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Archive for the ‘Catalysts’ Category

Corporate profit margins are presently 70 percent above the historical mean going back to 1947, as I’ve discussed earlier (see, for example, Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition). John Hussman attributes it to the record negative low in combined household and government savings:

The deficit of one sector must emerge as the surplus of another sector. Corporations benefit from deficit spending despite wages at record lows as a share of economy.

John Hussman spoke recently at the 2013 Wine Country conference. Here he describes the relationship between corporate profits, and government, and household savings (starting at 22.08):

Hussman’s whole talk is well worth hearing.

Order Quantitative Value from Wiley FinanceAmazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.

h/t Meb Faber

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Value Line’s Median Appreciation Potential (VLMAP) 2009

3to5year4yrchart10-8-10

Marketwatch’s Mark Hulbert has a great article Finding the best four-year market forecaster examining Value Line’s Median Appreciation Potential (VLMAP), which is the median three-to-five year gain that Value Line’s analysts estimate for the 1,700 stocks they cover.

From Value Line October 2010 update:

The estimate of the median price appreciation potential is found by first calculating the percentage change between the current price of each stock in our universe and the middle of its 3- to 5-year Target Price Range. These figures are then arrayed, and the median price appreciation potential is determined. We select the median of the array (the middle) as the most likely price, in order to play down the effect of outliers, that is, excessively large or small percentage price changes.

The chart included [above] depicts the results of those projections from 1983 to 2009, using the Value Line Arithmetic Index as our measure of the market. The actual price is taken as the average of the middle year of the 3- to 5-year forecast, so that a projection made at the end of 1983 would be compared to the average price of the index in 1987. Accordingly, we are comparing actual results to a 3 ½ year forecast.

Those who follow the VLMAP often adjust it downward when translating it into a forecast because Value Line’s analysts — like most of Wall Street (see my post on forward earnings) — are on average too optimistic. Note that the 2009 projection has turned out to be roughly right:

Our estimate for the year 2009 (made at the end of 2005) was 2683. The average price of the Value Line Arithmetic Index in 2009 was 1758. The large deviation arises from the effects of the recession that followed in the wake of the financial turmoil in late 2008 and early 2009. Meanwhile, the average deviation between the projected and actual average prices during this period was 18% (ignoring signs). The median deviation during this period was 11%. The projection for 2013 now stands at 3500. The 4-year projected price of 3500 now stands at 40% above the current level—suggesting respectable returns for patient investors.

The market closed Friday at 3,444. Why does this model work so well?

Mark Robertson, founder and managing partner of the Detroit-based advisory service Manifest Investing, also uses a version of the VLMAP. He thinks one answer lies in the willingness of Value Line’s analysts to focus on a longer-term horizon than is typical for most Wall Street analysts.

It may seem “counterintuitive,” he acknowledges, but “long-term forecasting is actually easier and more accurate than the quarterly whispering and chasing that we see from and on Wall Street.”

Because they are focusing on where the stocks they follow will be trading in three- to five-years’ time, Value Line’s analysts are less likely to get swept away by whatever mood has captured Wall Street’s attention, Robertson says.

Compared with analysts who focus on just the next couple of quarters, for example, Value Line’s are less likely to adjust their price targets based on the latest earnings. This makes them less inclined to get more bullish as the market goes higher — a tendency that leads to being excessively bullish at market tops.

Over the past five years the VLMAP has been as low as 45 percent and as high as 185 percent. It currently stands at 50 percent, which is close to the five-year low and only slightly higher than the 35 percent estimate logged in the weeks leading up to the bull-market high in October 2007.

Read Finding the best four-year market forecaster.

Order Quantitative Value from Wiley FinanceAmazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.

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In Fat Tails: How The Equity Q Ratio Anticipates Stock Market Crashes and The Equity Q Ratio: How Overvaluation Leads To Low Returns and Extreme Losses I examined Universa Chief Investment Officer Mark Spitznagel’s June 2011 working paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes (.pdf), and the May 2012 update The Austrians and the Swan: Birds of a Different Feather (.pdf), which discuss the “clear and rigorous evidence of a direct relationshipbetween overvaluation measured by the equity q ratio and “subsequent extreme losses in the stock market.”

Spitznagel argues that at valuations where the equity q ratio exceeds 0.9, the 110-year relationship points to an “expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P500 within the next few years; these probabilities continually reset as valuations remain elevated, making an eventual deep drawdown from current levels highly likely.”

