Lately I have been working on an intriguing project. A colleague, who is also our in-house biotech analyst, asked me if I could take a look at his sector in order to try and find some "leading indicators". Many investors, and indeed normal people, would probably find this sort of work rather dull - you can easily end up getting lost in a sea of numbers as your spreadsheets become larger and larger (indeed, in this particular project, I actually ran out of columns on Excel!). In my experience, people usually prefer to stock pick, rather than grind out the numbers for an entire industry or sector. Fortunately, being somewhat skeptical of the value-added potential of bottom-up stock-picking (and being a bit of geek), I actually quite enjoy these sorts of investigations. While the methodology can be long and laborious, it can be somewhat rewarding when you finally reach a conclusion.
So I set out by extracting all the necessary fundamental data from Bloomberg as far back as 2001. I had initially intended to go back further, but a brief experiment along these lines quickly showed that a)there was not enough data for each stock in the Bloomberg database, b)most of it would be distorted by the 1999 bubble anyway and c)any index returns would be distorted by a severe survivorship bias (still a problem going back to 2001, but less so).
I must admit that I did not really expect to find any "leading indicators". As someone who believes that markets are pretty efficient most of the time (although not perfectly efficient) I am generally skeptical of any variable that claims to have predictive power, especially if that claim is over short term returns (as I wrote in a previous post there are variables that appear to have long-term predictive power). Nevertheless, after some very extensive investigations over the past two weeks, it appears that I may have actually found such a variable: the EV/cash ratio.
The EV/cash ratio is the Enterprise Value of a firm divided by the cash and equivalents that the firm has on its balance sheet. Why should this variable be important? For most businesses it is not important at all. A supermarket, for example, does not typically hold a lot of cash on its balance sheet. Assuming it is well run, it will have a healthy positive cash-flow, so the amount of cash on the balance sheet should not have much relevance as far as valuation is concerned. However, for a biotechnology firm, especially one that is small, cash-flow is negative and the firm is not profitable. The business model is one of research and development, financed via the equity and debt markets, with the eventual aim of developing a blockbuster drug. This means that the cash on the balance sheet is actually very important as it gives some indication of how much resources the company has for research and development before it must go back to the market to raise more cash.
The interesting conclusion from the investigation is that if you had used the EV/cash ratio as a systematic trading strategy for the Biotech sector since 2001, you could have made substantial profits. On an aggregate level, there is a strong correlation between the EV/cash ratio and the price performance for the large, mid and small-cap US Biotech sectors. This is important because it suggests that the fluctuation, or mean-reversion, of the EV/cash ratio occurs more often than not through the price adjusting rather than the cash adjusting - a necessary condition for any ratio to be a useful indicator of future returns. Following on from this, comparing the aggregate EV/cash ratio with the subsequent 1-year return shows that buying when the EV/cash ratio is low and selling when it is high would have been a strongly positive return strategy since 2001. Finally, even within the mid and small-cap sectors, the trading strategy seems to work. For example, the one year rolling return of the small cap stocks trading on less than 2 times cash has outperformed, in almost every period, the return for those on greater than 8 or 10 times cash.
What I find most surprising about the results is that they work over a 1-year time period. Indeed, if I had accurate and reliable data going back to the beginning of the biotech industry, I would not be overly surprised if the correlations held over a 3, 5 or 10 year view. But 1 year is very intriguing, not to mention highly useful, at least from a fund management perspective.
But of course the results do not "prove" anything because the sample period is not long enough. So we shall have to wait to see if the relationship continues to hold. As we all know, history does not repeat itself - although it does tend to rhyme.
Wednesday, August 22, 2007
Thursday, August 16, 2007
Is the market overvalued?
In times of wild markets, market commentary and investor behaviour tends to become more short term. As volatility rises, we hear of the "flight to safety" as investors sell stocks and buy government bonds. In times like these I definitely find that it steadies the nerves to take a look at the bigger, longer term picture.
Is the stock market fundamentally overvalued? The answer to this question is probably yes, but not to such an extent that one should not be in the stock market at all. The most common measure of "value", at least that which is used by brokers and financial journalists, is the infamous p/e ratio. The idea behind the p/e ratio is that it gives you some idea of how much you are being asked to pay for the earnings that the companies in the stock market are generating. Earnings reflect value because they (in theory) belong to the stock holders who should see the benefits either in the form of dividends or from growth (if the earnings are reinvested). Currently the p/e ratio of the S&P500 is roughly in line with its long term average, a point which is often cited by stock market bulls.
