Monday, August 29, 2011

Recent active fund manager's performance.

The InvestorCookBooks blog posts some interesting statistics on recent fund manager performance - conclusion:   you're probably better off indexing.  But you knew that already, right?

Friday, August 26, 2011

A great analysis of the BRK - BAC deal

Aswath Damodaran - NYU expert on valuation - provides a really great analysis of the Berkshire Hathaway - Bank of America deal that I blogged on yesterday.   Aswath values the options at around $3 billion which means that Buffet got the preferred stock for only $2 billion.  At that price the yield is around 15%!   My own back of the envelope calculations came in around $8-9 billion for the deal - so basically, BAC shareholders just handed Buffet a nice gift of around $3 to $4 billion dollars.

Aswath concludes that this probably wasn't a good deal for BAC and I'm inclined to agree with his analysis - paying about $4 billion for the Buffet seal of approval seems pretty high.

Thursday, August 25, 2011

Advertising on my blog.

I was recently approached about putting an ad on my blog -  a first for me as a blogger!  But such a request presents a bit of a dilemma.  I maintain this blog primarily as a teaching tool - it allows me to collect and relay stuff that I think would be interesting for my students.  However, I sometimes update the blog during the day when I am at work and I think it would therefore be inappropriate for me to keep the proceeds of any ads.

Therefore I plan to donate all proceeds to charity.  I am involved in a small charity called The Haiti Tree Project.  We have a website and a facebook page .  The charity provides small grants to a couple of villages in Haiti so that they can raise trees in tree nurserys.  To date we have several thousand trees growing.  The trees are primarily fruit (mango) and hardwoods.  When the trees are big enough, the villagers can take them and plant them on their own land.  Ultimately the trees provide a source of sustainable agriculture that will provide an income for the villagers while reversing some of the effects of deforestation.

If you want to know more about the charity, go ahead and check out the pages above and feel free to contact me.  

Berkshire Hathaway buys BAC Preferred Stock and Warrants for $5bn.

Bank of America has been in trouble of late because of ongoing subprime losses.  The Bank needed a significant cash boost.  Warren Buffet has just provided that boost in the form of $5 billion of cash.   The deal is pretty straightforward (full details are here).
CHARLOTTE, N.C., Aug 25, 2011 (BUSINESS WIRE) --Bank of America Corporation announced today that it reached an agreement to sell 50,000 shares of Cumulative Perpetual Preferred Stock with a liquidation value of $100,000 per share to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of 6 percent per annum, payable in equal quarterly installments, and is redeemable by the company at any time at a 5 percent premium.
In conjunction with this agreement, Berkshire Hathaway will also receive warrants to purchase 700,000,000 shares of Bank of America common stock at an exercise price of $7.142857 per share. The warrants may be exercised in whole or in part at any time, and from time to time, during the 10-year period following the closing date of the transaction. The aggregate purchase price to be received by Bank of America for the preferred stock and warrants is $5 billion in cash.

So basically BAC issued preferred stock that pays a $300 Million dividend and together with 700 million calls with a strike of $7.14.

You don't have to be a financial rocket scientist to realize that this is a good deal, but I'll leave it as an exercise for my students to try to figure out what this deal is really worth.

Why P/E ratios are a poor predictor of market performance.

The Lex Column in the Financial Times today talks about why raw aggregate P/E ratios are poor predictors of stock performance.  Good stuff.  But the final part of the article caught my eye.

Likewise, history shows there to be no predictive power for stocks when comparing equity yields with bond yields. Why should there be? Dividends are risky and rise with inflation; coupons are risk free and do not. It is like buying apples because pears are cheap. There are good reasons why equities are due a bounce – flaky valuation metrics are not among them.
This is basically a take down of the so-called Fed Model (not endorsed by the Fed) that argues that comparing bond yields to earnings yields reveals information about the level of the stock market.  I posted on this a few days ago here.  With bond yields low and earnings yields high, numerous "experts" are claiming this is a signal that the market is undervalued.   They are wrong.  It is a signal that bond yields are low and earnings yields are high.  That is all.

