Saturday, January 26, 2013

The sale of a forest as an NPV problem.

A story in my local paper caught my attention this morning  - it's about the NCSU Department of Forestry which owns a large piece of forest land that they are considering selling.  Apparently, there are significant objections to the sale because of the perceived research and teaching value of the land.

Setting aside these objections for a minute, I thought it might be worth doing a quick NPV analysis on this project.

The proposed sale price is $117 million.   This money would be placed in the university endowment and would be invested to return about 8% per year - with 5% going to the Dept of Forestry.  

So $117 million * 0.05 = $5,850,000.

However, the current forest generates between 1.5 and 2 million dollars annually already and in an NPV analysis, we are interested in the incremental cash flows from a project.  In this case, the incremental cash flows are the difference between $5,850,000 and, lets say, $2,000,000 which is $3.85 million.

This is a perpetuity - it will keep on earning a return forever, so the value of these incremental cash flows is simply:

3.85/0.05 = $77 million.

The astute reader might say - "but won't the income from the forest go up over time with inflation?"   Actually, the income stream from the money invested in the endowment should also rise, as the principal amount will grow at the rate of inflation (this is the other 3% of the 8% return) - so the effects of inflation cancel.

So the decision facing the Department of Forestry is whether the educational and research opportunities of the forest are worth more or less than $77 million.  Alternatively, can these educational and research goals be achieved elsewhere for a sum of less than $77 million.  The cost of providing for these needs has not been included in my analysis.

Wednesday, January 23, 2013

Historical Returns by Asset Class

A great post on the investor cookbooks blog - showing historical returns by asset class for the past few years.

My takeaway - don't try and predict winners - just spread your chips widely and hope something comes up.

Academia vs Technical Analysis

The reformed broker (aka Josh Brown) has an interesting post on technical analysis and why academia is wrong about its effectiveness.  (Incidentally - Josh has an excellent blog - well worth checking out).

Finance academics as a group take a fairly dim view of technical analysis because, for it to work, you have suspend belief in weak-form market efficiency (the idea that past stock prices cannot predict future prices).  This is the finance equivalent of thinking that the earth is flat.

In his post, Josh quotes Phil Pearlman who states, among other things that:
Its a bias on the part of finance academia against technical analysis from a community that is still trying to prop up EMH and has moved so far  from the reality of markets they fail to acknowledge critical tools their students will be using in the future. 
The good thing is that it is becoming easier for those learning asset management to find educational material in books and on the internet and so universities are only risking moving themselves further from being relevant much less essential.
So let me get this straight - technical analysis should be taught because it is becoming easier to find out information on it on the internet and in books.   This statement might be fine if we are talking about, say capital budgetting, where there are standard approaches that can be used to create value.  But technical analysis is different.

The point of technical analysis is to beat the market - to use past trading patterns to predict where the market is going.   For this to happen you have to assume that you are the only person who has ever figured this out.   But if the technique can be found in your local Barnes and Noble, you can guarantee that the technique won't work - because prices will have adjusted to reflect all the past information. (they have Barnes and Nobles near Wall Street).

Another way of thinking about this is to ask yourself the question - if you were a brilliant technical analyst, why would you ever write a book on the subject and share your tips?  That is, unless you stand to make more money as an author than as a trader.   Of course you could just be doing it because you made your millions and you want to help other people get rich too.

Just because lots of professionals use technical analysis, doesn't mean that it works.  Actually it does work, just only about 50% of the time.   Unfortunately, despite how many books or web pages you read you'll never know which 50%.  

So  I don't spend much time teaching technical analysis - for the same reason astronomy professors don't spend much time teaching astrology.

An interview with Richard Thaler

Thaler, one of the "fathers" of behavioral finance talks about his career and life as an academic.

(via Marginal Revolution)