Showing posts with label finance. Show all posts
Showing posts with label finance. Show all posts
Friday, April 27, 2007
Fama or French - Matters of Credit
The three factor model extends CAPM with two factors size (small vs big) and value (market price relative to book value) in addition to the market risk premium. Basically, that leaves you with three betas. You can read more about it elsewhere, but what's hilarious is the article from Tuck School of Business (Dartmouth) that uncovers the real relationship between Fama and French, especially the real dope on who did all the work! Follow the link Fama Factors out French to read the article.
Thursday, April 26, 2007
Matters of Guidance
In a recent discussion about public versus private companies, a couple of us were wondering about the exact pros and cons of earnings guidance (earnings forecasts or estimates) and what is the impact of not providing any quarterly guidance.
Why give guidance at all? Basically the market trades on expectations (expected earnings). The catch with not giving guidance is analysts drop coverage or make up their own forecasts. This could potentially shoo away institutional investors and create unnecessary volatility. The argument for company executives giving earnings guidance is that they are likely in a better position than analysts and hence they could predict more reliably what the quarterly earnings report is going to look like.
The argument against giving guidance is that it fosters market myopia, which in turn causes companies to adopt a short-term "earnings management approach", rather than take a longer-term strategic view, one that includes making rational capital investments.
In "To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance," the authors find no evidence that firms that stop giving guidance, offer better visibility on longer-term strategy including any additional capital investments. On the contrary, they point to issues with management and more earnings volatility (including losses).
Similarly, in "Is Silence Golden? An Empirical Analysis of Firms that Stop Giving Quarterly Earnings Guidance" the authors suggest that firms couch poor performance and low external demand for guidance in altruistic terms, when they decide to stop guidance. Furthermore, stopping guidance causes the market to reduce its expectation.
From an operating perspective, my own dilemma is how do you reliably forecast earnings? I can see the value in making an attempt, just so you get a feel for all drivers of earnings, but sharing it with the investors is just likely to force managers to do their best to meet their guidance. For instance, not dispose off sunk investments, play tricks with non-cash generating activities like depreciation etc.
Some interesting bits on this on the web....
Google, the darling of the Wall St condemns the practice of giving guidance:
NY Times article on The Rational Mr Buffet points out that:
In an attempt to keep America's capital markets competitive, the chamber of commerce appears to have raised an issue with earnings guidance, among other things like Sarbox. Some of these are additional factors that may feed into the private equity, buyout binge.
WSJ reports:
Why give guidance at all? Basically the market trades on expectations (expected earnings). The catch with not giving guidance is analysts drop coverage or make up their own forecasts. This could potentially shoo away institutional investors and create unnecessary volatility. The argument for company executives giving earnings guidance is that they are likely in a better position than analysts and hence they could predict more reliably what the quarterly earnings report is going to look like.
The argument against giving guidance is that it fosters market myopia, which in turn causes companies to adopt a short-term "earnings management approach", rather than take a longer-term strategic view, one that includes making rational capital investments.
In "To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance," the authors find no evidence that firms that stop giving guidance, offer better visibility on longer-term strategy including any additional capital investments. On the contrary, they point to issues with management and more earnings volatility (including losses).
Similarly, in "Is Silence Golden? An Empirical Analysis of Firms that Stop Giving Quarterly Earnings Guidance" the authors suggest that firms couch poor performance and low external demand for guidance in altruistic terms, when they decide to stop guidance. Furthermore, stopping guidance causes the market to reduce its expectation.
From an operating perspective, my own dilemma is how do you reliably forecast earnings? I can see the value in making an attempt, just so you get a feel for all drivers of earnings, but sharing it with the investors is just likely to force managers to do their best to meet their guidance. For instance, not dispose off sunk investments, play tricks with non-cash generating activities like depreciation etc.
Some interesting bits on this on the web....
Google, the darling of the Wall St condemns the practice of giving guidance:
Although we may discuss long term trends in our business, we do not plan to give earnings guidance in the traditional sense. We are not able to predict our business within a narrow range for each quarter. We recognize that our duty is to advance our shareholders' interests, and we believe that artificially creating short term target numbers serves our shareholders poorly. We would prefer not to be asked to make such predictions, and if asked we will respectfully decline. A management team distracted by a series of short term targets is as pointless as a dieter stepping on a scale every half hour.