So where are we now?

Smithers & Co. tracks the equity q ratio for the US. The chart below shows each to its own average on a log scale.

According to Smithers & Co., the equity q ratio currently stands at 1.05, which is some 17 percent above 0.9, the ratio at which “an “expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P500 within the next few years.” Smithers & Co. note:

Both q and CAPE include data for the year ending 31st December, 2012. At that date the S&P 500 was at 1426 and US non-financials were overvalued by 44% according to q and quoted shares, including financials, were overvalued by 52% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

As at 12th March, 2013 with the S&P 500 at 1552 the overvaluation by the relevant measures was 57% for non-financials and 65% for quoted shares.

Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.

Like the Shiller PE and Buffett’s total market capitalization-to-gross national product measure, the equity q ratio is a poor short-term market timing device. This is because there are no reliable short-term market timing devices. If one existed, its effect would be rapidly arbitraged away. So why look market-level valuation measures? From Smithers & Co.:

Understanding value is vital for investors.

(i) It provides a sound way of assessing the probable returns over the medium-term.

(ii) It provides information about the current risks of stock market investment.

(iii) It enables investors to avoid nonsense claims about value.

Extreme discipline is required at market extremes. Gladwell’s profile of Taleb, Blowing Up, shows how difficult such periods can be:

Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. “It’s like you’re playing the piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and the only thing you have to keep you going is the belief that one day you’ll wake up and play like Rachmaninoff.”

Finally, even though we can plainly see that markets are presently overvalued on several measures, we can’t know when a sell-off will occur. All we can say is that returns are likely to be sub-par for an extended period, and that the probabilities are quite high that a substantial drawdown will occur in the next two to three years. One thing that we can be sure of, is that when it does occur, the catalyst that ostensibly triggers the sell off will be treated as a black swan, even though the real cause is massive overvaluation. From the perspective of behavioral investment, this story of Gladwell’s is interesting:

In the summer of 1997, Taleb predicted that hedge funds like Long Term Capital Management were headed for trouble, because they did not understand this notion of fat tails. Just a year later, L.T.C.M. sold an extraordinary number of options, because its computer models told it that the markets ought to be calming down. And what happened? The Russian government defaulted on its bonds; the markets went crazy; and in a matter of weeks L.T.C.M. was finished. Spitznagel, Taleb’s head trader, says that he recently heard one of the former top executives of L.T.C.M. give a lecture in which he defended the gamble that the fund had made. “What he said was, Look, when I drive home every night in the fall I see all these leaves scattered around the base of the trees,?” Spitznagel recounts. “There is a statistical distribution that governs the way they fall, and I can be pretty accurate in figuring out what that distribution is going to be. But one day I came home and the leaves were in little piles. Does that falsify my theory that there are statistical rules governing how leaves fall? No. It was a man-made event.” In other words, the Russians, by defaulting on their bonds, did something that they were not supposed to do, a once-in-a-lifetime, rule-breaking event. But this, to Taleb, is just the point: in the markets, unlike in the physical universe, the rules of the game can be changed. Central banks can decide to default on government-backed securities.

US equity markets are very overvalued on a variety of measures. If Spitznagel’s thesis is correct that the frequency and magnitude of tail events increases with overvaluation, investors need to exercise caution given the extreme level of the equity q ratio. If the eventual event precipitating a sell off is a black swan, but we can expect black swans because of the market’s overvaluation, is it still a black swan?

Order Quantitative Value from Wiley FinanceAmazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.

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Universa Chief Investment Officer Mark Spitznagel’s June 2011 working paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes (.pdf), and the May 2012 update The Austrians and the Swan: Birds of a Different Feather (.pdf) examine the “clear and rigorous evidence of a direct relationship between overvaluation measured by the equity q ratio and “subsequent extreme losses in the stock market.”

Spitznagel argues that at valuations where the equity q ratio exceeds 0.9 a 110-year relationship points to an “expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P500 within the next few years; these probabilities continually reset as valuations remain elevated, making an eventual deep drawdown from current levels highly likely.”

Today I examine the calculation of the equity q ratio and estimated market-level returns. Later this week I’ll take a look at the likelihood of massive drawdowns at elevated q ratios.

