Monday, April 13, 2015

Paper: "Books Average Previous Decade of Economic Misery"


"For the 20th century since the Depression, we find a strong correlation between a 'literary misery index' derived from English language books and a moving average of the previous decade of the annual U.S. economic misery index, which is the sum of inflation and unemployment rates. We find a peak in the goodness of fit at 11 years for the moving average. The fit between the two misery indices holds when using different techniques to measure the literary misery index, and this fit is significantly better than other possible correlations with different emotion indices. To check the robustness of the results, we also analyzed books written in German language and obtained very similar correlations with the German economic misery index. The results suggest that millions of books published every year average the authors' shared economic experiences over the past decade."
That's interesting - think of the period from 2005 until present. That is probably what people have integrated into their minds as "normal" economic conditions. That period includes only two crash years, 2008-2009 (20%), and quite a few mania years.

Saturday, March 28, 2015

Paper: "Noise Trader Risk in Financial Markets"

"Noise Trader Risk in Financial Markets" [pdf].

"In a world with mean-reverting noise traders' misperceptions, the optimal investment strategy is very different from the buy and hold strategy of the standard investment model. The optimal strategy for sophisticated investors is a market-timing strategy that calls for increased exposure to stocks after they have fallen and decreased exposure to stocks after they have risen in price. The strategy of betting against noise traders is a contrarian investment strategy: it requires investment in the market at times when noise traders are bearish, in anticipation that their sentiment will recover. The fundamentalist investment strategies of Graham and Dodd (1934) seem to be based on largely the same idea, although they are typically described in terms of individual stocks. The evidence on mean reversion in stock returns suggests that, over the long run, such contrarian strategies pay off."

Couple Other Good Thoughts From Falkenstein

Followup on the book review,

  • Why equities could have a return premium, but a very modest one: "cross-sectional equity returns over a hundred years are not positively related to economic growth, so it is not as if the economy is a representative firm and a risk averse individual is choosing how much wealth to allocate to a stochastic investment; rather, the stock market is a subtle game between insiders and outsiders where the insiders merely provide enough top-line returns to keep the rabble unaware they are being had."
  • "Stocks with higher volatility generate more news than less volatile firms. Such stocks are then in play and so become relevant to the investor interested in deviating from the index. Stocks that are in the news generate lots of information that fiduciaries can use to sell their ideas to clients. Such cocktail party stories are very helpful, and it is much easier to talk about something in the news..."
A stock like Conrad reports once a quarter and is otherwise never in the news. Think about how often Chesapeake Energy has been in the news.

Review of The Missing Risk Premium: Why Low Volatility Investing Works by Eric Falkenstein

Eric Falkenstein has a very underrated finance blog (no longer active), which we have mentioned before talking about his excellent Batesian Mimicry hypothesis, his well founded criticisms of Taleb, where the money made at trade desks really comes from, and on competitive advantage.

He gathered his thoughts on the non-existent risk premium in finance (which means that modern portfolio theory is wrong) and on low volatility investing into a short book, The Missing Risk Premium: Why Low Volatility Investing Works. Modern portfolio theory (MPT) is the idea that the expected return of a financial asset is a function of its risk.

MPT is incorrect and has been proven incorrect repeatedly, but taxpayer money is used to pretend it is still true for a number of reasons. Economists and finance professors like it because they have invested their careers in it, it is easy to teach and generates a mathematically tidy curriculum, and it is essential for thousands of 20th century finance papers to be relevant. Managers of pension funds need it because it implies that they can achieve higher investment returns, and therefore pretend they will meet their pension goals, by taking more risk. As Falky says, "there is no shortage of people believing [this] theory is true because of its convenient implications."

By the way, one complaint that people have about Falky's book is that it's old news. Nobody believes in MPT, and as he argues, "if risk premiums were really ubiquitous, finance-specific tools would be valuable to hedge funds." It is true; there are no successful investors who are using this theory. But it is still part of the CFA curriculum! Taxpayer money is going to finance professors trying to overcome all the empirical data against it.

