A 4-Minute Animated History of Economics

My favorite line: 1867, Das Kapital goes to press without Karl Marx ever visiting a factory (LOL!)

3 Ways to Spot Undervalued Stocks (Stock Picking Redux)

If you and Warren Buffett are of a like mind, then you should also have your "elephant gun" loaded and ready for times such as these, with pervasively depressed stock prices and shaky investor confidence precipitated by S&P's downgrade of US debt a couple of weeks ago.

If you haven't fired your gun yet (like Mr. Buffett, I already have) and you want something more specific than the criteria I presented in these (Part 1 and Part 2) posts, then here are three other signs that you can use to spot undervalued stocks that will most likely provide superior future returns and their corresponding supporting theories.

1. Low price-to-book ratio from "The Cross Section of Expected Stock Returns" by Eugene Fama and Kenneth French

"Price-to-book" is the ratio between the "market value of common equity" to the "book value of common equity," or stock price to "book value of common equity per share," where

Market value of common equity = stock price × total number of outstanding shares

Book value of common equity = total shareholders' equity on the firm's balance sheet

Book value of common equity per share = book value of equity ÷ total number of outstanding shares

According to the study by Fama and French, a low price-to-book is a good indication that a stock is selling for less than it is worth, so is likely to outperform other stocks, other things equal.

2. Significant decreases in stock price over five years from "Does the Stock Market Overreact?" by Werner De Bondt and Richard H. Thaler

This one's a bit harder to accept since going down by a considerable amount intuitively means that there might be something wrong with the stock. But according to the study by De Bondt and Thaler, portfolios consisting of "loser stocks" tend to outperform the market by a significant amount, a result which suggests that while there may be a justifiable reason for a stock's price decline, investors tend to overreact to this information.

3. Less equity issues relative to debt issues from "The Equity Share in New Issues and Aggregate Stock Returns" by Malcolm Baker and Jefferey Wurgler

This idea is based on the concept of information asymmetry: that managers know more about the prospects of a firm than do outside investors, and that managerial decisions can be taken as signals about how the company will perform in the foreseeable future. The results of the empirical study undertaken by Baker and Wurgler show that managers tend to favor equity over debt before periods of low returns and avoid equity before periods of high returns.

The Deal With Insurance

PERSONAL FINANCE 101

     Cat did not understand. "They pay him gold and silver, but he only gives them writing. Are they stupid?"
     "A few, mayhaps. Most are simply cautious. Some think to cozen him. He is not a man easily cozened, however."
     "But what is he selling them?"
     "He is writing each a binder. If their ships are lost in a storm or taken by pirates, he promises to pay them the value of the vessel and all its contents."
     "Is it some kind of wager?"
     "Of a sort. A wager every captain hopes to lose."

George R.R. Martin

A Dance with Dragons

What is he selling them, Cat asks? Well, insurance, of course.

Albert Einstein was quoted as saying that insurance is one of the most important innovations of modern history. Insurance makes it possible for us to live in this chaotic world, amid all the natural and man-made volatility and unpredictability. Insurance protects people from natural disasters, families from a burning house or the death of the breadwinner, individuals from car accidents or unforeseen hospital expenses, and even ship captains from storms or pirate attacks.

In the passage above, Martin correctly describes insurance as a wager or bet for both the individual who wants to be insured--the captain--and the person or organization (e.g., an insurance company) that sells insurance--the insurer. To understand how, let's take a look at the situation below.

Let's say a captain in Martin's story, let's call him Daario, owns a ship with precious cargo and is set to sail across the Narrow Sea and back for six months. The Narrow Sea is known for its violent waters and bloodthirsty pirates; while Daario does not consider himself to be a coward, he nonetheless recognizes that the threat of losing his ship and its precious cargo is real. A nameless man--the insurer--offers to pay Daario the value of his ship and its cargo--around one hundred thousand gold dragons--if it gets lost in a storm or taken by pirates within a six month window, at the low, low price of fifty gold dragons--the insurance premium. Say, Daario estimates that the probability of his ship getting lost in a storm or taken by pirates is one in one thousand, should he buy the offered insurance or not?

In other words, Daario faces the following choices:

To not buy insurance, which has the following consequences:

• a 1 in 1,000 (0.1%) chance that he will lose 100,000 gold dragons
• a 999 in 1,000 (99.9%) chance that nothing will happen

To buy insurance, in which case Daario will lose 50 gold dragons for certain for the insurance premium

If you were in Daario's shoes, what would you do? For many of us, 50 gold dragons (or Philippine pesos or US dollars, if you prefer) would be a small price to pay to prevent a possible monumental loss--be it your ship, your house, your husband's earning power, and so on--no matter how remote that possibility is. We would not hesitate to pay a certain amount just to avoid risk.

