2013 Risk and Profit Conference

Breakout Session Presenters

8. Investing 101 and Why Economists Drive Dodge Darts

Joe Arata <[email protected]>
Joe Arata teaches courses, provides information and conducts research on
commodity futures, options on futures and off exchange derivatives.
Currently he is working on an analysis of futures market price valuation and
market information; analyzing profit due to underlying asset price changes
as opposed to profit due to option mispricing; and decomposing option
mispricing into volatility and formula error.


Abstract/Summary
Economic financial theory is based in part on the theories that include the
Efficient Market Hypothesis, Random Walk theory and other that are
manifestly false and incorrect.
I ti Investing
Why Economist Drive
g
Dodge Darts
J oseph O. Arata Ph.D.
Department of Agricultural Economics
Kansas State University
2013 D d D t 2013 Dodge Dart
2
Heres the Plan
Saving - Investing
What Economists Believe What Economists Believe
Stocks
Fi i l R ti Financial Ratios
3
Saving VS Investing
Saving
Short-term Short term
Postpones spending
Has safety precautions y p
Investingg
Longer term capital
Exchanges money for something with the
f t t ti f i i fit future expectation of receiving a profit
Has risk factors
4
Saving VS Investing
Places to Invest
Bonds
Collectibles/Valuables Collectibles/Valuables
Mutual Funds
Retirement Plans
Real Estate
Stocks
5
6
What Economists Believe
Efficient Markets Hypothesis
RandomWalk Theory Random Walk Theory
Micro Economics Theory
7
Efficient Markets Hypothesis
Textbook Version
Security prices accurately reflect
available information, and respond , p
rapidly to new information as soon as it
becomes available
Richard Brealey & Stewart Myers,
Principles of Corporate Finance 2007 Principles of Corporate Finance, 2007
8
Efficient Markets Hypothesis
I t d b tt Investors, as a group, can do no better
than the market, because collectively they
th k t M t i t t il th are the market. Most investors trail the
market because they are burdened by
i i d f d commissions and fund expenses.
J onathan Clements, the Wall Street
J l Journal,
J une 17, 2007
9
Efficient Markets Hypothesis
80-90% of price volatility is the result of the p y
internal dynamics of speculators watching
other speculators: p
EMH idea of investors focusing solely
upon expected risk/return is wrong: p p g
Instead,
Prices are determined by speculation on
immediate behavior of other speculators,
rather than rational calculation
10
Market Realities
Professional managers: choose portfolios that
l t th b h k th l t d are close to the benchmark they are evaluated
against
To minimize the risk of underperforming this To minimize the risk of underperforming this
benchmark
Select stocks that other managers select,
f Again to avoid falling behind and looking bad
Add stocks that have recently done well, and
Sell stocks that have recently done poorly Sell stocks that have recently done poorly,
To look good to investors who are getting end of
year reports on portfolio holdings
11
Market Realities
Individual investors do not do this
Self-defeating (irrational?) behavior as well
follow the advice of financial gurus,
F il t di if Fail to diversify,
Actively trade stocks and churn their portfolios,
Sell winning stocks and hold on to losing stocks Sell winning stocks and hold on to losing stocks
thereby increasing their tax liabilities (Shleifer
2000 p. 10)
Undermines both EMH and possible gains from market
inefficiency
Also partly explains market inefficiency
As does behavior of money managers
12
Apple Stock
Apple
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510
Apple
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3333333333333333333333
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Apple Stock
Apple
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Apple
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350
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P t h f S k t h Potash of Saskatchewan
50
45
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25
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D CNH Deere - CNH
49 86
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M t S t Monsanto-Syngenta
90 110
85 105
80 100
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1
The Richest People
1. Carlos Slim Helu 2. William Gates
3 A i O t 4 W B ff tt 3. Amancio Ortega 4. Warren Buffett
5. Larry Ellison 6-7. C&D Koch
8 Li Ka-shing 9 Liliane Bethencourt 8. Li Ka-shing 9. Liliane Bethencourt
10. Bernard Arnault 11. Christy Walton
12. Stefan Persson 13. Michael Bloombergg
14. J im Walton 15. Sheldon Adelson
16. Alice Walton 17. Bobson Walton
18. Karl Albrecht 19. J eff Bezos
20. Larry Page 21. Sergey Brin
22 Mukesh Ambani 23 Michele Ferrero
18
22. Mukesh Ambani 23. Michele Ferrero
24. LeeShau Kee 25. David Thomson
People who earned it all
1. Carlos Helu-telecom 2. W. Gates-Microsoft
3. A. Ortega-Zara 4. 3. A. Ortega Zara 4.
5. L. Ellison-Oracle 6-7.
8. L. Ka-shing-stocks 9.
10. 11.
