Dollars and Jens
Friday, April 30, 2004
Re: put-call parity
My brother, via email, points out that the facts of the article on put-call parity to which he linked the other day glossed over a couple of important things, specifically dividends and the cost of capital. For example, the article says:
Finance theory states that, holding the underlying stock and buying a put will deliver the same payoff as buying a call and investing the present value of the exercise price.
This includes the cost of capital, but ignores the dividends.

Let's compare the strategies; S0 is the present stock price, St is the future stock price, Dt is the future value of any dividend payments between now and the expiration of the options, X is the exercise price, X0 is the present value of X (i.e., the amount you would have to pay now for a risk-free bond that pays you X on the date the options expire), P is the present price of a put, and C is the present price of a call.

Strategypresent costfuture value if St>=Xfuture value if St<=X
Buy the stock and a putS0+PSt+DtX+Dt
Buy a call, invest X0C+X0(St-X)+X, i.e., StX

Regardless of the future stock price, the "stock-plus-put" strategy ends up worth more by Dt. If we define D0 to be the present value of the dividends, this stock-plus-put strategy should cost D0 more than the call-plus-bond strategy. I.e., S0+P=C+X0+D0  =>  C-P=S0-X0-D0. That's the essential formula for put-call parity.
A simplified condition of this is where the strike price of the put and call is the same as the current underlying ETF price. In such a case,

Put = Call at same strike and maturity

For example, as long as the Diamonds Trust trades at 104, the call option to buy it at a price of 104 anytime between now and the date of options expiration should cost the same as the put option to sell it at 104. A brief glance at an options price screen will confirm this. When on April 22, DIA traded 104, the June 04 put and call options both cost just over $2, the January 05 put and call both cost about $5, etc.
This is true only if -- and only if -- the dividend paid by DIA equals the risk-free rate (in DIA's case, I wouldn't be surprised if they were close). If you buy a share of DIA and a put, you get the dividends paid by DIA in between now and the maturity date of the option, so this strategy is more attractive when you consider the dividends. If you buy a call instead, you don't get the dividends, but you also don't have to put up much money -- you could invest the money in a treasury bond instead, and collect risk-free interest, so this makes the call option more attractive.

In terms of the formula (C-P=S0-X0-D0), C=P not when S0=X, but when S0=X0+D0.

As it happens, the bond ETF to which the author refers carries a dividend of 5.5%, which is higher than any reasonable risk-free rate between now and January 2006. Even if shorting were possible, the cost of an at-the-money put would probably exceed that of an at-the-money call. I don't care to look up the cost of a risk-free January 2006 zero-coupon bond, and I can't do a precise calculation without it. That said, I suspect the difference between the put and the call would work out to something less than $6, but certainly far more than $0.

You may have noticed a few days ago, in my entry on oil, I said one thing that could cause prices to fall was a drop in demand. Well, the main thing that could cause demand to fall would be the crash of a Chinese bubble (I write "a" Chinese bubble, rather than "the" Chinese bubble, because I'm not certain they're having such a thing; if I were forced to bet, though, I suspect they do).

Thursday, April 29, 2004
Google plans Dutch auction for IPO
High, high kudos to Google for doing this the right way.
Internet search engine Google said Thursday it will sell $2.7 billion of its stock to the public through an auction process in an attempt to make sure individuals as well as institutions can buy the shares.

"Informed investors willing to pay the IPO price should be able to buy as many shares as they want, within reason, in the IPO, as on the stock market," the company said in its SEC filing revealing the plan.

"This has led us to pursue an auction-based IPO for our entire offering. Our goal is to have a share price that reflects a fair market valuation of Google and that moves rationally based on changes in our business and the stock market," it added.
Instead of pricing it cheaply so that there's a big, headline-making pop in share price on the first day of trading, to the profit of people who can get in on the IPO, they let anybody who wants to bid from the beginning, and keep all that capital in the firm. This is shareholder friendly management.

While we're on the Google IPO, though, I'm curious as to what the plans for the capital are. At expected values, they could almost make an all-cash offer for U.S. Steel, but realistically, are they planning just to acquire a lot of servers and real estate on which to put it? I wouldn't be surprised if they need to put a couple billion into that sort of thing in the next decade, but last year it had operating cash flow of $400,000,000, while "It plans to spend $250 million this year to expand its infrastructure."

This question is on top of the other point of discussion between my brother and me:
In the filing, Google admits that it faces significant competition from Microsoft and Yahoo and expects its revenue growth and operating margins to decline.
That question was, "How sustainable is Google's competitive advantage?" If you know the answer, let me know it so I can bid on the stock.

