Archive for the Investing Category

Advice to My Nephew Clayton

Posted in Investing, Life in the Country on 2, May 2017 by nathanbusch

Nephew Clayton:

You will, most probably, have by now been taught to work hard, get an education, and make a moderately good living working for some company or other.  That is total bullshit!  Were I forty years younger, here is what I would have done.

Get yourself into the Physics Department of the California Institute of Technology.  There, work on your Doctorate of Philosophy in the field of Quantum Field Theory.  You will want to study systems in which spacetime is subject to random fluctuations.  Examine the Radon Transform of information deriving from such a system: specifically, you would be looking for the Riemann-Stieltjes Integral of the underlying field weighted by the probability measure of the random fluctuations.

Once you have finished that, which should take you less than three years, tell the physics world to go shove it where the Sun never shines.  Instead, get yourself some financial backers and apply what you have learned to the system that is the international financial market.

If you have accomplished what I think is the correct way of evaluating this last mentioned system, you should be wealthier than both Warran Buffet and Bill Gates combined by the time that you reach 65.

The gauntlet has been thrown down.

I hope that this helps.

Nathan A. Busch

Stories and the Trump Bump

Posted in Investing on 14, January 2017 by nathanbusch

Because of Trump, “the market is going straight up with nothing to stop it,” explicated one very excited attendee at a local investing group that I attended during the third Thursday of December 2016.

Barely able to contain himself, this lad gave the following “story” regarding Dryships (DRYS):

Trump is going to put a “huge”, G_d I hate it when the illiterate use that word, tariff on Chinese steel. Investors, that word is second from the top of my most despised words in the English language and only barely above the use of the word “scientists”, in the United States are renting large warehouses to store steel that they intend to import from China into the United States in advance of the inauguration of “The Donald”. Once “The Donald” has become president and the tariffs imposed the price of steel in the United States would skyrocket and these “investors” would make a fortune by selling the steel, which they had imported from China whilst cheap, into an expensive U.S. steel market. Thus, Dry Ships will be rolling in money because the “investors” need dry ships to transport the cheap steel from China into the United States.

Whilst nearly hyperventilating with excitement, this lad exclaimed that DRYS stock price had risen over 2000% within a few days: he called it “the opportunity of a lifetime. Then he petitioned the members of the group to announce any similar opportunities of which they might be aware. In a very calm voice, I stated the general position of the group, as I had been attending the group and knew the investment strategies of most of its members, as follows:

I use the following rule to reach a decision regarding into what I will invest my money: have a strategy that works; and stick with it no matter what happens in the world.

Within a few days of the pronouncement of our hyperventilating lad, DRYS crashed from about 100 per share to barely above 1.87. What our lad seemed to have missed is the following: that DRYS had a 52-week high of 278.40 and a 10-year high of 3000.00 per share. The Ticker Symbol closed on 12th January 2017 at 1.84. Even without the glut of ocean shipping capacity and the bankruptcy of Hanjin, I would have never purchased shares in a company such as DRYS: its gross profit for the year ended December 2015 was less than half of its gross profit for each of fiscal year 2013 and 2014; its net income applicable to common shares was deep in red territory for 2013, 2014, 2015, and through third quarter of 2016. No one, except shorts, in their right mind would ever consider purchasing so much as one share of a company showing a market capitalization of 68.00MM that had a fiscal year 2015 net income in the red by more than 2.8B.

My call for the rise from a few dollars to over 100 dollars per share following the election of “The Donald”: this was a classic short squeeze. No one in their right mind would ever come within a country mile of such a Ticker Symbol.

The moral of this story: run, as fast as possible, from any one with a “story” about a “good” Ticker Symbol.

I hope that this helps.

Nathan A. Busch

They Were Informed

Posted in Investing on 4, April 2014 by nathanbusch

About four years ago I told my nephew, who was about 29 at the time, the following: open a Roth IRA; contribute $5,500 the first year; contribute $5,500 the second year; that is all the money that you will ever have to save for the rest of your life; invest precisely the way I tell you to; and, by the time you are 72, your Roth IRA will be valued at approximately $2.44 billion with probability 0.85.

