Facts and Fictions in
The Securities Industry
1st EDITION
Sam Vaknin, Ph.D.
Editing and Design:
Lidija Rangelovska
Lidija Rangelovska
A Narcissus Publications Imprint, Skopje 2009
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Introduction
The securities industry worldwide is constructed upon the quicksand of self-delusion and socially-acceptable confabulations. These serve to hold together players and agents whose interests are both disparate and diametrically opposed. In the long run, the securities markets are zero-sum games and the only possible outcome is win-lose.
The first "dirty secret" is that a firm's market capitalization often stands in inverse proportion to its value and valuation (as measured by an objective, neutral, disinterested party). This is true especially when agents (management) are not also principals (owners).
Owing to its compensation structure, invariably tied to the firms' market capitalization, management strives to maximize the former by manipulating the latter. Very often, the only way to affect the firm's market capitalization in the short-term is to sacrifice the firm's interests and, therefore, its value in the medium to long-term (for instance, by doling out bonuses even as the firm is dying; by speculating on leverage; and by cooking the books).
The second open secret is that all modern financial markets are Ponzi (pyramid) schemes. The only viable exit strategy is by dumping one's holdings on future entrants. Fresh cash flows are crucial to sustaining ever increasing prices. Once these dry up, markets collapse in a heap.
Thus, the market prices of shares and, to a lesser extent debt instruments (especially corporate ones) are determined by three cash flows:
(i) The firm's future cash flows (incorporated into valuation models, such as the CAPM or FAR)
(ii) Future cash flows in securities markets (i.e., the ebb and flow of new entrants)
(iii) The present cash flows of current market participants
The confluence of these three cash streams translates into what we call "volatility" and reflects the risks inherent in the security itself (the firm's idiosyncratic risk) and the hazards of the market (known as alpha and beta coefficients).
In sum, stocks and share certificates do not represent ownership of the issuing enterprise at all. This is a myth, a convenient piece of fiction intended to pacify losers and lure "new blood" into the arena. Shareholders' claims on the firm's assets in cases of insolvency, bankruptcy, or liquidation are of inferior, or subordinate nature.
Stocks are shares are merely options (gambles) on the three cash flows enumerated above. Their prices wax and wane in accordance with expectations regarding the future net present values of these flows. Once the music stops, they are worth little.
The Value of Stocks of a Company
The debate rages all over Eastern and Central Europe, in countries in transition as well as in Western Europe. It raged in Britain during the 80s.
Is privatization really the robbery in disguise of state assets by a select few, cronies of the political regime? Margaret Thatcher was accused of it - and so were privatizers in developing countries. What price should state-owned companies have fetched? This question is not as simple and straightforward as it sounds.
There is a stock pricing mechanism known as the Stock Exchange. Willing buyers and willing sellers meet there to freely negotiate deals of stock purchases and sales. New information, macro-economic and micro-economic, determines the value of companies.
Greenspan testifies in the Senate, economic figures are released - and the rumour mill starts working: interest rates might go up. The stock market reacts with frenzily - it crashes. Why?
A top executive is asked how profitable will his firm be this quarter. He winks, he grins - this is interpreted by Wall Street to mean that profits will go up. The share price surges: no one wants to sell it, everyone want to buy it. The result: a sharp rise in its price. Why?
Moreover: the share price of a company of an identical size, similar financial ratios (and in the same industry) barely budges. Why not?
We say that the stocks of the two companies have different elasticity (their prices move up and down differently), probably the result of different sensitivities to changes in interest rates and in earnings estimates. But this is just to rename the problem. The question remains: Why do the shares of similar companies react differently?
Economy is a branch of psychology and wherever and whenever humans are involved, answers don't come easy. A few models have been developed and are in wide use but it is difficult to say that any of them has real predictive or even explanatory powers. Some of these models are "technical" in nature: they ignore the fundamentals of the company. Such models assume that all the relevant information is already incorporated in the price of the stock and that changes in expectations, hopes, fears and attitudes will be reflected in the prices immediately. Others are fundamental: these models rely on the company's performance and assets. The former models are applicable mostly to companies whose shares are traded publicly, in stock exchanges. They are not very useful in trying to attach a value to the stock of a private firm. The latter type (fundamental) models can be applied more broadly.
The value of a stock (a bond, a firm, real estate, or any asset) is the sum of the income (cash flow) that a reasonable investor would expect to get in the future, discounted at the appropriate rate. The discounting reflects the fact that money received in the future has lower (discounted) purchasing power than money received now. Moreover, we can invest money received now and get interest on it (which should normally equal the discount). Put differently: the discount reflects the loss in purchasing power of money deferred or the interest lost by not being able to invest the money right away. This is the time value of money.
Another problem is the uncertainty of future payments, or the risk that we will never receive them. The longer the payment period, the higher the risk, of course. A model exists which links time, the value of the stock, the cash flows expected in the future and the discount (interest) rates.
The rate that we use to discount future cash flows is the prevailing interest rate. This is partly true in stable, predictable and certain economies. But the discount rate depends on the inflation rate in the country where the firm is located (or, if a multinational, in all the countries where it operates), on the projected supply of and demand for its shares and on the aforementioned risk of non-payment. In certain places, additional factors must be taken into account (for example: country risk or foreign exchange risks).
The supply of a stock and, to a lesser extent, the demand for it determine its distribution (how many shareowners are there) and, as a result, its liquidity. Liquidity means how freely can one buy and sell it and at which quantities sought or sold do prices become rigid.
