Sunday, April 19, 2015

Paulson, Dealing with China

Hank Paulson thrives on spanning divides, perhaps because his own two overriding passions may seem, at least at first glance, to be at odds with one another. As CEO of Goldman Sachs and, later, Secretary of the Treasury, he pursued his passion for banking and deal-making. He was “the hammer.” But he has also been an avid nature lover his entire life, dedicated to conservancy.

When he left the Treasury Department in 2009 and returned to private life, he was “as unhappy as [he’d] ever been.” He began his memoir about the financial crisis, On the Brink. “Writing is said to be therapeutic for some authors. I’d like to meet one or two of them. It sure wasn’t for me. Writing On the Brink, I found myself reliving the most harrowing moments of the crisis—complete with sleepless nights. The strain wore on my family. As a matter of fact, when I later told Wendy that I was thinking about writing another book—this one—she said simply: “Fine. And I’m going to start dating again.” (p. 266)

As he searched for what to do after On the Brink was published and he and his wife left Washington for Barrington, Illinois, he knew that he wanted to stay involved with conservation and with China. In 2011 he founded the Paulson Institute, “an independent ‘think and do’ tank that conducts environmental and sustainable development projects and research on economics and the environment in the United States and China.”

His new book, Dealing with China: An Insider Unmasks the New Economic Superpower (Twelve/Hachette, 2015), which should help to publicize the work of the Paulson Institute, was presumably less stressful to write than his first--the Paulsons are still together. It’s part memoir, part prescription.

As memoir, it’s a fascinating glimpse into how Goldman did deals in an evolving China. To paraphrase the old Smith Barney commercial, they made their money in China the old-fashioned way, they earned it. They not only had to be creative in structuring deals, they also had to learn how to read China’s political and business leaders. Paulson recounts the China Telecom IPO, where “the most obvious challenge” the Goldman team faced was that, “in conventional terms, there was as yet no actual company to underwrite.” (p. 61) And in a nation largely “ruled by men, not laws,” “trust and face were uppermost.” (p. 85)

As prescription, Paulson focuses on what he considers to be China’s foremost task—“retooling its economy for the long run.” (p. 370) He is a strong advocate of competition, as long as it’s fair, and offers some principles to guide U.S. relations with China. Prescription, almost by definition, is never as interesting a read as memoir, but policy wonks can learn from Paulson’s extensive experience in China. Environmentalists can also take heart reading about some of the projects China has undertaken, although what still lies ahead is daunting.

Paulson writes well (he was an English major, after all) and has a good story to tell. I found Dealing with China a captivating book.

Wednesday, April 15, 2015

Chirkova, The Warren Buffett Philosophy of Investment

Elena Chirkova, an associate professor of finance in the Higher School for Economics in Moscow, originally published this book in Russia, where it quickly became a bestseller. Although I have no idea how much has been written about Warren Buffett in Russian, I think it’s safe to say that it has to be a lot less than has been written about him in English. Russians may have needed this book. Do Americans and English speakers in general? Perhaps surprisingly, yes.

The Warren Buffett Philosophy of Investment: How a Combination of Value Investing and Smart Acquisitions Drives Extraordinary Success (McGraw-Hill, 2015) is a carefully constructed analysis of the key elements of Buffett’s investing prowess. The author relies heavily on previously published work, but she uses this material to present one of the most coherent accounts of Buffett’s achievement that I have read.

Take, for instance, her chapter on Berkshire Hathaway’s use of debt. When Berkshire purchases a company, “Buffett recommends that the acquired company reduce and gradually end its relationship with its bank. Berkshire becomes the company’s banker. This enables the company to take advantage of Berkshire’s credit rating.”