TiVo changes the way advertising is done
"Over the last six to 12 months, the advertising community has turned almost 180 degrees - from being uniformly opposed to TiVo and hating us to now seeing us very much as a benefit overall," he said.

With DVRs, the effectiveness of ads can be measured. Plus, there are opportunities to market products and services directly to consumers who are interested in them. TiVo is dabbling in both of those areas.
It is in the interest of both the advertiser and the intended audience that an ad be seen if that audience is interested in the product being advertised; it is in the interest of neither if not. Unfortunately, most advertising falls most of the time into the "2% of my most narrowly targeted audience will be interested", and sometimes there the benefit net of costs has a different sign for one than the other. Making ads entertaining is one way in which advertisers try to change the balance; in the long term, I expect advertising to be better targetted than it is now.

Incidentally, one possible problem for the new liberal talk-show radio network is that its likely audience overlaps so much with NPR. I expect it's aimed at a younger, more energetically political demographic; it will have to keep and strengthen that distinction to get listeners to decide that it's worth listening to advertising.

Det är cross-posted.

put-call parity
Hey, Steve, I don't suppose you remember last year when I was wondering whether options on stocks on which a short-squeeze was likely would imply an underlying price lower than the actual price? Well, it's happened with bond ETFs.
Why were the at-the-money put options with a strike of 84 over three times as expensive as the call options at the same strike? Why didn't an arbitrageur sell the 84 puts for $9.00, buy the 84 calls for $3.00, sell short the underlying TLT at 84 and pocket $6.00?

The answer is that there were no available TLT shares to short. Demand for hedging against a drop in long bonds apparently has far exceeded supply.
It still makes you wonder, though, who's sitting on the ETF shares rather than trading them in for an options position.

latest numbers
Advance Q1 GDP came in at 4.2%, well below expectations, while the deflator came in at 2.5%, leaving the bond market in turmoil. Nobody cares that initial claims came in at 338k, down from last week's number, which was revised up 3,000 to 356k.

Wednesday, April 28, 2004
fed policy argues that rate hikes may be farther off than people suppose, and presents an interesting little graphic to make its case:

I would note that interest rates are lower than they have been in previous cycles, and that employment is lagging other indicators even more than usual, but it's something to throw on the pile of reasons to expect the fed at least not to do anything next week.

Oil prices jumped half a buck yesterday on news that OPEC would raise their target price range from $22-$28 to $32-$34, mostly because the dollar has fallen quite a bit against most world currencies. But according to at least one anonymous source, it's not a done deal.

I don't think it'll matter all that much, anyway -- Saudi Arabia doesn't have much excess capacity right now, and I'm under the impression that nobody else has much, either. Unless demand slows (or the dollar rises a lot), the price isn't likely to drop substantially, whatever OPEC does.

So we'll have to wait for the commercialization of this:
A University of Illinois research team is working on turning pig manure into a form of crude oil that could be refined to heat homes or generate electricity, reported the Associated Press.

Years of research and fine-tuning are ahead before the idea could be commercially viable, but results so far indicate there might be big benefits for farmers and consumers, lead researcher Yanhui Zhang said.

Sanofi to buy Aventis
Shame on me for not having mentioned that Aventis has agreed to Sanofi's latest offer. And shame on the French government for interfering so much. Shares of both companies fell on the news.

Tuesday, April 27, 2004
Latest Numbers
Consumer confidence for April is 92.9, against last month's 88.5. Home sales are also up more than most people were expecting.

Friday, April 23, 2004
Philip Fisher, 1907-2004
Apparently, Fisher died last month. He was one of the biggest proponents of buy-and-hold, and probably best known for his book Common Stocks and Uncommon Profits.

latest numbers
By the way, durable goods orders came in quite a bit better for the past two months than was expected — that is to say, the March number was well better than anticipated, but the February number reported last month was revised significantly upward as well. (3.4% versus maybe 1% expected, and 3.8% revised up from 2.5%.)

interest rates
And then there's this discussion of adjustable versus fixed-rate mortgages by Liz Pulliam Weston over at I like the idea of a fixed-real-rate mortgage, with ammortization on a real schedule as well — in times of inflation the principal might actually be increasing in nominal terms — which might look like an adjustable-rate mortgage in terms of the interest expense (inflation is one of the biggest variables in the interest rate) but without quite the cash-flow crunches those can create.

