My advice to Bill Ackman and anyone else short the bond insurers

I have some advice to any of you who think that now is a good time to short the bond insurers: don’t do it. Don’t mess with the government. By all rights, the bond insurers are already insolvent, dead, and it is only a matter of time before they are gone. However, politicians do not like turmoil and they love bailouts. They also love cheap insurance for government bonds. Therefore, there will be a bailout in some way. It may not save current shareholders, but the bailout has the risk of killing the shorts. For that reason, now is a good time to stay away from MBIA [[mbi]] and Ambac [[abk]].

A theoretical trader who shorted the infamous Semper Augustus tulip bulb at 5000 florins during the Dutch tulip mania would have had a great win snatched by the government’s cancellation of all tulip contracts. This is a similar case where it would be smart to stay out of the government’s way.

For why I think the bond insurers are dead, see Bill Ackman’s letter to the rating agencies about the bond insurers.

Disclosure: I grow no tulips and have no position in any stock mentioned. I have a disclosure policy.

What Every Investor Needs to Know About Regression to the Mean

Perhaps one of the most widely disseminated and most widely misunderstood statistical concepts is that of regression to the mean. It is also one of the most important concept for investors to understand.

The simple definition of regression to the mean is that with two related measurements, an extreme score on one will tend to be followed by a less extreme score on the other measurement. This definition will not suffice for us as it is incomplete. Regression to the mean only happens to the extent that there is a less than perfect correlation between two measures. Thus, as a technical definition, let us use that of Jacob Cohen: whenever two variables correlate less than perfectly, cases that are extreme on one of the variables will tend to be less extreme (closer to the average or mean) on the other variable.

For those of you who have been away from math for too long, a correlation is simply a measure of how well one thing can predict another. A correlation of 0 indicates that two things are unrelated, while a correlation of 1 or -1 indicates that they are perfectly related. See this website for a nice graphical presentation of what different correlation coefficients mean. For example, the price of a restaurant is correlated with its quality at about .60 (this is just my rough guess)—more expensive restaurants tend to be higher quality than less expensive restaurants, but there are plenty of exceptions.

On the other hand, I would estimate that price correlates more strongly with the quality of chocolate—probably around .80. Except for exceptions such as Candinas and Sees, most really good chocolates are horribly expensive, while cheap chocolates (such as Russell Stover) are invariably bad. An example of a near-perfect correlation would be the correlation between altitude and temperature at any given time in any given place—as the altitude increases, the temperature drops.

Some people refer to regression to the mean as a statistical artifact. It is not. It is a mathematical necessity. Let us start with a very simple example. Suppose that people who have more money tend to be happier than those with less. This is actually true, but the correlation is weak—money really matters to happiness only to the extent that people can afford the basic necessities. If we were to predict the happiness of both 100 billionaires and 100 people who live on welfare, we might expect that the billionaires would be significantly happier. In fact, billionaires are only slightly happier than those on welfare. Because the correlation is so weak, we would be better off ignoring the correlation of wealth and happiness and just guessing that everyone was of average happiness.

Let’s try another example. Suppose that you work as an admissions officer for Harvard. You have two main sources of information in order to decide whether or not to admit prospective students. You have the candidates’ SAT scores and you have the results of their admissions interview. Suppose that one student has an SAT score of 1550 (out of 1600 possible points) and a very bad interview—the interviewer considered the student to be uninteresting and not very bright. Another student had an SAT score of 1500 and an outstanding interview. Assuming there is only one spot left, which student should you admit and which should you reject?

Take a moment to think and make your decision. You most likely chose the student with the lower SAT score and better interview, because the SAT score was only slightly lower, while the interview was much better than that of the first student. However, this is the wrong decision. Repeated studies have shown that admissions interviews have no correlation whatsoever with college student performance (as measured by graduation rate or college grades). SAT scores, on the other hand, do correlate (albeit less strongly than most believe) with college grades. Thus, you should completely ignore the interview and make a decision purely based upon SAT scores.

I admit that this example is unfair—truth be told, SAT scores are only correlated moderately well with college grades: about .60. That means that there is little difference between a score of 1550 and a score of 1500. However, a small, meaningful difference is still more informative than a large, meaningless difference.

To make this a little more clear, we can do this without an interview, since the interview is useless. Rather, we throw a die (as it is equally useless). For the student with the 1500 SAT, we roll a 6. For the student with the 1550 SAT, we roll a 3. Would you decide to admit the student with the 6 because of his higher die roll? Obviously not, because the die roll is pure chance and does not predict anything. The same reasoning applies to the interview, since its relation to school performance is just chance.

