Corporate finance in illiquid markets

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 territory. The best decision rule for investment analysis for a value-maximizing firm is the NPV rule and firms should accept all positive net present value investments. Within the NPV rule, you estimate expected cash flows on each investment and discount these cash flows back at a risk-adjusted rate. The expected cash flows are assumed to be available to the firm (to reinvest elsewhere or to pay dividends) and the risk adjusted for in the discount rate is macroeconomic or market risk.

How would introducing illiquidity alter this process? First, illiquid capital markets limit access to external funds (from both equity and debt) and may act as an impediment to taking every positive NPV investment. Second, if not all positive net present value investments can be accepted, the firm is better off getting the most bang for the buck. Thus, using a percentage return such as IRR to judge investments, instead of NPV, may allow a firm to generate the most value. Third, not all cash flows are equally liquid. Firms can be restricted in their use of cash flows, if they face regulatory or lender-imposed constraints or invest in countries with remittance restrictions.  Finally, the discount rates (costs of equity and capital) will be higher for firms, if there is illiquidity, since there will be transactions costs associated with raising money. Firms facing more liquidity constraints are therefore less likely to take longer term infrastructure investments, with large negative cash flows up front and positive cash flows on the back end.


b. Financing Principle: The optimal mix of debt and equity for a firm is the one that maximizes its value. If we hold operating cash flows fixed, this is usually achieved when the cost of capital is minimized. In conventional corporate finance, then, the optimal financing mix is the one that minimizes the overall cost of capital, with neither the cost of equity and debt reflecting liquidity concerns. In the APV approach, it is the dollar debt level that maximizes value, after taking into consideration the tax benefits of debt and expected bankruptcy costs.

Using both the cost of capital and APV approaches, bringing in illiquidity into the equation will alter the dynamics. Illiquidity will push up both the costs of debt and equity and the effects on the optimal debt ratio will then depend on whether the equity or the debt market is more illiquid. If the equity market is illiquid and the debt market (bonds or bank loans) is liquid, the optimal debt ratio will rise in the face of illiquidity. In contrast, if the equity market is liquid and the debt market is not, the optimal debt ratio will fall as liquidity concerns rise. In the APV approach, illiquidity will raise both the probability of bankruptcy (since distressed firms will be unable to raise new financing to keep going) and the cost of bankruptcy (since assets will have to be sold at much bigger discount in an illiquid asset market). The net effect should be a decline in the use of debt by illiquid firms.


c. Dividend policy: There are two big questions that animate the dividend principle: How much cash should you return to stockholders (and how much should you hold back)? What form should you return the cash in, dividends or stock buybacks? In conventional corporate finance, firms are advised to return any cash that they have no use for in the current period back to stockholders, since it is assumed that they can return to liquid capital markets and raise new funding. It follows that cash balances should be minimal. And the form in which cash gets returned will be a function of investor taxes. If dividends and price appreciation are taxed at the same rate, investors should be indifferent between the two. If dividends are taxed more highly, firms should use stock buybacks.

Introducing illiquidity into this decision changes the answers to both questions. Firms that are more concerned about illiquidity should return less cash to stockholders and hold back more cash. Thus, you would expect cash balances to be higher at small and emerging market companies or during liquidity crises. The evidence seems to back this proposition. Investors faced with illliquid markets will value dividends more, simply because they represent cash in hand, whereas price appreciation is more risky (since you have to sell your stock to get it). Consequently, you should expect dividends to rise in the face of higher illiquidity, while stock buybacks to fall off.

In summary, you should expect firms in illiquid market to invest less in long term projects, to use less debt to fund these investments and to accumulate more cash, while paying out more in dividends.

I have a paper on the effects of illiquidity on financial theory, where I look at the implications for corporate finance in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408

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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 that can be created out of illiquidity.

a. Illiquidity arbitrage: Not all investors value liquidity equally. To the extent that you need or care about liquidity less than the typical investor in the market, you should be able to exploit this difference to make money. How? Wait for a period of illiquidity (either on the entire market or on an individual stock), where asset prices are marked down by typical investors, who observe the illiquidity and price it in. Then, step in and offer to buy assets. You will get these assets at a bargain price (from your perspective) but at a fair price (from the perspective of the median market participant). Wait for the illiquidity to ease and then sell the asset. This may very well be the biggest weapon that an old-time value investor brings to the market. In fact, Warren Buffet did exactly this type of bargain hunting during the banking crisis of 2008, taking large positions in Goldman Sachs and GE, during their most illiquid days. (I know... I know.. technically, this strategy is not arbitrage, since it is not riskless.. )

"This is easy. I too can be a liquidity arbitrageur", you may say, but it is easier said than done. There are two factors that are at least partially under your control. The first is the use of financial leverage in your investment strategy. Borrowing money to fund investments may increase your expected upside, if things go well, but it also increases your need for liquidity.  The second  is a combination of patience and a strong stomach. Buying during periods of illiquidity will expose you to down side risk, at least in the short term, and you have to be able to ride it out. But the desire for liquidity is also a function of  factors that are not  in your control. First, if your income stream is stable, predictable and in excess of your spending needs (Do you have tenure?) and you have have less need for liquidity. Second, it is subject to what I will loosely term "acts of God". A sudden illness, accident or unforeseen event (Did you invest with Bernie Madoff?) may quickly eliminate whatever buffer you thought you had. Third, if you manage other people's money, it is their need for liquidity that will drive your decisions, not your own. It is one significant advantage that you and I have on the most skilled portfolio manager.

b. Illiquidity timing: Both the level of illiquidity and the price demanded for it change over time in the market. An investor who can forecast changes in illiquidity well can profit off these changes. But how does forecasting liquidity translate into a payoff? You have to be able to shift into liquid assets, before the market becomes illiquid, and into illiquid assets, ahead of periods of liquidity. With the former action, you cut your losses and with the latter, you gain as the illiquid asset regain their value. This is particularly true, if you use financial leverage and invest in illiquid assets, as many hedge funds do. In fact, one study argues that liquidity timing may be one of the biggest competitive advantages in the hedge fund business.

