Friday, January 27, 2012

Getting free learning

Aswath Damodaran is putting his whole Valuation, and Corporate Finance classes online this semester.  If you are interested in either, you can take them for free.  You get no official credit from NYU, but you do get to learn stuff from a really smart guy for free.

Here is a link to his instructions and why he's doing it.

Check out his wikipedia page here - he's a smart guy.

I'll be taking both courses.

I haven't blogged in almost two weeks.  I've been pretty busy.  I'll try to think of something to blog about soon.  I've almost finished re-reading The Intelligent Investor.  I'm getting much more out of it the second time around - maybe I'll do a post on that.

Tuesday, January 17, 2012

Measuring Whitney Tilson's alpha

Whitney Tilson is a value investor.  He co-manages T2 Partners with Glenn H. Tongue.  He was one of the authors of Poor Charlie’s Almanack, generally the best book on Berkshire Hathaway Vice Chairman and multi-billionaire Charlie Munger.

Tilson’s funds lost 24.9% of their value in 2011.  Despite that, they have returned an annualised 6.0% since inception in January 1999.  This is better than the S&P 500 which has returned 2.0% p.a since January 1999.  The total return is 114.2% (T2 Partners) vs 29.2% (S&P 500).

Given that substantial outperformance, you might think that it was obvious that Whitney Tilson can generate “alpha”.  Alpha is a financial term for the risk-adjusted return of an active manager.  Basically, if a manager generates alpha, the manager can achieve the same return as the market with lower risk, or higher returns than the market without a corresponding increase in risk.

I personally think it is very likely that Whitney Tilson can outperform the market.  His letters to investors seem well thought out and he usually has very good justifications for his stock positions.  This, coupled with his performance, suggest to me, a prima facie case for outperformance.  So I decided to test whether a regression shows that Whitney Tilson can generate alpha, or whether he is simply exposing his funds to more risk and achieving a corresponding return.

First, I found and inputted his monthly returns from his later letter from January 1999 to December 2011 into a spreadsheet.  I matched that to the market return minus the risk free rate for all those dates.  I then performed a regression to calculate the 3-factor (Fama-French) and 1-factor (capital asset pricing model) alpha.

I find the story of the 3-factor Fama-French story interesting.  Fama notes in a recent paper that one reason that “value” (as measured by low price-to-book ratios) might outperform growth is that people get some non-financial utility from owning growth stocks.  This makes sense to me.  Some people must like being able to say they own an “up-and-coming” stock rather than an old skeleton they’re just trying to squeeze the last bit of value from.  Think of the film (or book) Moneyball.  It must be exciting to pick young up and comers in your ball team rather than David Justice, a 37 year old who is clearly past his prime.  Despite that, there is more value (as measured by price for performance) in picking David Justice over young glamour players (or at least there was until the Oakland Athletics popularised the strategy). 

Anyway, the 3-factor Fama-French measurement came about because people started to notice that there was a persistent outperformance by “value” stocks (low price to book) and small capitalisation stocks.  One theory was that these stocks were inherently more risky.  But by all conventional measures of risk, they’re not more risky.  The next theory is that it’s “unmeasured risk”.  Effectively the argument is that because they outperform, they must be more risky.  This seems like a triumph of theory over evidence.  It presupposes that the market is perfectly efficient, then explains evidence of its inefficiency (the outperformance of value and small cap stocks) by referring back to the theory and insisting it must be true.  In the face of the question – where is the excess risk? The response is that it can’t be measured yet. 

If the risk can’t be measured, I find it implausible (although not impossible) that market participants are factoring in this unmeasured risk to cause the pricing discrepancy and outperformance.  I find Fama’s proposition of non-financial utility in growth and big cap stocks more convincing.

Now, whether there is more alpha in value and small cap stocks or whether there is more risk is largely irrelevant for our purposes of measuring manager performance.  The key is that you can cheaply access this higher return (be it alpha or risk) through an index fund devoted to value stocks (as measured by low price to book ratios) or small cap stocks (or even both).  Given that ability, you shouldn’t pay a manager high fees to just get you that.

So what does the regression show?

The regression shows that using the 1-factor capital asset pricing model, Whitney Tilson generates 0.305% of alpha per month.  That’s significant, but unfortunately we don’t have enough data points to make it statistically significant.  The null hypothesis is that Tilson has no alpha.  It’s been too long since I did any statistics, but from what I gather, the p-value suggests that if we assume the null hypothesis, there is a 33% chance of obtaining his results just by luck.  The t-stat is 0.977.

Using the 3-factor Fama-French data (ie, controlling for the value effect and the small cap effect), Whitney Tilson generates 0.216% of alpha per month.  That’s not bad either, but the p-value is 0.496 – ie, assuming that Tilson has no alpha, there’s a 49.6% chance of obtaining his results just by luck (assuming my interpretation of a p-value is correct).  The t-stat is 0.683.


Unfortunately, 154 months just isn’t enough to give us statistically significant results.  My own personal null hypothesis is that Tilson can generate alpha, but we won’t know for many many years.  By that time, we’re very unlikely to be able to invest money in his fund.  He’ll either be shown to have no alpha and have closed down, or be some alpha generating machine with too much money clogging up his alpha machine and anchoring his performance.

UPDATE: I realised I rudely forgot to thank Turnkey Analyst for the lesson in how to run this regression. He runs through the method and includes a video here.

