A Simple (and Impressive) New Three Factor Return Model

First, a little background on "factor models": The CAPM model for estimating expected returns is the oldest and most widely know of all finance models. In it, exposure to systematic risk (i.e. beta) is only factor that gets "priced" (i.e. that's related to expected returns).

In 1993, Fama and French showed that a three factor model (the CAPM market factor plus a size factor and a value/growth factor), did a much better job of explaining cross-sectional returns when compard to the "plain vanilla" CAPM.

Since the FF model became popular, a number of studies have come out that identify other factors that seem to be associated with subsequent returns, such as momentum (Jegadeesh and Titman, 1993), distress (Campbell, Hilscher, and Szilagyi, 2008), stock issues (Fama and French, 2008) and asset growth (Cooper, Gulen, and Schill, 2008).

Now, on to the meat of this post - another factor model. This one is based on q-theory (i.e. on the marginal productivity of a firm's investments). Long Chen and Lu Zhang (from Washington University and Michigan, respectively) recently published a paper "A Better Three-Factor Model That Explains More Anomalies", in the Journal of Finance. They propose a three-factor model", with the three factors being the aggregate returns on the market, the firm's asset-scaled investments, and the firm's return on assets). Their model significantly outperforms the Fama-French (FF) model in explaining stock returns, does a better job (relative to FF) at explaining the size, momentum, and financial distress effects (i.e. you don't need to add additional factors for these effects), and does about as well as FF in capturing the Value (i.e. Book/Market) effect. Here's a taste of their results:

• The average return to the investment factor (i.e. the the difference between the low and high investment firms) is 0.43% per month over the 1972-2006 sample period. When measured only among small firms, the return difference between low and high investment firms is about 26% annually)
  
• The average return to the ROA factor (the difference between returns to the firms with the lowest and highest ROA) is 0.96% per month over the sample period (with a high/low spread of about 26% for the smallest firms).
• The differences in high vs. low portfolios persist (albeit in smaller magnitudes) after controlling for Fama-French and momentum factors.

It's definitely worth a read (in fact, it'll be on the reading list for my student-managed fund class). You can find an ungated version of the paper on SSRN here.

HT: CXO Advisory Group

What's going on in the Unknown Family

Here's a short update on goings-on in the Unknown Household:

• The Unknown Daughter is now done with school for the summer. I get a feeling that she'll be doing a lot of social activities this summer - since Friday (the last day of school), she's already had one sleepover (at a cousin's house), and has her second one (at our house) this Wednesday. In addition, she's just finished Neil Gaiman's The Graveyard book. She gets a real kick out of describing the plot to others - it's an unusual tale where the humans are largely the evil characters, and the supernatural ones (ghosts, vampires, werewolves, etc) are the good guys. Next on the agenda is Madeiline L'Engle's A Wrinkle in Time (she just finished the 6th Harry Potter book, and is looking for some variety before tackling the 7th). All in all, not bad for someone who just finished 2nd grade.
• The Unknown Baby is now starting to make sounds - a LOT of sounds. So, he's become the star of any family gathering (he was anyway, but now that he's "talking" and laughing, we pretty much get a complete pass on having to take care of him at any event with others around --our rule is that to hold him, you have to do the associated diaper change). More importantly, he's now sleeping more that 6 hours at a pop at night. So, we give him his last feeding between 11 and 12, and don't hear from him until about 6.
  
• We've been doing a lot of social things - my sister and law and brother run a golf tournament to raise funds for cancer research (they lost their son to Neuroblastoma a couple of years ago). While we missed the tournament this year, we did make it up for the kid's mini-golf event this past weekend. In addition, the Unknown Wife is hosting her women's bible study group this morning, so the house will shortly be filled with about ten women. Finally, we'll be traveling to West Virginia shortly for a family reunion over the 4th of July weekend.