Unfortunately, statistical analysis shows quite clearly that the p/e ratio in this form does not tell you anything about value. My approach to assessing value metrics is to ask two questions: 1) Is there evidence that the metric is "mean reverting" over time? 2) Does the metric provide a useful indicator of future returns? In the case of the static p/e ratio, analysis shows quite clearly that the answer to question 1) is yes, but for question 2) it is a no.
Taking question 1) first, the point here is that in order for the ratio to have any use, you need to be sure that there is some force within the economy that brings it back to its average. Testing the data statistically yields a highly significant result for mean reversion - i.e. when the ratio is high, there is a high probability that it will come down in the future. Intuitively, this result can be explained in a number of ways. The most simple is to flip the p/e ratio upside down and think of it in terms of the e/p ratio instead, also known as the earnings yield, which is like the dividend yield except it includes all the earnings not paid out to stock holders. Now if the e/p ratio were, say, 2%, which would equate to a p/e ratio of 50, then you would have to be pretty (over)confident about the future earnings growth prospects of the stock market to buy it. Otherwise you would not be getting very much "e" for your "p", while at the same time also taking a substantial risk of capital loss. Usually, wild misvaluations such as these tend to correct themselves sooner or later, restoring some semblance of a risk premium for the ownership of equities.
The main problem with the p/e ratio is that has two parts to it - the "p" and the "e" - and the adjustment, the reversion to the mean, can happen by either of these values adjusting. For the ratio to be a good indicator of value, and hence future long-term returns, the adjustment needs to occur via the price. Unfortunately, history has frequently produced situations where the p/e ratio has been high because the "e" has been low, not because the "p" has been high. The two classic examples are 1933 and 2002-3, both of which saw high p/e ratios, but were nevertheless two very good years to invest in stocks (the former the best year of the whole 20th century in fact). The reason is that they were both followed by a cyclical rise in earnings, pushing down the ratio even while the "p" rose. It is this fact - the cyclicality of earnings - that renders the static p/e ratio useless as an indicator of value.
Thankfully, it is possible to get around the problem by taking a "cyclically-adjusted p/e ratio". In this calculation, the price is divided by an average of the past 10 years of earnings. The point is to eliminate the cyclical problem cited above, the assumption being that 10 years is enough to represent an economic cycle in corporate earnings. Unfortunately, the cyclically-adjusted p/e ratio currently tells a very different story about stock market valuation to the static version favoured by stock market brokers. Because corporate profit margins have been expanding since 2003 and are currently at multi-decade highs, the cyclically-adjusted p/e ratio is much higher than the static p/e ratio. Indeed, the ratio has been around 27 for the past couple of years, which is considerably above its long term average of 17, and clearly implies that the market is overvalued.
There is no question that, for all the reasons cited above, the cyclically-adjusted p/e ratio is statistically and intuitively a far superior measure of value than the static p/e ratio. However the fact that it is higher than its long-term average does not mean that owning stocks is a bad idea. Rather, it simply means that the probability of realising the long-term real return of 6.75% on equities is quite low, because at some point in the next 20-30 years the ratio is likely to mean revert. But even if the actual real return is less than 6.75%, it is more than likely to be higher than the alternatives of cash or bonds.
Interestingly, the key objection to this argument, and the one that I consider most valid, concerns the validity of using the past as a guide for the future. While the past has shown a cyclicality in earnings, as profit margins expand in booms, and contract in recessions, it could be argued that the current high profit margins are a result of structural rather than cyclical factors. For example globalisation and the emergence of a huge low cost labour force have unquestionably shifted the distributional balance in favour of capital, at the expense of labour, a development which could lead to permanently higher profit margins. Whether this is truly a case of "it is different this time" remains to be seen...
Is the stock market fundamentally overvalued? The answer to this question is probably yes, but not to such an extent that one should not be in the stock market at all. The most common measure of "value", at least that which is used by brokers and financial journalists, is the infamous p/e ratio. The idea behind the p/e ratio is that it gives you some idea of how much you are being asked to pay for the earnings that the companies in the stock market are generating. Earnings reflect value because they (in theory) belong to the stock holders who should see the benefits either in the form of dividends or from growth (if the earnings are reinvested). Currently the p/e ratio of the S&P500 is roughly in line with its long term average, a point which is often cited by stock market bulls.
