Thursday, January 28, 2016

Fischer Black's Guide to Value Investing

Fischer Black, one of the most creative financial economists of his generation and co-developer of the Black-Scholes option pricing model, offered what I use as a guide to value investing.  In his Presidential Address to the American Finance Association, Black stated that “we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value.”  Following Black’s tip, when I do a fundamental valuation, I check to see if the fundamental value I calculate is within a factor of 2 of the market price.  If it is, then I am reluctant to take a position. 
To some Black’s band of fair pricing may seem too large, but a word of warning.  When you, and by you I mean a prototypical value investor, find that your estimate value differs significantly from the market price there are two possibilities.  First, the market price is irrational.  A great deal of research in behavioral finance has uncovered evidence in support of this possibility.  The second possibility is that your analysis is faulty.  The simple fact is that even if the market can be irrational, as behaviorists suggest, individuals are likely to be a whole lot more irrational.  Thus, the most reasonable conclusion to draw when your estimate of value differs from the market is that you are the irrational one.  But what if it differs by more than a factor of 2?  In that case, either you or the market are really wrong.  You have passed outside Black’s limits.  Under such circumstances, the “mispricing” is worth a second look and may warrant taking a speculative position.
Over the course of the last couple of years, only three companies discussed in this blog have fallen outside the Black bounds – Tesla, GoPro and FitBit (in every case in the direction of overvaluation.)  In those three cases, taking a short position (or writing options to take simultaneous advantage of the high implied volatilities that accompanied the high valuation) turned out to be very profitable.  Unfortunately, a sample of three is too small to draw any reliable conclusion so be aware that the next example that may be discussed in this blog may not work out so well.   Nonetheless, Black’s bounds can serve a practical guide for any value investor.  Before you put your money at risk it should not be enough that you conclude that the market price is wrong, you should think it really wrong.

Wednesday, January 27, 2016

Google Passes Apple – And Watch out for Amazon

       The operating value of the company equals the value of the company’s debt plus equity minuses the amount of cash and investments on its balance sheet.  As of this morning, the latest data show that the combined value of Apple’s equity and debt was $616 billion.  Subtracting Apple’s $205 billion cash hoard gives an operating value of $406 billion.  In comparison, the value of Google’s equity and debt comes to $502 billion.  Subtracting Google’s cash of $73 billion gives an operating value of $428 billion – more than $20 billion greater than Apple’s.  Because cash represents past success and operations anticipated future success, from the standpoint of their tech business Google has already passed Apple and Amazon is getting close.

Tuesday, January 26, 2016

China, Oil and U.S. Stock Prices

In an article recently published in the Wall Street Journal, Alan Blinder asks a question that has puzzled many – why does the U.S stock market seem to drop on bad news from China or when oil prices slide?  As Prof. Blinder rightly observes, exports to China make up less than 1% of U.S GDP.  Furthermore, because the U.S. remains a net importer oil, falling oil prices saved the U.S. over $100 billion dollars in 2015 alone.  How can such savings be bad news for the American market?  True the U.S. oil and gas industry has suffered, but as Prof. Blinder notes employment in U.S. oil and gas extraction is one-eighth of 1% of total non-farm employment.  All this seems to make the reaction of the U.S. stock market to China and to oil, as Prof. Blinder says, slightly nutty.
But there is a more rational explanation.  Much of the research in financial economics in the past several decades has focused on what have been called “factor models.”  Eugene Fama won the Nobel Prize in 2014, in part, for work related to factor models.  The idea is simple – stock prices worldwide tend to move together because they are responding to a limited number of common factors.  The problem is that to date there is no objective procedure for identifying the factors.  As a result, an untold numbers of scholarly papers have been written suggesting what the factors ought to be.  While there is still no consensus on the precise identity of the factors, a common suspicion is that they are related to investor expectations regarding key macroeconomic variables such as world economic growth and inflation (or deflation) in major global economies.
Though the factor models imply that virtually all stock and commodity prices respond to the same basic factors they do not respond with the same intensity or even in the same direction.  According to the models, it is the intensity of its response to the factors that determines the risk of an investment.  The differential response to the factors can also explain, at least in part, the relation between Chinese stock prices, oil prices and U.S. stock prices.  All three are responding to the same factors so it is no surprise that they move together.  However, given then the fragility of the situation in China and the nature of the companies that trade on the Chinese exchange, Chinese stocks are more sensitive to the factors.  Therefore, negative factor innovations lead to large drops in Chinese stocks and smaller declines in American stocks.
The drop in the price of oil is far too large to be explained by factor sensitivity alone.  In the case of oil, much of the responsibility for the price collapse must be laid at the feet of producers who have been unwilling to cut output in the face of falling prices.  Nonetheless, there is every reason to suspect that oil is also responding to the same factors that have affected American and Chinese stocks.  The bottom line is the U.S. markets are not reacting to China or to oil.  They are responding, in a more muted fashion, to the same factors that affected Chinese stocks and oil prices.