Friday, January 13, 2012

Warren Buffet sent me a secret message

Back in May Warren Buffet did a video interview
Reuters: You’re always looking for value. What about Microsoft? I know you say you don’t do tech. But given that it has a forward P/E right now that’s below 10, it seems like a value play.
Buffett: Yeah. I agree with you. I regard myself as precluded from either personally or having Berkshire buy Microsoft because if something good happened the following week people would think Bill had told me. So I just see no way that we can ever buy Microsoft and be sure that we won’t look like we had some kind of inside information or something. So it’s off limits. It did look pretty cheap.
I was going to write up all the fundamental quantitative stuff that makes me like MSFT.  But then TurnkeyAnalyst did an amazing job so I'll just send you there.

The conclusion is:
So overall what are the quantitative data telling us about an investment in MSFT?  Perhaps its most distinguishing feature is that MSFT is a cash cow, earning high current and normalized returns on capital and assets based on the wide defensive business moat that its Windows operating system provides.  While in the longer run, MSFT may face significant competitive pressures, it is unlikely to be dislodged from its strong defensible position in a dramatic way any time soon.  There are no obvious red flags from any of our short screens, and the company is hugely profitable and stable, so there is a low risk of financial distress.  The stock looks cheap here, and its strong magic score suggests that you are not overpaying for this very high quality business.  If you are looking for a safe bet in a high quality company in the technology space, MSFT would appear to fit the bill.
We bought MSFT for the fund in early November 2011.  It has appreciated 9% since then and paid a dividend of 0.8% of our cost.  We bought after reading Warren Buffet's comment and taking a look at the return on invested capital and earnings yield.

Wednesday, January 4, 2012

Seth Klarman and contrarianism

I just read through a collection of Seth Klarman’s letters to shareholders in his fund – the Baupost Group. Klarman is a value investor and wrote the out of print “Margin of Safety”, now selling for over $1000 on Amazon. The Baupost Group has achieved an average annual return of 19% since 1983 for its three partnership funds. The particular letters I read were for a smaller fund that he set up in 1990.

One thing that struck me reading through his letters is his contrarian streak. I think it’s incredibly hard to confidently go against the grain when everyone around you seems like they’re printing money. That’s why Klarman’s letters are so refreshing.

In the letters between 1995 to 2000, he calls the internet bubble several times. You can feel the frustration in his letters as his funds lag various indices by substantial amounts. At one stage (April 1999) $50 000 invested in the particular partnership at its inception (December 1990) would have turned into $139 277. That’s not bad, but $50 000 in the S&P 500 passive index would have returned $250 971! That sort of persistent and dramatic underperformance has got to feel pretty bad.

Klarman makes passing mention of the internet fad in his 1995, 1996, and 1997 letters, but rips into it in 1998:

The U.S. stock market has been propelled by investors falling all over themselves to buy large-capitalization growth stocks like Microsoft, Coca Cola, and even General Electric. At least they are, more or less, good companies. Occasionally, periods of unbelievable excess occur, where near-worthless enterprises are propelled into the stratosphere. Such a period is now upon us.

It is bad enough that the shares of small growth companies announcing stock splits surge skyward as if something value enhancing has actually taken place. Now, suddenly, the siren song of the internet has become even more irresistible for hordes of growth investors.

Consider the case of K-Tel International, the company best known for selling music CDs and tapes on late night television. After hovering in a narrow trading range around $7 a share(for its 4.1 million outstanding shares) since January, the announcement that K-Tel plans to sell its music on the internet caused its shares to skyrocket from $7 to $45 in just one week and to $80 a week later with daily volume exceeding 100% of the freely tradeable shares outstanding. "You put 'dotcom' behind it and they'll buy it", said one analyst commenting on the behavior of internet-obsessed investors. In a similar vein, Market Guide, a provider of financial data, rallied from 3 to 29½ in three trading days after announcing a partnership with America Online. At 29½, the company had a market capitalization of almost $150 million yet it boasts current annual revenue of only $5 million. Watch out below!

And in 1999:

The $200 billion market capitalization of America Online recently exceeded that of IBM. Charles Schwab was recently valued 50% more highly than Merrill Lynch. Priceline, the Internet company that sells airline tickets, was valued more highly than the three largest airlines, combined! eToys came public and immediately jumped to a valuation well above that of the well established Toys "R" Us. The prevailing casino atmosphere must certainly put a damper on trips to Las Vegas or Atlantic City, where there are more losers than winners. In Internet-land, there have been no real losers as of yet; the illusion of a positive-sum casino is an attractive lure for the gambler. Recent exuberance notwithstanding, at today's valuations it is clear that Wall Street is certain to continue issuing shares of new Internet companies until the supply of shares overwhelms the resources of the buyers.

It’s obvious now and in hindsight that he was absolutely, 100% right. He ended up making up all his lagged performance (and then some) in 2000 and later. But at the time it must have been maddening.

Monday, January 2, 2012

End of year update

The total portfolio increased in value by 0.4% for the two months ended 31 December 2011. The market itself increased 1.5% over this time. So the fund is tracking below market. The internal rate of return of the fund (the compound growth rate, annualised) is 2.9% for the two months to date.

There are 18 stocks in the portfolio. We like each and every one of them, but we feel like 18 is towards the upper limit of how diversified we want to be. Given the limited amount of capital, having fewer stocks and making fewer trades is preferred because then we can keep trading fees as a percentage of funds to a minimum.

We expect to rebalance the portfolio in March. There are 13 businesses we own that we intend to hold for at least a year (and at least 4 we intend to hold for perhaps five years). This allows some room to introduce a few new stocks, but cull a few of the more marginal picks.

I only intend to update the portfolio performance quarterly from here on in. I think monthly forces us into a short term thinking (as does quarterly, but I've got to find something to do).

Over the break I read Warren Buffet's letters to shareholders on my kindle. I'll post some excerpts in the coming weeks. He's hilarious.