Example: if a controlling stake is sold - the buyer normally pays a "control premium". Another example: in thin markets it is easier to manipulate the price of a stock by artificially increasing the demand or decreasing the supply ("cornering" the market).
In a liquid market (no problems to buy and to sell), the discount rate is comprised of two elements: one is the risk-free rate (normally, the interest payable on government bonds), the other being the risk-related rate (the rate which reflects the risk related to the specific stock).
But what is this risk-related rate?
The most widely used model to evaluate specific risks is the Capital Asset Pricing Model (CAPM).
According to it, the discount rate is the risk-free rate plus a coefficient (called beta) multiplied by a risk premium general to all stocks (in the USA it was calculated to be 5.5%). Beta is a measure of the volatility of the return of the stock relative to that of the return of the market. A stock's Beta can be obtained by calculating the coefficient of the regression line between the weekly returns of the stock and those of the stock market during a selected period of time.
Unfortunately, different betas can be calculated by selecting different parameters (for instance, the length of the period on which the calculation is performed). Another problem is that betas change with every new datum. Professionals resort to sensitivity tests which neutralize the changes that betas undergo with time.
Still, with all its shortcomings and disputed assumptions, the CAPM should be used to determine the discount rate. But to use the discount rate we must have future cash flows to discount.
The only relatively certain cash flows are dividends paid to the shareholders. So, Dividend Discount Models (DDM) were developed.
Other models relate to the projected growth of the company (which is supposed to increase the payable dividends and to cause the stock to appreciate in value).
Still, DDM’s require, as input, the ultimate value of the stock and growth models are only suitable for mature firms with a stable, low dividend growth. Two-stage models are more powerful because they combine both emphases, on dividends and on growth. This is because of the life-cycle of firms. At first, they tend to have a high and unstable dividend growth rate (the DDM tackles this adequately). As the firm matures, it is expected to have a lower and stable growth rate, suitable for the treatment of Growth Models.
But how many years of future income (from dividends) should we use in our calculations? If a firm is profitable now, is there any guarantee that it will continue to be so in the next year, or the next decade? If it does continue to be profitable - who can guarantee that its dividend policy will not change and that the same rate of dividends will continue to be distributed?
The number of periods (normally, years) selected for the calculation is called the "price to earnings (P/E) multiple". The multiple denotes by how much we multiply the (after tax) earnings of the firm to obtain its value. It depends on the industry (growth or dying), the country (stable or geopolitically perilous), on the ownership structure (family or public), on the management in place (committed or mobile), on the product (new or old technology) and a myriad of other factors. It is almost impossible to objectively quantify or formulate this process of analysis and decision making. In telecommunications, the range of numbers used for valuing stocks of a private firm is between 7 and 10, for instance. If the company is in the public domain, the number can shoot up to 20 times net earnings.
While some companies pay dividends (some even borrow to do so), others do not. So in stock valuation, dividends are not the only future incomes you would expect to get. Capital gains (profits which are the result of the appreciation in the value of the stock) also count. This is the result of expectations regarding the firm's free cash flow, in particular the free cash flow that goes to the shareholders.
There is no agreement as to what constitutes free cash flow. In general, it is the cash which a firm has after sufficiently investing in its development, research and (predetermined) growth. Cash Flow Statements have become a standard accounting requirement in the 80s (starting with the USA). Because "free" cash flow can be easily extracted from these reports, stock valuation based on free cash flow became increasingly popular and feasible. Cash flow statements are considered independent of the idiosyncratic parameters of different international environments and therefore applicable to multinationals or to national, export-orientated firms.
The free cash flow of a firm that is debt-financed solely by its shareholders belongs solely to them. Free cash flow to equity (FCFE) is:
FCFE = Operating Cash Flow MINUS Cash needed for meeting growth targets
Where:
Operating Cash Flow = Net Income (NI) PLUS Depreciation and Amortization
Cash needed for meeting growth targets = Capital Expenditures + Change in Working Capital
Working Capital = Total Current Assets - Total Current Liabilities
Change in Working Capital = One Year's Working Capital MINUS Previous Year's Working Capital
The complete formula is:
FCFE = Net Income PLUS
Depreciation and Amortization MINUS
Capital Expenditures PLUS
Change in Working Capital
A leveraged firm that borrowed money from other sources (even from preferred stock holders) exhibits a different free cash flow to equity. Its CFCE must be adjusted to reflect the preferred dividends and principal repayments of debt (MINUS sign) and the proceeds from new debt and preferred stocks (PLUS sign). If its borrowings are sufficient to pay the dividends to the holders of preference shares and to service its debt - its debt to capital ratio is sound.
The FCFE of a leveraged firm is:
FCFE = Net Income PLUS
Depreciation and Amortization MINUS
Principal Repayment of Debt MINUS
Preferred Dividends PLUS
Proceeds from New Debt and Preferred MINUS
Capital Expenditures MINUS
Changes in Working Capital
A sound debt ratio means:
FCFE = Net Income MINUS
(1 - Debt Ratio)*(Capital Expenditures MINUS
Depreciation and Amortization PLUS
Change in Working Capital)
Also Read:
The Myth of the Earnings Yield
The Friendly Trend - Technical vs. Fundamental Analysis
The Roller Coaster Market - On Volatility and Risk
The Process of Due Diligence
A business which wants to attract foreign investments must present a business plan. But a business plan is the equivalent of a visit card. The introduction is very important - but, once the foreign investor has expressed interest, a second, more serious, more onerous and more tedious process commences: Due Diligence.