I do not have $5,500 for each of two years, said he.

I will give you the $5,500, said I.

He did not take me up on the offer: seems that his interests lay elsewhere.

I said the same to my niece at about the same time. She was about 28 at the time.

I do not have the $5,500, said she.

I will give you the $5,500, said I.

How can you guarantee that it will work, said she.

No guarantee, but merely probabilities, said I.

What about the other 0.15 probability, said she.

In that case, you will have somewhat less, said I.

She did not believe anything that I said.

Actually, with a relatively simplistic hedge, the efficiency can be increased three fold. Since the efficiency is the natural logarithm of the change in the underlying yield ratio, then a three-fold increase in efficiency represents a mere 2.5 percentage points increase in the annual yield ratio of the investment strategy over a 43 year investment horizon.

No one believes that this can be done.

But I am doing it.

Nathan A. Busch

CAPM, EMH, and other such Bunkum

Posted in Investing on 22, March 2014 by nathanbusch

I recently came across a fellow investor who was using beta to measure volatility of an asset in order to decide whether to purchase that asset. The following is my response.

***************

Beta is used in the Capital Asset Pricing Model to provide the expected return on an asset given the standard deviation of the price of that asset about its mean, which may vary with time, and the expected return on a benchmark asset, such as a zero-risk asset. The proper interpretation is as follows. Suppose you chose the 10-year treasury as your zero-risk asset. You immediately know your expected return on that asset. Now, consider a high risk asset such as GSS. Here, it is not simple to know what the expected return should be. The Capital Asset Pricing Model provides that answer: it is simply r_a = r_f + beta (r_m – r_f), where r_a is the expected return on the asset of immediate interest, r_f is the rate of return of a risk-free asset, and r_m is the expected rate of return of a benchmark asset, such as the S&P 500.

To compute beta requires simple linear regression which can be performed in Excel or any other relatively sophisticated spread sheet. Simply obtain the daily values for the market and compute the value of r_m = ∂S(t)/S(t) where S(t) is the value of the market at any given time and ∂S(t) is the change in the value of the market between any “base point” and the given time t. Perform the same simple computation for the price of the asset of interest. Then, do a linear regression with the quantity (r_m – r_f) as the abscissae values (x) and r_a as the ordinate (y) values. beta will be the slope of that regression result.

Personally, I think that the Capital Asset Pricing Model is extraordinarily useless as a measure of anything in the market. Of course, I know that Mr. William Sharpe won the Nobel Prize in Economics in 1990 for developing the model, but that does not mean that the model is of any practical use. Even if the Efficient Market Hypothesis and the Capital Asset Pricing Model had any basis in reality, what does the value of beta tell us about whether to invest in any given asset, say KO? In my humble opinion, it tells us nothing. I am not alone in my opinion. In 2004, E.F. Fama, another Nobel Prize Winner, observed that the empirical evidence demonstrated that the CAPM was invalid in real world application. He observed that passive funds that were invested in low beta, small or value, stocks tended to produce positive abnormal returns relative to CAPM predictions. Yes, one can fiddle with the CAPM to adjust for such real-world problems. Perhaps the better choice of action is to throw the entire CAPM, including beta, into the round file and use something that actually gives you some useful information about the stock that you are thinking of purchasing.

Perhaps you should leave your cash where it is for the next six months and carefully study the following two books very carefully: (1) Benjamin Graham: The Intelligent Investor; and, (2) John Burr Williams: The Theory of Investment Value. For some light reading, throw in Graham and Dood: Securities Analysis. It is worthwhile to set every thing in your world aside, except for your day job, until you have throughly understood every word in all three works. Then you will have all of the tools that Warren Buffet uses to select a company to buy.

Once you have done this, you will never, ever again think about using beta except for a late night joke.

I hope that this helps.

Nathan A. Busch

Mechanical Investing, Part I

Posted in Investing on 15, March 2013 by nathanbusch

From time to time on this web log, I have hinted at the possibility of using mechanical screens to build a profitable portfolio. Of course, the natural response is that one should have a deep understanding of both the company and the sector of the market in which that company exists to make appropriate and proper investment decisions. However, what if all the advice given by the investment advisors and financial planners is completely bogus. What if it is possible to screen the universe of public companies for certain attributes and simply buy the best of the companies passing that screen. What if it was possible to be successful doing so without even knowing what these companies do or sell. Let us take a pilgrimage for a while with the goal of finding a better way to invest.

