Wednesday, June 14, 2017

Bauer, Unsolved!

Sometimes I think I’m preparing for my reincarnation as a massively successful hedge fund manager, along the lines of Jim Simons. Thus my interest in code breaking.

In tackling Craig P. Bauer’s Unsolved! (Princeton University Press, 2017) I’m starting at the top, with ciphers that have resisted all attempts to crack them. Bauer does mix in a few ciphers that have solutions (which he helpfully provides) to shed light on those that remain unsolved.

Some of the unsolved ciphers come from the ancient world, but one of the more intriguing is the handiwork of Edward Elgar, the British composer. One of his Enigma Variations was a musical representation of a daughter of a close friend of his wife, whom he called Dorabella. It was in a letter to Dora that Elgar wrote the following squiggly cipher:

These squiggles were, it seems, a variation of the way he signed his own initials:

But the encoded message to Dora remains a mystery.

Then there were the so-called killer ciphers. For instance, the Zodiac killer, who went on a killing spree in 1968 and 1969, sent ciphers to newspapers. Some of these ciphers were solved, but one remains unsolved. The Zodiac killer’s identity was never discovered, and he was never apprehended.

Bauer’s lengthy book offers a panoply of ciphers ripe for the solving. Alas, I made no progress at solving any of them. I have the feeling I’m going to “come back” as a lowly ant.

Wednesday, May 31, 2017

Desai, The Wisdom of Finance

Mihir A. Desai’s The Wisdom of Finance: Discovering Humanity in the World of Risk and Return (Houghton Mifflin Harcourt, 2017) takes “the unorthodox position that viewing finance through the prism of the humanities will help us restore humanity to finance.” This sentiment is actually becoming more mainstream. For instance, there’s the just published Cents and Sensibility: What Economics Can Learn from the Humanities by Gary Saul Morson and Morton Schapiro. But Desai, a professor at the Harvard Business School and Harvard Law School, outshines his competition in at least two respects: he distills finance down to a few key components, and not the usual suspects, and he brings to bear on them insights from a wide range of often unexpected sources. For instance, “the first chapter lays down the foundations of risk and insurance, with the help of Francis Galton’s quincunx, the author Dashiell Hammett, the philosopher Charles Sanders Peirce, and the poet Wallace Stevens.”

In subsequent chapters Desai deals with such topics as options and diversification, risk and return, asset pricing, the principal-agent problem, mergers, and debt and bankruptcy. Again, with exceedingly well chosen examples from the humanities.

Everyone hates finance, including novelists. From Leo Tolstoy’s “How Much Land Does a Man Need?” and Theodore Dreiser’s The Financier to the increasingly less sympathetic main characters of Wall Street, American Psycho, and Cosmopolis, the theme is “the untrammeled desire for more.” And real life provides more than its fair share of these financial archetypes—for instance, Martin Shkreli. So is insatiable desire fundamental to finance? Desai argues that it’s not, that finance is primarily the story of risk, though he admits that “the asshole theory of finance” is powerful: that is, “it’s not the people who finance attracts who are bad. It’s just that finance fuels ego and ambition in an unusually powerful way.” To counter all the antiheroes in finance, real and fictional, he introduces the reader to Willa Cather’s O Pioneers!, a “story that truly belongs in every finance textbook.”

Desai’s book is an eye-opening, wonderful read. I highly recommend it.

Sunday, May 21, 2017

Barker, Barking Up the Wrong Tree

I am one of over 290,000 people who subscribe to Eric Barker’s weekly blog newsletter, “Barking Up the Wrong Tree.” Now, in a book of the same name (HarperCollins, 2017), he tackles the question of life success—what is it and what produces it? Through multiple anecdotes, all illustrative of the fruits of solid scientific research (he has nearly 50 pages of endnotes), Barker takes us on an often strange, counterintuitive journey.

Along the way we learn curious facts about prison gangs, pirates, even Moldovans. We discover that, despite the many significant advantages of optimism—a longer life, for instance—depressed people (and “depression is pessimism writ large”) are better at making predictions. We learn how to turn something that’s boring or overwhelming into a game that’s winnable, has novel challenges and goals, and provides feedback. We are told to “use trying and quitting as a deliberate strategy to find out what is worth not quitting” and then to set aside a small percentage of time for “little experiments” to keep learning and growing. And, oh yes, eminent scientists have traditionally had a lot of hobbies. “Getting lots of different ideas crashing together turns out to be one of the keys to creativity.”

We all need role models. Barker offers us one: a Toronto raccoon. “Their ability to get into trash cans shows a level of grit and resourcefulness that is almost beyond compare.” In 2002 Toronto financed the development of “raccoon-proof” trash cans. “How well did they work? Well, let’s just say that in 2015 the city spent an additional $31 million dollars to create a new, redesigned ‘raccoon-proof’ trash can. Not a good sign, folks.”

