equities in the US is pretty efficient. It is exceedingly difficult to earn abnormal risk-adjusted returns of any substantial magnitude over the long run. The statistics regarding active mutual funds that fail to outperform the S&P 500 confirms this. Hence, most mutual fund companies are wasting their time (and their investors' money). However, when you get into active management the way WL Ross does it, the game changes. They have access to opportunities not available to a mutual fund because of their investment process, their investment opportunity set, their time horizon, and their access to deal flow. The stark contrast between Oppenheimer Funds and WL Ross made it very clear to me that one firm is positioned to take advantage of market inefficiencies, and the other, not so much.
Overall sentiment: trending towards bearish.
It was a rare treat to go down to the trading floor of the NYSE for the opening bell. Although the vast majority of trading has gone electronic, they still have specialists for many stocks that manually open and close the trading day. The specialist we talked to seemed to base trading decisions on split second gut reactions and news events - there was no time for any kind of fundamental analysis or even technical analysis (one screen had a chart on it, but he didn't seem to rely on it much). Interestingly, these market makers get paid by the exchange for providing liquidity. There were also mad swarms of people running around writing down the expected opening price from the specialists, which was then sent upstairs. There is an electronic feed that provides similar information, but apparently this manual one is more accurate (one of the advantages of having a seat on the exchange is that you can get better pre-market information). Sadly, I learned that the funny looking colored jackets used to be used to identify different positions on the floor, but have since been made unnecessary (though many still wear theirs).
The NYSE gave us a sales pitch on how companies list on their exchange because they want to co-brand themselves. I'm skeptical that this is a prominent consideration when a company lists itself today - the increases competition with Nasdaq over fees has certainly had an impact on the NYSE. In the next 10 years, it would not surprise me if the trading floor was gone all together. Or, the room will be filled with actors hired by CNBC so they can still claim to be reporting from the middle of the action - a live shot of a room full of servers is less glamorous, but more likely where the real trading action is taking place.
WL Ross
It's not everyday that you get to meet a legend in the industry, so we were understandably impressed by Wilbur Ross and one of his managers. These guys were sharp. It is not an exaggeration to claim that before they make an investment, they know more about the company than its own CFO. They have the patience to wait and not bid up deals when dumb money is rushing in. They are also prudent about leverage - if a deal needs a ton of leverage to work, then you're probably paying too much for it. If they think it's an attractive opportunity, they'll consider restructuring an entire industry (such as the entire US steel market). If I could invest with anyone we met this week, it would be this firm.
Oppenheimer Funds
A quantitative fund manager and his team spoke to us about their fund. They have a multi-factor model with almost 100 inputs. They do a lot of back testing. They revise their model periodically. Overall, they seemed like intelligent guys. You'd think that all this fancy math would remove human emotion and mistakes from the investment process - but all of this quantitative analysis eventually came down to which factors they thought would best predict future performance. Given that their fund has been lagging its benchmark, I find it hard to believe that these guys have any edge in factor selection (despite their overall level of intelligence and sophistication). They were unwilling to engage in a discussion of active versus passive management, although they did mention that one of their small cap funds had about 1200 holdings in it (that sounds a lot like a closet index fund, with a higher expense ratio). A cynical observer might note that active management fees do provide for well appointed office space.
The old debate about active versus passive management really fascinates me. Generally, I believe that the market for public equities in the US is pretty efficient. It is exceedingly difficult to earn abnormal risk-adjusted returns of any substantial magnitude over the long run. The statistics regarding active mutual funds that fail to outperform the S&P 500 confirms this. Hence, most mutual fund companies are wasting their time (and their investors' money). However, when you get into active management the way WL Ross does it, the game changes. They have access to opportunities not available to a mutual fund because of their investment process, their investment opportunity set, their time horizon, and their access to deal flow. The stark contrast between Oppenheimer Funds and WL Ross made it very clear to me that one firm is positioned to take advantage of market inefficiencies, and the other, not so much.
Overall sentiment: trending towards bearish.
Mar 10, 2009
A Week on Wall Street: Day 2
MSD Capital
Among other things, this group manages money for Michael Dell. They have recently started buying equities again. An observation: bank debt is trading like equity, equities are trading like options, and options are through the roof. Future inflation is an inevitability. We will not end up like Japan because the American consumer does not want to save - this is rooted in cultural differences. We'll be more like Hong Kong after the last crisis, although their nation is primarily based on pass-through transactions, so not sure how relevant the comparison is.
Primus Financial Products
This company pioneered credit default swaps that didn't require them to post any collateral based on changes in the underlying contract. Just as the monoline insurers have been hammered, so has Primus. Despite having several billion dollars of negative equity under GAAP, Primus is still alive, primarily because they did not have collateral requirements. In theory, as long as actual defaults stay low, most of these mark-to-market losses should reverse out as the contracts mature. Their portfolio of CDS is in run-off mode and they're trying to reinvent their business model. Our speaker was not very bullish on the concept of a CDS clearinghouse - but I believe it is only a matter of time before CDS companies are regulated as insurance companies (they are basically the same thing).