How do you get to be a good liquidity timer? First, you have to track not just the standard investment measures - multiples and fundamentals - but also liquidity measures - trading volume, short selling and bid-ask spreads. In fact, those technical indicators that fundamentalists view with such contempt, such as trading volume and short sales, may be useful in detecting shifts in liquidity. Second, you have to be clear about how exposed an individual asset is to market shifts in liquidity - a liquidity beta, so to speak. In my extended paper on liquidity (linked below), I describe ways in which you may be able to estimate this beta.

For more on liquidity betas and the potential for making money off illiquidity, you may want to look at this paper that I just posted on liquidity and its effects on financial theory and practice:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408

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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 its fundamentals (intrinsic valuation), compare its pricing to how similar assets are priced (relative valuation) or price it as an option (contingent claim valuation). In each case, illiquidity can affect value.

 a. Intrinsic Valuation: There are many different intrinsic valuation approaches but they all share a common theme. The value of an asset is a function of its expected cash flows, growth and risk. In discounted cash flow valuation, for instance, the expected cash flows discounted back at a risk adjusted discount rate yields a risk-adjusted value. In conventional valuation, the expected cash flows are unbiased estimates of what the asset will generate each period and the risk adjustment is for non-diversifiable market risk (with equity) and for default risk (with debt). Nowhere in this process is illiquidity considered explicitly. Not surprisingly, we tend to over value illiquid assets.

So, how do you bring illiquidity into intrinsic valuation? There are two choices. The first is to estimate the risk adjusted value, using the conventional approach, and to then reduce this value by an illiquidity discount. That discount can be estimated by looking at  on how the market prices illiquid assets. For instance, studies have looked at restricted stock (stock issued by publicly traded companies that cannot be traded by investors for one year after the issue), pre-IPO transactions (where co-owners sell their stake in the months prior to an announced IPO) and companies with multiple classes of shares traded on different venues (with different liquidity characteristics). These studies generally yield large discounts (25-50%) for illiquid assets and  private company appraisers have generally used these studies to back up the use of similar discounts when valuing non-traded businesses. Perhaps, this approach can be extended to publicly traded companies.

The second is to adjust the discount rate for illiquidity, pushing it up for illiquid companies. The illiquidity premium added to the discount rate is usually estimated by looking at the past. In its crudest form, you can assume that the premium that small cap companies or venture capitalists have earned over the market (about 3-4% on an annual basis over the last few decades) is due to illiquidity and add that number on to the cost of equity of any "illiquid" company. In its more sophisticated version, the adjustment to the discount rate can be linked to a measure of illiquidity on the company - its turnover ratio, trading volume or the bid-ask spread. One study concludes that every 1% increase in the bid-ask spread pushes up the discount rate by 0.25%. Thus, the cost of equity for a stock with a beta of 1.20 and a bid-ask spread of $0.50 (on a stock price of $ 10), with a riskfree rate of 4% and an equity risk premium of 6% is:
 Cost of equity = 4% + 1.20 (6%) + 0.25% (.5/10) = 12.45%
With both approaches, the value will decrease with illiquidity.

 b. Relative Valuation: In its most common form, relative valuation involves screening the market for cheap companies, with one screen for pricing (low PE, low price to book, , low EV/EBITDA) and one or more for desirable fundamentals (high growth, low risk, high ROE). If you ignore illiquidity, your cheap stock portfolio will end up with a lot of illiquid stocks. The simplest way to incorporate illiquidity is to add it as a screen. Thus, in addition to screening for high growth and low risk, you could also screen for high liquidity (high float, high turnover ratios, low bid-ask spreads, high trading volume etc.). The tightness of the liquidity screen can then be varied to fit your liquidity needs as an investor.

 c. Contingent Claim Valuation: All option pricing models are built on two principles: replication (where a portfolio of the underlying asset and a riskfree investment is created to have the same cash flows as the option) and preventing arbitrage (the replicating portfolio and the option have to trade at the same price) . Both principles require liquidity: you be able to trade the option, the underlying asset and the riskfree asset in any quantity and at no cost. Illiquidity in any one of these markets will throw a wrench into the process and cause the option pricing models to yield incorrect values, with the imprecision increasing with illiquidity. So, what are your choices for bringing illiquidity into the process? You can try to modify the models to incorporate illiquidity explicitly but option pricing models are complicated enough already and this adds an additional layer of complication. Alternatively, you can adjust the inputs into the option pricing model. My choice would be the underlying asset value (S): using a lower value for illiquid underlying assets will reduce the value of call options on those assets.

In summary, no matter which approach you use, illiquidity is not a neutral factor. The investments you make within each asset class will reflect both the illiquidity of the investment and your own liquidity needs (and preferences) as an investor.

I have a paper on the effects of illiquidity on financial theory, where I examine the effects of liquidity on valuation in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408

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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, stocks, real estate, collectibles. In fact, defining asset classes loosely, private equity, hedge funds and mortgage backed securities can be considered new entrants in the game, vying for portfolio dollars.

In the classic mean variance framework, the optimum asset allocation mix is the one that maximizes expected returns, given a risk constraint. Thus, you feed in the expected returns and standard deviations of different asset classes, in conjunction with their covariances with each other, and let optimization work its magic. Here is the catch. The average returns, standard deviations and correlations all come from historical data. With illiquid asset classes, standard deviations tend to be under estimated (for a completely illiquid asset, there will be no trading and the standard deviation will be zero) and the covariances consequently will be misestimated. In fact, the least liquid asset classes often look like they offer the best risk/return tradeoffs, if you don't control for illiquidity. Plugging these values into the optimization framework will generate weights that are too high for the illiquid asset classes, for the typical investor. In the last decade, especially, this has led many endowment funds to over invest in real estate, private equity and hedge funds, categories notoriously over exposed to the vagaries of illiquidity.

So, how would you bring illiquidity into the mix and what are the consequences? There are two routes you can follow. In the first, you adjust the expected returns of illiquid asset classes downwards to reflect the expected cost of illiquidity.  That would make these asset classes less desirable and counter act the underestimation of standard deviations. The other is to restate the optimization problem thus: Maximize expected return subject to the constraints that risk be below a "stated" level and that liquidity be greater than a specified constraint.


With both approaches, the "right" asset allocation mix will vary across investors. Investors who desire or need more liquidity will tilt their portfolios towards more liquid asset classes (large market cap stocks, highly rated corporate bonds) . Investors who value liquidity less may actually gain by tilting their portfolios away from more liquid asset classes towards less liquid ones (real assets, small cap and low priced stocks, low rated corporate bonds).