NOVA: "Mind over Money"

I caught a re-run of the PBS NOVA documentary "Mind over Money" last night.   The documentary explores the role of behavioral finance in market bubbles and collapses.  For those wondering: Behavioral finance is the study of how human psychology affects financial decision making.  It is generally at odds with a lot of the predictions of the Efficient Market Hypothesis which states that prices reflect all available information and markets as a whole are rational.  Whether markets are efficient or not is of great importance to investors and policy makers.

Back to the video - this is a MUST SEE for any student of finance.  My current MBA students take note!

Here is the preview.

Watch the full episode. See more NOVA.

The video is well done and features interviews with those who are proponents of behavioral finance - notably Richard Thaler and Robert Shiller, and those that oppose it - Eugene Fama, John Cochrane and Gary Becker.

The experimental evidence for behavioral finance is very strong, but the link between what people do in a lab environment and what markets do as a whole is much weaker.  Consider, for example, the housing bubble: Behavioral proponents will claim that a housing bubble occurred because of various irrational behaviors.  For example people pay too much attention to recent events and see how prices rising and then extrapolate these increases.  In addition, people observe how others are making money in housing, and they feel remorse if they don't buy also.  Finally when prices do go up, people feel that their original decision to buy is being confirmed and that they were correct.  This creates a self feeding cycle until finally the bubble bursts.

But an efficient market proponent would offer a different story - low interest rates, easy credit and limited downside for buying a house you can't afford creates an incentive to buy.   In effect people who buy houses with close to 100% financing on teaser rates are really just buying a call option on the value of the house.  If it goes up then they make money, but if it falls they just walk away.  The rational thing to do for many people  is to take the gamble.

Regardless of where you fall in the efficient markets vs behavioral finance debate, the insights of behavioral finance at the individual level are really important and can protect people from their own irrationality.

Wednesday, August 24, 2011

A blog about my blog.

A marketing firm that has been working with the Poole College of Management wrote a little piece about my blog.  

I'll be sure to tag this one as "shameless self promotion"

Tuesday, August 23, 2011

Gold rally overdone?

Apparently some say so.  Presumably they are the ones who just sold.


The east coast earthquake is all over the interwebs.  But this tweet from "Zerohedge" caught my eye:

S&P upgrades earthquake from 5.8 to 6.0


SPY and GLD correlations and volatility.

Apparently the value of the GLD ETF (an Exchange Traded Fund that holds gold) has exceeded the value of the SPY ETF (which holds stocks from the S&P 500).  All this gold is held in bank vaults in London (which in light of recent riots may not be that sensible).  The total amount of gold held by the fund in these vaults is about 41. 5 million ounces, which is about 1300 tons.  That seems like a lot of gold.

In the article, a hedge fund manager was quoted as saying that
“Gold has become something of a near-perfect hedge for financial assets such as stocks,”
This got me thinking - I wonder what the correlation between GLD and SPY is?

Here are the daily correlations.  Note that GLD has been trading since 2004.
2004-2011: 0.0506
2008-2011: 0.0108
2010: 0.1961
2011: -0.2655

First of all we can see that over the long run, there has only been a weak correlation between GLD and SPY.  In 2010 however this correlation became positive and quite strongly so.   But for the first half of 2011 we can see a strong negative correlation.  While not a "near perfect" hedge, it certainly looks like GLD is moving against stocks.  The problem of course is predicting how long this movement will continue and at what point in time (if ever) the old pattern of a small positive correlation will reassert itself.

Looking at daily annualized standard deviations, (assuming 250 trading days) we see that GLD is a little less volatile that SPY.

SPY Std Dev:  22.6%
GLD Std Dev: 21.0%

SPY Std Dev. 20.00%
GLD Std Dev. 15.24%

Surprisingly SPY is not as volatile as you might think - perhaps a classic case of investors anchoring their beliefs too much on recent market gyrations.

While I don't make prognostications, it does seem likely that a large amount of the demand for GLD may be coming from people moving money out of stocks.  If this is the case, then if and when the stock market starts to rebound, we should see a pretty rapid fall in the price of gold.

Monday, August 22, 2011

Stock valuation Haiku

P Es are lower
Time to buy say the experts
high risk premium

Do repurchases destroy value?