Tuesday, January 19, 2016

A Question to Consider

        What if there was a massive new oil discovery that made crude essentially free, would that addition to world wealth be bad news?  If so, how?  Or to put it another way.  What if Saudi Arabia decided to sell all their oil at $1.00 per barrel, would that be bad news for the rest of the world?

Sunday, January 17, 2016

The Hotelling Theorem and the Future Price of Crude Oil

      Despite the avalanche of reports and prognostications regarding the future of crude oil prices, there is virtually no mention of the starting point on which all scholarly research on the subject is based – the Hotelling theorem.  Though the derivation can be daunting, the conclusion of the Hotelling theorem is straightforward.  The theorem states that, irrespective of the current spot price, the price of crude oil should be expected to rise at the rate of interest (adjusted for risk).  The intuition underlying the theorem is simple.  If prices are not expected to rise at the rate of interest, then owners of reserves should pump more oil and invest the proceeds in financial assets.  If prices are expected to rise faster than the interest rate, then it is rational to slow production and leave oil in the ground.
            In Hotelling equilibrium, the spot price is set so that as prices rise at the interest rate reserves are drawn so as to maximize the present value of the stream of oil profits.  Over the last 18 months, of course, prices have not risen but headed straight down.  So what has gone wrong?  Is the Hotelling theorem overly theoretical nonsense?  In defense of the theorem, note that throughout the oil price collapse during the last 18 months the futures curve has always been upward sloping just as the theorem predicts.  However, rather than following the curve upward, spot prices have been on a relentless decline from over $115 to under $30. 
            The Hotelling theorem points to three primary factors to potentially explain the spot price collapse.  The first is new information about either the stock of reserves or the demand for oil by final consumers.  The problem with this first factor is that during the last 18 months there has been little new news remotely sufficient to explain a 75% price drop.  On the supply side the impact of fracking has been known for years and there have been no large unanticipated discoveries.  On the demand side, the usage of crude has followed a predictable, slow upward trend despite the slowdown in China.
            The second factor is speculation.  Oil is not only a commodity, it is also a financial asset.  Like other financial assets, its price responds to speculation and sentiment.  Unfortunately, assessing the impact of this factor is next to impossible because motives for investment are not observable.  Suffice it to say that a change in speculative sentiment probably has played a role in the drop, but it cannot explain the massive collapse.

            Third, the Hotelling theorem depends on the long-run rational behavior of reserve owners to draw down their reserves so as maximize the present value of the future profit stream.  However, actual owners of reserves seem to be responding to other forces such as maintaining the political status quo, punishing competitors, undertaking strategic initiatives and so forth.  Given the relatively inelastic demand for oil, and the rising marginal cost of adding storage, pushing more oil into the spot market can have a dramatic impact on prices.  Nonetheless, for whatever reason, reserve owners keep pumping when they should be leaving oil in the ground.  It is this third factor which the Hotelling theorem suggests accounts for most of the dramatic price decline we have witnessed.  The theorem also suggests the when bleeding will end.  At some point, the spot price will be so low that the anticipated rate of future appreciation will be large enough to convince even the most skeptical reserve owners to leave more oil in the ground.  At that point, the spot price will stop falling.

