Internal Rate of Return

In response to my latest performance post, reader Hugh asks two questions:

1) What is "internal rate of return" and how is it calculated?

2) Why is it hard to compare your internal rate of return to that of the S&P500?

What is "internal rate of return" and how is it calculated?

The internal rate of return of a stream of cashflows (which is all an investment is in terms of its performance) is the annualized effective compound return rate.  A natural question is - well what's that?  The easiest way to think about it is to compare it to an interest rate on a bank deposit.  A bank term deposit of $10 000 may have an interest rate of 6% (let's assume after tax) for a term of 5 years.  As long as interest is paid yearly, the internal rate of return for the bank deposit is 6%, because the annualized effective compound return rate is what the bank tells you it is - 6%.

That's easy to work out.  But how do you compare that to:

• buying $5 000 IBM shares on January 1 2011, 
• buying $3 000 Microsoft shares on July 20 2011,
• receiving a $28 dividend from your Microsoft shares on November 20 2011,
• selling half of your IBM shares for $3 000 (they went up in value) on December 15 2011,
• buying $8 000 of Oracle shares on February 10 2012,
• after all that, finding yourself with $16093 worth of shares today (17 July 2012).

The answer is excel.  You simply make a list of dates and a list of cashflows that looks like this:

You'll see that those cashflows are events based on the bullet points above.  The internal rate of return formula in excel is simply "=xirr(values, dates)".  And you get 24% in my example.

Why is it hard to compare your internal rate of return to that of the S&P500?

The fund has data on all dividends, all purchases and sales of shares since inception.  We use that to get July 14's 7.52% internal rate of return.  But how do we compare that to an investment in the S&P500?  Do we assume that on the first day we purchased shares, the alternative was to purchase the S&P500?  But what if a month after the first purchase, we purchased some different shares?  If the S&P500 has gone up since then, our performance looks terrible if we backdate the comparator to having purchased the S&P500 at the earlier date (of first purchase).  Vice versa if the S&P500 has gone down.

The problem is knowing what to compare when you are slowly adding positions to your portfolio (as we are).  The only sound way to do it is to, at every purchase and sale, assume that you had purchased or sold the S&P500 at equal value to the actual purchase or sale.  So if the fund bought $50 000 of IBM on 20 January 2012, we assume that the alternative was to buy $50 000 of the S&P500.  If the fund sold $10 000 of MSFT, we assume that the alternative was to sell $10 000 worth of the S&P500.  This method removes any influence of "market timing" in the comparison. This seems fair, since the whole premise of the fund is that market timing (for us) is impossible, and all we can try to do is buy stocks cheaply whenever we see them.

Having set that all out, if I get hold of historical prices for the S&P500, I think I might actually be able to compare performance directly with a bit of tinkering in excel.  I might try to do that sometime this week.

Performance in 2nd Quarter 2012

Ignoring currency changes but accounting for trading expenses, the fund returned -3.09% in the 3 months to 30 June 2012. Over this same time period, the S&P500 returned -4.01%.

So the fund moderately outperformed the index.

For the half year ended 30 June 2012, the fund returned 5.52% Over this same time period, the S&P500 returned 6.66%, so the fund is still underperforming the index by a moderate amount.

The current internal rate of return of the fund (the best measure, but the hardest to compare to the S&P500) as of today (July 14) is 7.52%.

The best performers in the portfolio for the quarter were:

• Origin Financial (ORGN) (+35.51% including dividend) 
• Tree.com (TREE) (+16.10%), 
• Asta Funding (ASFI) (+15.45%), 

The worst performers for the quarter were:

• LCA-Vision (LCAV) (-42.95%), 
• Aperam (APEMY) (-40.49%) 
• Dell Computers (DELL) (-29.15%)

Diversification

Mark Weldon is the former CEO of NZX, the New Zealand stock exchange (which itself, is listed on the NZX as “NZX”.

In today’s stuff, there’s an article about his big sell down of his NZX shares which he accumulated while CEO of NZX. He's bought a vineyard.

The article makes him seem to be pretty confused, but I expect he’s skirting around the truth to be polite. He says:

''It is just not at all sensible to have all your money invested in one stock alone. If you work at a place, it is a different story, but once you have left an organisation to have all your eggs in one basket is just not a strategy anyone would advise''

The face of an undiversified man

In fact, if you work at a place, it’s an even worse strategy to have all your eggs in one basket.