I have a paper on the effects of illiquidity on financial theory, where I look at asset allocation in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408

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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 price with no transactions costs. Using that definition, no asset is liquid and the only question then becomes one of degree, with some assets being more liquid than others.

Given the premise that all assets are illiquid, here is a follow up question: how do you measure illiquidity? One obvious measure, especially in securities markets, is the total transactions costs, including not only the brokerage costs, but the bid-ask spread and the price impact from trading. The other is waiting time. In real estate, for instance, illiquidity manifests itself in properties staying on the market for longer periods. Days on market (DOM) is a widely reported statistic in real estate and is used to measure the health (and liquidity) of different markets.

There is significant empirical evidence that illiquidity varies across asset classes, within assets in a given asset class and across time.

• Across asset classes, illiquidity is more of a problem in real asset markets (real estate, collectibles) than in financial asset markets. Within financial asset markets, the US treasury market is the most liquid, followed by highly rated bonds and developed market stocks, with low-rated (junk or high yield) bonds and emerging market stocks bringing up the rear.
• Within each asset class, there are wide variations in liquidity. In the treasury market, the just-issued, standard maturity treasuries (3 month, 6 month, 10 year) are more liquid than the seasoned, non-standard maturity treasuries. Within the stock market, larger market cap and higher priced stocks are more liquid than smaller market cap, lower priced stocks.
• Liquidity also varies widely over time. While the long term trend in liquidity in equity markets has been towards more liquidity, liquidity moves in cycles, increasing in bull markets and decreasing in bear markets. Punctuating the long term trend are crises, like the 1987 sell-off in the US and the 2008 banking crisis, where liquidity dries up even for the largest market cap companies. During these crises, illiquidity manifests itself in many ways: trading halts, higher bid-ask spreads and bigger price impact when trading.

None of this evidence would matter if investors did not care about illiquidity but there is clear evidence that they do: liquid treasuries have lower yields (and higher prices) than illiquid treasuries and investors demand higher returns on stocks with lower trading volume and higher bid-ask spreads. One study find that every 1% increase in bid-ask spreads increased expected returns by 0.25%, and these higher required returns push down asset prices. Adding to the problem, the price that investors charge for illiquidity also varies over time, spiking during periods of crises: illiquid assets get discounted even more during these periods.

If illiquidity varies across asset classes, across assets and across time, and investors price in this illiquidity, it seems prudent that both portfolio  and corporate financial theory be modified to reflect the potential for illiquidity. Alas, given the length of this post, that has to wait for the next one.

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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_LeftTopHighlights
In 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 will go nowhere or worse, go somewhere bad.

To those who believe that complex models with more variables are the answer to uncertainty, my response is a paper by Ed Lorenz in 1972, entitled Predictability: Does the flap of a butterfly's wing in Brazil set off a tornado in Texas?, credited with creating an entire discipline: chaos theory. In the paper, Lorenz noted that very small changes in the initial conditions of a complex models created very large effects on the final forecasted values. Lorenz, a meteorologist, came to this recognition by accident. One day in 1961, Lorenz inputted a number into a weather prediction model; he entered 0.506 as the input instead of 0.506127, expecting little or no change in the output from the model. What he found instead was a dramatic shift in the output, giving rise to a Eureka moment and the butterfly effect. (One of my favorite books on the topic of Chaos is by James Gleick. It is an easy read and well worth the time.. for investors and economists)

Complex models work best with inputs that behave in thoroughly predictable ways: software and engineering models come to mind.  They break down when the inputs are noisy and the relationships are unstable: macro economic models are perfect lab experiments for chaos. The subjects (human beings) belong in strange and unpredictable ways, the variables that matter keep shifting and the relationships between them change over time. In fact, I will wager that the models that worked worst during the last crisis were the most complex models with dozens of inputs and cross relationships.

So, what is the solution? My experience in valuation suggests that you should go in the other direction. When faced with more uncertainty, strip the model down to only the basic inputs, minimize the complexity and build the simplest model you can. Take out all but the key variables and reduce detail. I use this principle when valuing companies. The more uncertainty I face,  the less detail I have in my valuation, recognizing that my capacity to forecast diminishes with uncertainty and that errors I make on these inputs will magnify as they percolate through the valuation. More good news: if I am going to screw up, at least I will do so with a lot less work!!

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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 talk about a bigger question. Not insider trading, because I have put my views on the topic down in a previous blog post, but about the hedge fund business. Note that many of the targets in this investigation are hedge fund managers. Since I have no reason to believe that hedge fund managers are any more immoral or unethical than any other random group of money managers, the question then becomes: What is it about the hedge fund business that seems to drive this constant search for an information edge? Or why do we not see more traditional mutual fund managers involved in these scandals?

At first sight, hedge funds and mutual funds share much in common. They both solicit money from investors, promising to deliver above-market returns to them and they get compensated for managing this money. But there are three significant differences:
1. Constraints on investing: Mutual funds are far more constrained in where and how they invest than most hedge funds are. Some of these constraints are imposed by regulators, some are self imposed and some are the created by clients.
a. Long versus long/short strategies: Most mutual funds can only buy stocks (The Investment Company Act of 1940 that governs mutual funds puts significant restrictions on short sales by funds), whereas hedge funds often can both sell short on some stocks and go long on others.
b. Investment choices:  There are several mutual funds that are judged based on "tracking error", measured by how far their returns deviate from a specified index's return. This constraint, usually imposed by clients, is designed to prevent fund managers from straying too far from the companies in the index. Hedge funds generally can invest not only in whatever company they want but many invest across asset classes.


2. Clientele mix: Hedge funds attract investments from either the very wealthy or institutions (pension funds, for instance). In fact, most of them actively discourage small, individual investors by requiring a large, minimum investment. Mutual funds tend to attract individual investors. At the risk of a gross generalization, institutional and wealthy investors are more demanding than individual investors; they move their money out of loser funds and into hot funds far more quickly than other individuals do. Put another way, if the herding effect is a phenomenon that affects all investors, it seems to affect wealthier and institutional investors more. (Some hedge funds put withdrawal restrictions on investors to counter.)