Several mechanical techniques for identifying good companies depend upon the calculation of the Return on Invested Capital (hereinafter denoted as “ROIC”). The normal formulation of ROIC is as follows:

ROIC = EBIT* / TIC,

where

EBIT* is a modified Earnings Before Interest and Taxes, and

TIC is the Total tangible Invested Capital.

Of particular interest at this juncture is the total tangible invested capital. This quantity is occasionally defined to be:

TIC = NWC + NFA,

where

NWC is the Net Working Capital, and

NFA is the Net Fixed Assets.

In The Little Book that Beats the Market, Joel Greenblatt used a floor function to obtain the Net Working Capital based upon the total current assets, the excess cash, and the amount of non-interest bearing payables. The problem is that Mr. Greenblatt was relatively opaque about how to obtain a value for the non-interest bearing payables and was an obscurantist with respect to the excess capital. To explore the derivation of the value of the net working capital, consider that Mr. Greenblatt used the following formulation:

NWC = MAX[0, TCA – EC – NIBP],

where

TCA is the Total Current Assets,

EC is the Excess Cash, and

NIBP is the Non-Interest Bearing Payables.

If your source for market information provides a value for the non-interest bearing payables for the 10,000 or so available companies in the market then you are in reasonably good shape: that is, if they provide the correct number. Mr. Greenblatt alludes to the possibility that the non-interest bearing payables could be obtained as the difference between the total current liabilities and the interest bearing payables. This may be written as:

NIBP = TCL – IBP,

where

TCL is the total current liabilities, and

IBP is the interest bearing payables.

It turns out that the interest bearing payables almost certainly show up on the EDGAR filings of the company and are designated as either the short-term debt or the current long-term debt due and owing. We define the interest bearing payables as the sum of the short-term debt and the long-term debt currently due and owing. It is common accounting practice to define the total current assets and the total current liabilities as follows:

TCA = (C + STInv) + (AR + Inv + OCA), and

TCL = (AP + STD + OCL),

where

C is the total amount of cash held by the company,

STInv is the amount of Short-Term Investments held by the company,

AR is the accounts receivable,

Inv is the inventory belonging to the company,

OCA is the “Other Current Assets” belonging to the company.

Also,

AP is the accounts payable,

STD is the short-term debt or current long-term debt due and owing,

OCL is the “Other Current Liabilities” of the company.

Fortunately, all of these last eight quantities are available in either the 10Q or 10K filed with the Securities and Exchange Commission and these quantities may, almost certainly, be available in the commerical market databases.

Now, we return to obtaining the value for the non-interest bearing payables. Following the aforementioned formulation, we may write that:

NIBP = TCL – STD,

or,

NIBP = (AP + OCL).

The import of this last step in the derivation is not to be overlooked. It is one of the two principle means by which a mechanical screen, which uses the ROIC, can differentiate between a management team that is being prudent and efficient with management of the cash flow of the company and a management team that needs some improvement in this area.

We now turn our attention to obtaining a formulation for the excess cash of the company. It has bee suggested that the excess cash should be the difference between the cash and cash equivalents and the working cash of the company. That is, the excess cash may be defined to be:

EC = (C + STInv) – WC,

where

WC is the working cash of the company.

The working cash of the company is not to be confused with the net working capital of the company. The working cash is defined to be the difference between the liabilities of the company, which relate to the general operation of the company, and the assets of the company. In other contexts, the working cash of the company may be used to describe how far the company is inside of the door of the bankruptcy court. This quantity has been defined as follows:

WC = MAX[0, (AP + OCL) – (AR + Inv + OCA)].

Of greater import, this quantity is positive only when the current liabilities, without the short-term debt, exceed the current assets. It is possible that companies may exist with a non-zero amount of working cash but still be quite viable companies as investment opportunities. At this time, we are in a position of expanding the formulation for the net working capital given above to obtain a working version for this quantity. Specifically, we may write that:

NWC = (C + STInv) + (AR + Inv + OCA) – [(C + STInv) – WC] – (AP + OCL),

or,

NWC = (AR + Inv + OCA) – (AP + OCL) – WC.

