Momentum is still significant

Campbell R. Harvey, Liu and Zhu present an analysis where they find that academic papers on cross sectional stock market factors are apparently about as untrustworthy as a large portion of medical literature. (HT: MR) Published papers in medical literature and on stock market factors suffer from data mining and publication bias issues where only positive results are analyzed and published. Not finding something is rarely seen as an accomplishment in the academic world. So after thousands of analysis are run, the paper that finds something that is only 1% likely to be a misinterpretation of random noise if you only did the study once - is likely to be exactly that - random noise. 

However, it's interesting that even with this bias there are still some very significant results to be found in cross sectional analysis of stocks. The stand out stock market cross sectional factors are value and momentum, which work well enough that even if they have been found by an explicit data mining processes the returns are good enough to suggest that they aren't just random noise.

The explanation behind value working is simple. Stocks trading at the largest premium to their book values are overvalued by overconfident market participants on average while stocks trading at lower book values are a bargain more often than not. The value approach is well known, with Warren Buffett being the prime example of a successful investor who utlizes the value approach.

Momentum is more interesting because it is less popular among the public. Adherents to momentum have often been denigrated as rash speculators, in contrast to the more stable and patient value investors. Momentum is the idea that prior price movements are preditive of relative future returns. This seems to be a violation of the weakest form of the efficient market hypothesis. Adherants to the EMH call momentum (and value for that matter) a "risk factor" - implying that stocks with higher momentum have a higher risk than low momentum stocks which keeps their theories from completely falling apart. 

But the actual mechanism behind momentum is more subtle- a fast growing company doesn't become a sensation overnight. It takes time for a company to overtake and replace its rivals even if the new company is better in almost every way. Along the way, small pieces of information will come out regarding the increasing success of the company and the well performing stock will be bought by more managers. The extra risk is that a market shock could induce aggressive managers to all sell their holdings at once or worse, change the environment that was making the company so succesful in the first place.

Momentum, value and small stocks are three of the classic cross sectional explanatory factors, with data on their performance available for download at Ken French's database - so the lack of significance of the small stock outperformance as determined by Harvey et al is notable. I've touched before on how public stock market size premium is likely to be lower than it has been in the past due to high valuations in the pre-IPO environment, but this suggests that looking to small stocks as a significant explanatory factor of performance might have always been a mistake. 

Size shouldn't be ignored - many people have found that value works much better among smaller stocks. 

The table above from Cliff Asness's white paper shows that momentum works slightly better among small cap stocks, though this result may occur more because small cap stocks are more volatile in general and not because momentum works any worse in the large cap world after adjusting for volatility.

Momentum works in multiple asset classes, and should be of interest to those who are pre-IPO investors. Everyone knows to invest in fast growing companies and to avoid companies who have had to take down rounds. An explicitly systematic momentum approach in pre-IPO companies is likely to generate significant alpha - particuarly in our current investment environment.

So when the value perspective of the 17 billion dollar pre-money Uber valuation can make the deal look ridiculous*, the investor who respects the momentum factor should be paying closer attention. After all, it seems far more likely that the dynamics of investors demand will have the company trading at a 30 billion dollar valuation before it trades at an 11 billion dollar valuation.


*The analysis underweights the increasing utilization of taxi-cab like services that the presence of Uber encourages, but apart from that it appears to be about as close to accurate as a valuation expert can be with the available information.

Addendums

In which I cover many prior topics in one post instead of making many follow up posts.

1. When will prosecutors go after Silicon Valley?  Looking at Gallup's 2013 industry poll we can see that tech is still more popular than the oil and gas industry ever was, and is currently viewed far more favorably than banking.
So despite the emergence of the trend of demonizing some people in Silicon Valley (See the TV show of the same name) - and recent lawsuits preventing wage fixing - Silicon Valley big shots still makes a less tempting target than industries like banking for a prosecutor that wants to attention and approval of the public. (The comparison to lawyers and the federal government approval rates are there purely for contrast - they aren't potential targets)

2. Following up on 10,000 hours of non-deliberate practice. The Economist looked at how much time is wasted passively watching a video. Gaming seems to be a closer substitute to work, given how both require problem solving. And the amount of time spent on gaming is growing - with 43 million people playing games for 22 hours a week in the US alone, gaming is one of the largest time sinks of intellectual power in human history.

3. High Frequency Trading - One additional worry is that trading firms pay for customer flow because they profit, but this seems much more about locking in their ability to arbitrage this flow without competing with other HFT firms rather than taking extra advantage of the retail investor.

