Category Archives: Risk Management

Whacked on W A C C (Wgt. Avg. Cost of Capital)

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Whacked on WACC

A reader asked how Prof. Bruce Greenwald determined WACC.

You can use traditional finance techniques of applying Beta (see links below) but I prefer estimating what other investors would require to risk their equity capital in the particular business because you are forced to think about business, financial and management risks.  Don’t substitute models for your own thinking. 

I will quote Prof. Greenwald’s discussion of WACC in Value Investing, pages 95-98

After we have completed the first step in arriving at an EPV (earnings power value) which is to calculate distributable earnings (Think of after-tax owner earnings using true maintenance capex instead of depreciation) for the company. Now we need to determine the appropriate cost of capital to use in the equation of EPV = Adjusted earnings x 1/R, where R = WACC.

Professional finance calls for a calculation of the weighted average cost of capital, known affectionately as the WACC.

There are three steps:

  1. Establish the appropriate ratio between debt and equity financing for this firm.
  2. Estimate the interest cost that the firm will have to pay on its debt, after taxes, by comparing it with the interest costs paid by similar firms.
  3. Estimate the cost of equity. The approved academic method for this take involves using something called the capital asset pricing model (see link below), in which the crucial variable is the volatility of the share price of the firm in question relative to the volatility of the stock market as a whole, as represented by the S&P 500 . That measure is called beta, and as much as it is beloved by finance professors, it is viewed with skepticism by the value investors. (98) Value Investing (Greenwald).

CSInvesting: Why? Because price movement is not risk! Risk always has an adjective preceding it like business-risk, management-risk, financial risk, regulatory risk, etc.

An alternative approach is to begin with the definition of the cost of equity capital: what the firm must pay per dollar per year to induce equity investors voluntarily to provide funds. This definition makes determining the cost of equity equivalent to determining the cost of any other resource. The wage cost of labor, for example, is what employers must pay to attract that labor voluntarily. There is no need to be esoteric about how to calculate the cost of equity in practice. We could survey other fund raisers to learn what they feel they must pay to attract funds. Venture capitalist in the late 1990s told us that they believed they had to offer at least 18 percent to attract funding. Venture investments are clearly more risky than those in WD-40 (wdfc); it is understandable that potential investors would demand higher returns. Alternatively, we could estimate the total returns—dividend plus projected capital gains—that investors expect to obtain from companies with characteristics similar to WD-40.  This method, the details of which we avoid here, produces a cost of equity of around 10 percent. Because long-term equity yields are about 12 percent per year, and because WD has a much more stable earning history than the average equity investment, 10 percent meets the reasonability test.

Summary

I do not like the traditional financial approach that uses Beta or CAPM.  Beta is misleading, See Beta vs Margin of Safety_Mauboussin and Beta and Risk.

I prefer the Greenwald approach because it forces you to think about the business and financial risk of the particular company. Also, the CAPM that uses the lower cost of debt financing would lead you to a lower WACC if you had 99.9999% debt financing and .0001 equity financing. Obviously the financial risk would rise dramatically for equity holders.

Glenn Greenberg of Brave Warrior Capital uses a 15% rate of return.   If he can buy at a price which he feels will return 15% per year compounded, then he will buy.  So let’s say the market reprices upward the business where the stock price infers an 8% return in the future because the stock price rose due to positive expectations, and then he might sell and redeploy his capital–no wonder he has averaged 18% returns. The market reprices his stocks before his estimated time- frame.   The point is not to double discount. If you can buy a business at a price that implies your required return of 15 (in Glenn Greenberg’s case) then you would not try to wait for a 50% discount on top of that.

Joel Greenblatt in his special situation class in discussing American Express described WACC in terms of valuation this way: If I can buy Amex here at $45 I think it will be worth $60 in two years because pension funds will need to buy it to meet their 9% hurdle.  I am paraphrasing and I may be misquoting, but that is one way he approached valuation. I guess that is where the art form comes in. How would he know pension funds would use 9%? Experience?

I always stress fundamentals. Try to sit down with a Value-Line and go back over companies’ 12-year history and see what the implied WACCs were on the businesses over time. After going through 2,000 companies month after month, you will have a good feel for when to use 8% vs. 12%. But wait for the obvious fat pitch. If the investment is too close to call at 9% or 10% then pass.

Read more:Whacked on WACC

Compare to traditional finance:

WACC_tutorial

Weighted Average Cost of Capital Article A short summary

Evaluating Debt and WACC Damoradan  More than you would ever want to know! :)

CAPM Damordaran

Choose what works for you!

Value Traps; The Dollar Crisis; Depression of 1929

worse

I owe my early success as an investor not to brains or knowledge, because my mind was untrained and my ignorance was colossal, The game taught me the game, And didn’t spare the rod while teaching.  