This form for the net working capital is quite close to the form typically used in standard accounting practices. Two differences are immediately apparent. The above form does not include the short-term debt but does include the working cash.

To complete the derivation of the total tangible invested capital, we may write the net fixed asset value as follows:

NFA = TA – TCA – TIG,

where

TA is the Total Assets of the company,

TCA is the Total Current Assets of the company, and,

TIG is the total amount of intangible assets and goodwill declared by the company.

We may obtain the earnings yield, {1/E}, and the return on invested capital, ROIC, as follows:

{1/E} = EBIT* / EV,

and,

ROIC = EBIT* / (NWC + NFA).

Whilst deriving the form for the net working capital, we observed that the short-term debt was removed. Also, it is essential to recognize that the taxes due and payable for the most recent fiscal quarter for a compay must be excluded from the current liabilities. To observe the effect of these two quantities on the computed earnings yield and return on invested capital, we conducted a study in which these two quantities were either separately included or excluded from the net working capital or both were included or excluded. The results are given in the following table.

Table 1: The effect of either including the short-term debt and taxes payable in the formulation for the net working capital. The fundamental data used to compute the values contained in this table are for PWER as at 31st December 2010.
Quantity   no STD&Tax with STD with Tax with STD&Tax
{1/E}   28.55% 27.05% 28.55% 27.05%
{ROIC}   127.2% 168.8% 234.3% 429.9%

It is immediately obfious that including the taxes payable in the net working capital, most likely as a “other current liability”, has the effect of dramatically raising the value of the return on invested capital.

Let us consider two identical companies with somewhat different tax structures. Say Company A owes taxes as at the end of the fourth quarter of 2010 in the amount of 51.8695 and Company B owes 103.739. Also assume that both companies include the taxes payable as an “other current liability.” The values obtained are as follows:

Table 2: The earnings yield as a function of the taxes payable for two otherwise identical companies. Company A owes taxes in the amount of 51.8695 and Company B owes taxes in the amount of 103.739. Assume that both companies include the taxes payable as an “other current liability.” The fundamental data used to compute the values contained in this table are for PWER as at 31st December 2010.
Quantity   Company A Company B
{1/E}   28.55% 28.55%
{ROIC}   164.84% 234.31%

What we see is that by including the taxes payable in the category of “other current liabilities”, the company that is not tax efficient obtains a higher return on invested capital. Given that the mechanical screening techniques gives a one to the highest return invested capital, the best ranking, then, would go to the company that was least efficient with managing their taxes.

Let us now consider the same two companies in a scenario for which the savings on taxes by Company A was contributed to the cash holding of the company. Table 3 contains the corresponding earnings yield and return on invested capital.

Table 3: The earnings yield as a function of the taxes payable for two otherwise identical companies. Company A owes taxes in the amount of 51.8695 and Company B owes taxes in the amount of 103.739. Assume that both companies include the taxes payable as an “other current liability.” Further, assume that Company A is able to contribute 51.8695 to its cash holdings. The fundamental data used to compute the values contained in this table are for PWER as at 31st December 2010.
Quantity   Company A Company B
{1/E}   30.09% 28.55%
{ROIC}   164.84% 234.31%

The result is that the earnings yield of Company A is slightly improved, but perhaps not enough to offset the superior rank of Company B with respect to the return on invested capital.

Let us examine a scenario in which Company A invested the net tax savings in new capital assets to generate a proportionately higher income in the next fiscal quarter. We know that if neither the short-term debt nor the taxes payable are included as current liabilities when computing the net working capital, the return on invested capital is 127.15%. Thus, investment of taxes saved into new fixed assets should increase the revenue by an amount equal to 1.2715 times the amount of saved taxes. For purposes of this analysis, we ignore the taxes on the additional revenue. The results are given in Table 4.

