Archive for January, 2010

Financial Statements: Monetary X-Rays for Decision Makers

Virtually everyone has been to a doctor’s office or hospital, and at some point gotten an x-ray. Typically, multiple x-rays are taken to give the doctor adequate data for determining a patient’s health and well-being. For example, a dentist will take numerous views in searching for disease and cavities, above and below the surface of the mouth. When it comes to financial markets, the same diagnostic principles apply to securities analysis. But rather than x-rays, we have financial statements. The income statement, balance sheet, and cash flow statement provide analysts multiple angles for making a proper company diagnosis. Each financial statement provides the user a unique perspective, and together, the statements paint a more complete picture into the financial condition of a company. In the coming weeks (and months), I will take a deeper dive into the world of financial statement analysis.

Financial Statement Reporting

What is the purpose of financial statement analysis?

“The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.”    -Howard Schilit (author of Financial Shenanigans) 

 

Sounds simple and pure in its aim, but as we will find out, there can be more to financial statements than meets the eye (see also EPS Tricks of the Trade). In order to profit (and protect oneself), financial statement users need to read between the lines.

The Bookkeeper Police

Policing the integrity of the financial bookkeeping process are the FASB (Financial Accounting Standards Board) – the entity behind the creation of GAAP (Generally Accepted Accounting Principles) – and the SEC (Securities and Exchange Commission). Unfortunately the goals of management (maximize wealth and shareholder value) do not always align with the objectives of financial statement users (accuracy and transparency). As we found out from the case of Bernie Madoff, investors cannot always rely on the SEC for law enforcement. A deep-rooted foundation in financial statement analysis mixed in with some common sense may protect you from some major financial pitfalls.

Why are Financial Statements so Important?

Transparency of Capital Markets: Our capitalistic society is based on the trust and transparency of available financial information, so key decision makers can make informed decisions. In many emerging markets, standards are more lax and well-versed decisions are more difficult to make. Ultimately, if you believe in free markets, money migrates to where it is treated best.  Reliable and transparent financial systems build investor confidence and make our system work. When companies like AIG and Enron have complex derivatives and opaque off balance sheet structures that are not clearly disclosed, then investors and key decision makers are at a disadvantage. The companies generally suffer as well, since investors afford lower valuations for complex organizations.

Investment Bankers / Sell Side ResearchInvestment bankers rely heavily on financial statements when determining the suitability of corporate marriage. A company cannot be bought or sold without determining an agreed-upon valuation. Financial statements help bankers establish an appropriate price for transactions.

Competitors: We live in a dog eat dog world. Assessing the strength and effectiveness of various competitor initiatives can lead to better decision making. For example, one can simply compare the revenue growth rates of two companies to determine who is gaining market share. In tough times like now, an analyst can look at items such as debt load on the balance sheet or cash generation on the cash flow statement to determine how a company is positioned to weather a potential cash crunch.

Employment/Compensation: Astute financial analysis by job seekers can lead to tremendous insights into a company’s financial condition. The process can also trigger shrewd questions to bounce back at the interviewers. Executives can also look at financial and proxy statements to uncover compensation practices of a company.

Fraud/Inaccuracies: The SEC and other regulatory agencies need tools to hunt down the bad guys and notify those stretching the letter of the law. The SEC and FASB are supposed to act as the industry financial cops. Our trust in these institutions took a deep hit when these organizations failed to catch the corrupt actions of Bernie Madoff, despite the multiple times outsiders waved red flags to the SEC.

IRS/Tax Collection: Uncle Sam wants to collect his revenue, especially in these times of large and expanding deficits. Verifying and auditing the correctness of a company’s tax liabilities can ensure correct tax revenues are accumulated.

Bankers/Creditors: Banks are becoming even more tight-fisted these days, and in order to provide loans to borrowers, financial statements become a key component of the loan equation.

Internal Finance Staff & Consultants: Chief Financial Officers and corporate finance department professionals need financial statements to steer strategy in the right direction. Many companies develop a six sigma type of approach whereby margin and cash flow improvements are targeted. In that vein, internal and external benchmarking can highlight areas of strengths and weaknesses.