Whenever I have lost money in the stock market I have always considered that I have learned something; that if I have lost money I have gained experience, so that the money really went for a tuition fee.  –Jessie Livermore

Mark Sellers and PRXI Value Trap

He put over 50% of his fund into MCF:

MCF

I added an update to yesterday’s micro-cap post. http://wp.me/p2OaYY-2tX.  The point is to try and understand prior investment successes or failures. Any lessons there?

An excellent book on the inflationary 1970s The-Dollar-Crisis by Percy Greaves

I just like the old photos to capture the spirit of the times: The-Stock-Market-Crash-of-1929

628x471 (1)

I am still in shock over Brazil’s World Cup blow-out.

628x471

A fat tail event?

Austrian Investing in a Distorted World

nq140705

Investors and Austrian Economics

Mises Daily: Friday, July 04, 2014 by 

Robert Blumen, a software engineer with a background in financial applications, recently spoke with the Mises Institute about the Austrian School’s growing influence among investors.

Mises Institute: In recent years, we’ve seen more and more Austrian-tinged economic analysis coming from investors like Mark Spitznagel and Jim Rogers, to just name two. As someone personally involved in the investment world, have you yourself seen growth in Austrian ideas among investors and similar professionals?

Robert Blumen: There has been tremendous growth in interest in Austrian economics among financial professionals. I started an interest group for Austrians in Finance on LinkedIn which, in a few years, has grown to almost 2,000 members from the US, South America, East, Southern, and Central Asia, Africa, and Eastern and Western Europe. Peter Schiff appears regularly on financial shows. The Mises Institute drew hundreds of people from the investment world to an event in Manhattan.

Since 2002, a number of Austrian-themed books in financial economics have come out. Alongside titles from established writers such as James Grant, there is Detlev Schlichter’s Paper Money Collapse, and several books by Peter Schiff. There are many popular Austrian bloggers such as Grant Smith and Robert Wenzel. Over two million viewers watched a 2006 video in which a parade of condescending media hosts heap ridicule on Peter Schiff, who, to his credit, did not back down in the face of their smugness.

MI: Did the financial crisis of 2008 help increase the sympathy for Austrian economics?

RB: I have heard the same story from many people in finance. When the bust of 2000 (or 2008) happened, it did not fit what they had been taught in school, nor could it be explained within the belief systems of their colleagues in financial markets. Their next step was reading, searching for answers, and then, finding the writings of Mises, Hayek, or Rothbard that enabled them to make sense of what had happened.

To answer your question, yes, I think that the failure of the popular economic theories — evidenced by these inexplicable crises — has driven the search for superior ideas. The Mises Institute has been publishing for years, explaining these boom and bust cycles with Austrian economics. When people searched, many of them ended up at mises.org.

MI: In spite of lackluster growth on Main Street, Wall Street appears quite happy with growth over the past two years. For the casual observer, one might argue that the Fed has managed things well. What do you see as problematic with the current approach, and are there some in the finance world skeptical of the Fed’s current strategy?

RB: The Fed has a series of mistaken theories supporting their belief that higher stock prices indicate the success of their policies.

The first is the thinking that asset prices are actual wealth, when they are only the prices of the capital goods, which are a form of real wealth. Asset prices, in real terms, are the exchange ratios between consumption goods and capital goods. Artificially-boosted asset prices mean only that the owners of assets who bought them at lower prices have increased their consumption possibilities in relation to non-owners of assets. The owners of most assets, the so-called “1 percent” are the beneficiaries of Fed policies.

There is no systemic economic benefit to any particular value for stock prices. Young people saving for the future and entrepreneurs who are looking to pick up capital goods at bargain prices would find lower stock prices give them a better deal. This is the same as for any good.

Their second error is that higher stock prices create a “wealth effect,” in which people see their asset values rise, feel richer, and consequently save less and spend more. Their goal is to boost consumption through pumping up asset prices. As Keynesians, they are all in favor of this because they think that consumption drives production.

Sound economic thought has recognized, at least since the classical school, that production must precede consumption, and that production drives demand, not the other way around. The Fed understands none of this because they have no understanding of the purpose of capital goods in the production process, which is to increase the productivity of labor.

 A one page summary of ABCT: http://www.auburn.edu/~garriro/a1abc.htm

Courses on Austrian Business Cycle Theory: http://kristinandcory.com/Austrian_Business_Cycle_Theory_1.html  (Watch the first seven-minute video of Tom Woods for a quick synopsis. Common sense?)

Wreckage_Austrian_Business_Cycle_Theory_by_Aguilar (An attack upon the Austrian theory)  You always seek out the opposing view to test the logic, facts and theory behind the other view.