Suppose we selected students based on a roll of the die—how would they fare? The students with the best scores would tend to do average, while those with the worst scores would also do average. This is perfect regression to the mean. Simply put, the die roll adds nothing.

Regression to the mean only happens to the extent that the correlation of two things is less than perfect (less than 1). If the correlation is 0, then there will be perfect regression to the mean (as with the die). If the correlation is between 0 and 1, then there will be partial regression to the mean. Let us now look at example of this.

There is a correlation between income and education level. I cannot find the actual data, so I will make it up—I will say that it is around .60. Therefore, level of education (as measured numerically by highest grade level or degree completed) is a fairly good predictor of a person’s income. More educated people tend to make more money. Let’s look at a sample of the top 10% of money-earners. If education perfectly predicted income, then those top money earners would be the top 10% most educated. Whereas education imperfectly predicts income, we will find regression to the mean. Those earning the highest incomes will tend to be well educated, but they will be closer to the average education level than they are to the average income level.

One of the beautiful things about regression to the mean is that if we know the correlation between two things, we can exactly predict how much regression to the mean will occur. This will come in handy later.

If all we had to worry about when two things are not perfectly correlated was regression to the mean, we would be fine. It is fairly simple to calculate a correlation coefficient and then figure out how much of some effect is caused by regression. Unfortunately, there is one more complicating factor: measurement error.

Imagine you have a bathroom scale that has 100% error. In other words, the weight it shows is completely random. One morning you weigh yourself at 12 pounds, while the next morning you weigh 382 pounds. Whereas height is normally correlated strongly with weight, your weight as measured by your scale will not correlate with your height, since your measured weight will be random. If we make the bathroom scale just a little more realistic and say that its measurement has 2% error (quite normal for bathroom scales), the same problem applies—the measurement error reduces the apparent correlation between height and weight and increases regression to the mean.

This is exactly the problem that we see in the stock market, although the errors are much larger than with your bathroom scale. The value of a company is a function of only one thing: the net present value of its future cash flows. That, in turn, is determined by two things: the company’s current price (as measured most typically by P/E or P/CF) and its future earnings growth. The measurement of P/E has very little error. The estimation of future growth has much error, though.

For the moment let’s assume that P/E and future growth each account for half of the current value of a company. (This is actually wildly inaccurate—as the growth of a company increases the growth will become much more important than the current P/E in determining the net present value of the company. Conversely, if growth is zero, then P/E will completely determine the net present value of a company.)

Since P/E accounts for half of present value, it is correlated at r=.71. (R2 is the proportion of variance explained, which is .50 in this case, so the square root of this is the correlation coefficient r). This is a fairly strong correlation. Nevertheless, it is far from perfect. Regression to the mean will ensure that companies with the most extreme P/E ratios will be less good values than is purely indicated by their P/E ratios. When you think about it, this makes perfect sense—some companies deserve low P/E ratios because their prospects are poor.

Now for the other half of the equation: growth. Growth is correlated at r=.71 with the net present value of the company. However, that is assuming that we can accurately predict future growth. This is simply not true. Analyst predictions of company earnings less than one year ahead are on average off by 17% of reported earnings (meaning that near-term estimates have a .83 correlation with actual earnings*). Their estimates of growth years in the future are of course much worse. So while the correlation between future growth and present value of a company is fairly strong, .71, the correlation between predicted growth and present value is very much less than that (about .28).

Due to this reduced correlation, there will be much greater regression to the mean for growth as a predictor of value than there is for P/E. The one problem is that investors do not take this into account. Investors and analysts put faith in projections of high growth for years in the future. However, the chances are only 1 in 1,250 that a company will go for 5 consecutive years without at least one quarter of earnings over 10% less than analysts’ estimates. This even understates the problem, because in the above calculation, the estimates can be updated until just before a company actually announces earnings. Estimating earnings five years in the future is impossible.

Remember how I earlier mentioned that as a company’s growth rate increases, its current P/E has less and less relation to its true value? The true value of these companies (such as Google [[goog]]) is determined primarily by their growth rate. So in effect, when the growth investors say that P/E does not matter if the growth is fast enough, they are correct.

There is one problem with this: because of regression to the mean, those companies that grow the fastest are also most likely to under-perform analyst and investor expectations. So the predictions of growth will be least accurate for those companies whose value most depends on their growth rate!

Investors do not realize this and they thus bid up the prices of growth stocks in proportion to the anticipated future growth of a company. Because of regression to the mean caused primarily by the lack of reliability of analyst estimates of earnings, earnings for the best growth companies (as measured by anticipated future growth rates) will tend to disappoint more often than other stocks. The converse will actually happen with the most out of favor stocks: analysts and investors are too pessimistic and thus they will underestimate future earnings and cash flow growth. See “Investor Expectations and the Performance of Value Stocks vs. Growth Stocks” (pdf) by Bauman & Miller (1997) for the data.