I continue to work on various research projects. I am finishing up one paper, and thought I only had a bit more to do. Then I decided to update our sample to include the most recent year of data. Unfortunately, as I worked through the program I'd written, I realized that I would also have to update two other datasets that the paper uses. One week, many lines of SAS code, and much profanity later, I'm almost done with the "simple" job that I thought would take only a day or two. So hang on, my coauthors - I'm almost done. Once this part is done, I move on to another piece, which is also in the final stages - once I finish my small part on this paper, we can put all the work we've already done since the initial version together and do the rewrite. My guess is that it'll be at the submittable stage before long. And then, once a third coauthor sends me the data set I need, I can do a bit of analysis on a third paper, which is also nearing completion.

As for the 500 pound gorilla in the room - we're coping fairly well with the whole grieving process. Of course, it's different for the Unknown Wife and I (hey - the process is different for any two people). For me, it's toughest at night (in the time just before sleep)- for the majority of the day, I don't think about it much, except for the odd moments when I see/hear something that reminds me of the little guy. For her, it occurs more frequently, mostly because she's at home most of the day, where she sees more reminders. We each have different "therapies" - for me, I think about Jonathan on bike rides (almost 17 miles yesterday), and for the Unknown wife, it involves talking about him with friends and family.

But, the sharpest part of the grief has largely passed. For now, it only hits us on occasion, and even then not to badly. It's a lot easier knowing that (1), this is not the end of Jonathan's life (but only the end of this part of his life), and (2), he's not only pain-free, but extremely happy now.

But the human psyche has an amazing capacity for dealing with pain and grief - we're an amazing species that way.

As I said, the Unknown Wife is hosting her ladies group shortly -- As I write, three women have already arrived. So, before I succumb to Estrogen overdose (and start watching the Lifetime channel), I'd better bolt.

Even Children Can Understand Economics

Every once in a while (actually, make that "on a regular basis), the Unknown Daughter comes out with something that really floors me.

The other day, UD was asking about my grandparents. I told her that both grandfathers worked it the fabric mills in my hometown (back in the day, there were three mills in town). Somehow, the topic morphed into what happened to the mills, so I told her that the mills eventually moved a lot of their business down south, and then (eventually) overseas.

"Why?" she asked?

I answered, "Because the people there would work in the factories for less, so the mill owners could make the fabric more cheaply. Unfortunately, that means that a lot of the workers in the mill lost their jobs."

"So why did they do it if the workers lost their jobs?"

"Well UD, since it cost less to make, they could sell the fabric at a lower price. So, while the workers lost jobs, the people who bought it actually benefited. This means that some workers lost money, and the people who bought the fabric benefited."

Here's what she said: "But Daddy - the people who bought the fabric weren't the only ones who got something out of it. The people who sold the fabric and the people who owned the stores made more money, so they could spend more on other things, like movies and meals and stuff, so they helped the people who sold those things. And then those people had more money, so they could hire more workers, so they benefited, too."

I asked her how she came up with this idea, and she said she just did. Then she gave me "that look" (i.e. 8 years old going on teenager), and said, "After all--my dad IS a finance professor, so I should be smart".

After thinking about it, I realized that she'd gotten that right, too. But the "genetic" story wasn't what I was thinking about--she picked this up largely through osmosis, since I'm often trying to get the Unknown Wife to think in economic terms (i.e. who benefits and who loses, and how). Of course, when I do this, it only serves to tick UW off.

But UD misses little, and remembers most things she hears or sees. So, when she turns teenager, I'm in biiiig trouble.

I shared this with one of my colleagues, and he suggested that I should have UD talk with our state legislators - she could teach them a thing or two.

But given this Wall Street Journal article, I'm skeptical.

A Good Private Equity Blog

Thanks to Analyst Forum (one of my regular stops), I just came across a pretty good blog on Private Equity called The Private Equiteer. It has a lot of posts that go through the basics of the private equity world (here's a list of many of them).

I'm adding it to the blogroll.

That D@!* Musical Swing (Punisher Version)

Like many new parents, we use a battery-powered swing to help the Unknown Baby Boy fall asleep for his naps. Our model comes with a musical option that plays an assortment of tunes. They range from "Ode to Joy" to some pretty irritating, calliope-sounding music that could be easily be heard at the circus. But one song in particular makes me smile every time I hear it.