An op ed piece in today's Financial Times claims that share repurchases destroy value because they are often done at market peaks.  In other words firms are paying too much when they repurchase stock.

Unfortunately, the article is a little sloppy in that it only looks at aggregate data and then only considers a very short time period.  More importantly though, I think that the article draws the wrong conclusion.

When we look at the the academic evidence on share repurchases we find support for firms timing their repurchases for periods when the firm's stock is low relative to the stock's fundamental value.   For example, a paper by Ikenberry, Lakonishok and Vermaelen in 1995 finds that value stocks in particular seem to do very well after repurchases - consistent with managers timing the repurchase when stock prices are low.  The opposite result is usually found for share issuances  - these usually occur when the firm's stock value is high and subsequent returns are low.  Both of these are manifestations of the "Market Timing" theory of capital structure - something that I've done a bit of research on.   In general there is pretty strong evidence that managers time stock issuances and share repurchases to benefit long term shareholders.

I'm also a little concerned about the idea that a share repurchase could destroy value.  First of all, firms are awash with cash - cash that is just sitting in corporate coffers - and share repurchases are an efficient way of getting that cash back to the shareholders.  Second, even if the firm buys back shares when the prices are high, this doesn't destroy value per se.  All it does is transfers wealth from the shareholders not participating in the buy back to those who are participating.

So while it might be the case that share repurchases may not have been optimally timed in the past 2-3 years, the larger evidence doesn't support the article's contention.

The article does make an interesting point however, that managers may be tempted to boost EPS by buying back shares.  They would do this because they are compensated on the level of EPS.   Surprisingly, many managerial compensation contracts are often pretty vague and may not preclude manipulation of EPS via repurchases thus opening the door for such window dressing.  However, if you buy stock in a company that uses such a poor performance metric to compensate the managers, then you probably deserve what you get!

For more on this topic - you can see an earlier post here and Damodaran's excellent post on the valuation effects of buybacks.

Saturday, August 20, 2011

Introducing another finance blogger.

Ron Elmer, author of "Investor Cookbooks" has started a blog.  Ron has an extensive background in investment management, so his blog should make for some good reading.

Welcome to the world of blogging Ron!

Thursday, August 18, 2011

Using Twitter to beat the market

About a year ago I blogged about a study that claimed to show that the mood on Twitter can predict stock market moves.   Well, it turns out that someone has started a hedge fund using this approach.

I was very skeptical about the original study and I remain skeptical about whether a hedge fund can make money in the long term using this method.   So far they have been going for a month and beaten the market.  As they say "one swallow does not a summer make"

HT: One of my MBA students - Damian.

Guest post on the current market volatility.

In a first for my blog, here is a guest post by Ron Elmer.  Ron talks about the current market volatility.

