Tuesday, October 10, 2006

Salute to the Deficient Market Hypothesis

Margin of Safety is delighted to have a post featured in the Festival of Stocks (Edition #5). The current edition is hosted by the kind folks at Value Discipline, a blog which celebrates value thinking and is a salute the common sense and straightforward logic. Value Discipline is run by Rick, a portfolio manager of institutional portfolios for over 25 years. Rick considers our recent post on the Deficient Market Hypothesis as providing "terrific insight" into the mantra of value investors. We thank Rick for his kind words and trust that our regular readers will find Value Discipline and the other posts shortlisted in this edition of the Festival of Stocks as highly enjoyable reading.


IT Boom

Frontline Technologies Corporation Ltd. (FT SP) (SIN:F02) is a provider of end-to-end IT services in Asia. It offers IT consulting, IT infrastructure and enterprise application solutions and systems integration. FT hires over 4000 professionals in eight Asian markets, such as Singapore, China, HK, India and Taiwan. The group is also rated in the top 10% of the Corporate Transparency Index in Singapore and its chairman, Steve Ting continues to hold a sizable 12% stake.

As one would expect, the IT space is a highly competitive and the environment is a "cut throat" one. This is evident in the thin profit margins of FT. Its net profit margin for FY2006 was 5.5%. Since any cash generated is utilized for capital expenditure or acquisitions, FT has not paid a dividend recently. Given these seemingly unattractive features, why would FT be featured?

The first reason is that it is trading at a low P/S of 0.66. The second, which is also the crux of this post, is that FT has a subsidiary that is listing soon. This Chennai based subsidiary, Accel Frontline Limited (Accel), is seeking a listing on the Bombay Stock Exchange. The IPO subscription period has just closed. This new issue was 2.44x over-subscribed. In particular, it is reported that retail investors had bid for 4 more times than the shares offered. As a result of Accel's listing, the net tangible assets of FT will swell to $0.14 per share. Curiously, trading for FT has been range bound between $0.13 to $0.135 per share. This price range is actually below its revised NTA! Perhaps the market is distracted by boom of the North Korean "nuclear" test? FT, which trades on the Singapore Exchange, closed at $0.135 today.


Sunday, October 01, 2006

Deficient Market Hypothesis

We need to be professional about this posting by starting with a health warning. Please do not read beyond this paragraph if you are schooled and strongly believe in the practical applications of the pillars of modern finance. In fact, reading on may be hazardous to your financial health.

In 1952, Harry Markowitz postulated that diversification reduces risk. It was proposed that assets should not be evaluated by their individual characteristics but by their effect on a portfolio. Hence, an optimal portfolio can be constructed to maximize return for a given standard deviation. Markowitz won the Nobel Price in Economics in 1990 for his work.

In 1964, William Sharpe unleashed the Capital Asset Pricing Model (CAPM) on an unsuspecting world. He defined risk as volatility relative to market in a concept known as beta. Arising from this, the expected return from a stock is positively correlated with the amount of risk. It soon dawned that the mindless price gyrations can be summarized by the succinct CAPM equation. Sharpe won the Nobel Prize in Economics in 1990.

In 1966, Eugene Fama developed the efficient market hypothesis (EMH). It asserts that market prices reflect values because information is accurately and rapidly imputed into prices. Hence, the implication is that it is not possible to capture returns in excess of market returns without taking levels of risk greater than that of the market. Consequently, investors would not be able to identify superior stocks using either technical or fundamental analysis.

The above works have become the bedrock of all fine finance education today. They are what we would refer to as "modern finance". However, the acid test question, to investors, has to be whether these theories can be applied in the practical context. We, obviously, question modern finance and their high priests. In the paragraphs that follow, we offer our take and our Deficient Market Hypothesis.

(1) Welcome Volatility

An integral component of CAPM is beta. Any finance student worth his salt would be able to expound on beta and what is measures. As a recap, beta is merely the measure of a stock's volatility in relation to the market. In this context, high beta stocks are supposed to be riskier but they provide potential for higher returns. The converse applies.
Whilst beta and its workings may appear great on paper, will it work in practice? We pour scorn on the idea of beta because it suggests that a security that has fallen greatly in price is more risky that it was before it fell. From a true investor perspective, a company should represent as a lower risk investment after it tanked. After all, investors can purchase the same company at a lower price despite an increase in the security's beta. Hence, volatility should actually be welcomed as it allows the investor to potentially purchase a stake at an attractive price relative to its intrinsic value.

