Monday, March 7, 2011

Lessons from the Legends: Joel Greenblatt

Joel Greenblatt is an esteemed professor at Columbia University (the only place I would consider doing a masters in anything finance related). He also is a very successful portfolio manager (the very rare breed of professors -- those with practical experience who care more about the real world than the theoretical).

For a top professor, you might expect he uses very complicated models or high level mathematics... well he doesn't:

"I look for obvious things when looking for bargains, not something terribly obscure ... wouldn’t involve higher mathematics or special sleuthing talents."

"When doing in depth analysis of companies, I care very much about long term earnings power, not necessarily so much about the volatility of that earnings power but about my certainty of “normal” earnings power over time. My goal is to buy a company at a low multiple to normal earnings power several years out and that the company earns good returns on capital at that level of normal earnings ... I usually just look at a simple multiple to normalized earnings. If I can buy something at a very low multiple and I have confidence in the earnings stream, I don’t have to calculate a DCF to know whether I want to buy it."

As you may have noticed in the video I posted on him in an earlier post, he uses a simple approach that works.

Sunday, March 6, 2011

Proof that capital markets are NOT efficient

This is an exercise that I've stolen from Warren Buffett. It's entitled "The super investors of Graham-and-Doddsville."

Let's imagine we have 5,000,000 monkeys all taking part in a coin toss contest. The rules? Each monkey is paired with another and they flip a coin. The one to guess it correctly moves on to round 2 where it will face another monkey who also guessed correctly in round 1. This continues for 20 rounds where all the remaining monkeys are the final winners.

Since in each pairing, 1 monkey wins and 1 monkey loses (eliminated) we will end up with 1/2 the # of monkeys in each successive round. We also know that a coin toss gives you a 50% chance of guessing correctly.

Round 1: 5,000,000 monkeys remain
Round 2: 2,500,000 monkeys remain
Round 3: 1,250,000 monkeys remain
Round 14: 610 monkeys remain
Round 15: 305 monkeys remain
Final winners: 153 monkeys (do me a favour and forget that we can't have 1/2 monkeys .. just assume the numbers work out well)

So what are the odds of being one of the 153 final winners? Probability of 0.00305% (0.5^15). Basically extremely low odds. Think of this as a metaphor for investors now. Academics say that yes, there will be some major winners (such as Warren Buffett), but it's just a very low probability and entirely luck.

But what would you think if I told you that 100 of the 153 winning monkeys all came from the same zoo and had the same trainer? You would think that had something to do with them all winning! You would think they actually had better odds than the 0.00305% probability. Well this is what Warren Buffett argues is the case with value investors. Of the "unlikely" group of investors that consistently beat the market averages, a large majority of them are value investors following the principles of Benjamin Graham. Buffett goes on to show the records of several such investors/friends who all use value investing but have significantly different looking portfolios, but they all beat the market consistently.

How can the efficient market hypothesis hold water in light of this argument? "Buffett's argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice" - Seth Klarman

For more information, check out this WikiPedia page. I haven't checked the numbers given there to confirm they are correct but you get the point of the article.

Friday, March 4, 2011

Student Loans

I promised an informative post about student loans a while ago, but you're getting a bit of a rant about them for now.

I was on campus today and there was a big student initiated campaign against the cost of tuition/student loans. They claimed that student loans from the ~650 people who participated with them totaled a bit over $16.8 million. They claimed the average loan per student in our province is $26,680, up from $20,500 10 years ago.

They are complaining about this increase, which I look at and think it isn't very much given that its over 10 years. So I calculate it out, and it turns out to be an average increase of 2.67% per year. Seems about in line with inflation... what are they complaining about?

Moreover, no one is being forced to get student loans. If you don't want to be in debt, but you want a degree then you had better stretch it out over a couple more years so that you can work at the same time. I'm graduating this semester and guess how much student debt I have? ZERO. Now these people who got interest free (while in school) money from the government want their debt loads to be decreased? I'm starting to feel like the US home owner who was responsible with their mortgage/home only to see their irresponsible neighbour crying for help from the government because of their own stupidity/mistakes when the real estate market tanked in 2008.

Thursday, March 3, 2011

Bad Internet!

While I'm still super busy with school, it's not as bad as during exams over the past week. The reason I've been inactive over the past few days is because my internet has been terrible!! I'm not sure if it's something wrong with my computer or just a shitty wireless router (I can't access it because I'm leasing). Either way it's driving me nuts to the point that I've been avoiding going online as much as possible.

I pay too much money to have such a bad internet connection...

Wednesday, March 2, 2011

Expectation Gap

So I mentioned this thing called the expectation gap in auditing. As you may have guessed it is the gap between what the client and/or public in general expect from an audit and what the auditors are delivering.

Auditors must work hard to narrow the gap as much as possible, so I'll do what I can by explaining what it is that the auditors provide.

Auditors do NOT prepare the financial statements of their clients. The clients themselves do that. The auditors come in and examine the financial statements that have been prepared, checking to make sure the accounting standards (e.g. Generally accepted accounting principles -- GAAP) have been applied properly and that everything is fairly presented.

The second part of an auditors job is to provide an opinion (unqualified, qualified, adverse, and I can't even recall the 4th one because it is rarely even used -- you will generally see unqualified or qualified opinions) on the statements. If everything looks great and any potential issues were cleared up (adjusted) with management, then an unqualified opinion will be issued (as weird as it sounds, this is the best opinion a company can hope for).

Notice, though, that the auditor does NOT go through every single transaction and balance to ensure they are 100% correct and free of error. They use sampling methods to test them. This means that the auditors do NOT provide 100% assurance (i.e. they are not providing insurance on the financial health of the company). There will be some small percentage of misstatements that are not caught by the auditors.

So, does that mean if I'm an investor and I invest in the company based on the audited financial statements and lose money due to the misstatement then I can sue the auditor for negligence? Well, it depends. It depends if they followed GAAS (generally accepted auditing standards) or not. If the auditor followed GAAS, then they provide reasonable assurance that the statements are fairly presented and have sufficiently done their job. If the auditor failed to comply with GAAS, then an investor could sue them!

This is a good place to explain the difference between business failure and audit failure. Business failure is where a business fails to make it's debt payments and could result in bankruptcy. Audit failure, on the other hand, is the failure of the auditor to comply with GAAS. They are NOT the same. As was explained above, business failure could occur while there was no failure in audit.

So do we want 100% assurance from the auditors? It would sure be nice, but it just means that it will cost the company more money in audit fees. More assurance = more work for the auditor = higher fees. The level of assurance that is currently provided is sufficient enough that investors can have confidence in it and make informed decisions based on the audited financial statements. It's currently cost-effective.