Sunday, December 19, 2010

The Role of Investor Selection Bias In Volatility Levels

This article is the second in a series of three articles investigating volatility as "the" measure of risk.  To read the first article, "A Thought Exercise: Is Volatility Really an Asset's Risk?", please click here.

In Richard Thaler and Cass Sunstein's Nudge: Improving Decisions About Health, Wealth, and Happiness, one of the most valuable parts of the book is the authors' separation of humans as they behave in economic models and as they behave in real life. TL;DR: quite differently.

In the realm of investments, financial scholars have largely described investors in their models as being essentially the same while retaining varying inherent risk appetites.  In a world where more risk is rewarded with more return (an issue I will address in the third article), this makes sense: some people are willing to risk more to make more, and vice versa.

This is where the "Econ" (human as they behave in economic models) vs. "Human" (human as they actually behave) dynamic that Thaler et. al. introduce becomes relevant.  The first important difference between the financial model human and the actual human is the tendency to benchmark with assets, leading to a world where payoffs are expressed as relative to a basket of securities such as the S&P 500 (this is exactly how the Motley Fool ranks their participants).  In a paradigm where indexing is rampant, perceptions of risk are strongly different than what modern financial theory would lead us to believe.

The second difference is a strong preference for relative wealth: i.e. a level that places one ordinally higher than others.  This has been seen in game theory experiments where participants preferred lower absolute payouts that were higher relative to other participant's payouts (i.e. $40 and everyone else getting $20 versus $70 where everyone else gets $80).  This further leads to a logarithmic preference scale as you compare the 1st to 2nd, 50th to 51st and 99th to 100th percentiles of wealth.  The change in the number of people you are now better off than in the first interval is much higher than the third interval, suggesting that the risk you'd be willing to take in the first instance (i.e. to jump from the 1st percentile to 2nd percentile in terms of wealth) would be much higher than in the third interval.

To change the interval size, and now look at the change from 1st to 75th percentile in relative wealth demonstrates why lottery payouts are so popular, even though from a high level perspective they're effectively like throwing money away (your probability adjusted return is less than the initial capital outlay). They represent the greatest possible delta in relative wealth for the least cost.

High Volatility Stocks: Another Form Of Lottery

This translates to a preference for assets with high volatility, which in conventional terms are seen as the riskiest/most lottery-like.  Authors such as Eric Falkenstein have covered this relationship rather extensively, but as it pertains to volatility as a measure of intrinsic risk I would like to go a step further.  In our market, investors searching for these lottery-like payouts are going to go in search of assets with already high volatility.  In this scenario, volatility is going to beget more volatility, as more lottery seekers pile in.  The lottery seeker, by preference for the highest relative wealth delta for the lowest cost, is going to prefer the assets with the highest ordinal ranking in terms of potential payout.  This would lead these investors to dramatically favor, say, the 10th decile of assets in terms of volatility over all other assets.

Why is this a problem for volatility's connection to risk?  The key is the self-selection going on when picking assets.  If the lottery payout seekers had a slope to their preference, this might still plausibly lead to an efficient market where volatility measures intrinsic risk of an asset, as the lottery seekers become more concentrated in higher risk assets.  But the preference for the highest risk stock in ordinal rank is going to lead to a disproportionate asset allocation, leading to a breakdown in volatility in its connection with risk.

The final article in this series will serve as an exploration in to the problems with the risk/return correlation

Saturday, December 18, 2010

A Thought Exercise: Is Volatility Really An Asset's Risk?

Over the next three articles (this article being one of them), I will be covering why I believe volatility comes up wanting as a proxy for risk.

Throughout a classic education in finance and economics, one core concept that became an assumption of my daily life was that volatility was risk.  To a certain degree this intuitively makes sense: if I'm buying an asset, and I have little sense what its value is going to be in an hour or two days from now, I should buckle up because it's going to be one hell of a ride.

In a relatively preset environment, volatility would certainly approximate risk.  For example, if we were to live on Mount Kenya as a subsistence farmer, where mean daily fluctuations of temperature equate to 11.5 degrees Celsius (20.7 degrees Fahrenheit), this could surely be seen as one approximation of the risk of being able to generate a successful crop, although another might be seasonal weather fluctuation, such as that seen over a year.  Still another would be fluctuation in weather over several years.  Thus these three time spans (daily, seasonal and yearly) of weather fluctuation could probably closely approximate your risk of survival (of course there would be others: see bears).

So why might a security's volatility not closely approximate its risk?  One answer would be the failure to translate observed volatility to actual volatility, although we would certainly run in to this problem when observing weather.  The other problem would come with what this volatility actually represents.  In the case of weather, it is the state of our atmosphere, something far beyond our control (although the aggregation of humans is doing a pretty good job: see climate change)

Is An Individual Investor Equivalent to a Subsistence Farmer?

In an asset market, for volatility to approximate "risk of survival" like it does in the natural world, it would have to retain some key characteristics:

  • Unchangeable by one or several individuals
  • Relatively constant over time

With the first item, we find little support that a small subsection of the population cannot move prices and ergo influence volatility.  By its nature, asset markets are a wealth adjusted voting machine, so were one to be so inclined, with the proper amount of money one could dramatically influence the price environment of one particular asset.  This further topples the second characteristic as big money moving in and out of trades can dramatically affect the volatility of individual assets.

Because volatility is easily manipulated and not an inherent characteristic of an asset, its value as an accurate predictor of risk is severely diminished if not totally obliterated.  Thus, while volatility might be high for an asset currently, there is no inherent dynamic that suggests that it might or should stay at this level for any amount of time going forward.

The next article in this series will look at sticky volatility induced by selection bias followed by an article exploring problems with the risk/return correlation.

Monday, July 26, 2010

Using Two-Tiered Canvassing to Generate Support Where There Previously Was None

In Influence: The Psychology of Persuasion by Professor Robert Cialdini, the author identifies how someone attempting to exert influence over another person can do so by getting said person to identify with a certain idea or group prior to the actual meat of the requested action.  In the book, the particular example involved the difference in agreement rates for putting up a massive "be safe and wear seat belts" sign in the person's front yard.  What was noted was people had dramatically higher rates of saying "yes" to the absurd sign in their front yard if they had previously been approached by a canvassing team asking them to sign a list that they felt seat belts should be worn for safety.

Are you anti-safety?

Signing the petition seemed pretty innocuous, and most people would not be too opposed to identifying as pro-seat belt and pro-safety.  With this simple action, however, those who signed in their minds began to identify with this cause and began to see themselves as agents for it.  Because of this decision and the personal identification which took place afterwards, the second request did not seem terribly ridiculous.  When approached and asked if they would put this sign up in their front yard, those asked did the mental equation of "I'm in favor of safety" and because of it were much more likely to agree to the large sign.

How This Can be Applied

With the California prop voting coming up in November, there are several special interest groups that will be trying to garner popular support for their proposition going in to the voting process.  For the sake of conversation, let us look at one of the the most polemic of these propositions: legalizing marijuana (Proposition 19).

Now how could Cialdini's identified phenomena be used to actually make the public more favorable to this proposition?  One methodology would be to first approach potential voters in a canvassing effort and request that they sign a pro-free choice or pro-freedom petition.  Reasons given for the request could be that the group is trying to help the people show the government that they feel that citizens should have the ability to make free choices without government interference.