12. S. Persson-H&M 13.M. Bloomberg-Bloomberg
14 15 S Adelson casinos 14. 15. S. Adelson-casinos
16. 17.
18 K Albrecht-Aldi 19 J Bezos-Amazon 18. K. Albrecht Aldi 19. J . Bezos Amazon
20. L. Page-Google 21. S. Brin-Google
22. M. Ambani-oil&gas 23. g
24. L. Kee-stocks 25.
The Richest Showbiz Women
1. Oprah Winfrey 2 J .K. Rowling
3 Martha Stewart 4 Celine Dion 3. Martha Stewart 4. Celine Dion
5. Madonna 6. Mariah Carey
7. J anet J ackson 8. J ulia Roberts
9. J ennifer Lopez 10. J ennifer Aniston
11. The Olsen Twins 12. Britney Spears
13 J d J d 14 S d B ll k 13. J udge J udy 14. Sandra Bullock
15. Cameron Diaz 16. Gisele Bundchen
17 Ellen DeGeneres 18 Nicole Kidman 17. Ellen DeGeneres 18. Nicole Kidman
19. Christina Aguilera 20. Renee Zellweger
What is a Random Walk?
Textbook Version
Formal Definition: In simple symmetric
random walk on a locally finite lattice, the y ,
probabilities of the location jumping to each
one of its immediate neighbors are the same. g
The best studied example is of random walk
on the d-dimensional integer lattice g
(sometimes called the hypercubic lattice) .
21
What is a Walk?
An Intuitive understanding: A series of
movement which direction and size are movement which direction and size are
randomly decided (e.g., the path a drunk
person left behind) person left behind).
Stock market prices evolve according to a
randomwalk and thus cannot be predicted It is random walk and thus cannot be predicted. It is
consistent with the efficient market hypothesis.
22
Random Walk
Individual stocks prices are extremely
volatile and that volatility is too large to
rationalize with a random walk
23
Definitions of Volatility
Historical Volatility based on the s d of Historical Volatility based on the s.d. of
continuously compounded stock returns.
Idiosyncratic Volatility based on the s d of Idiosyncratic Volatility based on the s.d. of
residuals from a factor model for returns.
I li d V l tilit th l tilit l l th t Implied Volatility the volatility level that
would produce an observed option price.
VIX (fear index) measures the markets
volatility expectation over the next 30 days.
Why Volatility Increased
Firm-Specific Factors:
The number of stocks on U.S. exchanges has
more than doubled since 1980, but the
i f th l li t d fi i average size of the newly listed firms is
smaller
Newly listed firms are younger riskier and Newly listed firms are younger, riskier, and
need a less proven track record (to be listed)
Increased Volatility of FirmFundamentals like Increased Volatility of Firm Fundamentals like
EPS and ROE (levels declining, variability up)
More Financial Leverage and Innovation More Financial Leverage and Innovation
Stock Price Volatility
Discrete jumps often occur when reported
earnings are different than expectations earnings are different than expectations.
Institutional investors now react quite swiftly
to such news and in similar fashion to such news, and in similar fashion.
Thus, stock price change distributions have
higher kurtosis/fatter tails (v normal) higher kurtosis/fatter tails (v. normal),
especially among lightly traded stocks.
Recently the magnitude of price changes Recently, the magnitude of price changes
has exceeded what fundamentals dictate.
Volatility v. Return
Stocks with large sensitivities to market
l tilit h l t volatility have lower average returns.
Periods of high volatility tend to occur in
bear markets, and periods of low volatility
occur in bull markets.
Return dispersion is countercyclical, but is
related positively to subsequent market p y q
volatility, and tends to lead unemployment.
Why Care about Volatility?
High Volatility may make a diversified
tf li l di ifi d portfolio less diversified.
Arbitrageurs can get it wrong when
volatility becomes too high.
Abnormal event-related returns are
strongly impacted by volatility.
Both stock and option prices are Both stock and option prices are
associated with changes in volatility.
