when quantitative investment strategies “add up to fraud”

Yesterday’s online Financial Times contains an article titled “When use of pseudo-maths adds up to fraud.”  It references an academic paper (which I haven’t read yet–and may never) which concludes that while quantitative management strategies may look impressive to neophytes, many are mathematically bogus.  This could be why they often fail deliver the superior investment performance they appear to promise.  Anyone with mathematical training needed to construct such a statistical stock-picking system should know this.

Quelle surprise!, as they say.

There’s a powerful cognitive urge to simplify and systematize data.  But that’ not why investment management companies typically create the mathematical apparatus they tout to clients.

The reality is that investment management has a large right-brain component to it.  It depends on individual judgment and intuition honed by experience.  This fact makes clients uncomfortable.

Typically the company treasurer, or other person in the finance department who is in charge of supervising the company pension plan, has little or no investment training or experience.  He may know corporate finance, but that’s a lot different from portfolio investing.  Suppose the manager I just hired begins to lose something off his fastball, he thinks.  He tells me he reads 10-Ks, but suppose he just goes into his office, takes an hallucinogen and picks stocks based on the visions he experiences.  How can I explain this to my boss if the pension plan returns go south?

That’s why his first step is to hire a third-party pension consultant.  It’s not necessarily that the consultant knows any more than the treasurer–in my experience, the consultant probably doesn’t.  Hiring an “expert” is a form of insurance.

Selecting a manager with a quantitative stock-picking system is another.  The supposed objectivity of the system itself–safe from emotions or other human foibles–is a second form of defense.

Up until now, the apparent safety net created by hiring the consultant and selecting a recommended manager who relies on “science” instead of intuition has been enough to clinch the deal for many quantitative managers.   Of course, while this decision may make the treasurer feel better–and may be an effective defense as/when the quantitative system in question blows up–it doesn’t eliminate the risk in manager selection.  It simply shifts the risk fulcrum away from the human portfolio manager to the statistician who has constructed the stock selection model.  The paper the FT references, “Pseudo-Mathematics and Financial Charlatanism,” argues that, empirically, this is a terrible idea.

I wonder if anything will come of it.

the Chinese economy (i): background

size by GDP

According to the CIA World Factbook, the US is the largest economic power on the globe, with 2013 GDP (calculated using the Purchasing Power Parity method) estimated at $16.7 trillion.

The EU is a close second, with GDP of $15.8 trillion.

China is in the #3 spot, with GDP of $13.4 trillion.

Together, the trio make up about half the world’s GDP.  (A quarter century of stagnation has left former co-#1, Japan, a mere shadow of its former self, with GDP of $4.7 trillion.)

China’s economic strategy

Since turning away from central planning toward a market economy under Deng Xiaoping, China has faced two related issues:

–creating enough new jobs to absorb new entrants to the workforce, thereby avoiding political instability, while at the same time,

–reining in the inefficient, loss making, often corrupt state-owned industrial sector, which accounted for three-quarters of all employment in the late 1970s.

Two other constraints:  China had to do this without an effective central bank and with a cadre of state and local government officials who thought (many still do) that the fastest and most lucrative road to the top was to create more labor intensive, inefficient (and corrupt) local analogues of big state-owned enterprises.

China has achieved spectacular economic growth by embracing capitalism.  To some degree, the remaining state-owned sector, which now accounts for just over one quarter of the economy, has also shaped up.  But while doing this, China has tended to lurch between periods of substantial credit restriction to try to force state-owned enterprises to become more efficient or die, followed by excessive expansion when layoffs become too severe.

the latest wrinkle

Emerging economies, following the post-WWII Japan model, start by offering cheap labor for simple manufacturing businesses, so that they can acquire training and technology from foreign firms.  At some point, a given country will run out of labor.  It must then transition to higher value-added endeavors.  Few succeed without a lot of heartache, because–I think–vested interests attached to the status quo are so powerful.

China now finds itself at this transition point, an issue which dominates its current economic policy.

More tomorrow.

 

why are former high fliers crashing?

There are two forces at work that are causing the weakness in former high-flying names in the US stock market:

1.  The lesser of the two, I think, is worry by predominantly European investors that Chinese will slow more than expected and that EU economic progress will be hurt by Russia’s expansionist tendencies.  It’s less those tendencies, in my view, than the fact that Russia supplies a lot of the natural gas the EU uses, and that the delivery pipeline goes through the Ukraine.

So EU portfolio managers are becoming defensive in a very conventional way.  This means moving money out of small caps and into large, pulling back from foreign markets to reinvest at home, and shifting away from issues whose attraction is strong future growth and toward (defensive) names that look more like bonds.

2.  More important is recent Fed action in continuing its very early steps toward normalization of domestic interest rates, despite apparent first-quarter slowdown in growth.  This affects stocks in a number of ways:

–during periods of interest rate rise after garden-variety recessions, stocks in general typically go sideways.  My guess is that this is the way events will play out this time around.  But the Great Recession was so deep–and Fed monetary accommodation so huge–that to some degree we’re currently in uncharted waters.  So Wall Street is nervous.

