Positive Normative

Looking at economics without rose colored glasses

The Reduction of Float

This is a post that I would normally not write, but given the dynamics of how one publicly traded company has such a strong influence, not only on consumers, but the press and especially market indexes, I could not resist. Apple (sym: AAPL) has announced a dividend and stock repurchase for the next three years. What is of most interest is the reduction of float, a nomenclature for repurchasing shares.

What is the significance? By reducing the float (shares available for public trading) the earnings per share increases even if profits remain the same. This provides a good benefit for stock holders. Also, we can with reasonable confidence believe that Apple’s stock is perceived as undervalued by Apple’s management and board members.

Float reduction is a great price manipulation tool. The strategy benefits non-selling shareholders and extracts value from shareholders who sell. If management is accurate in their analysis that the stock is undervalued and they purchase some of the float, they can sell the shares back by reissuing the shares at a higher price, thus making a nice return. The repurchase initiative should provide a better risk return than holding cash. The overall goal will entice institutional investors to become buyers and holders of Apple stock. This will greatly benefit Apple stock holders. Historically, repurchases have allowed stocks to outperform the market by 12-14% for the next 3-4 years.

Given past earnings calls with analysts, Apple’s management have repeatedly expressed strong optimism for their products and markets. This most surely indicated a town crier-like plea for undervaluation. If we look closely at Apple’s financials, the evidence points to a mandatory repurchase due to rapid rising corporate profits. Therefore, the only choice was to buy back shares.

Why dividends? My best guess, according to agency theory, is that Apple needs to issue dividends when cash is relatively large in relation to their valuation. In order to reduce risk in value-reducing investments, (investments in assets that have a higher probability for losing value) management would need to issue dividends. Also, when a company is able to self fund internal projects, the potential to reduce stockholder wealth is greatly increased. By issuing dividends with some excessive cash, companies can reduce risk of poor investments in internal self funded projects.

In summary, Apple has taken the helm in risk management and is looking towards a sustainable business model based on an extremely strong balance sheet. It is very rare for a technology company to exercise prudence. Most companies binge on purchasing performing and nonperforming assets to simulate organic expansion (Google and Cisco). Apple is displaying conservative and long lasting financial responsibilities and should do quite well for it’s stockholders.

Conjurer

One who performs conjurations is called a conjurer or conjuror. The word (as conjuration or conjurison) was formerly used in its Latin meaning of “conspiracy”.

The following is a fictitious movie script.

INT. STOCKBROKER CONFERENCE ROOM (slug line)

Kim Wales, Managing Director of Retail calls in her team to pitch newly allocated shares of a hot tech IPO (Initial Public Offering).  She gives each broker shares for their client list. The team is divided into High Net Worth clients that belong to Kim and two high producing brokers, next is the mid-tier that are serviced by a team of four brokers, and lastly the low level accounts that are under 7 figures in net worth along with potential screened prospects that are managed by the associates and interns.

KIM WALES (actor: managing director)

Here’s the new IPO and client sheet. I want the high ten group (clients with over $10 million in account) to get 1000 shares each. Give the unders (clients worth less than $10 million and more than $1 million) 100 to 200 shares each.

DAN DOOTLE (actor: associate broker)

What do we offer the zombies (clients worth less than $1 million and prospects)?

KIM WALES (actor: managing director)

They get nothing, but promise them shares with the disclaimer that we are already allocated. But, make sure to sell the hope of getting shares. Of course we won’t deliver, but we’ll pitch them a new stock on the dead sheet as a hot idea and the next IPO we’ll be able to deliver.

INT. BROKER DESK (slug line)

Dan Dootle makes his calls from the zombie list. His first zombie is Mike Golong. Mike is a new client with an account balance of $150,000.

DAN DOOTLE (actor: associate broker)

Hi Mike, I am calling to tell you that your portfolio is coming up for the quarterly review and I would like to discuss some issues that are urgent. Shall we get started?

MIKE GOLONG (actor: naive client)

Sure. What’s up?

DAN DOOTLE (actor: associate broker)

Before we begin, are you aware of the hot ABC Tech, Inc. IPO and the shares that we have been issued for distribution? We have the unique opportunity to be one of the exclusive dealers.

MIKE GOLONG (actor: naive client)

Yeah, I’ve been reading all about it on the tech blogs. It’s crazy stuff. Can I get some?

DAN DOOTLE (actor: associate broker)

Well, we do have some shares and it gets distributed to high net worths first, then the remaining inventory gets distributed out to my important clients such as yourself.

MIKE GOLONG (actor: naive client)

How much are we talking?

DAN DOOTLE (actor: associate broker)

I’d say a few hundred shares to start. The inventory is small (create urgency: FUD). Shall we book it, Mike?