3. Financial leverage: Hedge funds are far more likely to use borrowed money to lever their bets. Most mutual funds either do not borrow money or do so on a very restrictive basis.

4. Compensation systems: Mutual funds generally make their money in two ways. All mutual funds cover their expenses from the money under management; the management; these management expenses are public information and can be accessed at services like Morningstar. A subset of funds also assess a one-time up-front sales charge (load), when you invest, where a certain percent of what you invest is taken by the fund at the time of the investment. Hedge funds assess an annual load (1% or 2% of the invested amount each year) and a percentage of the profit on the investment (10 or 20% of the profits).

You may be wondering at this stage what all of this has to do with insider trading. Consider why people seek out insider information. If they succeed, they can buy or sell a stock prior to that information becoming public; when it goes public, the stock will pop up or down, depending on whether the information is good or bad news.

All four differences highlighted play into why hedge fund managers see more gain from seeking out and exploiting private information:

1. Hedge funds can exploit both good news and bad news, by buying stocks in advance of the former and selling short ahead of the latter. Mutual funds can only buy on good news (though they can sell any existing holdings of companies on which bad news lies ahead).
2. While money management at any level is a rat race, where funds try to keep their own clients and coax clients away from their competitors, the race becomes more frenetic with hedge funds. A hedge fund that lags its peer group can enter a death spiral, where losses spur withdrawals which feed into more losses.
3. If the "inside information" is precise, you can use even more debt in your investment strategy, creating huge payoffs on your investment, when the information becomes public. Financial leverage acts as a multiplier on profits from insider trading.
4. The compensation system at hedge funds essentially gives every hedge fund manager a call option: they make 10 or 20% of all profits, no matter how large, and do not share in losses. Trading on information ties in well with this system, since it delivers skewed returns: most of the time, information turns out to be worthless, but when it is relevant information, the payoff is very large. Thus, even if insider information is noisy and provides little benefits or even creates costs for investors over the long term, hedge fund managers may still benefit personally from its use because of the upside call built into their compensation systems...

In summary, hedge fund managers are far more likely to be "information traders" than mutual fund managers and "insider information trading" happens to be one of the more lucrative (albeit illegal) manifestations of the same. So I am not surprised to see them ensnared in insider trading scandals more frequently. (I think the clustering of hedge funds around Stamford, Greenwich and other old-wealth Connecticut towns also adds into the mix. I would assume that there are hedge fund managers constantly rubbing shoulders with each other in every expensive restaurant in those towns...  trading stories and comparing returns...

In closing, though, I am not sure that all of this seeking out of information is generating a payoff for hedge funds. In the aggregate, they continue to either match or under perform actively managed mutual funds (which, in turn, under perform index funds), when fees and transactions costs are factored in. It is entirely possible that some of the "super" performers among hedge funds got there because they had access to private information that no one else had. I just don't think it is likely! As Shakespeare would put it, this seems like much ado about nothing!

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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-ipo
I 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 of the time and lost some....  It is human nature to judge the quality of risk taking by looking at the outcome of the risk taking. Success is thus vindication and failure is calamity. If you follow this to its logical ends, if you succeed, you are a good risk taker and if you fail, you are not. This is the theme that is being tapped into by both Warren Buffet when he wrote his thank you note to the government for TARP and by the White House for its GM investment. "Things worked out well in the end... So, it must have been  a sensible decision up front"...


2. Process: A more complicated way of judging risk taking is to look at whether the risk taking made sense at the time that the risk was taken, with the information available at the time,  rather than with the benefit of hindsight. At least in theory, it is possible that even the best-deliberated risky decisions can have bad outcomes, if fate does not cooperate, and that terrible choices when faced with risk can have "good" outcomes. Playing devil's advocate, however, it is much more difficult and more work to evaluate process than outcome.

3. Side costs and benefits:When risk taking creates costs and benefits for others, judging risk taking by its outcome for just the risk taker may not be fair, since it is conceivable for risk takers to make money while creating costs for society. It is also possible for risk taking activity to create losses for the risk takers while generating benefits for society. A fair assessment of risk taking will require us to consider these side costs and benefits into account.

4. Future risk taking behavior:It should not be surprising that how we take and reward/punish risk taking in the present can affect how people take risks in the future. If risk taking of a certain type consistently is rewarded, you will see more of it in the future. If in contrast, risk taking of a different type leads to punishment/losses, you will see less of it in the the future. If markets are viewed as "too easy" on risk takers, there will be more risk taking in the future in the future.

When does it make sense to judge risk taking on outcome alone? If a risk taker takes many risks over time and is right on average on a consistent basis and there are no significant side costs and benefits, it is reasonable to argue that success is the result of good risk taking.  A portfolio manager who beats the market each year for 10 years must be doing something right in terms of risk taking. However, judging a large risk taking venture with significant side costs and benefits and consequences for future risk taking on whether it makes money or not may not be sensibel.

Returning to the GM investment, the judgment on whether it was successful becomes more nuanced when we consider the other factors, even if the government's original investment makes money.

a. Did the government investment in GM make sense at the time of the investment, given what was known then? Tough to tell, since we do not know what the government knew at the time of the intervention. Given what the rest of us knew at the time, it would have been difficult to justify the billions invested in the company. However, it is possible that the authorities had information about GM's assets and liabilities that we did not. So, I will give the benefit of the doubt to the government on this point.


b. What were the side costs and benefits of the government investment? On the plus side , GM's salvation prevented thousands of layoffs at the company and budgetary chaos at at least one state (Michigan). On the minus side, the government's intervention on GM's behalf has cost other carmakers a chance to make inroads in this market. To the extent that the other car makers are foreign (Toyota or Honda), this may seem like a good thing, but the belief in free markets cannot stop at the borders. It is also conceivable that GM's salvation may have cost Ford a chance to make inroads into the market and secure its position for the long term.

c. What are the long term lessons for risk taking behavior?
It is undeniable that GM made some really bad strategic and management decisions in the the last three decades. In the face of default, the government stepped in, upended bankruptcy and tax laws (which conveniently were written and interpreted by government officials) and saved the company. Other firms that took more prudent decisions in the face of risk were put at a disadvantage. It would seem to me that the lessons learned on risk taking from this experience are the wrong ones: if you take risks, make sure that you are a big firm with the right connections.