For many, financial statement analysis is not the sexiest endeavor. However, I think when properly applied, the process engenders clearer and more confident decision-making. A doctor feels much the same way upon reviewing a set of accurate x-rays and making an informed patient diagnosis. Do yourself a favor and don’t ignore the financial statement components. With appropriate financial analysis, I am confident you can make healthy investment decisions too.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in AIG or other securities mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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January 29, 2010 at 1:30 am 1 comment

Metrics Mix-Up: Stocks and Real Estate Valuation

When it comes to making money, investors choose from a broad menu of investment categories, ranging all the way from baseball cards and wines to collectible cars and art. Two of the larger and more popular investment categories are stocks and real estate. Unfortunately for those poor souls (such as me) analyzing these two classes of assets, the stock and real estate investor bigwigs have not come together to create an integrated metric system. Much the same way the United States has chosen to go it alone on a proprietary customary unit measurement system with Burma and Liberia – choosing inches and feet over centimeters and meters. On the subject of stock and real estate valuation, investors and industry professionals have been stubbornly defiant in designing unique and cryptic terminology, despite sharing the exact same financial principles.

Who Cares About Real Estate?

Well, apparently everyone. Southern California doesn’t have a monopoly on real estate, but through my practice in Orange County, I find it difficult to not trip over real estate investors on a daily basis. I work in effectively what was “ground zero” of the subprime debacle and the commercial real estate pains continue to ripple through “the OC.”

Ramping up the real estate learning curve reminds me of my high school Spanish class – I understood enough Spanish to work my way through a Taco Bell menu but little else. In order to actually learn Spanish I had to completely immerse myself in the language, even if it meant continually speaking to my classmates in Spanish through my alias (Paco).

Real Estate Foundational Terms

Despite being a relative new resident in the Orange County area, engrossing myself in real estate hasn’t been much of a challenge. Over a brief period, my interactions and conversations taught me my financial degrees and credentials were just as applicable in the realty world as they were in the stock market world. While evaluating real estate valuation techniques, I discovered two new key terms:

1)      NOI (Net Operating Income): Unlike stock analysis, which uses “Net Income” as a core driver in determining an asset’s value, real estate relies on NOI. Net operating income is generally derived by calculating income before depreciation and interest expense. In finance, there are many versions of income. I’m sure there are more explanations, but two reasons behind the selection of NOI in real estate valuation over other metrics is due to the following: a) NOI may be used as a proxy for cash flow, which can be integral in many valuation techniques; and b) NOI is “capital structure neutral” if comparing multiple properties. Therefore, NOI allows an investor to compare varying properties on an apples-to-apples basis regardless of whether a property is massively leveraged or debt-free.

2)      Cap Rate (Capitalization Rate): This ratio is computed by taking the NOI and dividing it by a property’s initial cost (or value). In stock market language, you can think of a “cap rate” as an inverted P/E (Price – Earnings) ratio – an inverted P/E ratio has also been called the “earnings yield.” Complicating terminology matters is the interchangeable use of income and earnings in the investment world. In the case of the P/E ratio, the denominator generally used is “Net Income.”

A shortcoming to the cap rate ratio, in my view, is the failure to deduct taxes. Although comparability across properties may get muddied, if determining profit availability to investors is the main goal, then I think an adjusted NOI (subtracting taxes) would be a more useful proxy for valuation purposes. Tax benefits associated with REITS (Real Estate Investment Trusts) complicates the metric usage issue further.

The simplistic beauty of marrying NOI and a cap rate is that a crude valuation estimate can be constructed by merely blending these two metrics together. For example, a commercial real estate property generating $500,000 in NOI that applies a 5% cap rate to the property can arrive at a valuation estimate of $10,000,000 ($500,000/.05).

Similarities between Stocks & Real Estate

At the end of the day, the theoretical value of ANY asset can be calculated by taking the projected after-tax cash flows and discounting that stream back into today’s dollars – whether we are talking about a stock, bond, derivative, real estate property, or other asset. Both stock and real estate analysis use readily available income numbers and price ratios to estimate cash flows and valuations. Regrettably, since real estate and equity investors generally play in different leagues, the rules and language are different.

The lingo used for analyzing separate asset classes may be unique, but the math and fundamental examination are the same. The formula for learning real estate is similar to that of Spanish – you need to dive in and immerse yourself into the new language. If you don’t believe me, just ask Paco.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in YUM or any other security mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 27, 2010 at 1:34 am 3 comments

Sports & Investing: Why Strong Earnings Can Hurt Stock Prices

There are many similarities between investing in stocks and handicapping in sports betting. For example, investors (bettors) have opposing views on whether a particular stock (team) will go up or down (win or lose), and determine if the valuation (point spread) is reflective of the proper equilibrium (supply & demand).  And just like the stock market, virtually anybody off the street can place a sports bet – assuming one is of legal age and in a legal betting jurisdiction.

