Friday, October 28, 2011

Diary: vix, nok, ko, value investing, kelly formula

I thought it would be interesting to look at the stats of the VIX (Volatility Index) dating back to 1990. Using Yahoo Finance, I downloaded monthly data, and crunched some numbers in Excel. Here are the deciles:

MIN    10.4
P10    12.1
P20    13.4
P30    15.3
P40    17.0
P50    19.5
P60    21.2
P70    23.5
P80    25.4
P90    30.0
MAX    59.9

The table does not take into account inter-month figures. What is fascinating is that the VIX reached an all-time low in Jan 2007, and then reached an all-time high of 59.9 in Oct 2008, a period of less than two years. The VIX has been over 30% for much of the last 3 months, which, as you can see, puts it in the top decile. It was a very good buying opportunity. As at the close yesterday the VIX stood at 25.5, putting it in the 8th decile. It is also interesting to observe that at the beginning of April, the VIX was at 14.8, which is quite a low number. It was also near the top - although to be fair, the market was mostly flat from January to July, barring the hiccup in March when Japan had a Tsunami. So, caveat emptor.

I found an interesting lecture by a "great investor" ("GI") linked by csinvesting. The lecture was given in March 2007 at Columbia Vusiness School. I will attempt a summary below.

GI says that  the book "Valuegrowth  Investing" by Glen Arnold is the best single book on the type of investing he is interested in. GI likes, and agrees with, the following quote from Fischer Black (of Black-Scholes fame):
"We might define an efficient market as one in which price is within a factor of 2 of value; i.e., the priceis more than half of value and less than twice value. By this definition, I think almost all markets are efficient almost all of the time. 'Almost all' means at least 90 percent." (Fischer Black, 1986, Journal of Finance 410).
 Buffett has echoed similar words:
He said the US govt. bond market is efficiently priced almost always. It isalmost never able to present an opportunity that he would consider worthwhile.
GI cautions:

The Fischer Black  idea that companies trade at ½ value and 2x value most of the time is something thatmeshes nicely with my experience. You may have had people come to this class and tell you that theycan find stocks trading at half of value. From my experience I have almost never found a companytrading at ½ of value. Usually when my analysis leads me to believe that the company is trading at 50%discount to value or less and I go back and do my analysis again to see where I made my mistake.Except in times of extreme pessimism or extreme gloom and doom like year-end 1974, I can‟t think of a time when there were a large number of stocks trading at ½ of value.
GI says that there are large insitutional investors holding Berkshire who claim it is undervalued. However, this is at odds with Buffetts's claim that it is one of his missions in life to try to keep Berkshire at a fair value. So GI concludes that people who argue for its cheapness are arguing against the man himself.

All businesses are cyclical to some extent. Companies that report very smooth earnings are probably smudging them. GI used to invest in severly depressed cyclical companies. It was a successful style. But he wasn't getting high enough returns for the volatility. You could make 20 times your money, but it would take 25 years - which is only 9.6% CAGR.[Footnote by me: subscriber F985B on the Motley Fool says largely the same thing - it's not shooting for the stars that makes the money, but the slow safe companies that outperform. Also, I can't give you a reference, but there's academic studies which show that CAPM isn't quite right, whereby it's the low-risk stocks that seem to have the best returns].

What worked for Buffett in the 50's and 60's no longer worked in the late 70's. So he shifted strategies. Buffett: Turnarounds seldom turn.

GI's current method of investing: deal with seasoned companies, which are big and have a long track record through a variety of economic conditions. The insight that I bring to these companies is that their stock prices - this is historically demonstrable - are much more volatile than their underlying values. Look for companies with superior financial characteristics. Forget about companies with stories or narratives. Look for a consistent long-term record instead.

If you wait for really great companies to trade at two-thirs of value then you will never buy anything. Really superior companies, when they are really cheap, may trade at a 10% discount to intrinsic value and most of the time they sell above. At the horse track and stock market, investors underestimate the probability that good horses will win and overestimate that long shots will win.

He then foes on to devising a matrix as to whether something is a buy based on price and value movements:

  • price up and value down - no
  • price flat and value down - no
  • price rising and value rising - possible - this is the hardest opportunity for a value investor to identify, as it means there is an under-reaction to the good news. It will need to be in your circle of competence to know if it is good to invest
  • price flat and value flat - possible - but an unlikely scenario
  • price flat and value rising - possible. One reason for this is that there is some external distraction: war, etc. An opportunity exists, but people are slow to deal with it
  • price is falling and value is falling - possible. This equates, of course, to a genuine overreaction to bad news
  • price is falling and value is flat - usually occurs when there is a misinterpretation to the news
  • price is falling and value is falling - possible, but an unlikely scenario. usually there is a big external distraction, or it could be that they make changes for improvement (e.g. more marketing or R&D) which will negatively near-term impact earnings
Note one of the implication of the above: five out of six of these scenarios involve a share price that is going nowhere or is falling. So basically, you should be concentrating on share prices that are either flat or falling

GI gives an example of Nokia and Coca-Cola. Just by looking at the numger, he says that there is evidence that there is something special going on. Here's the stats that he produces:
                                    Nokia             Coke
P/E                                   16x              20x
Return on Total Capital               36%             28.%
Return on Equity                      36%            30.5%
Debt as % of Capital                  0.5%            6.0%
Growth 10-yr/5-yr in Book Value    21% / 19%     12.5% / 12.5%
Sales                            18.5% / 14%      4.0% / 3.0%
Cash Flow                        18.5% / 11%      7.5% / 7.5%
Dividends                        33.5% / 22.5%   10.0% / 9.5%
Buy backs                             >5%             < 5%

It's interesting to see how he looks at things. An investment in Nokia turned out to be very successful for him. [Footnote: the price of NOK rose from 20 at the beginning of 2007 to a peak of about 40 in late 2007. However, over the last 5-years, NOK is down 63%. Their revenues have declined in 2009 compared with 2008, with further falls in 2010. People are now asking if it's a value trap. This does raise the question: was GI right all along, or did he just get lucky with his timing? Over a 5-year period, KO is actually up 46%, compared with the S&P500 of down 7%. I think one could easily argue that the problem with NOK is that it is in a rapidly-moving market place with keen competition. KO, although at a higher valuation, has soldiered on relentlessly, despite being at a higher valuation. So, it's difficult to form an opinion as to whether he's right or wrong, at least in my eyes. If he had "followed the story", maybe his thinking would be different.]

GI doesn't use the Kelly Formula.

Hedge funds are leveeraged mutual funds. There is not a lot of hedging.

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