Thursday, January 14, 2016

GoPro: I Made a Mistake

       For all the hand wringing in this blog about the lack of barriers to entry and GoPro being overpriced, I made a mistake.  After GoPro melted down for $90 to less than $30, I felt it was approaching fair value.  It looks like I was mistaken.  The price today is down to about $12.  This just underscores the point that technology markets are highly competitive and making consistently positive risk adjusted returns is no easy task.  GoPro, once a "market disrupter," is now just another camera maker.

Sunday, January 10, 2016

Making Sense of Apple's Valuation

When Apple’s stock price moves significantly it is hard not to pay attention.  The company is iconic and its products are everywhere.  Apple’s stock price hit a high of $134.54 on April 28, 2015.  It closed on Friday at $96.61, a drop of $37.93 or more than 28%.  That translates into the disappearance of more than $209 billion in equity valuation.
The question, of course, is why the drop?  The popular answer in the financial media is a shortfall in the sales of the new iPhone 6s and 6s plus.  This shortfall has been inferred from reported slowdowns in the sales of Apple’s suppliers.  Some fear the shortfall could be as large as 25 to 30%.  But what does that mean in dollars per share?  Apple earnings over the last 12 months were $50 billion.  The iPhone accounted for about 70% of that.  This means that a shortfall of 25-30% in iPhone sales in fiscal 2016 translates into lost earnings of about $10 billion or less than $2 per share, not $38.
Remember that the value of a company is the present value of its expected future cash flows.  Holding the discount rate constant, for Apple’s stock price to fall by 28%, its expected cash flows, in all future years, must drop by that percentage.  The story, therefore, cannot be the iPhone 6s and 6s plus unless the issues with those phones has led to doubts about all future Apple products – both future iPhones and other new products yet to be introduced.  But what is the bad news that could have caused such a reassessment of all Apple’s future products?  By most accounts, the Apple watch has lived up to expectations.  Mac computer sales have held up well despite the lack of new machines which are expected soon.  So what bad news vaporized $209 billion of market value?  As far as I can tell there hasn’t been any.  As always, Apple is secretive about new products and it is those new products that will produce essentially all the future cash flow.
This means one of two things and both are related to investor sentiment.  One is that the high price of $134.54 was unrealistic.  Perhaps the result of irrational exuberance related to the introduction of the iPhone 6.  The other is that the current price of $96.61 has been artificially depressed because of the negative buzz surrounding the iPhone 6s.  A reading of analyst reports indicates that most accept the second hypothesis because they retain price targets in the $130s.  But clearly all the people selling the stock for less than $100 have a different view.
This what makes valuing companies like Apple so difficult and makes the market so mercurial.  Almost all the value comes from unknown future products.  Investors attempt to infer the success of those future products from scraps of information about current products.  But those scraps are far too meager to be able to draw any reasonably accurate conclusions.  Instead, they serve as catalysts for sentiment that drives the price up and down in the short run.  If only there were a way to tell when that sentiment was overdone – if only.

Friday, January 8, 2016

George Soros Is Not Making Sense

      George Soros spoke at an economic forum in Sri Lanka on Thursday. The legendary investor said that global markets currently face a crisis that could be compared to the one seen in 2008.  This is makes no sense.  What made the 2008 recession so deep and long was that if affected virtually every major financial institution worldwide.  The housing related debt was so deeply embedded in those institutions that confidence it their financial viability was threatened and many actually failed.  Due to the central role of financial institutions in modern economies, the result was a worldwide crisis.
     This does not happen when there is simply a drop in equity prices.  Prices fall, we all get poorer, economic activity is depressed for a while and then we move on.  If Soros wants a better analogy, it would be 2001 when stock prices dropped dramatically and there was a short recession, but no financial crisis.  Even that though is an exaggeration.  Although stock prices are down, the drop, at least thus far, is not comparable to 2001.  Bottom line - Soros is wrong on this one.