(2) Markets are inefficient

Striking at the heart of EMH is our dagger thesis that markets are inherently inefficient. For example, we consider it impossible for every investor to receive information simultaneously, interpret it accurately and execute the correct trade. Instead we suggest that markets are in a constant state of flux because prices reflect both imputed company information and the psychological state of investors. As a result of the latter, markets cannot be efficient for the simple reason that humans are irrational creatures. This explains periods of financial markets history where there is irrational exuberance and manic depressions.

(3) Risk and return do not go hand in hand

When a market swings from one extreme to another, we suggest that the oft talked about positive relationship between risk and return breaks down. In fact, there will be instances where risk and return have an asymptotic relationship. For example, one would expect the expected return to outweigh the downside risk shouldered when a security whose price is way under its intrinsic value is purchased. Thus, the risk and return relationship is hunky dory only in the idealized state. Unfortunately, we feel markets deviate from this utopia.

(4) Doing nothing is a strategy

In today's electronic economy, we lead our lives in a fast paced pressure cooker. On this tack, the turnover ratios posted by certain mutual funds (some in excess of 100; i.e. entire portfolio flipped in the past reporting period) appear forgivable. But does doing so seem incongruent to what these guys preach to investors - buy and hold for the long term? To us, it amounts to having double standards if a fund manager wants his investors to buy and hold onto his fund for the long haul while he is actually furiously turning over the portfolio in search of returns.
Instead we suggest that in portfolio management, inactivity may actually qualify as the most appropriate strategy at certain junctures. Not many of us are blessed with the virtue of patience. But one who patiently awaits for the discrepancy between price and intrinsic value is likely to be handsomely rewarded. Just as with a leopard would lie in wait for its right prey to pass by in the African savannah. (Caveat: High turnover strategies do work for some quant shops. Kudos to folks like Steve Cohen of SAC.)

(5) Today may not be a good time to buy

The folks in the sales department will always suggest otherwise. We, of course, beg to differ. In the same vein as the arguments proposed above on market inefficiency, the optimal time to invest is when the market is oversold or when the price is substantially below its intrinsic value. Being able to wait for such opportunities will separate the super investor from the average one.

(6) Diversification is oversold

Diversification, unfortunately, has been used as a surrogate for knowledge and understanding your investments. Over diversification leads to mediocrity. Mediocrity means average results. An investor with excessive diversification should expect average results.
On the flipside, it may actually be worthwhile to concentrate one's portfolio holdings. At the very least, we suggest that an investor should concentrate his portfolio around securities which he possess adequate knowledge.

(7) Value = Growth, Growth = Value

To us, differentiation between value and growth is just the rich figment of a marketing man's imagination to move another mutual fund product. We believe that value and growth are two sides of a coin. Both are inseparable. Common media pigeon-hole value guys as those attempting to purchase a stake for less than what it is worth. Don't growth guys expect to do the same too? Have you ever wondered what a value pick would be worth if it had negative growth in earnings? No prizes for guessing that such a company will slip into abyss quickly. So value guys do seek some element of growth too. As a result, we argue that it is meaningless to categorize an individual as a value or growth investor. To our mind, the real distinction should really be between investors and speculators.

Final Words

In 1992, in what may amount to a U-turn on his earlier work, Fama collaborated with French to improve on CAPM. A three factor asset pricing model was developed with factors such as market, size and value to explain market return. Is this a tip of an iceberg which amounts to the unraveling of earlier theories?

The best thing about reading this piece is that you do not have to believe this whole lot of hogwash above. These ideas are admittedly too controversial for the mainstream media and a nightmare to the marketing folks. Investing, seen through the lens of the Deficient Market Hypothesis, would simply be too boring.

In science, we use classical Newton mechanics to explain the majority of the physics challenges encountered daily. But these wonderful laws, unfortunately, fail at the atomic level and set the stage for Einstein's quantum mechanics laws. Would the Deficient Market Hypothesis be reveled in such light one day? We honestly hope not because it may represent the day when we run out of opportunities.