Barker’s book is a first-rate read—illuminating, humorous, and compassionate. (“Self-compassion beats self-esteem.”) It’s by turns empowering and humbling. Sounds like life, doesn’t it?

Sunday, May 14, 2017

Clifford, The CEO Pay Machine

Everybody, except perhaps the CEOs themselves and their compensation committees, know that CEO pay in the U.S. is out of control. At large firms the CEO-to-worker compensation ratio, 20 to 1 in 1965 and 26 to 1 in 1978, is now more than 300 to 1, perhaps as high as 700 to 1. (In Japan the ratio is 16 to 1, in Denmark 48 to 1, and in the UK 84 to 1.) How did CEO pay in the U.S. become so untethered to the wages of average workers and what can be done to bring it back in line, if indeed doing so would be in the best interests of the companies themselves and the economy as a whole?

Steven Clifford, formerly CEO of King Broadcasting Company and National Mobile Television and a director of 13 companies, tackles these questions with wit and compelling logic in The CEO Pay Machine: How It Trashes America and How to Stop It (Blue Rider Press/Penguin Random House, 2017). He sets out to show “how the sausage is made—how the Pay Machine actually works, how its parts interact, and how every step in the process pushes CEO pay to higher and higher levels.”

He starts with a fairy tale about a loan officer at the Midwest Bank who asks his fairy godmother to help him get a promotion because his $75,000 salary isn’t enough. Ah, she replies, she can do better than that. She can get him more money for the same job. Applying CEO compensation practices to the loan officer’s pay package, the fairy godmother steers him, wide-eyed step by wide-eyed step, from his modest $75,000 salary to a whopping $5,845,000. In the process, the author sketches out the inner workings of the CEO Pay Machine.

Excessive CEO pay, the author argues, harms companies, shareholders, and the economy and undermines democracy. Not just because it is excessive but also because of the way in which it is typically structured. For instance, it usually misaligns CEO incentives with effective corporate practices and goals.

Clifford lays the blame for the emergence of the Pay Machine at the feet of “three totally unrelated actors: Michael Jensen, Milton Rock, and Bill Clinton. … They were not attempting to overpay CEOs and might be stunned and insulted to be grouped together as causal agents.” Jensen’s basically sound recommendations (that CEOs own a significant amount of company stock and be paid in part for performance) were largely misapplied.

Rock and his fellow compensation consultants introduced the idea of using peer groups to calibrate executive pay and benchmarking (usually above-average) to the salaries of the peer group CEOs. It’s easy to see that “the above-average benchmarking of pay within peer groups creates a relentless upward spiral in pay—a game of CEO leapfrog. Every time a CEO leaps, he establishes a higher compensation base for the next CEO in the group to leap over.” By the way, at this year's annual Berkshire Hathaway meeting, Charlie Munger said:"I have avoided all my life compensation consultants. I hardly can find the words to express my contempt." He did, however, find the words at the 2012 meeting when he said: for "compensation consultants, prostitution would be a step up." Warren Buffett added at this year's meeting, "If the board hires a compensation consultant after I go, I will come back mad."

The last culprit, Bill Clinton, executing on his campaign promise to clamp down on excessive executive compensation, set out to eliminate tax deductions for executive pay--at first above a certain level and then, in a compromise move, above a certain level that wasn’t performance based. Business was still unhappy, so he agreed to exempt stock options from this cap. “Boards could now pay unlimited amounts as long as they could pass it off as ‘performance based’ and could grant unlimited stock options with no performance requirements.”

Clifford examines the pay packages and performance of the highest-paid executives of 2011 thru 2014—the CEOs of UnitedHealth Group, McKesson, Cheniere Energy, and Discovery Communications. The disconnect should come as no surprise.

By way of a solution, Clifford proposes a simple, blunt instrument: “For every dollar above $6 million that the companies pay their CEO or any other executive [and this includes all forms of compensation], they would pay a dollar in luxury tax. It would not be tax deductible.” Punkt. No loopholes. And, he realizes, no way it would ever get through this Congress. But maybe someday….

Wednesday, May 10, 2017

Pirie, Derivatives

Wendy L. Pirie’s Derivatives and its companion Workbook (Wiley, 2017) are part of the CFA [Chartered Financial Analyst] Institute Investment Series, books “geared toward industry practitioners along with graduate-level finance students.” The main text is a hefty 600 pages; the workbook is about 100 pages. The text’s nine chapters cover derivative markets and instruments, basics of derivative pricing and valuation, pricing and valuation of forward commitments, valuation of contingent claims, derivatives strategies, risk management, risk management applications of forward and futures strategies, risk management applications of option strategies, and risk management applications of swap strategies. Contributing chapters to this text are Don M. Chance (who does most of the heavy lifting), Robert E. Brooks, Barbara Valbuzzi, Robert E. Brooks, David M. Gentle, Robert A. Strong, Russell A. Rhoads, Kenneth Grant, and John R. Marsland.