Over the past few weeks I’ve had numerous friends express concern about the economy and financial markets and have asked for my thoughts.  My thoughts follow…
The way I look at it, everyone has to make a choice between two possibilities and plan accordingly:
(1) Anarchy will reign - stockpile guns, ammo, barbwire around your farm and bomb shelter etc.
(2) We'll get through this like we have for 200 years - rebalance your portfolio and buy stocks when they are down.
I can respect folks who choose either of these options, but anything in between is pointless.
Being 100% cash won't work in either scenario. If the financial system collapses, they won't be able to get their cash out of whatever bank it is in.  Even if they could get it, cash will be worthless during true anarchy. Not many folks would sell their last loaf of bread for any amount of gold either.  
In 2008 we truly were standing at the edge of anarchy - that was scary.  That was the scariest time in our economic history... Oh wait, maybe World War I was scarier, and WWII. Oh yeah, 9/11 when stock market was closed for a week - now that was scary!  Don’t forget the turmoil caused by the Korean and Vietnam wars.  Then there were the race riots in the 60-70s. Can you imagine riots? I can't but it was going on when we were kids. Assassination of JFK, Reagan shot, Nixon's Watergate, Clinton's Lewinskigate. How about nuclear missiles a couple hundred miles off the shores of Florida? Now that must have been really scary.
I'm forgetting a dozen catastrophes I'm sure. Yet, the stock market averaged about +10% annualized return throughout all this. To be sure, the stock market is never up in a straight line.  What is beautiful is the crookedness of the returns. Each and every instance I listed above was a BUYING opportunity.  
Folks that are 100% liquid now may well look like geniuses.  Greece could default and implode the entire European Union. Moody's could agree with S&P and downgrade the US credit rating a meaningless notch. Politicians might shut down the federal government, again (yeah, that's right, it's happened before and in our lifetime too).
But, even if those "liquid" folks are right and the market dives another -20%, they'll never have the foresight or fortitude to buy back in at the bottom when everything looks it's worst. Thus, they can be right ONCE and cost themselves a ton of money when the market snaps back. The folks that are liquid now, are likely liquid because they sold out before the bottom in the market in March 2009.  They likely watched the Dow fall from 14,000 to 8,000 and finally decided to sell all their stock funds. They realized they were geniuses as the Dow continued it's descent to 6,500. But, in the end they would have been better off doing nothing as the Dow is now back up to 11,000 (even after the recent decline) and MUCH higher than where they likely sold. Better yet, instead if selling at 8,000 they would have done well to BUY at 8,000 even while that was not the bottom and the market fell further.
That is another great point; one does not have to pick the exact bottom in the stock market to make a lot of money. The folks that bought stocks at Dow 8000 surely felt more pain as they watched it continue to fall to 6500. But, with the Dow currently at 11,000 they certainly are happier now than the folks that sold at 8000.
We should almost be grateful for each of these "opportunities" that the "sky is falling" alarmists provide us.
Embrace the volatility. The easiest way to do that? Own a mixture of stock and bond index funds and....
Buy monthly with your paycheck and rebalance annually on your birthday.
Buy and rebalance, buy and rebalance - year after year after year.  Over the course of a lifetime, you will have bought low and sold high over and over and over again.  Rebalancing is easy to do in “normal” years. In fact, it’s almost unnecessary most of the time.  When rebalancing is crucial is in times like these – when you have to buy when everyone else is selling.  But, history has shown time and time again, the time to buy is when everyone else is selling.
Rebalance annually and mechanically, don't "think" about it.  Turn off CNBC. Be oblivious. Be happy. Be wealthy.

P.S. You can find more information in one of my 4 books on Amazon at the link below.

Supply and Demand for Corn

And then there is corn.   The Government subsidizes corn production, mandates its use in ethanol and imposes import restrictions.   The amount of corn being used for ethanol now exceeds that being used for food.  At the same time, ethanol production is doing nothing for the environment or oil prices.  Brilliant.

Reposted from Felix

Supply and Demand for Chicken

The USDA is buying $40 Million of chicken because, apparently there is an oversupply.   I have no comment.

Monday, August 15, 2011

New Finance Blog

Pat Larkin is a Finance Prof here in NC at Fayetteville St. U, just down the street from me.  He blogs on value investing.  Check out his blog here.

Sunday, August 14, 2011

The "Fed Model"

The so called "Fed Model" (not endorsed or used by the Federal Reserve) postulates that there should be a relation between the earnings yield on a broad stock index and the yield on medium term Treasuries.  Proponents of the model claim that when the earnings yield on stocks exceeds that of Treasuries, then one should buy stocks.

The model has been widely discredited by academics because it mixes apples and oranges.  Treasuries are nominal assets whereas stocks are real assets (their returns are a function of inflation).   The fact that these two series seem to move together doesn't prove that they have predictive ability over the mispricing of stocks compared to bonds.  For a great discussion of the Fed Model, see Cliff Asness's article "Fight the Fed Model"  I've also discussed this issue in my 2002 JFQA paper with Jay Ritter.

So why bring all this up today?   Well, my favorite finance blogger, Felix Salmon appears to be making the Fed Model mistake all over again, long after I thought that the model was dead and buried.  Felix doesn't refer to it as the Fed Model directly, but his presumption is that Treasury yields and earnings yields should track each other.  After 2002 they don't.