NY Times article on The Rational Mr Buffet points out that:
Mr. Buffett is also against the practice of issuing quarterly earnings guidance, the self-imposed benchmarks that drive executives to sacrifice long-term strategy for a short-term payoff.On the brighter side, there seems to be some rationality creeping up amongst investors. WSJ reports:
As the stragglers report actual results for 2006, investors have been unusually forgiving toward companies that have reported profits below expectations.
In an attempt to keep America's capital markets competitive, the chamber of commerce appears to have raised an issue with earnings guidance, among other things like Sarbox. Some of these are additional factors that may feed into the private equity, buyout binge.
WSJ reports:
The report, commissioned by the nation's biggest business lobby, called for an end to quarterly earnings forecasts, an overhaul of the Securities and Exchange Commission, and an increase in retirement savings.The Economist appears to have a good article on this topic. I don't have access to it. If you are a premium subscriber you can access it here.
Monday, January 8, 2007
Book Review: Magic Formula Investing - The Little Book That Beats the Market
A friend recommended Joel Greenblatt's Little Book about a year back. It starts out sounding like a joke or some kind of a hoax but it should takeall of 1-2 hours to read the entire book and I strongly recommend it - both for adults and teenagers!
Before I proceed to review the Magic Formula, the following points represent my underlying investing philosophy:
Written in a tongue-in-cheek style, Greenblatt appeals to the child in you, quite literally, to educate you on time tested concepts of value investing. Overall a good book targeted at the mainstream public that not only builds an appreciation for the rationale behind value investing but also gives you an almost mechanical method to invest using the "Magic Formula." Here's a quick summary of MFI...
Greenblatt's basic theory is that its pretty hard for most people (and especially individual investors) to reliably forecast future growth. He therefore recommends that the individual investor simply focus on buying good companies at a good bargain. Good, as defined by MFI, is used for a company with a high ROIC (return on invested capital) and you separate a good bargain from a bad one by looking at the Earnings Yield (EY).
With ratios, its basically garbage in, garbage out. We need to look under the numbers and see how they're calculated. Greenblatt defines them as follows:
The reason he adds back debt to EV is to make sure the Earnings Yield is not affected at all by the debt-to-equity ratio. He also wants to compare companies at different debt and hence tax levels.
The basic steps to building an MFI portfolio is as follows:
Based on back testing (17 years), the magic formula has yielded annual returns in excess of 30%. There hasn't been any 3 yr period with negative returns.
This method has some nice attributes: almost mechanical, focus on the portfolio and not individual companies/stocks, not much churn. Note that he recommends this for average individual investors who are not into doing a great deal of diligence on the companies.
Here's the best part. There's an MFI website, www.magicformulainvesting.com, which allows you to screen companies based on the ROIC, EY criteria.
ROIC or ROE or ROA?
ROE is return/book value of equity. This doesn't take into account the debt capital. ROA is return/book value of assets, which can include accounting gobbledygook like goodwill. In addition, Greenblatt removes uninvested cash from assets, and adds payables since in effect they are an interest-free financing of operations.
Not many have been able to reproduce the MFI screens. If you understand exactly how he calculates ROIC, do let me know!
Commissions?
As a Schwab customer, I'm looking at transaction costs of 25 (size of my MFI portfolio) times $12 = approx 300-600 depending on when you bought and when you started replacing them. Check out www.interactivebrokers.com or www.foliofn.com. I tend to holder longer than 1 year.
No Utilities, Financials & ADRs
To keep things simple the vanilla ROIC and EY don't apply to the capital structure of financials, possibly because they are usually highly levered.
Isn't Earnings an accounting artifact?
Earnings could be inflated temporarily by creative accounting! An equity from the MFI screen could be the subject of earnings restatement. I don't believe vanilla ROIC or EY can guard against that. Greenblatt remarks that sophisticated investors such as himself can calculate forward-looking versions of these parameters.
Macroeconomic factors
Capital intensive industries tend to be cyclical. The MFI screening criteria doesn't seem to account for business cycles that may affect industry fundamentals.