Explanation for Relationship
It is no surprise that high-risk stocks do
l ti l ll i k t b t l ti l relatively well in up markets, but relatively
poorly in down markets.
However, the negative effects from down
markets often dominate the positive effects
from up markets.
This might indicate an inverse relationship g p
between risk (historical volatility) +return.
Liquidity
Liquidity is like pornography. Easy to
id tif h b t it i diffi lt t identify when seen, but it is difficult to
define. But, CLM defines liquidity as:
Ability to buy or sell significant
quantities of a security quickly,
anonymously, and with minimal or no
price impact.
30
Extreme Volatility Events
Volatility Spikes tend to occur during times of
l i ffi i t li idit low or insufficient liquidity:
October 19, 1987 (portfolio insurance)
August (2
nd
half), 1998 (Russian financial
crisis))
September 11, 2001 (WTC / markets
closed for 4 days closed for 4 days
May 6, 2010 (Flash Crash)
Extreme Volatility Episodes
The Great Depression
The Internet Bubble
The Recent Financial Crisis
In 2008: the daily DJ IA changes were at
least 1% on 134/253 (53%) of all trading ( ) g
days
This compares to a 15.6% avg. (2004-
2007)
European Debt Crisis / U.S. Treasury p y
Downgrade (3
rd
Quarter 2011)
Micro Economic Theory
Normal micro economic theory:
Supply a positive function of price Supply a positive function of price
Demand a negative function of price
Supply and demand independent Supply and demand independent
If price rises
Supply rises Supply rises
Demand falls
Tendency towards equilibrium Tendency towards equilibrium
Supply
y = 2 +x y = 2 +x
$8
$9
Hypothetical Beer Supply
$5
$6
$7
B
o
t
t
l
e
$2
$3
$4
P
r
i
c
e

/
B
$0
$1
0 2 4 6 8 10 12
Quantity
Demand
Hypothetical Beer Demand
$7
$8
$9
Hypothetical Beer Demand
$
$5
$6
$7
/
B
o
t
t
l
e
y =12 -x $2
$3
$4
P
r
i
c
e
/
$0
$1
0 2 4 6 8 10 12
QQuantity
Market Realities
With the stock market
Supply (of assets shares) possibly a Supply (of assets, shares) possibly a
positive function of price
Demand also a positive function of price: Demand also a positive function of price:
If price of assets (shares, real estate, etc.)
rising demand also rises rising, demand also rises
Buyers hope to buy and sell on a rising
market market
The faster the rate of price increase
(generally speaking) the faster the growth of (generally speaking) the faster the growth of
demand
Market Realities
Tendency to move away from equilibrium
(f d t l l hi t i i t (fundamental value, historic price to
earnings ratios, etc.)
P i th d t bili t k t Price thus destabilizes an asset market
Far-from-equilibrium process means
O l ti f l th t k Overvaluation of popular growth stocks
Undervaluation of unpopular value stocks
Market Realities
Argument that investors
R t l l t React slowly to news
Under-react and Over-react
Ignore reversion to the mean Ignore reversion to the mean
Series of good reports leads to expectation
of more good news of more good news
Firm valuation rises, seen as growth stock
rise becomes self-fulfilling; bandwagon buying rise becomes self fulfilling; bandwagon buying
Market Realities
Firm cannot sustain above sector/economy
f i d fi it l performance indefinitely
Initial bad news reports ignored as firm
t t reverts to mean
Finally, bear valuations set in; bandwagon
lli selling
growth stock underperforms in medium term
Stocks
Standard & Poors 500: 90 U.S. stocks
t 1957 d 500 ft th t L d up to 1957 and 500 after that. Leaders
in their industries and among the largest
fi t d d U S M k t firms traded on U.S. Markets.
Small stocks: Securities traded on the
NYSE with market capitalizations in the
bottom 10%.
40
Stocks
S&P 500
J anuary 3, 2012 1,258.86
August 13, 2013 1,691.42 g , ,
J anuary 2 1975 70 71 J anuary 2, 1975 70.71
J anuary 3, 1977 107.00
41 42
Major Stock Classes
Large company growth stocks
Large company value stocks Large company value stocks
Small company growth stocks
Small company value stocks p y
Mid cap growth stocks
Mid cap value stocks
Mid Foreign stocks
Developed
E i Emerging
43
Small company growth stocks
Growth stock generates substantial
and sustainable positive cash flowand
whose revenues and earnings are
expected to increase at a faster rate
than the average company within the
same industry
Small stocks: Securities traded on the
NYSE with market capitalizations in the
bottom 10%.