Chirkova continues: “A business achieves its best results when both sides of the balance sheet are well managed. Berkshire Hathaway pays considerable attention not only to searching for good investments, but also to optimizing its capital structure. This optimization requires selecting the appropriate level of debt. Although Buffett’s views on borrowing may suggest otherwise, Berkshire’s level of leverage cannot be regarded as very low.” (p. 173) Between 1976 and 2011 it averaged about 37.5%. Nearly all of this leverage came from the capital float of Berkshire’s insurance companies. In more years than not, the cost of this “borrowing” was negative, in some years highly negative, “as payouts were far lower than the premiums collected.” (p. 178)

Chirkova suggests that, despite Buffett’s claims that nobody can time the market, he has been a savvy timer in the catastrophe insurance business. Moreover, “it is not purely accidental that Buffett’s insurance business is oriented toward supercatastrophe insurance. In supercatastrophe insurance, the payouts are separated in time from the moment of premium collection by a considerable period. Losses are accounted for not in the year of the catastrophe, but once the damage has been assessed. At the same time, the premiums received are invested. The longer the period that the collected funds are held, the greater the earnings on the investment of these funds. Buffett’s investment capabilities allow him to invest premiums with better returns than those that would be available to other insurers. The outcome reinforces itself. Premiums are invested with greater profitability, which assists the insurance business.” (pp. 181-82)

In another instance of “watch what Buffett does rather than what he says,” he has actively participated in the derivatives market. Perhaps his best known deal was his sale of long-dated puts on the S&P 500, FTSE 100, Euro Stoxx 50, and Nikkei 225, executed in 2006-2008. Buffett received $4.9 billion for the sale, money that Berkshire could invest as it pleased. In retrospect, the timing of these trades may seem less than fortuitous since for accounting purposes Berkshire had to write off $10 billion in 2008. But this was only a paper loss, and Buffett had a real $4.9 billion to put to work in the depths of the Great Recession. Moreover, even if the equity indexes were to fall to zero, the maximum amount Berkshire would owe the buyers of the puts (at intervals between 2019 and 2027) would be $37.1 billion. And if Buffett gets an annual return of 10% on the $4.9 billion, then in 15 years he will have accumulated about $20.5 billion; in 20 years, $33 billion. It’s hard to imagine that he can lose on this deal.

Chirkova explores multiple facets of Warren Buffett’s investment philosophy as it has evolved, from numbers to reputation. She compares his strategy to those of Robert Merton and Peter Lynch, arguing that “the first of these two investors was practically the direct opposite of Buffett, and the second a near perfect clone.” (p. 108) She traces out his circle of friends, and even reveals that he doesn’t always drink cherry Coke.

If you’ve never read a book about Buffett’s investing skills, The Warren Buffett Philosophy of Investment is a great place to start. If you’ve already read twenty books about Buffett, you owe it to yourself to make this one your twenty-first. You will undoubtedly learn a few new things, and you may well find unexpected interconnections among things you already knew.

Sunday, April 5, 2015

Philipsen, The Little Big Number

What we measure matters. As Dirk Philipsen writes in his forthcoming The Little Big Number: How GDP Came to Rule the World and What to Do about It (Princeton University Press), “Choices about what to count, and how to count it, define many of our core values.” (p. 5)

The strength of a national economy—and, by extension, the prosperity and progress that most people believe are byproducts of economic growth—is measured by a well-known but, Philipsen argues, fatally flawed metric, the gross domestic product.

GDP was born in crisis and forged in war. In 1933 Simon Kuznets and a small staff from the Commerce Department and the National Bureau of Economic Research got the job of providing estimates of total national income for the years 1929-1931. The team found that total national income paid out to individuals had declined by 40% between 1929 and 1932. Their report was something of a best seller: “within eight months of its printing, almost 4,500 copies were sold at $ .20 a copy.” (p. 103) Soon enough the concept of national income became part of everyday political culture. “As a 1936 New York Times editorial remarked, ‘Estimates of national income, once discussed only among a handful of economists and statisticians, are now cited glibly in conversations over cracker boxes and brass rails, and many campaign arguments are based upon them.’” (p. 105) By World War II Kuznets and his students “turned the statistics of the gross national income and product accounts into information essential for planning and wartime production.” (p. 115)

GDP began to take on a life of its own. “Growth of GDP promised to create employment and necessary demand; it allowed the United States to provide vital aid to Europe and Japan and to maintain a large military during times of rising tensions with Soviet communism and growing threats to global resources and foreign markets; it eventually helped the United States win the Cold War and a series of proxy ‘hot’ wars against communism; it helped ease domestic unrest and prevented possible ‘class wars’ by raising the standards of living (as defined by per capita GDP).” (p. 126) Eventually it became a global article of faith.

