Monday, February 29, 2016
A basic purpose behind accounting procedures, including GAAP, is to standardize financial statements. However, many companies are currently pushing non-GAAP earnings, which can exclude a number of non-recurring items. The write-down of an asset or restructuring are common non-recurring items. Another major item than can cause a big difference between GAAP and non-GAAP earnings is stock-based compensation, often in the form of employee stock options or restricted stock. As Warren Buffett argues: "If compensation isn't an expense, what is?" We would advise you to learn about accounting, not only because a lot about a company from reading its financial statements, as Buffett warns "Accounting tells you a lot and it can be used in many ways to deceive."
From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets. However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.
Thursday, February 25, 2016
Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.
Wednesday, February 17, 2016
Back in 2013, we posted about Warren Buffett's bet with the founders of the Protégé Partners hedge fund that the S&P 500 would outperform a hedge fund index chosen by Protégé Partners over a 10-year period. At that time, the S&P had cumulatively outperformed the hedge fund index by about 8.5 percent. Even though the hedge funds outperformed the S&P 500 in 2015, the Vanguard Admiral index fund is up a cumulative 65.7 percent in the last eight years, while the hedge fund index is up only 21.9 percent. One scenario for a possible comeback for the hedge funds, which is outlined by Ted Seides, the man who engineered the bet for Protégé, is a severe market downturn. Of course, he added about such a circumstance: "No one wins when that occurs."
Saturday, February 13, 2016
Last year, we posted about how the size and number of negative interest rates were increasing in Europe, and how one member of the Federal Reserve was pushing for negative U.S. interest rates. Since then, negative interest rates have increased again in size and number. For example, Sweden increased its central bank rate from negative .35 to negative .50 percent and Japan moved its central bank interest rate into negative territory. What is also surprising is that the market has joined into the negative interest rate fray as 2-year Swedish government bonds yield negative 1.12 percent. And, recent comments by Janet Yellen indicate that even the U.S. Federal Reserve may consider negative interest rates, although the legality of such a move in the U.S. is not clear. While negative interest rates by central banks are uncommon, they are not without precedent. What is without precedent is negative corporate bond yields, which happened last week as the yield to maturity on Nestle corporate bonds went negative!
A recent article discusses how golf and investing may be related, but also talks about several behavioral biases that can affect investors. For example, loss aversion shows up in golf as golfers are more likely to make a putt of the same difficulty for par than they are to make the putt for birdie (one under par). Another behavioral bias discussed is probability neglect, that is, people tend to worry about bad outcomes that have a very low probability, such as a plane crash or losing 40 percent of their investment. By overweighting events with a low probability, investors can incur large opportunity costs. Finally, an informational cascade occurs when investors believe the signals from other investors, even if they do not agree. For example, if a stock you view positively begins to drop, you may sell based off what other investors are doing, rather than what your research has revealed to you. As the article notes, smart investors aren't loss averse, they don't neglect probability, and believe in their own analysis.
Friday, February 12, 2016
The New Markets Tax Credit Program (NMTC) is a federal program that encourages investments which provide economic, social, or environmental benefits to low-income areas. The program provides loans that have interest rates which are typically 1 to 2 percent less than could otherwise be obtained, and borrowers only have to pay back 80 percent of the amount borrowed in seven years. The use of these loans in a project would necessitate the use of adjusted present value analysis. However, remembering that you should include all incremental costs in capital budgeting, NMTC loans are often more complex than traditional borrowing, which results in high legal and accounting fees. These additional fees should be included as an incremental cost when they would be incurred.
There is much disagreement over whether the stock market is efficient and what level of efficiency exists. Even if it is argued that the market is inefficient, it is still very difficult to identify those who can consistently beat the market as the recent performance of several well-known star mutual fund managers shows. For example, Bill Miller showed holes in his performance in 2008 when the Legg Mason Capital Value Trust fell 55 percent. Even worse, as the S&P 500 has fallen about 9.2 percent this year, the Legg Mason Opportunity fund, which he currently manages, is already down about 28 percent. Similarly, the Baron Partners fund is down about 24 percent for the year, the Federated Kaufman fund is down about 21 percent, and the Jacob Small Cap Growth fund is down about 27 percent. Each of the managers of these funds has been touted as a star manager during their career, but it appears none will be a star this year.
Thursday, February 11, 2016
We are often asked where to find the market expectations for stock returns. While there is no easy answer to that question, the market expectations on future interest rates are much easier to find. Recent comments by Janet Yellen indicated that there was a low probability of an increase in the Fed Funds rate. As the article indicates, the probability that interest rates will increase can be can be seen by Fed Funds futures, If you are not familiar with futures contracts, they are contracts traded and priced today that will be executed at some point in the future. Although there is more that goes into futures prices, futures prices can be used, in part, as the market expectation of the future price. And to show you how quickly markets can adapt, when the original Yahoo! Finance article was written, the probability that the Fed would raise interest rates by February 2017 was about 27 percent. As this is written, one day later, the probability has dropped to 6 percent.
Tuesday, February 2, 2016
Capital expenditures are affected by many factors, including corporate profits and sales. The recent drop in oil prices has caused a sharp drop in capital expenditures by oil companies. For example, BP dropped its capital expenditures for 2015 to $18.7 billion, significantly below its planned capex of $24-$26 billion. ExxonMobil dropped its 2015 capex by 25 percent to $23.2 billion, and Anadarko plans to drop its capex for 2016 to one-half of its initial budget.
As we mentioned in the textbook, companies often want and need to hedge exchange rate risk. A recent article in Treasury and Risk gives a good primer on methods to hedge exchange rates. First, a company must have an accurate forecast of foreign cash flows. With any forecast, GIGO (garbage in, garbage out) applies to hedging exchange rates. If the forecast is inaccurate, the company will over hedge or under hedge its exchange rate risk. Another suggestion made in the article is a layered hedge, which may help to reduce volatility. This means that a company does not hedge all of its exchange rate risk at a particular point in time, but rather hedges part of the expected exchange rate risk, then adds to the hedge over time as the date of the currency exchange approaches. If you are interested in hedging exchange rates, we suggest you read further.
Monday, February 1, 2016
Students (and a lot of investment professionals) think that timing that market, that is leaving the stock market before it goes down, is a good strategy. And while we would like to sell our stocks before a price drop, it is easier said than done. A recent article highlights the danger of missing the good days in the stock market. Fidelity Investments calculated the return from investing $10,000 in the S&P 500 from January 1, 1980 through March 31, 2015. If you were invested every day, your portfolio balance would have grown to $503,741. However, if you missed the five best days in the market, your balance would have been about $309,431, a 40 percent decrease! Missing the 50 best days would have dropped your portfolio balance to $41,803, or about eight percent of the value of being invested every day. There are about 252 trading days per year, so missing 5 days (or 50 days) out of about 8,800 days can have a serious impact on the value of your investments.
A recent survey by EY indicates that corporate divestitures are expected to increase in the next two years. Forty nine percent of the companies surveyed indicated possible divestitures in 2016, and only five percent of companies did not plan a divestiture over the next two years. Seventy percent of the companies that are planning a divestiture expect to reinvest in core businesses, invest in new products and markets, or make an acquisition. Divestitures have proven to be a method to increase shareholder wealth in recent years as companies that have divested more than 10 percent of their value have outperformed the stock market by more than six percent.