How about the insurer? Things don't look quite so good from his end, do they? Surely, in the 1 in 1,000 chance that Daario loses his ship, the insurer will be wiped out since the 50 gold dragons he receives from the captain is far from enough to cover his obligation. This is where the true beauty of insurance comes to light, when we look at things from the other side of the fence. Most definitely, Daario won't be the only captain who would be willing to buy insurance from the nameless man. When individuals or organizations with independent or low-correlated risk (like say, how a person dying from cancer does not increase the likelihood that another person will die from the same disease; or how a fire in a slum area in Quezon City is unlikely to result in another fire in Makati) buy insurance, risk is pooled and the total risk for the whole group is reduced. Therefore, as more ship captains buy insurance, the insurance provider is able to collect enough premiums to cover possible losses at any given time. This is how insurance companies make money. 

That's the end of it. In many instances, insurance is the simplest and cheapest way to manage risk, and we all should have it in one form or another. However, if you're interested in the math of how insurance is able to pool and reduce risk, read on. 

***

(WARNING: Elementary statistics involved!) Let's say n captains buy insurance from the nameless insurer and that the probability that a captain will lose his ship is p. If the possibility that a captain will lose his ship is independent of other similar occurrences, then the probability that x out of n ships will be lost, P(x), is said to follow a binomial distribution; the mean percentage or proportion of ships that will be lost is always equal to p, but the standard deviation of the proportion, a measure of how much the proportion can move away from the mean, is the square root of p*(1 - p)/n. With these formulas, we see that as more captains buy insurance from the insurer--as n increases--the mean proportion of lost ships will be constant but the standard deviation of the proportion--a practical proxy for risk--decreases.

Competition Schmompetition

This post is a response to the comment of one of our readers to the previous post about Cebu Pacific:

Anonymous said...

The only way to improve service is competition. If we have this "open sky" policy the local airline industry will shape-up. This is what Tourism Sec Alberto Lim was pushing and was also the cause of his early political demise.

The same is true for the local shipping transport industry this should be opened up to foreign investors to improve service and safety. The more competition the less we hear of poor safety standards . As MVP have said the limited local capital will not be sufficient to improve Philippine infrastructure.


Dear Sir/Ma'am,

Let me start by saying that additional capital does not necessarily mean more competition, so I don’t really  get the point of quoting what MVP supposedly said.

Now for the meat of the matter.

I understand how--given our love for democracy, capitalism, and all things American--many of us can believe that free markets and unfettered competition is the panacea to the world's multitude of woes. After all, it's what introductory economics taught us: perfect competition is always best for consumers.

Unfortunately, this can't be farther from the truth. I'll give you two examples that support this admittedly contentious stand. First, let's take a look at the 2008 global financial crisis. While there may be no single factor that caused that shitfest, the deregulation of the US's financial system should be at the top of the list. Arguably, what happened happened because the financial experts that have surrounded the past two American presidents--ex-Wall Street people, all-- pushed for industry-wide deregulation, which essentially told banks and other financial institutions that they could freely compete and do whatever they want. And do what they want, these greedy motherfuckers did. How’s that for laissez-faire economics?

Want something closer to home? Since we’re talking about the local transportation industry anyway, why don’t we take another look at that? Ever noticed how there’s no jeep, bus, or taxi whenever you desperately need one and there’s a glut of them whenever you don’t? That’s free competition at work. Things are as shitty as they are because anyone with enough dough to buy a second-hand Toyota Vios and who knows the right people can get a taxi franchise and run his or her own mini-taxi empire, despite “regulation” from the LTFRB and even if our streets simply don’t need another taxi. Things are as shitty as they are because whatever regulation is in place is either unwilling or powerless to shape capacity and supply--by requiring operators to retire or replace their aging vehicles or by setting a strict schedule based on a thorough study, for example--to meet demand.

People say that the surest sign of economic prosperity is a healthy and efficient public transportation system: you only need to go as far as Hong Kong and Singapore to see the truth in that statement. And an efficient transportation system can only be achieved with a tightly regulated monopoly or oligopoly. Here in Hong Kong, there are only two bus operators (and their routes don’t overlap), one taxi service, and one privately-operated subway system (MTR); regulation is there to serve the public’s interest by controlling the profits of these operators. The only competition there is is intermodal in nature: when people decide to ride a bus or taxi because they’re too lazy to walk to the nearest MTR station.

So is competition--from a foreign player or otherwise--the answer to Cebu Pacific’s deteriorating service? Why don’t we all give that another thought before we say yes.

Cebu Pacific Rant

I was once the biggest Cebu Pacific fan. I remember the first time I flew using my own money, years and years ago when I went with some friends to Cebu: I would not have been able to do it were it not for Cebu Pacific.