Presumably, with this decision to sign the seemingly innocent "pro-freedom" petition,  individuals approached would be linking themselves in their minds to being pro-free choice and as agents for this cause.

When approached, ideally the next weekend, by another canvassing group asking them to sign a petition saying that they feel people should have the right to choose whether to smoke marijuana on their own without government interference, the suggestion should be couched in terms of freedom and personal choice.  The jump could potentially be too large for many to make, between "freedom" supporter and "freedom to smoke marijuana" supporter, but I would guess that one would receive much more positive responses to the second request after the initial one.

The Approach Can be Two-Sided

Continuing with the marijuana proposition, opponents to prop 19 could have a two-tiered canvassing approach of first approaching potential voters and asking them to sign an "anti-drugs" petition.  This seems incredibly innocent and simple, and I would be surprised if there was too much resistance to it.

By signing the petition, individuals would be creating a link in their minds between themselves and the anti-drug cause.  This could be exploited in a proceeding canvassing effort with the petition to be anti-legalized marijuana.

Why Do People Need to Sign Something?

One of the important items in Cialdini's book is the associative significance of signing your name, and even better, if your position is to be visible by other members of your community.  While simple, the act of signing your name creates a very strong link in your mind, much stronger than a simple verbal 'yes' or 'no'.

While it involves more time and resources, the two-staged canvassing process can be used to create supporters where there were previously none.

Sunday, July 25, 2010

The Human Compulsion to Seek Short-Term Patterns When Investing

One of the details I always comment on when I am reading articles on Seeking Alpha is the inclusion of 'technical analysis' or other types of short-term price prediction based on patterns. It takes a lot of different forms, some as simple as merely looking at charts (i.e. past prices of the stock graphed with time on the x-axis), and others slightly more sophisticated (read: 'mathier'). I have seen citations including Fibonacci retracement, Bollinger Bands, and of course the common 50 day and 200 day moving averages, all interpreted to derive many a different conclusion.

Typical technical analysis mumbo-jumbo

Moving averages can be informative for one's first cold look at a stock: comparing them to the security's current price more or less gives you the market's impression of the company or security. This information can also be generally gleaned from the price relation to 52 week highs and lows and stock analyst buy/sell ratings.

Beyond that, however, I see technical analysis as market tomfoolery. It is an attempt to see patterns in short-term price movements, that depending on which theory you subscribe to, can be more or less random.

The random walk theory is the classic economic perception that because markets are efficient, prices are going to follow a random walk. Here is some analysis that attempts to separate the efficient market theory from the random walk theory. In essence, the idea is that prices are explained by successive random steps in any given direction. The third link above is important because I think it reconciles the fact that a random walk can only coincide with efficient market theory if the random walk is to be short-term noise while eventually leading to the efficient market price. This of course would not support a very rigorous version of the efficient market hypothesis (EMH).

While I subscribe to a weak version of EMH, I do not necessarily believe in the random walk theory, at least in the long term. I do believe that it could explain bubbles and short term market mispricings, but in my opinion these could be better explained with behavioral finance or simply by variance around an 'accurate' price. I find behavioral finance to have more explaining power due to a presumption by a great deal of the statistical analysis in investing that markets are 'cold' and that decisions are being made by efficient automatons and not by humans (Nudge: Improving Decisions About Health, Wealth, and Happiness provides an excellent framework for understanding the difference, except where I use 'efficient automatons' they use 'econs'). Behavioral finance provides a way of explaining mispricing in the market based on human emotion and the way we perceive.

Does that mean that market participants using statistics have not been successful? Of course not. One of the best success stories I have heard of is the hedge fund Renaissance Technologies, which according to their wikipedia page has averaged a 35% annual return after expenses and as far as I know has never had a losing year. Because hedge funds are such black boxes, it is difficult to understand how Renaissance is truly making money and I am not sure how to address them as a phenomena in the short-term trading sphere. Note: there are also a large number of high-frequency trading (HFT) rigs that use some sort of fundamental or technical indicator, but I have yet to see conclusive evidence that technical trading like this can make money over a longer time period.

The question will always be whether it is not the pattern but rather some fundamental idea being observed through the pattern that is what is making money. Instead of simply finding more complicated mathematical techniques to observe the pattern as it is seen through market prices, perhaps a more effective methodology would be to understand what is causing that event.

On the frontier of simply statistical analysis, Bruce Babcock suggests that over the longer term markets trend after you have looked past short-term noise, and suggests using chaos theory to understand it. This to me seems more plausible than patterns in the short-term, however once again I think it could be better explained by behavioral finance.

Considering the relatively small amount of market data we have to pull from to make statistical assertions lends one to reject a 'patterns for the sake of patterns' investment style. Sample size limitations and a lack of fundamental reasoning for why prices should behave in any given pattern leads me in the end to reject the notions provided by Babcock. While it could be successful as a trading strategy, without any underlying reasoning why prices should adhere to a given pattern might suggest that any given 'trend' he is observing could be better explained and modeled using some other methodology. I am of the persuasion that behavioral finance, while still in its infancy, offers the best methodology for explaining long-term price variance and that the way human emotions interact with capital markets would be the only effective way of attempting to predict future market prices.

As human beings, we are equipped with an innate ability and compulsion to see patterns. It is a very effective way to attain survival in the natural world. I will agree that there are some situations in investing where patterns can be informative, but not the geometric ones used in day trading. Without any fundamental reason why prices should behave in a certain way other than observation of historical data, it would seem ludicrous to go with the patterns.

Thursday, July 22, 2010

Droid Commercials Are Missing the Mark, and Potentially Damaging

Since the new Droid X has sold out online for Verizon, one could go ahead and say that Android has been doing a good job of marketing the newest Droid phones. Here is the most recent commercial that I've seen for the Droid X, and every Droid commercial has been along the same vein: humans turning cyborg or being like machines when they use the Droid.

It's very hard to find smartphone user demographics by age group, but from what I've read around the web the typical Droid user is young, male and single. In this regard, the Droid ads seem to be hitting the mark: they are somewhat edgy and while I would not say cool, they definitely get you talking (I think they are kind of creepy, but although I am the target demo it does not matter what I think, it's what everyone thinks).

What I would like to suggest, however, is that Droid could be inadvertently shooting themselves in the foot with these commercials. For their current market, it makes total sense. But as they start to expand to some of the older generations and females, these commercials could scare off potential users. Here I breakdown why the commercial fails to bring in new demographics, and why it actually scares them away.

Older users:
- Phone appears to be scary and difficult to use. Commercials suggest you have to be a machine in order to use one, and the usability is not emphasized, if anything the ad seems to suggest "unless you're a young male, get the hell away from this phone!"

- The 'cool' machinery imagery might be a selling point, but almost all of those featured in the ads are by themselves and males. To some the commercials can be kind of scary, and the ads suggests that most of the users are loners.