Right now investors are poring over data as part of the critical, quarterly earnings ritual. Thus far, roughly 20% of the companies in S&P 500 index have reported their results and 78% of those companies have beaten Wall Street expectations (CNBC). Unfortunately for the bulls, this trend has not been strong enough to push market prices higher in 2010.

So how and why can market prices go down on good news? There are many reasons that short-term price trends can diverge from short-run fundamentals. One major reason for the price-fundamental gap is the following factor: expectations.  Just last week, the market had climbed over +70% in a ten month period, before issues surrounding the Massachusetts Senatorial election, President Obama’s banking reform proposals, and Federal Reserve Bank Chairman Ben Bernanke’s re-appointment surfaced. With such a large run-up in the equity markets come loftier expectations for both the economy and individual companies. So when corporate earnings unveiled from companies like Google (GOOG), J.P. Morgan (JPM), and Intel (INTC) outperform relative to forecasts, one explanation for an interim price correction is due to a significant group of investors not being surprised by the robust profit reports. In sports betting lingo, the sports team may have won the game this week, but they did not win by enough points (“cover the spread”).

Some other reasons stock prices move lower on good news:

  • Market Direction: Regardless of the underlying trends, if the market is moving lower, in many instances the market dip can overwhelm any positive, stock- specific factors.
  • Profit Taking: Many times investors holding a long position will have price targets or levels, if achieved, that will trigger selling whether positive elements are in place or not.
  • Interest Rates: Certain valuation techniques (e.g. Discounted Cash Flow and Dividend Discount Model) integrate interest rates into the value calculation. Therefore, a climb in interest rates has the potential of lowering stock prices – even if the dynamics surrounding a particular security are excellent.
  • Quality of Earnings: Sometimes producing winning results is not enough (see also Tricks of the Trade article). On occasion, items such as one-time gains, aggressive revenue recognition, and lower than average tax rates assist a company in getting over a profit hurdle. Investors value quality in addition to quantity.
  • Outlook: Even if current period results may be strong, on some occasions a company’s outlook regarding future prospects may be worse than expected. A dark or worsening outlook can pressure security prices.
  • Politics & Taxes: These factors may prove especially important to the market this year, since this is a mid-term election year. Political and tax policy changes today may have negative impacts on future profits, thereby impacting stock prices.
  • Other Exogenous Items: Natural disasters and security attacks are examples of negative shocks that could damage price values, irrespective of fundamentals.

Certainly these previously mentioned issues do not cover the full gamut of explanations for temporary price-fundamental gaps. Moreover, many of these factors could be used in reverse to explain market price increases in the face of weaker than anticipated results.

For those individuals traveling to Las Vegas to place a wager on the NFL Super Bowl, betting on the hot team may not be enough. If expectations are not met and the hot team wins by less than the point spread, don’t be surprised to see a decline in the value of the bet.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at the time of publishing had no direct positions in JPM and INTC. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 26, 2010 at 12:15 am Leave a comment

Flogging the Financial Firefighter

There we were in the fall of 2008, our economic system burning up in flames, as we all watched century-old financial institutions falling like flies. At the center of the inferno was Federal Reserve Chairman Ben Bernanke. In coordination with other government agencies and officials, Bernanke managed to prevent the worse financial crisis since the Great Depression from completely scorching the economy into ruin. After successfully hosing down the flames (at least temporarily), Ben Bernanke is now being singled out as the scapegoat and getting flogged for being a major participant in the financial crisis.

 Execution Threatened Water Damage

In hind-sight could Bernanke have made better decisions? Certainly. Despite the Federal Reserve dousing out the flames, politicians are pointing the finger at Bernanke for causing water damage. I’m going to go out on a limb and say water damage is preferable to the alternative – a whole community of properties burned down to a large pile of charred ash.

Democrats are now flailing in the wake of the Massachusetts Democratic Senate seat loss to Republican Scott Brown. Even though I question President Obama’s blame-game tax and overhaul tactics (see Surgery or Amputation article), to his credit Obama realizes the instability of mass proportion that would occur if the reappointment of Bernanke were to come to fruition. If the head of the globe’s largest financial system is going to be kicked to the curb after saving our economy at the edge of an abyss, then heaven please help us.