4. Another example of 60's Conglomerate math. When Facebook bought Whatsapp, some analysts justified it on the basis of how the purchase was cheap for Facebook on a per user basis. Just like analysts in the 60's thought that when a growing company bought a stagnant company the stagnant company's earnings should be valued like a growth company, analysts are assuming that each user acquired brings a similar value to the Facebook shareholder as a current Facebook user.

Facebook's purchase might make sense strategically and might make even more sense if they violate their pledge to not serve ads to Whatsapp customers a few years down the line. But investors should constantly remind themselves that the earnings/revenue/users of one company is likely to be significantly different from that of another company. Any company using its high valuation to make significant acquisitions should be analyzed carefully so the effects of the acquisition aren't mistaken for intrinsic growth. 


Unassorted Links

1. A lot of private equity shops can get away with charging more fees than they agreed to because their limited partners (more specifically, those who invest on behalf of the limited partners) seem to have an attitude of "Don't blame me, I invested in a famous name!" On top of this, the people making capital allocation decisions for pension funds are often onto their next job before the results of their fund investments are known. Maybe the next CIO of Calpers can do something smart in this area.

2. Conferences like Bilderberg are unlikely to involve any real conspiracy, but like any off the record meeting between government officials and business leaders there is "access." The meetings give those on the business side a chance to try and figure out and potentially influence future policy moves. Unfortunately, it is hard to tell which politicians will play along in return for favors and which politicians merely want opportunity to hear the perspectives of those present on an ex-ante basis. 

3. The number of freshman deciding that they want to be computer science majors is way up. The students who stick out their major for four years will probably be mildly disappointed by what the startup landscape looks like four years from now.  Some combination of a higher supply of programmers, more institutionalized processes and less extreme early stage valuations is likely to make their careers less exciting than their peers graduating today. But overall it's still a smart choice. Even if their jobs aren't directly related to coding, the general ability to be comfortable thinking algorithmically will be as important as thinking quantitatively.

4. One of the more sane perspectives on school shootings in general. More generally, it's sad how many different interest groups try to get media exposure for their favorite pet issue in the wake of high profile tragedies. 

5. Occupational licensing - keeping both prices and unemployment high!

6. Looking at this extreme inequality, we are reminded that politics isn't about policy. It is about who deserves high status.

The 60's Conglomerate Boom and Today's Growth Companies

The Conglomerate Boom of the 60's, like all bubbles, sounds ridiculous in hindsight. From 1965 through 1969, the market was obsessed with rising earnings and investors didn't seem to care if the earnings came from new business or from buying other business. As long as earnings growth was up the company would keep its high valuation multiple.

The basic formula was that a fast growing company valued favorably by the market would use their stock to purchase low growth companies - and the earnings of the combined company would have the same multiple as the fast growing company. 

Investors didn't seem to realize that the low growth company's earnings wouldn't magically start growing just because it was bought by a company with a high multiple. The total valuation of the combined company would be higher than the prior valuation of the separate companies. The market's irrational behavior created incentives for unnecessary mergers. This lasted as long as the credit financing mergers was cheap (Conglomerates didn't have to properly account for convertible debt until 1969) and the market was willing to give high valuations to companies that produced earnings growth through the acquisition of other companies.

We might be seeing the start of similar incentives in today's private early growth stage companies. Most of the new start up companies are seen as competitors with the potential to disrupt whole industries. They are judged more on revenue than on earnings since the logic is that revenue will be more easily turned into earnings after the competition is decimated. Winning is what matters.

Whenever there are successful companies attracting capital and getting high valuations, there are less successful companies who will only succeed in mimicking the visible traits of successful companies. This creates some perverse incentives. The valuation given to successful growth companies is anywhere from five to ten times revenue - or higher. Meanwhile, the average company in the S&P 500 is trading at 1.7 times sales and the smaller companies in the Russell 2000 are trading around 1.2 times sales. Right now, it should be very tempting for a variety of early growth companies with high valuation multiples to go out and use their stock to buy companies with old economy valuations, point to total revenue growth, and hope that investors don't significantly change their valuation multiples.

Lending Club's $140 million cash and stock acquisition of Springstone Financial LLC looks like a good example of the conglomerate boom dynamic resurfacing in the current market. Lending Club is currently valued at 40 times its 2013 revenue, which appears to be significantly more than Spingstone Financial was valued. If the market mistakes the additional revenue from Springstone as indistinguishable from growth in Lending Club's core business then the acquisition will push up the market value of Lending Club's future IPO. This could happen regardless of whether or not the move into financing private education and elective medical procedures works out for the company in the long run.