Unfortunately, statistical analysis shows quite clearly that the p/e ratio in this form does not tell you anything about value. My approach to assessing value metrics is to ask two questions: 1) Is there evidence that the metric is "mean reverting" over time? 2) Does the metric provide a useful indicator of future returns? In the case of the static p/e ratio, analysis shows quite clearly that the answer to question 1) is yes, but for question 2) it is a no.
Taking question 1) first, the point here is that in order for the ratio to have any use, you need to be sure that there is some force within the economy that brings it back to its average. Testing the data statistically yields a highly significant result for mean reversion - i.e. when the ratio is high, there is a high probability that it will come down in the future. Intuitively, this result can be explained in a number of ways. The most simple is to flip the p/e ratio upside down and think of it in terms of the e/p ratio instead, also known as the earnings yield, which is like the dividend yield except it includes all the earnings not paid out to stock holders. Now if the e/p ratio were, say, 2%, which would equate to a p/e ratio of 50, then you would have to be pretty (over)confident about the future earnings growth prospects of the stock market to buy it. Otherwise you would not be getting very much "e" for your "p", while at the same time also taking a substantial risk of capital loss. Usually, wild misvaluations such as these tend to correct themselves sooner or later, restoring some semblance of a risk premium for the ownership of equities.
The main problem with the p/e ratio is that has two parts to it - the "p" and the "e" - and the adjustment, the reversion to the mean, can happen by either of these values adjusting. For the ratio to be a good indicator of value, and hence future long-term returns, the adjustment needs to occur via the price. Unfortunately, history has frequently produced situations where the p/e ratio has been high because the "e" has been low, not because the "p" has been high. The two classic examples are 1933 and 2002-3, both of which saw high p/e ratios, but were nevertheless two very good years to invest in stocks (the former the best year of the whole 20th century in fact). The reason is that they were both followed by a cyclical rise in earnings, pushing down the ratio even while the "p" rose. It is this fact - the cyclicality of earnings - that renders the static p/e ratio useless as an indicator of value.
Thankfully, it is possible to get around the problem by taking a "cyclically-adjusted p/e ratio". In this calculation, the price is divided by an average of the past 10 years of earnings. The point is to eliminate the cyclical problem cited above, the assumption being that 10 years is enough to represent an economic cycle in corporate earnings. Unfortunately, the cyclically-adjusted p/e ratio currently tells a very different story about stock market valuation to the static version favoured by stock market brokers. Because corporate profit margins have been expanding since 2003 and are currently at multi-decade highs, the cyclically-adjusted p/e ratio is much higher than the static p/e ratio. Indeed, the ratio has been around 27 for the past couple of years, which is considerably above its long term average of 17, and clearly implies that the market is overvalued.
There is no question that, for all the reasons cited above, the cyclically-adjusted p/e ratio is statistically and intuitively a far superior measure of value than the static p/e ratio. However the fact that it is higher than its long-term average does not mean that owning stocks is a bad idea. Rather, it simply means that the probability of realising the long-term real return of 6.75% on equities is quite low, because at some point in the next 20-30 years the ratio is likely to mean revert. But even if the actual real return is less than 6.75%, it is more than likely to be higher than the alternatives of cash or bonds.
Interestingly, the key objection to this argument, and the one that I consider most valid, concerns the validity of using the past as a guide for the future. While the past has shown a cyclicality in earnings, as profit margins expand in booms, and contract in recessions, it could be argued that the current high profit margins are a result of structural rather than cyclical factors. For example globalisation and the emergence of a huge low cost labour force have unquestionably shifted the distributional balance in favour of capital, at the expense of labour, a development which could lead to permanently higher profit margins. Whether this is truly a case of "it is different this time" remains to be seen...
Friday, August 10, 2007
Liquidity or Insolvency?
The current mayhem in the credit markets raises an interesting issue about the nature of the problem underlying the liquidity crisis. Throughout Thursday and Friday last week the ECB and the FED began pumping the financial system with liquidity in order to try and stem the credit seizure within the banking system. The banks are currently reluctant to lend to each other because they are fearful of taking on hidden subprime exposure, something which has been cropping up in all sorts of surprising places. Consequently, the overnight lending rate has been opening much higher, thereby obliging the central banks to engage in repo activities to push the rate back down towards the target rate.
