Sunday, October 16, 2016

Dimitrijević, Frontier Investor

If you’re considering expanding the global reach of your portfolio, Marko Dimitrijević’s Frontier Investor: How to Prosper in the Next Emerging Markets (Columbia University Press, 2016) is an excellent place to start.

First, a definition. What is a frontier market? Of the 193 members of the UN plus Hong Kong and Taiwan, 30 are developed markets and 14 (Brazil, Chile, China, India, Indonesia, Korea, Malaysia, Mexico, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey) are what the author calls mainstream emerging markets. The remaining 151 are frontier markets. Measured by purchasing power parity-adjusted GDP, frontier market countries generate 19% of the world’s PPP-adjusted GDP. By way of comparison, the United States and China each generates 16%; developed Europe, 15%.

Why go to the frontier? Because many of them are likely to be the next wave of emerging markets. Their economies are expected to expand an average of 50% faster than developed market economies over the five years through 2020, and this growth is structural. “With many frontier markets, investors can purchase a Turkey, Indonesia, or Brazil—not of today, but of twenty years ago, when policy and structural changes drove growth. … As a group, frontier markets exhibit the elements that create an auspicious economic outlook: manageable current account deficits (and sometimes surpluses); low levels of government and private debt; moderate inflation; and growing foreign direct investment.” They also have favorable demographics.

That, in a nutshell, is the top-down story. But “even with run-ups in 2013 and early 2014, frontier market equities are still cheap on an absolute and relative basis, especially given their expected growth. And most frontier equity markets are inefficient, which means they may hold undiscovered bargains that the frontier market investor can take advantage of. This market inefficiency also helps explain the low correlation of frontier equities as a whole with other asset classes, as well as the low correlations between individual frontier markets, making frontier markets an attractive portfolio diversification tool.”

So, how do you go about investing in frontier markets? For a variety of reasons Dimitrijević is not a fan of passive investing. To mention just one problem, passive investors are stuck with the index constituents. Active investors, on the other hand, “can use a combined top-down and bottom-up approach to not only pick better companies from those countries already in an index but also to expand their universe to encompass countries with strong and improving fundamentals that are implementing structural reforms.”

Dimitrijević gives tips for the do-it-yourself investor. For bond investors, he has a chapter on special situations in distressed debt. He also explains the opportunities available in privatizations, saying that they “can offer outstanding bargains to those willing to do the additional work.”

Of course, there are risks in frontier markets that the average retail investor may not be aware of. Dimitrijević outlines the most important risks, such as political risk, currency risk, and market liquidity risk.

Frontier Investor is a well-researched book, complete with detailed examples. It belongs in the library of every global investor.

Sunday, October 9, 2016

Harford, Messy

Back in the days that some people thought such things were important, I was criticized for having a messy college dorm room. Although I have no recollection of the details of my sub-par housekeeping (which may well have involved an unmade bed), I suspect that my books, notebooks, and papers were strewn about, left wherever I last used them, some probably in the unmade bed. All I can say in my defense is that I graduated at the top of my class, despite (or perhaps because of) being messy. Since then, over time, I have become neater, and less accomplished.

Tim Harford wouldn’t go so far as to assert a definite causal link. But in Messy: The Power of Disorder to Transform Our Lives (Riverhead Books/Penguin Random House, 2016) he argues that “often we are so seduced by the blandishments of tidiness that we fail to appreciate the virtues of the messy—the untidy, unquantified, uncoordinated, improvised, imperfect, incoherent, crude, cluttered, random, ambiguous, vague, difficult, diverse, or even dirty.”

“Messy,” as you can see from the above list, is itself a messy notion. Harford exploits this quality to cover a range of topics that might not otherwise seem related. Here’s a very short sampling: distraction, collaboration, workplaces, improvisation, winning, financial engineering, setting targets, computerized disaster, stomach ulcers, online dating, and playgrounds.

Harford, best known for The Undercover Economist, knows how to make his points with compelling stories and quotations. For instance, Harford uses Jorge Luis Borges’s tale of the “Celestial Emporium of Benevolent Knowledge,” a fabled Chinese encyclopedia, to explain that “organizing things into categories is not as easy as it might at first seem.” “This Oriental tome, according to Borges, organizes animals into categories thus: (a) those that belong to the emperor; (b) embalmed ones; (c) those that are trained; (d) suckling pigs; (e) mermaids; (f) fabulous ones; (g) stray dogs; (h) those that are included in this classification; (i) those that tremble as if they were mad; (j) innumerable ones; (k) those drawn with a very fine camel’s-hair brush; (l) etcetera; (m) those that have just broken the flower vase; (n) those that at a distance resemble flies.” Harford comments that although this looks like a joke, “most of these apparently absurd categories have practical merit. Sometimes we need to classify things according to who owns them; at other times we must describe their physical attributes, and different physical attributes will matter in different contexts. Sometimes we must be terribly specific—a cat is not a good substitute for a suckling pig if you are preparing a feast, and if we are to punish wrongdoing (whether breaking a vase or committing an armed robbery), we must identify the wrongdoer and no one else. But while each category is useful, in combination they are incoherent…. Our categories can map to practical real-world cases, or they can be neat and logical, but rarely both at once.”

