"In Theory" Pt. 2: Rationality

"...Theories are developed under perfect circumstances in the lab or classroom, and they're often challenged when those perfect circumstances don't hold. But the point is that one shouldn't just toss the theory out the window and ignore it; it just needs to be managed and adjusted." -Rick Bodio

Rick has done an excellent job summarizing my previous post: "In Theory" Pt. 1 and providing an excellent segue to this discussion. In the series opener, we discussed some of the problems with using academic models in real-world settings without questioning the assumptions that underly those models. To recap, models are excellent teaching tools and allow us to instantiate an ideal world in order to discuss how markets should work. Our charge as practitioners in any field -business, politics, or the sciences- is to take these theories with a grain of salt and apply them to the difficult, complex interactions that take place in reality.

In this post, I'd like to turn our attention to a first key assumption that is a pillar of economic and financial theory. This assumption have been well documented in numerous academic journals and dissertations, but I thought it well worth a recap that doesn't require footnotes, symbols, or polysyllabic constructs. MBA students are notoriously bad with numbers and words.

The first, most laughable assumption is that of the famed "Rational Actor." Like the Loch Ness Monster, the Abominable Snowman and a Cubs bid for the World Series, the Rational Actor has never been seen despite being an annual topic of discussion. Textbooks describe this incarnation of Homo Sapiens Sapiens as essentially self-interested, risk averse, and capable of conducting a cost-benefit analysis using all relevant information. This mythical creature makes calculated bets, never takes on catastrophic risk, and conducts his or her affairs with a realpolitik that would make Kissinger blush. The rational actor is the perfect, unemotional computer operating inside a human's body. And it doesn't exist.

Now, don't get me wrong; intelligent (and otherwise) human beings try their best to act rationally given their education, personality, and individual circumstances. But to believe that a marketplace based on human interactions will always operate smoothly because people make "smart decisions" is delusional. Work in psychology and behavioral economics have repeatedly shown astounding instances of humans making irrational decisions through heated emotions or simple breakdowns in logic. Humans are capable of denying themselves monetary or other gains in order to spite adversaries with greater losses, or to punish a class of people based on perceived injustices. Every boom and bust cycle -think Alan Greenspan's "irrational exuberance"- hinges on market participants sweeping stable markets past their equilibrium points into untenable extremes.

Technical traders use the concepts of support and resistance levels to mark the points where markets should "auto-correct" prices that have crept too low or too high, respectively. But a key part of technical analysis is that once these constraints are broken, market actors will start behaving differently in anticipation that underlying assumptions have changed. In a self-fulfilling prophecy, a cadre of traders anticipate further movements past the breaking points and hope to profit by being the first in and first out of these swings. Group psychology is an inherent component of market trading (and some would say long-term investing) and is difficult to reconcile with the emotionless "rational actor."

But can it be reconciled? Supporters of the rational actor theory might claim that these traders are making the best decisions given current conditions. Once a technical marker has been broken, conditions have changed and merit a change in tactics. The fact that everyone has panicked and run for the Exits like lemmings, thus causing a market collapse, is no reason to try to turn the tide by martyring one's portfolio and not cashing out. Indeed, the markets can stay irrational longer than I can stay solvent. In the study of systems and behavior, emergent behavior is an important consideration for group cohesion and disarray.

In a similar vein, firms that make seemingly irrational choices by forgoing a profit opportunity to spite a "rogue" counter-party actor may be trying to reinforce a set of established norms in order to preserve stability. Game theory and its implications for cartel behavior suggest that sometimes short-term considerations must be foregone for long-term stability.

But what does all of this mean for a discussion that supposedly lambasts the theory of rational actors? It means that we still need to question the market conditions in which we operate, even if we believe that our fellow players should act in accordance with our world view. After all, given the same set of information, why is a transaction taking place if we -as a market- both agree that a stock is worth $50?

When investing in finance, making capital purchases, funding a marketing campaign or running a government office, we should always remember that the customers and constituents we serve may not share our faith in rationality, or their reality may not seem rational to us. Organizations of any size and individuals of any kind may be blind-sided in their attempts to act rationally in an irrational world. In theory, we did the best we could. In practice, we should have known better.

-Brian Rozental is a 2nd Year MBA student at the University of Connecticut and a Vice President of the MBA Finance Club.

Is Conoco preparing for a big acquisition in the next two years?

This morning I caught a WSJ article about ConocoPhillips cutting capital spending and selling a huge amount of assets ($10B). This comes on the heels of yesterday's announcement that ExxonMobil, Conoco's main rival, closed on a reasonably large acquisition (~$4b) in a Ghanian oil field. 