This set is not for the casual reader who has only a passing interest in derivatives. It’s a textbook for those who want a solid foundation in derivatives, a foundation from which to engage in financial engineering, managing a trading book, or managing client portfolios. Or for those who simply have a keen interest in financial markets and want more in-depth insight into how derivatives can be used to hedge as well as to speculate.

Here’s but a single example of how derivatives, in this case equity swaps, can be useful: reducing insider exposure. Let’s say the personal wealth of the founder of a publicly traded company is almost entirely exposed to the fortunes of that company. The founder controls about 10% of the company and wants to retain this degree of control, so he doesn’t want to sell any of his shares. A swap dealer might offer him the following deal: the founder would pay the dealer the return on some of his shares in exchange for a diversified portfolio return. In this way the founder would keep his level of control but reduce his risk.

Sunday, May 7, 2017

Covel, Trend Following, 5th ed.

Michael W. Covel’s Trend Following first appeared in the spring of 2004 and went on to sell over 100,000 copies, with translations into German, Korean, Japanese, Chinese, Arabic, French, Portuguese, Russian, Thai, and Turkish. The fifth edition, subtitled How to Make a Fortune in Bull, Bear, and Black Swan Markets, is dramatically expanded. Whereas the first four editions ended on what in this edition is page 322, the text of the new edition continues on to page 561. It adds transcripts from seven interviews Covel conducted on his podcast (with Ed Seykota, Martin Lueck, Jean-Philippe Bouchaud, Ewan Kirk, Alex Greyserman, Campbell Harvey, and Lasse Heje Pedersen) and ten trend following research articles by guest authors.

Covel may be criticized for relying too much on the words of others. He is inclined to string quotations together with minimal commentary. He also uses the margins for more quotations—rightly so, I suppose, since some of them are only marginally related to trend following. This criticism is, however, primarily a stylistic one. The people Covel quotes were in the trenches and knew what they were talking about, so better to hear from them than from an outsider.

Trend trading is no longer as fashionable a concept as it once was—for instance, in the heyday of the “turtles.” It has been replaced, at least in part, by its cousin, momentum trading. What’s the difference between the two? Aside from the fact that relative (cross-sectional) momentum is a more popular factor than time-series momentum, one can say, in very rough outline, that time-series momentum is more forward-looking. In assessing momentum, analysts use a range of inputs, frequently including fundamentals and economic news. Trend following is, as its name indicates, backward-looking; it focuses on where price has been as an indication of where it will be in the future.

Trend trading, traditionally defined as a longer-term strategy, has always been most prevalent among commodity traders, the rationale being that commodity markets trend more than equity markets do. Still, many traders in all kinds of markets, short-term as well as longer-term, employ trend following strategies. Despite some premature obituaries, trend following outside of the managed futures world is far from dead.

And so a fifth edition of Covel’s classic was definitely in order. Covel was wise to add interviews and research articles to his book. They make it all the more valuable.

Wednesday, May 3, 2017

Tian, Invest Like a Guru

If you’re new to value investing and want a fast-reading primer, Charlie Tian’s Invest Like a Guru: How to Generate Higher Returns at Reduced Risk with Value Investing (Wiley, 2017) is just the ticket. If you’ve already read a couple of books on the subject, this one won’t add much to your store of knowledge.

Tian, who runs the website, draws on the insights of Peter Lynch, Warren Buffett, Donald Yacktman, and Howard Marks to advocate for a style of investing that avoids the sometimes bottomless pits of deep-value investing. Buy only good companies, he recommends, following Warren Buffett’s famous advice: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” He offers a 20-point checklist for buying a good company at a reasonable price, covering the nature of the business, its performance, financial strength, management, and valuation. The final question is more personal: “How much confidence do I have in my research?” That question, he says, “determines your action once the stock suddenly drops 50 percent after you buy.”

In 2009 GuruFocus began tracking a portfolio of 25 companies that had been consistently profitable over the previous ten years and were undervalued as measured by the discounted cash flow model. Between January 2009 and September 2016 the portfolio returned an annualized 15.7%, whereas the S&P 500 returned 12.0%. In 2010 the website started two other portfolios of consistently profitable companies that sold at close to the 10-year price/sales low and price/book low. Both of them outperformed the S&P 500 by about 2.5% a year.

Tian outlines some of ways analysts evaluate companies. It goes without saying that “none of these valuation methods can justify the stock prices of Amazon and Netflix.” Maybe not, but Bill Miller certainly juiced his Legg Mason Value Trust fund’s returns by investing in Amazon.