"Due Diligence" is a legal term (borrowed from the securities industry). It means, essentially, to make sure that all the facts regarding the firm are available and have been independently verified. In some respects, it is very similar to an audit. All the documents of the firm are assembled and reviewed, the management is interviewed and a team of financial experts, lawyers and accountants descends on the firm to analyze it.
First Rule:
The firm must appoint ONE due diligence coordinator. This person interfaces with all outside due diligence teams. He collects all the materials requested and oversees all the activities which make up the due diligence process.
The firm must have ONE VOICE. Only one person represents the company, answers questions, makes presentations and serves as a coordinator when the DD teams wish to interview people connected to the firm.
Second Rule:
Brief your workers. Give them the big picture. Why is the company raising funds, who are the investors, how will the future of the firm (and their personal future) look if the investor comes in. Both employees and management must realize that this is a top priority. They must be instructed not to lie. They must know the DD coordinator and the company's spokesman in the DD process.
The DD is a process which is more structured than the preparation of a Business Plan. It is confined both in time and in subjects: Legal, Financial, Technical, Marketing, Controls.
The Marketing Plan
Must include the following elements:
A brief history of the business (to show its track performance and growth).
Points regarding the political, legal (licences) and competitive environment.
A vision of the business in the future.
Products and services and their uses.
Comparison of the firm's products and services to those of the competitors.
Warranties, guarantees and after-sales service.
Development of new products or services.
A general overview of the market and market segmentation.
Is the market rising or falling (the trend: past and future).
What customer needs do the products / services satisfy.
Which markets segments do we concentrate on and why.
What factors are important in the customer's decision to buy (or not to buy).
A list of the direct competitors and a short description of each.
The strengths and weaknesses of the competitors relative to the firm.
Missing information regarding the markets, the clients and the competitors.
Planned market research.
A sales forecast by product group.
The pricing strategy (how is pricing decided).
Promotion of the sales of the products (including a description of the sales force, sales-related incentives, sales targets, training of the sales personnel, special offers, dealerships, telemarketing and sales support). Attach a flow chart of the purchasing process from the moment that the client is approached by the sales force until he buys the product.
Marketing and advertising campaigns (including cost estimates) - broken by market and by media.
Distribution of the products.
A flow chart describing the receipt of orders, invoicing, shipping.
Customer after-sales service (hotline, support, maintenance, complaints, upgrades, etc.).
Customer loyalty (example: churn rate and how is it monitored and controlled).
Legal Details
Full name of the firm.
Ownership of the firm.
Court registration documents.
Copies of all protocols of the Board of Directors and the General Assembly of Shareholders.
Signatory rights backed by the appropriate decisions.
The charter (statute) of the firm and other incorporation documents.
Copies of licences granted to the firm.
A legal opinion regarding the above licences.
A list of lawsuit that were filed against the firm and that the firm filed against third parties (litigation) plus a list of disputes which are likely to reach the courts.
Legal opinions regarding the possible outcomes of all the lawsuits and disputes including their potential influence on the firm.
Financial Due Diligence
Last 3 years income statements of the firm or of constituents of the firm, if the firm is the result of a merger. The statements have to include:
Balance Sheets;
Income Statements;
Cash Flow statements;
Audit reports (preferably done according to the International Accounting Standards, or, if the firm is looking to raise money in the USA, in accordance with FASB);
Cash Flow Projections and the assumptions underlying them.
Controls
Accounting systems used;
Methods to price products and services;
Payment terms, collections of debts and ageing of receivables;
Introduction of international accounting standards;
Monitoring of sales;
Monitoring of orders and shipments;
Keeping of records, filing, archives;
Cost accounting system;
Budgeting and budget monitoring and controls;
Internal audits (frequency and procedures);
External audits (frequency and procedures);
The banks that the firm is working with: history, references, balances.
Technical Plan
Description of manufacturing processes (hardware, software, communications, other);
Need for know-how, technological transfer and licensing required;
Suppliers of equipment, software, services (including offers);
Manpower (skilled and unskilled);
Infrastructure (power, water, etc.);
Transport and communications (example: satellites, lines, receivers, transmitters);
Raw materials: sources, cost and quality;
Relations with suppliers and support industries;
Import restrictions or licensing (where applicable);
Sites, technical specification;
Environmental issues and how they are addressed;
Leases, special arrangements;
Integration of new operations into existing ones (protocols, etc.).
A successful due diligence is the key to an eventual investment. This is a process much more serious and important than the preparation of the Business Plan.
Financial Investor, Strategic Investor
In the not so distant past, there was little difference between financial and strategic investors. Investors of all colors sought to safeguard their investment by taking over as many management functions as they could. Additionally, investments were small and shareholders few. A firm resembled a household and the number of people involved – in ownership and in management – was correspondingly limited. People invested in industries they were acquainted with first hand.
As markets grew, the scales of industrial production (and of service provision) expanded. A single investor (or a small group of investors) could no longer accommodate the needs even of a single firm. As knowledge increased and specialization ensued – it was no longer feasible or possible to micro-manage a firm one invested in. Actually, separate businesses of money making and business management emerged. An investor was expected to excel in obtaining high yields on his capital – not in industrial management or in marketing. A manager was expected to manage, not to be capable of personally tackling the various and varying tasks of the business that he managed.
Thus, two classes of investors emerged. One type supplied firms with capital. The other type supplied them with know-how, technology, management skills, marketing techniques, intellectual property, clientele and a vision, a sense of direction.