Spitznagel is perhaps best known to we folk who do not trade volatility as Nassim Taleb’s chief trader at Taleb’s Empirica. Here’s Malcolm Gladwell describing Spitznagel in his New Yorker article Blowing Up:

Taleb was up at a whiteboard by the door, his marker squeaking furiously as he scribbled possible solutions. Spitznagel and Pallop looked on intently. Spitznagel is blond and from the Midwest and does yoga: in contrast to Taleb, he exudes a certain laconic levelheadedness. In a bar, Taleb would pick a fight. Spitznagel would break it up.

The three argued back and forth about the solution. It appeared that Taleb might be wrong, but before the matter could be resolved the markets opened. Taleb returned to his desk and began to bicker with Spitznagel about what exactly would be put on the company boom box. Spitznagel plays the piano and the French horn and has appointed himself the Empirica d.j. He wanted to play Mahler, and Taleb does not like Mahler. “Mahler is not good for volatility,” Taleb complained. “Bach is good. St. Matthew’s Passion!” Taleb gestured toward Spitznagel, who was wearing a gray woollen turtleneck. “Look at him. He wants to be like von Karajan, like someone who wants to live in a castle. Technically superior to the rest of us. No chitchatting. Top skier. That’s Mark!”

In his 2011 and 2012 papers, Spitznagel describes the equity q ratio as the “most robust aggregate overvaluation metric, which isolates the key drivers of valuation.”

The “equity” q ratio is similar to Tobin’s q ratio, which is the ratio of enterprise value (market capitalization plus debt) to corporate assets or invested capital. With no debt, Tobin’s q is market capitalization over total assets. The equity q ratio (or “Q ratio”, as Spitznagel describes it in his papers) is market capitalization over shareholders’ equity. Shareholders equity is total assets less total debt. With no debt, shareholders’ equity is equal to invested capital. The equity q ratio is a market level price-to-shareholders’ equity ratio, where shareholders’ equity is calculated using assets valued at replacement cost.

Spitznagel examines the long-run tendency of the equity q ratio to mean revert, noting:

[T]he arithmetic mean to which it has been seemingly attracted is, surprisingly, not 1, but rather about .7. This, then, would be the appropriate “fair value” for use in gauging over- or under-valuation (and the March 2009 low actually came very close to this mean). 

Why doesn’t equity q mean revert to 1?

It would have been expected for this Q ratio level to be where ROIC = WACC, that is, where the price equals the net worth of the businesses, Q=1. Ostensibly, the current value of invested capital (i.e., the replacement cost of company assets) has been systematically overstated (and its depreciation understated). This is evident in the historical aggregate ROIC as computed from Flow of Funds data vis-à-vis the actual known aggregate ROIC (and adjusting thereto is consistent with Q ≈ 1).

Is the equity q ratio predictive?

If the Q ratio … is in fact the most robust and rigorous metric of aggregate stock market valuation and represents all there is to know about aggregate stock market valuation, shouldn’t it be the case that it has empirical validity as well? That is, shouldn’t it tell you something ex ante about subsequent aggregate equity returns? (The caveat of course, from Williams, is that, since “the public is more emotional than logical, it is foolish to expect a relentless convergence of market price toward investment value.“)

Just a casual perusal of Figure 2 [above] (and a basic memory of what U.S. stocks did during this period) tells the story quite well, but let’s put some numbers on it.

Figure 3 from the 2011 paper shows Spitznagel’s backtest of the relationship between mean one-year S&P 500 total returns and the starting level of the equity q ratio going back to 1901:

Spitznagel 1

Spitzagel notes:

When stocks are overvalued on aggregate, as identified by the Q ratio, their returns have been lower (with 99% confidence) than when they are less overvalued, not to mention undervalued. (Whenever one hears a reference to historical aggregate stock returns to support forecasts of future returns, it is good to recall that not all historical returns were created equal.)

Spitznagel’s white papers are important because they demonstrate that, like the Shiller PE and Buffett’s total market capitalization-to-gross national product measure, the equity q ratio is a highly predictive measure of subsequent stock market performance. Spitznagel is a specialist in tail risk, and so the most intriguing part of Spitznagel’s papers is his demonstration of the utility of the equity q ratio in identifying “susceptibility to shifts from any extreme consensus” because “such shifts of extreme consensus are naturally among the predominant mechanics of stock market crashes.” I’ll continue with the rest of the paper later this week.