The Unknown Wife asked why, so I showed her this clip (I just linked it because embedding was disabled for this clip). Caution - turn the sound down, because it cuts to a pretty loud, discordant piece near the end.

The Unknown Wife said she'll never hear that tune again without seeing this clip in her mind's eye.

Mission accomplished - my work here is done.

On Teaching Math

The Unknown Daughter is also known by most of my family as "The Math Princess." She seems to get math concepts more quickly than almost anyone else at her grade level. Well, there is one one boy in her class who is just about at her level, but she has a better Rear Naked Choke than him (knowing what boys can be like, I started teaching her various martial arts techniques at age 4 - I figure if she cripples the first boyfriend, my work is largely done).

She's really good at the rote learning/memorization/multiplication tables part of math, and that's important (hey - if you know your tables cold, many things seems to get easier). But what makes me happiest is that she really enjoys the math puzzles I give her. When she finally sees a pattern, she gets really excited. For example, when she realized that she could use the distributive law (i.e a(b+c) = ab + ac) to do mental math, she got really excited.

So, I enjoyed this piece titled "A Mathematician's Lament" by Paul Lockhart. Here's the best line(s) IMO:

Part of the problem is that nobody has the faintest idea what it is that mathematicians do. The common perception seems to be that mathematicians are somehow connected with science— perhaps they help the scientists with their formulas, or feed big numbers into computers for some reason or other. There is no question that if the world had to be divided into the “poetic dreamers” and the “rational thinkers” most people would place mathematicians in the
latter category.

Nevertheless, the fact is that there is nothing as dreamy and poetic, nothing as radical, subversive, and psychedelic, as mathematics. It is every bit as mind blowing as cosmology or physics (mathematicians conceived of black holes long before astronomers actually found any), and allows more freedom of expression than poetry, art, or music (which depend heavily on properties of the physical universe). Mathematics is the purest of the arts, as well as the most misunderstood.

So let me try to explain what mathematics is, and what mathematicians do. I can hardly do better than to begin with G.H. Hardy’s excellent description:

"A mathematician, like a painter or poet, is a maker of patterns. If his patterns are more permanent than theirs, it is because they are made with ideas. "

So mathematicians sit around making patterns of ideas. What sort of patterns? What sort of ideas? Ideas about the rhinoceros? No, those we leave to the biologists. Ideas about language and culture? No, not usually. These things are all far too complicated for most mathematicians’ taste. If there is anything like a unifying aesthetic principle in mathematics, it is this: simple is beautiful. Mathematicians enjoy thinking about the simplest possible things, and the simplest possible things are imaginary.

He's an advocate of teaching by puzzles. like "if you inscribe a triangle in a rectangle, can you figure out how much of rectangle's area is captured by the triangle" (for an arbitrary triangle, that is). Read the whole thing - it's worth it.

HT: Kids Prefer Cheese

How Much Is $100 Million?

This posting is WAAAAY late, but It's still good. As a "perfesser" type, I always enjoy a good visual aid.

Back in April President Obama had announced that he's try to cut $100 Million in spending from the budget. Most people have a hard time visualizing large figures, and an even worse one with fractions or percentages. So,here's a great illustration of what the $100 million means in terms of tital expenditures:

Whether you agree or disagree with Obama's policies, you have to admit - this is brilliant!

A Good Paper on "Return Factors"

Robert Haugen is one of (if not THE) best-known figure in the behavioral finance (i.e. "markets are not efficient") camp. He wrote one of the earliest books on the topic in 1995 (The New Finance) and runs a quantitative finance shop based on much of his research. In a recent paper with Nardin Baker of UC-Irvine, he examines the explanatory and predictive ability of a wide array of observable factors. Here's the abstract