Thursday, April 22, 2004
neutral interest rates
We can easily tell the so-called natural rate today by observing the yield of the inflation-protected Treasury bond
Kudlow's beat this drum before, and while the traders I know revere Kudlow — insofar as they're reverent, which isn't insoveryfar — if real long-term rates were 2% and nominal were 10%, I have trouble thinking a funds target of 5% would be tight — or anything but exacerbating.

Dow Jones CBOT Treasury Index
I didn't find this interesting enough yesterday to blog it, but I do today:
The Chicago Board of Trade and Dow Jones Indexes have created the Dow JonesSM CBOT® Treasury IndexTM--a reliable, accurate and broad-based benchmark that allows bond market investors to measure performance. The index, to be calculated by Dow Jones Indexes, will be offered for licensing on April 28.
It will be based on CBOT treasury future prices, a decision that can be justified on liquidity grounds.

latest numbers
Initial claims of 353k, which is troubling as a follow-through of last week's revised 362k; aside from last week, this number is the highest since early February, and seems to suggest a deceleration. March PPI was up .5%, .2% core, also slightly worse than expected, and market indicators dropped on the news.

Novartis Agrees to Enter Talks With Aventis on Possible Merger
An update on recent discussion:
Novartis AG Thursday said it is ready to enter merger talks with Franco-German drug maker Aventis SA, which is the target of a €48 billion ($57.1 billion) hostile bid by smaller rival Sanofi-Synthelabo SA.

"The board of directors of Novartis has decided to accept the offer of the Aventis supervisory board to negotiate conditions for a potential business combination," Novartis said in a brief statement. "No assurances can be given that an agreement can be reached," it said.

Novartis also posted a 22% jump in 2003 profit on a 16% revenue rise.

The Switzerland-based pharmaceutical giant previously had said it wanted to accept the invitation from Aventis to begin merger talks, but only if the French government drops its implicitly hostile stance toward a possible deal and declares itself "neutral."
If you subscribe to the Journal, you can read the rest of the story. If you don't, I assume someone else will publish a version shortly, but the Journal's is the only online version I've seen so far.

Wednesday, April 21, 2004
Greenspan's morning testimony
The Federal Reserve recognizes that sustained prosperity requires the maintenance of price stability and will act, as necessary, to ensure that outcome.
Best guesses for next week's advance report on Q1 GDP see about a 5% annual growth rate.

Buffett got 84% of the vote to be re-elected to Coke's board of directors.

Taser has a volatile stock. It's one of those high short-interest, priced for growth kinds of stocks, and it's hard to say with conviction what it's worth.

Interest rates and the Fed
August fed funds futures have moved 7.5 basis points since settlement yesterday afternoon, and indicate an average fed funds rate of 1.275% in August, but don't appear too liquid. July is priced at 1.1%, having been around 1.13% earlier this morning.

The raw data are at the CBOT website; subtract prices from 100 to get percentage points. (I assume the convention was designed for T-bill traders.)

Tuesday, April 20, 2004
Interest rates
I commented to my brother this weekend that the fed should raise rates a quarter point — barring unforeseen developments, which will undoubtedly occur between now and the next fed meeting — just to give the markets a kick in the shins. Well, Greenspan can give the market's shins a certain amount of rough treatment just by opening his mouth:
Greenspan told Congress that the nation's banking system is well prepared to deal with rising rates, which the market interpreted as a new signal that the Fed will tighten its policy sooner rather than later. The Fed chairman didn't directly discuss interest rate policy in his remarks to the Senate Banking Committee, but was expected to do so Wednesday, before the Joint Economic Committee.
The markets are very sensitive to what Greenspans says, in part because he tries to very gently correct it when he thinks it has different expectations of fed policy than he does. (If this is stupid, let me know; as I took yesterday off, today is my Monday, and my brain never does seem to have engaged.)

Monday, April 19, 2004
The new CEO of McDonald's died this morning:
When James Cantalupo became chairman and chief executive of McDonald's in January 2003, he set out a plan to reverse the company's missteps under former CEO Jack M. Greenberg. Cantalupo's untimely death this morning from an apparent heart attack at a company convention in Florida leaves unfinished efforts that were just beginning to show results.

Cantalupo, a 28-year veteran of the company, started by returning its focus to McDonald's core menu and unwinding the so-called partner brands acquired by Greenberg. The company had spent $325 million buying non-hamburger chains like Donatos Pizzeria, Boston Market and Chipotle Mexican Grill. The deals were duds that cost McDonald's management time and money, and in December it sold Donatos back to its founder for $50 million, half of what it had paid.
Fortunately for the company's shareholders, it wasn't a one-man operation. The board apparently had done one of its most important jobs -- preparing for an event like this one:
Today, following the sudden death of Chairman and Chief Executive Officer Jim Cantalupo, the board of directors of McDonald's Corporation announced that Charlie Bell, 43, currently President and Chief Operating Officer, has been elected President and CEO. The Board also announced that Andrew J. McKenna, 74, the Board's presiding director, has been elected non-executive Chairman of the Board.
They should be able to finish what Cantalupo started.

