Risky Returns

I recently stumbled across my Risky Returns blog and really enjoyed reading the few incredibly nerdy posts. It's wild to think how cool I was 10 years ago...

At the time I began the blog I was, as I wrote, studying for the CFA exam, but also beginning to hunt for a buy-side investing job. The blog (and my CFA study effort...oops) died a quick death when I was fortunate enough to land an analyst role at a quickly growing TMT hedge fund. Going from zero to, well, something, in tech investing overnight required everything I had.

After what has so far been a rewarding ten year investing career, I couldn't help but laugh at my dedicated younger self.

In a clearly vain attempt to relive my unbridled, free-form youth, I have decided to reawaken Mr. Risky Returns, and populate the odd post with stock research musings as they arise. Get ready to be thrilled. Enjoy!

Mr. RR

Experience proves that I am not going to be updating this blog with any hoped for regularity. I apologize to my extensive and diverse readership (embodying 77 countries and 313 languages/dialects). I will continue to update as my intensely busy schedule permits.

Regards and Regrets,

Mr. Risky Returns

Tonight's reading included [part of] Chapter 4, Analysis of Equity Investments: Valuation, by Stowe, Robinson, Pinto and McLeavey.

I say "part of" because the damn chapter is approx. 80 pages long. I originally picked up the book to read up ch. 5, Residual Income Valuation, but apparently got side tracked...

Anyways, Ch.4 briefly explains the Fed Model on pg. 202, and I figured with the recent yield curve inversion and heated debate regarding the future of the 10yr yield, that a few links revolving the model might be timely.

For the uninitiated, the Fed Model is simply the theory that, since interest rates are implicit in any DCF or market multiple, one can gauge the under/over valuation of the stock market by comparing it's earnings yield to a 10-year T-bond. So, you take the P/E for the S&P 500 and you flip the fraction or take the inverse to get E/P, and compare this to the 10-yr rate. If the treasury rate is higher (lower) than the earnings yield, then stocks are overvalued (undervalued).

• Daily Speculations Resource - Victor Niederhoffer & Laurel Kenner
  
• Summary of Clifford Asness Paper published in the Journal of Portfolio Management. A take away quote,"The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test..."
  
• The Street's piece, "The Fed Model Impels, but Does Not Compel"
  

On a side note, I came across a great Federal Reserve Board of NY Q&A on inversions, titled, "The Yield Curve as a Leading Indicator"

As far as the fed model goes, I don't think anyone truly believes it is anything more than a back of the envelope metric to view the market valuation in another light. Besides, it is also a relative measure which doesn't save you if both treasury bonds and the market are due for a correction, or vice versa.

Good Night

Mr. Risky Returns

My apologies for the extended holiday hiatus, however with the New Year, I am back big time!

For Level II, study session 9, I read the candidate reading, "Mergers," chapter 33 in Principles of Corporate Finance, 8^th edition, Richard A. Brealey, Stewart C. Myers, and Franklin Allen (McGraw-Jill Irwin, 2006).

Brief chapter outline:

• Genuine motives for mergers
  
  • Economies of scale - leveraging fixed costs, sharing resources
    
  • Economies of vertical integration - upstream / downstream
    
  • Complementary resources - e.g. distribution channels, manufacturing expertise
    
  • Inefficiency elimination - mgmt removal
    
  
  
• Dubious merger motives
  
  • Diversification - conglomerate discount
    
  • Bootstrapping - eps accretion in return for slower growth
    
  • Lower cost of capital
    
  
  
• Estimating merger gains and costs
  
  • Right and wrong ways to estimate benefits
    
  • When financed by stock / by cash
    
  • Asymmetric information - stock signals an overvalued currency
    
  
  
• Merger mechanics
  
  • Antitrust law - Clayton Act of 1914 & Hart-Scott-Rodino Antitrust Act of 1976
    
  • Purchase accounting - fair value allocation, goodwill impairment
    
  • Tax considerations - generally cash is taxed & stock is tax free
    
  
  
