My Students Are NOT Off To A Good Start

This semester I tried something a bit different in my security analysis class. Since the finance principles (i.e. required core finance) class is a prerequisite for this one, I always assumed that they had at least a fair grasp of the basics (like time value, using their financial calculator, constant dividend growth valuation, and so on). This time, the first day of class, I announced that they'd get a quiz at the beginning of the second week on "the basics). I figured this would serve two purposes: It would give me (and them) a better idea as to what they retain from their previous classes. And just as important, since it counted toward their grade, it would give them an incentive to review the material at the beginning of class. The questions I said I'd give them included:

• A couple of questions on time value (PV of a lump sum, PV of an annuity, find the interest rate on the FV of an annuity)
  
• A constant dividend growth stock valuation problem
• A non-constant dividend growth valuation problem
• An NPV problem
• An IRR problem
• A CAPM question
• A basic question on financial statements

The results were eye-opening, and not exactly in a good way. Although the questions were pretty basic (except for the non-constant dividend growth problem), the average score was about 65, and only 3 out of the 45 students got a perfect score. Let's just say that it was a less than stellar grasp of the material. So, I told them that those who got less than 80% have a LOT of catching up to do.

After all, if they don't understand the basics, they surely won't get the more advanced material. And I simply don't have the time to review everything they're supposed to know from the class they supposedly already passed. After all, they ARE mostly finance majors.

At least I didn't teach the principles class, so I get to grouse about those who did...
It should be interesting. I think the herd may be losing a few slow antelopes shortly.

A Good Day, and A Good Ride

This was a good day - I went into the office around 11:00, finished a paper to send to a conference and then finished my PowerPoint slides for the next week's classes.

Then I went on a 22 mile bike ride. It was a bit windy, but other than that,conditions were just about perfect for a long ride - mostly flat terrain with just enough gently rolling hills to make it interesting, and a temperature of 64 degrees. It was so nice that I actually ended up holding a faster pace for the 22 mile ride than I usually do for my 16 mile course. I even passed one of my students on the road. I wonder how he felt getting smoked by a teacher more than twice his age?

Hey - I may be carrying about 15 extra pounds, but my legs and cardio are both in pretty good shape. O.K - enough bragging...

Now, it's time to read a bit to the Unknown Son before bed (Unknown Daughter is at a friend's house). The kids just watched Lemony Snicketts, so now he's reading the books (he just got the first two from the library). I particularly like them because they use some pretty complicated words, but follow them with an explanation in an aside). So, they're great not just for the story itself but also for feeding the lad's inner nerd.

How Much Should CEOs Be Paid?

There's a great editorial in today's WSJ by Robert Reich, titled "CEOs Deserve Their Pay (note: online subscription may be required). He starts out with the usual facts that get compensation activists so lathered up: the average CEO compensation for a Fortune 500 firm made almost $11 million last year (about 364 times the average employee's salary), and the 20 highest-paid execs earned an average of 436 million.

Reich then goes on to explain the increase in CEO pay over time as a rational consequence of increasing competition. In other words, 50 years ago, most large firms were in oligopolistic industries, with stable unions and predictable revenue streams. So, CEOs were almost like quasi-bureaucrats.

In contrast, now the level of competition is so fierce (and entry barriers so low) that even small differences in managerial quality can result in huge changes in profitability and market value. So, having a slightly better CEO can result in big gains to shareholder wealth. Not surprisingly, shareholders (or actually, boards of directors acting on the behalf of shareholders) realize this, and end up bidding up the price of good CEOs:

So how does the modern corporation attract and keep consumers and investors (who also have better and better comparative information)? How does it distinguish itself? More and more, that depends on its CEO -- who has to be sufficiently clever, ruthless and driven to find and pull the levers that will deliver competitive advantage.

There are no standard textbook moves, no well-established strategies to draw upon. If there were, rivals would already be using them. The pool of proven talent is small because so few executives have been tested and succeeded. And the boards of major companies do not want to risk error. The cost of recruiting the wrong person can be very large -- and readily apparent in the deteriorating value of a company's shares. Boards are willing to pay more and more for CEOs and other top executives because their rivals are paying more and more for them. Former Home Depot CEO Robert Nardelli to the contrary notwithstanding, the pay is usually worth it to investors.

RTWT here

All in all, it's a great piece. But alas, after such great writing, Reich can't help himself, and finally reverts to type:

This economic explanation for sky-high CEO pay does not justify it socially or morally. It only means that investors think CEOs are worth it. As citizens, though, most of us disapprove. About 80% of Americans polled by the Los Angeles Times and Bloomberg in early 2006 said CEOs are overpaid. The reaction was roughly the same regardless of the respondent's income or political affiliation. But if America wants to rein in executive pay, the answer isn't more shareholder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the super pay of those in super demand. (emphasis mine)

Ah well. Other than that line, it's still a great piece, and well worth reading.

What's the Return to Shorting Naked Puts?