It appears as though Exxon and Conoco are moving in different directions. Why is that? 

Well, I think the story cuts a little deeper. And to explain why, I'll rehash a little bit of the news story, then give a little context in the energy sector, and then give my spin on what I get from this article. 

According to today's article, Conoco is drawing down it's 2010 capital expediture budget and raising cash by selling assets. This is after the company previously decided  in 2009 to lay off employees and cut 2009 capital expenditure budget. Proceeds from the sale of assets is set to go to lowering debt obligations. 

That's the bad news. The good news, for Conoco shareholders at least, is that they plan on raising the dividend 6.4% 

Exxon has cut a bit of a different path over the last 18 months. While Conoco has been cutting costs, Exxon has been spending. According to a WSJ article in March 2009, Exxon raised its capital spending 11%, even as oil prices plummeted to below $45 and margins were squeezed. 

The entire energy sector runs on capital spending by upstream exploration and production companies, like Exxon and Conoco. All drilling, services, transportation, storage, refiners and marketers that operate in the oil and gas space depend on upstream exploration and production companies continuing their development, exploration and production operations. When the upstream shuts down, everything down the value chain suffers. 

Capital spending is extraordinarily important for these upstream entities because global reserves of oil and natural gas a.) is no cheap thing, and b.) are very limited. It's not easy to find new production. State owned entities (Saudi Arabia, Iran, Russia) control much of the world's viable oil producing geography. That which is not claimed is not easy to get to. So cutting capital spending and reducing assets will usually mean that the company will not be able to match previous production capacity for quite a while. 

But what I really think is happening here is: Conoco is circling a potential acquisition in mid-2010.  I think they're cutting debt to create space for acquisition debt. I think they're shedding assets to free up some liquidity to deploy later. And I think they're raising their dividend to juice their stock price a little bit. All of these present acquisition opportunities (increased debt and cash for a traditional acquisition, increase value of shares to make a stock-for-stock transaction easier). Conoco knows that Exxon is running away from them, and they need to increase production. They can't keep up as cash strapped as they are. So they'll shed some weight now - including some assets that come from their refineries, an industry which is strangled by a huge overcapacity. So that's not a loss.  

The WSJ article about Conoco can be found here: http://online.wsj.com/article/SB10001424052748703298004574459160822113116.html?mod=WSJ_hps_LEFTWhatsNews

"In Theory" Pt. 1

"In theory..." -the two favorite words of any professor, and the bane of any investment professional attempting to justify their analysis or decision. The two words, "in theory", represent so many assumptions and suspensions of reality that we seldom stop to think about how they impact our decision making process in the real world. Although modern finance owes a great deal to past theoreticians like Modigliani and Miller, Fischer, or even Black and Scholes, these theories have been the downfall of countless practitioners who have forgotten to question the whether the assumptions that underly these theories are correct.

Like a size-o model walking down the runway and representing an "ideal", academic models rarely reflect the messier and, lets face it, uglier version of life that we call reality. In this column, we'll explore the key distinctions between the much-vaunted products of the ivory towers with the day-to-day operations of a modern investment analyst, fund manager, or central banker.

Despite cautions against taking academic models for granted, we frequently see financial players throw up their hands in disbelief -even abject horror- that they had been led astray by their finance textbooks. When financial models are based on "two standard deviations" and "a 95% chance nothing will go wrong", we should not be surprised that a financial crisis seems to recur every 20th year (Hey, the other 95% of the time we were coining money...before we went broke). Models can be made for any assumption: equilibrium, perfect competition, perfect information, arms-length transactions, rational actors. Ask any finance professional worth their salt if their equilibrium model ever helped them make a successful decision.

Should we despair then, and simply throw darts at a board to pick stocks or forecast growth and interest rates? Certainly not. But as responsible managers, we are obliged to perform due diligence that stretches beyond the balance sheets and balance of payments. We are obliged to always question our own assumptions, not with cynicism but with healthy skepticism. And we are obliged to dust off our textbooks and ask the crucial questions: "What happens if my assumptions are incorrect? What does this mean for my decisions?"

With these initial questions in mind about our fiduciary responsibilities, we'll return on our next post to compare some popular academic theories to past successes and failures. With credit to Lane Barrow: In theory, there is no difference between theory and practice. In practice, there is.

Brian Rozental is a 2nd Year MBA student at the University of Connecticut and a Vice President of the MBA Finance Club.

Collar Option Strategy

Charlie Murrin sent me the below presentation regarding collar option strategies.

http://www.optioneducation.net/select/downloads_direct/qqqDirect/CISDM_QQQActive_Brochure.pdf

I did a little analysis to describe how a collar option strategy works, when they are used and some upside and downside scenario's. I hope everybody enjoys and learns something from my analysis.