In many cases, the strategic investor also provided the necessary funding. But, more and more, a separation was maintained. Venture capital and risk capital funds, for instance, are purely financial investors. So are, to a growing extent, investment banks and other financial institutions.
The financial investor represents the past. Its money is the result of past - right and wrong - decisions. Its orientation is short term: an "exit strategy" is sought as soon as feasible. For "exit strategy" read quick profits. The financial investor is always on the lookout, searching for willing buyers for his stake. The stock exchange is a popular exit strategy. The financial investor has little interest in the company's management. Optimally, his money buys for him not only a good product and a good market, but also a good management. But his interpretation of the rolls and functions of "good management" are very different to that offered by the strategic investor. The financial investor is satisfied with a management team which maximizes value. The price of his shares is the most important indication of success. This is "bottom line" short termism which also characterizes operators in the capital markets. Invested in so many ventures and companies, the financial investor has no interest, nor the resources to get seriously involved in any one of them. Micro-management is left to others - but, in many cases, so is macro-management. The financial investor participates in quarterly or annual general shareholders meetings. This is the extent of its involvement.
The strategic investor, on the other hand, represents the real long term accumulator of value. Paradoxically, it is the strategic investor that has the greater influence on the value of the company's shares. The quality of management, the rate of the introduction of new products, the success or failure of marketing strategies, the level of customer satisfaction, the education of the workforce - all depend on the strategic investor. That there is a strong relationship between the quality and decisions of the strategic investor and the share price is small wonder. The strategic investor represents a discounted future in the same manner that shares do. Indeed, gradually, the balance between financial investors and strategic investors is shifting in favour of the latter. People understand that money is abundant and what is in short supply is good management. Given the ability to create a brand, to generate profits, to issue new products and to acquire new clients - money is abundant.
These are the functions normally reserved to financial investors:
Financial Management
The financial investor is expected to take over the financial management of the firm and to directly appoint the senior management and, especially, the management echelons, which directly deal with the finances of the firm.
To regulate, supervise and implement a timely, full and accurate set of accounting books of the firm reflecting all its activities in a manner commensurate with the relevant legislation and regulation in the territories of operations of the firm and with internal guidelines set from time to time by the Board of Directors of the firm. This is usually achieved both during a Due Diligence process and later, as financial management is implemented.
To implement continuous financial audit and control systems to monitor the performance of the firm, its flow of funds, the adherence to the budget, the expenditures, the income, the cost of sales and other budgetary items.
To timely, regularly and duly prepare and present to the Board of Directors financial statements and reports as required by all pertinent laws and regulations in the territories of the operations of the firm and as deemed necessary and demanded from time to time by the Board of Directors of the Firm.
To comply with all reporting, accounting and audit requirements imposed by the capital markets or regulatory bodies of capital markets in which the securities of the firm are traded or are about to be traded or otherwise listed.
To prepare and present for the approval of the Board of Directors an annual budget, other budgets, financial plans, business plans, feasibility studies, investment memoranda and all other financial and business documents as may be required from time to time by the Board of Directors of the Firm.
To alert the Board of Directors and to warn it regarding any irregularity, lack of compliance, lack of adherence, lacunas and problems whether actual or potential concerning the financial systems, the financial operations, the financing plans, the accounting, the audits, the budgets and any other matter of a financial nature or which could or does have a financial implication.
To collaborate and coordinate the activities of outside suppliers of financial services hired or contracted by the firm, including accountants, auditors, financial consultants, underwriters and brokers, the banking system and other financial venues.
To maintain a working relationship and to develop additional relationships with banks, financial institutions and capital markets with the aim of securing the funds necessary for the operations of the firm, the attainment of its development plans and its investments.
To fully computerize all the above activities in a combined hardware-software and communications system which will integrate into the systems of other members of the group of companies.
Otherwise, to initiate and engage in all manner of activities, whether financial or of other nature, conducive to the financial health, the growth prospects and the fulfillment of investment plans of the firm to the best of his ability and with the appropriate dedication of the time and efforts required.
Collection and Credit Assessment
To construct and implement credit risk assessment tools, questionnaires, quantitative methods, data gathering methods and venues in order to properly evaluate and predict the credit risk rating of a client, distributor, or supplier.
To constantly monitor and analyse the payment morale, regularity, non-payment and non-performance events, etc. – in order to determine the changes in the credit risk rating of said factors.
To analyse receivables and collectibles on a regular and timely basis.
To improve the collection methods in order to reduce the amounts of arrears and overdue payments, or the average period of such arrears and overdue payments.
To collaborate with legal institutions, law enforcement agencies and private collection firms in assuring the timely flow and payment of all due payments, arrears and overdue payments and other collectibles.
To coordinate an educational campaign to ensure the voluntary collaboration of the clients, distributors and other debtors in the timely and orderly payment of their dues.
The strategic investor is, usually, put in charge of the following:
Project Planning and Project Management
The strategic investor is uniquely positioned to plan the technical side of the project and to implement it. He is, therefore, put in charge of:
The selection of infrastructure, equipment, raw materials, industrial processes, etc.;
Negotiations and agreements with providers and suppliers;
Minimizing the costs of infrastructure by deploying proprietary components and planning;
The provision of corporate guarantees and letters of comfort to suppliers;
The planning and erecting of the various sites, structures, buildings, premises, factories, etc.;
The planning and implementation of line connections, computer network connections, protocols, solving issues of compatibility (hardware and software, etc.);
Project planning, implementation and supervision.
Marketing and Sales
The presentation to the Board an annual plan of sales and marketing including: market penetration targets, profiles of potential social and economic categories of clients, sales promotion methods, advertising campaigns, image, public relations and other media campaigns. The strategic investor also implements these plans or supervises their implementation.
