margins, not quite what they seem

There’s a persistent belief among investors that companies with high margins are better than those with low ones.  To a limited extent, this is true, but the issue is much more nuanced than is commonly thought.  In fact, in many cases, a high-margin firm in a given industry is in an inferior position to one with lower margins.

I’ll be writing about this over the rest of this week, after my Keeping Score analysis of the sector performance of the S&P 500 for May tomorrow.

What are margins?

They are ratios.  They’re ratios of profits to sales, usually expressed as percentages.  The most commonly used are:

–gross margin, which is the based on profits after deducting direct costs of providing goods or services

operating margin, which is based on profits after deducting both direct and indirect costs

pre-tax margin, which is based on profits after all costs ex tax (the main added item is interest expense), and

net margin, which is based on profits after all costs, including income tax.

 

another topic

I received an email a while ago explaining that I might be one of a large number of Twitter users whose account might have been hacked in 2012.  The email suggested I change my password   …which, of course, I failed to do.

Last night I got another email noting possible suspicious activity in my account.  For anyone who might be interested, no, I am not the scantily clad woman whose picture appeared on my account yesterday.  Nor am I touting her sex site.

I have since changed my password and removed all (I think) the offending material.  A weird experience.

 

volatility, non-correlation …and beta

risk as volatility

Today is about volatility as a measure of risk.

It’s the standard academic method of assessment.  It has a certain initial intuitive plausibility.  After all, if your portfolio values is going all over the map, that sounds bad compared with one that just stays in one place.  Of course, the latter strategy is less damaging when there’s no inflation.  And there’s embedded just below the surface the efficient markets assumption that the highest possible return one can achieve is the market return.  The extra movement created by active management is not only occasionally scary, it just subtracts from your wealth.

you can’t spend risk-adjusted dollars

One of my old bosses used to say that you can’t spend risk-adjusted dollars.  What he meant is that higher volatility may be the price of achieving higher returns.  It doesn’t follow from this, other than in the ivory tower, that lower volatility/lower return investing is just as good.

Take the following two portfolios:

–one is trending upward at the rate of 15% annually, but at the end of any given month, can be as much as either 10% above or 10% below that trend

–the other is trending upward at the rate of 10% annually, but at the end of any given month can be as much as either 3% above or 3% below the trend.

At the end of ten years, the first portfolio is up by 300%, +/- 10%.

The second is up by 160%, +/- 3%.

Try explaining to the second client that he’s just as well off as the first.

why use volatility

Why use volatility as a measure, then?

The main reason, I think, is that data are easily available for computers, so volatility has the feel of being objective.  Another is the semi-religious belief that outperformance is impossible, in which case having extra volatility is an undiluted negative.  (By the way, having a portfolio that outperforms the market day after day, month after month, in an up market is, by definition, more volatile than an index fund.)

caveats

For someone who needs the money tomorrow, or next week or next month, a long-term investment with short-term volatility is the last place we want money to be.

Older investors, who are using savings to live on, have got to have a substantial cash reserve to avoid having to sell potentially volatile holdings during a -10% phase.

And a portfolio that consistently produces low returns coupled with high volatility has trouble written all over it.

daily volatility, non-correlation …and beta (ii)

This post is about hedge funds.

hedge funds:  a purist’s view

To a purist, a hedge fund is about hedging.  That is, it’s about running a portfolio with offsetting long and short positions.

Conceptually, this can be done either by assembling pair trades (one long, one short, often both in the same industry) or by creating opposing portfolios of good ideas and clunkers.  By using the money obtained from borrowing, and then selling, the hoped-for clunker stocks to fund the hopefully strong-performing good ones, the hedge fund manager ends up with no net exposure to the securities market he’s working in.  His return consists in the spread, if any, between the performance of the aggregate long portfolio and the shorts.  In a perfect world, he never loses money, although the amount he makes in a given year is up in the air.  It depends on the relative valuations of the “good” and “bad” securities that his market gives him.