Politics Will Reign Supreme in 2010

“Change” was promised in the 2008 Presidential election and the impatient natives are not seeing results fast enough, given lofty unemployment rates and unsuccessful implementation of other initiatives (thus far). Needless to say, the media is going to be awash in an orgy of political mudslinging and campaign promises that will overwhelm the airwaves for the balance of the year.

From a market standpoint, Republicans and Democrats, alike, do share some common ground…jobs. As a countervailing trend to the forces dragging down the economy, the unified focus on job creation should provide some support to the financial markets.

Unfortunately, the independence of the Federal Reserve is being dragged into the political ring as Ben Bernanke’s reappointment process cannot escape the Capitol Hill circus. Berkshire Hathaway (BRKA/B) CEO Warren Buffett has likely handicapped the market’s reaction to a failed Bernanke reappointment when he recently stated, “Just tell me a day ahead of time so I can sell some stocks.” If the fires of 2008 concerned you, you may want to have your fire alarm and water hose ready for action if Chairman Bernanke is shown the exit.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, and at the time of publishing had no direct positions in BRKA/B. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 24, 2010 at 9:12 pm Leave a comment

Banking Surgery or Amputation?

Photo Source: (c)iStockphoto.com Artist: Powerofforever

Deciding whether to sever the proprietary trading arms of the commercial banks, rather than instituting regulation, seems a lot like deciding whether amputation is a healthier path for those suffering terrible frostbite cases. Even if this legislation is unlikely to pass, I find the recommendations severe in relation to other measured alternatives. I’m no right-wing conspiracy theorist, but I don’t think the timing of the Obama administration’s announcement is coincidental. Why is this proposal surfacing two years into the financial crisis and a whole year after the President entered office?

Politicians have always been masterful at introducing coincidental distractions at opportune times, in order to generate patriotic voter sympathies. Some examples include, Margaret Thatcher in the Falkand Islands; George Bush #41 in the Iraqi war; and President Obama’s current ant-banker populist brigade. Perhaps miserable and declining approval ratings and a healthcare bill on the verge of collapse may have something to do with the timing? I want President Obama to succeed, and he may have good intentions, but let’s not rush to an overzealous knee-jerk reactions before other less-draconian solutions are thoroughly explored.

Glass-Steagall Redux

Theoretically, the argument of forcing banks to adopt lower risk sounds great on paper. Overall, I think this initiative is a worthy one Americans could buy into. As a matter of fact, investment guru Jeremy Grantham makes the same argument in my Investing Caffeine article (“Too Big to Sink). However, I think a more relevant question is, “How do we implement more responsible risk taking by the banks, without a massive overhaul to the system?” Certainly there were some regulators asleep at the switch, and some financial institutions that pushed the envelope on risk assumption, but I’m not convinced a return to Glass-Steagall (or Glass-Steagall Lite) is going to bring miracles. If the regulators cannot adequately curb risk taking by the banks, then cross the more dangerous bridge later. The economy is presently in the midst of a fragile recovery and we do not want to change the airplane engine during mid-flight.

Political Pendulum Swings

This isn’t the first time Washington has reversed previous decisions. If the cries of voters reach a feverish pitch, and these wishes coincide with a politician’s re-election agenda, then the probabilities of sub-optimal, rushed legislation increases. Consider AT&T (T), which because of antitrust concerns was forced to split operations in 1982. Lo and behold, some twenty years later, we witnessed the re-consolidation of the “Baby Bells” back into AT&T. Now, Glass-Steagall is the topic of conversation and with an unambiguous scapegoat needed by politicians, Washington is targeting the banks with taxes and operations splitting.

Hasty legislation is nothing new with the populist flames fanning in the background. Sarbanes-Oxley is another example of less-than-ideal legislation introduced in the wake of  relatively low number of corporate scandals, such as Enron, WorldCom, and Tyco (TYC).

Regulation Reform Solution

Here are 3 constructive steps:

1)      Institute transparent trading of derivatives (i.e., Credit default Swaps) over exchanges with adequately capitalized clearing houses.

2)      Require higher capital requirements for banks conducting proprietary trading and mandate adequate disclosure.

3)      Consolidation of regulators, thereby creating a more simplified, accountable structure (see also Regulatory Web article). Savings from redundant costs could be used to hire additional regulatory oversight staff.

