Wednesday, February 22, 2017

Equity Management #3 : The Dividend Discount model is overrated

One of the fundamental building blocks taught in the CFA is the dividend discount model or DDM. In Chapter 4 of the Equity Management book, empirical studies would succeed at demolishing the explanatory power of DMM when it comes to stock returns.

For the novices, the dividend discount model is basically the  idea that a stock price should be the net present value of all future dividend payments.

V = D1/(1+r) + D2/(1+R)^2 + D3/(1+r)^3 +....

If dividends grow at a constant rate, the equation collapses to  V = D1 / (r - g)

V = Price of the Stock
Dx = Dividend in year x.
r = risk free interest rate
g = rate of dividend growth

If you read a brokerage report which employs the dividend discount model, you can now objectively take those results with a pinch of salt. There are simply too many variables which require a future prediction for your value calculation have a chance of being accurate at all. First you have predict future dividends. Second, you have to know future interest rates. Even if you are able to plug everything into your spreadsheet, in essence, you are getting an estimate derived from other estimated values. No wonder many analysts cover their tracks and recommend a buy only when the current market price is discounted from this calculated value estimate.

This authors performed a series of regression exercises and concluded that the DDM does not adequately explain what drives investment returns.

An investor is better off relying on a low P/E ratio and a low price/sales ratio to make investment decisions.

The chapter ends with a valuable quote from Paul Samuelson which I am still trying to channel when it comes to my own investment portfolio. The quote goes like this," I prefer paradigms that combine plausible Newtonian theories with observed Baconian facts. But never would I refuse to houseroom to a sturdy fact just because it is a bastard without a name and a parental model. "





Tuesday, February 21, 2017

The Singaporeans you will meet in the Economy of the Future.

Perhaps it is time for a semi-serious look into the four kinds of Singaporeans you will meet in the future. 

I call this is new 4P model of the Economy of the Future.

a) Prince / Princess

You will find Princes in those schools along Bukit Timah Road that offer the New Age International Baccalaureate syllabus because only rich people can buy a ticket out of taking the A levels. 

The Future Economy is the oyster of the Prince. Someone who was born in a family where their parents has amassed plenty of capital while there were still stable jobs. 

As labour becomes replaced with automation, capital which flows into companies which harness the technology to produce the marvels of innovation allows capital owners to attain a level of wealth and financial independence which would be very much better than whatever model we have today. 

The stewards of such immense wealth in the future are the Princes.

b) Polymath  

The future economy is all about training, attaining breadth, and plumbing the depth in multiple fields of knowledge so that a person can adapt to all forms of technological disruption. First the economy will demand T-shaped professionals, then it will not be enough. We will need those who are "pi" shaped. Soon only a #-shaped professional will be able to get a decent job.  

Unfortunately, only a very tiny and elite group of citizens can attain the title of Polymath. Someone comfortable with the Liberal Arts and hardcore sciences to become a force for disruption rather than a victim. 

Only the Polymath will have stable jobs in the future, and they will be very well paid. In spite of the relative stability of such jobs, a Polymath will have a new jobs scope every few years.

As a Polymath becomes older, he needs to scales vertically and horizontally to survive in the future economy. 

Failing which he joins the masses as...

c) Peasant

The CFE report does not really address what happens to peasants in the future. I would rather think that if I were in charge, I would say that Singapore needs to start conducting feasibility studies on a basic income which pays off $200 - $400 from cradle to grave without any conditions. This is not for actual implementation but for the event that automation and AI destroys jobs faster than we can create them.

How should peasants live ? 

Will unqualified men be permanently tied to the gig economy and find entertainment in virtual games which by then will increase in levels of sophistication so they lead blissful matrix-like lives ? 

Will attractive peasants become tied to just a few Polymaths and Princes via a systems of irrevocable trusts to maintain the semblance of a new clan-like family structure.

Nevertheless, it does not look good for Peasants....

But there is worse...

d) Prostitute

It does not take a stretch to figure out that perhaps some people may not not want to fuck a chunk of metal no matter how much you enjoyed watching Westworld. One survivor of disruption would be the world's oldest profession.

Depending on how cynical you are, you might also realise that suckers are still born every minute so the folks who hustle, work in sales might fall into this category if you bother to broaden this category. 

I will not live long to see the future economy. But I will be making choices to the best of my ability to allow my children to either qualify as Princes or Polymaths when every single task in the Singapore economy gets automated away.

Have you read the CFE report ?

What will you do and where will you be in the future ? 

 





Sunday, February 19, 2017

CFE post : How SMU can fit into the future economy.

Yay ! Mid-terms are over.

Today, I wanted to combine several posts into one.