S&P, Structured Finance Ratings
Originally on the agenda, S&P's lawyers cancelled our meeting at the last minute since they are revamping the method they use to rate structured financial products. The phrase "a day late and a (billion) dollars short" comes to mind. I am amazed that the NRSROs have any credibility left at all.
Overall sentiment: slightly less bearish.
Among other things, this group manages money for Michael Dell. They have recently started buying equities again. An observation: bank debt is trading like equity, equities are trading like options, and options are through the roof. Future inflation is an inevitability. We will not end up like Japan because the American consumer does not want to save - this is rooted in cultural differences. We'll be more like Hong Kong after the last crisis, although their nation is primarily based on pass-through transactions, so not sure how relevant the comparison is.
Primus Financial Products
This company pioneered credit default swaps that didn't require them to post any collateral based on changes in the underlying contract. Just as the monoline insurers have been hammered, so has Primus. Despite having several billion dollars of negative equity under GAAP, Primus is still alive, primarily because they did not have collateral requirements. In theory, as long as actual defaults stay low, most of these mark-to-market losses should reverse out as the contracts mature. Their portfolio of CDS is in run-off mode and they're trying to reinvent their business model. Our speaker was not very bullish on the concept of a CDS clearinghouse - but I believe it is only a matter of time before CDS companies are regulated as insurance companies (they are basically the same thing).
S&P, Structured Finance Ratings
Originally on the agenda, S&P's lawyers cancelled our meeting at the last minute since they are revamping the method they use to rate structured financial products. The phrase "a day late and a (billion) dollars short" comes to mind. I am amazed that the NRSROs have any credibility left at all.
Overall sentiment: slightly less bearish.
Mar 9, 2009
A Week on Wall Street: Day 1
I had the privilege of joining a group of fellow finance MBAs last week for a trip to Wall Street. I don't know that there's ever been a better (worst?) time to visit Manhattan. Over the next five days I'll post my observations for each of our company visits. It was a great trip, and I really appreciated all of our speakers taking the time to meet with us. Disclaimer: These notes are my completely subjective recollection of the day's events and should not be interpreted as official statements by any of the organizations mentioned.
Wachtell, Lipton, Rosen & Katz
A partner from this law firm met with us and discussed the government's involvement in the financial markets beginning with the failure of Bear Stearns. His firm does a lot of work with M&A for financial services firms. A common theme throughout his remarks was that the government (i.e. the Fed and the Treasury Department) had forced many firms to accept a deals at the eleventh hour with verbal promises that they later reneged on. At the risk of sounding like a tinfoil hat enthusiast, it would not be an exaggeration to say "don't trust the government." As far as his investment outlook was concerned, he mentioned that he had moved his entire portfolio to cash and treasuries. On the plus side, this firm seems to have more work than it can handle (or at least, this practice area).
Deutsche Bank, Structured Products Group
This group creates options strategies to limit downside or lever upside. They'll either sell you the strategy and/or implement it for you, although I don't envy anyone trying to sell these products to retail investors (anything that sounds like "derivatives" is going to be anathema). If they put a package together for you, it will probably be with OTC options contracts, so be aware of the limited liquidity that accompanies such a program. I haven't heard of any bailouts for Deutsche Bank lately, but counterparty risk is also a concern for these one-off strategies.
Overall mood for day 1: moderately bearish.
Wachtell, Lipton, Rosen & Katz
A partner from this law firm met with us and discussed the government's involvement in the financial markets beginning with the failure of Bear Stearns. His firm does a lot of work with M&A for financial services firms. A common theme throughout his remarks was that the government (i.e. the Fed and the Treasury Department) had forced many firms to accept a deals at the eleventh hour with verbal promises that they later reneged on. At the risk of sounding like a tinfoil hat enthusiast, it would not be an exaggeration to say "don't trust the government." As far as his investment outlook was concerned, he mentioned that he had moved his entire portfolio to cash and treasuries. On the plus side, this firm seems to have more work than it can handle (or at least, this practice area).
Deutsche Bank, Structured Products Group
This group creates options strategies to limit downside or lever upside. They'll either sell you the strategy and/or implement it for you, although I don't envy anyone trying to sell these products to retail investors (anything that sounds like "derivatives" is going to be anathema). If they put a package together for you, it will probably be with OTC options contracts, so be aware of the limited liquidity that accompanies such a program. I haven't heard of any bailouts for Deutsche Bank lately, but counterparty risk is also a concern for these one-off strategies.
Overall mood for day 1: moderately bearish.