Bottom line. As a taxpayer, I am happy that the GM investment looks like it will break even or better.. As an investor, I am less happy about the long term consequences of this success. I am afraid that it sends the wrong signals on risk taking to the market and investors.

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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 big name colleges, the television networks and bookmakers. I got my MBA and Phd at UCLA and I know that no faculty member at UCLA brought in a fraction of the revenues that the UCLA basketball coach did and none was as widely recognized in campus. In college football, Auburn is ranked second in the country and could very well be playing for a national championship this year. The New York Times has an article on the impact that Cam Newton at quarterback has had on Auburn's economics:
http://www.nytimes.com/2010/11/14/weekinreview/14belson.html


Here comes the hypocrisy. The NCAA likes to maintain the illusion that college sports is not  business and that college players are amateurs. While this may in fact be true for most athletes at second and third tier schools, playing lower profile sports, it is certainly not true for college football and basketball at Division I schools. The NCAA then has rigid rules on what college players can receive in return for playing their sports: not only can they not get monetary gifts from the school but the ban extends to cover the most trivial of gifts. From an economic standpoint, this strikes me as a modern version of indentured servitude. If you are a superb basketball or football player, you have to play for a college of your choice (that is the NCAA's concession to free choice) for nothing, before you can play professional football or basketball. The colleges and the networks make millions but the players (who are the stars of the system) get scholarships, worth a few thousands and risk career ending injuries while doing so.

As I watch the "amateur" label debated in college athletics, I am reminded of similar debates that occurred in tennis and the Olympics. For decades, we kept our best tennis players out of the big tournaments in the interests of maintaining the illusion that these tournaments were just for amateurs; I can only imagine how many Wimbledons that Rod Laver would have won, if he had been allowed to play in his prime. For decades, the Olympics forced great sprinters and athletes to pick between being champions and making a living, before bowing to the reality that you cannot win the 100M by practicing just on weekends.
Don't get me wrong. I love college sports, but I think it is time to strip the hypocrisy out. My proposal is that we create two classes of college athletes: The first would be "student athletes", who get scholarships, but focus on taking classes (regular classes, not Mickey Mouse ones) like other students and get college degrees. Some of them may find that they are good enough to become professional, but most of them will play college sports and then move on to bigger and better things in life. The second would be "semi-pro" athletes, who will be allowed to earn an income (we can put caps on the income and restrict what colleges can pay, if need be) while they played and earn money from advertisements and sponsorships. They would be required to be visible on campuses and allowed to take classes, if they choose to.  Colleges would also be required to set aside a portion of their revenues to cover the health and personal costs incurred by college athletes. I think I would still enjoy watching UCLA play basketball... while knowing that the Bruins on the court are making a reasonable living while playing the game.

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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, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

My explanation for the puzzle. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt  idek, 

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes. In the table below, I list the investment philosophy that fits best given your time horizon and views on the market:

	Momentum	Contrarian	Opportunisitic
Short term (days to a few weeks)	·      Technical momentum indicators – Buy stocks based upon trend lines and high trading volume. ·      Information trading: Buying after positive news (earnings and dividend announcements, acquisition announcements)	·      Technical contrarian indicators – mutual fund holdings, short interest. These can be for individual stocks or for overall market.	·      Pure arbitrage in derivatives and fixed income markets. ·      Tehnical demand indicators – Patterns in prices such as head and shoulders.
Medium term (few months to a couple of years)	·      Relative strength: Buy stocks that have gone up in the last few months. ·      Information trading: Buy small cap stocks with substantial insider buying.	·      Market timing, based upon normal PE or normal range of interest rates. ·      Information trading: Buying after bad news (buying a week after bad earnings reports and holding for a few months)	·      Near arbitrage opportunities: Buying discounted closed end funds ·      Speculative arbitrage opportunities: Buying paired stocks and merger arbitrage.
Long Term (several years)	·      Passive growth investing: Buying stocks where growth trades at a reasonable price (PEG ratios).	·      Passive value investing: Buy stocks with low PE, PBV or PS ratios. ·      Contrarian value investing: Buying losers or stocks with lots of bad news.	·      Active growth investing: Take stakes in small, growth companies (private equity and venture capital investing) ·      Activist value investing: Buy stocks in poorly managed companies and push for change.

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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 more borrowing by consumers and companies. I see four problems:

1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?

2. Existing leverage: The average US household already has too much debt, some of it reflecting a hang over from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more? It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?

3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counter productive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?

4. Currency devaluation: Related to inflation fears is the effect on the US dollar, which has been under selling pressure for a while. A dollar devaluation will also make imported goods more expensive in the US, and given the trade deficit, that has to feed into price increases in the future.

Having listed these concerns, I must confess I am not a macro economist (and have no desire to be part of that crew). The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs. At least, I hope so...

I don't know about you, but I am starting to wonder about these multiple stimuli. Using the analogy of the emergency room,  those electric paddles used to shock a faltering heart back into a rhythm are a godsend for someone with cardiac arrhythmia, but I also know that they sometimes do not work. That is when the cardiac surgeon is called in for more radical remedies or worse. To stimulate the US economy, we tried QE1 and it did not work, we tried FS1 (Fiscal Stimulus 1) and it did not work either. Now we are trying QE2  and if we listen to Paul Krugman (who must be having seances with Keynes every night), we should try mega FS2 next...Perhaps, it is time to accept the reality that there is something fundamentally wrong with the economy that stimuli will not fix. And perhaps, it is time to call in the surgeons! (Let's not even think about the other alternative)

And for those of you who may be wondering about the title of this post, here is the original QE2.