We're talking (briefly) about option payoffs in class this week. So, I was excited when I came across this piece titled "Why are Put Options So Expensive?", by Oleg Bondarenko of the University if Illinois at Chicago. In it, he provides some very interesting figures. First off, the abstract:

This paper studies the "overpriced puts puzzle" - the finding that historical prices of the S&P 500 put options have been too high and incompatible with the canonical asset-pricing models, such as CAPM and Rubinstein (1976) model. Simple trading strategies that involve selling at-the-money and out-of-the-money puts would have earned extraordinary profits. To investigate whether put returns could be rationalized by another, possibly nonstandard equilibrium model, we implement a new methodology. The methodology is "model-free" in the sense that it requires no parametric assumptions on investors' preferences. Furthermore, the methodology can be applied even when the sample is affected by certain selection biases (such as the Peso problem) and when investors' beliefs are incorrect.

We find that no model within a fairly broad class of models can possibly explain the put anomaly.

Writing put options should make consistent small profits,. but with a chance that the option writer will occasionally get really hosed. But by Bondareknko's analysis, markets consistently overvalue at the money (ATM) and out of the money options (OTM) that are "close" (i.e. within 6% of ATM). In fact, writing options seems to result in average returns of 39% per month, with returns for deep OTM options of almost double that. That's right - almost 40% per month.

So, how likely is the "hosing"? Does this merely reflect the risk of large losses? By his estimates, there would have to be a meltdown like the one in October 1987 1.3 times a year for the option writer to lose money.

So, why are put options so apparently overvalued? There are at least two possible explanations (other than something really funky/wrong with the data): one is that investors systematically overestimate the chance or severity of large market declines. The other is that option buyers have a utility function that is extremely risk averse. In either case, there's apparently an excess demand for insurance that option writers can benefit from (if they're willing to bear the risk).

HT: CXO Advisory group

What Non-Finance Courses Should Finance Majors Take?

Since school just started here at Unknown University, that means undergraduates with questions about majors, classes, internships, and so on. This is the first time I advise students her at my current school (I got a pass for the first year). Our program is such that they don't have a lot of options for the finance part of their curriculum, but I get a lot of questions about what other classes (besides finance) to take. So, I though y'all might also benefit from my take on things (or at least get a good laugh):

• Financial Accounting: The typical undergraduate finance major takes one or two introductory level accounting classes. Then, when they get their first entry-level job, they often find themselves doing tasks that use a lot of financial statement information. Accounting can be hard and (to many finance majors) a bit dry, but taking more accounting classes definitely sets you apart from other new graduates. Back a few years, I used to place a number of students with the credit analysis unit of Bank of America. They didn't even look at most students unless they had three or (preferably) four accounting classes. There's not that much advantage to taking Tax or Auditing for a finance major, but there is to taking Financial - I'd recommend at least Intermediate Accounting I (and if you can manage it, Intermediate II).
  
• Macro Economics - Although the undergraduate business curriculum typically requires an introductory class in macro, most students come out of it with only the barest hint of what's going on. A second class in this area will help you to get a much better understanding of the larger economic forces that effect equity (and to an even greater extent, fixed income) markets.
• Money and Banking (from the Econ department)- Similar to the above, it's also good to see the money and banking material twice. Although you often get a money and banking class in the finance department, it's good to see the same topic taught from a different perspective.
  
• Statistics and Econometrics - The undergrad finance curriculum usually has an introductory statistics class. Almost everyone can benefit from more exposure to this material. But most importantly, make sure the class is "hands on". There's no substitute for analyzing real data.
  
• More math - You might not use linear algebra or higher-level calculus, but taking extra math (and getting getting good grades in those classes) serves as a pretty good signal that you're either smart or hard working (or both). Today's finance world is math and stat -driven. So, the more you take of these topics, the better.
• A programming class - like math, programming is also hard. Having a little more background in a commonly used language always helps.
  

Of course, this is only my opinion, and a lot of it has been shaped by what I hear from employers (or see on the CFA exam). If you have other thoughts, I'd love to hear them.

Advice For New College Freshmen

Ben Stein has said some pretty goofy and (IMO) off base things about private equity, but he hits the mark here with advice for new college students (he's sending his first son away to college):

Make friends with your teachers. To get on their good side, read the material before class, ask questions, and use their office hours to get clarifications on material that's unclear.

Learn to manage your time. Make sure you do your work on time (and neatly) and follow the instructions carefully on assignments.

Be well rounded - take classes in the area you want to specialize inm, but also in others. You never know what you might end up using, so it's important to have both depth and breadth of knowledge.

Affability and netness count. Join a frat or sorority, or some other group. And if you dress like a slob, make sure your thoghts and speech are more ordered - it'll offset the impression your appearnace makes.

Finally, don't indulge to excess, get some exercise, and develop good work habits.

Read the whole thing here.

As a professor, I can vouch for the first piece of advice. Most students don't make the effort to get to know me outside of class. So, I tend to go the extra mile for those who do (particularly when they need reference letters).

How Often Should You Meet With Your Advisor?

Like in most things, corner solutions aren't optimal.