This video has circulated the internet, but I think it does a great job of showing the type of misconceptions there can be regarding iPhone vs. Droid

WARNING: NSFW [Language]

While the video is of course satire, one point that I think it does a great job of bringing across is that less sophisticated users care less about the facets of the phone, and more about how it works and the applications one can use. In this regard, I think a good deal of Droid's billboards that I have seen in Portland, Los Angeles and San Francisco are excellent:

Picture soon to follow

Emphasizing this one point is very important. While the billboard does not necessarily sell viewers on the Droid, it introduces the concept that the Droid could potentially do as good or a better job as that performed by the iPhone in terms of applications.

Moreover, while the Droid adverts might be doing a great job in the near term, they are cultivating an image that the device is difficult to understand for non-tech savvy users and that it is not a sociable device (see above commercial). I strongly feel that Droid needs to shift their marketing effort to be more all encompassing with the understanding that the device will not always be able to grow in sales by finding more young, single males.

Sunday, July 4, 2010

The Impact of Corporate Social Responsibility on Executive Compensation

I figured I would put up for public viewing the paper I wrote for my senior thesis, analyzing the impact of a firm's inclusion on the KLD 400 Socially Responsible Index on its executive compensation when controlling for additional factors. The index is used as a proxy for isolating social responsibility in companies.

The paper also contains an in depth overview of behavioral finance literature as it pertains to executive compensation.

I will try and put up a more detailed abstract shortly.

You can download the paper as a PDF by clicking on the "Download" button below.

The Impact Of Corporate Social Responsibility On Executive Compensation

Sunday, May 30, 2010

A Jelly Belly Blunder of the Pudding Cup Variety

While perusing my local Kroger grocery store (mine in particular is King Soopers), I saw something that I just needed to purchase, just to see how bad it was (and holding out a small hope that it was amazing). This product was Kroger Jelly Belly pudding cups.

Now there has already been a pretty exhaustive review of the pudding cups from an eating perspective (the consensus: they are terrible), but I wanted to address the branding issues associated with the product, since I feel that it is an excellent case study for what not to do (like, ever) when thinking of partnering with an existing company or venturing in to a new product line.

For my personal encounter with the product, it was selling for $1.04 (not on sale) for a pack of four pudding cups. Since I am a big fan of watermelon Jelly Bellies (I think it is especially great that they are red inside a green outer shell like an actual watermelon), I figured I should try the watermelon pudding. I got 3/4 of the way through it before I felt nauseous and threw the rest of them away. But anyone's personal experience should never be the end-all-be-all of investing (even though this is a private company), or determining whether a product line is successful. Instead, I will look at couple of other reasons why this product line was doomed from the start.

Recognize Your Brand Value

While the company itself has been around since 1869, Jelly Belly is most famous for their jelly beans, and would be considered one of the premier candy makers. Their price point is dramatically higher than most of the other sweet goods you would see, helping to further cultivate their perception as a luxury brand in this space.

Now if one were working with Jelly Belly, and thinking of partnering with another company to make a product (say, Kroger), the first thing that should be going through one's head is how this partnership will impact the consumer's perception of your brand. With any good that commands such a premium to its competitors, perception is HUGE in maintaining this price moat.

Kroger is the store brand for many competing knock-offs of branded items. As such, it is not by any stretch of the imagination a luxury brand. In fact, it's relatively low rent. This creates a dramatic brand dichotomy when you see Kroger right next to Jelly Belly for the pudding cups. Even if the pudding would have been successful, to be associated with a brand most well known for knock-offs is not going to increase the consumer's perception of your brand.

Maintain Price Points That Support Other Products

Whether it be $1.99 or $1.04, these price levels are still fairly low compared to Jelly Belly's other lines. By placing a lower marginal price tag on a product seemingly by a luxury company, you threaten to erode the luxury perception of the other product lines. Thus, even if the pudding was still successful, it could potentially be a negative net present value project when you take in to account the losses from having to lower other products based on a changed consumer perception of the brand.

Luxury automakers like BMW and Mercedes are constantly walking this line when they offer products that cross the lower end of the auto market. While it can boost sales, it also threatens to erode the luxury perception and can hurt future profitability.

Final Take

Obviously Jelly Belly should have just focused on what they were good at. But presuming they did think that they had a good idea with the pudding, they should never have brought Kroger in to the mix, and should have potentially created a separate brand, such that any negative perceptions would not find their way up to the company, and presuming the line was successful, they could begin to put the Jelly Belly name on the product and raise the price.

Saturday, May 29, 2010

Wendy’s/Arby’s Group: Struggling Giant on the Rise or a Falling Knife?

It is difficult to write about a company focusing on such accessible and widely marketed products as those in the restaurant business. This is especially the case with the quick service (read: fast food) industry, whose price entry point makes it possible for essentially everyone to try their products if they wanted to. Every investor likely has a personal experience with places like Wendy’s, Arby’s, or some of their competitors, so it is important to keep personal perceptions from influencing the investment decision.

But to get past the typical hurdles when talking about companies that are so well known throughout our culture, the story behind Wendy's/Arby's Group's (WEN) faltering stock price has been one of profitability, debt burden and concern over the Arby’s side of the group. The stock has been down in the dumps lately, even passing the 1 P/B threshold that puts stocks on my radar. As of Friday’s close (5/29/10), WEN’s P/B was 0.86.

I will get to the assets equity holders are actually getting a hold of when they chase that 0.86 P/B ratio later, but to begin with I think it is important to understand what is going on with the business. While WEN does hold both Arby’s and Wendy’s, after reading through the holding company’s 10-K I did not get the impression that there was much coordination between the two. I did not see the pitch book for the merger, which took place in September 2008, but I would imagine that part of the idea was to achieve savings through shared resources and common supply contracts. This currently does not seem to be the case, since as far as I can tell Arby’s and Wendy’s are being run as two independent companies (although the company does mention adding more coordination as a goal going forward).

Focus on Arby’s: Isolating the Problem

To understand what has been happening with Arby’s, one need look little further than what has been going on with average stores sales over the years (especially in comparison to Wendy’s):

The fact that Arby’s stores count for roughly half of the stores that the holding company owns (the other half being Wendy's stores) makes one fully understand how important the success of Arby’s is to shareholders:
As has been cited by several people, Arby’s has been suffering from a schizophrenic product portfolio. On the one hand, there are the roast beef sandwiches and the fried foods (fries, poppers, etc,) and the other the slightly “healthier” and much more expensive Market Fresh sandwich line (along with other sandwiches...including a roast beef gyro!). While Arby’s recently introduced a dollar menu in an effort to help bring down their menu price (which by industry levels had been quite high), it still did not address the fact that their product portfolio still lacks a central focus.

There is optimism that Arby’s new president Hala Moddelmog, who started her career at Arby’s and has significant experience in the industry, can help Arby’s in their makeover. The one thing that I think that Arby's needs the most is to answer the question: "why roast beef"? Obviously Arby's has been suffering from demand issues, so maybe it is a problem with the market not appreciating their product. That is why I feel like you either convince the customer that they should want roast beef (maybe the protein content? studies associating eating roast beef with improved health?) or change up the game. But right now, without a product line to center around, the company seems without focus and undefined.

