Monday, September 15, 2014

Kobayashi-Solomon, The Intelligent Option Investor

Just when I thought there wasn’t room for another book on options for the beginning to intermediate retail trader/investor, along came a text to prove me wrong--Erik Kobayashi-Solomon’s The Intelligent Option Investor: Applying Value Investing to the World of Options (McGraw-Hill, 2015). It’s not just that the author sets out to blend clashing cultures but that he looks at options from a fresh, albeit sometimes controversial perspective.

Value investors are known to be patient, to hold onto their positions for long stretches of time as price catches up to value—or so they hope. Options traders, by contrast, always have to keep one eye on the calendar, perhaps even on the clock. Value investors who decide to include options in their portfolios eschew short-dated options; they tend to look a couple of years out. And they embrace directionality—no iron condors for them. As the author contends, “flexibility without directionality is a sucker’s game. … Winning this sort of bet is no better than going to Atlantic City and betting that the marble on the roulette wheel will land on red—completely random and with only about a 50 percent chance of success.” (p. 28) At this point short-term probability traders would most likely throw the book across the room (or stop reading this post). But that would be rash; even they can find useful information in this book.

The author’s theoretical probability cones, creatable with a few plug-in numbers on his subscription website, extend indefinitely into the future. The value investor can then overlay his rational valuation range for a particular stock on its Black-Scholes-Merton probability cone and look for discrepancies.

Kobayashi-Solomon uses probability cones to describe basic option positions as well as to explain how input variables to the Black-Scholes model affect the prospect of profits on options trades. For instance, a trader who buys short-dated calls at 55 on a $50 stock has “a little corner of the call option’s range of exposure within the BSM cone, but not much.” (p. 68)


In the above diagram implied volatility is assumed to be 35%. If it falls to 15%, here’s what happens. “The stock price moves up rapidly, but … the BSM cone shrinks as the market reassesses the uncertainty of the stock’s price range in the short term. The tightening of the BSM cone is so drastic that it more than offsets the rapid price change of the underlying stock, so now the option is actually worth less!” (p. 69)


Options, of course, provide the investor with leverage, but this leverage is not the same as the leverage you get when you buy a stock on margin. Let’s say you have a $50 stock that you believe is worth $85. Call options at the 65 strike are $1.50. You can either buy the stock on margin or buy options. If you decide to buy options, the $1.50 per contract is essentially an interest payment because it is all time value; it is made up front and is a sunk cost. This “prepaid interest can be offset partially or fully by profit realized on the position, but it can never be recaptured.” (p. 170) On the other hand, “payment on the principal amount of $65 in this case is conditional and completely discretionary.” (p. 168) No matter how the stock performs, you’ll never receive a margin call. By contrast, repayment of a conventional loan from your broker is mandatory, so if the stock drops heavily, you’ll get a margin call from your broker.

Two simple measures for measuring option investment leverage are lambda and notional exposure. The author discusses these measures but then explains why they are insufficient to help an investor manage a portfolio containing option positions. The challenge for the intelligent option investor is to “find as large an asymmetry” between valuation and market price “as possible and courageously invest in that company. If you can also tailor your leverage such that your payout is asymmetrical in your favor as well, this only adds potential for outsized returns.” (p. 184) The author considers a -1.8/2.6 leverage ratio especially attractive; it is similar to that of Berkshire Hathaway’s portfolio. A recent AQR Capital paper, "Buffett's Alpha," found that “a significant proportion of Buffett’s legendary returns can be attributed to finding firms that have low valuation risk and investing in them using a leverage ratio of roughly 1.8. The leverage comes from the float from his insurance companies.” (p. 185)

Although The Intelligent Option Investor is not the first book an aspiring option investor should turn to, it is a worthy complement to some of the classic options texts.

