Tuesday, May 31, 2011

Beta chasing

Via my colleague, Craig Newmark.  Apparently 80% of quants use beta as a key factor in stock screens.

The idea behind "chasing beta" is that high beta stocks have higher expected returns than low beta stocks.  Therefore, if you are chasing absolute returns, then high beta is the way to go.  

The idea does have a few flaws.  First it assumes that there is a direct relation between historic beta and future returns.  While academic studies have shown this to be true, the magnitude of the relation is below what theory predicts.  Second, assuming that you can juice up your portfolio returns with higher beta, also assumes that your benchmark is not risk adjusted.   A risk adjusted performance measure (such as alpha etc) would strip away this higher beta effect.  Finally, why not just buy the low beta stocks (which by implication are being ignored) and then lever up?

Friday, May 27, 2011

Letters in ticker symbols.

It used to be the case that you could tell what market a stock traded on by the number of letters in its ticker symbol.   3 or less meant the NYSE or AMEX.  4 or more meant NASDAQ.   Since 2007 the SEC has allowed NASDAQ companies to trade under one letter and recently Zillow (the web site that allows you to see how much your neighbor's house is worth) has petitioned to use the letter "Z".

LNKD is actually an example of a 4 letter stock trading on the NYSE.

Source: Bloomberg

Options on LinkedIn

Options are now trading on LNKD according to Bloomberg.  Apparently the most active contracts are the $80 June Puts.  Not much surprise there.

Thursday, May 26, 2011

Median earnings by major

A report on median salaries by different academic major.  Graph here.  Report summary here.

Are speculators causing higher oil prices?

My colleague, Srini Krishnamurthy and I have an op-ed piece in today's News and Observer that answers this question.  The bottom line is that global supply and demand is a more likely explanation for the price you pay at the pump than speculation in the futures markets.  Furthermore, manipulating oil prices by trading futures contracts is very difficult because for every buyer of a contract there has to be a seller.  In effect, the futures market is just a bet on the level future oil prices.

The N&O also published an excellent editorial from the LA Times next to our Op-Ed piece.  The gist of the editorial was that increasing oil production in the US is unlikely to have any effect on short term oil prices - despite the claims of numerous politicians.  This is due to two reasons.  First, bringing new oil production online takes years - so any new drilling is only going to impact future oil prices at best.  Second, and I think this is the point often not well understood, the US buys oil in a global market.  It doesn't really matter if we increase domestic production 10% because that increase will be a drop in the proverbial global bucket.  We could only hope to lower oil prices by increasing supply to such an extent that it impacts the global supply of oil.   Even then, OPEC could just as easily cut production to offset the new supply increase.
The best way to deal with higher oil prices would seem to be to focus on the demand side and use less oil.

This all ties back to basic finance.  When should an oil company drill for oil?   The answer is when doing so is a positive NPV project after taking account of all the real options involved.  MBA students will study real options in MBA 521 - Advanced Corporate Finance.

Tuesday, May 24, 2011

Stock picks by the House of Representatives

Following an earlier study that found that Senator's stock trades earned significant abnormal returns, a new study shows that the same effect exists for members of the House of Representatives. 

I have no comment, at least none that is fit to print.

FYI: the original study was published in 2004 in the Journal of Financial and Quantitative Analysis (a top finance journal).  The abstract states:

The actions of the federal government can have a profound impact on financial markets. As prominent participants in the government decision making process, U.S. Senators are likely to have knowledge of forthcoming government actions before the information becomes public. This could provide them with an informational advantage over other investors. We test for abnormal returns from the common stock investments of members of the U.S. Senate during the period 1993–1998. We document that a portfolio that mimics the purchases of U.S. Senators beats the market by 85 basis points per month, while a portfolio that mimics the sales of Senators lags the market by 12 basis points per month. The large difference in the returns of stocks bought and sold (nearly one percentage point per month) is economically large and reliably positive.