For those looking to make long term investments in growth stage companies, it's important to make sure that the revenue these companies are valued against is the type of revenue that can scale and not revenue gained from the acquisition of businesses. Nostalgia for the 60's should have its limits.

Assorted Current Events

1. The DOJ is finally putting pressure on the Chinese government hackers that have been attacking multinational corporations for the past decade.  

It seems like the main difference between the Chinese and the Russian hackers is that Russian hackers are more often working purely for ways to immediately enrich themselves via theft/fraud, while the Chinese hackers have also mounted operations to support their state-owned enterprises. 

I wonder if the calculation of real return on equity for state-owned companies in China included these services as part of their hidden subsidies. 

2. The seemingly increasing closed mindedness of the political youth is an interesting phenomena. Between these graduation speaker protests and requests for trigger warnings on class material, it's hard to tell if the college students have gotten crazier or if the rest of society has gotten used to taking crazy people more seriously. 

3. Twitch TV, online game streaming platform, is rumored to be in talks to sell themselves to Youtube. This would make sense for Twitch for numerous reasons. Most obviously, tech valuations are relatively high but have been unstable recently so it makes sense to look to sell while values are still high. (Whether or not one billion dollars is a high price for Twitch is unclear, in 1999 Broadcast.com was able to sell themselves to Yahoo for $5.7 billion)

Beyond the volatility around technology valuations, a further risk to Twitch is that a very significant portion of their viewers come from a single game - League of Legends (LoL). Many of the popular LoL streamers are paid directly by Riot, the owner of LoL. If Riot decided to make their gamers stream on a platform of their own creation then Twitch could lose a lot of eyeballs/advertising revenue. 

If Riot does this successfully, it shows that those who own the games can choose to monetize their streamers directly unless Twitch works to keep them on board. This could lead to a situation where the economics of Twitch resemble music streaming services more than Youtube channels. If viewers left to watch their games on other services, this would also show that Twitch viewers aren't necessarily as sticky as Twitch would like buyers to think*. 

*Whether or not users will stick around in the long run seems to be one of the big questions when it comes to the valuation of many current tech companies. 

Pay more attention to the newer guys at the Ira Sohn Conference

The Ira Sohn Conference is going on today. This is a charity event where top fund managers pitch trade ideas to attendees who spend (donate) thousands of dollars for the right to attend. Looking at the performance of last year's picks gives some clues to the incentives the presenters have. 

The big names, people like Bill Ackman, David Einhorn, Jeffrey Gundlach, Kyle Bass* and Jim Chaos, can push their largest positions or trades that have been doing well recently. They can impress investors just by the media and market reaction to their views. The common stock of Fannie Mae and Freddie Mac, two companies whose stock might go to zero without extensive lobbying efforts, shot up today after Bill Ackman talked about them. And given that these managers are already well known, the marginal value of additional positive press is relatively small.

It's the smaller investors who need to make their name. The exposure from the conference gives many of these managers more media exposure than most of them have had in the past. A big win that was widely publicized ahead of time can help their funds gain a lot of exposure and make it much easier to raise assets. We know that the best ideas of fund managers are often be good ideas - so when lesser known managers are pitching their best ideas it makes sense to take a closer look.


*Apparently his fund makes money for investors, but every time his views are expressed in the news (Japan hasn't gone bankrupt yet!) it seems like following those views would lose a lot of money so I'm genuinely curious as to how that happens.

A little bit of help

My friend Ben (via his awesome tumblr) pointed me towards an article in National Geographic that highlights an empirical study on the impact of privilege and luck.

In order to study this topic, they looked at four different ways of giving out small levels of success - small amounts of funding on Kickstarter, positive ratings on Epinions, signatures on Change.org petitions, and awards to Wikipedia editors.


(van de Rijt et al, 2014.)

Those who were randomly given a random initial boost went on to do significantly better than those in the control group. Whether this is because the success attracted notice by others or more because the success made those granted positive feedback try harder isn't clear (except in the case of ratings, where additional effort would be less likely to impact a comment that is already made).  

But whichever effect dominates, the implication for what to do when you have friends embarking on projects is clear. Helping them a little bit can have a large impact on their eventual success. 

The study also found that large amounts of help were only marginally better than small amounts of help. This implies that helping four friends a little bit is probably going to have a higher return than spending four times as much effort helping just one person.  