This article provides conclusive evidence that the U.S. stock market is highly inefficient. Our results, spanning a 45 year period, indicate dramatic, consistent, and negative payoffs to measures of risk, positive payoffs to measures of current profitability, positive payoffs to measures of cheapness, positive payoffs to momentum in stock return, and negative payoffs to recent stock performance. Our comprehensive expected return factor model successfully predicts future return, out of sample, in each of the forty-five years covered by our study save one. Stunningly, the ten percent of stocks with highest expected return, in aggregate, are low risk and highly profitable, with positive trends in profitability. They are cheap relative to current earnings, cash flow, sales, and dividends. They have relatively large market capitalization and positive price momentum over the previous year. The ten percent with lowest expected return (decile 1) have exactly the opposite profile, and we find a smooth transition in the profiles as we go from 1 through 10. We split the whole 45-year time period into five sub-periods, and find that the relative profiles hold over all periods. Undeniably, the highest expected return stocks are, collectively, highly attractive; the lowest expected return stocks are very scary - results fatal to the efficient market hypothesis. While this evidence is consistent with risk loving in the cross-section, we also present strong evidence consistent with risk aversion in the market aggregate's longitudinal behavior. These behaviors cannot simultaneously exist in an efficient market.

Here are some of the factors that they find statistically significant:

• Price Multiples such as price to cash flow, sales, book value, and earnings (negative relationship with subsequent returns
  
• Profitabiliy measures such as ROE, ROA, and Profit Margins (positive relationship)
• Volatility in returns, whether "raw" or "residual" (negative relationship)
• Momentum (positive relationship)
• Recent returns (positive rel;ationship with last year's return, negative with last month's return, and last month's "residual" return)

Read the whole thing here

It's worth reading. Haugen is clearly not an ubiased observer (he does run a shop based on the idea that markets are inefficient), and there's definitely some serious data mining going on here. Having said that, it's definitely worth reading. It gives a very good summary of many of the factors that prior research has found to be significantly related to subsequent returns. I'll be making the next group of student in Unknown University's student-managed fund read it.

HT: Empirical Finance Research

It Is Done, And Yet Also Just Beginning (updates)

At 1:55 this morning, the Unknown Son (his name is Jonathan, by the way) eased away and stopped breathing. Our son has finally let loose the bonds of earth and gone home. No more suffering, no more limitations, and no more cancer. He now rests in the lap of the Father with his cousins Jacob and Jennifer. And that's NOT a figure of speech - it's a description.

It's been a tough time - 2,439 days since his diagnosis on 10/1/2002. After gallons of chemotherapy, multiple surgeries, and visits to six hospitals, our son is finally free. After years of pain and limitations, he can now run without tiring, jump without limits, and stay up as long as he wants.

We miss him, and will every day for the rest of our earthly lives. But believe it or not, it's not all grief (but there is that). We're glad that his pain and struggles are over. But now he doesn't just have the absence of pain. He has JOY. For him, this isn't the end - merely the end of the beginning. We know that we'll be together again.

If you know us in our "real" lives and would like to read our son;s story (or just want directions to the memorial service Saturday), send me an email.

UPDATE:

Since many of you have have asked, our charity of choice is: The Tomorrow Fund, 593 Eddy St., Providence, RI 02903. Put "Jonathan" in the note of the check. They're affiliated with Hasbro Children's Hospital where Jonathan had a significant part of his treatment done, and they're a very worthy recipient of any donations - they both support research in cancer and provide a lot of support (financial, emotional, etc...) to families of children undergoing treatment. They'll allow us to choose the manner in which the funds will be spent (probably something relating to computers, books, or videos), so that we can come up with something that really captures something of who Jonathan is.

A Fairly High Profile (Non) Tenure Case

Inside Higher Education profiles the tenure case of Boyce Watkins, an untenured African-American assistant finance professor at Syracuse University. He was recently denied tenure.

What make his case interesting is that he's been quite possibly one of the highest-profile assistant professors at a non-tier1 school I've ever seen. He's got a list of media appearances longer than my arm (heck - longer than both arms), all of which you can see on his website here. His research record has been fairly good (not outstanding, but not terrible), with a couple of solid b-level publications (both sole-authored), and a number of pubs in lower-tier outlets.