HT: George

Monday, May 23, 2011

What is Finance?

Anant Sundaram (Finance Prof at Dartmouth) explains.   (Potentially useful for students considering studying Finance).

A few from the blogosphere...

How would the end of the world affect stock prices?

The FT has a tongue in cheek look at how impending Armageddon would effect markets.

For example:
Growth assumptions also must be adjusted, not to mention interest rates at which cash flows are discounted (as the risk-free rate approaches infinity)

Short sellers could yet ruin the LinkedIn party

The FT discusses LKDN, bubbles and the upcoming effect of potential shorting on Thursday (presumably because the share lockup has expired).

Friday, May 20, 2011

So why can't you short LinkedIn?

A contributor at SeekingAlpha.com notes that he can't buy put options on LNKD, nor can he short it.  This really shouldn't come as much of a surprise.  

Finance professors often argue that prices should accurately reflect all public information and should be unbiased measures of the true fundamental value.  But they will add one important caveat - and that is that there are limits to arbitrage.   In the case of LNKD, which by any reasonable measure is ridiculously overvalued, an obvious strategy would be to short sell the stock or to buy put options.   But as with most overvalued IPOs neither option (excuse the pun) is available.  

First of all, to short the stock you would need to find someone to borrow the stock from.  Most of the current holders of the stock have no interest in lending their shares to someone who is going to bet on the price going down.  And even if you could borrow the stock, the lending cost would be astronomical.  Case in point: I vaguely remember the annual borrowing cost for Krispy Kreme stock (an overvalued donut maker) being 50%+ per year.   This means that the stock would have to fall by 50% just for your short position to break even.   Suffice to say, shorting LNKD is unlikely to be feasible.   

Buying put options is also unlikely to be a possibility.  This is because option writers (those selling puts) are not stupid.   If you write a put you expose yourself to losses if the price of the underlying stock falls, and as a result most put writers will offset this risk by simultaneously shorting the stock.  Again we're back to the problem that you can't find anyone to lend you shares. 

I'm sure that LNKD will eventually fall back to earth, that is, unless MSFT buys it.

Thursday, May 19, 2011

LinkedIn IPO

LinkedIn went public today and is currently trading at over $100 per share from an offer price of $45.  That is apparently 25 times 2011 revenue.  To put that valuation in perspective, when I used the yahoo stock screener tool I could only find 3 stocks with greater than $10 billion market caps that had Price to Sales ratios greater than 25.

How much is Skype worth?

MSFT recently agreed to buy Skype for $8.5 billion.  This seems high, but is it?  Thankfully Aswath Damodaran (NYU Finance Prof and Valuation expert) has done the heavy lifting and put together a valuation of Skype.   You can download his spreadsheet from his posting.

I've taught valuation for several years and I think Prof Damodaran's model is a great example of what a good valuation should contain:
1. Clearly defined inputs and assumptions - don't make your model a black box.  Make it transparent.
2. Sensitivity analysis.  Accept that valuation is not a precise science so show the value changes over a sensible range of inputs.
3. No math errors!

I won't spoil the surprise of telling you what Prof D's valuation ended up at, but it isn't $8.5bn.

Are bond yields low?

Greg Mankiw tackles the meme of whether bond yields are low today.  His answer: there is no indication that this is true.

I am always surprised when people claim that they know that interest rates are low and are going to rise.  In effect they are saying that the investors in an incredibly efficient, liquid, multi-trillion dollar market are overpricing bonds.

An interesting side note of Greg's post was a link to a really great site that posts correlations between major asset groups.  I'll be showing this in class.

Wednesday, May 18, 2011

Google's bond issue...

Perhaps Google issued bonds because of a tax angle (a large amount of Google's cash is parked overseas and will incur taxes if it is repatriated.)  As a colleague of mine said (on more than one occasion) - "I bet there is a tax story here somewhere."