Monday, September 8, 2014

Brakke, Letters to a Young Analyst

As I await the fall offerings from my usual sources, I have wandered off the beaten path—though not this time, I must admit, with especially satisfactory results. I started reading (and, alas, eventually discarded) a couple of books that were longlisted for the Booker Prize, with two more to try out.  I’m part way through Opium and Empire, which I may write something about later on or then again may not.  And I skimmed two motivational books in search of nuggets to share—looks as if I’ll have to dig deeper since nothing original popped up at first glance.

Today, more on point, I’d like to call your attention to a delightful little ebook that the author, Tom Brakke, sent me—Letters to a Young Analyst: Advice and Resources for Aspiring Investment Professionals. It’s available through the author’s website, The Research Puzzle.  Those who purchase the book also receive a quarterly newsletter with “additional resources, advice from other investment professionals, feedback from readers, and further ideas from Tom about changing opportunities in the industry.”

The book begins with letters written by the author in 2010 to an aspiring analyst at the start of his career, inspired by Ian Stewart’s Letters to a Young Mathematician. The second part of the book is devoted to advice from twelve “other voices”—among them, Aswath Damodaran, David Merkel, Jack Rivkin, and Barry Ritholtz—as well as a few people who commented on the original letter series on the author’s website. Part three contains a new letter and part four, a selection of resources.

Most of the advice in this book is applicable to anyone starting out in the financial world (or pausing to reflect in the course of his career), not only to analysts. The advice ranges from “read around your subject” to learn VBA (a project that’s been on my to-do list for longer than I would care to admit) to recognize the risks of both insufficient quantitative analysis and over-reliance on quantitative analysis. On balance, pretty sound advice.

The author introduces the reader to a wide range of resources—books, periodicals, websites, even Twitter handles. I was familiar with most of these resources but was delighted to find some hitherto unknown gems in the lists.

All in all, a pleasant, occasionally uplifting read.

Sunday, September 7, 2014

The hazards of going on autopilot

For those who already have automated their trading, as well as those who are trying to, here's a word of warning from the airline industry. I've written about this before, but it's worth another look, this time thanks to The New Yorker.

Tuesday, September 2, 2014

Carlisle, Deep Value

Tobias E. Carlisle, co-author of a book I put on investors’ “must read” list—Quantitative Value, is back with another compelling volume, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of “Losing” Corporations (Wiley, 2014).

The most public face of deep value investing is Carl Icahn, known for his “battering-ram personality,” who has had a long, storied career as a discount options broker, arbitrageur and liquidator of closed-end mutual funds, corporate raider, and activist investor. In 1976 he wrote a memorandum, which his biographer dubbed the “Icahn Manifesto,” in which he stated: “It is our contention that sizeable profits can be earned by taking large positions in ‘undervalued’ stocks and then attempting to control the destinies of the companies in question by: a) trying to convince management to liquidate or sell the company to a ‘white knight’; b) waging a proxy contest; c) making a tender offer and/or; d) selling back our position to the company.” (p. 4) By the way, the last option, known as greenmail, in which the company in effect pays a ransom by buying back the raider’s stock at a premium to the market price, is now illegal.

Few people have the qualities necessary to be the next Carl Icahn. But they can still profit from the well tested principles of deep value investing.

Carlisle traces out the evolution of deep value investing, beginning with Benjamin Graham’s notion of net nets, companies whose “market capitalization was net of the net current asset value.” That is, these companies had a surplus of current assets (cash, receivables, and inventory) over all liabilities (current and long term) and had market capitalizations no higher than two-thirds of their net current asset value.

Warren Buffett viewed the acquisition of net nets as foolish “unless you are a liquidator.” He essentially rejected deep value investing with its strictly quantitative metrics and its cigar butt investment philosophy. He incorporated qualitative considerations into his company analyses and famously said that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Carlisle aligns himself more with Graham than with Buffett, in large part because he believes there is compelling evidence for mean reversion in stocks. His firm, Eyquem Investment Management, examined returns of the top 50% of stocks by market cap in 23 developed-market countries from 1980 to 2013. Each stock was sorted according to its ratio of market price-to-book value, cash flow, and earnings. The sorted stocks were then divided into five quintile portfolios, fifteen portfolios in all. No matter which ratio one looks at, the average annualized five-year returns of the value portfolio end up in quintile 5 (c. 13-14%) and those of the glamour stocks in quintile 1 (c. 8-9%). The most sensitive ratio was price-to-cash flow; glamour stocks performed worst and value stocks best when sorted on this metric.

