Eugene Fama Interview

Professor Eugene Fama from the University of Chicago is regarded as a financial leader, with some of the most cited research in Finance. In a recent interview, Fama discusses a wide range of financial topics, including the ability of portfolio managers to beat the stock market, the equity risk premium, CAPM, and a discussion of underfunded pensions, among other topics. As for the equity risk premium, Fama argues that because of an increase in PE ratios, the equity risk premium going forward is about 4 percent, significantly lower than the approximately 7.5 percent historic risk premium since 1926. In the discussion of underfunded pension liabilities, Fama argues that "The sponsor should be discounting the liabilities at the expected return implied by the risk of the liabilities, not the expected return of the assets." To show the link between different areas of Finance, consider that while the interview discusses capital markets, this statement is a fundamental tenant of capital budgeting, that is, the cost of capital depends on the use of funds, not the source of funds.  

Currency Risk

If your company has operations, sales, or production in different countries, hedging is a necessity. With the recent rise of the U.S. dollar, some companies have become complacent about hedging. While U.S. companies can benefit from a rise in the dollar, it is difficult to predict future exchange rate movements. Hedging should be an ongoing process, even if the company feels exchange rate moves might be favorable. As the article notes, the business of most companies is not to take currency risk, but rather buy or sell a product. Unfortunately, some CFOs try to use currency markets to generate additional revenue. And while this may sound appealing, as with any investment, it is very hard to beat the currency market.

Which EPS?

One problem with using financial ratios is that the calculation of these numbers is done differently by different people. You would think that EPS would be calculated the same all over, but in fact there are two common EPS numbers, the basic EPS and the diluted EPS. The basic EPS is calculated as we have done in the textbook, that is, net income divided by shares outstanding. The diluted EPS is the net income divided by the total potential shares outstanding. Many companies use stock options to motivate employees, especially upper management. If there are a large number of employee stock options issued by the company and not yet exercised by employees the number of shares outstanding could grow rather quickly if the options are exercised. The diluted EPS uses the number of shares as if all employee stock options were exercised. This gives a lower EPS, which is a more conservative estimate of the company's EPS.

Luck Or Skill?

The efficient markets hypothesis may be the most bitterly debated topics in Finance. Portfolio managers believe that the market is not semistrong form efficient, otherwise their contribution is negligible. However, many proponents argue that beating the market is nearly impossible. Michael Mauboussin, the chief investment strategist at Legg Mason Capital Management, argues that on the skill/luck continuum, stock picking requires just abount as much luck as roulette or slot machines. In part, he argues that the number of intelligent people in the investment industry means that the distinction between the best and the worst narrows. And, as people become more skillful, luck becomes a more important component of performance.

A Prospectus Is Meant To Be Read

One cause that some have given for the recent financial problems is that the underwriters and sellers of the securities misled investors. With the discussion of various financial regulations, and passage of others, the government agrees. While we have no stance on whether investors were misled in verbal communications, it appears that these claims may be overstated. For example, in the famous Abacus CDO prospectus, Goldman Sachs stated they "..shall not have a fiduciary relationship with any investor," and that the firm "may have conflicts of interest." Even more directly in another deal, Citigroup and Credit Suisse stated that the firms may have conflicts, but also that the firms’ “actions may be inconsistent with or adverse to the interests of the Noteholders.” As an investor, you must remember that just because the SEC approves a prospectus does not mean that the SEC feels the investment is a good idea, but rather that all relevant information is disclosed. It is up to the individual to research the investment and decide for themselves.

Apple Cannabilization

One key consideration in calculating the cash flows from a new project is side effects, including cannibalization, or erosion, of existing product sales. When Apple announced its new iPad Mini, one of the key considerations for Apple should have been the potential cannibalization of sales of the regular iPad. However, as the article points out, not all of the cannibalization is relevant. If Apple hadn't cannibalized some of its iPad sales, Amazon or Google would have taken these sales from Apple with their smaller tablets.

Using Time Value Of Money

Recently, GM decided to remove future pension liabilities from its balance sheet. To accomplish this, GM gave its salaried employees a choice: keep the pension payments as promised, although the pension payments would be made by Prudential, not GM, or take a lump sum payment now. So what information is necessary to make a decision such as this? The main components are the interest rate offered by the pension payments, the rate of return an employee could earn on the lump sum, and the difference in the risk between these two options, including the likelihood of default on the pension payments. While we doubt many GM employees made such a comprehensive analysis, 30 percent of the salaried employees took the lump sum option.