–rising interest rates are devastating to the valuation of stocks whose price is justified mostly by earnings far in the future.  If we calculate today’s value of $1 to be paid to us in five years using current 10-year Treasury bond rates, we find it’s worth $.90.  If we use an interest rate of 5%, which is what the Fed says it’s ultimately aiming for, then that future dollar is only worth $.78.  That’s about a 15% drop.  If the dollar is only going to be paid in ten years, then its present value shifts from $.81 to $60, a 25% fall.

For many “concept” stocks no one really knows for sure the timing of future earnings.  Even experienced Wall Street securities analysts struggle to forecast next year’s earnings, so in reality they only a general sense of the way future profits may be trending.   Still, whether we have precise figures or not, rising interest rates make future earnings much less valuable to an investor today.

–it’s a commonly held belief–and a correct one, I think–that when there’s too much money sloshing around in the economy it finds its way into highly speculative areas.  Highly leveraged transactions and “concept” stocks are two examples.  The Fed’s declared intention to syphon away some of this excess should provoke–and has–selling in the most speculative end of the stock market.  This is different from the more rational idea that future earnings are less valuable as interest rates rise.  This is more like the casino is closing, so no one can make crazy bets any more.

what now?

If you’re concerned and realize you have an asset allocation problem–meaning you have too much money in stocks that are way out on the risk spectrum–you should make your portfolio more conservative.  Maybe you shouldn’t do 100% today, but you should at least do some.

When will the selling stop?  …either when the negative emotion currently in the market dissipates (it’s hard to be very fearful for an extended period of time) and/or stocks that are being sold off begin to look very cheap.  In the case of stocks whose earnings payoff is, say, five years in the future, some are starting to look more reasonable.  the market overall cheap?    …not yet, in my view.  In normal times, we’d have to see the market testing the bottom of the channel we’re in before veteran traders would step in.  That’s 5% – 6% below where we are on the S&P 500 now.

 

 

rent vs. buy: financing and Solarcity (SCTY)

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.

 

 

 

 

 

rent vs. buy: why rent a product instead of selling it?

Adobe (ADBE) used to sell physical copies of a given edition of its Creative Suite of products to individuals or small businesses for $2600 apiece.  Now it rents the same thing as Creative Cloud for $50 a month.  In 2012, selling physical copies (let’s ignore the other cloud-based tools ADBE sells–the big change is in its media tools), ADBE made $1.66 a share in profit and had $2.24 in cash flow.  This year, having gone totally digital the company says it will have earnings of around $.30 a share and will generate, I think, $1 or so in cash flow.

How can this be a good deal?  It takes over four years of rental income to generate the same revenue that a sale would do all at once.  In addition, in a world where interest rates were back to normal, present value considerations make the rental stream worth less than cash in hand today.

So why switch?

I can think of four reasons:

pricing umbrella   $2600 for Creative Suite, or $700 for Photoshop alone, leaves the door wide open for a competitor to enter the market with a lower-priced product–even a shareware entry–that does more or less the same thing as an ADBE product.

piracy  I’ve seen bootleg copies of Creative Suite on Craigslist for $100.  Yes, they’re illegal and, yes, maybe they won’t all work forever, but still the price difference is enormous!  Back when I was following Microsoft carefully–which is over a decade ago–that company thought that almost half of the copies of its Office suite being used by small- or mid-sized companies were stolen.  Because the rental model matches the cost of the software more closely with the potential buyer’s cash flow, stealing the software becomes much harder to justify.  If it’s all on the cloud, it’s impossible for most people to do.

upgrades (or lack thereof)  Before I signed up for the cloud version of Photoshop, I was using a version (CS5) that was several years old.  I’m sure there are individuals and businesses using much older versions.  Same general argument as for piracy–using outdated tools become much less worthwhile.

selling direct  Delivering Creative Cloud products through downloads eliminates the commissions paid to distributors of physical copies.  It also eliminates the expense of making the physical copies, but I think that’s a minor expense (the box and shrink-wrap are probably the largest cost elements).

 

ADBE thinks it will make $2 a share in 2015 and $3 a share in 2016 because of switching to the cloud for its media tools.  I’m not sure these number make the stock cheap at today’s price (I have a small position and would be a buyer at lower levels), assuming they come in as ADBE anticipates.  But I’m convinced that the piracy thing is real and that the incremental cost of selling an extra copy is as close to zero as you can get.  Also, once you start using the better tools it’s highly unlikely you’re going to go back.  You’ve probably thrown out the disks anyway.

Therefore, there’s at least a shot that number s are better than that.

But in this post, my main point is that the rental model is an extremely powerful one.

Examples tomorrow–Anixter, Olympus and EA.

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