Some converging evidence for my regression to the mean hypothesis would be useful. According to my hypothesis, earnings growth for the lowest P/E or P/BV (Price/Book Value) stocks should increase over time relative to the market, while earnings growth for the highest P/E or P/BV stocks should decrease relative to the market. The value stocks in the following data are those with the lowest 20% of P/BV ratios, while the growth stocks are those with the highest P/BV ratios. Ideally, I would look not at P/BV, but at projected earnings growth, but these data will do.

The value stocks have earnings growth of 6.4% at the point in time when they are selected for their low P/BV ratio. After 5 years, their earnings growth increases to 11.6%. Their increase in earnings growth rate was thus 5.2%. The growth stocks, on the other hand, see their earnings growth rate fall from 24.6% to 12.1% (decrease of 12.5%), while the market’s rate decreases from 14.2% to 10.6% (decrease of 3.6%). The figures for cash flow growth are similar: value stocks increase their growth rate by 2.3%, while the market decreases its growth rate by 3.3% and the growth stocks see a decrease in growth rate of 10.3%. Changes in sales growth rates are not as convincing, but do not contradict my hypothesis: value stocks do as well as the market (seeing a 3.6% decrease in sales growth), while growth stocks see a whopping 6.5% decrease in sales growth rate.

The icing on the cake is in return on equity (ROE) and profit margin. In both cases there is no such benefit for value stocks over growth stocks. Why? Both ROE and profit margin are primarily determined by the industry a company is in: commodity industries will see lower ROE and lower profit margins, while industries with a possibility of long-lasting competitive advantage will see higher ROE and profit margins. ROE and profit margins tend to remain relatively stable (but generally decreasing over time for every company), meaning that they are reliable measurements. More reliable measurements means less regression to the mean.

So what does this all mean? Investors do not overreact to good or bad news. Or at the very least, it is not some sort of emotional overreaction—rather, they predict that current (either negative or positive) trends will continue. They do not take the unreliability of their estimates into account. Thus, they do not anticipate nor do they understand regression to the mean.

For this reason, value stocks will out-perform growth stocks until people understand how faulty earnings predictions are. Given the complexity of the topic, I doubt many investors will ever figure out that they should not trust predictions for earnings growth. Besides helping to ensure that value stocks will outperform and giving us a reason to avoid high P/E stocks no matter the projected growth rate, how can we improve our investing based on this data?

Perhaps the best way to use this knowledge would be to seek out all the most reliable predictors of future growth. P/E and other measures of current value are pretty darn reliable (excepting for Enron-style accounting), so we only need to look for more reliable predictors of growth and profitability.

Luckily, much of this work has already been done for us. I described one important piece of information in the review of Joel Greenblatt’s Little Book That Beats the Market. That information is ROC, or return on capital. ROC is a good measure of how easy it is for a company to expand, and thus should be highly correlated with future earnings growth. It is also more reliable than analysts’ predictions of future earnings growth, though it is less reliable than measures of current value.

In addition to ROC, academics have done many studies on all sorts of variables that correlate more or less with stock returns. I have previously highlighted one study, for example, that showed that stocks with high short ratios tend to do poorly. This correlation is not very strong, however, so it should not be very important to us in deciding upon an investment. Rather than just use one or two types of data, however, we can use every piece of data that correlates with stock returns. The key is to use all these variables together—by looking first at P/E, then at ROC, then at insider ownership and short interest, as well as some subjective measures such as management quality, we can more accurately predict a company’s true value. The key is to correctly weight each component.

People in general tend to make decisions based on only a few pieces of data. They often ignore important data and concentrate on salient data. By using a formula as our investing guide, we will be able to avoid making that mistake.

*This is not true. I am not sure how to calculate the correct number, though, so I will use this as an approximation.

Book Review: The Theory of Investment Value

John Burr Williams wrote The Theory of Investment Value as his dissertation. First published in 1938, this book is one of the classics of investing. I will not say that the book is a fun read, for it is not. It is dry and difficult. Half the pages are filled with equations. However, this book was a landmark and it remains relevant. This book is far too large and detailed for me to describe in detail, so I will present but a few of the highlights.

John Burr Williams invented the dividend discount model of stock valuation. Previous economists and stock analysts had only guessed at what the proper P/E valuation was for a company or what the proper dividend yield was. Also, most previous analysts ignored the sustainability of the dividend. In his book, Williams made the point that a company could be valued by calculating the present value of the future dividends (discounting those future dividends at the risk-free interest rate).