(By the way, I worked on, and briefly ran, a very successful short-only portfolio for an innovative institutional client in the early 1980s. We pruned “bad” stocks from an S&P 500  index fund and reinvested the money in the rest of the index.)

today’s version

In today’s world, hedge funds are a motley group of mostly strongly net long, mostly highly concentrated portfolio strategies.  They do have common characteristics, though.  They charge very high fees, and as a group they’ve underperformed the S&P 500 pretty continually for more than a decade.  Also, many times it’s hard to get your money back if you no longer want to participate.

why institutional support, despite weak returns?

Why do pension funds continue to support hedge funds with a tolerance for weak performance they would never exhibit with long-only managers?

Two reasons:

–the claim of non-correlation with stocks and/or bonds.  This is basically a rerun of the fallacy of gold as a zero-beta asset, and

–the low expected return from stocks and bonds.  To pluck numbers out of the air, let’s say that over the next five years we can expect returns of 2% annually from bonds and 6% from stocks.  A portfolio made up of equal portions of both asset classes would have an expected return of 4% per year.  Suppose the actuarial assumption of a plan sponsor is that the plan is fully- or mostly-funded if the plan can achieve of 5% annual returns–or maybe 6%.  The plan managers, who hire outside portfolio help, have no way of get to either goal using conventional long-only investments.  That’s even going all in on stocks, which sponsors find too risky.  So the managers can either tell the sponsoring organization to add more money to the pension plan   …or they can hire hedge fund managers with pie-in-the-sky stories of high potential returns.  Until very recently, my observation is that they’ve by and large chosen the latter.

 

 

 

 

daily volatility, non-correlation …and beta

My wife and I are in the process of hiring a financial planner.  While I think this is important to do, our search has brought me back into vivid contact with some of what I consider the nonsensical jargon of academic finance.  I want to write about the general idea of “non-correlated assets,” but I’m going to start by writing about beta.

beta…

In the early days of computer-driven finance, just after WWII, economist Harry Moskowitz proposed beginning to assess the risk of a portfolio by analyzing the interrelationships among individual stocks in it.  That task proved too daunting for the computers of the day for anything but small numbers of stocks.  Others suggested correlating everything to one standard, an index like the S&P 500, for instance, instead.

The regression that would do this has the form of y = α + β(S&P).  This is how beta, the correlation between a given stock’s price movement and that of the market, was born.

So far, so good.

…and gold stocks

One day, people discovered that there was a class of stocks–gold stocks, in particular– that had a beta of 0.  This spawned the idea, encouraged by the gold-bug prejudices of the day, that one could lower the beta of a portfolio just by adding gold stocks.  One could add, say, technology stocks with a beta =2 and offset the risk by adding gold stocks in the same amount.  Simple math said the combination had a beta = 1, or risk exactly equal to that of the market.

Some institutional investors actually bought the theoretical argument about the “magic” property of gold and altered their portfolios in the way I just described.

By doing so, they exposed themselves to the 20-year bear market in the yellow metal that lasted from 1950 to 1970.  They lost their shirts.

They realized only afterward that a beta of zero did not mean that the asset in question had no risk.  It meant instead only that the zero-beta asset did not rise and fall in price in line with the stock market.  In this case, the “uncorrelated” price went straight down during a period when the S&P gained 500%+.  So much for non-correlation.

More tomorrow.

 

 

 

Fed rate hike in June?

I think the Fed will raise the Fed Funds rate on overnight deposits by 25 basis points in June.

Five reasons:

–I think the economy is in considerably better shape than the consensus realizes

–We’ve been in intensive care for close to a decade.  We’re at the point where remaining in this state is more harmful than moving elsewhere in the hospital

–The Fed is, to some degree, a political animal.  It doesn’t want to be seen as attempting to influence the presidential election, which would have been a routine action by the Fed a generation ago

–Other than psychologically, it really doesn’t matter to the economy whether the cost of overnight borrowing is 0.25% or 0.50%

–Neither political party has a viable economic policy, in my view.  Leaving rates at zero prolongs the Fed’s role in enabling dysfunction in Washington (which seems to me to be the key issue in the election, whether ordinary citizens are articulating this or not).