Rather than return being a function of risk as MPT claims, "as a first-order approximation, asset pricing theory has the wrong sign," with either no correlation or a negative correlation between risk and return. Some examples, including papers he cites in the book:

  • "[T]he return premium for the smallest capitalization group [of stocks] is an order of magnitude lower than what was originally discovered around 1980."
  • In corporate bonds, "the rate of return lined up almost perfectly with the rating, with AAA having the highest return, C the lowest." Investing in senior debt beats investing in subordinated debt, over time.
  • "Karl Diether et al. (2002) found the quintile of stocks with the greatest opinion dispersion underperformed a portfolio of otherwise similar stocks".
  • "Sophie Ni (2007) looked at data from 1996 through 2005 and found that the highest out-of-the-money calls, with one month to expiration, have average returns of −37 percent over a month".
  • For motion pictures, R-rated movies can be high grossing movies but have very high variance. G-rated movies are a lower variance strategy that have higher expected value. (see Hollywood Economist)
  • "Barro (2006) surveyed a number of financial collapses in the twentieth century and found that this adjustment suggested a 3 percent reduction to equity risk premia."
  • "Giesecke (2011) found that the total default rate for the 1873–1875 period was a whopping 36 percent, which for an entire bond market is much larger than what occurred in the Great Depression."
  • "Snowberg and Wolfers (2010) looked at more than 200,000 races and reported the rate of return to betting on horses with odds of 100/1 or greater is about 61 percent, betting randomly yields average returns of 23 percent, whereas betting the favorite in every race yields losses of only around 5.5 percent. They found this bias has been persistent for fifty years at least..."
In general, gamblers (like the retail investors who buy worthless stocks), prefer bets that offer the greatest maximum return even though they have very poor (negative) expected returns. "[T]he rich are stupid because they contain a disproportionate number of lucky morons who did not realize they were taking as much risk as there were," see "Noise Trader Risk in Financial Markets" [pdf].

Philosophically, "the idea that financial courage [to take risk] produces a strictly increasing and linear expected payoff to risk bearing is contrary to the payoffs to every virtue, which all require moderation and trade-offs with competing virtues" He points out that "a theory that implies a ubiquitous linear payoff to an action like exposure to volatility, regardless of context or quantity, would be unprecedented"

For Falkenstein, the result of the knowledge that risk is actually inversely proportional to return leads him to constructing low-volatility portfolios. This is something that he was on the cutting edge of, although it was simultaneously invented by a number of people and there are now a variety of low-volatility exchange traded funds. There is now ample evidence that these low-volatility portfolios outperform the market indices, and they are cheap to run. And as Falky points out, it's pretty funny that you can beat the index just by applying the idea that risk does not lead to reward!

One funny thing about low-volatility superiority is that is that we already know what ideosyncratic volatility means: it is a sign that something is worthless. Right now the low-volatility indexes are full of utility stocks: the S&P 500 utility weighting is 3.2% but the largest LV ETF has a 13% weight in utilities. It will be interesting to see whether, if electric utilities suffer from distributed solar, they are kicked out of the LV indexes because of rising volatility before they can cause too much damage.

I give this 5/5; nice and brief with lots of well-articulated points. Some of the more detailed rebuttals of MPT are irrelevant for practicing value investors. What's important is that it discredits buy-and-hold investing and asset allocation. I agree with Falky's advice for how you should invest, in light of MPT being wrong:
  • "[I]f you have no reason to presume you have an edge assume it is negative and invest in assets where this hurts you the least." (Similar to Whitebox principles)
  • "Finding good investments is like finding good ideas in general, things that are new, true, and important." (Thiel job interview question)
  • Stupid money buys "lottery tickets hoping to get rich quick with no effort. The effect is for really high-risk investments to have the most delusional investors, the most opportunistic sellers, and pathetic returns. [...] By ridding your asset classes of these objectively bad assets, you can improve your returns"
  • "It is essential to have the right connections when you have a good idea, more so the bigger the idea." Meaning people who can give you money. He did not have the right connections and did not make the money he should have on his low-volatility investing idea.
  • "Classic investors like J.P. Morgan and Benjamin Graham distinguished between gambling and investing, the former being simple exposure to randomness, the latter something amenable to special insight and intuition. A good investment has the odds decidedly stacked in its favor via some special insight."
Having special insight is the key. There's only so much one person, or company, can know or focus on. And if you don't have a special insight, be in cash. His thoughts are similar to those of another Minnesotan, Andy Redleaf (see 1,2,3).

