Tuesday, October 19, 2010

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.
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?

Wednesday, October 13, 2010

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.

Thursday, October 7, 2010

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.
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.

Monday, October 4, 2010

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:
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:
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:

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:
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.