The Difficulty of Measuring the Gains To Fundamental Research

Here's a paper by Bradford Cornell that I've had in my in box for a while. It's titled "Investment Research: How Much Is Enough?" Here's the abstract

Aside from the decision to enter the equity market, the most fundamental question an investor faces is whether to passively hold the market portfolio or to do investment research. This thesis of this paper is that there is no scientifically reliable procedure available which can be applied to estimate the marginal product of investment research. In light of this imprecision, investors become forced to rely on some combination of judgment, gut instinct, and marketing imperatives to determine both the research approaches they employ and the capital they allocate to each approach. However, decisions based on such nebulous criteria are fragile and subject to dramatic revision in the face of market movements. These revisions, in turn, can exacerbate movements in asset prices.

I raises some interesting issues about the difficulties in measuring gains to fundamental research. To name a few:

• The difficulty in measuring "abnormal" performance", given the stochastic (i.e. random) nature of stock returns
• The time-varying nature of any possible gains to analysis (funds and strategies change over time).
• Given the needs for sample size and duration necessary to get high levels of statistical significance, most findings are of pretty low confidence
• The ad hoc nature of many analysis strategies and the role that judgement plays
  

It's worth reading, and give some good points for discussion in a class module on efficient markets (and the related topic of "anomalies" like the size and value effects). You can read the working paper on SSRN here

My First Century (Bike Ride, That Is)

I recently signed up to ride in my first "Metric Century" - a 100 kilometer (that's about 62 miles for those of you who don't speak metric) bike ride. Fittingly, it's a fund-raiser for the Hole In The Wall Gang Camp.

The Hole In The Wall Gang Camp was started by Paul Newman (yes, that Paul Newman) in the late 1980s to provide seriously ill children with a Wild West-themed camp experience (the original HITWG camp was formed in Ashford CT and was based on the movie "Butch Cassidy and the Sundance Kid"). The original camp has been built up over the years - it now has an "OK Corral" for its infirmary (with a 24 hour medical staff), horse stables, totem poles, tee pees, swimming pools, boating, horseback riding, sports, theater, and camping, along with much, much more. Over the years, the HITWG camps (there are now 11 separate camps in several countries) have hosted over 130,000 seriously ill children.

My nephew (who also died of cancer a little over two years ago) went there several times in his final years. And while Jonathan never made it out there, the HITWG camp would send two staff workers out to the clinic where he was treated several times each week to play with the kids. These guys were amazing. One had gone to clown college (and no, I never taught there, but one of my previous schools resembled it on a regular basis) and could do everything from magic tricks to impersonations to juggling. The other had technical skills that would let him make rap tapes for the kids, PhotoShop their faces onto pictures of Superheroes (I have one of "Jonathan Hulk"), and do just about anything else they'd want with a computer. They made quite an impact on the kids - for most, they made the clinic a far brighter place.

In any event, this give me a good goal to shoot for. So far, the farthest ride I've taken this summer has been today's ride of 33 miles. I did it at a (for me) good pace, and it had a couple of pretty good hills in it. But I'll have to step up my game a bit if I want to make it - I'm still only halfway there, and the terrain for the ride is pretty hilly. So even if I slow down significantly, it'll be a stretch. Since every pound counts when going up hills, I'm hoping to ease the burden of schlepping up all those hills ny losing 8-10 pounds over the next 5 weeks.

This means you'll have to put up with occasional training posts. Ah well - them's the breaks.

Data Analysis With Stata

The Unknown Family went to the Unknown Sister-in-Law's family's house in an adjacent state (their youngest daughter is going off to college, and Unknown Wife wanted to see her before she leaves for the Big Adventure). So, I got a couple of days to myself. Nothing very exciting - I've been grinding data during the day, and went on a couple of longish bike rides (I'm up to 25-30 miles at a time at what for me is a pretty good clip).

On the data analysis front, I finally took the plunge and started using Stata. It's a pretty amazing package of tools. I work with a lot of large and complicated data sets, and there's always a lot of data manipulation before I get to the point where I'm running statistical analyses. When it comes to moving data around (merging data, sub-setting, mean adjusting, etc...) SAS wins hands down. And I've put a lot of time getting my SAS chops, so I'd put off learning Stata for a long time.