While it looks like you'll earn a higher yield on stocks rather than bonds, this is very misleading.  First earnings are not cash flows - something that we hammer home at the beginning of any stock valuation class.   Second, whereas bond cash flows are pretty secure, the cash flows from stocks are much more uncertain - the risk premium is zero for bonds and who knows what stocks!   Finally, the bond cash flows are fixed in nominal terms, while the stock cash flows are real - they change with inflation.

Again: apples to oranges. 

Saturday, August 13, 2011

Dilbert on hedge funds

Short selling bans in Europe

This week, 4 eurozone countries announced a coordinated ban of short selling of some bank stocks.   This move is designed to stabilize prices and prevent "market manipulation".   In reality this is a bad policy.   The overwhelming evidence from careful academic research shows that short selling increases pricing efficiency and allows information about the true value of assets to be more rapidly incorporated into those asset prices.   If anything, eliminating short selling will increase volatility rather than reduce it.

There is an argument made that naked shorting (short selling without borrowing the stock) can have real economic effects, particularly when employed on financial stocks.  I think that this may have some merit in that if naked shorting could drive down a bank's stock price, that lower price might lead creditors of the bank to withdraw funding which might precipitate a bank run.   In reality, however, this is very unlikely because the total amount of naked shorting is tiny, as for most market participants it is illegal.

Naked shorting can be achieved by purchasing a credit default swap (CDS) however.   A CDS allows the holder to basically bet against the value of the debt issued by the underlying stock.  For a bank which is typically very highly levered, a CDS is really a tool for shorting the bank stock.   The "naked" feature of the CDS is that the holder doesn't have to actually hold the underlying debt of the bank.  Unsurprisingly, the eurozone regulators did not ban this type of shorting.

Groupon "the myspace of daily deals"

Groupon - the daily coupon company, is desperately trying to hang on until its investors can unload their stock via the firm's IPO in September.  The basic business of Groupon is unsustainable - the firm subsidizes deals on the grounds that doing so builds a loyal customer base.  But people who chase coupons are notoriously fickle - they'll switch to whoever has the best deal.

 In reality though, the daily deal space is becoming very crowded with some deep pocket players including Google and Amazon wading in.  Groupon doesn't have a hope.  For a full analysis, see an article in today's FT, which gives a thorough takedown of Groupon's "business model".  This will be an interesting IPO.

Monday, August 8, 2011

Flawed investing depleting pension fund assets

When state pension funds hire new money managers, they tend to hire winners who then underperform and fire loosers who then tend to overperform.   In fact the newly hired managers trail the bench mark by about half a percent - exactly what you'd expect to observe if past returns were random and we merely hire managers who got lucky.

The lesson is clear:  states, endowments, and indeed everyone should index and stop wasting money pretending that they have superior investment skills.
HT: Ron Elmer

Saturday, August 6, 2011

The US is downgraded.

Well the big news is that S&P has downgraded US Government debt.  In true form for Standard and Poors, the rating agency made a $2 trillion math error which was quickly pointed out to them by the White House.  Still they proceeded with the downgrade.  Ironically, S&P played a big part in getting us in this sorry mess because of their worthless ratings of mortgage backed securities.

The truth is, as several commentators have pointed out, that the debt should be downgraded, not because the US doesn't have the money to pay its bills but because there has emerged a political willingness to use default as a bargaining chip.  The reason the debt has been downgraded is largely because the tea party crowd refused to increase the debt ceiling (something that was done frequently and without fuss in prior administrations).  Their action has shown the markets that default is now a possibility.  It's hard to know what the costs will be in terms of higher interest rates, but what is clear is that this is not what the US economy needed right now.

Thursday, August 4, 2011

The best and worst trades of all time

Via Newmark's door.  The best and the worst.

How to use the FF 3 factor model

Via the financeprofessor blog - how to implement the Fama French 3 factor pricing model.

Grade Inflation

My colleague, Steve Allen, discusses grade inflation.  Grade inflation is a problem that "cheapens" the effort of the hardest working and brightest students.

I'd agree with Steve that the correlation between grades and teaching evaluations is weak at best.  One possible solution is to scale teaching evaluations by the course GPA.  This would reduce the incentive to "buy" evaluations.

Post Crash Book Recommendations

Via Craig Newmark.  The Big Short comes out as the most popular - I've read it and I would recommend it highly.