What does GDP measure? For the most part, only goods and services that have a price, that are bought and sold in the market. The author introduces us to Ms. Golden Arrow, our guide to how this all plays out. Here are a few examples. “If Ms. Arrow stays home with [her children], perhaps even schools them at home, none of her work is factored into GDP, and officially nothing grows. If she does any of the things increasing numbers of American parents do—send them to private schools, enroll them in after-school activities, drive them from music lesson to math tutoring to basketball practice, hire babysitters for the much-needed evening out with her spouse—her GDP contribution grows by leaps and bounds. … If Ms. Arrow manages to stay happily married throughout all this, her spousal bliss adds nothing to official accounts of national economic success. If she runs into marital problems, requiring doctors, pills, and therapists, or perhaps even law enforcement, her GDP meter starts ticking in earnest. It hits full stride if she ends up in divorce: lawyers, courts, domestic help, separate living quarters, eating out, membership fees for dating services.” GDP remains stagnant when she lives in a safe, stable neighborhood. “But introduce things like severe inequality, social strife, or economic distress, and the resulting need of extra security measures—added police, home security systems, locks, handguns, jails—will advance GDP growth. So does her decision to move to a distant suburb: more roads, more gasoline, more construction, more accidents, more residential services.” (pp. 155-56) You get the picture. GDP is quality-blind, people-blind, justice-blind, ecosystem-blind, complexity blind, accountability-blind, and purpose-blind.

Philipsen maintains that, as a measure, GDP is both primitive and dangerous and should be abandoned. It is a delusion that jobs, the good life, or progress itself depends on GDP growth. (p. 208) Sustaining and expanding human well-being, which should be our goals, are not the same as promoting growth or income.

We need new measures that speak to these goals. We need “a national dialogue about goals of an economic constitution based on the four essential sides of our goalpost: sustainability, equity, democratic accountability, and economic viability. Simultaneous to this dialogue, taking place nationally and internationally, we can have ‘experts’—legal scholars, economists, ecologists, climatologists, medical professionals, philosophers—begin the process of figuring out how best to measure the performance of the goals embedded in our new economic constitution, and thus establish structures and regulations that support and incentivize the pursuit of these goals.” (p. 271) Some efforts are already underway, most notably the “Beyond GDP” initiative by the European Commission, but much remains to be done. Philipsen’s book is a clarion call.

Wednesday, April 1, 2015

Seifert, Profiting from Weekly Options

If you like taking quizzes you’ll love Robert J. Seifert’s Profiting from Weekly Options: How to Earn Consistent Income Trading Weekly Option Serials (Wiley, 2015). About a third of the book is devoted to test questions and answers. The author also has a glossary that he presents in full as an appendix and in part in the early chapters.

At the book’s core are four basic weekly trades—long call or put, credit spread, risk reversal, and backspread (1 x 2). Seifert explains when to initiate them and how to manage them. For instance, higher-priced stocks don’t lend themselves to the outright purchase of a call or put or to a backspread. “Once you move to the higher-priced stocks, you must go to the synthetic in order to overcome the premium. Although the option model works the same for higher-priced and lower-priced stocks, the dollar risk comes into play, and since our goal is to minimize the dollar risk and maximize our leverage, you must use the risk reversal on high-priced stocks.” (p. 113)

He analyzes how the trader should deal with these four types of option positions in varying market conditions—in a congestion phase, a trending phase, and a blowoff phase. To take but a single example, you could sell a bullish credit spread in a congested market, especially at a double bottom. You’re looking for a reward/risk ratio of approximately 2/3. “If you are more aggressive, you could consider the 60/40 [delta] spread and see if you can do it ‘Vega neutral.’” (p. 140) If the market rallies after you put your trade on, you can do nothing and allow it to expire worthless or you can roll it up. To play defense, you can sell another credit spread on the other side of the market, turning your initial position into an iron condor.