44
Wrong ETF
Brazil
China China
Chile
T k Turkey
United States
South Africa
45
Price Earnings Ratio
Ratio of a stocks price to the companies
earning per share
P0/E1
P0 market price per share P0 market price per share
E1 Earnings per share
Earnings per share net income dividends Earnings per share net income dividends
average shares
46
Price Earnings Ratio
Ratio of a stocks price to the companies
earning per share
P0 / E1
Conventional wisdom,
Riskier stocks have lower P/E
47 48
Price Earnings Ratios
Problems with the P/E
E i M t Earnings Management
Practice of using flexibility in accounting
r les to impro e apparent profitabilit of firm rules to improve apparent profitability of firm
Large amount of discretion in managing
earnings earnings
2012 P/E Ratios
11 0
10.2
8.5
Money center banks
Integrated oil & gas
Aerospace/defense
14.9
14.7
13.2
11.8
11.0
Industrial metals
Telecom services
Computer systems
Health care plans
Money center banks
17.4
17.2
16.5
15.6
Chemical products
Pharmaceuticals
Home improvement
Electric utilities
21.4
21.1
17.5
17.5
A t f t
Restaurants
Food products
Asset management
Application software
57 8
34.7
32.4
28.0
25.3
Biotech
Business software
Heavy construction
Trucking
Auto manufacturers
57.8
0 10 20 30 40 50 60
Biotech
P/E ratio
Financial Statements
www.sec.gov/edgar.shtml
dripinvesting.org/Tools/Tools
51
Financial Ratios: Can the
Business Pay Its Debts? Business Pay Its Debts?
CURRENT RATIO is the ratio of current assets to
current liabilities.
Current assets
Current liabilities Current liabilities
For instance if J OE'S BAR ANDGRILL has $10 For instance, if J OE S BAR AND GRILL has $10
million in current assets and $5 million in current
liabilities, you get: , y g
Current Ratio =$10 million/ $5 million =2.0
As a general rule, a current ratio of 1.5 or greater is
normally sufficient to meet near-term operating
needs.
Financial Ratios: Can the
Business Pay Its Debts? Business Pay Its Debts?
The ACID TEST (QUICK) RATIO, the ratio of
current assets minus inventory to current liabilities,
is more rigorous is more rigorous.
Current assets - inventory
Current liabilities
The balance sheet of J oe's Bar and Grill shows that
th h $2 5 illi f th i t t i they have $2.5 million of their current assets in
hamburger buns that are sitting in inventory. You
nowcan figure out the company's quick ratio: now can figure out the companys quick ratio:
Financial Ratios: Can the
Business Pay Its Debts? Business Pay Its Debts?
The ACID TEST (QUICK) RATIO,
The balance sheet of J oe's Bar and Grill shows that
they have $2 5 million of their current assets in they have $2.5 million of their current assets in
hamburger buns that are sitting in inventory. You
now can figure out the company's quick ratio: g p y q
Quick Ratio =(Current Assets - Inventories)
C t Li biliti Current Liabilities
=$10 mm - $2.5 mm / $5 mm
54
Financial Ratios: Can the
Business Pay Its Debts? Business Pay Its Debts?
WORKING CAPITAL is the amount of
current assets less current liabilities.
Current assets - Current liabilities
55
Financial Ratios: Can the
B i P It D bt ? Business Pay Its Debts?
ACCOUNTS RECEIVABLE TO WORKING
CAPITAL shows the riskiness of the
company's ability to make current payments.
Accounts receivable
W ki it l Working capital
INVENTORY TO WORKING CAPITAL
states the riskiness in terms of inventory.
Inventory
Working capital
56
Bottom line
Inefficiency markets generate opportunities
Fund managers cant pursue because of short- Fund managers cant pursue because of short
term monitoring
Individuals tend to miss by following the crowd
Fund Managers
Short-term horizon forces index following
Individuals Individuals
Behavioral herding causes following of fads
Opportunities to profit fromindividual investing Opportunities to profit from individual investing
Buy high out of favor sectors, low volatility, low PE
Worse performance over short term possible
Better performance over medium-long term likely
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