Of recent note, SMU has been on the radar of social media as of late. Exchange student Kerry Dwyer has written very candid comments about her SMU and Singapore experience here. In a mid-term party which was conducted by my JD pals yesterday,  my foreign classmates felt more inclined to agree with Kerry. There are clearly some issues with SMU.

Now I tried to get as much information on the Committee on the Future Economy (CFE) study and, like everybody else, I was unable to find anything unique or special about this report. What I did detect is the overwhelming use of the word "innovation".

Right now, based on my three years spent in SMU as a law student in the JD program, I do not think that SMU is fully aligned with the CFE's innovation drive. We obviously have the physical infrastructure to make it happen, but one of the biggest impediments to make it happen is our lack of software.

SMU students, and this includes myself, simply cannot shake away the Tyranny of the GPA.

The need for high GPAs are real. A cum laude is more valuable by $500 a month than a normal pass degree. Higher GPAs also grant access to objectively better companies and this is natural - HR departments don't want to waste their time interviewing so many students so find ways to keep their selection pool to those with better grades which immensely unfair to students with more average grades but an interesting CCA record.

Instead of whining about the problem, I can think of several really immediate and actionable solutions to make the SMU experience better for folks like Kerry Dwyer and align SMU towards the future economy.

a) Make GPAs invisible

This is not a suggestion to eliminate the GPA. GPAs which are invisible still allow students to be sorted according with their performance. Having visible GPAs have the effect of making our industries apply for shortcuts in their hiring practices. If GPAs are invisible, companies will have to make a decision by visual inspection of grades followed by an evaluation of CCAs. This way students are not reduced to a single number.

Elites may hate this idea but 20 years ago, we never a GPA and the industry did fine.

b) Have only two degree classifications Pass and Merit Scholar.

After making GPAs invisible, it is better to simply identify the top 10% cohort and give them some sort of Merit rating. Students can spend their time pursuing what interests them instead of trying to get a better honors classification.

This is definitely better than just treating us like grades of Kobe beef. The Harvard Business School MBA gives out a pass or a Baker Scholar designation, so once again this is not something new.

c) Give students the option of converting subjects to a pass/fail grade.

This is a pet peeve of mine because I think I just ruined my degree classification picking subjects which add value to my investing skills.

Students, when choosing electives, we are faced with a difficult choice when deciding which electives to pursue. Many students are forced to choose subjects which promise a fair grade or less work to maintain good GPA. This creates a perverse incentive to focus on their strengths. An economics H3 student will feel pressured to take an economics and law module because he gets to stick to his comfort zone. Conversely, if you choose subjects which are taught by great lecturer who have a rigorous approach to their curriculum, you can be penalised even though objectively you would have learnt more during the semester. Lecturers who wish to remain popular may also start to inflate the grades they give out or make the curriculum lighter to maintain their course's relevance.

One good workaround is to always allow students the option to waive away grading requirements for perhaps just two electives in their degree program. This way, students are safe to take up subjects like "Quantum mechanics, general relativity and the Law" without impacting their GPA. The beneficiaries of this approach is very likely the Computer Science courses where there are high-risk classes on writing new apps which could mean an A+ or an F grade.

d) Allow groups of any size in group work.

Group work is a bugbear for many of us because they have a serious impact on grades.

Local students do not discriminate or hate foreign students. They avoid them because foreign students do not come from a perverse culture where GPA determines the fate of your entire life and will not put in what local students perceive as a fair share in group presentations. The other issue is that there are students who are so objectively bad that no one will form a group with them.

It is manifestly unfair to force students to take them in because it penalises their grades as well.

One solution is to simply allow groups of variable sizes with a limit of perhaps 8 students. Students know how to sort themselves out and form groups which optimise their capabilities and that grades should account for the number of people chosen in a team.

This way, the untouchable student can work alone and be graded fairly.

Collectively, my suggestions will not make students innovative overnight, but it certainly removes the impediments which allow students to take a chance and expand their horizons. It would also certainly reduce the odds of the University experience scarring exchange students so badly, they put up a B grade essay in condemnation to our approach which has so far, made us one of the largest GDP per capita nations in the world.








Thursday, February 16, 2017

Equity Management #2 : What strategies are the real deal when investing in stocks ?

[ This article is based on Chapter 3 of Equity Management by Jacobs and Levy ]

It is not easy to tell who is the real deal when they about investing in equities and who is merely making up a story on a good investment strategy ?

The really smart quants have a decent answer : Disentanglement.

When we say that a low P/E strategy produces returns which are above average compared to the rest of the markets, this concept of P/E is entangled with many other value measures. If lower P/E stocks also tend to be smaller companies, then it may well be said that the outperformance was attributed to smaller companies rather than the low P/E strategy itself.