My take is that he ruffled feathers. Whether fair or not, most assistant professor are not clear slam-dunks for tenure. Since most are therefore somewhere near the margin, the non-publishing things end up having a disproportionate impact. So, having a reputation for being a "good" colleague makes a big impact at most schools. This means having at least a few people who will have your back and almost no one who's looking to stick a knife in it.

So, I can understand Dr. Watkins not getting tenure. I don't necessarily agree with it, but I understand it.

And yes, this is one of the reasons I blog under a pseudonym. Maybe after tenure, I'll change. But for now, I'll play defense, thank you very much.

Tough Times Ahead

This tough to write. The recent post on the Unknown Son's treatment was somewhat encouraging. In the blink of an eye, this one turns our lives around 180 degrees.

This morning, Unknown Son tried to go for a walk around the hospital unit (the walking helps expand the lungs, and would speed his recovery). We noticed after a few steps that his left leg was dragging. We put him back in bed, and he was unable to squeeze my hand with his left hand. A quick CT scan followed, and revealed that the cancer had spread to his brain – in three separate spots. We hadn't known this previously since all our scans had been focused on his chest region. One was pretty large, and since it was on the right side, it was the likely cause of the problems with his left leg, arm, and hand.

This changes everything – he now likely has a matter of days rather than weeks. We gave him some radiation to see if we could slow the swelling, but at best that only buys a bit of time. So, we took him home tonight in an ambulance so that he can be in familiar settings and be as comfortable and safe as possible in the short time he has left with us.

In the meanwhile, The Unknown Wife's mother and father and one of her sisters are here. Her other sister and her family (and my mother, brothers and sister) are coming down tomorrow to lend support and see the boy.

Please keep us in your prayers as we ease his transition. For him, this is not the beginning of the end of his life – only the end of the beginning. But even though we know that he's going to a place with no more pain or limitations, and only joy, it’s going to be a rough week or so for us – likely the toughest we’ll ever have to go through.

So keep us in your prayers.

Rediscovering Late Night TV

The Unknown Wife is a morning person, and I'm a night owl. So, I usually get the later feedings for the Unknown Baby Boy. He gets fed around 8 or 9, and then I hang out until his next feeding (sometime between 11 and 1). The little guy usually sleep for 4 hours, and the Unknown Wife takes the next feeding. Since she drops off around 9, she gets a good 6-7 hour uninterrupted sleep stretch.

Because of the schedule, I'm up until 12 or 1 most nights. I do a little work on the computer (o.k., a lot of web-surfing and a little work, but let's not quibble). But I've also gotten reacquainted with late-night television. Between Deadliest Warrior, the UFC (and WEC) and 1,000 Ways To Die, (thank you, Spike TV) I get my guy stuff out of the way while Unknown Wife is already asleep.

Who knows - maybe it'll have a subliminal effect on Unknown Baby Boy.

Students Sitting For the CFA Exams

I just realized that I have at least six students that I know of sitting for the CFA exams in a couple of days. Three are sitting for Level 1 - all either graduated this past month or last December, and three are sitting for Level 2 (they graduated either last June or last December). There are a couple of other former students who'd indicated they might be taking the Level 1 exam, but that was a while back and I hadn't heard from them since.

Good luck, one and all.

Bad Biopsy News

About a week back, the Unknown Son had a CT scan that showed some suspicious spots in his right lung. He had his biopsy today.

Unfortunately, the news wasn't good. His cancer (Wilms Tumor) has recurred. According to the surgeon, there was at least one clear tumor (pea-sized) in his right lung, and clear evidence that it had also metastasized into some of the lymph nodes. I'm currently in the ICU with him as he recovers from the biopsy, and I'll spend the night (the Unknown Mom will take over tomorrow).

He's awake and in good spirits. Looks like we'll be watching Sponge Bob DVDs for a while longer, followed (hopefully) by sleep).

I'll post more information as I get it.

update: It's the morning after, and he's doing well - his fever has broken, he's talking up a storm, getting all the tubes out except for his chest drainage tube, and about to start drinking fluids on his own.