The issue is whether this policy will actually work. From a fundamental perspective it is difficult to see how it will because the underlying problem is not one of liquidity but one of insolvency. If the only problem were liquidity then this policy would probably work because the provision of liquidity would allow market participants to roll over their obligations. Unfortunately, many of the mortgages in issue in America were predicated on 10-15% house price appreciation, something which is obviously behind us now. So now we have large numbers of actual insolvencies emerging.
I therefore believe that the FED and the ECB have a very difficult task at hand. Providing liquidity to the system is not going to solve the underlying problem. The seizure of credit is not simply a result of risk aversion, it reflects an underlying real debt and insolvency problem. My guess is that they have calculated (hoped) that the true scale of the problem is less than the bears are fearing. They will provide liquidity for just long enough so that all the exposure and the mess is out in the open. The provision of liquidity should stop the crisis spilling over into other financial asset classes such as equities, thereby limiting the scale of real economy effects. We can only hope that the true scale of the exposure is less that is widely feared...
The issue is whether this policy will actually work. From a fundamental perspective it is difficult to see how it will because the underlying problem is not one of liquidity but one of insolvency. If the only problem were liquidity then this policy would probably work because the provision of liquidity would allow market participants to roll over their obligations. Unfortunately, many of the mortgages in issue in America were predicated on 10-15% house price appreciation, something which is obviously behind us now. So now we have large numbers of actual insolvencies emerging.
I therefore believe that the FED and the ECB have a very difficult task at hand. Providing liquidity to the system is not going to solve the underlying problem. The seizure of credit is not simply a result of risk aversion, it reflects an underlying real debt and insolvency problem. My guess is that they have calculated (hoped) that the true scale of the problem is less than the bears are fearing. They will provide liquidity for just long enough so that all the exposure and the mess is out in the open. The provision of liquidity should stop the crisis spilling over into other financial asset classes such as equities, thereby limiting the scale of real economy effects. We can only hope that the true scale of the exposure is less that is widely feared...
Sunday, August 5, 2007
Google-Plex
A couple of days ago I visited the Google-plex, aka Google's head office. It is based in a place called Mountain View, a quiet little town about an hour south of San Francisco. The impression I got was that there wasn't really much to draw you to the place apart from Google.
It wasn't a business trip. A good friend of mine works for Google-India and she happened to be over visiting colleagues for a few days. It was her first time at the Google-plex too - although she was officially my guide, she seemed to be equally as astounded by much of what we saw as I was.
Upon entering the "campus", as it is affectionately referred to by the "Googlers", the first thing I saw was a 6-a-side game of beach volleyball taking place in the sand pit within the main courtyard. As we walked past and entered one of the main buildings, my guide asked me if I was hungry. Observing the gourmet food on offer, I rapidly began to regret the large fish and chips I had eaten before getting on the train. Never mind, I went for some non-alcoholic wine and a tub of B&J ice cream instead.
As we left the restaurant and began strolling around the buildings, I couldn't help but be struck by how little work was being done. Admittedly it was after six, but it definitely seemed like there were at least 10 people involved in recreational activities - eating, playing volleyball, chess, Go, pool, designing train sets etc. - for every person sitting in front of a terminal.
After having a go on one the Google-peds (blue push bikes with orange flags that Googlers use to get around campus), I decided that I was very impressed by it all, but it was time to try and understand what the actual point of it all is. I asked my guide whether she thought that the success of Google had anything to do with the fantastically generous manner in which the company appears to treat its employees. The purpose of my question was to explore what I saw as the intriguing cause-effect dynamic that was playing itself out in front of my eyes.