A couple of years previously, flying--even domestic flying--had been the exclusive domain of the well-to-do. Back then, someone who wants to fly somewhere only had a choice between Philippine Airlines with its unreasonably high prices and legendary unreliable services (remember this? PAL = "Plane Always Late") and a couple of new budget airlines with a not-so-enticing reputation (remember this? "You fly an Asian, you land a Spirit"). Then Cebu Pacific came along and changed the local travel landscape. With its cheap and on time flights, the Gokongwei carrier opened the floodgates to the local tourism industry: flights-that-won't-kill-you had now become within the reach of the ordinary Juans and Juanas--mostly twenty- to thirtysomething young professionals who had the right mix of disposable income, vacation leaves, and thirst for exploration and adventure.

Then, like any other enterprise that is worth its salt, Cebu Pacific decided that it wanted to grow. It sought a massive amount of capital to buy new planes and open new routes, and in October 2010 the investing public more than willingly (and, in hindsight, naively) supplied the firm with the financing it needed. So grow, the budget carrier did, and eventually Cebu Pacific was able to wrest the title of "the Philippines' number one flag carrier" from PAL.

Unfortunately, the airline may have bit off more growth than it could chew. I first noticed that something might be amiss when I heard some of my friends here in Hong Kong swear that they would not fly Cebu Pacific anymore, that they would be willing to pay a premium for reliable services from someone else. I was puzzled when I heard this, I could not understand why anyone would want to pay more for something when Cebu Pacific can offer the same thing for less. That was until I experienced the reason first hand.

In the past three months, I've traveled six times in and out of and within the Philippines, all with Cebu Pacific. Five out of six times, my flight was delayed. Three out of five times, my flight was delayed by more than an hour. One time, my flight back to Hong Kong had been delayed so much that I missed a very important appointment. Understandably, I was so pissed, but at the same time I was wondering how Cebu Pacific's once very reliable service could deteriorate by so much in such a short amount of time, how the "on time performance" displayed on the flag carrier's website could go from a consistent 90+% to an embarrassing 60+%.

As soon as I got home from that horrible MNL-HKG flight, I contacted my friend who's a senior manager at Cebu Pacific to ask about this issue. This is what she had to say about the matter (she was kind enough to allow me to quote her anonymously):

I'm so sorry to hear that. I apologize in behalf of CEB.

The "investor relations" reply to that issue is: "Our on-time performance has been affected by a new air traffic control system in NAIA. Aside from increased capacity from airlines, the new ATC system does not complement our fast turnarounds. We are working with CAAP to address this." The unofficial reply is: "Pinatalsik na yung @#$%^%& na foreign consultant na walang silbi. So things will get better. We want to keep loyal customers happy."

But seriously, The ATC issue is real and affects not only Cebu Pacific but all carriers. We say we want growth but the Philippines ain't ready. Airport infrastructure pa lang inadequate na. And they want open skies?

So the the heart of the problem is that Cebu Pacific has been unable to successfully address a systemic issue.  Regardless, the firm needs to take decisive and effective action soon if it wants to hold on to its number one status: it's not the only attractive pang masa alternative to PAL anymore--smaller but nimbler carriers like Zest Air currently pose a serious threat in the domestic market and Airphil Express has started to offer competitive no-frills international flights.

I guess I'm willing to wait for things to turn around for the airline, but my patience is not without bounds; so unless Cebu Pacific improves it service in a sustainable manner in the foreseeable future, it will lose another loyal customer.

Unsolicited Advice

If I were you, this is what I would do:

1. If you have just incurred significant paper losses, don't panic--DON'T SELL. There's every reason to believe that things will go back to "normal" in the foreseeable future; if they don't, then you have bigger problems than the money you have lost. 
2. Invest half of your investable funds "in the market" (i.e., a diversified equity fund such as an equity UITF or equity index ETF) today
3. Use all your remaining capital to buy more of the same funds as soon as the market index (e.g., the PSEi) drops another 5% or so
4. Sell everything when the index reverts to its "pre-panic" level

If you're comfortable with your stock picking chops, you can apply the same strategy to individual stocks: your potential return will be several times higher. Of course, if you make the wrong pick, your potential losses would also be proportionately bigger.

I actually tried doing this yesterday; fortunately my bid was too low so my order was not executed. This gave me the means to buy at the bottom of this morning's trading, around 7% lower than yesterday's close.

Are you as excited as I am for what lies ahead?

After 70 Years, the US Loses AAA Credit Rating

IN THE NEWS from Reuters

Ratings agency Standard & Poors has just downgraded the credit rating of the United States from AAA to AA+ amid concerns about the country's debt problems and shaky economic outlook. The move comes a few days after US lawmakers reached an agreement to address the government's worsening budget troubles and a day after the worst US stock market decline since the 2008 financial crisis.