Do deal with this problem,  the quants will employ a mathematical process to disentangle P/E from the effect of small companies. One possible approach would be to divide companies into buckets of differing market capitalisation and then choose the low P/E stocks from each bucket to see how they perform rather than just buying the lowest P/E stocks from the market.

The results of disentanglement enables us to answer who is the real deal when they talk about equity investing.

Based on market data, only a few strategies work after disentanglement.

a) Low P/E : Generally speaking investing in low P/E stocks tend to work.
b) Small size : Smaller sized companies tend to do well.
c) Sales/Price : Higher sales to price seems to work as well.
d) Analyst Estimates tend to be useful within one month from publication.
e) Residual Reversal

Residual reversal deserves some additional mention. To employ this strategy, look at stocks over the past month and buy the stock which has declined the most and sell the counters which gained the most. It seems that this strategy is fairly effective as well but I have yet to back test this on Bloomberg. Executing this strategy seems cheap and easy as you only need a copy of Share Investor magazine to get the job done.

The above information gives hints to investors who wish to build  starting screen to pick the best stock to buy in the market.

What does this mean for yield investors like myself who find that our favourite strategy show little promise after the process of disentanglement ? The first thing to note is that such studies are done in the US where dividends taxation is high compared to capital gains tax.

Beyond this, yield strategies may still outperform because they also employ low P/E stock counters. If a company has a payout ratio within 100% and yields 8%, you are effectively capping your P/E to less than 12.5.

At the end of the day, intermediate income investors need to get off their high horse and see dividend payments as part of lifestyle design rather than a direct attempt to outsmart the markets. They are, in effect, making the extra returns from low P/E counters.











Tuesday, February 14, 2017

Valentine's Day : A Celebration of the Ordinary and of Loneliness.


This Valentine's Day is a good one for internal reflection.

I had morning classes and had front seat rows to observe LLB Law students celebrate the event and was unsurprisingly underwhelmed. A few classmates for cookies and flowers but otherwise VD was a sombre affair in law school. This is not particularly different from engineering school, which is the modern functional equivalent of a monastery on campuses Singapore wide.  This week, law students are too busy preparing for mid-terms this week and many of my classmates have bigger problems on their minds like getting a training contract and coping with the downturn in the sector.

As for myself, my Valentine's day plans got torpedoed by my daughter who insisted that every romantic meal between mum and dad must be eaten at McDonalds. Me and my wife ended up eating burgers with each other on Valentine's Day. We did not even managed to eat the cheese cake my daughter chose from the neighbourhood confectionary because she fell asleep once she got home.

When you look back in your 40s, you will realise that VD is not so much a celebration of love and soppiness as presented but that of ordinariness and sometimes loneliness for most of us. Most couples date for only a couple of years before they get married and have kids. If you give about 5-8 years of formal VD celebrations, that's less than 15% of a person's lifespan.  The bulk of Valentine's Day is actually about living an ordinary life and the rest of it is about loneliness.

For many singles, VD is a day to hide from social media. Without knowing that they are in fact a majority online, it must be quite harrowing to see so much pink on Facebook. If you combine Valentine's Day with the effect of dating advice from gurus, books on relationships, old bulletin board systems like nus.talk.romance where I used to do most of my trolling before I discovered the importance of money, it is all about loneliness and whether it is better to cope with it or fight it aggressively.

Once you are a single who has figured out that Valentine's Day is all about loneliness, then half the battle is won. Mark Manson writes a hugely popular blog and has a great book called The Subtle Art of Not Giving A Fuck. 

Amongst the singles and the love-lorn, there is a distinction between even singles who cope with loneliness on a daily basis.

If you look at my LLB classmates, they don't give a flying fuck about Valentine's Day or loneliness for that matter, they give a huge fuck about the bigger goal of building a long term professional career.

We may have to distinguish my classmates from singles who don't give a fuck about loneliness but have yet to find something greater to give a fuck to. That's still easy to achieve. This blog suggests financial independence.

And then there are those who do give a fuck about VD, refuse to admit it, and then decide to take cover from all that soppiness online, but then tell everyone they don't give a fuck about VD. These guys have to accept that Valentine's Day is recurring (like herpes ) and comes every year. As a general principal, loneliness will not leave you alone if you give it any fucks in your daily life.

The folks who reflect upon themselves and decide that thy do give a fuck about loneliness can take this day as a day to start acting as if they give a fuck.

This is a good state to be in because it opens a person up to examine their flaws and how they can make themselves a better person to deal with that loneliness.
