Furthermore, if you want to sell at the higher price points (with products like the market fresh line), you need to drop the elements that make your products seem low rent. This would include getting rid of the nacho-cheese like substance that goes on some of the roast beef sandwiches and dramatically scaling back the fried food sides. They would want to position their menu price between the McDonald's (MCD) and Burger Kings (BKC) of the world yet below the Subways and Quiznos, hopefully becoming known for being cheap, fast and relatively healthy.

Can You Buy WEN on Asset Quality?

After the stock for any company crosses the 1 P/B threshold, each person buying equity is technically getting more than a dollar in assets from the company. The statement it sends when a company drops below this level is that there is absolutely no "whole being greater than the sum of the parts", i.e. this company would be worth more broken up than is together. One would think from a prospective buyer position this would be great, but you really have to look at the assets you are getting a hold of before you make the plunge.

This is because items like Goodwill and Intangible Assets can quickly approach zero if the company starts really going through problems. This is especially the case with Goodwill, since it is technically the amount paid in excess to what the other company is worth in a merger or acquisition. My guess is that WEN's goodwill is from the merger, and while it is important to add this Goodwill in to the balance sheet to make everything balance out, the implicit assumption by accountants is that the price paid during a merger or acquisition was justified. One need not search too hard to find instances of terrible, terrible mergers and acquisitions (my personal favorite? Time Warner and AOL) where Goodwill was later slashed and burned.

With Intangible Assets, such as brands, these are usually recorded at cost since there is little room in U.S. GAAP to revise assets up on the balance sheet. In a period of duress, such as bankruptcy, brands can get tarnished and watch their value plummet. Because of this, I try and be really careful around Goodwill and Intangible Assets since these are probably the first to go once things start heading south, and since equity holders are the last in line, probably what they would get stuck with.

This being said, when you take out Goodwill and Intangible Assets there is no shareholder's equity left over, in fact it is negative. So what kind of writedowns can they withstand to Goodwill and Intangible Assets to still maintain a 1 P/B level? 14%. Not much, if you ask me.

The Final Take

As of their most recent 10-Q, WEN was standing at an S&P credit rating of B+, by technical definition highly speculative non-investment grade. Ironically, they have also been participating in a share buy back plan and at their 2010 shareholder's meeting they just approved another $75 million, bringing the total up to $325 million. Why a company with a terrible debt rating (which is also responsible for the crippling debt payments that are destroying the company) is buying back shares in addition to posting a dividend when they are making operating losses is a mystery to me and if I was holding their debt I would be incredibly mad.

This combined with the fact that the stock price is not low enough for current buyers to actually be getting a hold of real assets (instead of Goodwill and Intangible Assets) makes me feel like this is a company an investor should stay away from.

I'll personally never understand why there ever was a merger between Arby's and Wendy's. If it brings down Wendy's, others will wonder the same thing.

Tuesday, April 20, 2010

The Mistaken Connection Between Natural Gas and Utilities

As a shareholder in Mirant (see: Is There Significant Value Behind this Coal-Burning Utility?) I've come to follow the movements in their share price on a day to day basis.

Because of this, I'm very interested in determining what influences the movement of the stock price and whether the downward move that the company has experienced recently was caused by outside factors (i.e. changes in commodities prices, the weakening economy) or internal factors such as market distaste with the company or other problem areas that have yet to crop up in tangible news.

Blurbs that I've read, such as Bob Pisani's Stock Talk from March 31st, 2010, point to natural gas as being a big mover for utility companies like Mirant. Commenting on the movement in independent power producers, Pisani notes:

"Natural gas happened. Independent power producers usually work in regulated markets, where the price they can charge is often tied to natural gas prices. Nat gas went from $6 to $4…a disastrous impact on profits, since fixed costs did not change."

So I thought I'd take Pisani's hypothesis to the data and see what the data had to say. I performed a linear regression in STATA to try and see what connection daily returns in natural gas had on energy producers such as Mirant (MIR), AES Corporation (AES), Dynegy (DYN), RRI Energy (RRI) and NRG Energy (NRG).

The short answer: except for Mirant, natural gas has no statistically significant explanatory power for the companies' stock prices for the time period considered. Even the explanatory power of natural gas for Mirant becomes statistically insignificant when a proxy for market performance (i.e. the S&P 500) is added in.

What I Did

To begin, I used Yahoo! Finance to collect historical daily stock price data for all of the companies mentioned above and for the S&P 500 index. The West Texas Natural Gas Wellhead price was used for natural gas and this data was obtained from GFD (Global Financial Data). For further testing, I also used the WTI Crude price, GSCI Energy Index, Moody's Commodity Index and Dow Jones U.S. Electricity index, all obtained from GFD.

All data was converted to percent return, and to try and control for changing correlation and dependency in the data I only looked at the time elapsed since the beginning of 2009 through the 9th of April 2010. The cut off at Apirl 9th was done to correct for the fact that Mirant and RRI just entered in to a merger agreement.

For the first step, I simply performed a linear regression of the daily percent change in natural gas prices on the daily percent change in the company stock price. Below please find the adjusted R-squared values, coefficients on the natural gas variable and corresponding t statistics from my regressions.

To put the coefficient in to perspective, for Mirant, if there is a 1% positive change in natural gas prices we would expect the stock price to go up by 0.04%.

As we can see above, in AES, Dynegy and RRI adding in natural gas rendered a negative adjusted R-squared value, meaning that it'd be better to guess randomly than look to natural gas as an explanatory variable. It is very easy, from the results shown above, to see that natural gas clearly does not have an impact on utility stock prices for the time period considered.

From a Longer Time Horizon

When I used data spanning back to 2006, the answer started to change. Natural gas became statistically significant for all companies except for AES, and this was even when market performance (i.e. the S&P 500) was added in. The negative coefficient of natural gas in the Dynegy instance is somewhat strange, but the coefficient is so low one can essentially assume it is zero. In fact, in all of the companies the impact of natural gas on stock price was far dwarfed by the S&P 500 variable, in all cases by at least a degree of magnitude.

The conclusion from this study would be that while over the long term utility stock returns are more generally tied to natural gas movements this effect absolutely does not exist on a shorter time frame (i.e. 1-1.5 years going back). This could be because most utilities today hedge for inputs, so they probably are not sweating the day to day movement. These hedges typically go out a year in advance, which could explain why data periods over longer time periods, which can take in to account longer trends, show more significance.

The extremely low values on the coefficients for natural gas, in both the longer and shorter term analysis, suggest that Pisani is mistaken is his connection between natural gas prices and stock price moves of power producers.


Responses to the Previous Article

My most recent article (Does Software Development Threaten to Dethrone Apple) got published on Seeking Alpha, and typical to what I expected there was a lot of discussion following in the comments section. In spite of the fact that it is exceptionally well covered already, I like writing on Apple because there is a very passionate community bullish on the company. This makes a great audience to write for because it serves as a trial-by-fire for your writing style and attention to detail.

Some of the points were very interesting, and one that was reiterated a few times (the argument that Apple's 30% take from App Sales is just enough to cover expenses) is a topic I'd like to do a follow-up article on in the future.
Along these same lines, I actually received two very well-written personal messages from Seeking Alpha members regarding Apple and the topic discussed in the article. I'm going to post them here, unedited by myself, since I feel that they bring up some interesting points, albeit not in favor of the point I was advocating for. If either of the authors are uncomfortable having their messages posted here, feel free to contact me at and I will take them down immediately.