The strategic investor is usually possessed of a brandname recognized in many countries. It is the market leaders in certain territories. It has been providing goods and services to users for a long period of time, reliably. This is an important asset, which, if properly used, can attract users. The enhancement of the brandname, its recognition and market awareness, market penetration, co-branding, collaboration with other suppliers – are all the responsibilities of the strategic investor.
The dissemination of the product as a preferred choice among vendors, distributors, individual users and businesses in the territory.
Special events, sponsorships, collaboration with businesses.
The planning and implementation of incentive systems (e.g., points, vouchers).
The strategic investor usually organizes a distribution and dealership network, a franchising network, or a sales network (retail chains) including: training, pricing, pecuniary and quality supervision, network control, inventory and accounting controls, advertising, local marketing and sales promotion and other network management functions.
The strategic investor is also in charge of "vision thinking": new methods of operation, new marketing ploys, new market niches, predicting the future trends and market needs, market analyses and research, etc.
The strategic investor typically brings to the firm valuable experience in marketing and sales. It has numerous off the shelf marketing plans and drawer sales promotion campaigns. It developed software and personnel capable of analysing any market into effective niches and of creating the right media (image and PR), advertising and sales promotion drives best suited for it. It has built large databases with multi-year profiles of the purchasing patterns and demographic data related to thousands of clients in many countries. It owns libraries of material, images, sounds, paper clippings, articles, PR and image materials, and proprietary trademarks and brand names. Above all, it accumulated years of marketing and sales promotion ideas which crystallized into a new conception of the business.
Technology
The planning and implementation of new technological systems up to their fully operational phase. The strategic partner's engineers are available to plan, implement and supervise all the stages of the technological side of the business.
The planning and implementation of a fully operative computer system (hardware, software, communication, intranet) to deal with all the aspects of the structure and the operation of the firm. The strategic investor puts at the disposal of the firm proprietary software developed by it and specifically tailored to the needs of companies operating in the firm's market.
The encouragement of the development of in-house, proprietary, technological solutions to the needs of the firm, its clients and suppliers.
The planning and the execution of an integration program with new technologies in the field, in collaboration with other suppliers or market technological leaders.
Education and Training
The strategic investor is responsible to train all the personnel in the firm: operators, customer services, distributors, vendors, sales personnel. The training is conducted at its sole expense and includes tours of its facilities abroad.
The entrepreneurs – who sought to introduce the two types of investors, in the first place – are usually left with the following functions:
Administration and Control
To structure the firm in an optimal manner, most conducive to the conduct of its business and to present the new structure for the Board's approval within 30 days from the date of the GM's appointment.
To run the day to day business of the firm.
To oversee the personnel of the firm and to resolve all the personnel issues.
To secure the unobstructed flow of relevant information and the protection of confidential organization.
To represent the firm in its contacts, representations and negotiations with other firms, authorities, or persons.
This is why entrepreneurs find it very hard to cohabitate with investors of any kind. Entrepreneurs are excellent at identifying the needs of the market and at introducing technological or service solutions to satisfy such needs. But the very personality traits which qualify them to become entrepreneurs – also hinder the future development of their firms. Only the introduction of outside investors can resolve the dilemma. Outside investors are not emotionally involved. They may be less visionary – but also more experienced.
They are more interested in business results than in dreams. And – being well acquainted with entrepreneurs – they insist on having unmitigated control of the business, for fear of losing all their money. These things antagonize the entrepreneurs. They feel that they are losing their creation to cold-hearted, mean spirited, corporate predators. They rebel and prefer to remain small or even to close shop than to give up their cherished freedoms. This is where nine out of ten entrepreneurs fail - in knowing when to let go.
The Myth of the Earnings Yield
In American novels, well into the 1950's, one finds protagonists using the future stream of dividends emanating from their share holdings to send their kids to college or as collateral. Yet, dividends seemed to have gone the way of the Hula-Hoop. Few companies distribute erratic and ever-declining dividends. The vast majority don't bother. The unfavorable tax treatment of distributed profits may have been the cause.
The dwindling of dividends has implications which are nothing short of revolutionary. Most of the financial theories we use to determine the value of shares were developed in the 1950's and 1960's, when dividends were in vogue. They invariably relied on a few implicit and explicit assumptions:
That the fair "value" of a share is closely correlated to its market price;
That price movements are mostly random, though somehow related to the aforementioned "value" of the share. In other words, the price of a security is supposed to converge with its fair "value" in the long term;
That the fair value responds to new information about the firm and reflects it - though how efficiently is debatable. The strong efficiency market hypothesis assumes that new information is fully incorporated in prices instantaneously.
But how is the fair value to be determined?
A discount rate is applied to the stream of all future income from the share - i.e., its dividends. What should this rate be is sometimes hotly disputed - but usually it is the coupon of "riskless" securities, such as treasury bonds. But since few companies distribute dividends - theoreticians and analysts are increasingly forced to deal with "expected" dividends rather than "paid out" or actual ones.
The best proxy for expected dividends is net earnings. The higher the earnings - the likelier and the higher the dividends. Thus, in a subtle cognitive dissonance, retained earnings - often plundered by rapacious managers - came to be regarded as some kind of deferred dividends.
The rationale is that retained earnings, once re-invested, generate additional earnings. Such a virtuous cycle increases the likelihood and size of future dividends. Even undistributed earnings, goes the refrain, provide a rate of return, or a yield - known as the earnings yield. The original meaning of the word "yield" - income realized by an investor - was undermined by this Newspeak.