Blood is in the streets and with mid-term elections just around the corner, the Obama administration is looking to salvage anything they can bring back to the voters. Frost bite (and greedy bankers) is a painful and horrible predicament, however if healthy functioning limbs can be saved with targeted surgery rather than amputation, then I vote for this solution.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VFH), and at the time of publishing had no direct positions in T, TYC. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 22, 2010 at 1:30 am 2 comments

John Paulson and the “Gutsiest” Trade Ever

Although the pain and suffering of the 2008-09 financial crisis has been well documented and new books are continually coming out in droves, less covered are the winners who made a bonanza by predicting the collapse of the real estate and credit markets. Prizewinning Wall Street Journal reporter Gregory Zuckerman decided to record the fortunes made by hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).

Paulson’s Cartoonish Cut

Zuckerman puts Paulson’s massive gains into perspective:

“Paulson’s winnings were so enormous they seemed unreal, even cartoonish. His firm, Paulson & Co., made $15 billion in 2007, a figure that topped the gross domestic products of Bolivia, Honduras, and  Paraguay…Paulson’s personal cut was nearly $4 billion…more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together.”

 

As impressive as those gains were, Paulson added another $5 billion into his firm’s coffers and $2 billion into his personal wallet over 2008 and early 2009. 

There are many ways to skin a cat, and there are countless strategies used by the thousands of hedge fund managers looking to hit the jackpot like Paulson. John Paulson primarily made his multi-billion fortune thanks to his CDS positions (Credit Default Swaps), the same product that led to massive multi-billion bailouts and government support for various financial institutions.

Bigger Gamble than Perception

One surprising aspect I discovered from reading the book was the uncertainty surrounding Paulson’s negative real estate trade. Here’s how Zuckerman described the conviction level of John Paulson and Paolo Pelligrini (colleague) as it related to their CDS positions on subprime CDO (Collateralized Debt Obligation) debt:

“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”

 

Often the trades that cause you to sweat the most tend to be the most profitable, and in this case, apparently the same principle held.

Disingenuous Dramatic License

Before Paulson made his billions, Zuckerman uses a little dramatic license in the book to characterize Paulson as a small fry manager, “Paulson now managed $1.5 billion, a figure that sounded like a lot to friends outside the business. But the firm was dwarfed by its many rivals.” Zuckerman goes on to call Paulson’s hedge fund “small potatoes.” I don’t have the industry statistics at my fingertips, but I’ll go out on a limb and make an educated guess that a $1.5 billion hedge fund has significantly more assets than the vast majority of hedge fund peers. Under the 2 and 20 model, I’m guessing the management fee alone of $30 million could cover Paulson’s food and shelter expenses. Before he struck the payload, the book also references the $100 million of his personal wealth he invested with the firm. I think John Paulson was doing just fine before he executed the “greatest trade.”

What Drove the Greatest Trade

Hind sight is always 20/20, but looking back, there was ample evidence of the real estate bubble forming. Fortunately for Paulson, he got the timing generally right too. Here are some of the factors leading to the great trade:

  • CDO Leverage in Subprime: By the end of 2006, the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). But thanks to the introduction of CDOs, there were more than $5 trillion of risky investments created from all the risky subprime loans.
  • Liars & Ninjas: “Liar Loans” loans based on stated income (using the honor system) and “ninja loans” (no income, no job, no assets) gained popularity and prevalence, which just led to more defaults and foreclosures in the mid-2000s.
  • No Down Payments: What’s more, by 2005, 24% of all mortgages were completed with no down payment, up from approximately 3% in 2001. The percentage of first-time home buyers with no down payment was even higher at 43%.

Overall, I give kudos to Gregory Zuckerman, who spent more than 50 hours with John Paulson, for bringing something so abstract and homogenous (a skeptical real estate trade) to life. Zuckerman does a superb job of adding spice to the Paulson story by introducing other narratives and characters, even if the story lines don’t blend together perfectly. After reading The Greatest Trade Ever I came away with a new found respect for Paulson’s multi-billion dollar gutsy trade. Now, Paulson has reloaded his gun and is targeting the U.S. dollar. If Paulson’s short dollar and long gold position works out, I’ll keep an eye out for his next book…The Greatest Trad-er Ever.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VNQ), but at time of publishing had no direct positions in companies mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 20, 2010 at 11:30 pm 8 comments

Mauboussin Takes the Outside View

Michael Mauboussin, Legg Mason Chief Investment Strategist and author of Think Twice, is a behavioral finance guru and in his recent book he explores the importance of seriously considering the “outside view” when making important decisions.