FROM: GregZw

This is the second article I have read predicting the downfall of Apple because they won't allow third parties unfettered access to their technical environment.

I took my first computer programming class in 1966. I evaluated the original Macintosh computer for Atlantic Richfield Co. before it was originally released in 1984. I worked with one of the original software developers for the TRS80 from Radio Shack that was the first product to use MS-DOS from Microsoft.

I was involved in many debates about the pros and cons of open verses closed technical environments in computing technology. Apple made a decision In the early 80's to keep control over their environment. Microsoft took the open approach.

Apple new they would lose market share in the sort term as most 3rd parties jumped on the Microsoft bandwagon. Apple knew they could provide a richer environment with greater innovation in the long run.

I believe Apples strategy has overtaken Microsofts and will continue to dominate in the future. The battle has begun with Google and will be very interesting to watch over the next several years as google search is replaced by Apple Apps. Google's "open" approach to phones is similar to microsofts approach to computers in the 80's.

Pandora's box is open for Google and it will be interesting to see how they support early adapters to their approach as new technology comes available.

FROM: doncarp

Within the larger context of open markets, your opinion on Apple's control of software on the iPhone and iPad seem to make some sense. But you ignore the role of technology standards has played across the entire spectrum of digital technology. One of Apple's strengths is its control of all hardware integral to its products. This might be, along with Steve Jobs's understanding that Apple is now a media company as much as a technology firm, one of the most important reasons that Apple is now matching Microsoft CPU products in new unit sales. The Windows brand has been damaged by the immense diversity of device interfaces it must accommodate.

Third party software is, I suppose, your exception to this rule. But for what reason? Certainly mainframe computers, automobiles, medical devices have controlled their software and hardware. In most cases, it was not only desired, it was necessary for the product to function safely and be service supported by the manufacturer. Why should the success of Apple products cause them to be excluded from such proprietary control? I'm sure Apple has thought about what margin they can justify within the context of market demand and growth. You make it sound as though they do not deserve the fruits of their success. A rather socialist opinion I might add.

Apple's proprietary marketing system has allowed single programmers to become wealthy in just a few months. It is an exciting and valuable means for tapping the immense diversity of talent and vision that exists all across the far reaches of Internet tethered individuals.

Perhaps you don't recall when Microsoft strong-armed retailers to muscle out Apple from their best display space. In the years that followed, Apple almost was sold out as a near death business. Do you recall the way the Bell system dominated communications here and in the process were able to influence government and their regulators in such a way that Bell became a pure money machine and in the process became an impediment to our national telecom policies. Now many smaller nations such as Korea have more advanced broadband available at cheaper prices than the US will have for many years. Business always tries to optimize its market advantage. If at some time in the future Apple's dominance hinders viable competition, as did Microsoft and Bell, then they should be the target of government anti-trust action. But at the moment, Apple is not keeping software vendors from doing business with competing hand held devices. They are simply doing what they do better than anyone else is doing it. They deserve to be where they are and they are rewarded by their customers with their present market dominance.

What young analysts here sometimes forget is that the country's technical rise to world dominance would not have happened if there were no laws protecting trade secrets and other intellectual property. There is a mistaken sense of entitlement in some consumers which suggests that there should be no reward for a company's technological excellence, that all innovative new products should be subject to immediate generic product cloning. If that were the case, who in their right mind would make the investment to even create an iPhone, iPad or iMac.

Friday, April 16, 2010

Does Software Development Threaten to Dethrone Apple?

A couple of months ago I wrote an article speaking to how Apple (AAPL) was the fourth largest company in the United States by market cap according to the S&P 500 (it is currently the 3rd largest), and began speculating as to whether or not the company deserved this highly coveted position. While being a tech company with no debt obligations is going to bias Apple's position upward in the S&P 500, I do think investors should re-evaluate whether Apple deserves this position in the market.

Yesterday there was a very interesting article posted in Slate (Apple Wants to Own You), and while I feel that the title is far too fear-mongering, I do think that a few of the issues raised are pertinent to Apple's ongoing success.

The biggest point raised in the article is the fact that the locking-out of third-party software that originally only pertained to the iPhone is now being included in the iPad, something at the very least controversial given that the iPad is being hailed as a tablet computer. This is to say that except by ways of the Apple marketplace for apps, you are unable to install any non-Apple endorsed piece of software on the iPad without manually unlocking the device and voiding your warranty. While this may not be a short-term concern for Apple, the Slate article identifies that one of the key draws to Apple products is the rich environment of downloadable apps.

This of course raises the question of whether software begets users, or users beget software. As it stands now, Apple gets 30% of the sales from all apps. That's a pretty lucrative business for being referee and market maker on your own devices. With Apple additionally trying to take 30% out of magazine subscriptions on the iPad as well as growing rumblings over the subjectivity and increasing conservatism of iPhone and iPad app acceptances, there is concern that Apple is starting to take more advantage of the moat of user base it has built up with the lights-out success of past products.

While the iPad currently has no side-by-side competitor, other phones such as those using the Android operating system produced by Google potentially offer users a more unfettered access to third-party software than those using the iPhone.

The story of the iPad has been a huge success thus far, with Apple reporting over 500,000 units sold. Apple's stock momentum appears to be one of maintained margins and continually growing revenue, with revenue expected to jump 47-80% from last year's second quarter. While Apple has been a very strong performer in the past, it might be worthwhile to current investors to re-weight the risks and evaluate whether the price that Apple is currently trading at is pricing in a significant amount of optimism regarding future success.

My Take on the Goldman Sachs Allegations

BACKGROUND: here is Felix Salmon going in to really great depth on the Goldman Sachs S.E.C. allegations for those of you unfamiliar with the story.

I'm personally long Goldman Sachs (GS) after they lost almost $13 billion in market cap today. The settlement is expected to be in the hundreds of millions of dollars, and GS as a whole only made $4 billion off of subprime bets in general.

Obviously the market is expecting this to have residual effects on their other lines of business, however when I look at the landscape for the business they're involved in I think they've got a pretty good lock down. I would expect GS to distance themselves from the ABACUS events, and potentially blame it on the actions of a few individuals rather than GS internal protocol.

They may end up being liable, however if the trial of the former Bear Stearns hedge fund managers is any indication, some times it's hard to get these charges to stick. Especially since Goldman is going to throw A LOT of money at this to try and make it go away.

This may be my own personal bias, but Goldman Sachs has the ability to snap up the best and brightest minds. If you get a job offer from them, you think long and hard about dropping everything to give it a shot. I'm not going to say I necessarily morally agree with the sorts of things they do, but in terms of having the capacity to make money, they certainly have it. When you have the best minds and a corporate culture that rewards you very well for making contributions to the P/L, you're going to continue to have success in the financial services industry.

Tuesday, April 6, 2010

Is Volatility Getting Cheap Again?

One of the indicators that I like to watch, if for nothing else than for entertainment value, is Barron's Investor Sentiment readings. Last week, depending on which indicator you look at, Bullish consensus ranged from 41.3% to 70%.