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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.html
Taleb 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.) I think he badly misplays his hand by arguing that Markowitz, Sharpe and Miller are to blame for the excesses in financial markets. In fact, let's take each of their contributions to finance and put them to the test:

a. Let's start with Merton Miller, who was the oddest target of all. (Perhaps, the story got the name wrong and Taleb really blamed Bob Merton, not Merton Miller...) Miller and Modigliani argued that great firms acquire that status by taking good investments (that generate higher returns than it costs them to raise capital), and that finessing capital structure or messing with dividend or buyback policy adds little or no value at the margin. Since much of the advice and deal making in Wall Street is directed towards capital structure solutions (recaps, leveraged transactions) and dividend policy (buybacks, special dividends), it would seem to me that what corporate finance departments at investment banks do is in direct violation of what Miller would have propounded.

b. How about Markowitz? The singular contribution to finance that Markowitz made to finance was his recognition that the risk in the investment has to be measured as the risk it adds to a portfolio rather than the risk of it standing alone. In effect, his work is a statistical proof that diversification eliminates a significant portion of risk in investments. It is true that he worked in a simplified world where an investment's worth is measured on only two dimension - the expected return (which is good) and standard deviation (which is bad), but his conclusion that diversification reduces risk would hold with any of the distributions that Taleb claims are more realistic descriptions of investment behavior. The mean-variance framework has been critiqued and adapted from within and without the discipline for forty years, starting with Mandelbrot in the 1960s and continuing through to the behavioral economists today. Perhaps, you can indirectly critique the dependence on the normal distribution for the failure of risk management systems such as VaR, but that is na stretch.

c. Bill Sharpe is targeted for his role in the development of the CAPM. Let's face it. Betas and the CAPM have become the whipping boys for everything that goes wrong on Wall Street! That's right. It was beta that drove the creation of those mortgage backed securities. And those homeowners who were borrowing up to the hilt and buying houses they could not afford.. The fault lay in their "betas" and not in them...

I have been with and around traders and investment bankers for much of the last three decades and most of them are too busy to obsess about financial theory. There are a few rogue bankers who think that they are smarter than everyone else, have contempt for the average individual and believe that they can create wealth out of nothing. They are not believers in efficient markets (how can they, if their success depends on claiming to find market inefficiencies?) and have little time for betas or mean-variance theory (in their view, these are abstractions, when deals and trades make money). In short, they are nothing like Miller, Markowitz and Sharpe, who in spite of all of the faults you can find with their work, were open to honest intellectual debate. In fact, in their arrogance and self-righteousness, these "investment bankers" remind me of someone else! Mr. Taleb, do you happen to own a mirror?

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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 sense of what macro economists say but you probably have a point of view on inflation and are wondering how inflation or deflation will affect your portfolio.

To understand how inflation affects the value of a company, let's get down to basics. The value of a company can be written as a function of its expected cash flows over time and the discount rate appropriate for these cash flows. In its simplest form, the value of a stable growth firm can be written as:
Value = (Revenues - Operating Expenses - Depreciation) (1- tax rate) / (Cost of capital - Stable growth rate)
Assume now that inflation jumps from 1% to 5%. For value to be unaffected, everything has to increase proportionately. Thus, revenues, operating expenses and depreciation all have to increase at the inflation rate, the tax rate has to remain unchanged and the discount rate will have to increase by that same percentage. So, what might cause this to break down?
a. Lack of pricing power: Even though the overall inflation rate may be 5%, not all firms may be able to raise prices by that magnitude. Put simply, firms with loyal customers, a strong brand name and significant competitive advantages will be able pass inflation through better than firms without those benefits.
b. Input costs: By the same token, not all input costs will increase at the same rate as inflation. If oil prices increase at a rate higher than inflation, an airline that lacks pricing power may find itself squeezed by higher costs on one side and stagnant revenues on the other.
c. Tax rate: The tax code is written to tax nominal income, with little attention paid to how much of the increase in income comes from real growth and how much from inflation. Thus, the effective tax rate you pay may increase as inflation increases.
d. Cost of capital: The effect on higher inflation will be felt most directly in the risk free rate, which will rise as inflation rises. However, equity risk premiums (which determine cost of equity) and default spreads (for cost of debt) may also change.

Historically, higher inflation has not been a neutral factor for stocks. Stocks have done worse during periods of high and increasing inflation and much better in periods of lower inflation. This graph, which I borrowed from a Wall Street Journal article, illustrates the stark divide:

That may seem puzzling because we are often told that it is bonds that are hurt by inflation and that stocks are good inflation hedges. Here is why I think the logic breaks down. When inflation increases, equity investors are hurt for two reasons. The first is that the discount rate (cost of equity and capital) increases more than proportionately, because risk premiums increase with inflation. For instance, the equity risk premium in the United States increased from 3.5% in 1970 to 6.5% in 1978 and default spreads also widened. The second is that the tax code is not inflation neutral. For companies that have substantial fixed assets, depreciation is based upon historical cost and not indexed to inflation. Consequently, the tax benefits from depreciation become less valuable as inflation increases; think of it as an implicit increase in your effective tax rate.

If I believed that high inflation was around the corner, I would first shift more of my portfolio from financial assets to real assets. Within my equity allocation, I would invest more of my money in companies that have pricing power (allowing them to pass inflation through to their customers), inputs that are not very sensitive to inflation (so that costs don't keep up with inflation) and few fixed assets (to prevent the depreciation tax impact). I can think of several technology, consumer product and entertainment companies that fit the bill. As a bonus, I would like the companies to have long term debt obligations at fixed rates; inflation is likely to dilute the value of the debt. These companies are likely to see their cash inflows increase at a rate faster than inflation and will be able to buffer the impact of inflation on discount rates. In my bond portfolio, I would steer my money to short term government securities, inflation indexed treasury bonds (TIPs) and floating rate corporate notes; they are least likely to be devastated by higher inflation.

If deflation was my concern, I would invest more of my portfolio in financial assets; bonds, even with 2.5% interest rates, would be a bargain. Within my equity allocation, I would steer away from cyclical companies. At least in recent decades, deflation has gone hand-in-hand with low or negative economic growth. Consequently, I would invest in companies that sell non-discretionary products and necessities.  In my bond portfolio, my holdings will be in more credit worthy entities, since default is a very real possibility in poor economic conditions.

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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-sentence
I 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 don't share in the losses) at banks as a culprit, but I think there are three "behavioral" factors that contribute to disasters such as this one.

1. Selection bias: Experimental economists have been exploring differences in risk aversion across sub-groups of people and their conclusions are fairly strong. For the most part, their studies find that younger people tend to be less risk averse than older people, single people are less risk averse than married folks and men are less risk averse than women (especially young). Now think about your typical trading room in any investment bank. It is over populated with 25-35 year old males, selected primarily because they had the right "trading" instincts. In fact, I think you can safely assume that if you were picking the least risk averse group in a population, it would look a lot like that trading room.