Order Quantitative Value from Wiley FinanceAmazon, or Barnes and Noble.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.

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There are good reasons for tracking activists. For one, research supports the view that stocks the subject of activist campaigns can generate significant above market returns, on the filing and, importantly, in the subsequent year. Recent industry research by Ken Squire, manager of the 13D Activist mutual fund (DDDAX), finds an average outperformance of 16% over the subsequent 15 months for companies larger than $1 billion in market cap:

Ken Squire is founder and principal of 13D Monitor, a research service that tracks activist investing and has data on Icahn-led activist situations since 1994, when the investor targeted Samsonite Corp. The average return of the 85 positions since then was 18.7% (measured until he closed the position, if at all), compared to 12.7% for the Standard & Poor’s 500 over comparable time frames.

Yet this impressive-seeming average outperformance should be viewed in the context of a general tendency of stocks to outperform once they have attracted the intense interest of known activist investors. In other words, this doesn’t apply to Icahn alone.

Squire calculates that, following a 13D filing, the shares of companies larger than $1 billion in market value have historically outperformed the S&P 500 by an average of 16 percentage points over the subsequent 15 months. A separate study of nearly 300 activist actions by hedge funds between April 2006 and September 2012 found a similarly strong record of success. Squire runs the relatively new (and so-far small) 13D Activist mutual fund (DDDAX), which chooses stocks from among ongoing activist situations and beat the S&P 500 by 5.27% in 2012, after fees.

Squire takes into account the past record of specific activist investors when considering fund holdings. Hedge fund JANA Partners, for example, has a strong success rate in its arm-twisting maneuvers on corporate executives it deems lacking. One of its prominent targets currently is Canadian fertilizer giant Agrium Inc. (AGU).

Squire’s research accords with earlier studies on this site, most notably these two:

  1. In Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, April Klein and Emanuel Zur examined recent “confrontational activism campaigns” by “entrepreneurial shareholder activists” and concluded that such strategies generate “significantly positive market reaction for the target firm around the initial Schedule 13D filing date” and “significantly positive returns over the subsequent year.” The authors find that the filing of a 13D notice by an activist hedge fund is a catalytic event for a firm that heralds substantial positive returns in the stock. Klien and Zur found that “hedge fund targets earn 10.2% average abnormal stock returns during the period surrounding the initial Schedule 13D. Other activist targets experience a significantly positive average abnormal return of 5.1% around the SEC filing window. These findings suggest that, on average, the market believes activism creates shareholder value. … Furthermore, our target abnormal returns do not dissipate in the 1-year period following the initial Schedule 13D. Instead, hedge fund targets earn an additional 11.4% abnormal return during the subsequent year, and other activist targets realize a 17.8% abnormal return over the year following the activists’ interventions.”
  2. In Hedge Fund Activism, Corporate Governance, and Firm Performance, authors Brav, Jiang, Thomas and Partnoy found that the “market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of [7%] seven percent, with no return reversal during the subsequent year.” Further, the paper “provides important new evidence on the mechanisms and effects of informed shareholder monitoring.”

h/t @reformedbroker

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One of my favorite Benjamin Graham quotes:

Chairman: … One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realise it until a lot of other people  decide it is worth 30, how is that process brought about – by advertising, or what happens? (Rephrasing) What causes a cheap stock to find its value?

Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know from experience that eventually the market catches up with value.

Benjamin Graham
Testimony to the Committee on Banking and Commerce
Sen. William Fulbright, Chairman
(11 March 1955)

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Quantitative Value Cover

I’m excited to announce that the book Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (hardcover, 288 pages, Wiley Finance) is now available.

In Quantitative Value, we make the case for quantitative value investment in stock selection and portfolio construction. Our rationale is that quantitative value investing assists us to defend against our own behavioral errors, and exploit the errors made by others. We examine in detail industry and academic research into a variety of fundamental value investing methods, and simple quantitative value investment strategies. We then independently backtest each method, and strategy, and combine the best into a new quantitative value investment model.

The book can be ordered from Wiley Finance, Amazon, or Barnes and Noble.

Look Inside

(more…)

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New research co-authored by London Business School’s Elroy Dimson suggests that investors who actively engage with the companies they own to improve governance and strategy outperform more passive rivals.

The paper, Active Ownership with Oguzhan Karakas and Xi Li, focuses on corporate social responsibility engagements on environmental, social and governance issues.

