Wednesday, June 21, 2017


        The risk of investing in the overal stock market is measured by the market "volatility."  That volatility is measured the annualized standard deviation of daily stock market returns.  During the years from 1962 to 2016 the average standard deviation has been approximately 15.50%.  Of course, it was much higher during crises and lower during quiet time, but on overall average 15.50%.

         To compute historical standard deviation requires data past data on returns, but there is another way to get an estimate of how volatile the market returns are expected to be on a forward looking basis.  That can be done by solving for the volatility that equates the market prices of options on the S&P 500 index to theoretical prices derived from option pricing models.  The Chicago Board Option Exchange computes the number on a daily basis for S&P 500 puts and calls with a maturity of 30 days.  That number is referred to as the VIX index.  Like the S&P 500 index, options and futures are traded on the VIX index.

         The reason for all this background is that despite what seems like a turbulent situation in Washington and around the world, the VIX index is currently trading at all time low of about 10.80%.  What's more it has pretty much been stuck as this level for about the last six months.  Now you may think that such a low level is not sustainable and the volatility should tend to rise back toward its historical average.  If that is your conclusion, you are not alone.  The figure below shows the futures curve for the VIX.  To a high degree of approximation, futures prices can be interpreted as the market's expectation of the future level of the index.  The figure shows the expected volatility rising steadily to 16.94%, a level higher than the historical average, by next February.  Note this means that you can't make money betting on the increase because the market prices have already impounded the expect rise.  Ironically, the market has been expecting such an increase for the last six months while the VIX has remained locked at record lows.  As a result, the people who made money during that time were those who bet against the anticipated increase.

         My advice for now is to watch the VIX index closely.  In future posts, I will explore some of the investment implications of its record setting behavior.

Thursday, June 15, 2017

Is the Fed Responsible for the Chaos at Uber?

      Uber is awash in easy cash.  Private investors have pumped money into the company on increasingly generous terms with surprisingly few constraints for years.  Why?  Because with real interest rates so low and monetary policy so loose, they were reaching for return anywhere they hoped  they could to find it.

       In this respect, Uber is not alone.  Snap was able to go public on terms that gave shareholders remarkably few rights.  The values of major tech stocks like Google, Apple, Facebook, Netflix and Amazon have all soared to record highs.  In such an environment, one fears another "Minsky moment."  It is time for the Fed to change course.  It is reassuring to see that Janet Yellen is apparently thinking the same way.

Saturday, June 10, 2017

Come on Analysts, Do the Analysis

            As a manager of a small hedge fund, I like to compare my views on the valuation of common stocks to those of other analysts in order gain perspective.  This turns out to be a remarkably frustrating exercise.  Here is the problem.  Ultimately, the assessed valuation of a stock depends only on two factors:
1.  The size and timing of the future cash flows (what I call the cash flow profile) the analyst forecasts for the company.
2.  An assessment of the appropriate risk adjusted rate for discounting those forecast cash flows.
Everything else affects assessed valuation only to the extent that it alters those two factors.  So naturally I look for other analysts’ opinions regarding those two factors to compare with my own.  And I virtually never find them.  This is not to say that I can’t find opinions.  The internet is awash in opinions, but those opinions, even in the case of many Wall Street analysts, are almost never translated into the two factors that matter.
            Take Tesla as an example.  Given the celebrity of Elon Musk and the immense run-up in Tesla’s stock price there is an active debate regarding whether the stock is fairly valued.  Unfortunately, that debate is usually couched in terms of vague and incomplete verbal analyses such as, “The Model 3 is a game changer that could support a stock price as high as $500” or “Tesla cannot be valued as a car company because it is an energy technology company.  When seen it this light, its stock price is understandable.”  And on and on.  Lots of words, but no cash flow profile and no discount rate.
            Fortunately, there are exceptions to this rule.  One that stands out is the blog of Prof. Aswath Damodaran.  For the companies he analyzes, Prof. Damodaran not only provides the cash flow profile and the discount rate, along with explanations and calculations showing how he arrived at each, he posts a complete Excel spreadsheet that combines them in a discounted cash flow model that produces his value indicator.  Of course, this careful work does not mean Prof. Damodaran is always right.  Read, for example, his posts on Valeant.  But it does makes it possible for the reader to compare their own opinions with his and to use his spreadsheet to alter the assumptions to assess the impact on valuation. 
            One reaction to analysis such as Prof. Damodaran’s is that forecasting cash flows years into the future is speculative.  Of course it is!  No one ever said valuing stocks is easy.  There is simply no way to avoid the difficulty of long-run cash flow forecasting.  It can be hidden behind vague and incomplete verbal analysis, but that does not make the opinion more accurate or less speculative.  It just makes it more vague and incomplete.
            So I say, Come on analysts, do the analysis.  Follow Prof. Damodaran and let us see the valuation implication of your views.  That requires spelling out their implications for the cash flow profile and the discount rate.  Words without translation into a cash flow profile are pretty much empty words.

Thursday, June 8, 2017

What is a "Technology" Company from an Investment Perspective

       When most people are asked what a technology company is, they think of computers, software or bioscience - companies with a lot of PhDs doing complicated things.  But that definition applies to companies not that are not commonly thought of as "technology" like those involved in oil fracking.  From an investment standpoint, I argue that a technology company is defined by two characteristics: miniscule marginal costs and network effects.  Facebook is a perfect example in both respects.  With regard to marignal costs, what does it cost them to add one member or one advertiser?  With regard to network effects, people want to be on Facebook because other people they know are there.  These two characteristics are so important from an investment standpoint because they allow for rapid and massive scaling at remarkably little costs.  Hence, the massive market capitalization of successful technology companies.