One of the questions I constantly want to be asking myself is whether the market is getting complacent, which I would argue is the primary cause of bubbles. I would posit that if the market starts to get too single minded, market efficiency starts to weaken and you start seeing opportunities to take advantage of the follies of other market participants.

Just looking at the way the Dow Industrial Average has been moving (i.e. in terms of scale of the movements), things seem to be quieting down in the market. The standard deviation of daily returns for the Dow Industrial Average has dropped from 2.38 percentage points (from the beginning of 2008 to the end of 2009) to 0.82 percentage points (YTD).

Even when you look at the Dow during a more "pleasant" period of time (mid 2003 to end of 2007), standard deviation of daily returns is 0.74 percentage points, not that much lower than where we are now.

But the key test for whether the market is getting complacent or not is to look at implied volatility. The most common metric for this, the VIX, does so by backing out volatility expectations from S&P 500 put and call options expiring in 30 days (CBOE methodology). When you look at historical VIX levels, the answer to this question is debatable.

Will the Future Be More like 2004 to July 2007 or 1992 to 1999?

These are the two times periods for which there is VIX data that I would call "good" for shareholders. What I was curious about was what the VIX level looked like during these periods.

For 1992 to 1999, you have a geometric mean of 17.03, arithmetic mean of 17.90, and standard deviation of 6.02. For 2004 to July 2007, you have geometric mean of 13.52, arithmetic mean of 13.71 and standard deviation of 2.35 for the VIX.

These are obviously very dramatically different numbers, and the most reasonable explanation for the higher values for the 1992 to 1999 period was the tech boom, and the volatility that that presented. That was a bull market the likes of which was unseen previously, so perhaps an expectation that that will happen again in the near future is foolish. So if you're looking at 2004 to July 2007 as the most likely market climate for the upcoming future, the VIX, which closed at 16.23 today, is still a little bit high.

That being said, 16.23 is the lowest level the VIX has closed at since December 10th, 2007. Depending on how you're feeling about the economy, now might be an interesting time to try and profit off of volatility underpricing.

Trading Strategies

The simplest option would be to buy futures on the VIX, or check out the VXX or VXZ, two ETNs managed by iPath (Barclays).

Another option would be to literally buy options on the S&P 500 to perform a straddle. This would be done by buying a put and call at the same strike price, presumably with the strike price at the current market price. Your hope would be (presuming strike price is market value on day of purchase) that the closing price on the day your option expires would be the strike price plus or minus the sum of the premiums paid for the put and call options.

I've also written another article on volatility: Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns? if you're interested in reading it.

Saturday, April 3, 2010

The Dangers of Anecdotal Evidence

Perhaps it's something that has been embedded in us by the process of evolution, but humans seem to really enjoy articles, snippets, and stories from real human beings rather than data.

Consider every instance you've ever heard of someone doing something that objective reason and presumably some sort of data would suggest is wrong. This could include driving very infrequently yet choosing to lease, or buying a can of Coke every day from the local corner store when one could save 50-75% of this cost by buying a twelve pack and bringing the soda from home.

Now think of when those instances match up with a story or personal experience that seems to fly in the face of data or statistics. "Well my friend blah-blah bought her car and then the engine went out and she had to pay (large sum of money), so I just lease now". Or "my sister so-and-so used to bring her sodas from home, but then one day some of the cans exploded and ruined everything in her pantry, so now I just buy my soda from the corner store on the way to work".

These stories are extremely appealing, because we can identify with them. You imagine yourself in that situation, and since it happened to your friend/family member, it seems to suggest the probability is high that it can happen to you. If you look at this person's experience as a foretelling of what will happen to you (i.e. probability of negative event = 100%), then making a choice that goes in the face of objective data makes sense. However, it could just be that the probability of the effect is fixed, and your friend or family member just happened to be on the wrong end of the probability distribution.

While citing personal experiences to show how personal anecdotes are oftentimes blatantly false is a logical absurdity in and of itself, consider the following article that was on the front page of Yahoo! Finance this Saturday. Entitled: "How My $499 iPad Purchase Became a $1,170 Credit Card Bill", by Jeff Fox from, the article instantly grabs your attention because of the large change, as if to suggest Apple is tricking you.

The article itself is a misnomer because one of the first things Jeff says is that he decided to get the $829 64GB 3G model (because you can use it with more than just Wi-Fi) that evidently releases later in April. Right there, the article should have simply become "How a $829 purchase became $1,170", but Jeff seems to suggest that he was "lured in" with the $499 version.

The other $341 comes from a greater insurance and tech support plan and accessories, all of which Jeff had the choice to purchase. I personally resent the fact that he seems to be suggesting that Apple made him buy these additions. To make his point even more ridiculous, if you go to the Apple website and begin trying to purchase an iPad, all of the accessories are defaulted as "no", which is counter-intuitive if Jeff is right and Apple is trying to pull a fast one.

Outside of the error in trying to make Apple sound like a baddie is the justification for his splurging on additional memory. Jeff states: "As for stepping up to the 64GB iPad, my philosophy is that you can never have too much memory. I have no doubt that I will fill much of that 64GB within the next year or two. Speaking only for myself, the breathing space was worth the extra couple of hundred dollars."

I find this comment particularly hilarious, because if Jeff was most concerned about memory, why not have simply bought a net book, which for around $360 dollars can give you 290% of the memory and 60% more processing power than the 64 GB iPad? (the iPad only has a 1 GHz processor whereas most net books baseline at 1.6 GHz. The iPad beats net books in weight however by being roughly a pound lighter).

Jeff had essentially narrowed down the known universe of purchasable products to between the the higher and lower memory iPad 3G models because of prior selections he had made. When you consider the additional price he paid for the memory in the spectrum of the computing world, the extra cost/amount of memory added seems like highway robbery.

I think that Jeff speaks for a lot of Apple consumers in that his purchasing decision seems to have been driven by the presentation of the product and its ease of use. I'm personally too practical to buy a product who aside from it's touch screen and lower weight is already obsolete from a processing and memory standpoint, yet costs more than double that of competing net books. (granted tablets and net books are by definition not the same, but do accomplish similar tasks by being "mini-PCs")

This isn't the first time I've written about Apple products (see: Is Apple Really the Fourth Most Valuable Company in the United States? ), partly because I find the cult of product so fascinating with this company. If you were to ask a robot which he/she would be willing to pay more for, my guess would be the one that was the cheapest in terms of computing power/dollar (presuming the two products were made with the same quality of components). This doesn't play out the same way in the real world, and I think it's a perfect example of the impact of the "human factor": how presentation and ease of use can put value multipliers on products that are inferior from a hardware perspective.

Sunday, March 21, 2010

When People Forget to Implement Present Value Adjustments

In a recent New York Times piece by Op-Ed Contributor Douglas Holtz-Eakin, entitled: The Real Arithmetic of Health Care Reform, the author points out several "gimmicks" employed in the proposed health care legislation that supposedly reduce the Federal Budget deficit.

I'm not an expert in this field. I couldn't precisely tell you how the Congressional Budget Office (CBO) works, or what methodology is employed. What I can tell is when an author is failing to discount to present value.