2. House money effect: You tend to be much less careful when taking risks with "house" money than with your own. Traders almost always are playing with house money, especially when they are doing proprietary trading, and not surprisingly are more cavalier about taking risk than they would be with their own money.

3. Break even effect: Here is a phenomenon that every casino owner knows. When a gambler loses money, he tries to make it back, and the deeper he gets in the hole, the rasher he becomes in his risk taking. So, a trader who loses $ 100 million will try to win it back with big bets (even if those bets don't make much economic sense); the more he loses, the wilder his risk taking will become.

One of the problems with the risk management systems that we have is that they deal with the symptoms and not the causes of erratic and bad risk taking. If we want to reduce the likelihood of more Jerome Kerviels in the future, here are some things we should do:

a. Create more diverse trading rooms: I am not a fan of diversity for the sake of diversity, but I think that opening up trading rooms to a wider range of people will dampen some of the excess risk taking. Maybe we should hire every trader's mother or grandmother to trade side by side with him; in fact, I would give her the next desk. Seriously, though, this will require investment banks to revamp their hiring processes and look more kindly on those "not cool" kids on campus who right now would not make the cut.

b. Restrict or eliminate proprietary trading: I know that proprietary trading is viewed as too lucrative to let go by banks, but I have my doubts as to whether it actually generates long term profits for any of its architects. One side cost of the increase in proprietary trading at banks has been the increase in house money that traders have to play with.

c. Information systems: To stop the "break even" effect from kicking in, we have to intervene much earlier when traders start losing money to prevent them from accelerating the cycle. To intervene, we need to know how much traders are making or losing in real time and have automated or computerized systems step in and stop trading at a defined loss point. Traders will try to devise ways around the system, but the system has to be responsive enough to adapt.

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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/b0MrBt
Briefly 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 dividend yield stocks in the Dow 30. A more detailed sales pitch for this strategy can be found here:
http://www.dogsofthedow.com/
Over time, its proponents argue that the strategy would have paid off richly for investors.

To add even more ammunition to dividend seekers, studies over the last three decades have also shown that stocks in the top decline in dividend yield generate about 2-3% higher returns, after adjusting for risk, than the rest of the market. This newsletter nicely summarizes the evidence:
www.tweedy.com/resources/library_docs/papers/highdiv_research.pdf

So, is this a winning strategy? In my book, "Investment Fables", I have a chapter on this strategy which you can download by clicking below:
http://pages.stern.nyu.edu/~adamodar/pdfiles/invfables/ch2new.pdf
Briefly summarizing, I argue that as with all investment stories, there are caveats and these are the most significant ones for "dividend" heavy strategies:
1. Dividends are not legally binding: Unlike coupons on bonds, where failure to pay leads to default, companies can cut dividends without legal consequence. The fact that "dividends are sticky" and companies don't usually cut dividends does not take away from this point.
2. Higher tax liability: At least in the United States, for much of the last century, dividends have been taxed at a higher tax rate than capital gains. (Since 2003, the tax rates on the two have been the same, but that law is set to expire on December 31, 2010, returning us to the old tax laws).
3. May be "liquidating" dividends: When companies are in decline, they may pay large liquidating dividends, where assets are sold to fund the dividends. While these dividends are cash flows, they are not sustainable and will run out sooner rather than later.
4. Sector concentration: If you pick the highest dividend yield stocks across a market at any point in time, you may find yourself holding stocks in one or two sectors. In early 2008, for instance, you may have ended up with five banks in your portfolio. If there is a shock to that sector, your portfolio will collapse.
5. The market "knows" something you do not: Remember that the dividend yield for a stock shoots up almost always because the price drops, not because the dividend is increased. In other words, it is a sudden drop in the stock price that makes the stock look attractive. It is true that markets make mistakes, but it is also true that sometimes price drops of this magnitude occur because there is a serious problem looming on the horizon.

Here is how I would modify the strategy to protect myself against these three issues:
1. Look for companies with positive earnings, low debt burdens and high cash balances. They will be under less pressure to cut dividends.
2. Use this strategy for "tax protected" portions of your portfolio. Even in the US, investments made in pension plans are allowed to accumulate income, tax free. Even if you cannot pick individual stocks in your pension fund, you may be able to redirect the money to a high dividend yield mutual fund.
3. Steer away from companies with dividend payout ratios that exceed 80% and have negative revenue growth. That may help keep liquidating companies out of your portfolio.
4. Try for some sector diversification. In other words, classify companies at least broadly into sectors and look for the highest dividend yield stock in each sector, rather than across the whole market.
5. Check every news source that you can find for news stories or even rumors about the company. 

In short, buying high dividend yield stocks makes sense for a long-term, tax-advantaged investment. One point that I disagree on is that this strategy requires you to give up on diversification. I don't see why you cannot construct a reasonably diversified portfolio (of 30-40 stocks spread across sectors) of high dividend yield stocks.

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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 management, from a broader perspective.

Risk management, as practiced currently, is splintered among different disciplines. The risk hedging and measuring part has been taken over and reshaped by the finance folks, using numerical measures of risk such as beta and Value at Risk. The risk taking part has been hijacked by strategists, many of whom talk a good game, but are reluctant to put their ideas to any numerical test. Economists have largely sat out the debate, preferring to debate risk aversion in the rarefied world of utility functions. Statisticians have nipped at the edges, primarily pointing out what the rest of the crowd is doing badly.

I put together a presentation for a one-day seminar on risk management, from a corporate governance standpoint, and  delivered it in four venues: Antigua (Caribbean), Bogota (Colombia), Lima (Peru) and St. Petersburg (Russia). I have turned over my slides for others to use in more venues, but my task is done. For closure, I decided to pull together the slides and create a manual for directors. While the IFC will be officially printing and distributing a variant of this manual, I want to make it available to anyone who wants it. You can download this manual by going to the following link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1681017

For those of you who have my Strategic Risk Taking book, this is a compressed version, with the added bonus of tasks that you can use to assess how good risk management is in your firm. For those of you who do not have the strategic risk taking book, this manual captures the essence of my argument.

