The Difficulty of Measuring the Gains To Fundamental Research

Here's a paper by Bradford Cornell that I've had in my in box for a while. It's titled "Investment Research: How Much Is Enough?" Here's the abstract

Aside from the decision to enter the equity market, the most fundamental question an investor faces is whether to passively hold the market portfolio or to do investment research. This thesis of this paper is that there is no scientifically reliable procedure available which can be applied to estimate the marginal product of investment research. In light of this imprecision, investors become forced to rely on some combination of judgment, gut instinct, and marketing imperatives to determine both the research approaches they employ and the capital they allocate to each approach. However, decisions based on such nebulous criteria are fragile and subject to dramatic revision in the face of market movements. These revisions, in turn, can exacerbate movements in asset prices.

I raises some interesting issues about the difficulties in measuring gains to fundamental research. To name a few:

• The difficulty in measuring "abnormal" performance", given the stochastic (i.e. random) nature of stock returns
• The time-varying nature of any possible gains to analysis (funds and strategies change over time).
• Given the needs for sample size and duration necessary to get high levels of statistical significance, most findings are of pretty low confidence
• The ad hoc nature of many analysis strategies and the role that judgement plays
  

It's worth reading, and give some good points for discussion in a class module on efficient markets (and the related topic of "anomalies" like the size and value effects). You can read the working paper on SSRN here

My First Century (Bike Ride, That Is)

I recently signed up to ride in my first "Metric Century" - a 100 kilometer (that's about 62 miles for those of you who don't speak metric) bike ride. Fittingly, it's a fund-raiser for the Hole In The Wall Gang Camp.

The Hole In The Wall Gang Camp was started by Paul Newman (yes, that Paul Newman) in the late 1980s to provide seriously ill children with a Wild West-themed camp experience (the original HITWG camp was formed in Ashford CT and was based on the movie "Butch Cassidy and the Sundance Kid"). The original camp has been built up over the years - it now has an "OK Corral" for its infirmary (with a 24 hour medical staff), horse stables, totem poles, tee pees, swimming pools, boating, horseback riding, sports, theater, and camping, along with much, much more. Over the years, the HITWG camps (there are now 11 separate camps in several countries) have hosted over 130,000 seriously ill children.

My nephew (who also died of cancer a little over two years ago) went there several times in his final years. And while Jonathan never made it out there, the HITWG camp would send two staff workers out to the clinic where he was treated several times each week to play with the kids. These guys were amazing. One had gone to clown college (and no, I never taught there, but one of my previous schools resembled it on a regular basis) and could do everything from magic tricks to impersonations to juggling. The other had technical skills that would let him make rap tapes for the kids, PhotoShop their faces onto pictures of Superheroes (I have one of "Jonathan Hulk"), and do just about anything else they'd want with a computer. They made quite an impact on the kids - for most, they made the clinic a far brighter place.

In any event, this give me a good goal to shoot for. So far, the farthest ride I've taken this summer has been today's ride of 33 miles. I did it at a (for me) good pace, and it had a couple of pretty good hills in it. But I'll have to step up my game a bit if I want to make it - I'm still only halfway there, and the terrain for the ride is pretty hilly. So even if I slow down significantly, it'll be a stretch. Since every pound counts when going up hills, I'm hoping to ease the burden of schlepping up all those hills ny losing 8-10 pounds over the next 5 weeks.

This means you'll have to put up with occasional training posts. Ah well - them's the breaks.

Data Analysis With Stata

The Unknown Family went to the Unknown Sister-in-Law's family's house in an adjacent state (their youngest daughter is going off to college, and Unknown Wife wanted to see her before she leaves for the Big Adventure). So, I got a couple of days to myself. Nothing very exciting - I've been grinding data during the day, and went on a couple of longish bike rides (I'm up to 25-30 miles at a time at what for me is a pretty good clip).

On the data analysis front, I finally took the plunge and started using Stata. It's a pretty amazing package of tools. I work with a lot of large and complicated data sets, and there's always a lot of data manipulation before I get to the point where I'm running statistical analyses. When it comes to moving data around (merging data, sub-setting, mean adjusting, etc...) SAS wins hands down. And I've put a lot of time getting my SAS chops, so I'd put off learning Stata for a long time.

