In corporate finance, we examine how a business decides what investments to take (the investment decision), how much to borrow to fund these investments (the financing principle) and how much to return to stockholders (the dividend principle), if it wants to maximize its value. Traditional corporate financial prescriptions on each of these dimensions assume that both capital and asset markets are liquid. Introducing illiquidity into the process changes the game in significant ways.a. Investment Principle: In most corporate finance books, the capital budgeting chapters wend their way through familiar...
Making money off illiquidity: Two Strategies
At first sight, illiquidity is bad news for investors, since it gives rise to transactions costs, which, in turn, can lay waste to investment strategies. In a post from a few months ago, I examined how transactions costs can explain why so many strategies that look good on paper don't deliver their promised upside.However, in this post, I want to take the "glass half full", optimistic view of the phenomenon. Illiquidity or potential illiquidity is not all bad news for investors. After all, to beat the market, you have to have an edge over other investors and here are two competitive advantages...
Asset selection & Valuation in Illiquid Markets
In my last post, I looked at how the asset allocation decision can be altered by differences in liquidity across asset classes, with the unsurprising conclusion that investors who desire liquidity should tilt their portfolios towards more liquid asset classes. Assuming that you have made the right asset allocation judgment, how does illiquidity affect your choices of assets within each class? In other words, if you have decided to invest 40% of your portfolio in stocks, how does illiquidity affect which stocks you buy?To select assets within each asset class, you can either value each one on...
Asset allocation for illiquid markets
In my last post, I argued that illiquidity is not a minor problem restricted to a few stocks. In fact, it can affect all stocks, at least during some time periods, with its effect varying across stocks. I also noted that much of financial theory is built around the presumption that markets are liquid.So, how would financial theory and practice change, if illiquidity is explicitly incorporated into the process? Let's start with the first step in investments, asset allocation, where you decide how much of your overall wealth you will invest in different asset classes - treasuries, corporate bonds,...
All assets are illiquid
Much of financial theory is built on the premise that markets are liquid for the most part and that illiquidity, if it exists, occurs in pockets: it shows up only with very small, lightly traded companies, emerging markets and privately owned businesses. In fact, almost the prescriptions we provide to both investors and corporate finance reflect this trust that both security and asset markets are liquid.To see how unrealistic the assumption of liquidity is, consider what a liquid market would require: you should be instantaneously be able to sell any quantity of an asset at the prevailing market...
Are complex models the answer?
There seems to be consensus that conventional economic models did a poor job predicting the magnitude of the last crisis and that we need to do better. In today's Wall Street Journal, we see the beginnings of one response:http://online.wsj.com/article/SB10001424052702303891804575576523458637864.html?mod=WSJ_economy_LeftTopHighlightsIn short, a physicist, a psychoanalyst and an economist believe that they can build a bigger model that captures the complexities of the real world and does a better job of forecasting the future. Good luck with that! While I wish them well, my response is that this...
The insider trading scandal: Thoughts about the hedge fund business
As many of you are aware, the last week has been filled with news stories about imminent arrests in an insider trading scandal that supposedly entangles multiple hedge funds and bankers at a couple of large investment banks. I am being leery about naming names, even though they are now in the public domain, since these selective leaks can be devastating not only to the individuals named but also to the entities that they represent. While some may feel that "they" deserve this, I think we still live in a country where you are innocent until proven guilty.So, I am going to use this story to...
How do you evaluate risk taking?
The GM IPO is the news of the week. The fact that GM has been able to go public and that the government may not only get its money back on its investment but may even make a profit has led to some celebration in the White House:http://www.whitehouse.gov/photos-and-video/video/2010/11/18/president-obama-gm-ipoI don't begrudge the White House its victory dance that the GM bet looks like it has paid off, but it is an auspicious moment to examine how we judge risk taking, in general. As I see it, risk taking can be judged on four dimensions.1. Outcome: The nature of risk taking is that you win some...
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Amateur Athletics
This post spans two topics I love - finance and sports- and what triggered it was the hullabaloo over Cam Newton, Auburn's quarterback, and the purported attempts by his father to extract money from Auburn. The National Collegiate Athletic Association (NCAA) will be the ultimate arbiter on whether rules were broken and the penalties that will follow, but this entire debate about college sports strikes me as hypocrisy of the highest order.Let us start with basic facts. College sports in the United States is big business and big money, generating hundreds of millions of dollars in revenues for the...
The secret to investment success: Self Awareness?
I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.In one of my books, Investment Philosophies, I start with a puzzle. There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly,...
QE2 or the Titanic?
The big news of the moment (other than the election) is the Fed's decision to inject $ 600 billion into the economy, as a monetary stimulus to get the US out of a recession. Here is Bernanke's rationale:http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash...