What is Behavioral Finance?

Behavioral finance is a branch of economics that delves into the non-numeric forces impacting a diverse set of economic and investment decisions. Often these internal and external influences can lead to sub-optimal decision making. The study of this psychology-based discipline is designed to mitigate economic errors, and if possible, improve investment decision making.

Two instrumental contributors to the field of behavioral finance are economists Daniel Kahneman and Amos Tversky. In one area of their research they demonstrated how emotional fears of loss can have a crippling effect in the decision making process. In their studies, Kahneman and Tversky showed the pain of loss is more than twice as painful as the pleasure from gain. How did they illustrate this phenomenon? Through various hypothetical gambling scenarios, they highlighted how irrational decisions are made. For example, Kahneman and Tversky conducted an experiment in which participating individuals were given the choice of starting with an initial $600 nest egg that grows by $200, or beginning with $1,000 and losing $200. Both scenarios created the exact same end point ($800), but the participants overwhelmingly selected the first option (starting with lower $600 and achieving a gain) because starting with a higher value and subsequently losing money was not as comfortable.

The impression of behavioral finance is burned into our history in the form of cyclical boom, busts, and bubbles. Most individuals are aware of the technology bubble of the late 1990s, or the more recent real estate/credit craze, however investors tend to have short memories are unaware of previous behavioral bubbles. Take the 17th century tulip mania, which witnessed Dutch citizens selling land, homes, and other assets in order to procure tulip bulbs for more than $70,000 (on an inflation-adjusted basis), according to Stock-Market-Crash.net. We can attempt to delay bubbles, but they will forever be a part of our economic fabric.

The Outside View

 Click here for Michael Mauboussin interview with Morningstar

In his book Think Twice Mauboussin takes tenets from behavioral finance and applies it to individual’s decision making process. Specifically, he encourages people to consider the “outside view” when making important decisions.

Mauboussin makes the case that our decisions are unique, but share aspects of other problems. Often individuals get trapped in their heads and internalize their own problems as part of the decision making process. Since decisions are usually made from our personal research and experiences, Mauboussin argues the end judgment is usually biased too optimistically.  Mauboussin encourages decision makers to access a larger outside reference class of diverse opinions and historical situations. Often, situations and problems encountered by an individual have happened many times before and there is a “database of humanity” that can be tapped for improved decision making purposes. By taking the “outside view,” he believes individual judgments will be tempered and a more realistic perspective can be achieved.

In his interview with Morningstar, Mauboussin provides a few historical examples in making his point. He uses a conversation with a Wall Street analyst regarding Amazon (AMZN) to illustrate. This particular analyst said he was forecasting Amazon’s revenue growth to average 25% annually for the next ten years. Mauboussin chose to penetrate the “database of humanity” and ask the analyst how many companies in history have been able to sustainably grow at these growth rates? The answer… zero or only one company in history has been able to achieve a level of growth for that long, meaning the analyst’s projection is likely too optimistic.

Mean reversion is another concept Mauboussin addresses in his book. I consider mean reversion to be one of the most powerful principles in finance. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. In describing this occurrence he directs attention to the currently, overly pessimistic sentiment in the equity markets (see also Pessimism Porn article). At end of 1999 people were wildly optimistic about the previous decade due to the significantly above trend-line returns earned. Mean reversion kicked in and the subsequent ten years generated significantly below-average returns. Fast forward to today and now the pendulum has swung to the other end. Investors are presently overly pessimistic regarding  equity market prospects after experiencing a decade of below trend-line returns (simply look at the massive divergence in flows into bonds over stocks). Mauboussin, and I concur, come to the conclusion that equity markets are likely positioned to perform much better over the next decade relative to the last, thanks in large part to mean reversion. 

Behavioral finance acknowledges one sleek, unique formula cannot create a solution for every problem. Investing includes a range of social, cognitive and emotional factors that can contribute to suboptimal decisions. Taking an “outside view” and becoming more aware of these psychological pitfalls may mitigate errors and improve decisions.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AMZN, but at time of publishing had no direct positions in LM, or MORN. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 19, 2010 at 11:30 pm 3 comments

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