But I now understand what so many of my friends have been telling me for so long - once you get to the point that your data is all nice and neat, Stata rocks. I was able to do many permutations of regression models (fixed effects, random effects, robust and/or clustered errors, etc...) in about a quarter of the time it would take in SAS. And while it's possible to work in batch mode by writing "do" files, you can do quick and dirty analyses with drop down menus.

I have seen the statistical light, and it reveals that I'll be doing a lot more with Stata in the future.

Capital Structure, Buybacks, and Free Cash Flow

I'm in the process of putting together material for my Advanced Corporate Finance class. Of course, it has a module on capital structure and payout policy. One of concepts we'll get across is that holding extra cash often gives managers incentives to invest in negative NPV projects (the old "free cash flow" problem). So, according to agency theory, managers should lever up and pay out the excess cash to shareholders in the form of buybacks and/or dividends. Unfortunately, higher leverage and lower cash holdings exposes the firm to increased risk of financial distress.

Along those lines, I was going through my "clippings file" and came across this piece in the Economist. It discusses some of the costs of excess debt during recessions. Of course, it's always easy to look back after the fact and say that firms shouldn't have levered up so much, since it means they'll face distress costs during a recession (hindsight's always 20/20, after all).

In a related piece David Merkel id a piece a while back on financial slack and how he uses it in evaluating cyclical companies in Real Money. He illustrates his approach using the steel industry. When identifying good companies in the steel industries he looks for several things:

...With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer term, it comes down to finding companies that have these four characteristics:

1. They're industry leaders with impeccable balance sheets.

2. They have reasonable operating leverage; they should be profitable at the cycle trough.

3. Their industry is hated, so their stocks can be bought at a cheap price.

4. They use free cash flow at a cycle peak in a way that prepares for the trough.

...Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

Point 4 is the most relevant to the whole leverage/payout discussion: what's the best use of free cash flow? Should it be invested, used to pay down debt, or be distributed to shareholders? If good time are expected to continue, the company is best off investing the excess in positive NPV projects and then paying out excess free cash in the form of dividends and buybacks (and buybacks result in increased leverage). However, if troble is expected ahead, they're better off paying down debt or holding more cash in reserve.

I think it'll make for a good discussion in class.

Dilbert On Mutual Funds

Nuff said.

Tutorials For The BA2+ Calculator

In any class, there are some sections that take up a disproportionate amount of class time but are only needed by some of the class. For example, in my case course, some of the students have a very good grasp of how to use their business calculators, while others somehow made it out of the introductory class without learning something as basis as how to calculate simple present and future values using the built in financial functions of their calculator.

So, how do I make sure that all my students have the basic background knowledge needed to survive the class? My solution this semester is to use screen recording software to create a few tutorials for the Texas Instruments BA2+ calculator (the model we encourage our students to use in the intro class).

I made a short 5-6 minute video that goes over how to change the settings on the calculator (i.e. the number of decimals displayed, number of periods per year, etc), and another to demonstrate how to solve problems involving present and future values of lump sums (and how to solve for interest rate and number of periods, too). I'll make a third video to cover annuity problems, a fourth to cover NPV and IRR problems, and a fifth to work some problems in depth.

I've posted a link to one of the videos below. In case you're interested, I created the guides using Techsmith's Camtasia software, Texas Instrument's calculator software emulator, and hosted it on Techsmith's Screencast platform. It's not professionally done by any stretch of the imagination, but I think it gets the basics across (and there aren't enough "ummm's" and "Ah's" to be too distracting).

Updated 8/22: I put all the tutorials in one spot for easier access. Updated 8/20: They're in MP4 format, which should be playable on the latest versions of Windows Media Player and most other video players. If you want to download them, feel free, but realize that the largest is about 20 meg. So it might take a while (depending on your connection speed).

Introduction To The BA2+ Calculator

Solving Present and Future Value Lump Sum Problems On The BA2+ Calculator.

Solving Annuity Problems on the BA2+ Calculator

Using the Cash Flow Register on the BA2+ Calculator

Any feedback is appreciated.