• Takeover defense / tactics
  
  • T Boone Pickens - Cities Services, Gulf Oil & Phillips Petro
    
  • Pacman
    
  • Greenmail
    
  • White knight
    
  • Two-tier offer
    
  • Poison pills
    
  • Shark-repellent
    
  • Golden parachutes
    
  
  
• Mergers and the econ

The very last section stood out in particular. The authors discussed the reality that "intense merger activity," occurs concurrent with periods of buoyant stock prices, although they couldn't provide an explanation for the concurrence.

It seems rather simple to me: If I take a page from Buffet and view the purchase of part of a company with the same logic and perspective as if I am buying the entire company, the merger mania occurrence makes perfect sense. Executives, as humans, are not immune to the same irrational exuberance being displayed in the stock market. Plus, in times of abundant merger activity, numerous companies are seen as possible takeover candidates, which translates into increased equity valuations. Journalists do it all the time.... "Google buys XYZ, thus these three similar companies in the same niche space may be acquired by MSFT, YHOO, etc..." To take it to the extreme, if every company where a likely takeover candidate, then the entire market would reflect a portion of the implied tender premium. I guess the question becomes, what comes first, lofty valuations or intense merger activity...my take is that they feed off each other.

HAPPY FREAKIN NEW YEAR

Mr. Risky Returns

...for not publishing...really good surf. Did I mention holidays are off limits?

Wow, okay, so whipping up formulas in HTML can get quite complicated. I was doing fine until I tried to create two dimensional fractions. I guess the way to go, is to get away from code by creating an image of the formula, and then to source the image into your doc. Or if you are a pro with css, you can use style sheets to create the fractions........either way, this is about finance, not html...nor am I about to spend all my time on this (although the challenge made it entertaining).

So we turn to commentary (known as, my 2 cents):

Is CAPM worth learning? yes and no. Folks at firms like Barra and RiskMetrics will put any pure CAPM derived cost of equity to shame. At the same time, none of these firms will truly capture the future risk of stock. The trick is how to apply CAPM in a practical, value added way...

The best example I have seen (warning: I have not been around the investing block) of applying these risk management tools in an active management context is Richard C. Grinold and Ronald N. Kahn's book fittingly titled, Active Portfolio Management. What Grinold and Kahn do is modify our beloved CAPM to allow for the premise that markets are not efficient. I could write forever on these topics, although I'd rather hear what my informed readers have to say (anyone out there??:) (side note: I would probably add more value to myself by finishing that book over writing this entry...)

σ²= variance
σ= standard deviation
ρ= correlation coefficient
β= beta
α= alpha
r_f= risk free rate

CAPM

r_i = r_f + α + β_i(r_m - r_f) + ε_i

Systematic and Specific Risk

σ_i² = σ_ε² + β_i² σ_m²

Portfolio Variance

σ_p² = w_a² σ_a² + w_b² σ_b² + 2w_aw_bρ_abσ_aσ_b

portfolio variance = (squared weighting of stock a, times, variance of stock a) + (squared weighting of stock b, times, variance of stock b) + (2, times weighting stock a, times weighting of stock b, times correlation coefficient, times the stnd deviation stock a, times the stnd dev stock b)

Enough formulas for now....

Mr. Risky Returns

Part of the process of studying for CFA level II involves rehashing some of the basics from round one. This works out great, with my work today bringing me straight to Study Session 10, section C: Leases and Off-Balance-Sheet Debt.

First the textbook lesson, second my commentary....

There are 2 different types of leases, capital and operating.

Capital leases are treated as sales (purchases) by the lessor (lessee). The asset is carried on the lessee's books and the capital lease is rightfully treated a debt on the balance sheet. Furthermore, the lessee makes interest and principal payments to the lessor which accordingly records incoming interest and principal payments. The payment of principal is key because when it comes to the cash flow statement, a principal payment is a financing CF, not operating. The effect is to make capital leases favorable to operating leases, from an operating cash flow and free cash flow perspective.