A Light Read
Last week, I emailed some people a delightful paper by Hal Varian called "How to Build an Economic Model in Your Spare Time". I got some positive comments about it, so now I'm sharing it with you.

Friday, April 16, 2004
Re: expensing options
Morningstar also has a new piece on expensing options, one which takes pretty much the line Dean and I take.

I'd like to add that Dean is right that the disclosure of the determinants of an option's value is substantially more important than incorporating an expense into the income statement, where it belongs. But if a company's management truly considers options to be free when they're deciding how many to hand out, that doesn't bode well for shareholders.

Thursday, April 15, 2004
federal budget
A breakdown of where your federal tax dollars go. Of $14,506 per household that doesn't go to Social Security and Medicare, $2,860 goes to payments on previously incurred obligations — viz. interest on the debt and retirement benefits for federal employees, including veterans; I expect we are incurring new obligations at a rate in excess of this. (If the net change in obligations to federal employees were zero — I expect it's significantly higher — we're still incurring almost $2,000 above what we're paying.) How to count the $7,165 that goes to the elderly is debatable.

expensing options
Ramesh Ponnuru offers a relatively fair presentation of the options expensing debate, but as a supporter of expensing, I'd like to respond to his arguments against.
Corporations already disclose all the information that the reformers want, albeit not as prominently as they want. Moreover, the impact of the options on price-per-share is revealed the moment the options are exercised — which is to say, the moment a cost is actually incurred. Opponents also say that there is no reliable method of estimating what options will cost years before they are exercised.
All of this, Ramesh indicates, is true; and, in its way, it is. On the other hand, corporations do release earnings statements, and we might as well make them mean something.

The calculation of a bottom-line "profit" is not necessary, perhaps; investors can read all the raw data themselves and do with them what they like. So long as there is to be a bottom line reported, however, it should as accurately as possible reflect the value generated by the company during the reporting period. The cost is not actually incurred when the option is excercised (though that may be the closest it gets to a cash-flow drain, if the company buys back shares to prevent dilution); the option is issued in exchange for labor over a certain period of time, and should be marked against earnings over the same period. That the number assigned to that cost cannot be derived with precision, and that
companies will have to make choices, not only about the model to be used but the various inputs that the model requires
creating a risk of legal liability if they use the wrong one applies no more to this than it does to estimates of pension obligations or depreciation; a company should be immune to prosecution in any case for any assumptions that are not simply untenable. An example of a value for the typical issued option that is untenable is 0; a Black-Scholes model (which understates option values) using 10% annual volatility — a low value for any stock — will still produce a better estimate than what is being used by many companies now.

Update: My brother writes to note that accountants refer to this as "matching"; revenues should be temporally matched with the expenses that generate them. I kind of knew this, but the term "matching" is simply too prosaic for my tastes; if they had called it something in Latin I would have used that term.

Health care
Pharma's having a good day, while health care providers are being particularly hard hit. Any news I've not heard?

NYSE yesterday
Say, did you notice the advance/decline ratio on New York yesterday? It was much worse than the index moves. Nasdaq wasn't quite so bad.

Chinese trade deficit
China, a country usually boasting a considerable foreign trade surplus, witnessed a trade deficit totaling 8.43 billion US dollars in the first quarter of 2004 because of three successive months of import growth, more than 8.2 percentage points higher than exports.
Stumbled upon at Xinhuanet.

Latest Numbers
The number of Americans filing initial claims for jobless aid climbed a surprising 30,000 last week, the biggest jump in over a year, according to government data on Thursday that economists took with a grain of salt.
As my brother frequently points out, economists always take weekly claims numbers with a grain of salt.
First-time claims for state unemployment benefits climbed to 360,000 in the week ended April 10, their highest level since early February, from a revised 330,000 in the prior week, the Labor Department said.

Wall Street economists had expected claims to rise to only 335,000 from the more than three-year low reached in the previous week.

latest numbers
Gold prices dropped $7 yesterday on inflation fears, or something like that. I figure this is why I'm not a trader. In any case, the price drop was at least subsequent to a report that the CPI rose .5% last month, or .4% stripping out the volatile components. I think they should report a moving average of the difference between the two, so we can ignore the volatile components in the short run but account for them in the longer term. Taking the volatile component and smoothing it seems to be something they mostly do when the whole figure is volatile, like initial claims of unemployment, which came in this week at 360,000, well above last week's figure, which was revised up to 330k. Well, the four week average is 344k, still up from last week, but only 5k or so.