Take his first gimmick: "the bill front-loads revenues and backloads spending. That is, the taxes and fees it calls for are set to begin immediately, but its new subsidies would be deferred so that the first 10 years of revenue would be used to pay for only 6 years of spending."

Now if you sum up the benefits and the costs, you may very well get what the author is talking about. However, if you employ present value in your analysis, you might arrive at a very different conclusion.

If you were to ask someone if they'd rather have a dollar today or a dollar a year from now, they would say the dollar today. Why? Because they could spend it now, or invest it and earn some sort of return. So how much would you have to give someone a year from now to make them indifferen between the dollar today and the sum a year from now? Well if it's a sure thing they'll get that sum from you, that's essentially the risk-free rate of return. If there's a risk that they'll get that amount from you, the rate should be the risk-free rate plus the risk premium you represent.

Typically, people look at Treasury bills and bonds as the risk free rate. So right now, the one year Treasury bond is yielding 0.41%. So if you knew you would get the sum a year from now, you would demand $1.0041 a year from now to make you indifferent between that and a dollar today (part of the reason this is so low is because interest rates are at record lows right now).

So to determine the real cost of a project, you have to discount the yearly costs and payoffs by (1 + discount rate)^(t), where "t" is the time that has passed in years (presuming the discount rate is an annual rate). If there is no risk in the payoff and costs, then you discount by the risk free rate. If there is risk, it's the risk free rate plus the risk premium.

So what does this all mean? Essentially, even though when you do a strict summation the project might net zero or a negative value, when you employ discounting it could very well be positive. By the nature of the plan identified by the author (payoffs early on, costs later), I'm extremely skeptical about his conclussion since he doesn't note employing any type of present value adjustements. I'd guess the CBO does. I think I'll side with what the CBO says.

Sorry Doug.

Before There Was The Motely Fool, There Was The Sane Investor

On this one topic.

There was an article that recently graced the front page of the Motley Fool, talking about how big Apple (AAPL) is compared to its brethren on the S&P 500. It's interesting, because I wrote practically the same article more than a month ago on this subject.

I'm definitely not trying to cite any sort of "copying" (they probably didn't read my article), but it did feel good to have a major investing website run with the same tag line that I recently wrote a piece on.

I'm sorry about the complete absence of content for this blog...I've been really busy. But I will say that I'm happy to be employed now (yay!) although still weighing out two offers I received. Hopefully not having to find a job will give me more time to write on the site.

Saturday, February 20, 2010

Is Apple Really the Fourth Most Valuable Company in the United States?

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Upon glancing at the top holdings in the SPDR S&P 500 ETF (SPY), I must admit I was very surprised to see that Apple Inc. (AAPL) was the fourth most heavily held company in the index. Smack between Proctor and Gamble (PG) and Johnson and Johnson (JNJ), as I looked at the list I started to wonder whether the assumptions behind AAPL's valuation might be a little rosy.

To do this analysis, I used the financial information from Apple's most recent 10-K to build a discounted cash flow valuation model. My goal was to see whether the assumptions built in to AAPL's stock price were realistic. After really digging in to the numbers I feel confident that Apple, especially with a one year target price from analyst estimates of $248.33, is in a bubble.

Looking At the Numbers

From a price to earnings perspective, Apple (at 19.64) is somewhat overvalued. Exxon Mobil (XOM) trades at a P/E of 16.56, Microsoft (MSFT) at 15.85 and Proctor and Gamble (PG) at 15.11 (these are the only other companies in the S&P 500 more highly valued than AAPL). If one were to take an average of these three, and infer from this Apple's stock price, one would get a price of $162.68, $38.99 less than what it closed at on Friday.

But price to earnings ratio comparison would be a ridiculous way to value Apple, since obviously its shareholders believe there is still some growth to be had for the company. To see what these growth assumptions are, I projected out through 2015 a balance sheet and income statement for Apple and then did sensitivity analysis with a discounted cash flow to see how operating profit margins and sales growth rates impacted the company's valuation.

>To schedule out the balance sheet, I looked at Apple's ratio of either the various line items to sales or the line items to cost of sales from 2008 and 2009. I then used the average of these two ratios to infer the future values for the line items. While this is a relatively simplistic way of doing this and will no doubt not occur as projected in reality, I wanted to see how Apple would perform if they ran the company much like they have been doing in the recent past.

Looking at Apple's income statement, I tied R&D as a ratio to sales based on recent historical levels and cost of sales based on an operating profit margin. Looking at Apple's recent history, it becomes quite apparent that this company has been immensely profitable and successful based on its extremely high operating margins (40% in 2009) and robust sales growth, with 34% in 2008 and 13% in 2009.

For my DCF valuation, I just did a simple 10% discount rate. Looking at the sensitivity analysis, it becomes quite evident that Apple's future valuation is pricing in consistently strong sales growth and operating margins:

Based on Apple's current market valuation, it appears as though the market is presuming that Apple is going to maintain operating profit margins of 40% in perpetuity and that sales growth would be 14-15% next year tapering off to a terminal growth rate of 4% in 2015.

Since I thought that 40% operating margins in perpetuity was a little much, I looked at what would happen if it tapered off to a terminal level. In my opinion, I feel like it'd be very difficult to constantly stay ahead of the curve and provide products that were just so downright amazing so as to justify a 40% operating profit margin for the life of the company. To find this terminal rate, I took Dell's operating margin from their most recent 10-K and added 5% for good measure:

The valuations under these assumptions are no where near that of the market, which leads me to believe that this stock might be in a bubble.


Of course some of the assumptions I used in this model were a bit simplistic and if I had a little more time I could go in to more detail, but from my simple analysis I feel comfortable saying that the market has absurd expectations for Apple. Does this mean that I don't think Apple is a great company? Of course not. But I do feel like it's overvalued right now, and the analyst estimates seem downright ridiculous, putting it at a market capitalization of $225 billion one year from now.

When the very best case scenario is what seems to be driving the stock price I think it's time to look for greener pastures.

You can download my model below and play with the numbers if you like.

AAPL DCF Valuation

Tuesday, February 16, 2010

Winn-Dixie Earnings Surprise

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I mentioned last Friday that I was hoping to do some analysis on Winn-Dixie Stores (WINN) once they released their second quarter 10-Q. Looks like they beat analyst earnings expectations, which while not a buy signal in and of itself in my book is still a positive because it means they weren't losing money.

I'm hoping to write up some formal analysis and a recommendation on the stock either tonight or tomorrow night. I haven't looked at their 10-Q yet aside from reading the headlines, but I am slightly optimistic that their balance sheet has improved. The roughly 2.5% move up today also likely means that they're still at the P/B ratio I discussed in a recent post.

I'm also hoping to at some point dive in to the 10-Q The Pantry (PTRY) released February 2nd. My apologies for not being more on top of that. It seems that they went below analyst expectations with their loss, and I'll take a look to make sure that this stock still makes sense. Part of the way I pitched it was conditional upon them being able to turn a profit soon, and there's a certain point where your patience has to run out. It's not out of the realm of possibilities that upon further analysis I'll close my position on my motley fool profile.

In case you haven't seen it, a more formalized version of the VIX pitch I put up on my blog here got published on Seeking Alpha today. I think it turned out pretty well, so if you haven't read it yet you should take a look.