Mar 8, 2009
Why the stock market is close to the bottom
You know stocks are overbought when your hairdresser starts giving you investment advice. When everyone started talking about dot-com stocks in the early part of the decade, it was time to get out. When everyone was boasting about fat profits from flipping condos in Las Vegas, the bubble was obvious.
In the last few days, I've heard from several people, both sophisticated investors and 401k participants alike, talking about how much they hate equities. All of them have stopped making new contributions, and many have switched their portfolio entirely to cash and bonds over the last few months. People have started volunteering information about how much their portfolio lost before they capitulated. Not what you expect to hear from a complete stranger in the seat next to me on a recent flight.
I don't expect that things will turn around tomorrow, but if retail investor sentiment is any guide, 2009 will mark the low point in the market.
In the last few days, I've heard from several people, both sophisticated investors and 401k participants alike, talking about how much they hate equities. All of them have stopped making new contributions, and many have switched their portfolio entirely to cash and bonds over the last few months. People have started volunteering information about how much their portfolio lost before they capitulated. Not what you expect to hear from a complete stranger in the seat next to me on a recent flight.
I don't expect that things will turn around tomorrow, but if retail investor sentiment is any guide, 2009 will mark the low point in the market.
Mar 4, 2009
Mar 3, 2009
Federal Reserve: We don't mind traveling first-class
Recently, much attention has been paid to the travel destinations of banks and insurance companies. Call it the "AIG effect." CEOs were grilled over off-site meetings held at the beach or the casino that were supposedly financed with taxpayer dollars. Now the era of such extravagant travel has come to an end. Never mind the fact that hotels in Las Vegas and Hawaii are laying employees off because so many companies have cancelled their visits.
Surprisingly, the Federal Reserve didn't get the memo that these types of trips were no longer acceptable. Ben Bernanke is sponsoring and attending a posh off-site meeting in May, 2009 at Jekyll Island, Georgia to discuss financial crises and innovation. They are also footing the travel and lodging bills for many of the participants who work in the industry. No one can argue that this conference is extremely relevant, but why is the Fed hosting it at an island retreat? Is there really no cheaper option? The vast majority of attendees are probably coming from in New York and DC - was there no conference space available in either of these cities? Why can't the Fed's guests pay their own way?
The lesson: If a company wants to reward top perfoming employees with a trip to the beach, they should be drawn and quartered. But if the government wants to host a party for its friends, they just get out their checkbooks (and keep the party out of the media spotlight).
Surprisingly, the Federal Reserve didn't get the memo that these types of trips were no longer acceptable. Ben Bernanke is sponsoring and attending a posh off-site meeting in May, 2009 at Jekyll Island, Georgia to discuss financial crises and innovation. They are also footing the travel and lodging bills for many of the participants who work in the industry. No one can argue that this conference is extremely relevant, but why is the Fed hosting it at an island retreat? Is there really no cheaper option? The vast majority of attendees are probably coming from in New York and DC - was there no conference space available in either of these cities? Why can't the Fed's guests pay their own way?
The lesson: If a company wants to reward top perfoming employees with a trip to the beach, they should be drawn and quartered. But if the government wants to host a party for its friends, they just get out their checkbooks (and keep the party out of the media spotlight).
Mar 2, 2009
S&P 500 Earnings for 4Q 2008
S&P publishes an excel file with total earnings per share for all the companies in the index. Currently, 93% of companies have reported their 4Q 2008 numbers, and the total EPS for the index is: -$11.97. That is to say, if you added up the earnings of every company in the index, there were enough losers to counteract the winners and the group lost money as a whole. Earnings for the year will be $39.73. However, the Wall Street Journal claims this is misleading. Although the index itself is market-cap weighted (larger firms have more impact on the index), the published EPS is equally weighted across all firms. S&P takes earnings from every firm and adds them up, so a dollar of EPS from Abbot Labs counts as much as a dollar from Zimmer Holdings. The Journal argues that since an investor doesn't hold every stock in the index in equal amounts, each firm's EPS should be weighted by its proportion in the index. If you adjust 2008 earnings this way, you arrive at $71.10 for the year. If you are trying to determine if the market is over- or under-valued based on a P/E ratio, it makes a big difference if you use $39 or $71 for the E.
I think both methods are useful. Consider the following scenario with only two stocks in the index:
S&P's method of calculating aggregate EPS is informative for the health and total earnings of the entire index, or economy as a whole. The Journal's method of weighted earnings is useful for an investor who wholds the index, since it better represents his share of earnings based on his proportional ownership in the companies.
I think both methods are useful. Consider the following scenario with only two stocks in the index:
S&P's method of calculating aggregate EPS is informative for the health and total earnings of the entire index, or economy as a whole. The Journal's method of weighted earnings is useful for an investor who wholds the index, since it better represents his share of earnings based on his proportional ownership in the companies.
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