Wednesday, April 14, 2004
Double Negatives
I'm currently dealing with an earnings report from a company that I'll decline to name that labels a particular line of negative numbers as "gain on disposition of assets". Obviously, this means that the company sold property at a loss in each reporting period, right? No -- it seems that their gains were positive, but they felt like using negative numbers because -- in this example -- the gain reduces operating cash flow (relative to earnings).

And the reason they didn't simply indicate that these were negative losses, perhaps using an explicit label like "loss (gain) on disposition of assets"? I'll leave that question for the psychiatrists.

Monday, April 12, 2004
Re: Everything on Red
Of course, we're each welcome to remain silent as to which outcome we were cheering for.

Everything on Red
Following up a story from last Friday:
Ashley Revell, a 32-year-old Londoner, sold all his possessions in March, took $135,300 to the Plaza Hotel in Las Vegas, did some low stakes gambling and then placed everything he had left on "Red."

The wheel was spun, a crowd of supporters including his Mum and Dad from London went wild, the ball bobbled over the slots and landed on Red '7' -- and Revell walked away with $270,600.

Sunday, April 11, 2004
Coke holders urged to drop Buffett
A leading shareholder advisory firm is urging Coca-Cola shareholders not to re-elect Warren Buffett to the company's board later this month, pointing to the beverage giant's business dealings with a company he controls.
Buffett has noted that independence, especially as it tends to be defined, is not a great proxy for whether a director acts in shareholders' interests. Berkshire Hathaway owns 8.2% of Coca-Cola, and I expect accounts for far less than 8.2% of Coke's business. (I own equity in Berkshire Hathaway, though substantially less than 8.2% of the company.)

Saturday, April 10, 2004
external price shocks
The first charge of monetary policy is to maintain a stable currency, because an economy without a medium of exchange is a barter economy of ditch-dwelling heathens. As a currency begins a slide into devaluation, other issues — full employment, I'm talking to you — have to take a back seat in the short term, largely because 1) there are other levers that can deal with that as effectively as the monitary, and none that can save the currency, and 2) in the long term, having defended the currency will prove to be much, much more valuable than allowing it to deteriorate to stave off economic collapse by a few more weeks. Money is the oil in the machinery of capitalism.

When light sweet crude costs more of the green stuff, though, the fed has to decide the appropriate response. Creating more or less money does little (especially in theory) to affect relative prices; that oil becomes more expensive relative to baking powder is a fact to be accepted by the Fed. Unless something has caused a demand shock from inside the United States, the higher price represents to the United States a shortage of supply, whether due to an actual slowdown in production or a demand spike somewhere else; I heard a fellow on the radio this weekend argue that the fed will not react to the recent expense of oil, because "they know they can't print oil".

I have a lot of respect for that position, the rest of this post notwithstanding, but a given amount of money chasing fewer goods is quite as capable of cheapening as is an increasing amount of money chasing a constant quantity of goods. A decreasing quantity of goods may decrease the velocity at which the money in circulation moves, but unless that effect outstrips the diminishing ratio of goods to money — and I don't believe that, in the long term, it can — the issue is not why the currency fails to hold its value, merely that it does; if the fed declines to tighten in response to higher oil prices, it isn't because higher oil prices should never trigger a response, but because the increase is really not as economically significant as portrayed in the press, and other considerations outweigh it.

When I refer to depreciation, devaluation, stability etc., I have meant against goods that are typically purchased by Americans; I mean against foreign currencies only insofar as Americans are in the habit of purchasing foreign currencies (which is to say somewhat more than none whatsoever). Fed policy toward the exchange rate should primarily be to take it into account when assessing the likelihood of future inflation or deflation. They will have an impact on this, to the extent that we engage in international trade, and to exactly that extent should be material to the determination of fed policy. So if the falling dollar raises the price of oil in dollar terms, and this is likely to trigger a general loss of faith by sellers in the dollars they're expected to accept in exchange for their goods. That is currently not a large, obvious threat, and the fed will have other things to worry about that will at least temper interest rate hikes.

Friday, April 09, 2004
High-Risk Investment
I will, on occasion, refer to a high-risk investment as "putting everything on black 17", but this guy is taking that awfully literally:
A British man who has sold all his possessions, including his clothes, will stand in a rented tuxedo on Sunday and bet everything on a single spin of the roulette wheel.

