Tuesday, April 30, 2013

Optimal Capital Structure and Apple.

Today Apple announced a $17 billion bond issuance to allow it to return capital to shareholders and at the same time increase the firm's leverage.    Even with this issuance, AAPL will still have a very low debt to total assets ratio of about 10% based on book values and a mere 4% based on market value.

For most firms, the optimal capital structure (i.e. the blend of debt and equity) is not zero debt.   We know this because the Trade-Off theory states that firms should trade off the benefits of debt (interest tax deductibility) against the costs of debt (mainly bankruptcy costs).  The optimal capital structure results in the highest firm value because it minimizes the firm's cost of capital.   Students of corporate finance should fully understand what is going on here  -- we discuss this in great detail in my MBA class.

Clearly AAPL has a way to go before bankruptcy costs loom, but in the meantime the positive stock price reaction observed today confirms that the firm is moving in the right direction.

Friday, April 26, 2013

The retirement gamble

The investorcookbooks blog has an interesting post on a recent Frontline TV documentary called "the Retirement Gamble"   The documentary is a must see for anyone saving for retirement - i.e. pretty much everyone.  

The take away is: Buy Index Funds and avoid fees.  Of course readers of this blog will know that I preach those two ideas every chance I get.

Here's the link to the documentary - you can watch it on your computer.

Thursday, April 25, 2013

A couple on statistics - yes statistics.

First: Nate Silver (the guy who predicted the election) crunches the numbers on the recent senate gun control vote.  Of interest to me was that Nate is a Stata guy (you can tell by his output).

Second, Montse Fuentes, Prof of Statistics at NCSU has a column on why statistics is the hot job in this area.

Tuesday, April 16, 2013

90% Debt, GDP growth and MS Excel errors.

I hadn't been paying that much attention to this, but it turns out that a well cited statistic is that countries that have debt that is 90% of GDP grow slower than lower debt countries.  Hence a strong reason for reducing federal debt...or so it would seem...

The original idea was put forward in a paper by two Harvard economists, Carmen Reinhart and Ken Rogoff, and since then it has been very popular with the Tea Party crowd as a reason why federal debt is a "bad thing".

Unfortunately, it turns out that the analysis was wrong.  The researchers apparently missed some observations, used a somewhat dubious weighting system and worst of all made a fundamental excel error.

I am not sure what is more shocking, that Harvard economists would make such analysis errors, or that they are actually using Excel as their primary analysis tool.

Full details in the LA Times here, and a more detailed analysis of the errors are here.  Both articles are well worth reading.

(Thanks to my colleague Srini for sending me the link)

Thursday, April 11, 2013

"All washes - half price, every day" - JC Penney's failed strategy.

On a recent road trip in my home state of NC, we passed through a small town with a puzzling sign outside of a small laundry.   The handwritten sign said:

All washes - half price, everyday.

My first reaction was - what a stupid marketing strategy!  Surely customers would see through it.  But then I realized that this is exactly the strategy that JC Penney has used for years.  The retailer's recent deviation from this strategy led to a near collapse of its stock price and the firing of its CEO.

Read more about why Penney's customers are like laundry customers in rural NC.

Wednesday, April 10, 2013

Potential, possible, or probable predatory scholarly open-access journals

Of interest to academics:  It turns out that there is a who industry of less than reputable journals that are all about making money and will take any research (even plagiarized work).  An example is given here.

And here is a full list of potentially dubious journals.

The pension rate of return fantasy.

Yet another article on why most state pension funds are living in a fantasy world where a mixed portfolio is expected to return 8%.

I posted on this a while ago.

Social security should be indexed to Chained CPI.

The difference between different inflation measures didn't seem too important to most people, until the President unveiled his budget which proposes to link Social Security (among other things) to something called "Chained CPI".  This seems like some arcane adjustment, but in fact it is very important.

Background:   We frequently refer to the change in CPI (consumer price index) as being the rate of inflation - but in reality it is merely one way of estimating the rate of inflation.   The CPI-U (U refers to urban consumers) measures the price level of a representative basket of goods.   The problem with the CPI-U is that it doesn't account for substitutions of one item for another.  For example, this week apples are expensive, but bananas are not, so a consumer may switch between the two.   If the price index is measuring the cost of living, then it makes sense to include these substitutions.  This is what the Chained CPI does.

The President's proposal is to link increases in Social Security benefits to this Chained CPI measure.   Because the Chained CPI doesn't increase quite as fast as the non-chained CPI which is currently being used, the net result is that Social Security benefits won't increase as rapidly.

In the short run, there won't be much of a difference, but in the long run the difference will be far more noticeable.  Not surprisingly, many advocates for seniors are complaining that this amounts to a reduction in benefits.  While technically correct, the fundamental question is what are the benefits that Social Security recipients are entitled to?

As The Economist explains, by indexing Social Security to the ordinary CPI, retirees have, in effect, been getting a real increase in their benefits (note that the word "real" means an increase above the rate of inflation).  Even if we were to link Social Security to an index that tracks a basket of expenditures that are more typical of retirees, the rate of increase would still be less.

Given that we're facing an ever increasing federal debt, this seems like a reasonable and fair way of tackling at least part of the problem.  It is also worth noting that by not dealing with this problem, the children and grandchildren of today's retirees will most certainly be paying more in taxes and getting less in benefits.

Sunday, April 7, 2013

How not to market time, and why the EMH isn't a cult.

A student forwarded me this link about the market timing escapades of a couple of individual investors.   Unfortunately the two individuals sold when the market collapsed and then bought back in only after the market had been rising for a while.   Buy high and sell low is not a good trading strategy.

I agree with the author of the article that there are probably many people who are timing the market this way, and suffering the disastrous financial consequences.  But then the author surprised me and went in a completely different direction.

He argues, that the problem is partly due to:
"...the spreading influence of a cult called the Efficient Market Hypothesis, which downplays the importance of the actual price you pay for stocks. It is horrifying how many financial advisers have bought into the nonsense of the EMH, often without even understanding it."
The author states that what investors should do is buy low and sell high.  And the way to figure out when these times are is to follow the old Warren Buffet adage of buying when others are fearful and selling when others are greedy.

Although it sounds easy, this is very hard impossible to do.  For example, today the market is doing really well.  Are people greedy today?   Maybe, but if I sell today and the market goes up another 20%, then I have lost out big time.  What if the market falls 10% tomorrow?  Are people fearful then?  Is that a buying opportunity?  What happens if the following it falls another 20% after I bought in?

It is easy after the event to see when we should have bought and sold, but at any given point in time, we cannot know what the market will do tomorrow or in 6 months time.   This is what the Efficient Markets Hypothesis states.   It doesn't not state the prices are not important.  Far from it, it states that prices incorporate all past information, but they don't tell us anything about the future.   There is no EMH cult, and to say that EMH is nonsense is just silly - the evidence supporting the EMH is vast and very robust.

As always, the conclusion is the same.  You cannot reliably predict future prices and you cannot time the market.   The only solution for individual investors (or any investors) is to pick a risk level that you are comfortable with and then ride the ups and downs of the market.   In the end you'll come out ahead.

HT: John.