If you’ve been reading The Investment Ecosystem for a while, you know that one of our specialties is due diligence. Here’s a one-pager that shows the consulting, training, and content resources that are available.
EPS maximization
“Modeling Managers As EPS Maximizers,” by Itzhak Ben-David and Alexander Chinco (via NBER), opens with this:
Textbook corporate-finance theory assumes that firm managers maximize the net present value of future cash flows. If a policy increases this net present value (NPV), they do it. If it does not, they do not.
There’s only one problem with the theory. That’s not the way of the world. If you ask corporate managers or observe their actions, you know that EPS (earnings per share) considerations predominate. So:
We take firm managers at their word and show that EPS maximization provides a single unified explanation for a wide range of corporate policies such as leverage, share repurchases, M&A payment method, cash accumulation, and capital budgeting.
That sets up a conundrum for investors, as to how to judge what companies do as opposed to what we think they should do. By and large, the industry has chosen EPS as the yardstick for analysis, although those with longer time horizons usually favor other measures. Clarity about what matters and why — and the implications of ignoring the opposite point of view — is essential.
Marks on SVB
The latest memo from Howard Marks starts with a good synopsis of the fall of Silicon Valley Bank, followed by elements it shared with other banks: asset/liability mismatches (despite liquidity being a “transient quality”), high leverage, and a reliance on trust. A combustible mixture, making banks “essentially, highly levered fixed income investors.”
He writes of the differences from the financial crisis, when everyone “ignored the possibility that excessive faith in mortgages — and the resultant lowering of lending standards — could precipitate massive numbers of mortgage defaults.” (See the flashback item below.)
Also, “financial regulation is highly cyclical,” reactive and focused on the latest problems. And diligence standards are too:
I once wrote of Bernie Madoff that you can say you did thorough due diligence or you can say he passed the test, but you can’t say you did thorough due diligence and he passed the test. Likewise, in the case of Credit Suisse’s AT1, you can say you read and understood the prospectus, or you can say you thought they were like ordinary debt securities, but you can’t say both.
As for ripple effects from the bank troubles, Marks expects a tightening of credit standards but not widespread contagion. Commercial real estate is his area of greatest concern.
Flashback
Speaking truth to power — and to the “collective wisdom” of the day when it needs to hear some corrective wisdom — is never easy and often career threatening. Such a moment came in 2005 when Raghuram Rajan warned the assembled experts at the Fed’s annual symposium in Jackson Hole about the house of mortgage and derivative cards that would collapse a few years later. They didn’t listen. Frank Martin put it all in proper perspective in an August 2022 piece. As a NYT article said, Rajan “nailed it.”
Other reads
“Stock-Based Compensation,” Michael Mauboussin and Dan Callahan, Morgan Stanley. This survey lives up to the billing of its subtitle, “Unpacking the issues.”
“Why Do Investors Fire Their Financial Advisor?” Danielle Labotka and Samantha Lamas, Morningstar. Three main reasons:
1) insufficient focus on the person side of personal finance; 2) advisors’ inability to communicate their value; and 3) a mismatch of expectations early in the relationship.
“Investment Beliefs,” Bob Seawright, The Better Letter. A mix of analytical and behavioral underpinnings for investment success.
“Battle Scars,” Ian Cassel, MicroCapClub. Speaking of analysis and behavior, Cassel provides some good have-you-ever situations to ponder.
“ChatGPT in Knowledge Management,” Wouter Klijn, Investment Innovation Institute.
“We should not trust it yet. It is a little bit dangerous because it is so elegant and confident. The lies it is telling you feel believable,” [Ashby Monk] says.
“Solicited Career Advice,” Phil Bak, BakStack. Seven rules for career success, beyond “do what I did.”
“Inside the 5-hour psychological interview that can make or break your career at Citadel, Blackstone, and other finance titans,” Emmalyse Brownstein and Alex Morrell, Insider.
The interviewer will ask these 5 questions about every job you’ve had:
What were you hired to do?
What did you accomplish?
What were your low points and/or mistakes?
Who did you work with? What would each say were your biggest strengths back then and your biggest areas for improvement?
Why did you leave?
“Picking a Stock for the Year 2048,” Jason Zweig, Wall Street Journal. “Meet the stock pickers who pick stocks once and then stop — for a quarter of a century.”
“Timing the Factor Zoo,” Andreas Neuhierl, et. al, SSRN.
In this paper we conduct a comprehensive analysis of factor timing, simultaneously considering a large set of risk factors and of prediction variables.
Our evidence reveals that factor timing is greatly beneficial to investors relative to passive “harvesting” of risk premia.
“Are Private Equity Valuations Too High?” StepStone. The private markets firm offers a dissenting view from current concerns: “We think valuations are probably about right.”
“Private Equity Secondary Funds,” Kunal Shah, iCapital. An overview of secondaries; where will the average pricing of them bottom out this cycle?
“When You Should Know Everything,” Tim Hanson, Permanent Equity.
See, when you’re in charge of upside, you need to focus on what matters. But if you’re accountable for the downside, you need to know everything.
“A beginner’s guide to accounting fraud (and how to get away with it),” Leo Perry, Financial Times. Some tales from Perry’s time as a hedge fund manager.
Always there
“Performance comes, performance goes. Fees never falter.” — Warren Buffett.
A triumvirate of challenges
In “A Painful Epiphany,” a report from AllianceBernstein, investors face “a new investment regime with a triumvirate of challenges: lower returns, higher inflation and less diversification.” At more than two hundred pages, the report is full of ideas and charts. A summary gives a shorter sense of each of the three parts — the environment, allocation issues, and the investment industry.
The graphic above is the the first of 188. That’s fitting given how it maps the changes in risk and return that the firm expects — and it also sets up the dissonant discussion of private equity that unfolds.
That PE appears as a low-volatility asset class in the anchor image is a disservice to asset owners, furthering a narrative that serves providers and enables poor decision making. Later the report puts forth “a broad case for increasing allocations to private assets” while noting “a growing tension” regarding liquidity needs — and also predicting returns that won’t live up to expectations. The mixture is confusing.
A “black book” of this heft includes a lot of ideas worth considering and debating. Among them: that the evolution of 60/40 from “an investment heuristic” to “a default allocation” is a result of “a fallacious view” dependent on an abnormal last two decades; that “the active investing industry will soon be synonymous with ESG investing” (on the basis of engagement and long-term thinking); and that there should be a rethinking of some key benchmarks. Namely, at the portfolio level, “more investors identifying inflation as the true benchmark, not a financial market index.” With regard to managers, selecting (and rewarding) only on the basis of “idiosyncratic alpha” (after beta and factor exposures) rather than excess return.
Postings
A new series of postings about investment culture will kick off this week.
If you missed it, “The Banality of Investment Process” uses the Beatles documentary Get Back to explore the “aimlessness and alchemy” that can be involved.
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: April 24, 2023
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