If he wins, he doubles his money. If he loses, he will be left with only the television crew documenting his every move.

Wednesday, April 07, 2004
credit risk
An article on mortgage lending finds me in a sarcastic mood.
With "Low Doc" loans, a borrower may choose not to supply income-tax returns in exchange for a slightly higher rate. That allows a self-employed person with an erratic income to borrow.
How many kinds of "self-employed" people can you think of that don't have income tax returns, and with how many would you trust a house-sized loan? ("But he offered to pay the closing costs in cash...")

When the industry ceases to believe in adverse selection we're in dangerous territory.
Although it becomes more expensive for banks to borrow money when rates rise, ARM borrowers start paying more interest
Unless they don't.
At the current rate of 5.5% on a conventional 30-year fixed-rate mortgage, a homeowner will pay $567 a month for each $100,000 borrowed; an interest-only 4% adjustable-rate mortgage (ARM) costs just $333 a month, figures IndyMac Bancorp Inc. in Pasadena, Calif.


However, if rates rise by just 2 percentage points, the $333 monthly cost on that $100,000 loan could nearly double when the interest-only period ends, leaving some homeowners unable to make their payments.

Tuesday, April 06, 2004
Tyco Dissenter Speaks
There's an article today about Kozlowski's Henry Fonda.
Saying she alone grasped the concept of presumption of innocence, Ruth Jordan stands by her vote and chides the other 11 on the panel
It'd be nice if there were some more meat to that story -- in particular, I'd like to know whether she would have voted "guilty" under a preponderance-of-the-evidence standard.

Link from Howard Bashman.

US business confidence seen at 20-year high
Confidence among US business leaders is stronger than it has been for 20 years, according to a long-running measure of boardroom attitudes, as rising profits finally encourage companies to start hiring.

The quarterly survey by the Conference Board confirms last week's official employment data suggesting concerns about a jobless recovery may be waning.
I find this almost literally unbelievable. I know things are picking up, but more optimistic than 1999? Wow.

Corporate Taxes
The Journal reports:
More than 60% of U.S. corporations didn't pay any federal taxes for 1996 through 2000, years when the economy boomed and corporate profits soared, Tuesday's Wall Street Journal reported, citing the investigative arm of Congress.
If you subscribe, you can read a longer version of the story. One paragraph not in the summary:
The report examined a sample of tax information for the years 1996 through 2000; for 2000, it covered about 2.1 million returns filed by U.S.-controlled corporations and 69,000 filed by foreign-controlled corporations. It showed that big companies -- defined as those with at least $250 million in assets or $50 million in gross receipts -- were more likely to pay taxes than smaller ones. Still, the GAO said 45.3% of large U.S.-controlled companies and 37.5% of large foreign-controlled companies had no tax liability in 2000. More than 35% paid less than 5% of their income.
I, like most Americans, generally support simplification of the tax code -- i.e., fewer deductions. But if you poll people about specific deductions, they usually support keeping them, and I'm not certain I'd disagree.

Monday, April 05, 2004
Penney finally sells Eckerd
Department store giant J.C. Penney Co. Inc. is selling its financially troubled Eckerd chain of drug stores for $4.525 billion to rivals CVS Corp. and Canada's Jean Coutu Group Inc.

Sunday, April 04, 2004
Introduction to Valuation
There are two broad types of methods used to value shares of a company. I will refer to these as the "comparable" type and the "discounting" type.

Comparables are generally simpler and less precise. The general idea is to look at how similar companies are valued by the market, and figure out how the target company compares to them. The comparisons are usually based on simple ratios: price to earnings (P/E) is the most popular, but you can also look at price to sales, price to book, price to free-cash-flow, or various ratios involving "enterprise value" -- the market value of all of the shares outstanding, plus the value of the firm's debt, minus free cash -- rather than simply share price.

You might notice that most of the firms in the industry in which your target company operates have P/E ratios of 13-18, with the better companies having higher ratios and the worse companies getting lower ratios. If your target company seems to be better than most in the industry -- maybe it has better growth prospects and less risk -- you might argue that it should be worth 16-19 times earnings. Then you go have lunch.