Misconceptions about Austrian Business Cycle Theory

They believe this about home prices as well, which is arguably an even greater fallacy because homes are consumption goods. A rising standard of living means that we are able to buy consumption goods at lower real prices over time, not higher.

And finally, they see the stock market as a sort of public referendum on their policies. They point to the stock market and say, “see, the market approves of what we are doing.” But when you realize that through its monetary expansion, the Fed itself is responsible for the rising stock market, that calls into question whether we can use it as independent measure of public opinion, or instead, the Fed voting for itself with money that it prints.

Austrian-informed financial thinkers understand this. There are hundreds of Austrian-oriented blogs and commentary sites, as well as some excellent heterodox sites with a very Austrian-friendly perspective such as Zero Hedge, Jim Rickards, Marc Faber, and Fofoa.

MI: We’ve mostly been talking about the US so far, but speaking globally, do you see any areas that are of particular concern, such as China or the Euro zone?

RB: Credit allocation in China is not market-based. They import the Fed’s inflation through their currency peg, which diverts dollars into their sovereign wealth fund where it is “invested” by bureaucrats in various forms of dollar-zone assets. Their domestic savings go into their banking system, where it is wasted on politically-favored projects due to non-market allocation of bank credit. The entire system is experiencing a series of bubbles in real estate and other sectors.

Their rate of infrastructure spending for comparably developed economies is about twice as high as normal. This is because the communist party officials are under great pressure to hit GDP targets — as if prosperity could be spent into existence by hitting a number. Infrastructure such as roads and empty cities present an opportunity to spend a large amount of money, all in one place, on a lot of Very Big Stuff, which under market-based economic calculation would be revealed as wasteful.

The problems in Europe are a combination of the massive debts that can never be paid back, the unfunded entitlements, and the growth in the burden on producers, a theme that I addressed in my recent Mises Daily article on Say’s law. This burden consists of the totality of regulation, taxation, inflexible prices and labor markets, and the threat to the confiscation of wealth. If you project these trends into the near future, I’m not sure where the lines cross, but the system is clearly unsustainable in its present form because it relies on sustaining current levels of consumption as fewer and fewer people produce.

Curated Alpha; Update on the Resource Markets, Michael Marcus

Tin cup

 

A Blog worth exploring

http://www.curatedalpha.com/category/behavorial-economics/

An update on the resource market

Mr. Rule, a Graham and Dodder in the resource sector, is a smooth communicator, but move on and do your own work. Start here:

https://www.explorationinsights.com/

Free course on resource investing: http://www.sprottgroup.com/natural-resource-investing/investment-university/

http://oreninc.com/orenthink

One of the better gold funds:  www.tocqueville.com

Market Wizard, Michael Marcus Speech:

http://www.curatedalpha.com/2011/curated-interview-with-michael-marcus-from-market-wizards/

 

Dare to be Great! Position-Sizing.

 

finance devil

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.  –Charlie Munger

Dare to Be Great  You have to weight your opportunities. Of course, how do you know when you have an exceptional opportunity? Experience and method.  Joel Greenblatt was a master at position-sizing when he found low risk investments.

position_sizing  (Academic paper)

One secret: http://www.tradermike.net/2005/07/position_sizing/

Position sizing http://stansberryresearch.com/investor-education/position-sizing/

Trembling with Greed http://www.fool.com/news/foth/2001/foth010213.htm

Trading Places (SELL!): http://youtu.be/1tmI867fAYU?t=1m55s    Note the patience, patience and then ACT IMMEDIATELY IN SIZE.

In Gold We Trust; A Reader’s Question

Gold   In-Gold-we-Trust-2014-Incrementum

The above 100-page report on gold will provide a good financial history lesson.

A Reader’s Question

I was thinking about how many people think that the sell-side is just wrong about everything and completely untrustworthy.  From what I can tell, they are pretty good with the facts and a really valuable source when you want to learn about a new industry via a primers or initiation reports.  This led me to think that most of the sell-side critics think that they have an analytical edge over the sell-siders.  Maybe even an informational edge (which I think is very unlikely since these analysts cover one industry full-time.) But certainly an edge in judgment or behavior.  This I think is possible if you have a longer-time horizon and no man-with-a-hammer syndrome.

What sort of edge do you think is most achievable over the markets in general for an investor that is dedicated?  I’m thinking about full-time investors.

It seems to me that analytic edges are often overstated.  What are some cases that the sell-side or entire markets are just completely off on their analysis?  Maybe the optimistic analysts during the bubble years?  Is this just misaligned incentives?

I would guess that the market usually mis-weighs the probabilities of what may happen in the future, but that would be more of a misjudgment in my opinion.  (Maybe this is just semantics.)
I’d love to hear your thoughts.