This also explains why networking properly - helping lots of people you meet in little ways - can have a large impact in the long run.

Assorted Links: Politics, Google, politics and antiobiotics

1. South Korean politics are strange. I could pretend that my model of scapegoats could somehow have predicted this, but the fact that a prime minister would have to resign after a (very tragic) regional accident really surprised me.

2. An interesting article on Larry Page and Google.  Investors should take note of the following:

"Page recognized that Google’s search-advertising business, with its insane profit margins and sustained growth, was exactly the kind of cash-generating machine that his hero, Nikola Tesla, would have used to fund his wildest dreams. "

A portfolio allocation towards Google seems less about betting on them creating shareholder value in the short or medium term, and more about making sure that if this company takes over large sections of the economy then at least they are hedged. A third scenario is that Google is more like the Xerox of our day. They might be the first to invent and implement a product that becomes as common as a computer mouse (Wow, this example might be a bit dated), but they might not be the company that fully benefits from their advancements. This is a risk as long as the cost of computing keeps falling, since what only a big company can do today might be cheap enough for college students to do from their dorm rooms five years from now.

3. The US Treasury is cracking down on financial insiders trading on material nonpublic government information.  Perhaps "cracking down" is the wrong set of words, "facilitating" seems to be a better word choice.  They are warning privileged investors about additional Russian sanctions before the rest of the market finds out.

Unfortunately this is nothing new - many financial players will attend events like the World Economic Forum because policy makers will often tell market participants what they are thinking before it is more widely known - Trichet in particular told attendees at a meeting a few years before the financial crisis that the ECB's monetary policy was going to be tighter than expected because of petrodollar flows. 

And it should be mentioned that the ones who go there to learn about policy ahead of time are the less harmful ones - those who use access to help shape policy in their interest, leading to regulatory capture, are the ones that do the most damage.

4. New Delhi metallo is an enzyme that can be produced by some bacteria that turns them into antibiotic superbugs. There were 6 cases in the UK in 2008 and 143 in 2013. Scientists are only sure about one treatment working, and expect that treatment to eventually stop working. 

Antibiotic resistance is one of the more interesting (and troubling) collective action problems of our day. Our medical system currently doesn't incentivize research into novel antibiotics enough since novel antibiotics are saved as a last line of defense against resistant bacteria. Part of the solution to this problem involves X-prize type bounties that incentivize researchers and companies to discover novel forms of antibiotics the can be used against bacteria with these new defenses. This is much more important than developing a tricorder, but perhaps it is too backwards looking for those who might otherwise want to be affiliated with the project.

Why haven't prosecutors gone after Silicon Valley yet?

One of the patterns of modern day politics is that prosecutors can move on to higher political offices by taking down a big name or two. Rudy Giuliani famously took down Michael Milken by threatening him and his company with the RICO act, a law that was designed to only apply to Mafia style organized crime organizations. That victory gave him the name recognition that helped him become the mayor of NYC.

Eliot Spitzer publicly went after many people on Wall Street, which raised his profile enough to become governor or New York State. He was eventually caught with a prostitute, but his story still adds another data point to the idea that all a prosecutor needs to do to achieve higher office is win high profile cases against big names. 

It doesn't matter to the prosecutor's career if the company or person getting prosecuted is acting significantly worse than their peers. All that matters is that the prosector gets positive press for fighting a big name (That they help the press demonize) and that the prosecutor finds some way to win. 

Today, inequality is a growing political issue. Many people see technology, and Silicon Valley as its proxy, as one of the driving factors of inequality. That leads to the obvious question: Why haven't prosecutors gone after any big Silicon Valley targets? 

It isn't because they don't have anyone to go after. Carl Icahn's attack against Marc Andreessen gives an overview of plenty of grey areas where it looks like a prosecutor could make his career.  The quote, "No conflict, no interest" is frequently attributed to John Doerr.  He sits on numerous public company boards while making VC investments in companies while benefiting from internal information gained at these board meetings. While there are many ways to break federal law, breaches of fiduciary duties are generally regarded as civil actions. So regardless of whether or not a determined investigation would find wrongdoing, this might not be as fertile an area for prosecutors as the headlines make it appear.

There are still other places prosecutors can look. Despite what many people seem to think, insider trading in private companies is illegal. And there are likely to be a few big names out there involved with situations where employees, the most sympathetic of the investors allowed to own shares in private companies, are found to have been ripped off by insiders who traded with them while misrepresenting relevant information about the company.