Friday, March 27, 2015

Notes From Munger's Q&A Session After The Daily Journal Annual Meeting

  • I didn't hear a single person admit to owning and DJCO shares. Everyone was there to hear Munger.
  • On a question about the Daily Journal software business and the operating losses as it grows, he said "I think of it like Jeff Bezos," which implies that he is bullish on Amazon, because the bullish case is that they are unprofitable because of growth investments.
  • His thought about product development: "make a list of everything that irritates the customer" and work on eliminating those things.
  • He seemed really depressed about capitalism, in the sense of opportunities to make easy money being arbed away. I've noticed really rich investors get that way late in the market cycle before [pdf]. He gave the example of "widow and orphan" stock Kodak, which made it through the Great Depression only to be disrupted many years later, "wiping out shareholders". He, Buffett, and Gates believe that this is a unique risk of "technology". Of course, everything is technology: RadioShack disrupted by Amazon, electric utilities disrupted by distributed solar.
  • It seemed like he was saying he doesn't even really try to make money investing anymore; it's too hard in this market. He did say that real value investors need to be small and focused on the least efficient markets; something we obviously agree with.
  • Speaking of utilities, somebody asked about Berkshire's huge investments in electric utilities. He was absolutely confident that solar would not hurt their business, but basically brushed off the question and articulated no actual explanation.
  • Speaking of entrepreneurs that Munger name-dropped, he surprised everyone by saying that he had a meal with Elon Musk and told him he thought Tesla would fail, just because of how difficult the automobile business is.
  • Charlie Munger was very impressed with Lee Kuan Yew. It was all he could talk about. Here's a funny take on LKY: "I had an idea once for a recurring sketch comedy bit called 'Korean Mother-in-Law' about a nice white liberal guy who has to live with his Korean mother-in-law who cackles mercilessly at all his nice white liberal delusions. The late Lee Kuan Yew, founder of the Singaporean state, was like the world’s Korean mother-in-law, if the Korean mother-in-law was male, hyper-intelligent, a native English-speaker, and an extraordinarily successful statesman." Munger talked about "commissioning a bust" of Yew and "sticking it someplace" in his house.
  • Pessimistic about the future: "I think that someone my age has lived through the best and easiest period in the history of the world." Thinks the next 50 years will be more difficult than last 50 (no kidding). "Be prepared for adjusting to a world that's harder."
  • He was "pleasantly surprised by the lack of consequences of bouts of inflation" this century. But he says you can "count on the purchasing power of money to go down over time".
  • He had no thoughts or interesting theories about low-to-negative interest rates throughout the world. Unlike Credit Bubble Stocks, he did not predict the big bond rally last year
  • He said the way to get rich is to "keep $10 million in your checking account in case a good deal comes along". People always ask him how to get rich quick. There's no way to do that, plus he says getting rich slowly "protracts a pleasant process."
  • There was lots of discussion of 3G and it's ability to generate returns by firing people at consumer packaged goods companies. My observation is that they are able to reverse Parkinson's Law of Multiplication of Subordinates.
  • One other good subject was indexation: "Index funds will be permanent owners who can never sell. That will give them power they are not likely to use well."
I can't see paying more than book value for DJCO, which is $136 million - 50% downside to current price.

Conrad Repurchased 100,000 Shares in 2014

"During the first quarter of 2012, we purchased 59,881 shares at an average price of $15 per share. During the third quarter of 2012, we purchased 150,000 shares at an average price of $15 per share. During February 2013, the board approved an increase in the stock repurchase program of $10 million. No shares were purchased under the program in 2013. In November 2014, we purchased 100,000 shares at an average price of $32 per share. On December 11, 2014, the board approved an increase in the stock repurchase program of $20 million."