 

Atlantic City casino gambling

For a couple of years I was an adjunct at Rutgers business school.  I worked on a course where teams of MBA students provided management consulting services for actual companies.  For one project, one of my teams interviewed a pizza parlor owner about the key characteristics of his restaurant that attracted business.  He said:  good food, extensive menu, fast service, friendly staff, tablecloths on the tables.  These enabled him to get customers from as far as 7-8 miles away from his store.

How close was the nearest competitor?   …15 miles away.

All of the attributes he named may have been important to get any customers to his restaurant, but it’s hard not to think that distance is key to defining his market area.  That’s true of any generic bricks-and-mortar business.

…which brings us to Atlantic City.

That beach resort has had its annual gambling revenue cut in half since competing casinos began to open in neighboring Pennsylvania in late 2006.  Additions in Maryland and Delaware haven’t helped, either.  The issue is the same as with pizza. Absent some incredible attraction (think:  Las Vegas), the average gambler will typically choose the closest casino to patronize.

The response of government in New Jersey to the competitive threat has been quite odd, in my view.  It hasn’t been to build up the city as a resort destination or to improve transportation access.  The main thing I’ve seen has been the attempt several years ago to help yet another casino, the Revel, to open, adding new slot machines and table games to a market already awash in overcapacity.

Potential good news is that, after the closing of four casinos (Atlantic Club, Revel, Showboat and Trump Plaza) in 2014, the market appears to have stabilized.  Even online gambling is perking up, having brought in $16+ million in April (although this is still a far cry from the $80 million average monthly take the state had been touting when online was legalized).

The other side of the coin is that Trenton is again “helping” Atlantic City by opening the door to building two new casinos in northern New Jersey.  Local voters will vote on proposals later this year.  Maybe the idea is to stabilize the state’s gambling tax revenue at any cost.  But nothing seems to me more likely to snuff out a nascent recovery in AC than this.

 

Tesla (TSLA)’s new common stock offering

the motivation

TSLA has been surprised and pleased by the public response to its proposed new Model 3 (the company has reservations–and deposits of $1,000 each–nearly 400,000 units for a car slated to appear in limited numbers next year or the year after).  …so much so that it has junked its plan to become cashflow breakeven this year (meaning operations would no longer consume cash and might generate it).  It has decided instead to accelerate its factory building to speed the debut of the Model 3.

To do so, it needs fresh capital.

the offering

So, for the third time in three years TSLA is having a public offering.  In a preliminary prospectus revision filed today, TSLA indicates it intends to sell 9.3 million new common shares at a price of $215.  Of that number, 2.8 million are being sold by Elon Musk to pay taxes due on exercise of options on 5.5 million new TSLA shares. The underwriters have the right to sell an extra 1.4 million shares in what is called an “overallotment.”

When the dust clears, TSLA will have raised between $1.4 billion and $1.7 billion and will have about 145 million shares outstanding.

Press reports indicate the offering has occurred today, even though the prospectus says underwriters expect the offering to happen next Wednesday.

my thoughts

–the prospectus contains the most up-to-date data on the company

–the new money will allow TSLA to being volume production of the Model 3 in 2018 instead of 2020

–I’d be a little miffed at the offering price if I had participated in the 2015 stock offering at $242 a share, or bought convertible bonds in 2014 with a conversion price of $350.  Neither, of course, makes any difference for new buyers

–if the press reports are correct, that hasn’t mattered too much to the investing public, either

–I wonder how much retail participation in the offering there is.  Lack of institutional support is usually a bad sign, although I’m not so sure that rule holds true here

–TSLA could barely get off a stock offering half this size last year

–achieving a stock sale like this almost always marks a near-tern bottom for the stock price

–dilution of existing shareholders is minimal and bringing forward the volume launch of the Model 3 by two years is probably a very big positive thing.  So, if the Model 3 is the success it appears to be, the offering will have been good for everyone.