However, companies sometimes pay dividends that are unsustainable or that are below their true dividend-paying ability. Williams thus showed how to calculate the sustainable dividend payout. This is also known as owner earnings—it is a measure of the earnings after subtracting necessary reinvestment.

Williams also shows that this can be applied even to companies that do not pay a dividend. He made the point that a company increases in value once it has made money, and thus dividends are not necessary (the stock will increase in value proportional to how much would have been paid out in dividends). (As history has since shown, though, companies that do not pay dividends tend to do worse than those that do, simply because they may reinvest the money unwisely.) Williams thus laid the groundwork for what has later become discounted cash flow (DCF) models of valuation. For some types of companies, dividend discount models are still useful today.

Besides this, the last section of the book is a series of examples, ranging from Phoneix Insurance to GM and US Steel. Even if you only read this section, the book is worth the price. The problems facing investors 70 years ago remain today. We would be wise to learn from the past. By all means buy this book and read it.

Disclosure: This article was originally written two years ago and published elsewhere.

A short book review of much importance

I could have spent a few pages extolling the virtues of David Dreman and his book, Contrarian Investment Strategies: The Next Generation. Fortunately for you, I did not do that. Instead, I tell you simply to buy the book. It deserves a spot on your library shelf adjacent to Ben Graham’s Intelligent Investor. It is one of the most important investment books you will read. In the book, Dreman discusses at length the problems with estimating future earnings and psychological impediments to effective investing. He also lays out the key reasons why value investing works so well and he gives much data that support his arguments. Much of the data in my forthcoming article on regression to the mean is taken from this book.

Buy this book.

A day in the life of a short seller

What is it like to be a short seller? What is it like to be reviled? What is it like to be feared utterly? It is the most wonderful experience known to man. To give you a glimpse into my wonderful life as a short seller, I give you here a glimpse of what my days look like.

I wake up every morning at 5AM and run 10 miles. I get home and punch a punching bag until my fists are bloody. Each day I pretend it is someone different. Yesterday it was William Telander (of US Windfarming). Today it was Richard Altomare of Universal Express. Tomorrow it will be the despicable Judd Bagley.

My breakfast is the same every morning: oatmeal flavored with ox blood, followed by a banana. I then peruse my favorite blogs before the market opens. There’s Gary Weiss, Herb Greenberg, David Milstead, David Baines, Sam Antar (blah blah blah former CFO of Crazy Eddie’s and convicted felon; okay, we get it Sam, now shut up!), Tracy Coenen, the SEC litigation releases, and the Forbes Informer.

I usually spend my mid-morning tweaking my stock positions. I run a few quantitative screens to search for new stocks to target. I also search all SEC filings for certain phrases that indicate bad companies (such as “Our CEO is a convicted felon who is also a registered sex offender”). I do not stop for lunch. Rather, I grab a few Ks and Qs and a bottle of whiskey and settle down to find weaknesses in the companies I have targeted. Depending upon the companies I am short my midday reading may also include patent applications, scientific articles, and policy papers.

If my energy starts to flag during the day I rip off my shirt, stand in front of the mirror, and shout the following:
“I am a wolf among sheep!”
“I am a master among slaves!”
“I am a god among men!”
“I shall not only destroy my enemies, but I shall annihilate them, wipe them from existence. When I am done they will be gone, forgotten, they will cease to ever have been!”

To really get the blood boiling, I pump my fists and shout, “I am MICHAEL GOODE and I am a SHORT SELLER. I AM ALL POWERFUL! I CANNOT BE STOPPED!” After this motivational interlude I can face the market even if I am down seven digits on the day.

In the afternoon I always call up Patrick Byrne to harass him. I actually get through to him once in awhile. I once pretended I was his father and he believed me for 10 minutes into my diatribe against his conspiracy theories. Late afternoon there are usually more phone calls to many of the big short-selling hedge funds. So far I’ve got a better IRR than Jim Chanos and I like to shove that in his face. He is too much the gentleman to point out that he manages 10,000 times more money than I do. I then call up the Sith Lord, Patrick Byrne’s best friend. I had a bet with him about Overstock.com’s [[ostk]] inventory turns and it looks like he won that.

Sometimes I call up my journalist buddies. I have several journalists on the take, although I do not use their services too often. Anyway, when I focus on truly deplorable companies I have no need of any help. After I am done with phone calls I will usually look up the new financial research (shout out to my buddy Dr. Sloan! Booya!).