Via Greg Mankiw

Reverse stock splits, part deux

A few days ago I blogged about reverse stock splits and Duke Energy's planned 3:1 reverse split.  I was quoted in an article in the local paper saying that:

"If (Duke officials) thought their stock had really good prospects, they wouldn't do this."
Today, the Director of External Relations for Duke published a letter in the paper rebutting the article.  I've taken the liberty of quoting the letter in full here.

Your May 13 article "Utilities' stock split puzzles investors," about the reverse stock split planned following the completion of our merger with Progress Energy, wrongly mixed apples and oranges when it discussed Duke Energy's stock performance with the price of the company's plans to do a three-for-one stock split.
Duke Energy's planned reverse stock split is intended to address our high number of outstanding shares, which occurred as the result of doing several major mergers and acquisitions over the past 15 years. It will also put our company's stock price more in line with our industry peers. It has nothing to do with what you printed, without specific attribution, that our company's stock performance was lackluster. In fact, Duke Energy's stock recently reached a 52-week high. Our performance has exceeded our industry peers (in the Philadelphia Utility Price Index that tracks the top utilities in the U.S.) and S&P 500 over the last one, three and five years.
Twelve months ending May 13, 2011, Duke Energy's total shareholder return was 20.5 percent, the utility index was 16.7 percent and the S&P was 17.9 percent. The past three years, Duke's total return was 22.8 percent, the utility index was negative 3.2 and S&P was 1.9. The past five years, Duke's total return was 51.7 percent, the utility index 31.4 percent and the S&P 15.1.

A few of comments: First the past performance of Duke stock is not relevant to the discussion of the motivations for a reverse split.  Second, no one said that Duke's past performance was lackluster.   In fact companies that have seen strong stock performance often engage in stock funded mergers because, in effect, their currency is highly valued.  Third, as a finance researcher I am interested in generalizations about how stocks do rather than specifics about individual stocks.  The data pretty clearly shows that stocks that do reverse splits on average underperform after the split.  This doesn't mean that Duke will do poorly, it just means that if Duke Energy continues to outperform it will be "the exception that proves the rule".   But in the end only time will tell.

Tuesday, May 17, 2011

Who knows more about economics - the right or the left? The sequel.

About a year ago a blogged about a study (that got a lot of press) that purported to show that those on the left seemed to have a poorer understanding of basic economics than those on the right.  A criticism of the study was that most of the correct answers were what you might call "pet issues" of the right or those with a more libertarian leaning.  

Like all good researchers, the authors of the first study saw an opportunity for a follow up study which also included questions that might play to left or progressive leaning individuals.  A nice summary of the new findings is here, and the link to the full article is here.

The bottom line:  when the correct answers to the questions are consistent with more liberal view points, the leftward leaning survey takers do a lot better than their conservative counterparts.   In fact, the authors conclude:

However, the new test consisting of all 17 questions yielded results that vitiated prior evidence of the left being worse. Now, all groups do poorly, with each group tending to do relatively poorly on the questions challenging its positions
Hopefully the Wall Street Journal will publish a follow up to their original article...although I'm not betting on it.

Via: Tyler Cowan, Marginal Revolution.

Google plays the yield curve

Greg Mankiw talks about Google's recent sale of $3billion of bonds.  The sale is a little surprising given that Google is sitting on $37 billion of cash.  One potential explanation is that Google is looking to stock pile more cash in case it wants to go on a spending spree.  An alternative explanation is that Google is seeking to establish a debt rating for future debt issues.  

The details of the deal are documented in the Wall Street Journal article.  Clearly Google has extremely low borrowing costs.
The (Google's) 10-year bond, for instance, will yield 3.734%, compared to 10-year Treasurys, which yield 3.15%.

Ken French talks about homemade dividends

Ken French explains the concept of homemade dividends.  The basic idea is that you should be indifferent (all else equal) between owning a stock with a 5% dividend yield and a stock with a 0% yield where you sell 5% of your holdings annually.