Implications for the US

The credit rating downgrade signifies an increase in the perceived riskiness of the financial securities issued by the US and reflects concerns that the recent debt deal might not be able to resolve the country's medium-term fiscal woes. There has been widespread clamor from various sectors to include provisions that will increase taxes for the wealthiest Americans, a detail that US lawmakers have agreed not to include in the deal. The downgrade effectively increases the cost of borrowing of the US (remember, higher risk, higher return), devaluing its outstanding bond issues and increasing the interest rate on all future debt issues.

Implications for everyone else

Apart from an initial negative reaction by international markets on Monday, the move is expected not to have much of a global impact. Then again, the way these things go, no one can ever really say for certain. We all just have to wait for how things will unfold in a couple of days and be ready to pounce on any opportunity that may arise.

Measuring Investment Performance with Arithmetic and Geometric Averages

PERSONAL FINANCE 101

Say you're choosing between two fund managers, Tyrion and Bronn, both of whom have only been in business for two years. In choosing between the two, you decide to use their actual performance in the past two years as an indicator of their "investment skill," thinking that how well they did in the past would be a good sign of how well they'll do in the future (some experts might disagree with this). The historical returns of the portfolios managed by Tyrion and Bronn are as follows:

	% Returns
	Year 1	Year 2
Tyrion	-50	100
Bronn	10	20

Given this information, who would you entrust your money with, Tyrion or Bronn?

Most of us would probably to it this way: get the average of the returns of the two managers, and choose the manager with the higher average return. For Tyrion, it would be (-50% + 100%)/2 = 25% per year; for Bronn, it's (20% + 20%)/2 = 15% per year. Since Tyrion has earned a higher average return than Bronn, then you should choose him to be your fund manager. Makes sense, right?

No, it actually doesn't! What's wrong with this picture? I'll give you a few moments to figure it out...

Bronn and Tyrion: Happier times

Here's what's wrong with the previous analysis: Tyrion hasn't actually performed better than Bronn in the past two years, regardless of what our computations tell us. In fact, if you invested your money with Tyrion two years ago, you would have ended up with the same amount today, compared to if you invested with Bronn where you would have earned 32% more than what you started with over two years.

The problem is that we used simple or arithmetic average to compute for the average annual return of the two fund managers; based on what we saw above, it's clear that this method is inadequate for such a purpose. What's more appropriate to use for this kind of analysis would be the geometric average; the geometric average of n returns is given by

geometric average return = [(1 + r1)(1 + r2)...(1 + rn)]^(1/n) - 1

Using the example above, we get the annual geometric return for Tyrion and Bronn:

Tyrion: [(1 - 0.5)(1 + 1)]^(1/2) - 1 = 0% per year
Bronn: [(1 + 0.1)(1 + 0.2)]^(1/2) -1 = 14.9% per year

Which is consistent with our earlier observation that Bronn actually outperformed Tyrion in the past two years, and specifically, that you would have ended back where you started (i.e., zero return) had you entrusted your money with Tyrion.

That's it. Just remember, in assessing past performance of managers, funds, or portfolios, always use  geometric average instead of arithmetic average.

Countdown to Extinction, Part 3: The End of the End... Or Is It?

IN THE NEWS from Post-Tribune

The impasse is finally over. After weeks of political posturing and endless debates, the US House of Representatives finally passes a bill that addresses the country's pressing debt concerns. The US Senate is expected to ratify the bill at noon on August 2, US time, and be signed into law by President Obama soon after.

Bad news for those who are wishing for another crisis, and good news for everyone else? Maybe.

Apart from increasing the US government's debt limit to avoid default, the deal also includes provisions to decrease government spending by US$$ 2.1 trillion spread over 10 years. However, some experts point out that while the bill may adequately address the US's immediate fiscal issues, it may not be enough to make any lasting difference since it does not involve any attempt to increase revenues (by repealing tax cuts implemented during the Bush administration, for example). The US government survives this one, yes, if only barely, but there's no reason to celebrate yet... not by a long shot.

Asian markets reacted favorably to early news of an agreement between Democrats and Republicans, with sharp price increases at yesterday's trading. More realistic expectations about the goings on in the US may have just sunk in today, however, as the Hang Seng Index in Hong Kong and the PSEi in the Philippines suffer losses as of this writing (noon of August 2), wiping out gains made the previous day.

UPDATE: 08/03/2011, 11:00 AM

President Barack Obama signs the debt ceiling bill into law

UPDATE: 08/03/2011, 12:30 PM

Fault Lines: The Top 1% - A very relevant documentary from Al Jazeera