Read Carefully, Think Critically

The Economist recently published an article debunking the already well-debunked myth that U.S. Treasury bonds are risk-free (see Problem 22 in Chapter 10). While we expect that many people are not aware that Treasury bonds have inflation, or purchasing power risk, we hope that by now you do. It is well-known that there is no true risk-free asset, but Treasuries are used as a proxy for the risk-free rate. What is really disappointing is the time value of money skills displayed by the author. The article notes that the real return in Treasury bonds was a loss of about 2 percent per year, for a cumulative purchasing power loss of 91 percent for the period 1946-1981. And of course, this got us fact checking. Based on the returns reported by Ibbotson, an investor in long-term Treasury bonds would have earned a nominal return of 2.35 percent over this 35-year period, while inflation averaged 4.90 percent per year. This gives a real return of -2.43 percent per year, which results in a cumulative real loss of 57.76 percent. Pretty bad, but not even close to the 91 percent reported.

We would also like to point out dangers in any article that chooses a specific period from a longer dataset. If the investor has stayed in the market for the period 1982-1991, the average real return on Treasuries was 12 percent per year for this period. So, over the entire 45-year period, the real return for Treasury bond investors was .78 percent per year.

Investing In Athletes

Fantex recently announced its first pro athlete IPO. The company will issue 1 million shares of tracking stock at $10 each, with the proceeds to be paid to Houston Texans running back Arian Foster. In return, Foster, or the "brand" as he is called in the prospectus, will give Fantex 20 percent of his future earnings. Right now, you likely believe that the stock price will depend on Foster's future earnings, and it will to a degree. But further reading unlocks a host of other risks. For example, the company may never pay dividends to stockholders, but instead reallocate the cash for company expenses. Or, the company can convert the Foster stock into shares of Fantex stock at the discretion of company management. If Fantex fails, investors in Foster stock are left with one percent (or less) of the bankrupt company. All in all, Arian Foster stock appears to be a very risky investment, which brings us to our main point: Many believe that SEC approval of a prospectus means that the SEC feels the security is a good investment. In reality, the SEC merely reads the propesctus to ensure that all required information and risks are disclosed in the prospectus. The SEC does not certify that the security is a good investment. It is up to the individual to determine if the investment is appropriate for their risk tolerance.

The JOBS Act Explained

The Jumpstart Our Business Startups (JOBS) Act has received press recently since Twitter filed its registration documents with the SEC under this Act. An important part of the JOBS Act, which will allow crowdfunding, is not in place yet, although the SEC is meeting today to propose crowdfunding rules. Since the JOBS Act is only a year and a half old, many are unclear of what the Act actually covers. CFO posted a JOBS Act tutorial that answers many questions about the Act.

Reasons For Holding Cash

John Maynard Keynes identified three theories as to why firms hold cash: the speculative motive, the precautionary motive, and the transaction motive. In 1980, firms had about 12 percent of total assets in cash. By 2011, this number had jumped to 22 percent. There are several factors that have lead to this increase. For example, low inflation has lowered the opportunity cost of cash. Additionally, much of the cash horde is held overseas. Bringing the cash back to the U.S. would result in large tax liabilities. However, recent evidence suggests that the previous experience of managers may be the key factor. CEOs who have experienced financial difficulties are likely to hold more cash than CEOs who have not experienced financial difficulties, a nod to the Keynes' precautionary motive.

Finance And Retirement Planning

We have had a number of students claim that they will never use anything they have learned in this class in the future. We hope you are not one of those students. If you are, we could tell you countless stories like a former student who is Director of Marketing at his company, but also responsible for capital budgeting decisions, but we won't do that. One thing we are sure you will use the knowledge you have gained is for retirement planning. A recent poll indicates that 82 percent of workers 50 and over say that it is at least somewhat likely that they will have to work in retirement. And while the recent market downturn affected some of these potential retirees, we would guess that most simply did not prepare early and often enough for retirement.

To help you prepare for your retirement (and it is never as far away as you would like to think), we would like to direct you to Professor Joshua Rauh's free MOOC at Stanford University. The course is the Finance of Retirement and Pensions, and although you do not get a grade, it may help better prepare you for your own retirement planning. Notice, you will get the most out of the course if you understand the value of diversified portfolios, interest rates, inflation, perpetuities, and annuities, which we hope you  already have learned.

The Market Is Efficient, Or It Isn't, Wins Nobel Prize

The Nobel Prize in Economic Sciences was awarded today to Eugene Fama, Robert Shiller and Lars Peter Hansen. By now you are aware of Eugene Fama, one of the earliest and most vocal proponents of stock market efficiency. Fama's research centered around testing for market efficiency and attacks on market efficiency. What is interesting about this year's Nobel Prize is that Robert Shiller is a proponent of behavioral finance, arguing that markets are often inefficient. He is known for predicting the housing bubble and has argued that while the stock market may exhibit random price fluctuations in the short term, it is predictable over three to five year periods. As is noted by Nobel Laureate Robert Solow, the award this year is a little like an award to both the Yankees and Red Sox.

Economic Profit

McKinsey Quarterly recently published an article on the results of its study of economic profit for 3,000 large companies. If you prefer, a narrated slideshow discussing the results is also available. As a quick review, economic profit is also known as Economic Value Added (EVA) and is similar to an NPV calculation for the company as a whole. The results of the study show the disparities between the top and bottom performers from middle-of-the-pack companies. Surprisingly, bottom performers tend to have higher revenues than middling performers, have the highest tangible-capital ratio, but the lowest asset turnover. They are likely to be in a capital intensive industry such as airlines, electric utilities, and railroads. Top performers tend to have high margins and a low tangible-capital ratio.

Interestingly, top performers were likely to remain as such, in part due to more fresh capital. In other words, they stay on top because they get bigger and seem to invest in profitable projects. Of course, a company can improve its performance, but much of the improvement lies in the industry. In fact, companies that do improve (or experience a decline) in economic profit tend to be driven by industry performance. The results of the study indicate that as much as 54 percent of a company's economic profit is due to its industry. Interestingly though, top quintile companies rely the least on industry effects.