Carlisle admits that the value premium also seems to mean revert; recently value has underperformed glamour. The level of underperformance from 2010 to 2013 is perhaps payback for the huge outperformance from 2000 to 2005, and this outperformance may be attributable to the underperformance of value stocks in the late 1990s. Over the long haul, however, value stocks beat both the market and glamour stocks.

The graph below shows the annual returns of the largest 40% of U.S. stocks by market cap from 1951 to 2013. The value portfolio comprised one tenth of the All Stocks universe (c. 114 of 1,140). This portfolio was further subdivided. The cheaper half of the value decile, those with the highest ratio of EBIT to enterprise value, is the Deep Value Stocks portfolio; the more expensive half is the Glamour Value Stocks portfolio. The Deep Value portfolio saw a compound annual growth rate of 15.72%; the Glamour Value portfolio, 8.84%.



I don’t want to give the impression that Carlisle’s book is simply a bunch of numbers and charts. Far from it. It recounts famous deals and portrays successful deep value investors, which makes it an enjoyable read. But the most important takeaways—and why the book is worth careful study, not just a quick read—are that “valuation is more important than the trend in earnings” and, counterintuitively, that, “even in the value portfolios, high growth leads to underperformance, and low or no growth leads to outperformance.” (p. 211) In brief, contrarianism pays off.

Wednesday, August 27, 2014

Brooks, Once in Golconda

John Brooks (1920-1993), a financial journalist best known for his contributions to the New Yorker, was also the author of ten nonfiction books on business and finance. The three most famous were Business Adventures, The Go-Go Years, and Once in Golconda. Open Road Integrated Media is reissuing all three books this year.

The title of Brooks’s 1969 book, Once in Golconda: A True Drama of Wall Street 1920-1938, needs some explanation. “Golconda, now a ruin, was a city in southeastern India where, according to legend, everyone who passed through got rich. A similar legend attached to Wall Street between the wars.”

Brooks is a captivating writer who is adept at both setting the stage and portraying some of the leading actors. He can also step back to poke fun at the entire drama. For instance, in addressing the issue of speculation, he quotes the British sociologist Elias Canetti who “has a rather more engaging and original explanation” for the urge to speculate than the normal reply that “it is rooted in human venturesomeness, acquisitiveness, and love of risk for its own sake.” Canetti suggests that “the essence of trading is the giving of one object in exchange for another. The one hand tenaciously holds on to the object with which it seeks to tempt the stranger. The other hand is stretched out in demand towards the second object, which it seeks to have in exchange for its own. As soon as it touches this, the first hand lets go of the object; but not before, or it may lose both…. The trader remains on his guard during the whole transaction, and scrutinizes every movement of his opposite number. The profound and universal pleasure men take in trading is thus partly explained by the fact that trade is a translation into non-physical terms of one of the oldest movement patterns. In nothing else today is man so near the apes.” (p. 69)

Brooks continues: “In Wall Street in the later 1920s, where speculation in stocks reached a degree of intensity and subtlety and an extent of public participation probably not matched anywhere before or since, it is doubtful that it occurred to any of the speculators that they were recapitulating the movement patterns of their subhuman ancestors swinging from tree to tree. Nor did this occur to the explainers and defenders of speculative activity. On the contrary, these explainers and defenders, led by the authorities of the New York Stock Exchange, emphasized as lyrically as their gifts would allow, the creative, human, even almost superhuman accomplishments of speculation and speculators.” Princeton economist Joseph Stagg Lawrence went so far as to make the (fortunately hedged) claim that “it is probable that upon this stage [the NYSE] can be discovered the aristocracy of American intelligence.” (p. 70)