Table 4: The earnings yield as a function of the taxes payable for two otherwise identical companies. Assume that Company A is increases its tangible working capital by 51.8695 for the next fiscal quarter. The fundamental data used to compute the values contained in this table are for PWER as at 31st December 2010.
Quantity   Company A Company B
PPE   115.195 63.325
Revenue   1904.779 1047.1
{1/E}   113.44% 28.55%
{ROIC}   411.23% 234.31%

In this simple analysis, it becomes clear that by managing the tax burden efficiently, Company A stands to see an earnings yield, all other things held the same, in the next quarter of 113.44% as compared with the earnings yield of Company B. Of greater import, Company A will be able to provide the investors with a return on invested capital in the next quarter of 411.23%, all other things held fixed, as compared with the 234.31% for Company B. By including the taxes payable in the other current liabilities, Company A obtains an inferior ranking in the mechanical screen as compared with Company B, even though Company A was more tax efficient and was able to realise a considerable increase in revenue in the ensuing quarter by investing the saved taxes.

To compare two otherwise identical companies, it is essential to exclude the current tax liability from the computations for the net working capital of the company. Since short-term debt would be handled in the same manner in computing the net working capital as was the current taxes payable, it is also essential to exclude the short-term debt. The logic behind this is as follows: consider two otherwise identical companies; Company A maintains a very low level of short-term debt, whilst Company B is not so prudent. Even though Company A carries a lower short-term debt, it will be ranked inferior to Company B if that short-term debt is included in the calculation of the net working capital. However, Company B will, most likely, suffer from two possible maladies: a portion of any revenue generated by the company will be used unproductively to pay interest and principle on the short-term debt; and, Company B is at a higher risk of defaulting on the debt and, therefore, drive shareholder value down.

When confronted with a choice between two otherwise identical companies, the prudent investor will drive down his risk of exposure to a default by choosing that company that properly manages its long- and short-term debt and operates in a tax efficient manner.

It is, therefore, possible to use a mechanical screen for efficient use of capital resources by management. Management that operates the company efficiently will seek tax efficient alternatives amongst various possible trajectories and will use only an optimum amount of short-term debt. By excluding both the short-term debt and the current taxes payable from the computation of the net working capital, the mechanical screen can separate the management of lesser quality from the superior management team.

I hope that this helps.

As at 8th March 2013

Posted in Investing on 12, March 2013 by nathanbusch

ZAZA, VGZ, PDLI, QCOR, LECO, CPIX, STRXA, FLWS, BA, LF, DECK, SPMD, LMCA, TTWO, ACAT, HFC, CRUS, CHRW, LTD, CVRR, MEG, COH, CXS, BLC, MGLN, ITW, INTX, CVI, NVDA

I hope that this helps.

Nathan A. Busch

This Just Might Work, Part I.

Posted in Investing on 8, March 2013 by nathanbusch

As part of a portfolio, it just might work to equally weight the companies found in Table 1. If this part of the portfolio fails, we will investigate to determine whether any signals were available on the date of purchase that might have allowed for a premonish as to potential failure. The same is also true for the success of this portfolio.

Table 1: The following companies were selected based upon data available as at 1st March 2012. A portfolio was started by equally weighting each of the companies in this list based upon the price as at 7th March 2013. Prices for each month thereafter are given as at the 7th of the month or the nearest trading day. This is a real-money portfolio.
Co.   Mar Apr May Jun Jul Aug Sep Oct
PDLI   6.95              
CPIX   4.52              
FLWS   4.71              
STRZA   4.77              
BA   79.08              
ACAT   41.02              
HFC   58.16              
DECK   48.70              
SPMD   4.21              
TTWO   15.43              
LECO   56.10              
CRUS   22.47              
LF   8.60              
CHRW   57.23              
BLC   9.27              
CVRR   29.84              
COH   49.93              
INTX   10.57              
CXS   13.34              
ITW   62.61              
CVI   61.01              
NVDA   12.79              
BAH   12.59              
MGLN   53.26              
VCI   28.33              
GTN   4.45              
PETS   13.56              
SAI   12.05              
Average   26.934              

However, I suspect that it might be better to weight according to the exponential of the relative beta values.

I hope that this helps.

Nathan A. Busch