My reply: I agree that analysts can provide great overviews of companies and industries in their initiation reports.  I will read them as a supplement to my own reading of original source documents.  I would not read them for valuation or investment recommendations.  The idea that analysts can predict next quarter’s earnings is absurd. Finding a reasonable range of normalized earnings three years to five years out is what matters, not the next six months of earnings.

Another reason I might try to read analysts reports is not for new ideas, but to see the extent to which the market is already discounting my own views.  Note the universal calls from analysts at Goldman and UBS for gold to trade to $900 or $800 See www.acting-man.com:

“Goldman Sachs lowers gold price target to $1,050” (Bloomberg, Reuters, etc. sometime in January and repeated ad nauseam ever since)

“Moody’s lowers gold price target to $900”  (January)

“Morgan Stanley: Gold price won’t see $1,300 again” (April)

Also, analysts may overlook key values in a company because they fixate on the next six months. For example, the most common way of valuing an exploration and production company is an appraisal of net asset value, based on sum-of-the parts approach. But most appraisals tend to ignore exploration assets which are not going to be drilled within some arbitrary time period, say the next 6 to 12 months. For some companies, much of the value is in assets which are not going to be drilled in the next year.

I think most of an investor’s edge is behavioral. (See http://www.amazon.com/Inefficient-Markets-Introduction-Behavioral-Clarendon/)

Take Coach’s (COH) recent plunge.

Coach

Coh Comments June 2014  and June 23 VL 2014 The company has to increase its investment to rebuild its brand. Wall Street analysts then act like this:

Over the Cliff

Therein lies opportunity or maybe not.   But if the markets didn’t act that way, then markets would not overreact. Markets tend to over-discount a known risk or uncertainty and under-discount an unknown uncertainty.

Compare and Contrast

MINERS-GOLD-RATIO-CHARTS-JUN-18

MINERS-INDEX-MONTHLY-LINEAR-CHART-JUN-18

TMS-2-long-term-dosh-slosh

The above represents my understanding of INFLATION, not prices rising. Prices may or not rise depending upon supply/demand for goods and currency. Usually, as the supply of currency increases much faster than the production of goods and services, then prices rise or the value of the currency declines.

World-stock-vs-GDP

inflation_jerryholbert

Thanks to www.acting-man.com and www.zerohedge.com

TREASURE CHEST!

Hashtag

INFLATION

http://www.acting-man.com/?p=31075  Note the ZIRP-induced distortion in the production structure.

production-capital-and-consumer-goods-ann

Fed and Stocks

BB

bPKW

PKW is a buy-back ETF which only chooses companies that will buy back at least 5% of their shares per year.

Treasure Chest 

Lecture Links  Thanks to a generous contribution! Let me know what you learn.

Value Investing During Worldwide QE

Godzilla

The Risks of investing during times of deflation/inflation: inflation-june-2014

Interesting…………..Massive short position built up by managed money in silver.

Shorts in silver

www.marketanthropology.com

 

Be Fearful

Pluto

BUBBLE

It’s fascinating how investors come to forget that markets move in cycles and not perpetual diagonal lines. As value investor Howard Marks wrote in The Most Important Thing, “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.” A normal, run-of-the mill cyclical bear market wipes out more than half of the preceding bull market advance.

http://www.hussmanfunds.com/wmc/wmc140602.htm

 Where we are today

Tobin Q

PE Expensive

Money Losing IPOs

Credit Balances

Margi

HUI Cheap

riskyvssafe

http://globaleconomicanalysis.blogspot.com/2014/06/investor-bets-in-risky-vs-safe-assets.html

All of the above doesn’t mean an imminent reversal of trend only that investors are acting as if risk is low.   Remember Buffett’s line, “Be fearful when people are greedy and greedy when people are fearful.”

Skyscraper Index (or curse)

http://library.mises.org//media/Audio/The New 20 Skyscraper Curse.mp3

http://wiki.mises.org/wiki/Skyscraper_Index

Central Bank Stimulus Will Not Work

The governments and central banks of the world are engaged in a futile effort to stimulate economic recovery through an expansion of fiat money credit. They will fail due to their ignorance or purposeful blindness to Say’s Law that tells us that money is the agent for exchanging goods that must already exist. New fiat money cannot conjure goods out of thin air, the way central banks conjure money out of thin air. This violation of Say’s Law is reflected in loan losses, which cannot be prevented by any array of regulation or higher capital requirements. In fact rather than stimulate the economy to greater output, bank credit expansion causes capital destruction and a lower standard of living in the future than would have been the case otherwise. Governments and central bankers should concentrate on restoring economic freedom and sound money respectively.

Read more: http://mises.org/daily/6770/Why-Central-Bank-Stimulus-Cannot-Bring-Economic-Recovery

fin-profits2-14

http://www.oftwominds.com/blogjune14/buying-time6-14.html