Beloit College Publishes Its Latest Mindset List

Every year, Beloit college publishes its "Mindset List." This list is updated annually to reflect what the latest crop of incoming freshman has experienced. Here are some of my favorites:

12. The KGB has never officially existed.
13. Text has always been hyper.
18. They have never understood the meaning of R.S.V.P.
30. There has always been a Cartoon Network.
51. Britney Spears has always been heard on classic rock stations.
61. “Womyn” and “waitperson” have always been in the dictionary.

Read the whole thing here.

It's CFA Level 2 and Level 3 Results Day

Today is the day they give out results for the Level 2 and Level 3 CFA exams. Looks like pass rates for the Levels 2 and 3 exams were lower than their historical levels.

To all who passed, congratulations - you're now one step closer to finishing the process. If not, here's some perspective from the "Godfather of the Analyst Forum" (he goes by the pseudonym of "Joey DeVivre"). It was geared towards the Level 1 Exam, but it fits for L2 and L3 as well:

If You Failed
1) You are in distinguished company
I know a college finance professor who took 7 tries to pass three exams. This guy even wrote a college textbook on corporate finance. (That sounds like an apocryphal story, but I swear it's true but there is no way I'm posting his name).

2) Nobody will care
Everybody seems to have this dread that something terrible will happen when they tell their colleagues, boss, significant other, and parents. What will happen is they will say "Wow, hard test. When are you taking it again?"

3) You will be 6 months older when you get your charter.
I was in my late 30's so most of you will be at least ten years ahead of me when you get it even if you fail a few times.

4) You will get a solid foundation to build on for the next two levels
Learning this stuff again means you will learn it better, deeper, and more committed to long-term learning. This will pay dividends over the next couple of exams.

5) You failed a really hard exam
Every year the pass rate is less than 50%. In that >50% who fail number are oodles of smart people who studied hard. There is a ton of material on this exam and you have a career and a life outside of this exam. It's a bear and you don't even need an excuse for failing.

And to those who passed - Congrats and well done.

If you haven't yet done so, go register on Analyst Forum - it's worth it.

So far I've heard from the three former students who took the L2 exam this time around (all took the L1 exam in the last 18 months) - one passed, and two failed. Not bad, given the overall pass rate was 41%.

Finding the Lowest-Cost Textbooks

I've blogged on this previously, but this piece on sources for finding low-cost textbooks bears repeating (particularly with school starting back up shortly).

Of the sources mentioned, I tried out CampusBooks to search for a few reference materials I needed (used, of course). It's outstanding, and well worth checking out.

HT: Newmark's Door

How To Remember Material For the CFA Exam

I just read a study that is highly applicable to anyone who's studying for the CFA exams, since there's a ridiculous amount of information that must be retained. When people ask me how much they have to study for the L1 exam, I answer "about 16 pounds", since that's the weight of the curriculum.

But the study is applicable to students in many other disciplines.

The study is titled "The Critical Importance of Retrieval For Learning" by Jeffrey Karpicke and Henry Roediger, and it's in the February 2008 issue of the journal Science. They examine the question of how best to improve long-term recall. Specifically, they tested whether, once a student can recall a piece of knowledge once, they most improve their long term recall by repeated studying of the material, by repeated testing of the material, or both. Here's the abstract:

Learning is often considered complete when a student can produce the correct answer to a question. In our research, students in one condition learned foreign language vocabulary words in the standard paradigm of repeated study-test trials. In three other conditions, once a student had correctly produced the vocabulary item, it was repeatedly studied but dropped from further testing, repeatedly tested but dropped from further study, or dropped from both study and test. Repeated studying after learning had no effect on delayed recall, but repeated testing produced a large positive effect. In addition, students' predictions of their performance were uncorrelated with actual performance. The results demonstrate the critical role of retrieval practice in consolidating learning and show that even university students seem unaware of this fact.

So, the takeaway is that the best way to retain (for example), the Black-Scholes option pricing formula isn't to keep going over the formula once you've gotten it down - it's to repeatedly TEST yourself on it. I don't necessarily mean a formal test -- just put the formula on a flash card and periodically (every couple of days at first, but eventually at longer intervals) try to write it out. After that, check your results against the flash card.