The world is a messy place, and people and companies that enjoy outsize success are often messy as well. “The story of Amazon is a long series of crazy goals, brutal fights, and squandered billions—an utter mess.” The most creative people work on multiple projects. (Harford shares some tips on how to do this without becoming unduly stressed.)

Messy is a wonderful book that challenges the “good housekeeping” approach to life. It’s well worth a read.

Wednesday, October 5, 2016

Belcher, The Beginner’s Handbook for Stock & Bond Investing

Financial markets will remain vibrant only if ordinary folks consider them an attractive place to invest their hard-earned cash. For many, investing is simply a matter of ticking a box (let’s say for a 401K) or hiring a professional. They can reap the benefits of investing without knowing much of anything about stocks or bonds. Just like they pay people to mow their lawns, wash their cars, take care of their kids, they pay people to manage their money.

Then there are the DIYers. And those who, though they may opt to hire a professional, at the very least want to understand what he’s doing.

Everybody has to start somewhere. The Beginner’s Handbook for Stock & Bond Investing by John G. Belcher, J., is a short, ridiculously inexpensive introduction. And it’s surprisingly thorough. It covers stock pricing and valuation, bond pricing, stock and bond categories, mutual funds and ETFs, and sound investment practices.

If you’re trying to convince your teenager to become an investor, this is probably not the best place to start. The book doesn’t have a hook. But for the person who has some interest in investing but knows next to nothing about it, this is a fine primer. It would also be useful to someone who knows a little bit about stocks but for whom bonds are a black hole. Actionable knowledge for the price of a donut.

Monday, October 3, 2016

McIntosh, The Snowball Effect

In The Snowball Effect Timothy J. McIntosh, the founder and CIO of SIPCO Investment Management Company, makes the case for investing in dividend paying stocks. His argument is that “time is the best ally of the long-term, buy-and-hold income investor. The initial results are slow to come about and not that impressive, but in due time, compounding dividends and interest end up snowballing into mindboggling returns, even during periods of market stagnation.”

McIntosh points to four long-term secular bear markets in the Dow between 1906 and 2015: 1906-1924, 1929-1954, 1966-1982, and 2000-2011. During these four periods, almost 70% of the 110-year range, stock prices barely budged. They saw annualized price returns of -0.24%, 0.11%, 0.21%, and 0.32%. With dividends reinvested, however, the annualized returns during these four periods were 6.19%, 5.53%, 4.82%, and 2.78%. “The conclusion: The only reliable way to make positive returns during secular bear market periods is to invest in dividend-paying stocks like those in the Dow.”

McIntosh also investigates small cap stocks, bonds, and covered calls as income-producing investments. But the primary focus of the book is large-cap dividend companies. Although the author recommends some corporate bond ETFs and micro-cap dividend stocks, the bulk of the book is taken up with a detailed description of “the top 100” dividend-paying companies. IBM leads the pack. Rounding out the top ten are Wal-Mart, McDonald’s, Nestle, Lockheed Martin, Chevron, Verizon, Cisco, Occidental Petroleum, and Travelers. In each case the author provides values and rankings for dividend yield, dividend growth, trailing P/E, S&P financial rating, and beta and has a table for the past 11 years showing the company’s yearly dividend, dividend growth, and average dividend yield.

Will investments that generate income continue to be the key to earning consistent returns, as they were for the last 110 years? The problem is that the income component from both stocks and bonds is currently near cycle lows. Between 1906 and 1990 Dow stocks provided an average dividend yield of over 4%. No longer. McIntosh expects the dividend contribution to total return over the next decade to be closer to 2%. “This is a direct result of companies giving preference to stock buybacks and reinvesting their profits in capital expenditures.”

Hence the sample portfolio of 100 especially attractive dividend-paying stocks. McIntosh put together a $100,000 portfolio and projected the dividends and interest it would return for each year between 2016 and 2020. In 2016 the total income would be about $3650; in 2020, about $6475. Continuing this projection further into the future, McIntosh anticipates a total income of $14,350 by 2025. The upshot is that “although the prices of all the stocks and the DVY ETF held in the portfolio stagnated from 2016 through 2025, the portfolio’s value continued to grow the original investment, $100,001.20, to $163,498.85 by the end of 2025—a 4.99 percent annual total return.” That’s some decent snowballing.

Thursday, September 29, 2016

Garfield, Timekeepers

Another in my series of off topic posts, this one, in the interest of time (yours and mine), very brief.