Fed policy was impotent to stem the tide of speculation. In 1928 “it progressively reversed its easy-money policy. In three steps it raised the discount rate from 3.5 to 5 percent; at the same time bank reserves available for lending were reduced by Federal Reserve sales of government securities on an unprecedented scale. At the beginning of the year the Fed held $616 million in such securities …; a little more than a year later, in the early part of 1929, constant and vigorous selling had reduced the portfolio to below $150 million.” (p. 98)

“The effects of the new Fed policy began to be felt in the second half of 1928 and were to be felt in full force early in 1929. Nationwide, interest rates rose and the classic concomitants of dear money followed: building construction fell off, the borrowings of state and local governments were postponed, small businesses starved for the want of new funds. And meanwhile stock speculation—the chief target of the policy—went its merry way as if harassed by nothing more than a persistent mosquito. … In short, the new Fed policy was an instant and spectacular failure.” (p. 99)

New York bankers thrived in this environment. They could borrow from the Federal Reserve at 5 percent and lend to speculators at 10 or 12 percent. “[B]oth transactions were cut and dried, requiring no business initiative and involving practically no risk, and although starting in early February [1929] the Federal Reserve Board officially disapproved of the practice, it continued to be done. Bankers, like royalty in a constitutional monarchy, were in the position of being handsomely paid simply for existing. A plum tree had been grown, tended, and brought to fruit just for their shaking.” (p. 100) The Fed might announce that “the Federal Reserve Act does not … contemplate the use of the resources of the Federal Reserve System for the creation or extension of speculative credit” (or, as Brooks paraphrases, “please don’t shake the plum tree any more for a while”), but this prohibition was unenforceable. Speculation continued apace.

The central character in Brooks’s book is Richard H. Whitney, who went from Wall Street hero to Sing Sing inmate. He was a hero on October 25, 1929, when the panic was at its height: “the Morgan broker strode to the post where U.S. Steel was traded and placed the most celebrated single order in Stock Exchange history—a bid for 10,000 shares at 205, the price of the last previous sale, although the stock was actually being offered at that moment at well below 200…. He then matched this grandly uneconomic gesture by proceeding to various other posts on the floor and placing similar orders for other blue-chip stocks—each in huge quantity, each at the price of the last previous sale. Within a few minutes his orders aggregated more than twenty million dollars, and everyone knew that the bankers’ consortium was in action and that Richard Whitney was its floor man.” (pp. 123-24)

But Whitney himself sustained considerable speculative losses, and even his vast borrowings (“well in excess of five million dollars” in early 1938) were insufficient to allow him to stay afloat and maintain his extravagant lifestyle. He resorted to embezzlement. In 1926 (although it wasn’t known until more than a decade later) this future president of the NYSE embezzled from the New York Stock Exchange Gratuity Fund, entrusted to his care. He later stole money from the New York Yacht Club and his father-in-law’s estate.

His misdeeds uncovered, he pled guilty, reading a mea culpa “in a firm, clear voice—almost with a certain joy.” Before sentencing, he was examined by the court’s psychiatric clinic and its probation officer. “The psychiatric clinic found his reactions to be ‘urbane and sportsmanlike,’” and the probation officer wrote: “Contributing factors in his delinquency are pride, obstinacy, unshakable belief in his own financial judgment, and a gambling instinct…. Egotistical to a marked degree, it was apparently inconceivable that he, a figure of national prominence in financial circles and one whose judgment in economic matters was considered that of an expert, should prove a personal failure.” (p. 262)

Monday, August 25, 2014

Dutton & McNab, The Good Psychopath’s Guide to Success

According to a controversial 2011 study by researchers at the University of St. Gallen, traders are more reckless and more manipulative than psychopaths. The traders in the study were intent on getting more than their opponents; in fact, “they spent a lot of energy trying to damage their opponents.” They behaved as though their neighbor had the same car, “and they took after it with a baseball bat so they could look better themselves.”

I suppose Kevin Dutton and Andy McNab would characterize these traders as bad psychopaths. They possess some character traits that could propel them to great profits, but if left unchecked these traits may lead to financial implosion instead.