Seifert’s vocabulary is sometimes idiosyncratic, so the reader has to pay close attention early on or risk having to go back for remedial education.

Profiting from Weekly Options is not the most obvious place to begin an options education even though it assumes no previous knowledge. But those seeking to capitalize on the growing weekly options market will find it a worthwhile addition to their trading library.

Sunday, March 29, 2015

Sull & Eisenhardt, Simple Rules

In 1948 Warren Weaver, of the Rockefeller Foundation, wrote an article in which he described science “as progressing through successive eras, defined by the three types of problems—simple, uncertain, and complex—that they solved. Simple problems address a few variables that can be reduced to a deterministic formula.” Newton’s laws are examples. “By the late nineteenth century, scientists shifted their attention to problems of uncertainty, such as the motion of gas particles in a jar.” They used probability theory and statistical analysis to predict how large numbers behave in aggregate, “paving the way for advances in thermodynamics, genetics, and information theory.” That left us with the most difficult set of problems, those dealing with complexity. (pp. 9-11)

The financial markets are complex adaptive systems. They cannot be described by deterministic formulas. They don’t lend themselves to statistical prediction. What, then, is an investor or a trader to do?

MIT and Stanford professors Donald Sull and Kathleen M. Eisenhardt offer some suggestions in their forthcoming Simple Rules: How to Thrive in a Complex World (Houghton Mifflin Harcourt, 2015). Their book will inevitably be compared to Daniel Kahneman’s Thinking, Fast and Slow and Malcolm Gladwell’s Blink. But it is more practical than its predecessors, written for people (especially business people) who have to make tough decisions.

Simple rules often work best. “In contrast to complicated models, simple rules focus on only the most critical variables. By ignoring peripheral factors and tenuous correlations, rules of thumb eliminate a great deal of noise. The absence of noise results in decisions that work reasonably well across a wide range of scenarios, rather than being optimized for a single situation. … In very complex systems, like the stock market or the economy as a whole, where causal relations are poorly understood and shift over time, the risks of overfitting past data are particularly acute. Statisticians have found that complicated models consistently fail to outperform simple ones in forecasting economic trends, and the accuracy of their predictions has not improved over time. When it comes to modeling complex systems, sophisticated does not equal effective.” (pp. 34-35)

Simple rules “are particularly effective when the situation is in flux, flexibility trumps consistency, and the benefits of seizing opportunities exceed the cost of making mistakes. “ (p. 44)

Admittedly, there are situations in which complicated decision-models work better than simple rules. For instance, “decisions that can be made by computers, such as via automated trading programs, are better candidates for complicated models than those that rely on human willpower to implement.” (p. 37) In general, however, simplicity wins the day.

Effective simple rules can be sorted into six broad categories: boundary, prioritizing, stopping, how-to, coordination, and timing. The authors give examples of each type of rule, drawing on a range of behaviors (from which house to rob to when to sell a stock, from how to deal with out-of-control forest fires to how starlings flock).

The authors describe ways to develop simple rules in business, non-profit, and personal settings. These rules, of course, cannot be created in a vacuum. “Investing the time upfront to clarify what will move the needles dramatically increases the odds that simple rules will be applied where they can have the greatest impact.” (p. 144)

Investors and traders who want to simplify their overly complex systems or who want to create an efficient rule-based system or plan will be well served by this book. The task will remain difficult (or not, if they opt to follow the 1/N rule). In any event, the recommendations in Simple Rules should keep the investor or trader from straying too far off course.