This is actually a very important concept, and one not well understood by many stockholders.  Case in point;  the recent concerns of some local shareholders of Progress Energy who have expressed concern about the dividend yield on Progress stock declining after its merger with Duke Energy.

Side note: any students who have taken MBA 521 know this well.

Sunday, May 15, 2011

Speculators and oil prices

In my local Sunday paper today, there was a pretty poor article about the effect of speculators on oil prices.  The article was a McClatchey piece and so probably appeared in numerous other papers.  The article's basic premise was that oil prices are high because the proportion of speculative traders relative to commercial traders is high.  Therefore speculators are causing high oil prices.

I've blogged on this before.   The argument is flawed for several reasons.

  1. The assumption that the relationship runs from speculators to oil prices is a classic case of confusing correlation with causality.  
  2. It makes little sense that highly informed traders would bid the price of oil up way beyond its fundamental value.  If they did, they would expose themselves to monumental risk of the price collapsing.
  3. Most oil speculators are trading futures contracts.  As a result they never actually take delivery of the oil.  It is hard to manipulate a market if you don't actually take possession of the commodity.
  4. The presence of more speculative traders makes it far more likely that a bubble in oil prices would burst sooner rather than later for the simple reason that bursting the bubble would make a lot of traders who bet against high oil prices very rich.
  5. The argument that shows that US refineries are not running at peak output and that US demand is down completely ignores the global demand for oil which is increasing steadily.
  6. The biggest "speculators" are the oil companies themselves who choose not to refine more oil and instead keep it in their reserves.  They just understand that real options have value.
Both Forbes and The Economist have excellent articles on this topic.  Notably these articles were written last time Congress went looking for a scape goat to explain supply and demand.

Saturday, May 14, 2011

Finance Jobs

My colleague, Steve Allen, blogs on where the growth in the finance job market is.   Summary: Pack your suitcase and make sure your passport is up to date.

Friday, May 13, 2011

Reverse Stock Splits

Our local paper, the News and Observer, interviewed me a couple of days ago about reverse stocks splits.  The article was about a proposed reverse split by Duke Energy (NYSE:DUK) that is going to occur before it consummates its stock purchase of Progress Energy (NYSE:PGN).  Duke is planning a 3 for 1 reverse split which will raise its stock price from around $19 to about $57.  

The motivations for reverse splits are usually to get the stock into some sort of optimal trading range of $50 - $100 which will result in a nominal increase in EPS.  Of course economically, the transaction has no real impact, as all we've done is change the shares outstanding.

The evidence on splits shows that in general firms that do reverse splits underperform in subsequent years.   For example, a 1997 paper in the Journal of Business by Desai and Jain shows that reverse splitters underperform by 34% on average over the three years following the split.  There are a couple of possible reasons for this.  One is that reverse splits are sometimes done as a last ditch effort to avoid a delisting from a stock exchange.   In this case, the firm is probably on a serious decline and this decline just continues.   I doubt that this is the case for Duke Energy.   Another explanation for the poor performance, is that firms that are expecting significant stock price appreciation are unlikely to do a reverse split because their price will increase anyhow.   Therefore, the firms that do end up doing reverse splits are the ones that are not overly optimistic about their future performance.

Monday, May 9, 2011

2010 CEO Pay

CEO pay from the Wall Street Journal.  Phillipe Dauman of Viacom leads the table with $84 million for 2010.   I am sure he's good at what he does, but $84 million does seem to be an awful lot of money.

The ins and outs of high frequency trading.

A great article that explains how high frequency trading works and how the "flash crash" of May 2010 occurred.  

Friday, May 6, 2011

Who should study for the CFA?

An interview with the CFA Institute Managing Director on who should study for the Chartered Financial Analyst Designation.  The bottom line:  If you want to get into investment management, then you should probably give it some thought.

HT: Steve Allen