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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 a few years ago.  Starting in 2007, the fund's assets have exploded and it is now up to $ 5 billion. Its growth coincides with its superb performance over the period.
http://online.wsj.com/article/SB10001424052748704858304575497662644720960.html?mod=WSJ_hps_MIDDLEThirdNews
So what? Only about a third of the fund is invested in stocks; 25% is invested in gold and silver and 35% in cash. Its performance over the last three years can be explained largely by the fact that it is under weighted in stocks and over weighted in precious metals. In other words, its success comes almost entirely from its asset allocation, rather than asset selection.

History provides a cautionary note on why return chasing often comes to a bad end. Momentum investing, which is what this comprises, requires two components to succeed:
1. Long runs in returns. You need asset prices to move in the same direction for long periods. If good years are followed by bad years and vice versa, you will end up with whip lash as a momentum investor. In statistical terms, you need strong positive correlation in returns across time. Whether there are long runs in returns is an empirical question and there is evidence that is hopeful. There have been long historical runs (positive and negative) in returns in stock and bond markets and even longer runs in currency and commodity markets. The evidence is less positive when it comes to individual stocks; while there is some short term momentum, it is much weaker than in the asset marekts. Thus suggests that momentum investing is more likely to pay off for market timers playing the asset allocation game than for individual stock pickers.

2. Detecting the end of the runs: All good things come to an end and long runs in prices (up or down) end at some point in time, with the size of the correction directly proportional to how long the run lasted in the first place. A momentum investor can see years of positive returns wiped out in the course of a few weeks or even days. The evidence is not as positive on this factor. Models and investors that claim to detect imminent market corrections don't do very well, at least in the long term.  However, there may still be hope. I am not a great believer in technical analysis, but this is is one place where price and volume charts may help, especially in assessing how close to the cliff you are. I have a chapter on momentum investing in my investment philosophies book that you may find interesting and you can download it by clicking below.
http://www.stern.nyu.edu/~adamodar/pdfiles/invphil/ch7.pdf

If you are a momentum investor, making money on your gold investment right now, I am happy for you. I just hope that you have a mechanism that  will tell you when it is time to get out. With momentum investing, knowing when to sell is even more important than knowing when to buy.

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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, especially in the last decade of his tenure.

While I have not had a chance to read Eisner's book yet, I was interested to read that he used his partnership with Frank Wells as one of the great partnerships that succeeded. On that count, I completely agree. When Eisner came to Disney as CEO, from Paramount, the company was moribund; its theme parks were getting old, its animated movies lacked pizzazz and the ghost of Walt Disney wandered through the halls. Eisner, with his then side-kick Jeff Katzenberg, brought a fresh energy to the company that was complimented by the operating savvy of Frank Wells, Disney's Chief Operating Officer. Wells operated as a check on Eisner, channeling his visions to practical success. By 1994, the two men had turned Disney around and put it on the path to being an entertainment powerhouse.

In 1994, Wells died in a helicopter crash and the only person in the company capable of reining in Eisner was gone. Eisner packed the Disney board with me-too directors, far too eager to rubber stamp whatever he did, and he let his manias and paranoia run rampant. Disney made investments it should not have made (buying Capital Cities was a mistake; it is revisionist history to claim, as Eisner does, that he bought ABC to get ESPN, since he could have bought just ESPN for a fraction of the $ 18 billion he paid for the entire company) and did not make investments it should have (buying Pixar early in the game for millions rather than wait a decade and pay billions), fired people who should not have been fired and did not fire people it should have. By 2003, stockholders in Disney were in full revolt and deservedly so; the company's earnings had plateaued and its stock under performed the market.

My larger point, though, is not about Disney, but about why we needs checks and balances in positions of power. Even the smartest, best-intentioned individuals have weaknesses. At some point in time, without constraints, these weaknesses rise to the surface and subsume the successes. When we push for stronger, more independent boards of directors, it is not because we operate under the illusion that such boards will make bad managers into good ones, but that they will keep good managers from going over to the dark side. We will never know how much good Eisner could have continued to do in Disney, if he had a strong board of directors to guide him, confront him and sometimes stop him or slow him down.

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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_LEFTWhatsNews

Finding 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 expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
 There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.


So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period.  I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.


What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.

Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.
 

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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 shifted to valuing technology companies, in general, and young technology companies, in particular. The last decade saw the rise of emerging market companies in the first part and the banking crisis, towards the end.  My lectures and notes reflect these shifts.

2. First principles endure: While the issues and challenges that we face in valuation change constantly, I have adhered to the same first principles over time. In fact, it is these first principles of valuation that I return to, at times of uncertainty and crisis, to look for answers. I truly believe that if you "get" these first principles, you are capable of answering any question in valuation, and I view that as one of the primary objectives for this class.

3. The audience changes: As any teacher knows, the material may stay the same but the experience of a class can change, depending on audience interaction and background.

4. It is theater: I love having an audience (even if it is a captive one), especially since I get to review their performance, rather than the other way around. What actor would not kill for this set up?

I invite you to join in and follow the class. The lectures will be webcast, though not in real time. You can download them and watch them on your computer or iPod, or watch it as a streaming video. You can get the lecture notes, follow my emails and even take the quizzes/exam (you have to grade them yourself, but I will put my grading template online). Everything you need should be at this link:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
Just a note of caution. You will not get credit for the class but I hope that the material is worth the effort. Let me know if there is something I can add (at low cost in terms of time) to the website to make your experience better.

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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=1648164
My second chapter builds on a theme that has been a bit of an obsession for me on risk premiums and how they have become more unstable, unpredictable and linked across markets. The paper titled,
A New Risky World Order: Unstable Risk Premiums - Implications for Practice, is now ready to download and you can get to it by clicking on the link below.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669398

The paper is long (about 60 pages) but hopefully not verbose. A great deal of what I say in the paper, I have said before in my papers and posts on equity risk premiums. The difference in this paper is two fold.

1. I expand my analysis to look at risk premiums in different markets - default spreads in bond markets and real asset premiums in real asset markets. In the process, I can examine how risk premiums in different markets have begun more moving together and how divergences across markets can be used to fine tune both investment and corporate financial decisions.
2. I do present a template that can be used by practitioners to choose between the bewildering array of risk premium estimates that are out there. When should you use a current premium and when should you use a historical premium?

I am working on my third chapter of the book: What if nothing is liquid?, where I hope to look at what would happen to valuation and corporate finance practice, if markets essentially shut down. I hope I will have something interesting to say.

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