Michael Milken was largely thought to be a target of Giuliani because of how unpopular he was among certain groups of people. His work in high yield bonds took business from banks (if it weren't for the "junk bond" market, companies would have to get much higher cost loans from banks) and facilitated leveraged buy outs which were unpopular with both existing management and with workers at the companies that might get laid off after a takeover.  Eliot Spitzer only became the Sheriff of Wall Street after the stock market crash.

This presents two ways that Silicon Valley can be dragged into the bullseye of prosectors.

1. A financial crash centered around tech stocks. If investors start losing lots of money in tech stocks, a scapegoat will be required. This is the Spitzer scenario. In this case those behind the most inflated valuations will be most at risk.

2. The continued success of Silicon Valley as entrepreneurs focus on more traditional industries. If software continues to eat the world, those incumbents who find themselves being pushed to the sidelines will fight back. They might do more than fight to protect their rents, they might use their political connections to get prosecutors to punish those who they see as responsible for their business's growing irrelevance.

Either way, those in Silicon Valley should remember to be careful in their electronic communication. I'm sure that many of them are ahead of the curve when it comes to this issue, maybe that is why all of those secret sharing applications are getting funding.

Simple Truths about High Frequency Trading

The interest in High Frequency Trading, of HFT for short, comes from how it combines finance, technology and secrecy. The press around the subject has increased dramatically as Michael Lewis has been promoting his new book on the topic, Flash Boys.  A chapter appeared in the NYTimes that is well worth the read. Discussions around the issue made CNBC's daytime market coverage look very similar to Fox News (because of the yelling and screaming, not because of any right wing agenda).  In the midst of this uproar, the high frequency trading firm Virtu has delayed their IPO.

Michael Lewis is a good author, but he likes to tell narrative stories with good guys and bad guys. And as Tyler Cowen once said, "As a simple rule of thumb, just imagine every time you’re telling a good vs. evil story, you’re basically lowering your IQ by ten points or more."  So without getting into some of the more esoteric details, what's really going on?

1. The market has always needed intermediaries, the people who help connect buyers and sellers when they don't want to buy and sell at exactly the same time. These intermediaries need to make money. Without some money being paid to liquidity providers there will be no liquidity.

2. As floor traders have been replaced by computers running algorithms, spreads have narrowed. Investors spend significantly less money getting into and out of positions compared to 10 or 15 years ago.

3. HFT firms attempt to front run large traders. Any market intermediary needs to try to get out of the way of big buyers after the shares they have offered to buy or sell have been taken because if they didn't they would go out of business very quickly. But HFT set ups allow them to pretend there is are more shares available to be bought or sold in the market than there actually is which can be quite frustrating for those trying to execute large trades.

4. Googling "backing away" shows that intermediaries have been causing issues well before they consisted of the population labelled as "high frequency traders".

5. The ones losing the most money from high frequency traders are those attempting to trade large amounts of stock on the market. These are institutions such as mutual funds, pension funds and hedge funds.

6. While the situation remains annoying to institutions, HFT volumes and profits have actually been falling over the past few years. 

Wall Street rips people off all the time, but there seems to be more of an outrage when the people making money are outsiders and the people losing money are closer to being insiders. 

HFT firms have been the best customers of many of the exchanges - they pay high fees to get their servers situated next to the exchange and provide large amounts of volume to the exchange. In an effort to increase their profits from HFT traders many of the exchanges have implemented some trading rules that benefit HFTs at the expense of other traders on the exchange. Michael Lewis's story explains how some large institutional traders have figured out how they are being taken advantage of and are turning to people such as the IEX Group (The "good guys" in his book) in order to trade without having to worry about people gaming the system. 

Exchanges are going to have to reevaluate their own systems and make them more favorable to institutions that engage in relatively simplistic trading if they want to be profitable in the long run. (Part of this also involves setting up incentives for market makers which reduce the probability of future flash crashes, but that's a much more complicated subject).

If you are a retail investor, the hubbub over HFT shouldn't matter that much to you. You are getting better execution than you ever did under a system managed by human market makers. HFT traders are small parasites that have outcompeted bigger parasites. Overall they've been a net benefit to the ecosystem.  

And it is worth keeping in mind that the impact of HFT firms is small compared to other financial players. The only surprising thing about revelations that many large banks have been manipulating numbers they trade in both the interest rate and foreign exchange markets is that they finally got caught. And the additional 0.1% market impact that HFT firms might cause on large trades is very small when compared to the 5.1% average commission that Real Estate brokers take in on every transaction they make.  The HFT story is smaller than it looks.