MIKE GO LONG (actor: naive client)

Yep, and thanks for keeping me in the loop.

INT. DAN DOOTLE’S DESK (slug line)

Dan makes another call from the zombie list. He calls Angie Onfence, a prospect with about $25,000 to invest.

DAN DOOTLE (actor: associate broker)

Hi Angie, it’s Dan with Waddle Investments. I just received limited shares of ABC Tech, the hottest and most anticipated IPO for 2012 and I know that you follow tech and I thought this opportunity to get in on the ground floor would be great for you.

ANGIE ONFENCE (actor: stooge)

Can I get some shares?

DAN DOOTLE (actor: associate broker)

Well, Angie, if you can open the account and wire the $25,000 I can put a reservation on the shares for you….

INT. REALITY (slug line)

Dan Dootle, has no intention or even any shares to fulfill for any of his clients or prospects. His role is to use the IPO bait as a way to turn over some dead deals or build his book with fresh money from new clients to earn his share of the next bonus pool. Thus, you the average investor will never receive IPO deals and will have to buy at market to pad the wallets of those that are included and allocated shares prior to the market offering.

Your best bet is don’t worry about IPO’s and focus on low holding cost investments. Each 1% difference in yield equates to nearly a 55% difference in portfolio value over the course of a persons probable investment lifespan.

Your economic roadmap to a Roman style fall.

“…Rome has always favored the doctrine which most completely subjugated the human mind and annihilated reason”, François-Marie Arouet.

Arguably, the slow decline of Rome started September 4, 476, under Romulus Augustus. The Romans thought to protect their valuations and wealth they needed to debase their currency, raise property taxes, and sell confiscated properties. These were Normative practices to maintain the Romans’ prosperity.

Normative economics is best described as decisions on value judgement based on economic fairness or specifically what the economy ought to be like. The Romans practiced economic policies to create a fair value system for the elite class. By implementing “what ought to be” policies for the elite, Rome was set to fail, or more appropriately transform to irrelevance.

A common Normative economic practice would entail increasing prices to raise a standard of living. For example, a fictitious farmer named Joe needs to earn a higher living standard. He will need to sell his corn for 1000.00 cents per bushel instead of 670.00 cents per bushel in the open market. This value statement makes the judgement that in all fairness to farmer Joe, his only means to raise his living standards is to raise prices.

Investors use similar Normative judgement to place value on companies using metrics such as PE, and PEG, and other fundamental analytics. However, a distinction in economics called Positive economics, which is focused on the facts and behavioral relationships thwarts the attempts of Normative practices. Positive economics is concerned with “what is”, and is a thought process that avoids value judgement.

Under the guise of Normative economics, investors have had their returns ravished by the markets. Interestingly enough, 0.6% of all money managers are effective in stock picking using fundamental analysis. This presents the question, is it luck or are the models incorrect? Normative would like to claim inferior modeling, however Positive economics will attest to luck.

Much like the Romans, money managers find Normative economics appealing by using PE, PEG, and other fundamental analytic tools to make judgement for fair valuation. The PE is especially appealing for it’s intuitiveness of how price relating to earnings equates to a simple statistics. It allows analysts to avoid being explicit about their assumptions on risk, growth and payout ratios.

Some managers compare PE ratios to the expected growth rate to identify under and overvalued stock. This is just another form of Normative economics and fails to appreciate the quality of earnings, along with using historical earnings that are not correctly adjusted to correlate to future earnings. Similar to the Romans and their economic policies, our investment models and decision process to seek some fair “valuation” is really a process to irrelevance.

“As a bull market continues, almost anything you buy goes up. It makes you feel that investing in stocks is a very easy and safe and that you’re a financial genius.”, Ron Chernow, an American biographer and winner of the Pulitzer prize and National Book Award.

Lions, and tigers, and bears! Oh, my!

“Toto, I’ve a feeling we’re not in Kansas anymore. We must be over the rainbow!” – Dorothy

Dorothy and her new friends set off on the yellow brick road to seek the sage Wizard of Oz. Hopefully, to give Scarecrow a brain, the Lion courage, the Tin-Man a heart, and Dorothy a way home. The irony to the story is the wizard himself was in need of much help and had been serendipitously put in his position by the citizens of Emerald City. The great Wizard of Oz could not even help himself or the four companions who sought his advice.

Much like the four friends in the movie “Wizard of Oz,” the market professionals sought answers to the markets from Dr. Harry Markowitz, Nobel Laureate for his work in Modern Portfolio Theory and the Efficient Frontier. While Modern Portfolio Theory has become institutionalized with many brokerage firms, Dr. Markowitz, himself, after failing in the markets with his own theorem, invests with 50% in equity index and the other 50% in government bonds. All the while, the industry sells analytics and products based on those analytics that Dr. Harry Markowitz researched and developed, and they consistently underperform the markets.