Operating leases on the other hand result in NO balance sheet liability, nor a corresponding asset. The periodic lease payment is considered a rent expense and thus has the effect of depressing operating margins (whereas capital leases, with interest payments, have no negative effect on operating expenses). Just because no on-balance liability is recorded, this doesn't mean that a real liability does not exist. In the footnotes (generally only found annually in 10ks), the liabilities are recorded in the form of a schedule of future required minimum lease payments (MLPs). Actual prior year rent expense is also provided; actual rent expense generally is always larger than the MLP schedule would suggest.

Now, from an accounting perspective, firms would generally prefer not to record a liability on the balance sheet. For this reason some crafty tinkering of lease contracts occur so as to ensure a lease is classified as operating rather than capital. You may ask, "what are the criteria for classifying a lease as capital?" Well, I am glad you asked!

Four criteria (thanks to SFAS 13):

1. The lease transfers ownership of the property to the lease at the end of the lease term.


2. The lease contains a bargain purchase option.


3. The lease term is equal to 75% or more of the estimated economic life of the leased property (not applicable to land or when the lease term begins within the final 25% of the economic life of the asset).


4. The present value of the minimum lease payments (MLPs) equals or exceeds 90% of the fair value of leased property to the lessor.

The basic idea is that if looks like a purchase, smells like a purchase, then account for it like a purchase.....and put that debt on the balance sheet!

Time for Commentary:

But wait a minute, what about the fact that capital leases result in higher cash flows than operating leases? Do investors employing a discounted cash flow based valuation not use these very cash flows to value a business? Yes, yes they do. However, it seems that companies are more concerned with making their leverage ratios pretty than they are worried about cash flow. Its the accounting stupid, not the cash flows...

In my last job in the treasury of the ole fortune 500 company, I completed several lease versus buy calculations for the treasurer and in each case the purchase decision made the most economic sense, yet in each case we went with the lease. Our cost of capital through our credit facility was soo cheap that not a single third party leasing company could offer us a cheaper implied interest rate. Used to drive me crazy...the damn savings to be had were multiples over my measly salary!! Part of the problem came right down to bureaucracy. The division for which the equipment was needed had fixed operating budgets. In order to authorize an adjustment to the budget for the clearance of a purchase, way too many people had to sign-off...I think the CFO even needed to touch it.

Anyways, today at work I was analyzing a few companies that all had substantial operating leases....come on folks....we know what game you are playing!! I capitalized all the leases and threw the assets back on the balance sheet. One of the unnamed companies likes to also include proceeds from sale-leaseback in its free cash flow calculation....puuuuulease.

An operating lease is just another option of several financing alternatives for a company...albeit often times the most economically expensive option...but a favored option nonetheless.

additional source:
Aswath Damodaran is the man

Anything to add??

Mr. Risky Returns

I am well aware that changing the long established tone and direction of this commentary may alienate my massive and loyal readership (I am often told by readers that they would, without hesitation, risk their life in defense of this blog). However, it has become apparent that the time required to maintain this voice to the world, will leave zero remaining time to study for the June CFA level II exam. With intentions to knock the freakin socks off that test, I must be prepared to devote every waking (and sleeping) second to embodying the test material.

In short, this blog is now the "learn a new CFA related item daily" blog. Everyday I will post some interesting (or not) lesson pulled from my daily studies. My hope is that this created publishing obligation will in turn actually result in me studying everyday. So, under that premise, I now promise my servants, err, loyal readers, that from now until the exam, I will try to post at least one CFA item daily (of course barring any extraordinary circumstances such as death, or hospitalization (of the near death type)(or really good surf)(experience has proven the daily post unlikely).

Yours Truly,
Mr. Risky Returns