Why was this oxymoron - the "earnings yield" - perpetuated?
According to all current theories of finance, in the absence of dividends - shares are worthless. The value of an investor's holdings is determined by the income he stands to receive from them. No income - no value. Of course, an investor can always sell his holdings to other investors and realize capital gains (or losses). But capital gains - though also driven by earnings hype - do not feature in financial models of stock valuation.
Faced with a dearth of dividends, market participants - and especially Wall Street firms - could obviously not live with the ensuing zero valuation of securities. They resorted to substituting future dividends - the outcome of capital accumulation and re-investment - for present ones. The myth was born.
Thus, financial market theories starkly contrast with market realities.
No one buys shares because he expects to collect an uninterrupted and equiponderant stream of future income in the form of dividends. Even the most gullible novice knows that dividends are a mere apologue, a relic of the past. So why do investors buy shares? Because they hope to sell them to other investors later at a higher price.
While past investors looked to dividends to realize income from their shareholdings - present investors are more into capital gains. The market price of a share reflects its discounted expected capital gains, the discount rate being its volatility. It has little to do with its discounted future stream of dividends, as current financial theories teach us.
But, if so, why the volatility in share prices, i.e., why are share prices distributed? Surely, since, in liquid markets, there are always buyers - the price should stabilize around an equilibrium point.
It would seem that share prices incorporate expectations regarding the availability of willing and able buyers, i.e., of investors with sufficient liquidity. Such expectations are influenced by the price level - it is more difficult to find buyers at higher prices - by the general market sentiment, and by externalities and new information, including new information about earnings.
The capital gain anticipated by a rational investor takes into consideration both the expected discounted earnings of the firm and market volatility - the latter being a measure of the expected distribution of willing and able buyers at any given price. Still, if earnings are retained and not transmitted to the investor as dividends - why should they affect the price of the share, i.e., why should they alter the capital gain?
Earnings serve merely as a yardstick, a calibrator, a benchmark figure. Capital gains are, by definition, an increase in the market price of a security. Such an increase is more often than not correlated with the future stream of income to the firm - though not necessarily to the shareholder. Correlation does not always imply causation. Stronger earnings may not be the cause of the increase in the share price and the resulting capital gain. But whatever the relationship, there is no doubt that earnings are a good proxy to capital gains.
Hence investors' obsession with earnings figures. Higher earnings rarely translate into higher dividends. But earnings - if not fiddled - are an excellent predictor of the future value of the firm and, thus, of expected capital gains. Higher earnings and a higher market valuation of the firm make investors more willing to purchase the stock at a higher price - i.e., to pay a premium which translates into capital gains.
The fundamental determinant of future income from share holding was replaced by the expected value of share-ownership. It is a shift from an efficient market - where all new information is instantaneously available to all rational investors and is immediately incorporated in the price of the share - to an inefficient market where the most critical information is elusive: how many investors are willing and able to buy the share at a given price at a given moment.
A market driven by streams of income from holding securities is "open". It reacts efficiently to new information. But it is also "closed" because it is a zero sum game. One investor's gain is another's loss. The distribution of gains and losses in the long term is pretty even, i.e., random. The price level revolves around an anchor, supposedly the fair value.
A market driven by expected capital gains is also "open" in a way because, much like less reputable pyramid schemes, it depends on new capital and new investors. As long as new money keeps pouring in, capital gains expectations are maintained - though not necessarily realized.
But the amount of new money is finite and, in this sense, this kind of market is essentially a "closed" one. When sources of funding are exhausted, the bubble bursts and prices decline precipitously. This is commonly described as an "asset bubble".
This is why current investment portfolio models (like CAPM) are unlikely to work. Both shares and markets move in tandem (contagion) because they are exclusively swayed by the availability of future buyers at given prices. This renders diversification inefficacious. As long as considerations of "expected liquidity" do not constitute an explicit part of income-based models, the market will render them increasingly irrelevant.
Technical vs. Fundamental Analysis of Stocks
The authors of a paper published by NBER on March 2000 and titled "The Foundations of Technical Analysis" - Andrew Lo, Harry Mamaysky, and Jiang Wang - claim that:
"Technical analysis, also known as 'charting', has been part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis.
One of the main obstacles is the highly subjective nature of technical analysis - the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper we offer a systematic and automatic approach to technical pattern recognition ... and apply the method to a large number of US stocks from 1962 to 1996..."
And the conclusion:
" ... Over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value."
These hopeful inferences are supported by the work of other scholars, such as Paul Weller of the Finance Department of the university of Iowa. While he admits the limitations of technical analysis - it is a-theoretic and data intensive, pattern over-fitting can be a problem, its rules are often difficult to interpret, and the statistical testing is cumbersome - he insists that "trading rules are picking up patterns in the data not accounted for by standard statistical models" and that the excess returns thus generated are not simply a risk premium.
Technical analysts have flourished and waned in line with the stock exchange bubble. They and their multi-colored charts regularly graced CNBC, the CNN and other market-driving channels. "The Economist" found that many successful fund managers have regularly resorted to technical analysis - including George Soros' Quantum Hedge fund and Fidelity's Magellan. Technical analysis may experience a revival now that corporate accounts - the fundament of fundamental analysis - have been rendered moot by seemingly inexhaustible scandals.
The field is the progeny of Charles Dow of Dow Jones fame and the founder of the "Wall Street Journal". He devised a method to discern cyclical patterns in share prices. Other sages - such as Elliott - put forth complex "wave theories". Technical analysts now regularly employ dozens of geometric configurations in their divinations.