Discounting methods rely on two fundamental concepts:
  1. A share of stock is a claim on the future cash generated by the company, and should be valued as such.
  2. Cash today is worth more than the same amount of cash tomorrow.
Concept two is the fundamental rule of investing -- if an investment doesn't provide a fair return on the money you have tied up in it, you sell it and put your money in an investment that will give you a fair return (or a better-than-fair return, if you can get it). This "fair rate of return" can be referred to as the "cost of equity" or -- within the context of a valuation model -- the "discount rate" (this should not be confused with the "discount rate" set by the Federal Reserve, which is mostly unrelated). If you decide that it's worth giving up a dollar today to get $1.10 a year from now, that's a discount rate of 10% -- you're demanding a 10% return per year. At the same rate, you'd demand $(1.1)5, or about $1.61, in five years to give up a dollar now. Alternatively, we'd say that the present value of $1.61 five years from now is $1. The present value of an investment, then, is the sum of the present values of all of the cash flows it generates.

But what "cash flows" does one use? One can use dividends, or one can use free cash flow (i.e., cash generated by operations, minus cash used in investments and financing), or one can use earnings on the grounds that they represent a less-lumpy estimate of free cash flow. Or -- my personal favorite -- one can use "residual earnings", which I'll explain in a moment. As it happens, for any company that doesn't sit on its cash -- i.e., it either pays any excess cash back to shareholders or invests it -- all of these cash flows provide the same result1. The main factor in deciding which cash flows to use is which cash flows one considers easiest to estimate.

As I said, I like the residual earnings model. A company's residual earnings for a period are the earnings minus a charge for equity employed. For example, a company with a 12% cost of equity and a book value of one million dollars has to earn $120,000 per year to justify retaining its equity, rather than paying it out to shareholders. If it earns $150,000 in a year, the retained earnings for that year are $30,000. This is the amount of value added by the company not having sold off its parts at the beginning of the year with the proceeds invested elsewhere. The value of a company, then, is the total of its current book value and the present values of its residual earnings.

I like the residual earnings model for both practical reasons and psychological reasons. By "psychological reasons" I mean that it pushes the modeler to think properly about costs of capital, and sustainable competitive advantage. Most companies are worth more alive than dead -- to a first approximation, worth more than book value -- but one can't understand the company if one doesn't consider whether this is so and, if it is, why it's so. If the company has assets of $5 billion and a market value of $10 billion, why is it worth more than a start-up company with $5 billion in cash? Does it have a strong brand name (like Coke), intellectual property (like Pfizer, with its drug patents), a "network effect" (like EBay, which is more attractive to a seller every time a new buyer signs up, and vice versa), a product with replacement parts (like Gillette, which distributes razors that only work with Gillette blades), or at least a good customer list or stable top-notch management? How durable are its advantages?

But I also like residual income for practical reasons. As an industry matures, companies in that industry tend toward a state of competition -- in other words, residual income approaches zero. Free cash flows or dividends never have to stop, and the farther out you estimate them, the wronger you get. Like any model, garbage in will lead to garbage out, but the residual earnings model makes it easier to limit garbage than most models do.

If you want to read more, my brother has written up something related to, but different from, this entry.

1. Technically, one also has to assume "clean accounting". This doesn't mean a lack of fraud; this means that the retained earnings line on the balance sheet changes exactly by the reported earnings in a period minus dividends for that period. There are a few "comprehensive income" figures which don't follow this rule, but I feel comfortable ignoring them for now.

Seasonal adjustment
The employment report has an interesting discussion of seasonal adjustment of data. I find it interesting, anyway.
Over the course of a year, the size of the nation's labor force and the levels of employment and unemployment undergo sharp fluctuations due to such seasonal events as changes in weather, reduced or expanded production, harvests, major holidays, and the opening and closing of schools. The effect of such seasonal variation can be very large; seasonal fluctuations may account for as much as 95 percent of the month-to-month changes in unemployment.

Because these seasonal events follow a more or less regular pattern each year, their influence on statistical trends can be eliminated by adjusting the statistics from month to month. These adjustments make nonseasonal developments, such as declines in economic activity or increases in the participation of women in the labor force, easier to spot. For example, the large number of youth entering the labor force each June is likely to obscure any other changes that have taken place relative to May, making it difficult to determine if the level of economic activity has risen or declined. However, because the effect of students finishing school in previous years is known, the statistics for the current year can be adjusted to allow for a comparable change. Insofar as the seasonal adjustment is made correctly, the adjusted figure provides a more useful tool with which to analyze changes in economic activity.

Most seasonally adjusted series are independently adjusted in both the household and establishment surveys. However, the adjusted series for many major estimates, such as total payroll employment, employment in most supersectors, total employment, and unemployment are computed by aggregating independently adjusted component series. For example, total unemployment is derived by summing the adjusted series for four major age-sex components; this differs from the unemployment estimate that would be obtained by directly adjusting the total or by combining the duration, reasons, or more detailed age categories.