Wednesday, March 25, 2015

Allman, Impact Investment

Impact investors believe in the power of private capital to solve intractable social problems and, at the same time, deliver a financial return. Impact investing is a burgeoning field. “As of 2014, over USD12.7 billion has been committed to impact investing, representing a growth of 19 percent from the prior year. Numerous investors are active ranging from lone high net worth individuals to a multitude of private equity funds. Even larger-scale financial institutions and investment services have dedicated funds and resources to impact investing.” (p. 1)

Keith A. Allman and Ximena Escobar de Nogales have written a how-to manual for the would-be investor. Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis (Wiley, 2015) takes the reader through the steps that an investor would normally follow: sourcing and screening, investment analysis and valuation, due diligence and investment structuring, term sheet and documentation, and building value to exit.

The process is arduous and more constrained than traditional private equity investing. Private equity funds have a single mission—to make money. Impact funds have a dual mission—to deliver both financial and social/environmental returns. This means that impact investors will have a smaller pool of potential investments from which to choose. It entails a more complicated set of metrics throughout the process. It also means that the compensation of the fund manager has to be pegged to both financial and social goals—a tricky calculation at best.

Impact Investment is an excellent guide for investors who want to venture into the field of idealistic capitalism. As this book amply demonstrates, they will need all the help they can get.

Sunday, March 22, 2015

Lichtenfeld, Get Rich with Dividends, 2d ed.

In Get Rich with Dividends: A Proven System for Earning Double-Digit Returns (second edition, Wiley, 2015) Marc Lichtenfeld, chief income strategist of the Oxford Club, lays out a plan to consistently achieve above average returns. He calls it the 10-11-12 system because it is designed to achieve an 11% yield and a 10-year average total return of 12% in 10 years. To accomplish this, the investor needs a 4.7% starting yield, a 10% dividend growth, and a market that performs as it has historically.

Lichtenfeld provides a step-by-step guide to constructing a winning dividend portfolio. Since his guide doesn’t lend itself to brief summary, I’ll focus on two points: (1) the historical performance of stocks that raise their dividends and (2) buybacks versus dividends.

According to Ned Davis Research, assuming an initial investment of $100, between 1972 and 2010 dividend cutters were worth $82 (a compound annual growth rate of -0.52%), companies that didn’t pay a dividend were worth $194 (1.76%), companies that paid a dividend but kept it flat were worth $1,610 (7.59%), and dividend raisers were worth $3,545 (9.84%). The author’s system would turn the initial $100 investment into nearly $7,500 over the same period.

As for the performance of stocks versus high-yield bonds, historically, stocks have “a greater chance of suffering a loss, but only by 3%. To compensate for the risk, stocks generate 92% in extra return. …[I]n the past, you’ve had a 9% chance of losing 27% of your money over 10 years investing in stocks or a 6% chance of losing 40% of your money investing in high-yield bonds.” (p. 49) Dividend stocks, the author concludes, are a better investment than junk bonds.

When companies have excess cash, they can pay a dividend, buy back stock, make an acquisition, or simply horde the money. Which is better for the investor—a dividend or a stock buyback? Not surprisingly, Lichtenfeld comes down in favor of dividends.

A stock buyback does not require a company to repurchase the amount of stock it announces in its stock repurchase authorization. But when it does buy back its own shares, it decreases the share count and thereby increases the earnings per share. So when a company announces a stock buyback, it normally sees a pop in its stock price, even if its profits don’t move at all. “It’s simply an accounting trick that doesn’t reflect any change in the business.” (p. 60)

By contrast, “when a company pays a dividend, that’s real. It’s not part of an authorization plan that may or may not be executed. … A dividend declaration is like a vote of confidence by management not only affirming that there will be enough cash to pay the dividend and run the business but also stating that it has set an expectation for a certain level of earnings and cash flow.” As a 2007 study concluded, “share repurchases are associated with temporary components of earnings, whereas dividends are not.” Or, as another study found, “dividends are paid by firms with higher ‘permanent’ operating cash flows.” (pp. 60, 61)

Investing in dividend-paying stocks is a sound strategy for those who seek income or, if they have time on their side, who want to reap the wondrous rewards of compound interest. Long-term investors will find an abundance of valuable, actionable advice in Get Rich with Dividends. It’s definitely worth a read.