Collar writing is pretty interesting strategy. Originally the concept was made to meet the needs of corporate officer’s at publicly traded companies. When they received their stock options a covered collar would allow them the hedge any major losses in the value of the stock. In essence buying a put and selling a call are the same thing except when buying a put you obviously buy a strike below the current price (how far? According to this article that depends on a passive or active collar). When writing a call, the call writer is taking the position that one believes the stock may appreciate but not past the strike price they write the call for. This is dangerous when you see a month like September with mass appreciation in stocks, a large portion of your gains on the underlying are offset by the losses on the options you wrote, you have given yourself a semi- neutral position.

A real problem occurs when the following scenario occurs- As a CEO you got your GE Stock at $30/ share. When it was trading at $13.50 in August you wrote covered calls on your shares with a strike of $15 expiration in September and pocketed a nice $83 in premium (quoted as $.83 per 100 shares). When expiration of this September option comes GE is trading at $17.00 well you can let your stock get called away which in essence is taking a capital loss $15.67/ share or buy back your option for $200 (200-83) taking a loss of $117 on the covered call position.

If this were in a collar let’s say you bought the January $12.50 Put for $20 (quoted as $.20) simultaneously selling the September $15 Call, at the time of the expiration of your covered call the option you bought would be worth roughly $4 (which is just time value that’s left no intrinsic). So writing this covered collar on the company you work for and believe will recover and succeed has cost you $117 + $16 = $133 on stock worth $1,700. Where just holding the stock with no options your position would have appreciated by $350 dollars compared to a net appreciation of $217 (350-117 or losing 33% of your stock appreciation) , since you own at $30 you wouldn’t have sold it anyway.

If the stock had dropped to $10 ( we will assume you are in for the long haul with GE) you would have made $230 ($250- $20 paid for the put) + $83 (premium for selling the call) = $313 on this position, these are all rough numbers but hopefully you can see the upside/ downside of the collar’s. Essentially taking a short within a long position or if you don’t actually hold the stock you have constructed a nice short position because you offset the purchase of the puts with the premium from the calls you wrote. I don’t think the results would have been as flattering UMASS had used WMT as the underlying stock. Also keep in mind that this type of strategy has to be managed more frequently than a value investors portfolio and we know time = money.

As a side note, from working in this business over the summer ETF index securities (E.g. QQQQ, SPY) are a different game and the options are traded in mass amounts uncovered (naked).

Can Asian spending close the gap? II

Front page of WSJ yesterday asks this question in an article about Chinese companies trying to tap into domestic demand. There are some interesting graphs here. Chinese consumption growth has outdone any other area of the world since 1992. Of course it is easy to double (or triple in this case) a value when it starts out so small. Clearly this growth is still in it's nascent stages, and the dissipation of Chinese stimulus spending is aiding the continuation of spending. Olivier Blanchard, Economic Counsellor and Director of the IMF’s Research Department, chimes in on this subject reiterating that spending in other parts of the world are needed to get the recovery going. "Two rebalancing acts will have to come into play. First, rebalancing from public to private spending. Second, rebalancing aggregate demand across countries, with a shift from domestic to foreign demand in the United States and a reverse shift from foreign to domestic demand in the rest of the world, particularly in Asia.". Certainly the recent slide in the Yen will make imports much more attractive. This may be an intentional strategy to reduce Japan's dependence on exports. China will be paying attention.

Ramblings on airlines and capital goods producers

What is going on with aircraft leases? Two months in a row have seen significant declines in lease rates. The main issue here is that airlines are taking production – aircraft and thus passenger miles – out of supply. What is driving that – the main drivers – we found in a project for GE Aviation – were fuel costs, GDP, and consumer spending. We did use more economic drivers but through factor and cluster analysis boiled it down to these major components. Easier to tell the story. The thing that interests me is we never put into play aircraft cost, because it has been relatively stable though increasing for many years. If aircraft costs reduce, do airlines start to become more profitable again, since they have been so aggressive cutting capacity? Also, I am starting to think about how this affects Boeing – do we have an aircraft bubble that is now starting to burst? Most airlines lease their planes – it’s just so expensive to own. And anything they do own is heavily leveraged. When leasing there are all those capital structure/expense advantages. Thus most airlines are expensing an enormous capital good that is critical to their operation. I know this is done in other industries, but it makes me wonder if there isn’t something more systemic in capital goods producers having over-leveraged their pricing power to maintain profitability through all the leasing and corporate financing a la GE. AMR was going to try to own it’s planes, but it needs cash so badly that it recently sold some new ones that were coming online to GE Aviation for a lease back. No one can afford these things, and the used ones are starting to pour into the market via leases and the prices are coming down. Maybe the party mansion should get one...