Technical analysis is defined thus in "The Econometrics of Financial Markets", a 1997 textbook authored by John Campbell, Andrew Lo, and Craig MacKinlay:
"An approach to investment management based on the belief that historical price series, trading volume, and other market statistics exhibit regularities - often ... in the form of geometric patterns ... that can be profitably exploited to extrapolate future price movements."
A less fanciful definition may be the one offered by Edwards and Magee in "Technical Analysis of Stock Trends":
"The science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in 'the averages' and then deducing from that pictured history the probable future trend."
Fundamental analysis is about the study of key statistics from the financial statements of firms as well as background information about the company's products, business plan, management, industry, the economy, and the marketplace.
Economists, since the 1960's, sought to rebuff technical analysis. Markets, they say, are efficient and "walk" randomly. Prices reflect all the information known to market players - including all the information pertaining to the future. Technical analysis has often been compared to voodoo, alchemy, and astrology - for instance by Burton Malkiel in his seminal work, "A Random Walk Down Wall Street".
The paradox is that technicians are more orthodox than the most devout academic. They adhere to the strong version of market efficiency. The market is so efficient, they say, that nothing can be gleaned from fundamental analysis. All fundamental insights, information, and analyses are already reflected in the price. This is why one can deduce future prices from past and present ones.
Jack Schwager, sums it up in his book "Schwager on Futures: Technical Analysis", quoted by Stockcharts.com:
"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."
Not so, retort the fundamentalists. The fair value of a security or a market can be derived from available information using mathematical models - but is rarely reflected in prices. This is the weak version of the market efficiency hypothesis.
The mathematically convenient idealization of the efficient market, though, has been debunked in numerous studies. These are efficiently summarized in Craig McKinlay and Andrew Lo's tome "A Non-random Walk Down Wall Street" published in 1999.
Not all markets are strongly efficient. Most of them sport weak or "semi-strong" efficiency. In some markets, a filter model - one that dictates the timing of sales and purchases - could prove useful. This is especially true when the equilibrium price of a share - or of the market as a whole - changes as a result of externalities.
Substantive news, change in management, an oil shock, a terrorist attack, an accounting scandal, an FDA approval, a major contract, or a natural, or man-made disaster - all cause share prices and market indices to break the boundaries of the price band that they have occupied. Technical analysts identify these boundaries and trace breakthroughs and their outcomes in terms of prices.
Technical analysis may be nothing more than a self-fulfilling prophecy, though. The more devotees it has, the stronger it affects the shares or markets it analyses. Investors move in herds and are inclined to seek patterns in the often bewildering marketplace. As opposed to the assumptions underlying the classic theory of portfolio analysis - investors do remember past prices. They hesitate before they cross certain numerical thresholds.
But this herd mentality is also the Achilles heel of technical analysis. If everyone were to follow its guidance - it would have been rendered useless. If everyone were to buy and sell at the same time - based on the same technical advice - price advantages would have been arbitraged away instantaneously. Technical analysis is about privileged information to the privileged few - though not too few, lest prices are not swayed.
Studies cited in Edwin Elton and Martin Gruber's "Modern Portfolio Theory and Investment Analysis" and elsewhere show that a filter model - trading with technical analysis - is preferable to a "buy and hold" strategy but inferior to trading at random. Trading against recommendations issued by a technical analysis model and with them - yielded the same results. Fama-Blum discovered that the advantage proffered by such models is identical to transaction costs.
The proponents of technical analysis claim that rather than forming investor psychology - it reflects their risk aversion at different price levels. Moreover, the borders between the two forms of analysis - technical and fundamental - are less sharply demarcated nowadays. "Fundamentalists" insert past prices and volume data in their models - and "technicians" incorporate arcana such as the dividend stream and past earnings in theirs.
It is not clear why should fundamental analysis be considered superior to its technical alternative. If prices incorporate all the information known and reflect it - predicting future prices would be impossible regardless of the method employed. Conversely, if prices do not reflect all the information available, then surely investor psychology is as important a factor as the firm's - now oft-discredited - financial statements?
Prices, after all, are the outcome of numerous interactions among market participants, their greed, fears, hopes, expectations, and risk aversion. Surely studying this emotional and cognitive landscape is as crucial as figuring the effects of cuts in interest rates or a change of CEO?
Still, even if we accept the rigorous version of market efficiency - i.e., as Aswath Damodaran of the Stern Business School at NYU puts it, that market prices are "unbiased estimates of the true value of investments" - prices do react to new information - and, more importantly, to anticipated information. It takes them time to do so. Their reaction constitutes a trend and identifying this trend at its inception can generate excess yields. On this both fundamental and technical analysis are agreed.
Moreover, markets often over-react: they undershoot or overshoot the "true and fair value". Fundamental analysis calls this oversold and overbought markets. The correction back to equilibrium prices sometimes takes years. A savvy trader can profit from such market failures and excesses.
As quality information becomes ubiquitous and instantaneous, research issued by investment banks discredited, privileged access to information by analysts prohibited, derivatives proliferate, individual participation in the stock market increases, and transaction costs turn negligible - a major rethink of our antiquated financial models is called for.
The maverick Andrew Lo, a professor of finance at the Sloan School of Management at MIT, summed up the lure of technical analysis in lyric terms in an interview he gave to Traders.com's "Technical Analysis of Stocks and Commodities", quoted by Arthur Hill in Stockcharts.com:
"The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas."