Simon Garfield is a prolific British author and journalist who has written about an assortment of things, from fonts to war diaries to the color mauve. Timekeepers: How the World Became Obsessed with Time (Canongate, 2016) is something of a hodgepodge itself, with essays on watchmaking, photography, Roger Bannister, production lines, Poundbury (“another of [Prince Charles’s] bright ideas”), music recording, and filibusters. Which I suppose “leaves us in no doubt of time’s unassailable presence in our lives.”

Timekeepers is a lightweight, disappointing book. But I chuckled over a cartoon and learned “how the French messed up the calendar.” So I’ll share the cartoon and, feeling lazy, simply give a link to the Wikipedia article on the French Republican calendar.

Wednesday, September 21, 2016

Keohane, Capital and the Common Good

Sometimes, even when there is agreement that a project is pressing and that money should be allocated to it, traditional public and philanthropic funding is insufficient. In addressing major challenges, “our aspirations” may be “deeper than our pockets.”

We have witnessed a horrendous example of how financial engineering, by creating deceptive financial products, can encourage people to let their aspirations outstrip their means. But if financial innovation can get the world into serious trouble, innovative finance can help solve its problems. With “a kind of creative and ‘visible hand’ … that corrects for market failure and provides for the public good,” innovative finance can be a powerful social force. What is new here is “not the engineering, but the application.”

In Capital and the Common Good: How Innovative Finance Is Tackling the World’s Most Urgent Problems (Columbia University Press, 2016) Georgia Levenson Keohane looks at climate change, healthcare, financial inclusion and access to capital, disaster finance, and U.S. community and economic development.

Innovative finance is definitely not charity. Firms that engage in innovative finance expect a return on their investment. For instance, LeapFrog, a private equity firm, has invested in “companies providing insurance, savings, pensions, and payment services to customers earning less than $10 a day. According to the company, the current portfolio showed a 40 percent increase in operating revenue and a 39 percent rise in profitability in 2013.” Admittedly, these figures aren’t especially meaningful in isolation, but I assume that LeapFrog is, as they say, doing well by doing good.

Keohane gives example after example of how finance can be applied creatively for the public good. For instance, “an expert in securitization who translates future development aid pledges into vaccines today; an entrepreneur who turns a mobile phone into pay-as-you-go solar electricity; the conversion of pay-for-success contracts from bridges and roads to affordable housing, early childhood education, and maternal health.”

This book may not be an antidote to the constant barrage of attacks on the financial industry, but it shows that finance can be, and often is, allied with the interests of the public good.

Sunday, September 18, 2016

Derman & Miller, The Volatility Smile

Options traders know about, but often don’t know what to do about, the volatility skew/smirk/smile. In The Volatility Smile (the word “practitioners have persisted in using … to describe the relationship between implied volatilities and strikes, irrespective of the actual shape”) Emanuel Derman and Michael B. Miller take us into the weeds, but by their own accounting not too deep into the weeds. The book, over 500 pages long, with the expected math, offers “an accessible, not-too-sophisticated introduction to models of the volatility smile.”

The Black-Scholes-Merton options pricing model “assumes that a stock’s future return volatility is constant, independent of the strike and time to expiration of any option on that stock. Were the model correct, a plot of the implied BSM volatilities for options with the same expiration over a range of strikes would be a flat line.” This is in fact what implied volatilities, at least in equity index option markets, looked like before the stock market crash of 1987. After that fateful day traders realized that they should pay more for low-strike puts than for high-strike calls. The flat line began to slope and curve. And the Black-Scholes model, never in perfect accord with reality, was now seen to be decidedly imperfect.

Researchers thus set out to create a options pricing model that could explain the volatility smile. As might have been expected, they came up with not one but many models, each of which explains some aspects of the volatility smile, but none of which is “perfect” enough to replace BSM as the dominant pricing model. Don’t despair, the authors advise: “Models not only change the pattern of trading in existing markets, but make possible trading in new, previously unimagined markets. Thus, new and improved models lead to new markets which lead to newer models, ad infinitum.” Financial engineers won’t be joining a bread line any time soon.

If you’re a trader, do you care that the BSM model is wrong? In most cases, if you’re trading very liquid options, the answer is no. “The model is merely a quoting convention.” However, “the model becomes critical for vanilla options, even liquid ones, when you want to hedge them, because even if the option price is known, the option’s hedge ratio is model-dependent. … The model is also critical if you want to trade illiquid exotic options, whose prices are not obtainable from a listed market. In that case, you have no choice but to use a model to estimate both the price and a hedge ratio.”

And so the authors delve into models that are consistent with the smile: local volatility models, stochastic volatility models, and jump-diffusion models.

Although there are nuggets in this book that the retail options trader might find useful, the book is really written for professional traders and budding financial engineers. For those using the book as a self-study guide, there are end-of chapter problems with answers.