For both the household and establishment surveys, a concurrent seasonal adjustment methodology is used in which new seasonal factors are calculated each month, using all relevant data, up to and including the data for the current month. In the household survey, new seasonal factors are used to adjust only the current month's data. In the establishment survey, however, new seasonal factors are used each month to adjust the three most recent monthly estimates. In both surveys, revisions to historical data are made once a year.

Saturday, April 03, 2004
American Productivity
There are a few interesting facts about the economy in today's David Brooks column (the reading of which requires no-cost registration):
The McKinsey Global Institute breaks the economy down into 60 sectors. U.S. workers are the most productive on earth in at least 50 of them. Productivity gains cause standard of living increases. Productivity gains lead to employment gains. If history is any judge, yesterday's excellent job numbers could mark the beginning of another surge in job creation.

As William W. Lewis, a former McKinsey partner, writes in "The Power of Productivity," about half the U.S. productivity gains have occurred in just two sectors, wholesale and retail trade. We've gotten really efficient at getting stuff from the hands of manufacturers to the hands of consumers. These innovations have had more important effects on how people really live than anything done in Washington.

Some of the effects have been entirely positive. In part because of scanners, companies now know how much stuff they are selling. Inventory-to-sales ratios shrink; companies are less likely to overproduce. That helps reduce the boom-bust cycle, which disrupts lives. During the first half of the 20th century, the U.S. economy was six times more volatile than it is today, according to a study by Bill Martin of UBS Global Asset Management and Robert Rowthorn of the University of Cambridge.

Other effects are double-edged. WalMart, a productivity powerhouse, gives middle class folks access to great products at great prices. It also decimates small merchants and contributes to the uglification of American suburbia.
I wouldn't say Wal-Marts are visually unappealing so much as visually uninteresting, especially if you see a lot of them, which I don't.

Friday, April 02, 2004
Judge Declares Mistrial in Tyco Case
A judge declared a mistrial Friday in the trial of two former Tyco International executives accused of looting the company of $600 million, citing intense outside pressure placed on one of the jurors.

"It is certainly a shame that this has to be done at this time," state Supreme Court Justice Michael Obus told jurors after announcing his decision.

I still have some Tyco stock.

Incidentally, I don't think Kozlowski should be found guilty if he didn't break the law. I don't know how radical a position that is these days, but it's heartfelt. (Mind, he should be found guilty if he did.)

Eurex US
A story on the early travails of Eurex US and LIFFE as they attempt to compete with Chicago's derivatives exchanges.
March's average daily volume on Eurex US was 7,381 contracts, all in futures, down from 18,215 in February.
I know some parties tried to be supportive right after the launch, but lost patience quickly.
"Liquidity is like a virtuous circle -- if you have a lot of business you do a lot of business, then you have a lot of business..." said Michael Spencer, chief executive of brokerage firm ICAP Plc.
And if you don't, you don't. Check back in a couple years.

Update: I don't know whether this is even newsworthy, but apparently the CME CEO is ready to declare victory.
"They have already failed. A week or a month is a long time in this market," CME Chief Executive Craig Donohue told Reuters ahead of a briefing to reporters in London.
Eurex says this is premature, and I'm inclined to agree. As I said, check back in a couple years.

eCBOT (the Chicago Board of Trade's electronic platform) has announced that it will begin, later this month, trading of a German government bond derivative. I can't imagine why that would possibly be of interest to them. cough

latest number
Payrolls were up 308,000, and the markets went nuts. The most optimistic man in the Bush reelection campaign wouldn't have floated that number; consensus estimate was 120,000, and optimistic estimates I heard got no higher than 200,000. Last month's figure was also revised up 25k from 21k to 46k.

Thursday, April 01, 2004
Dow Jones Replaces 3 Stocks in Index
American International Group Inc. (NYSE:AIG - News), Pfizer Inc. (NYSE:PFE - News), and Verizon Communications (NYSE:VZ - News) will replace AT&T Corp. (NYSE:T - News), Eastman Kodak Co. (NYSE:EK - News) and International Paper Co.(NYSE:IP - News), Dow Jones said.

The change will take place at the start of trading April 8.

Update: Another story on this. A bit more prolix.

latest numbers
They tell me on the radio only that the number of initial claims of unemployment has fallen 3,000 from last week; I have to get to the web to find out that it's fallen to 342,000 from a figure for last week of 345,000, revised from 339,000. Insofar as the number has any meaning, it's not how it relates to last week — weekly movements will be swamped by noise — but how it relates to the average for last month, or the past couple months.

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