Google operates in a "winner-takes-all" industry. In these industries, there are what economists call "increasing returns" and "network effects". The more people who use Google, the more valuable it becomes to advertisers - and they will pay more for the targeted advertising the Google can offer. Meanwhile, as Google's network of advertisers expands, the product potentially becomes more valuable for the users as they will get a more extensive and relevant set of paid advertising links. Therefore, it is only natural that this be a winner-takes-all industry, and one has to ask the question of how much was this down to pure chance, rather than some brilliantly predefined business model. Indeed numerous commentators have pointed out that Google's "pure search" model was very much a case of "right place, right time", with predecessors, such as Alta Vista, failing due to unfortunate events (in the case of Alta Vista it was a parent company that did not see the benefit of pure search - back then everyone was only interested in "portals")
My guide did not take too kindly to my probing and she lodged three objections to my position. The first point was that the founders had not changed philosophy from the day they founded the company - i.e. they had always spent a lot on their employees. Unfortunately this does not really prove anything because it could still just be a coincidence. The second perfectly reasonable point was that the founders do not give a toss anyway about the shareholders. They would rather spend the profits on the employees than on the owners. While there may well be a sizable element of truth to this, it merely confirms the fact that Google is a monopolist because in any other competitive industry such a business model would not survive. A competitor would simply enter the industry and generate superior returns on capital by cutting down cost. The third and final objection was the only one that stands up: according to my guide, Google pays its staff less than major competitors do. The perks are simply a way of making up for this, while at the same time encouraging employees to be happy staying at the office because they have everything they need there. It would be interesting to see if this is actually true, but I am not familiar enough with the relative cost structures for the major players in the US internet-tech industry to know for sure.
Having said all that, criticisms aside, I use Google multiple times a day and I even used Google-map to find directions to the Google-plex. So they must be doing something right...
It wasn't a business trip. A good friend of mine works for Google-India and she happened to be over visiting colleagues for a few days. It was her first time at the Google-plex too - although she was officially my guide, she seemed to be equally as astounded by much of what we saw as I was.
Upon entering the "campus", as it is affectionately referred to by the "Googlers", the first thing I saw was a 6-a-side game of beach volleyball taking place in the sand pit within the main courtyard. As we walked past and entered one of the main buildings, my guide asked me if I was hungry. Observing the gourmet food on offer, I rapidly began to regret the large fish and chips I had eaten before getting on the train. Never mind, I went for some non-alcoholic wine and a tub of B&J ice cream instead.
As we left the restaurant and began strolling around the buildings, I couldn't help but be struck by how little work was being done. Admittedly it was after six, but it definitely seemed like there were at least 10 people involved in recreational activities - eating, playing volleyball, chess, Go, pool, designing train sets etc. - for every person sitting in front of a terminal.
After having a go on one the Google-peds (blue push bikes with orange flags that Googlers use to get around campus), I decided that I was very impressed by it all, but it was time to try and understand what the actual point of it all is. I asked my guide whether she thought that the success of Google had anything to do with the fantastically generous manner in which the company appears to treat its employees. The purpose of my question was to explore what I saw as the intriguing cause-effect dynamic that was playing itself out in front of my eyes.
Google operates in a "winner-takes-all" industry. In these industries, there are what economists call "increasing returns" and "network effects". The more people who use Google, the more valuable it becomes to advertisers - and they will pay more for the targeted advertising the Google can offer. Meanwhile, as Google's network of advertisers expands, the product potentially becomes more valuable for the users as they will get a more extensive and relevant set of paid advertising links. Therefore, it is only natural that this be a winner-takes-all industry, and one has to ask the question of how much was this down to pure chance, rather than some brilliantly predefined business model. Indeed numerous commentators have pointed out that Google's "pure search" model was very much a case of "right place, right time", with predecessors, such as Alta Vista, failing due to unfortunate events (in the case of Alta Vista it was a parent company that did not see the benefit of pure search - back then everyone was only interested in "portals")
My guide did not take too kindly to my probing and she lodged three objections to my position. The first point was that the founders had not changed philosophy from the day they founded the company - i.e. they had always spent a lot on their employees. Unfortunately this does not really prove anything because it could still just be a coincidence. The second perfectly reasonable point was that the founders do not give a toss anyway about the shareholders. They would rather spend the profits on the employees than on the owners. While there may well be a sizable element of truth to this, it merely confirms the fact that Google is a monopolist because in any other competitive industry such a business model would not survive. A competitor would simply enter the industry and generate superior returns on capital by cutting down cost. The third and final objection was the only one that stands up: according to my guide, Google pays its staff less than major competitors do. The perks are simply a way of making up for this, while at the same time encouraging employees to be happy staying at the office because they have everything they need there. It would be interesting to see if this is actually true, but I am not familiar enough with the relative cost structures for the major players in the US internet-tech industry to know for sure.
Having said all that, criticisms aside, I use Google multiple times a day and I even used Google-map to find directions to the Google-plex. So they must be doing something right...
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