Tuesday, August 23, 2016

Negative Yield Triangular Arbitrage

A question we often get is if the material we discuss is actually relevant to the real world. However, we can see the application of triangular arbitrage with the seemingly strange desire of investors to purchase the $9 trillion in below zero interest sovereign debt. A Japanese 3-month government bill is currently returning about negative .24 percent. The buyer can borrow at the yen 3-month LIBOR, which is about negative .02 percent and receive the dollar LIBOR at .82 percent. The buyer then executes a yen-dollar swap, which results in a dollar-hedged yield on the trade of 1.24 percent. With the 3-month U.S. Treasury yield about .25 percent, and increase in annualized return of about one percent is a huge increase for portfolio managers.

High Yield Bond Defaults Expected To Rise

Standard & Poor's Ratings Services expects default rates on high yield bonds to increase to 5.6 percent over the next 12 months, which implies that 99 issuers will default. The increase is due in large part to the decline in oil prices, although a delay in an interest rate increase by the Federal Reserve could offset the increase risk. However, in large part due to the low and negative interest rate environment, investors are pouring money into high yield investments resulting in a decline in the yield spread of high yield bonds dropping from 815 basis points in February to 560 basis points in July.

Monday, July 25, 2016

Indexes Win Again

One method that has been used to examine if the stock market is semistrong form efficient is the performance of actively managed mutual funds. A recent study by S&P indicates that most actively managed mutual funds still lag the appropriate market index. From 2011 to 2015, over 88 percent of mutual funds failed to beat the S&P Composite 1500. And 84 percent of large cap funds failed to outperform the S&P 500. In fact, over the past five years, the fund category with the best performance for retail investors relative to its index was the mid-cap value category, with only about 30 percent of mutual funds in that category outperforming the S&P Midcap Value 400. Small cap growth funds were the worst, with only about 8 percent of funds beating the S&P SmallCap 600 Growth index. So, even if you don't believe the stock market is efficient, as this shows, it is very difficult to outperform the stock market.

Monday, July 18, 2016

2016 Working Capital Survey

CFO just published the 2016 working capital survey by REL Consulting. The 1,000 large U.S. companies included in the survey had about $1 trillion in excess working capital based on companies in the survey matching the top quartile performers. Overall, the cash conversion cycle increased by 2.5 days, although much of this was driven by the oil & gas sector. If this sector was excluded, the cash conversion cycle actually fell by .1 day.

The best performer in the cash conversion cycle was Murphy Oil a negative 463 days due to a payables period of 600 days! Some of the other top performers in the cash conversion cycle were Noble Energy (negative 295 days), ITC (negative 282 days), Anadarko Petroleum (negative 245 days), and Apple (negative 66 days). On the other end of the performance scale, some of the longest cash conversion cycles were at United Therapeutics (794 days), Zoetis (344 days),  Eli Lilly (277 days), and KLA-Tencor (246 days).

What Is Dell Really Worth?

While students often expect that stock price valuation should result in an exact price that everyone agrees with, this almost never happens in practice. Take the court case involving Dell's management buyout (MBO). When the MBO went through in 2103, the price calculated by management experts, through a year-long process, was $13.78 per share. However, a group of dissident shareholders had independent experts value Dell at $28.61 per share, a difference of $28 billion. In the valuation, both parties used the same components: the forecast cash flows for a specific period, the value of the cash flows beyond that period, and the discount rate (WACC). However, the experts differed on the company's capital structure, as well as the cost on equity. In the end, the court used its own assumptions and arrived at a share price of $17.62 per share. As you can see from Dell, experts can use the same technique and arrive at widely differing answers when valuing a company.

Sunday, July 17, 2016

Dow 150,000!

With the DJIA at about 18,500, it may be hard to imagine the DJIA hitting 150,000, yet there is a good chance the Dow hitting or exceeding that mark in your lifetime. Even though the number may seem impossible, such is the power of compounding. As this article points out, for the Dow to hit 150,000 by 2046, the annualized return only needs to be about 7.25 percent. One important note on the Dow is that it is a price index, not a total return index, so it excludes dividends. Unfortunately, many people, including business writers, have little idea of the effect of compounding. In 1995, when mutual fund pioneer Bill Berger predicted that the Dow would hit 116,200 by 2040, the business writer audience laughed. However, based on the level of the Dow when he made the prediction, such a move only required an annual return of about 7.5 percent. While we hope you take many things from this textbook, time value of money and compounding is perhaps the most important. 

Thursday, July 7, 2016

A Critical Examination Of Earnings

A recent article made us think about the importance of definitions. The article states: "After all, in the long-run stocks are fundamentally driven by earnings and expectations for earnings growth." While we agree in part with this statement, we bet most people reading the article automatically think of earnings as net income and EPS. In reality, "earnings" is often used loosely to relate more to cash flow, which is a more important driver of stock price than accounting earnings. Remember, accounting numbers can be distorted much more easily than cash flow. There is another factor that is equally, if not more important, that is the required return. In increase in the required return on the market or a stock can often have a large impact on stock prices.