        Notice by this definition, Tesla is not a technology company.  That is primary reason why I have such a hard time explaining its valuation.

One final word on Tesla

       One thing I have not discussed regarding Tesla is risk.  In my view, the risk for anyone buying the stock north of $350 is extraordinary.  What will happen, for instance, if the Model 3 turns out to be a modest success with very small profit margins?  Put simply, the company's cash flow situation will become critical, particularly if the Model 3 cannabalizes the more expensive and more profitable Models S and X.  Under such circumstances, the stock price could easily drop more than 50%, supported at that level by a potential buy out.  My point is that this possibility is not a "lightning strikes" consideration.  Given the demand for electric cars and the move away from sedans, I see it as a real possibility.  So the downside risk at current stock price levels is extraordinary.  And I do not see any upside potential.  But I have been wrong about the upside before.  However, it is critical to remember that for the foreseeable future Tesla has to make money by making, selling and servicing cars.  That is not a technology business like UBER where the marginal costs are close to zero.  Building and servicing cars costs money and there is no evidence that Tesla is any better at it then established competitiors.

Wednesday, June 7, 2017

Was I wrong about Tesla

       With Tesla hitting new highs over $350, it seems only fair to admit that I was wrong when I thought it was overvalued at $300.  But was I wrong?  The truth is I don't know.  TWhile the stock has run-up further, it has done so without the release of any fundamental information that would alter my valuation.  The Model 3 is still an unreleased four door electric sedan.  The battery and solar panel business are still highly competitive and not very profitable.  The logistical problems of manufacturing and servicing the new Model 3s remains.  So before I finally fall on my sword on this one, I need some actual information.  Hopefully, that will be forthcoming in the next couple of months, but who knows.  It is possible that the hype will continue to year end even if the Model 3 appears in only modest numbers.

Wednesday, May 31, 2017

The Mystery of Tesla

       The Model 3 will be coming soon.  The Model 3 is a cheaper version of the Model S, a four-door electric sedan.  A car design not very popular in America or elsewhere in the world.  It is unclear that Tesla can sell it at a price that will make a meaningful profit.  Meanwhile, the company is involved in the highly competitive home solar business for which government subsidies are coming under fire and the highly competitive battery business.  In many investors' minds this somehow adds up to being the next Amazon.  The stock has risen nearly 70% since December 2015 on virtually no fundamental news.  I can see why Mr. Musk suggested that the stock was overpriced.  It will be a very interesting next few months as the Model 3 actually begins to appear.

Monday, May 29, 2017

Tesla, Ford and GM

     Recently, the fact that the market capitalization of Tesla passed that of Ford and GM attracted a good deal of attention.  In some quarters, it was taken as evidence that Tesla was overvalued.  How could a company the manufactures a small fraction of the number of vehicles be "worth more" than Ford and GM?

     While I agree that Tesla is overvalued - my DCF models suggest values of abour $170, not in excess of $300 - comparison of market capitalizations is not the appropriate benchmark.  Instead, what should be compared are the operating values of the companies or what is often called enterprise value.  The enterprise value equals the value of the equity plus debt minuses cash and short-term securities.

      The table belows shows the calculation for all three companies.  As advertised, the equity value of Tesla exceeds that of its competitors.  However, the enterprise value of Tesla is less than half that of Ford and GM.  Therefore, while it might be right to conclude that Tesla is overvalued, that conclusion should not be based on a faulty comparison.

Sunday, May 28, 2017

Investment Performance

     Superior investment performance relative to a given benchmark can be attributed to some combination of three basic drivers.  The first is investor skill – the ability to find and exploit mispricing as it arises.  The second is valuation changes combined with an investment strategy that diverges from market capitalization rates.  For example, a manager who tends to purchase large cap growth stocks will outperform its benchmark, assuming its benchmark is broader than large cap growth stocks, when the valuation of those securities rises.  The final is bearing risks that are not captured in the benchmark.  For instance, a value manager who is measured against a CAPM benchmark will outperform, on average, if there is a risk premium associated with holding value stocks that is not captured by the CAPM benchmark.

     What distinguishes the three drivers is that they have markedly different implications for whether the observed historical superior performance can be expected to continue.  If performance is attributable to skill then clearly it should persist as long as the skillful managers run the portfolio, but with a caveat as described by Berk and Green (2004).  Berk and Green note that skillful investment managers have an incentive to capture the return on their skill.  There are two ways to do that – by charging higher fees and by accepting added funds to manage.  The first method reduces the net performance, but not the gross performance.  The second, however, could eliminate much of the gross outperformance because as funds under management grow it becomes increasingly difficult for even a skilled manager to earn superior returns.

     To the extent that superior performance was a result of valuation changes, and to the extent that the manager continues with the same investment strategy, superior performance should not be expected to continue. Over the horizon on which most managers are evaluated, typically three years or more, there is no evidence of momentum in stock prices.  In fact, academic research suggests that there is a slight tendency toward mean reversion.  This implies that to the extent the past performance was a result of valuation changes, managers who outperformed in the past can be expected to slightly underperform going forward.

     Finally, if historical superior performance was the result of bearing a price risk that was not reflected in the benchmark, that performance should be expected to continue.  However, it is somewhat misleading to call it superior performance.  Investors who interpret the higher returns as evidence of skill will be disappointed in those states of the world when the risks they did not recognize they were bearing are realized.