Sunday, February 12, 2017

Quick Personal Update : End of CNY

Just like that CNY is over. I am hunkering down for a week of 3 mid-term exams and my blogging will slow over the next few days.

a) Personal Finances

It has been quite good for the past few weeks for income investors. We should be expecting juicy pay-offs at the end of this month and, in spite of every negative thing that has been said about Trump, his approach towards the fiduciary rule and Dodd Frank is creating some sort of rally in the markets. At the rate the rate things are going, I might actually be ahead compared to my last day of paid employment with law school with three years of expenses hardly making a dent to my total capital size.

( This is mainly because I have managed to sock away some small dividends reinvestments over the past three years. )

Some months ago,  some friend asked me why I supported Trump because his election would hurt me financially the most because he is anti-globalization. My reply is that we don't really know what Trump means for the financial markets. It takes quite a lot to be able to predict what an incoming US President can do for a 40 plus stock Singapore portfolio.

At that time, I argued that in spite of my own personal wishes, Trump might not even be elected. Even if elected, checks and balances may stop him from executing his priorities, Even if Trump gets his way, the effect on my financial portfolio is unknown. We don't even know how long he can remain elected and the length of my investment horizon might not make the election consequential at all.

Right now, the financial markets have vindicated all my investment choices so far and we are winning BIG.

Bigger if you consider that I was never very bullish on Telcos in the first place and they are not doing all that hot recently. I don't even have an objective reason to hate Telcos, I just think that every conventional yield investor will turn to them for help which makes them really unattractive as yield instruments.

But I should remind myself that a market can reverse itself rather suddenly.

Somewhat disappointing is that I liquidated my Ethereum holdings at a negligible profit to create some liquidity for the Chinese New Year only to see it go up slightly. Perhaps I can get back in later before April.

b) Law School

I am prepared for the worse this semester because I was teetering around 3.4 GPA and have a decent chance of losing a good cum laude classification. Apparently I took up some really hardcore subjects this semester because I wanted to pick up skills in M&A and Insolvency because the material may improve my investing skills. While grading for these classes are harsh, the material was taught quite well and I was enjoying the practical aspects of it.

My only consolidation is that now I already have a foot in the door for a firm and grades will matter less after some years of practice.

Hopefully.

c) Books I am reading

There are too many good options when it comes to my extra-curricular readings. I was shifting between two really powerful books.

The Subtle Art of Not Giving a F*ck by Mark Manson is something I will definitely blog about because it presents a lot of basic self-help ideas in a harsh tone which I really like !

The other book being Algorithms to Live By by Brian Christian which is a harder read but has really nifty ideas to apply algorithms to live normal productive lives.

Of course, the report by the Committee of the Future Economy is now a big distraction in the news. I feel an obligation to go through the 170+ page report and figure out what this means for readers.

Unfortunately, I only have so much spare time.

Anyway, so far the Year of the Rooster has been a good one.



Tuesday, February 07, 2017

Equity Management #1 : Ten investment insights which matter

I thought I should look for a more advanced book after reviewing Tim Feriss' Tools for Titans and have settle on Jacobs and Levy's Equity Management which I doubt anyone would read because it is quite an advanced guide and looks like a huge brick. The way I'm going to cover this book is going to be slower, with about one article a week.

This book is, upon inspection, quite difficult to understand but still considered way easier than Benjamin Graham's Security Analysis.

Today I am just going to give everyone a snippet of Chapter 1 which is entitled Ten Investment Insights which matter. 

I will try to summarise each insight into a sentence for a start :

a) The Stock Market is a complex system - The stock market is essentially random but it has a web of return regularities in the form of market anomalies so it cannot be characterised simply as a random or predictable system at all.

b) Market complexity can be exploited with a rich multidimensional model - The more predictors you build to forecast returns, the bigger your informational advantage.

c) Return-predictor relationships should be disentangled - Low P/E needs to be disentangled from the small firm effect because most low P/E firms are small companies.

d) An investment firm should abide by the law of one alpha - Your value strategy may buy a stock which your momentum strategy wants to short. 

e) The investment process should be dynamic and transparent - Tight risk control is bad for returns.

f) Customised, integrated process preserves insights - When you try to optimise your portfolio, don't forget to include costs in your model.

g) Integrated long-short optimization can provide enhanced returns and risk control for market neutral and 130-30 portfolios - Nobody in the financial blogosphere pairs their long positions with a short position to capture alphas. One of us should try this one day.

h) Alpha from security selection can be transported to any class - Basically it means that if your long-short positions generate alpha returns, they can be paired with a long position in the permanent portfolio for a boost to your returns.

i) Portfolio optimization should take into account an investor's aversion to leverage - The CFA program uses the mean-variance optimization to control leverage. This is not cool anymore.

j) Beware of risk-shiifting, free lunches and irrational markets - Mostly about LTCM.

As you can see, this is fairly complicated box and targetted at professionals.

Let's see where this journey over 39 chapters will take us.