Can Asian spending close the gap?

Here is an interesting piece on LVMH - the monster luxury goods conglomerate. While the Economist initially starts out with a love fest for Monsieur Arnault's concern, they also point out some weaknesses in the business model and get to a nifty bit of data. 45% of the revenue for the fashion an leather goods comes from Asia. That's roughly €1.35B in revenue (H1 2009) and in the one part of the world that seems to be doing okay right now. The question for me is not whether one should discount LVMH's sales potential due to a generational shift in preferences in part of that business. Rather does this part of the world, which has been saving voraciously, have the muscle to get us over the confidence hump in the consumer discretionary segment? In an earlier article there is some convincing evidence that this may be the case.

Here is where I turn pessimistic. From the second article they point out that Chinese consumer spending has dropped from 46% of GDP to 35% of GDP in the last year. Imagine what would happen if that kind of fall off occurred in the US. Assuming no growth in other sectors GDP would fall 25%. For China the same conditions would cause a 17% dip in GDP. I believe other segments of the Chinese economy can make up part but not all of the loss. I don't believe that of the US. Which leads to two questions. Is China really doing as well as their official GDP statistics? Many people suspect they are manipulated - I don't see how they can't with that level of slowing in activity. Second, is the US consumer really in that much pain considering the decline we have experienced? Is it just a slight slackening where people are buying a Honda Civic instead of a Hummer? Still buying but buying for quality and price. The consumer has not slipped that much as a proportion of GDP.

It seems that ever since the industrial revolution visions of selling chopsticks and other products to the perceived potential of the Chinese consumer market have been as successful as military control in Afghanistan. There is some hope, but I think this area will only provide the spending boost by comparison to a lack of spending from their North American counterparts who have some massive de-leveraging to complete and are toning down their purchases.

How Do You Make Money Investing in a Consumer-less Economy?

Recently, we at the SMF have been spending the majority of our time determining how to allocate capital amongst the ten sectors we have used as a proxy to divvy up the markets. Like any other fund, we're taking extra precautions in which sectors are over-weighted or under-weighted. 


One of the more interesting discussions, I think, has revolved around consumer discretionary. We don't need to spend a lot of time discussing what has happened to the consumer over the last eighteen months, but it's worth discussing where the consumer is going. Interesting data was released this past week that, on the top line, indicated the consumer was back. Retail sales from August showed better than expected gains of 2.7%, which was the biggest jump in three years (Is that really much of a contest, anyways?). Of course, last month was spurred by the cash for clunkers deal, which drove the retail numbers. However, after netting out the auto sales numbers, retail still gained 1.1%, well ahead of the 0.4% expected number. So, net-net, it still appears that consumers stumbled back into retail stores and bought stuff.


Predictably, stocks gained on the day (Sept. 15, 2009) and made a new high on the year. Optimism returned to the markets for the first time in quite a while (it helps when Warren Buffett publicly proclaims that he's optimistic as well). But is it rational?


What's not really focused on in the news is the rise in the PPI, indicating possibility of future inflation. Moreover, I just don't trust the consumer number. Sure, buyers found the markets again in August, but was that a sustainable development? Or is it that when people get deals, they like to buy other stuff? So were people buying cars and thinking, well, what's another couple hundred bucks at this point? It's at the very least possible. 


Jim Breyer seems to agree, as well as the majority of attendees at this week's Private Equity Analyst conference in New York. Breyer, who sits on the board of Wal-Mart, also expressed doubt  about the strength of the consumer. In a Wall Street Journal blog posting, Breyer is quoted as saying that shoppers are still hesitant to part with cash for non-essential items. 


Another development to watch is the upcoming resetting of Option ARM's around the country. According to mybudget360.com, there is currently $189 billion in option ARM's outstanding; 70% of those will be resetting in the next 12 months. It goes without saying that this isn't going to help the wallet. 


Shopping season is right around the corner. We at the SMF will continue to eye the discretionary sector cautiously as consumer sentiment is extremely hard to predict at the moment. 


The Wall Street Journal blog post can be found here:


http://blogs.wsj.com/venturecapital/2009/09/18/jim-breyer-and-tim-draper-at-odds-on-vc-outlook/


Option ARM data can be found here:


http://www.mybudget360.com/option-arm-disaster-arrival-mortgages-more-problematic-than-originally-thought-134-billion-recasting-in-next-two-years-94-percent-made-only-minimum-payment-only-35000-of-the-1-million-option/