Category Archives: Academic Theories

should corporate stock buybacks be banned?

August 19, 2015 By in stock buybacks, Tobin's q Tags: , , , , , , Leave a comment

This is becoming an election issue.

Elizabeth Warren, deeply suspicious of anything to do with finance, regards them as a form of stock manipulation.

Many more mainstream observers note that $7 trillion (according to the New York Times) spent on buybacks by S&P 500 companies has consumed a large chunk of their cash flow at a time when both wage growth and new investment in physical plant and equipment in the US have been paltry.  They argue, without further elaboration that might have the argument make some sense, that the latter are being caused by the former.  Therefore, they think, if only stock buybacks were eliminated, employment and wages would rise and the US would reemerge as a global manufacturing power.  I imagine the same people are saving their old calendars in case 1959 should come back.

There are instances where, in my view, stock buybacks are clearly the right thing to do.  Imagine a publicly traded company that has a profitable business that generates free cash flow, and that has no liabilities plus $1 billion in cash on the balance sheet.  Let’s say the firm’s total market capitalization is $500 million.  In this situation, which actually happened for a lot of companies in 1973, stock buybacks would accommodate shareholders who wanted to liquidate their holdings and create $2+ in value for remaining shareholders for every $1 spent.  I can’t see any reason to outlaw this.

There are also cases—IBM comes to mind–where continual buybacks make investors think that this is all the firm has left in the tank.  So though buybacks keep on generating increases in earnings per share, by shrinking the number of shares outstanding, they no longer support the stock price.  The generate selling pressure instead.  In theory, and provided management understands it can’t play with the big boys any more, the firm should liquidate and return funds to shareholders rather than to continue to destroy value.  Like that’s ever going to happen.  But investors will vote with their feet.  While maybe management conduct should be different, I can’t see how that could be legislated.

My big beef with stock buybacks is that the main purpose they serve is to disguise the gradual transfer in ownership for a company from shareholders to employees that happens in every growth company (more about this tomorrow).  This could be/ should be made clearer.

I also think managements should show more backbone when “forced” into buybacks to satisfy activist investors, in what is the 21st century equivalent of greenmail.

But the idea that barring stock buybacks will cause corporations to make massive capital investments in advanced manufacturing in a country that has a sky-high 35% corporate tax rate, a shortage of skilled labor and rules that bar a firm from bringing in needed technical and management employees from outside is loony.  It isn’t clear to me that removing legislative impediments to investment will be enough to roll back the clock and make the US a manufacturing power.  It isn’t clear, either, that we should want to return to an earlier stage of economic development.  But outlawing buybacks won’t achieve that goal.

The Signal and the Noise

July 23, 2015 By in Academic Theories, Books, Getting financial advice, Portfolio management Tags: , , , , 1 Comment

I’ve been reading statistician Nate Silver’s 2012 book The Signal and the Noise.  He makes three points that I think are useful for us as investors:

1.  Some ostensible information sources aren’t really that.

TV and radio weathermen, for example, deliberately forecast more rainy days, and amp up the amount of rain that will fall, than they actually think will occur.  Why?  People apparently like to hear about bad weather.  Also, we only get mad if the weather is worse than predicted.  If it’s better ,we regard it as a pleasant surprise.  So there’s every reason for TV and radio to have a consistent “wet” bias–and they do.

Same thing for shows on politics.  Pundits on the McLaughlin Group, for example, have a startlingly bad record at making political predictions.  The show’s many fans don’t seem to care.  Broad, sweeping views, confidently and articulately presented, are all that matters.

It seems to me the same applies to TV financial shows.

 

2.  The group with the absolute worst forecasting record is professional economists.  In fact, predictions about the course of the overall national and world economies are not only highly inaccurate, they’ve gotten worse over time, not better.

In other words, don’t bet the farm on a macroeconomic forecast.

 

3.  Foxes are better thinkers than hedgehogs.

Silver separates forecasters into successful = foxes (he’s one), and really bad = hedgehogs.

The differences:

hedgehogs

highly specialized

“experts” on one or two narrow issues that define their careers; contemptuous of “generalists”

often in the academic world

all-encompassing theories

theory over facts

believe in a neat universe, defined by a few simple relationships

highly confident, meaning resistant to change

foxes

interdisciplinary

flexible

self-aware and self-critical

facts over theory

think the world is inherently messy

careful, probabilistic predictions.

In other words, be careful of highly confident people with overarching theories and elaborate forecasting systems.

 

 

 

Hope over experience?—S&P Indexology

May 26, 2015 By in Academic Theories, index funds, Investment firms, securities markets, stock market Tags: , , , , , Leave a comment

I subscribe to the S&P Indexology blog.  It’s written by S&P staff involved in manufacturing the company’s well-known financial markets indices.  Usually it’s interesting, although the writers’ true-believer conviction that no active manager is capable of matching–to say nothing of outperforming–his benchmark index often shines through.

Yesterday’s post, titled “Hope over Experience, ” is a case in point.  It takes on a recent, pretty silly Wall Street Journal article that muses about an “Old-School Comeback”  of active stock mutual fund management, based on recent outperformance of the average active manager over the S&P 500.  “Recent” in this case means the first four months of 2015; “outperformance” means a gain of .33% versus the S&P.