Sunday, February 14, 2010

Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns?

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I've uploaded the PowerPoint I just made for my presentation tomorrow for the Claremont McKenna College Student Investment Fund.

I was looking at the VIX, and whether or not having exposure to it might serve as a better-than-normal hedge for S&P 500 returns. My thought process was built on the assumptions that:
(1) Assets can be conditionally correlated (i.e. different events can result in different correlations between assets)
(2) In hedging against black swan events (statistically insignificant and unpredictable events that can cause financial ruin), the goal would be to ideally find assets that were uncorrelated to the market during sideways or bullish markets but highly-negatively correlated to market returns during market panics and sell offs.

You should read the presentation for my findings (note: the graphs used are from the Barclays prospectus for their VXX and VXZ ETNs and from Standard & Poor's website. I want to make sure I give credit where credit is due). In terms of my looking at the VIX, I tried to break up my time periods either based on significant market events (for example, the Bear Stearns bailout of their Sub Prime funds) or based on market bottoms or tops. It's somewhat of a mixed bag, but I feel like there's evidence, at least based on recent market history, to suggest that this conditional correlation is partially correct.

In terms of looking at what products to gain exposure to the VIX, I looked at Barclays' iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). While the Short-Term VXX has more liquidity and is more highly correlated to the VIX (and this correlation is more statistically significant), based on the way the indices that both funds are based on move (as seen in the graphs from the Barclays' prospectus I mentioned earlier), I feel that mid-term index has offered a better risk-reward payoff since 2005.

I justify this largely by the fact that humans seem to extrapolate market panic in to the future and to be skeptical during the boom times of future performance. While this skepticism might not be evident in the asset markets themselves, I do believe you'd see it in the derivative markets to insure against these positions.

The expense ratio of 0.89% for both funds is a level I believe to be reasonable, especially faced with the impossibility of effectively creating a product like VXX or VXZ on the small scale for retail investors.

From the articles I've read on the two products, the major complaint that I've heard is that the ETNs don't accurately capture the daily changes in the VIX. While I'm sympathetic to these concerns, I think it's important to remember that you're invested in futures based on the VIX and not the VIX itself (which isn't actually possible). To me it's plausible that you'd actually have meta-volatility (i.e. the volatility of the VIX) impacting the pricing of the products. Also, because the products are looking at what the VIX is going to be at in the future, the day to day movements are less significant.

My final conclusion with the PowerPoint is that I would go long the VXZ. I was not able to get actual data for the index that it is priced off of however, so my statement is more based on the chart and my behavioral explanation for the reason it has outperformed the VXX in both the upside and downside.

Friday, February 12, 2010

Analysis On Winn-Dixie Stores

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Although I'm waiting until they release their earnings next week, one stock I've been looking in to and have gone long on for my motley fool account is Winn-Dixie Stores Inc. (WINN), the southern grocer. I'm waiting for the earnings announcement so I can go in to more detail for my analysis rather than simply guesstimating what is going to happen. That doesn't seem prudent based on how close their earnings announcement is.

But here's a little preview of some numbers I ran off their Q1 10-Q:

As you can see, even after discounting intangibles and basically anything that you can't put your hands on, they still have a P/B of less than one. I'm not quite sure how I feel about their Property Plant and Equipment (PPE), since it appears they only own 8 stores and 1 distribution center, but I guess trading below hard assets is all I can really ask for.

If you ask me this seems very very cheap, especially since they have no long term debt, but I'll be interested to see how their Q2 earnings come out. Mean analyst estimate is a loss of $0.16, with a high estimate of -$0.09 and a low estimate of -$0.27. If they surprise on the upside it might push them past this price to tangible book ratio of one, but I think that's a risk you have to be willing to take.

Tuesday, February 9, 2010

A Justification for Government Interference in Pollution

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Although not a recent phenomenon, the particular flavor of the times (temporarily pushed under the rug over concern for the economy) is what should be done about global warming. Topics have included carbon cap and trade agreements, green energy grants and requirements, etc. One thing I think that is important to discuss is whether government regulation could effectively create a positive solution for the climate change problem.

To begin, I'll have to posit some assumptions, for which if one were to disagree with would inherently prevent the same conclusions I am about to draw from being reached:

(1) Pollution has a negative impact on everyone's health, yet remains unpriced because of a tragedy of the commons scenario and an incapability of observing its true cost
(2) Ceteris paribus, a firm earning a profit has positive externalities for society in so much that either through direct distribution or wealth trickle down effects, people are better off (i.e. profit seeking is positive for society, all other things staying equal)
(3) Earning a profit is not a zero sum game, in that if someone is making money someone else does not have to be losing money.

To start off, I think it's important to think of a basic scenario of two polluting companies, G and E. These two companies produce the exact same product for the same market, and the only two choices available to them are whether they're going to implement capital intensive pollution control devices, or not. This breaks out in to a game theory problem.
The picture above represents the payoff matrix for firms G and E in the market described earlier

We'll say that the market is fixed in terms of demand and whichever company can produce the product the cheapest is going to capture the entire market. In the case where the cost of producing the good is the same for the two firms, they will split the market. In splitting the market in the 'Not Pollute' scenario, both firms' payoffs are less than in the 'Pollute' scenario because of the cost of the pollution limiting capital expenditures, let's presume.

The payoff matrix is quite simplistic, but the goal is to convey that in a situation where the winner is the company that can produce the product the cheapest, the Nash equilibrium is going to be that the firms will pollute (in this case, [4,4]).

Now this might not be the most beneficial situation for society, based on the cost we place on pollution (or value on clean air). Let's say cost of pollution to society is 10, such that even though the firms in aggregate would be making a profit of 8 in any combination involving pollute, society as a whole would be incurring a negative payoff even with the addition of this 8 of profit.
In this scenario, it might be in the best interest of the society (of course not for the companies individually) for the government to require a certain level of pollution control, thus forcing the [2,2] payoff to be the Nash equilibrium by preventing the choice of pollution. Presuming this 10 cost is eliminated in this scenario, there's a positive 4 aggregate payoff where before there would have previously been a negative 2.

This can generally be summarized such that the government should intervene when the aggregate payoff from not-polluting is greater than polluting, or:

Er(Diminished G and E earnings, bureaucracy costs, no pollution payoff) ≥ Er(Heightened G and E earnings, pollution cost)


While this is a fun way to look at the problem, it doesn't address the fact that we still don't have a price for pollution. Some have tried in this department, but you will still have difficulty valuing some of the side effects not directly related to human health (i.e. how do you value things like biodiversity?).

In addition, although the bureaucracy cost of implementing said regulation should be a considered cost, it is very likely that the group determining if and how we should regulate (the bureaucracy) might not consider this cost or might dramatically undervalue it.

In light of this, while it is theoretically easy to determine whether to regulate, the inputs of the equation are still unknown. To an investor involved with the G or E firms of the world, a big chunk of the valuation of your investment is determining what the likelihood is that those making decisions will determine that the left side of the equation is greater than the ride side i.e. the value they and their constituents place on clean air. Perhaps this is why in a Democratic regime coal burning utilities and other environmentally questionable investments have gotten crushed.