Nassim Taleb and the Nobel Committee
I just read this article, where Nassim Taleb, who seems to have taken on the mantle of the "anti-theorist" in finance, argues that the Nobel committee should be sued for giving the prize to Harry Markowitz, Bill Sharpe and Merton Miller.http://www.bloomberg.com/news/2010-10-08/taleb-says-crisis-makes-nobel-panel-liable-for-legitimizing-economists.htmlTaleb has written a few books, "Fooled by Randomness" and "The Black Swan", which have brought him acclaim and his warnings seem to have been borne out by the recent crises. (I have put down my thoughts about these books in an earlier blog post.)...
Inflation, deflation and investing
I must confess that I have never seen such dissension and disagreement among economists about whether we are going into a period of inflation or one of deflation. On the one side, there are those who are alarmed at the easy money, low interest rate policies that have been adopted by most central banks in developed markets. The surge in the money supply, they argue, will inevitably cheapen the currency and lead to inflation. On the other side, there are many who point to the Japanese experience where a stagnating economy and weak demand lead to price deflation. I have given up on trying to make...
Jerome Kerviel is sentenced: Ruminations on risk and trading scandals
A French court has sentenced Jerome Kerviel, the SocGen trader who caused the company to lose 5 billion Euros, to five years in prison and a fine of 4.9 billion Euros.http://www.guardian.co.uk/business/2010/oct/05/jerome-kerviel-jail-sentenceI think we can safely assume that Mr. Kerviel is now bankrupt for life. Reading about the case did raise a question in my mind. How can one person cause this much damage and how did the damage remain undetected until too late? I know that people have pointed to the asymmetric reward structure (where huge bonuses are paid if you make large profits and you really...
High dividend stocks: Do they beat the market?
I was browsing through the Wall Street Journal this weekend and came across this story about "high dividend" stocks:http://bit.ly/b0MrBtBriefly summarizing, the author argues that investing in five high dividend paying stocks is a better strategy for an investor than investing in an index fund, and that the "loss of diversification" is made up for by the higher returns generated on the dividend paying stocks.It may be surprise you, but I don't disagree with the core of this strategy, which is not a new one. In fact, in what is known as the "Dow dogs" strategy, you invest in the five highest...
A Corporate Governance Risk Manual
About a year ago, I agreed to do a series of seminars for the IFC, an arm of the World Bank that invests in privately owned businesses, primarily in emerging markets. The focus of the seminars was risk governance and the audience was directors in companies. While I was leery of getting entangled in the layers of bureaucracy that characterize the World Bank, I agreed to do it for two reasons. First, I had done the bulk of the work already in my book on Strategic Risk Taking (published by Wharton Press), published a couple of years ago. Second, I thought it would be interesting to talk about risk...
Past performance is no guarantee of future performance... but is anyone listening?
Most mutual funds end their advertisements with this statement: "past performance is no guarantee of future results". I don't know why they bother because investors don't seem to act like they care. In fact, one phenomenon that we know characterizes investors is that many of them try to invest in whatever asset class, fund or stock has done well in the past.I was reminded of this return chasing phenomenon by an article I read on Permanent Portfolio, a fund that has been around a while but has generally struggled to survive for most of its life, with about $ 50 million in money under management...
Checks and Balances: Eisner and Disney
I just read about a forthcoming book, written by Michael Eisner, ex-Disney CEO, titled "Working Together: Why great partnerships succeed". My first reaction was incredulity.. What next? Madonna on "The Importance of Celibacy" and Bernie Madoff on "Investing Wisely"...As some of you may know, I have used Disney as my laboratory case study in my applied corporate finance book through three editions and fifteen years. I love the company and its products but have not always cared for its management. In fact, I have been particularly harsh about Eisner, who I think did serious damage to the company,...
Capital Structure: Optimal or Opportunisitic?
Contrary to the prediction of doomsayers during the banking crisis of 2008, firms seem to be returning with a vengeance to the debt markets. Today's story in the Wall Street Journal provides some details:http://online.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=WSJ_hps_LEFTWhatsNewsFinding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest...
Time for class!!
I am getting ready for the first day of my Fall 2010 Valuation class and am just as excited as I was the day that I taught my first class. I taught my first valuation class in 1986 and have taught it every year since (twice a year, in most years). I am often asked whether I get bored, teaching the same class over and over. Not for a second, and here is why:1. The issues that we face in valuation change constantly. When I first started teaching the class, the big issue was recapitalization, as many large US companies were shifting to using more debt in their capital structure. In the 1990s, interest...
Unstable risk premiums: A new paper
I am back from a long hiatus from posting, but I had nothing profound (even mildly so) to post and I was on vacation for a couple of weeks and Latin America last week.As many of you have read in my postings, I am working on a book where I look at shaking up some of the fundamental assumptions that underlie modern finance. My first chapter on "what if nothing is risk free?" was posted about four weeks ago and you can still get to it by going to:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164My second chapter builds on a theme that has been a bit of an obsession for me on risk premiums...