One way to see this is to think of your assets as two things - your human capital (your skills, connections, current employment) and your financial capital (money, shares, house, etc). When you are heavily invested with both your human and financial capital in the same basket, you are incredibly undiversified. That's what Weldon was when he was at NZX.

The easiest intuition to think about is those Enron employees who had invested their pensions in Enron shares. When Enron was found out to be the fraud that it was, those employees lost their jobs and their savings. Had they diversified away from Enron with their financial capital, they would have been much better off, and exposed to much less risk. So there’s a reason to think that the story is not different when you work at a place. In fact it’s a scarier story.

From a shareholder’s perspective, often we’d like the CEO to own a lot of stock of the company – to some extent it aligns the CEO’s interests with ours (both parties want the price to go up, and hopefully the CEO can actually do something about it). But from the CEO’s perspective it’s very risky. Sometimes the risk can pay off, and it certainly makes sense if, as the CEO, you believe you can have a meaningful impact on the business, and that impact will increase the share price more than the increase in other stocks who presumably have CEOs who are as confident as you in their own abilities.

In other words, if as a CEO you can answer the question “am I an above average CEO?” in the affirmative, then maybe it’s worth trading off some diversification for this outsized performance. Of course, almost every CEO, by their nature, will think that they are above average, so it’s probably not a bad strategy to just ignore your subjective belief, assume that you are overconfident in your belief of your above averageness, and do not invest any financial capital investment in the firm you are CEO of (and if you did the numbers, depending on the amounts of your physical and financial capital it might even make sense to go short the shares (but then you’d probably lose your job so....)).

In Weldon’s case, the share price of the NZX performed very well over his tenure, so there’s (at least) weak empirical evidence that he is an above average CEO. And you’ve got to expect that the board who appoints you as CEO know how many shares you own and like the fact that you’ve doubled down on the company – you are incentivised.

So why is Weldon selling? The real answer must surely be a combination of two reasons:
· He needs the money for his vineyard, and
· He has no ability to influence the share price by now, and suspects that the new CEO will not be as good as him (or at least the information asymmetry of him knowing his own abilities intimately but not knowing the new CEO’s abilities as intimately brings enough risk into the situation that he should sell down).

The first reason is almost certainly dominant, but the second reason is more fun to think about.

Too busy to blog

I've been too busy with work and other stuff to blog well lately.  Don't worry though - I'll have next quarter results out in a few weeks after I've updated my spreadsheets.

I'm going to read this book soon - it's been suggested by many people.

Value investing evidence roundup

The past week or so, Greenbackd has been collecting evidence for the outperformance of value investing, use of the magic formula, and the use of other ratios to outperform the market.  It's great stuff.

I had planned to write a post this weekend with links to all, but I just checked google reader and another excellent blog, Alpha Vulture, already did that in this post.

Here's the blogger known as Alpha Vulture, with his master - an unlikely looking older woman.  Alpha Vulture is about to scan the pink sheets for prey, and report back on his blog.  I may then select the tastiest morsels to invest in.

So now I don't have to find all the links and try to put them into html, just click on the link above.

Venture capital returns

The hilariously named and always good to read Felix Salmon has a great post on How venture capital is broken.

Here's a picture of Felix's face.

This is one of those times where I could summarise his post, but it's really good anyway and already summarises a larger report.  Basically, he's got data for venture capital returns (which there was very limited data on before) showing that there aren't insanely high returns to limited partners (ie, investors).  In fact, the marginal investor is earning a negative return, and probably has been since about 1995.  

I like this because I once sat in a meeting with a senior government official who glibly told the 8 or so attendees that "what happens is off shore private equity [of which venture capital is a subset] borrows overseas at 4%, and invests here earning 25%, and leverages up even more to make three digit returns".  I didn't even know what to say and so said nothing.  (I could have said this, or this, but no one else seemed shocked so I just blinked as loudly as possible).

I like confirmation of the fact that he was almost certainly wrong, and had probably been to too many meetings with people like this.

Pure magic, or just an illusion?

Doesn't look like 30.8% to me

Greenbackd has an excellent round up of recent evidence on the outperformance of Joel Greenblatt's so called "magic formula".

I won't repeat his post - just go and read it.  But basically, it outperforms, but nowhere near the 30.8% cumulative annual growth rate that Greenblatt reported in his book.  Wes Gray has elsewhere noted that Greenblatt has dropped that number from his speeches.  Gray suspects that Greenblatt made an error in his backtesting.