Also Read:
The Myth of the Earnings Yield
Portfolio Management Theory and Technical Analysis Lecture Notes
Volatility and Risk
Volatility is considered the most accurate measure of risk and, by extension, of return, its flip side. The higher the volatility, the higher the risk - and the reward. That volatility increases in the transition from bull to bear markets seems to support this pet theory. But how to account for surging volatility in plummeting bourses? At the depths of the bear phase, volatility and risk increase while returns evaporate - even taking short-selling into account.
"The Economist" has recently proposed yet another dimension of risk:
"The Chicago Board Options Exchange's VIX index, a measure of traders' expectations of share price gyrations, in July reached levels not seen since the 1987 crash, and shot up again (two weeks ago)... Over the past five years, volatility spikes have become ever more frequent, from the Asian crisis in 1997 right up to the World Trade Centre attacks. Moreover, it is not just price gyrations that have increased, but the volatility of volatility itself. The markets, it seems, now have an added dimension of risk."
Call-writing has soared as punters, fund managers, and institutional investors try to eke an extra return out of the wild ride and to protect their dwindling equity portfolios. Naked strategies - selling options contracts or buying them in the absence of an investment portfolio of underlying assets - translate into the trading of volatility itself and, hence, of risk. Short-selling and spread-betting funds join single stock futures in profiting from the downside.
Market - also known as beta or systematic - risk and volatility reflect underlying problems with the economy as a whole and with corporate governance: lack of transparency, bad loans, default rates, uncertainty, illiquidity, external shocks, and other negative externalities. The behavior of a specific security reveals additional, idiosyncratic, risks, known as alpha.
Quantifying volatility has yielded an equal number of Nobel prizes and controversies. The vacillation of security prices is often measured by a coefficient of variation within the Black-Scholes formula published in 1973. Volatility is implicitly defined as the standard deviation of the yield of an asset. The value of an option increases with volatility. The higher the volatility the greater the option's chance during its life to be "in the money" - convertible to the underlying asset at a handsome profit.
Without delving too deeply into the model, this mathematical expression works well during trends and fails miserably when the markets change sign. There is disagreement among scholars and traders whether one should better use historical data or current market prices - which include expectations - to estimate volatility and to price options correctly.
From "The Econometrics of Financial Markets" by John Campbell, Andrew Lo, and Craig MacKinlay, Princeton University Press, 1997:
"Consider the argument that implied volatilities are better forecasts of future volatility because changing market conditions cause volatilities (to) vary through time stochastically, and historical volatilities cannot adjust to changing market conditions as rapidly. The folly of this argument lies in the fact that stochastic volatility contradicts the assumption required by the B-S model - if volatilities do change stochastically through time, the Black-Scholes formula is no longer the correct pricing formula and an implied volatility derived from the Black-Scholes formula provides no new information."
Black-Scholes is thought deficient on other issues as well. The implied volatilities of different options on the same stock tend to vary, defying the formula's postulate that a single stock can be associated with only one value of implied volatility. The model assumes a certain - geometric Brownian - distribution of stock prices that has been shown to not apply to US markets, among others.
Studies
have exposed serious departures from the price process fundamental to
Black-Scholes: skewness, excess kurtosis (i.e., concentration of
prices around the mean), serial correlation, and time varying
volatilities. Black-Scholes tackles stochastic volatility poorly. The
formula also unrealistically assumes that the market dickers
continuously, ignoring transaction costs and institutional
constraints. No wonder that traders use Black-Scholes as a heuristic
rather than a price-setting formula.
Volatility also decreases
in administered markets and over different spans of time. As opposed
to the received wisdom of the random walk model, most investment
vehicles sport different volatilities over different time horizons.
Volatility is especially high when both supply and demand are
inelastic and liable to large, random shocks. This is why the prices
of industrial goods are less volatile than the prices of shares, or
commodities.
But why are stocks and exchange rates volatile to start with? Why don't they follow a smooth evolutionary path in line, say, with inflation, or interest rates, or productivity, or net earnings?
To start with, because economic fundamentals fluctuate - sometimes as wildly as shares. The Fed has cut interest rates 11 times in the past 12 months down to 1.75 percent - the lowest level in 40 years. Inflation gyrated from double digits to a single digit in the space of two decades. This uncertainty is, inevitably, incorporated in the price signal.
Moreover, because of time lags in the dissemination of data and its assimilation in the prevailing operational model of the economy - prices tend to overshoot both ways. The economist Rudiger Dornbusch, who died last month, studied in his seminal paper, "Expectations and Exchange Rate Dynamics", published in 1975, the apparently irrational ebb and flow of floating currencies.
His conclusion was that markets overshoot in response to surprising changes in economic variables. A sudden increase in the money supply, for instance, axes interest rates and causes the currency to depreciate. The rational outcome should have been a panic sale of obligations denominated in the collapsing currency. But the devaluation is so excessive that people reasonably expect a rebound - i.e., an appreciation of the currency - and purchase bonds rather than dispose of them.
Yet, even Dornbusch ignored the fact that some price twirls have nothing to do with economic policies or realities, or with the emergence of new information - and a lot to do with mass psychology. How else can we account for the crash of October 1987? This goes to the heart of the undecided debate between technical and fundamental analysts.
As Robert Shiller has demonstrated in his tomes "Market Volatility" and "Irrational Exuberance", the volatility of stock prices exceeds the predictions yielded by any efficient market hypothesis, or by discounted streams of future dividends, or earnings. Yet, this finding is hotly disputed.
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