Of course, if you're studying for the CFA exams, most of the test-prep companies have test banks with numerous questions on each topic, so using them would be perfectly consistent with this approach.

I almost forgot - you can read the Science article here.

Penn and Teller on Progressive Taxation

I try to get across to my students that the government has no money of its own - everything either comes from taxes or from borrowing(which is paid off with future taxes). So in the end, most government programs involve taking money from one group and giving it to another. That's not necessarily bad (there might be a compelling reason to do so in some circumstances), but it's useful to frame things this way.

Here's a videos by Penn and Teller from their Bullsh*t (this is mostly a family friendly blog) series that hits the nail pretty much on the head:


HT: Ace of Spades, which, FWIW, is NOT a family-friendly blog. Funny, but not family friendly)

A Good Ride

I just went on my longest ride of the year (26 miles). I know it's not long by serious cyclists' standards, but it's as long as anything I did last summer (but slower than last year's rides). Unfortunately, it was also the hottest day of the year in UnknownVille - 90 degrees and very humid.

Still, not too bad considering I only started riding the week after Jonathan's passing (eight weeks ago). So, I have hopes of getting up to a 40 miler before Unknown University starts classes 4 weeks from now.

It takes longer to get it back as I get older. But still, an almost 2 hour ride (and at a fairly good clip- just under 16 mph) isn't too bad considering I just turned 51.

Ah well, pain is just nature's way of telling you you're fat, lazy, and out of shape.

The 50 Greatest Film Monologues

Here's something for your weekend viewing pleasure - the 50 Greatest Movie Monologues of All Time (from Film.com)


I think Pacino's in there about 4 times, and there are a lot of other big names - James Earl Jones, Mel Gibson, Morgan Freeman, etc...

Enjoy.

Markets in Receivables

Here's an interesting article in the WSJ from a while back (7/16) titled "CIT's Woes Prompt Surge In Activity At Receivables Exchange".

CHICAGO (Dow Jones)--The turmoil surrounding finance giant CIT Group Inc. (CIT) is driving a surge in new business for a New Orleans-based company that runs a market in receivables.

The Receivables Exchange, which lets small- and mid-sized companies auction their accounts receivable to buyers that include hedge funds and commercial banks, on Wednesday recorded its busiest day ever and is fielding a flood of calls from businesses searching for financing alternatives.

"These people want to do their own underwriting and do their own credit determination," said Justin Brownhill, co-founder and chief executive of The Receivables Exchange, or TRE.

Events this week have shown that "they can't rely on others like CIT to do it," Brownhill said.

New York-based CIT, among the biggest U.S. lenders to small and mid-sized businesses, disclosed this week that it could face bankruptcy and won't be able to get help from the U.S. government.

The company is among the biggest names in the factoring marketplace, a $125 billion sector that functions as a middleman for short-term financing - paying vendors for goods up front and collecting full payment from retailers later.

It's a pretty neat example of how markets can be used as a solution to an old problem. Factoring companies have been around for quite a while, but typically dealt with firms with working capital needs on a one-to-one basis. Exchanges like these allow those companies to better diversify their portfolios and reduce their risk. At the same time, since it makes for multiple bidders, it could also extract some of the factoring companies' surplus and transfer it to firms selling their receivables (i.e. they get a higher price for their receivables).

Read the whole thing here (online subscription required, unless you find it through Google News).

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Research Love/Hate

I love doing research. Actually, I like finding out new stuff. But sometimes the research process makes me rue the fact that I work on a dry campus.

Like this week.

I've been working on a paper where I needed to update the data on. Since the latest version was a rush job put together for a conference (yes - this happens a lot), I decided to go back and check every line of my program (always a good thing to do). I also wanted to do the anal-retentive (I know, that's redundant. - except in research, where it's expected) thing where I can relate what happens to my sample at each filtering step. While doing this, I found out that I'd used the wrong data code for one of my variables - one of my MAIN variables. So, the whole data set was, in a word, crap.