But I now understand what so many of my friends have been telling me for so long - once you get to the point that your data is all nice and neat, Stata rocks. I was able to do many permutations of regression models (fixed effects, random effects, robust and/or clustered errors, etc...) in about a quarter of the time it would take in SAS. And while it's possible to work in batch mode by writing "do" files, you can do quick and dirty analyses with drop down menus.

I have seen the statistical light, and it reveals that I'll be doing a lot more with Stata in the future.

Capital Structure, Buybacks, and Free Cash Flow

I'm in the process of putting together material for my Advanced Corporate Finance class. Of course, it has a module on capital structure and payout policy. One of concepts we'll get across is that holding extra cash often gives managers incentives to invest in negative NPV projects (the old "free cash flow" problem). So, according to agency theory, managers should lever up and pay out the excess cash to shareholders in the form of buybacks and/or dividends. Unfortunately, higher leverage and lower cash holdings exposes the firm to increased risk of financial distress.

Along those lines, I was going through my "clippings file" and came across this piece in the Economist. It discusses some of the costs of excess debt during recessions. Of course, it's always easy to look back after the fact and say that firms shouldn't have levered up so much, since it means they'll face distress costs during a recession (hindsight's always 20/20, after all).

In a related piece David Merkel id a piece a while back on financial slack and how he uses it in evaluating cyclical companies in Real Money. He illustrates his approach using the steel industry. When identifying good companies in the steel industries he looks for several things:

...With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer term, it comes down to finding companies that have these four characteristics:

1. They're industry leaders with impeccable balance sheets.

2. They have reasonable operating leverage; they should be profitable at the cycle trough.

3. Their industry is hated, so their stocks can be bought at a cheap price.

4. They use free cash flow at a cycle peak in a way that prepares for the trough.

...Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

Point 4 is the most relevant to the whole leverage/payout discussion: what's the best use of free cash flow? Should it be invested, used to pay down debt, or be distributed to shareholders? If good time are expected to continue, the company is best off investing the excess in positive NPV projects and then paying out excess free cash in the form of dividends and buybacks (and buybacks result in increased leverage). However, if troble is expected ahead, they're better off paying down debt or holding more cash in reserve.

I think it'll make for a good discussion in class.

Dilbert On Mutual Funds

Nuff said.

Tutorials For The BA2+ Calculator

In any class, there are some sections that take up a disproportionate amount of class time but are only needed by some of the class. For example, in my case course, some of the students have a very good grasp of how to use their business calculators, while others somehow made it out of the introductory class without learning something as basis as how to calculate simple present and future values using the built in financial functions of their calculator.

So, how do I make sure that all my students have the basic background knowledge needed to survive the class? My solution this semester is to use screen recording software to create a few tutorials for the Texas Instruments BA2+ calculator (the model we encourage our students to use in the intro class).

I made a short 5-6 minute video that goes over how to change the settings on the calculator (i.e. the number of decimals displayed, number of periods per year, etc), and another to demonstrate how to solve problems involving present and future values of lump sums (and how to solve for interest rate and number of periods, too). I'll make a third video to cover annuity problems, a fourth to cover NPV and IRR problems, and a fifth to work some problems in depth.

I've posted a link to one of the videos below. In case you're interested, I created the guides using Techsmith's Camtasia software, Texas Instrument's calculator software emulator, and hosted it on Techsmith's Screencast platform. It's not professionally done by any stretch of the imagination, but I think it gets the basics across (and there aren't enough "ummm's" and "Ah's" to be too distracting).

Updated 8/22: I put all the tutorials in one spot for easier access. Updated 8/20: They're in MP4 format, which should be playable on the latest versions of Windows Media Player and most other video players. If you want to download them, feel free, but realize that the largest is about 20 meg. So it might take a while (depending on your connection speed).

Introduction To The BA2+ Calculator

Solving Present and Future Value Lump Sum Problems On The BA2+ Calculator.

Solving Annuity Problems on the BA2+ Calculator

Using the Cash Flow Register on the BA2+ Calculator

Any feedback is appreciated.

Beloit College Publishes Its Latest Mindset List

Every year, Beloit college publishes its "Mindset List." This list is updated annually to reflect what the latest crop of incoming freshman has experienced. Here are some of my favorites:

12. The KGB has never officially existed.
13. Text has always been hyper.
18. They have never understood the meaning of R.S.V.P.
30. There has always been a Cartoon Network.
51. Britney Spears has always been heard on classic rock stations.
61. “Womyn” and “waitperson” have always been in the dictionary.

Read the whole thing here.