Micro ($50m-$300m) vs Small ($300m-$2b) vs Mid ($2b-$10b) vs Large cap ($10b+)
In my experience micro and small cap pickings from MFI have shown a lot of volatility AND negative returns. My recommendation is to stick with mid & large cap.
Before I proceed to review the Magic Formula, the following points represent my underlying investing philosophy:
- The market is noisy (capricious) in the short run, efficient (values companies efficiently) in the long run. I believe in mean reversion, that is, temporarily undervalued stocks are likely to rebound back to their 'true' values.
- Given my net worth, I don't see any value in paying someone to manage my money. As a result, I am not too excited by mutual funds. I prefer ETFs.
- I'm too lazy to keep constant track of my portfolio and I hate transaction costs. I therefore like buy-and-hold approaches.
- Diversification globally is goodness.
Written in a tongue-in-cheek style, Greenblatt appeals to the child in you, quite literally, to educate you on time tested concepts of value investing. Overall a good book targeted at the mainstream public that not only builds an appreciation for the rationale behind value investing but also gives you an almost mechanical method to invest using the "Magic Formula." Here's a quick summary of MFI...
Greenblatt's basic theory is that its pretty hard for most people (and especially individual investors) to reliably forecast future growth. He therefore recommends that the individual investor simply focus on buying good companies at a good bargain. Good, as defined by MFI, is used for a company with a high ROIC (return on invested capital) and you separate a good bargain from a bad one by looking at the Earnings Yield (EY).
With ratios, its basically garbage in, garbage out. We need to look under the numbers and see how they're calculated. Greenblatt defines them as follows:
ROIC = EBIT/(Working Capital + Fixed Assets),
where EBIT: Earnings before Interest & Taxes
EY = EBIT/EV,
where EV, the Enterprise Value = Market Cap+Net Interest Bearing Debt
The reason he adds back debt to EV is to make sure the Earnings Yield is not affected at all by the debt-to-equity ratio. He also wants to compare companies at different debt and hence tax levels.
The basic steps to building an MFI portfolio is as follows:
- Create a composite ranking of companies by ROIC and EY.
- Buy stocks for 20-30 of them (you could do it gradually)
- At the end of the year, review and:
- sell losers 1 day before before the end of the year
- sell winners 1 day after the year end
- replace losers with new companies, go back to 1.
Based on back testing (17 years), the magic formula has yielded annual returns in excess of 30%. There hasn't been any 3 yr period with negative returns.
This method has some nice attributes: almost mechanical, focus on the portfolio and not individual companies/stocks, not much churn. Note that he recommends this for average individual investors who are not into doing a great deal of diligence on the companies.
Here's the best part. There's an MFI website, www.magicformulainvesting.com, which allows you to screen companies based on the ROIC, EY criteria.
ROIC or ROE or ROA?
ROE is return/book value of equity. This doesn't take into account the debt capital. ROA is return/book value of assets, which can include accounting gobbledygook like goodwill. In addition, Greenblatt removes uninvested cash from assets, and adds payables since in effect they are an interest-free financing of operations.
Not many have been able to reproduce the MFI screens. If you understand exactly how he calculates ROIC, do let me know!
Commissions?
As a Schwab customer, I'm looking at transaction costs of 25 (size of my MFI portfolio) times $12 = approx 300-600 depending on when you bought and when you started replacing them. Check out www.interactivebrokers.com or www.foliofn.com. I tend to holder longer than 1 year.
No Utilities, Financials & ADRs
To keep things simple the vanilla ROIC and EY don't apply to the capital structure of financials, possibly because they are usually highly levered.
Isn't Earnings an accounting artifact?
Earnings could be inflated temporarily by creative accounting! An equity from the MFI screen could be the subject of earnings restatement. I don't believe vanilla ROIC or EY can guard against that. Greenblatt remarks that sophisticated investors such as himself can calculate forward-looking versions of these parameters.
Macroeconomic factors
Capital intensive industries tend to be cyclical. The MFI screening criteria doesn't seem to account for business cycles that may affect industry fundamentals.
Micro ($50m-$300m) vs Small ($300m-$2b) vs Mid ($2b-$10b) vs Large cap ($10b+)
In my experience micro and small cap pickings from MFI have shown a lot of volatility AND negative returns. My recommendation is to stick with mid & large cap.
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