After taking a deep breath, I made the corrections and redid most of the analysis. Luckily, the results still held, with minor modifications.

Then I discovered a minor discrepancy in the number of observations at one step. It's likely not very important at all. But I need to track it down before I go further. So, since my coauthor reads the blog, he'll just have to wait another day or so. But I'm getting close, so I should be able to finish my part of the work and ship it off to my coauthors in another day or two.

Then a coauthor on another paper told me that she'd found an error she made in her coding. In this case, when she found and corrected her error, it quadrupled our sample size. If you're an empiricist, you know how much an increase from about 90 observations to about 400 means. If not, let's just say it's a big deal to the alpha nerds among us (and that description applies to most of my friends).

So, like most days in the research salt mines, there's some good and some bad.

Now about that "dry campus" thing...

The Ideas Report

I just came across an interesting new blog: the Ideas Report for Serious Investors. It's put out by the Manual of Ideas (a for-fee service) and obviously) geared towards investing. However, it ranges pretty far afield. Check it out.

Advice From A Journal Editor

Here's a very interesting and informative piece titled "Edifying Editing" by R. Preston McAfee (former co-editor of AER and editor of Economic Inquiry). It's not entirely applicable to finance because he's an econ guy. But there is a great deal of similarity between the fields. Here are a few things that stuck with me:

1. He cites a paper by Dan Hamermesh (1994), who discovered that, conditional on not receiving a report in 3 months, the expected waiting time was a year. So, if you want to endear yourself to editors and you're a reviewer, get stuff done quickly. I know that the longer I wait on a referee report, the less I feel like punching it out.
2. Around 25% of the to AER during his tenure were rejected due to poor execution. That is, the paper represented a good start on an article worthy topic, but provided too little for the audience. I recently was discussing a former student (and current coauthor) with a friend of mine who edits a pretty good journal. His comment was that my friend does good work, but "needs to finish his papers". Unfortunately, my friend often sends papers out to journals to get feedback from referees. That's what colleagues are for.
   
3. He feels like a a surprising number of papers provide no meaningful conclusion. Don;t merely reiterate your introduction in the conclusion. The introduction is to motivate a problem and summarize your results, and the conclusion is your opportunity to tie things together and make some parting shots.
4. He feels that submitting a paper where the editor has deep expertise usually produces a higher bar but less variance in the evaluation.
   

All in all a very worthwhile read. So read it here.

HT: Marginal Revolution

Things You Wish You Could Write On Students' Papers

Here's a pretty good list of things I wish I could write on some students' papers, from Sapience Speaks. #6, while harsh even for this list, is my favorite. Feel free to add your own in the comments.

1. "You certainly have a way with words. A long, long way."
2. "You seem to be attempting a very delicate approach to the assignment--so delicate, in fact, that you fail to touch on it at all."
3. "Every one of the words in this sentence is utterly devoid of meaning."
4. "I can't help feeling that you treat the ideas in your paper much as a black hole treats its neighboring star systems: forcefully and vigorously synthesizing them, you condense them beyond recognition, leading to utter destruction and chaos."
5. "like the broad swift stream / a thesaurus will go far / but yields no great depth."
6. "This paper isn't even bulls*&t. Bulls*&t has substance. This is diarrhea."
7. "I find your rhetorical strategy in this expository to be similar to that of a rhinoceros in extracting a tooth: large, blunt, and wholly ineffective."
8. "This entire page says exactly NOTHING."
9. "Every teacher wishes she could read a paper like this one. It makes the rest of her life so much brighter by contrast."
10. "As I was reading, I felt that you were trying to include in your paper every type of fallacy possible. If so, you only missed one."
11. "The level of disorganization in your paper suggests that your true topic must be chaos theory, not, as your title implied, Wordsworth."
12. "the wind speaks all day / yet with only empty breath: / you have no thesis"
13. "I'm not sure even you believe this sentence."

Robert Shiller on Charlie Rose

Here's an interesting interview of Yale finance professor Robert Shiller on the Charlie Rose show. The early part of the clip is an interview of Winston Churchill's grandson - it's also interesting (I'm a Churchill fan), but if you want to skip it, Shiller starts around 14:15.