The obvious observations are that the time period cited is extremely short and that the gain versus the index is probably statistically insignificant.  S&P Indexology goes on to say that the comparison itself is bogus. The S&P 500 is neither the appropriate or the actual official benchmark for many stock mutual funds, which have, say, growth, value, small-cap or other mandates and other benchmarks than the S&P 500.

So far, so good.

Then come two comments straight out of the university professor’s playbook:

–The first is the argument that because an active manager’s portfolio structure may be dissected, after the fact, into allocations that could have been replicated by indices, actually creating and implementing that structure in advance has no value.  That I don’t get at all.

–Indexology concludes by suggesting that because investing in the aggregate is a zero-sum game–the total winner’s pluses and losers’ minuses exactly offset one another, before costs–there can’t be any individual investors who consistently outperform.

I believe that life in general, and investing in particular, is a lot like baseball.  (I’ve been thinking about baseball recently because it’s in season).  The second Indexology comment is much like saying that the Giants’ winning three World Series in five years is a random occurrence.   …or that the change in ownership of the Cubs and the hiring of Theo Epstein have nothing to do with the club’s success this year.  Yes, bad teams get a preference in the draft each year, but the end to a century of futility?

…and what about the Braves and Cardinals, who consistently field above-average teams even though their draft positioning does them no favors.

To be clear, I’m an advocate of index funds.  My reasoning for this is not that outperformance is impossible (the ivory tower orthodoxy) but that it takes more time and effort than most people like you and me are willing to put in to locate and monitor active managers.  I’d be much more comfortable with Indexology saying this.

more on discounting

April 22, 2015 By in Academic Theories, Basic Concepts, Capital Asset Pricing Model (CAPM), Discounting Tags: , , , , , , Leave a comment

In actual practice, judging what the market has already discounted in the price of an individual stock or the prices of stocks in general, is a tricky thing.  Even seasoned professionals are often wrong.

There are trends in overall market direction that are relatively easy to spot.  In a bull market, investors tend to ignore bad news and respond strongly to good.  In bear markets, the opposite happens.

Perhaps the main reason for professionals that technical analysis is more than a curious practice of a more primitive time is that watching for deviations from the usual daily price action of individual stocks can give clues to what other investors are thinking/doing.  Rises on unusually high volume, for example, can suggest that others are figuring out what you already know and have acted on.  On the other hand, failure of the stock to react positively to news that supports your positive thesis suggests that what you thought was a new, investable insight actually wasn’t.

The reality that investors only act piecemeal, or the idea that we act differently when infused with greed than when in the vise grip of fear are both much too untidy for the statisticians who formulated the Efficient Market Hypothesis/Capital Asset Pricing Model that arose in the 1970s (and which–mind-bogglingly–is still taught in business schools).

These theories have no place for observation/practical experience.  They assume that everyone has the same information and that the market factors new information into prices instantaneously.  What’s particularly ironic is that they were formed during the early 1970s.  How so?

–1972 was the peak of the “Nifty Fifty” or “One-Decision Stocks” speculation.  Investors believed that a small number of stocks–Kodak, Xerox, National Lead, for example–would grow rapidly forever.  Therefore, they should never be sold, and no price was to high to pay to acquire them.  The result was that this group of names traded at as high as 110x earnings–in an environment where the 10-year Treasury yielded 6% and the average stock traded at 11x.

–this high was immediately followed by a vicious bear market in 1973-74 that saw stocks trade in mid-1974 at discounts to net cash on the balance sheet–and still go down every day, on the theory that money in the hands of management scoundrels wasn’t worth 100 cents on the dollar.

How is it that these guys didn’t notice?

uncorrelated returns: hedge funds as the new gold

March 18, 2015 By in Alpha and Beta, Current Market Thoughts, Gold, hedge funds, liquid alternatives Tags: , , , , Leave a comment

Every stock market person knows what beta is.

It comes from a regression analysis, y = α + βx, where y is the return on a stock and x the return on the market).  It shows how a given stock’s past tendency to rise and fall is linked to fluctuations in the market in general.  A stock with a beta of 1.4, for example, has tended to rise and fall in the some direction as the market, but move 40% more in either direction; a stock with a beta of 0.8 has tended to exhibit only 80% of the market’s ups and downs.

The professor in a financial theory course I took in business school asked one day what it meant that gold stocks had, at the time, a beta of zero.

The thoughtless answer is that it means they aren’t risky, or that they don’t go up and down.

A consequence of this thinking is that you can lower the beta, and therefore the risk, of your investment portfolio by mixing in some gold stocks.What’s interesting is that in the early days of beta analysis that’s what some institutional portfolio managers actually did with their clients’ money.

That didn’t work out well at all.

What should have been obvious, but wasn’t, is that the zero beta didn’t mean no risk–or that gold stocks are/were a good investment.  It meant what the regression literally indicates–that none of the movement in gold stocks could be explained by movements in the stock market in general.

The riskiness of gold stocks is there, but it came/comes in other dimensions, like:  how mines develop new supply, the ruminations of the gnomes of Zürich (in today’s world, Mumbai and Shanghai), the potential for emerging country craziness, the propensity of the industry to fraud.

Why write about this now?

I heard a Bloomberg report that institutional investors as a whole are upping their exposure to hedge funds, despite the wretched performance of the asset class.  Their rationale?   …uncorrelated returns.

It sounds sooo familiar.

Admittedly, there may be a deeper game in progress.  It’s impossible to say your plan is fully funded by projecting a gazillion percent return on stocks or bonds.  But who’s to say that a hedge fund can’t do that?