By the time I am done with all this it is usually 7pm and I stop for a quick bowl of rice and steamed vegetables. I then settle into my easy chair for another 4 hours of reading financials. And that is a day in the life of a short seller.

Disclosure: If you cannot guess what I should disclose about the above article then I cannot tell you.

Just One Thing

I just finished John Mauldin’s new book, Just One Thing. It took me only two days to read. I cannot enthusiastically recommend this book even thought there are some nuggets of wisdom in it. In the book, twelve investment writers each give their one best investment idea.

Some of the authors rambled and others (Bill Bonner, George Gilder, John Mauldin) did not have anything useful to say that you could not have already picked up from reading Mauldin’s email newsletter or other sources. For those who are not familiar with Dennis Gartman, James Montier, Gary Shilling, and Richard Russell, their chapters make good reading.

The two best chapters were Ed Easterling’s chapter on the capital asset pricing model (CAPM) and its faults and Rob Arnott’s chapter on non-market-weighted index investing. Easterling does a good job of explaining problems with how we look at risk. Arnott makes a good case for avoiding index investing in market-weighted indexes such as the S&P 500. In a market-weighted index, companies that are selling above their true value will be overweighted while companies that are selling below their true value will be under-weighted.

The solution is to invest equal amounts in all different companies. By investing equal amounts in the stocks in the S&P 500, you can average a return of 2% more per year over the market-cap weighted S&P 500. Of course, that is what investors in individual stocks should do. By putting the same amount of money into each stock, regardless of market-cap or price, investors lower their risk while increasing our returns.

Overall, Just One Thing is a decent book and a quick read. Consider buying it.

Disclosure: This review was originally written two years ago and published elsewhere.

Comcast to Shareholders: Screw You!

Comcast [[cmcsa]] has agreed to pay its founder a salary for a full five years after he has ________. The logical (and upsetting) conclusion of that sentence is “retired”. No public company or even private company with minority shareholders should ever pay an executive who is retired or otherwise not contributing. However, Comcast has decided to take callous disregard of shareholders to a whole new level by agreeing to pay its founder for five years after he has died. He will even be paid a bonus in that time. Ouch.

Disclosure: I have no position in CMCSA, nor am I a customer. I have a disclosure policy that shall never die!

Echostar’s $63 million dollar mistake

Oops. Echostar [[dish]] lost $63 million more over the last few years because they included the same income in multiple years. A new SEC reg requires companies to disclose financial errors that are not material but through repetition have become material in aggregate. Sadly, companies do not have to run this through the earnings statement and can take it straight to the balance sheet. Unsophisticated investors may never even notice. See the original article by David Milstead over at the Rocky Mountain News. I recommend subscribing to his column via RSS.

Disclosure: I have no position in DISH; I am a customer. I have a disclosure policy.

Penny Stock Touting Stays in the Family

I came across the following information when investigating my favorite penny stock, Continental Fuels (OTC BB: CFUL). Continental Fuels hired Crosscheck Capital 7 months ago to pump up its stock. It appears that Crosscheck Capital is associated with George Mahfouz Jr., who was previously fined $230,000 by the SEC back in 2000.

I should note that George Mahfouz Jr. is not listed as a member of Crosscheck Capital, but a trust with the name Mahfouz and a Paula Mahfouz are listed as members. Furthermore, there is a Paula Mahfouz who is a member of Crosscheck and who is related to George Mahfouz Jr. (probably his wife, although I am not sure). How do I know she is related? On a shareholder list of Pantheon Technologies back in 2000, the two are listed as shareholders and have the same address (search the 10sb12g form for ‘Paula Mahfouz’ to find this). Considering how few Mahfouz there are in Arizona (23 total according to phone records), and considering the base rate probability of <.001% of any one person being a penny stock promoter, I can conclude beyond a reasonable doubt (but not with certainty) that the Paula Mahfouz of Crosscheck is related to George Mahfouz Jr. and therefore that George Mahfouz Jr. is thus associated (if not directly involved with) Crosscheck Capital.

I should also mention that if Mr. Mahfouz has been actively involved with Crosscheck Capital from its inception in 2004, then he violated his agreement with the SEC that prohibited him from touting microcaps for five years after September 2000. If he has not been actively involved with the business then he has has not violated his agreement or any law. That being said, sending out fliers to hundreds of thousands of unsophisticated investors touting worthless companies and only disclosing a conflict of interest in the fine print is immoral, even though it is legal.

Disclosure: I hate stock pumpers, whether their activities are legal or illegal. I would also like to express my displeasure with the Arizona state agency that deals with businesses: they had no record of Mr. Mahfouz’s previous business, despite an SEC litigation release that stated it was an LLC formed in Arizona. I have no position in CFUL.