The authors find average one-year abnormal return after initial engagement is 1.8%, with 4.4% for successful engagements whereas there is no market reaction to unsuccessful ones. The positive abnormal returns are most pronounced for engagements on the themes of corporate governance and climate change:

We find that reputational concerns and higher capacity to implement corporate social responsibility changes increase the likelihood of a firm being engaged and being successful in achieving the engagement objectives. Target firms experience improvements in operating performance, profitability, efficiency, and governance indices after successful engagements.

Figure 1 from the paper shows cumulative abnormal returns around corporate social responsibility engagements (click to enlarge):

Returns to CSR Activism

Dimson is perhaps best known for his global equity premia research (for example, Triumph of the Optimists and Equity Premia Around the World) with LBS colleagues Paul Marsh and Mike Staunton.

A version of the paper can be found on SSRN here.

Via Financial News’ Studies reveal the value of activism.

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What do requests for confidentiality reveal about hedge fund portfolio holdings? In Uncovering Hedge Fund Skill from the Portfolio Holdings They Hide, a paper to be published in the upcoming Journal of Finance (or see a February 2012 version on the SSRN), authors Vikas Agarwal, Wei Jiang, Yuehua Tang, and Baozhong Yang ask whether confidential holdings exhibit superior performance to holdings disclosed on a 13F in the ordinary course.

Institutional investment managers must disclose their quarterly portfolio holdings in a Form 13F. The 13(f) rule allows the SEC to delay disclosure that is “necessary or appropriate in the public interest or for the protection of investors.” When filers request confidential treatment for certain holdings, they may omit those holdings off their Form 13F. After the confidentiality period expires, the filer must reveal the holdings by filing an amendment to the original Form 13F.

Confidential treatment allows hedge funds to accumulate larger positions in stocks, and to spread the trades over a longer period of time. Funds request confidentiality where timely disclosure of portfolio holdings may reveal information about proprietary investment strategies that other investors can free-ride on without incurring the costs of research. The Form 13F filings of investors with the best track records are followed by many investors. Warren Buffett’s new holdings are so closely followed that he regularly requests confidential treatment on his larger investments.

Hedge funds seek confidentiality more frequently than other institutional investors. They constitute about 30 percent of all institutions, but account for 56 percent of all the confidential filings. Hedge funds on average relegate about one-third of their total portfolio values into confidentiality, while the same figure is one-fifth for investment companies/advisors and one-tenth for banks and insurance companies.

The authors make three important findings:

  1. Hedge funds with characteristics associated with more active portfolio management, such as those managing large and concentrated portfolios, and adopting non-standard investment strategies (i.e., higher idiosyncratic risk), are more likely to request confidentiality.
  2. The confidential holdings are more likely to consist of stocks associated with information-sensitive events such as mergers and acquisitions, and stocks subject to greater information asymmetry, i.e., those with smaller market capitalization and fewer analysts following.
  3. Confidential holdings of hedge funds exhibit significantly higher abnormal performance compared to their original holdings for different horizons ranging from 2 months to 12 months. For example, the difference over the 12-month horizon ranges from 5.2% to 7.5% on an annualized basis.

Read a February 2012 version on the SSRN.

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Embedded below is my Fall 2012 strategy paper, “Hunting Endangered Species: Investing in the Market for Corporate Control.

From the executive summary:

The market for corporate control acts to catalyze the stock prices of underperforming and undervalued corporations. An opportunity exists to front run participants in the market for corporate control—strategic acquirers, private equity firms, and activist hedge funds—and capture the control premium paid for acquired corporations. Eyquem Fund LP systematically targets stocks at the largest discount from their full change‐of‐control value with the highest probability of undergoing a near‐term catalytic change‐of‐control event. This document analyzes in detail the factors driving returns in the market for corporate control and the immense size of the opportunity.


Hunting Endangered Species: Investing in the Market for Corporate Control Fall 2012 Strategy Paper

This is the investment strategy I apply in the Eyquem Fund. It is obviously son-of-Greenbackd (deep value, contrarian and activist follow-on) and, although it deviates in several crucial aspects, it is influenced by the 1999 Piper Jaffray research report series, Wall Street’s Endangered Species.

For more of my research, see my white paper “Simple But Not Easy: The Case For Quantitative Value” and the accompanying presentation to the UC Davis MBA value investing class.

As always, I welcome any comments, criticisms, or questions.

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