Conrad Industries Announces 2014 Results and Backlog $CNRD

The 2014 results and backlog:

For the quarter ended December 31, 2014, Conrad had net income of $5.2 million and earnings per diluted share of $0.88 compared to net income of $10.1 million and earnings per diluted share of $1.70 during the fourth quarter of 2013. The Company had net income of $22.8 million and earnings per diluted share of $3.84 for the twelve months ended December 31, 2014 compared to net income of $28.6 million and earnings per diluted share of $4.80 for the twelve months ended December 31, 2013. [earnings down 20% from 2013 to 2014!]

Conrad’s backlog was $180.2 million at December 31, 2014, compared to $152.9 million at December 31, 2013.

Johnny Conrad, President and CEO stated, “While our net income was lower in 2014 compared 2013, we achieved the highest gross profit in our Company’s history in the vessel construction segment. The decline in earnings was attributable to our repair and conversion segment, in which gross profit decreased $11.8 million or 65.6%, compared to 2013. This decrease was primarily due to a significant loss on a large conversion job, and a decrease in demand and customer activity, which we believe is due to the decline in crude oil prices; additionally in the second half 2013, we had a large job which added significantly to repair and conversion gross profit.

As of December 31, 2014, we had cash of $68.6 million and no long-term debt.
[The market cap is $182 million, enterprise value is now about $110 million.] During the past five years, we have made approximately $44.8 million of capital expenditures to add capacity and improve the efficiency of our shipyards. Our Board has approved a $27.3 million capital expenditure program for 2015, which includes $16.7 million for the continued development of the Conrad Deepwater South yard. The additional improvements at Deepwater South will continue to enhance our ability to build larger vessels, and we believe these investments in our business will improve our efficiencies and competitiveness.”

Mr. Conrad continued, “Throughout the years, we have used our cash generated from operations to make investments in our business to continue to diversify our product mix, take advantage of business opportunities and improve efficiencies. We believe these investments have allowed us to remain competitive, meet changing customer needs and navigate effectively through business cycles. Additionally, we have returned cash to our shareholders through our stock repurchase program and special dividends in each of the past three years, and in 2015, we initiated a quarterly dividend.”

Mr. Conrad also stated, “We have been actively pursuing increased opportunities to produce different types of vessels for new markets, and are encouraged by our recent success in obtaining the contract to construct the LNG bunker barge. Some of these vessels, including the LNG bunker barge, are larger, take longer to start production, and take longer to complete than vessels we have constructed in the past. While we remain optimistic about the long-term prospects for our business, we must also take note of near-term risks. We have experienced a decline in demand for inland tank barges primarily used to transport petroleum products produced from shale plays, delays on orders for larger projects, and a soft repair market, which we believe is due primarily to the decline in crude oil prices. We currently expect these factors to negatively impact our financial performance during 2015, compared to 2014.

We have met these types of challenges in the past, and we continue to be confident that because of our record of success, talented and dedicated employees, strong balance sheet, and diversified customer base, we will continue to be responsive to changing market conditions, with our goal remaining to continue to enhance shareholder value.”
They announced the signing of an LNG bunker barge contract:
Conrad Industries, Inc. announced today that its subsidiary Conrad Orange Shipyard, Inc. has entered into a contract to construct the first LNG bunker barge to be built for the marine market in North America. The contract signing was hosted at the residence of the French Consulate General Sujiro Seam in Houston, TX.

Conrad’s customer, WesPac Midstream, and its affiliate Clean Marine Energy, will deploy the barge in Tacoma, WA to service ship owner TOTE and its “Orca Class” vessels, then subsequently relocate the vessel to Jacksonville, FL to service the TOTE new build “Marlin Class” vessels as well as other LNG powered vessels in the Port of Jacksonville.

The vessel will be constructed at Conrad Orange Shipyard in Orange, TX. It will be outfitted with French engineering and technology company Gaztransport & Technigaz (GTT) Mark III Flex cargo containment system, which will also be built by Conrad under a license from GTT. The barge delivery is scheduled for early 2016.
This barge is not exactly what you think. Bunkering is the provision of fuel to a ship.

So, with the enterprise value of ~$110 million, you are paying about 5x last year's earnings. Spending $27 million on capex in 2015 is pretty shocking, though. Sounds like it may be necessary to "pivot" into an entirely new business of much larger, riskier ships.