What can we do? Dr. Daniel Kahneman, Nobel Laureate in behavioral economics, offers some lessons:

Distrust data. Rather than leaping to conclusions based on scant data, look at as many numbers as possible. Don’t rely just on recent performance; look at several time periods. “It doesn’t take many observations to think you’ve spotted a trend,” warns Kahneman, “and it’s probably not a trend at all.”

Anchors aweigh. When pundits like Goldman Sachs’ Abby Joseph Cohen predict where the Dow is heading, or when analysts like Morgan Stanley’s Mary Meeker forecast Amazon.com’s stock price, the market often moves magnetically in their direction. But don’t anchor your expectations to the tea leaves of the so-called experts. At best, they’re making educated guesses; at worst, they’re manipulating you to make money for their own companies.

Use mad money. If you can’t resist the temptation to trade stocks, put the bulk of your portfolio in a broad stock-index fund; then take a little (10% tops) to “play the market” yourself. This way, you keep your hunches on the fringe, where they belong. “It’s like going to the casino with only $200,” says Kahneman. “It helps protect you from regret.”
Fly on autopilot. Irrational mood swings lead people to trade too much as they veer erratically between glee and dismay. “All of us,” says Kahneman, “would be better investors if we just made fewer decisions.”

Look within. Most financial advice, especially on TV and the Internet, suggests that investing is an endless race to beat the market. Every day brings a breathless stream of bulletins about who’s ahead or behind. If anyone else wins, it seems, you lose. But Kahneman’s insights teach us something very different and vastly more profound: Investing isn’t about beating others at their game. It’s about controlling yourself at your own game. I’m not a penny poorer if someone in Dubuque beats the S&P 500 and I don’t.

Another helpful item is a book authored by Gerald Loeb, “The Battle for Investment Survival.”

“The real fortunes in the marketplace have been made by concentration, not diversification!”
– Gerald Loeb

“Why, if I had a brain I could…
I could wile away the hours,
Conferrin’ with the flowers,
Consultin’ with the rain.
And my head I’d be scratchin’
While my thoughts were busy hatchin’
If I only had a brain.” – Scarecrow

Pavlov’s canine subject salivates at the sight of a lab assistant.

“While you are experimenting, do not remain content with the surface of things.” – Ivan Pavlov

Ivan Petrovich Pavlov was a famous mathematician who contributed many ideas to physiology and neurological science. He is probably most famous for his work in “conditional reflex.” The well known research and phrase “Pavlov’s dog,” is often used to describe someone who merely reacts to a situation rather than use critical thinking skills.

Like Pavlov’s dog, we have been trained to evaluate undervalued and overvalued assets based on financial ratios, and the mere sight of values triggers a response to defend in some irrational manner why the particular investment is superior or inferior. If less than 0.6% of professional money managers can effectively and sustainably pick assets to outperform the market based on fundamental analysis, why do we still rely on such analysis?

Dr. Daniel Kahneman, Nobel Laureate for studies on behavioral economics, points to our conditioning to use quick value judgement techniques. His two books, “Thinking, Fast and Slow” and “Heuristics and Biases” evaluate how humans make decisions. Just like Pavlov’s dog seeking immediate gratification no matter the consequence through conditioning, Dr. Kahneman’s work also states we are basically creatures of quick judgement and according to Prospect Theory, if given two choices, one expressed in terms of potential gain and the other in possible losses, we’ll more likely choose the former.

For example if provided by an solicitor a historical measure that investment ‘A’ returned 8% for the last 5 years and told by another solicitor the same investment has seen above average returns in the last 10 years but has been declining in recent years, we will tend to sway with the first solicitor’s prospects. Obviously the investment has changed, but we evaluate on the surface what is appealing and take the historical facts as truth for future performance.

Another example of testing conditioned behavior is a popular analytic question to test for failure is, if given the parameter of 2, 4, and 6, what is the “best” logical conclusion for failure? Since we have been conditioned to look at patterns and not behavior, many people answer by giving a series of odd numbers in ascending order. When, the “best” conclusion of failure is any descending order of value, since the behavior of the given parameter 2, 4, and 6 are in ascending order. We have been conditioned like dogs salivating for the analysts report and fail to use objectivity to dispute or question the analyst.

“Don’t become a mere recorder of facts, but try to penetrate the mystery of their origin.” – Ivan Pavlov

Here Come the Tax Man

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B.S. in Now What? 2012

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