The Good Psychopath’s Guide to Success: How to use your inner psychopath to get the most out of life (Apostrophe Books, 2014) is co-authored by a (good) psychopath and a psychologist. McNab is an SAS (British Special Air Service) legend who, as he himself claims, is “considered to be one of the top thirty writers of all time”—I assume by someone whose education was tragically cut short. Dutton, a research fellow at Oxford, has spent a lifetime studying psychopaths. The book, reflecting the penchants of the authors, illustrates self-help principles with rough and tumble adventure tales.

A psychopath has a distinct subset of personality characteristics, including ruthlessness, fearlessness, impulsivity, self-confidence, focus, coolness under pressure, mental toughness, charm, charisma, reduced empathy, and a lack of conscience. Depending on how these traits are dialed up, down, or omitted, the psychopath can be either good or bad.

I’m not going to try to construct a profile of the ideal trader (who presumably would be a good psychopath) using the book’s guidelines. Instead, let me give two examples of how a good psychopath would proceed.

The first, actually a negative example, comes from a London cabbie. Asked how business was, especially since it was a beautiful day and lots of people were about, he replied: “The sun brings them out all right. But no one wants to take a cab in this weather. All they want to do is sit about in parks and get pissed. I wanted to watch the football tonight but instead I’ll probably be working now. I have to make £200 a day just to cover the cost of hiring this thing. Then there’s the diesel on top of that. Give me the rain and the cold any day of the week. Once I’ve reached my quota I can knock off early.”

As McNab pointed out, the cabbie has things the wrong way round. “If it was me I’d be working my bollocks off on the good days and knocking off early on the bad days instead. Think about it. If you’re going to knock off early, why do it on a day when you’re coining it right, left and centre? It’s madness! On a day like that you should keep your foot on the gas and maximize your profits, surely? On the other hand, it actually makes sense to knock off early on a slow day because not only is your profit margin going to be jack shit anyway, you’ll be conserving energy for your next shift—which could turn out to be a good ’un.”

The second example comes from a study of how we make financial decisions. “The study took the form of a gambling game consisting of twenty rounds. At the beginning of the game each participant was handed a roll of $20 bills and, at the start of each new round, was asked whether they were prepared to risk the princely sum of $1 on the toss of a coin. A loss incurred the penalty of that $1 invested, but a win swelled the coffers by a cool $2.50. Now, it doesn’t take a genius to work out the winning formula. Logically, … the right thing to do is to invest in every round.”

The study participants were divided into two groups. One group had lesions to the emotion areas of their brains; the other had lesions in other areas. Predictably, “as the game unfolded, ‘normal’ participants began declining the opportunity to gamble, preferring instead to conserve their winnings. But participants with problems in their brains’ emotion neighbourhoods—participants whose brains were not equipped with the bobby-on-the-beat, everyday emotional police force that the rest of us take for granted—kept right on going. And ended the game doing quite a bit better than their thriftier, more cautious competitors.” As one of the researchers claims, “This may be the first study that documents a situation in which people with brain damage make better financial decisions than normal people.”

Wednesday, August 20, 2014

Brooks, The Go-Go Years

It is fitting that Michael Lewis wrote the foreword to an earlier reissue of John Brooks’s 1973 book The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (just republished by Open Road Integrated Media). Like Lewis, Brooks was a skilled writer with a nose for compelling financial stories.

Brooks’s most famous book, Business Adventures, has stood the test of time; it was on Bill Gates’s 2014 summer reading list—45 years after it first appeared. Time has not treated The Go-Go Years quite so kindly, although the book is still an interesting, if sometimes pained, commentary on a troubled era of change, both in society at large and on Wall Street in particular.

