Wednesday, February 11, 2009

Odds & Ends

On one of my previous post regarding Alex from Moneyvidya posed a question to me and I quote him

“Are margins of safety not based on intrinsic values which can only be estimated from the fundamentals. Do you know of a way to create or measure a margin of safety for an investment which protects you from the possibility that all your knowledge of the fundamental properties of the security are incorrect?”

I think one of the most important things in investing or in all aspects of our lives is to understand the concept of probability and the potential payoff arising out a probable event.
When we buy a lottery ticket lets assume the following structure
Scenario 1
Price of ticket – Rs 1
No of participant - 100
Potential payoff = Rs 100 – Rs 10 ( Lottery provider’s fees) – Rs 20 ( Government taxes)= Rs 70

So for a probability of 1 in a 100 we have a potential payoff of 70 times.

The net payoff of this transaction is 1*(70) + 99*(-1) = -29

Most lotteries/ casinos are structured in such a manner where the participants lose money.

Scenario 2
Now let us assume that the lottery provider waived of his fees and the government its taxes and some benevolent donor added a extra Rs 25 to the kitty. Lets examine the structure now

Price of ticket – Rs 1
No of participant - 100
Donor contribution Rs 25
Potential payoff = Rs 100 + Rs 25 = Rs 125

So for a probability of 1 in a 100 we have a potential payoff of 125 times.
The net payoff of this transaction is 1*(125) + 99*(-1) = +26 times

In scenario 2 the odds are structured in our favour and hence a margin of safety is built in the trade. This need not necessarily mean that you will win the lottery but the odds are stacked in your favour.

Lets take this forward to stocks. When I evaluate stocks my starting point is management. What is the margin of safety in terms of management?. When I see a promoters personal yacht being put on the companies books it doesn’t necessarily mean the promoter will take the company down like Satyam but for me the odds are against me on this variable. There is a higher probability that the promoter will siphon out a bigger chunk on a latter date or indulge in corporate actions that is detrimental to shareholders.

I remember in one of my chats discussing real estate with one of my fellow bloggers and he telling me how can u expect ethical promoters in a business which is intrinsically unethical in India. It was a wonderful insight. So whether there is a problem today or not the odds are extremely high of encountering a black swan event in a real estate stock because of promoter action.

Will it happen? Not necessarily but the odds are stacked against you. To compensate for this is the margin of safety high enough on the financials in terms of intrinsic value to price and on a net off basis factoring both this variables is the odds in your favour.

Let us say that one has a portfolio of 10 stocks with positive payoffs on each stock. Lets look at the following structure

Number of stocks - 10
Probability of + returns on each stock - 60%
Probability of – returns on each stock - 40%
Can I eliminate a potential black swan event in a individual stock? The answer is no. To answer Alex’s question, we might encounter a black swan event in a single stock which cannot be eliminated but by building a margin of safety in each stock position one will on a overall portfolio basis achieve positive returns.

Friday, February 6, 2009

Déjà vu

This story is about a organisation which was structured to look at potential mispricing in the bond markets in terms of spreads between 2 instruments and look at those spreads reaching the long term average. The organisation worked its models around bonds, mortgages, equities and derivatives across myraid asset classes. The organisation spearheaded extensive use of quant and modeling in bond trading.

The organisation worked on magnifying its return by taking enormous amount of leverage 30:1. In a 5 year tenure it delivered a return of over 40% per annum. However its enormous leverage in the derivatives market of over $1 trillion wend bad in a month when markets across the world collapsed with a correlation of 1 throwing all the models out of the window. So we reached the stage where the organisation was on the verge of bankruptcy and threatened to take the entire financial system down with them. The huge counterparty risk coupled with fear threatened to freeze markets across the globe.

The bankers of course rushed to the big daddy FED who promptly worked out a bailout package to save the organisation and the markets. And we all lived happily ever after or did we?

I m sure most of us will look at this and the names that will come to our mind are Lehman Bros, AIG, Citi etc

Well this was about a hedge fund called Long Terms Capital Management which went down under in 1998 before the bailout.

The fund was started by John Meriwether ex head of bond trading for Salomon Brothers where he was forced to resign after his top bond trader admitted to falsifying bids in the US treasury auction. J M managed to rope in Nobel price winners Robert Merton and Myron Scholes of the famous Black Scholes model as partners and the funds partners were positioned as a intellectual breed apart. I just finished the book When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein. Interesting read.

There is a strong sense of déjà vu that creeps in as you see the same cycle repeating itself bringing financial markets to a crisis and I can lay a bet that we will see it play out again. “We learn from history that we don’t learn from history” - I had earlier written a blog on this.

PS: Here’s the amazing follow up to the storyline - John Meriwether post the LTCM fiasco went on along with his colleagues to start JWM partners which floated a Relative Value Opportunity Fund where the fund document stated that it would keep its leverage down to 15:1.

The funds posted gains for several years, but in the first quarter of 2008 posted losses, of 31% in the flagship Relative Value Opportunity bond fund.

JM quotes “While we are clearly disappointed by our recent performance, we remain optimistic about the current opportunity set,".
"While we do not welcome the increased volatility in our returns, we believe that increased market volatility is one of the primary preconditions for creating interesting relative value situations," he added
And this was first quarter last year. Bond spreads kept widening significantly post that. History repeats.