“In the nineteen twenties,” Brooks wrote, “it was in a real sense what Wall Streeters always cringed to hear it called, a private club—and not just any private club but probably the most important and interesting one in the country, a creator and reflector of national manners and a school for national leaders. In the nineteen sixties, despite declining aristocratic character and political influence, it was still those things, playing out week by week and month by month its concentrated and heightened version of the larger national drama. But after the convulsion with which the decade and that particular act in the drama ended, its days in the old role seemed to be numbered. … If the certificate and the floor go, Wall Street will have moved a long way toward transforming itself into an impersonal national slot machine—presumably fairer to the investor but of much less interest as a microcosm of America.” (pp. 314-15)

The late sixties were a time of social and political unrest. But “all through the stormy course of 1967 and 1968, when things had been coming apart and it had seemed that the center really couldn’t hold—the rising national economic crisis culminating in a day when the dollar was unredeemable in Paris, the Martin Luther King and Robert Kennedy assassinations, the shame of the Chicago Democratic convention, the rising tempo of student riots—the silly market had gone its merry way, heedlessly soaring upward as if everything were O.K. or would surely come out O.K., as mindlessly, maniacally euphoric as a Japanese beetle in July. Or as a doomed man enjoying his last meal. One could only ask: Did Wall Street, for all its gutter shrewdness, have the slightest idea what was really going on?” (p. 17) Obviously not. By the end of the decade and into 1970 the stock market “had gone into a sickening collapse,” interest rates were at near-record highs, and one hundred or more Wall Street firms were near failure.

Not that the early part of the decade was exactly tranquil. The stock-market collapse of 1962 sent the Dow down more than 25 percent. Brooks writes of it: “Diabetic coma, the preventable catastrophic crisis of a human disease, comes on slowly; the sinister lassitude it induces neutralizes the rational alarm that would otherwise lead the patient to take measures to head it off. So it is with stock-market crashes.” (p. 55)

The Dow reached a high just shy of 735 at the turn of the year, after which “a gradual, fairly consistent decline began. But experts who a year earlier had been sounding prudent warnings of the dangers of speculation were now victims of the very euphoria they had warned against; in January and February, 1962, they pointed out that business was good, spoke of a ‘healthy correction,’ and recommended the continued, if cautious, purchase of stocks.

“What a falling market needs to become a diving market is not a reason but an excuse, and in April it found one when President Kennedy chose to engage in a to-the-death confrontation with the steel industry and its bellwether, U.S. Steel, on the matter of a price increase.” The steel industry eventually capitulated, “but at what a cost! Investors, who had profited so handsomely from the ‘Kennedy market’ of the previous year, suddenly decided that the energetic young man in the White House was an enemy of business, after all. Whether or not Kennedy, in the heat of confrontation, had actually said in private, ‘My father always told me that businessmen were sons of bitches,’ was not the point; the point was that a good proportion of the 17 million American owners of corporate shares believed he had said it. For several weeks in succession, the market slumped ominously, until the week of May 21-25 saw the worst decline for any week in more than ten years. And then, on May 28, the day that has gone down in Wall Street annals as Blue Monday, the Dow average dropped 34.95 points, a one-day collapse second in history only to that of October 28, 1929, when the loss had been 38.33. Moreover, the decline took place on the then-fantastic volume of 9,350,000 shares.” (pp. 55-56)

Brooks recounts how the late sixties became, “for a shockingly brief moment, the heyday of the young prodigy, the sideburned gunslinger. … He came from a prospering middle-income background and often from a good business school; he was under thirty, often well under; he wore boldly striped shirts and broad, flowing ties; he radiated a confidence, a knowingness, that verged on insolence, and he liberally tossed around the newest clich├ęs, ‘performance,’ ‘concept,’ ‘innovative,’ and ‘synergy’; he talked fast and dealt hard (but unlike the back-office people he seems to have seldom used drugs, including marijuana); and, if he was lucky, he made 40 or 50 percent a year on the money he managed and was rewarded with personal earnings that often exceeded $50,000 a year.” (p. 189) Alas, “the look of eagles became a vacant stare once the ever-rising market began to plunge,” and “many of the gunslingers who had touted [the glamor stocks] would leave, or be fired from, the securities business.” (p. 192)