The market value of Tiger Woods

Tiger Woods has been in the news in these last few weeks, though not in the way he has been in the past. As his personal travails have mounted, his endorsements have dropped off. Now comes a study by two professors at UC Davis, looking at the companies that sponsor Tiger.
http://www.news.ucdavis.edu/search/printable_news.lasso?id=9352&table=news
They find that the collective market value of these firms dropped $10-$12 billion between November 27, the fateful day when Tiger drove into a fire hydrant outside his house, to December 17 (thirteen trading days later).

Note that Tiger is not the first high profile athlete whose market impact has been studied. A study of Michael Jordan's announcement that he would return to basketball (after he retired and tried baseball for a year) resulted in an increase of 2% in market value of his sponsor firms. In fact, an earlier study of firms endorsed by Tiger Woods in his glory days found that Nike and American Express gained about 1% in market value around the endorsement dates.

As an interesting aside, the UC Davis study also found that three firms, Tiger Woods PGA Tour Golf, Gatorade, and Nike, fared worst during the period after the Woods scandal came to light. Accenture, a consulting firm, showed no signs of loss in value. I would take this as an indication that Accenture has been wasting its money all these years, using Tiger Woods as a spokesperson.

On a more general note, I think this incident points to both the upside and downside of using celebrity endorsements. While there is a commercial benefit, it has to be weighed off against the potential cost of celebrities behaving badly and affecting the sponsor's reputations. For firms like Nike, both the benefits and the costs are large, since their customers are more likely to be swayed by celebrity endorsements and misadventures, but the net effect is likely to be positive. For firms like Accenture, I really do not see the net plus of using celebrity endorsements. As a business, it is unlikely that I pick my management consultant, based upon an endorsement by Tiger Woods.

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Greece, EU and more on Implicit Backing for Debt

Building on the theme of my last post, i.e., that implicit guarantees for debt are common and potentially dangerous, Greece offers an illustration of both the upside and downside of implicit guarantees.

Greece has been in the news as both S&P and Moody's have lowered its sovereign rating, from A- to BBB+ (for S&P) and from A2 to A1 (for Moody's). The harsher downgrade from S&P drew Greece's ire:
http://www.ft.com/cms/s/0/d4bdc8f2-eb13-11de-a0e1-00144feab49a,dwp_uuid=2b8f1fea-e570-11de-81b4-00144feab49a.html
Questions have been swirling about Greece defaulting and how the rest of the EU will react to potential default.

Taking a longer term view, though, Greece's debt travails are a test of the EU as implicit guarantor. I visited Greece in 1998, before the Euro came into being, to talk about valuation and at the risk of infuriating Greeks, the country was more an "emerging" than a "developed" market. The Greek currency, the Drachma, had little power outside the domestic market and Greece had a sovereign rating of BBB- (below investment grade) in 1995.

Becoming part of the EU and adopting the Euro as currency in 2002 improved the credit standing of the Greece, Spain and Portugal. While some of the improvement can be attributed to the fiscal discipline required by the EU (including restrictions on budget deficits), some of it can also be traced to the belief that the stronger countries in the EU would provide backing in the event of debt problems.

The bigger question is whether this umbrella has been a net plus for the EU countries as a whole. For Greece, Portugal and Spain, the benefits clearly have exceeded the costs over the period. For Germany and France, the effect has been more ambiguous, with the benefits of having a bigger and more prosperous market weighed off against the costs of the subsidies offered to the weaker economies. The subsidies also skewed economic activity in strange ways:
http://www.nytimes.com/2009/12/28/world/europe/28olives.html

Collectively, having one currency has made it easier for businesses to operate across Europe and those European firms that have adapted to this reality have emerged as more vibrant. While it has made Europe more competitive with the US, the big winners over the last decade have been the emerging markets, especially India and China. The biggest cost, as I see it, has been the bureaucracy that the EU has created to regulate itself and the companies that operate within its borders. In a dynamic global economy, putting more shackles on European companies will not make them more competitive.

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Dubai and the "implicit" guarantee

In the last two weeks, we have seen the damage wrought by the potential default of Dubai World, a Dubai-government controlled company that funded some of the most extravagant projects on the face of the earth over the last decade.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aoFe12bwzZ2M

While the magnitude of the default was large, it is interesting that it has shaken markets as much as it has. After all, there have been other large loan defaults in markets over the decades. So, why the panic? I think the reason lies in the unraveling of what I would call the "implicit guarantee".

What is the implicit guarantee? Consider a standard loan agreement, where a lender assesses a borrower's credit worthiness in determining how much to lend and on what terms. Through the ages, though, lenders have been willing to lend to borrowers who may not meet their credit worthiness tests, because their loans are backed up implicitly by others with deep pockets. Thus the money lender who granted a loan to the wastrel son of a wealthy merchant was trusting in the "implicit guarantee" of the father to pay back the loan; family honor was assumed to trump the absence of a legal obligation.

So, what does this have to do with Dubai World? Dubai is a city-state, with limited resources and economic capacity. The projects that were funded with the loans showed little potential of generating the cash flows needed to service the debt. However, Dubai is part of the United Arab Emirates, which has significant oil wealth and lenders assumed that the UAE would step in and provide backing, when the payments came due. At least so far, that has not happened.

Why does this have global consequences? Let's face it. A significant proportion of all lending is based on implicit guarantees. From bondholders in companies that are too big to fail (where the government is the implicit guarantor) to banks that lend to troubled family group companies (expecting the parent group to step in and save them), it is the implicit guarantee that allows for the lending. To those lenders, the Dubai World default is the stuff of which nightmares are made. The initial worry was that other implicit guarantors would use this crisis as the opportunity to walk away from their implicit obligations. While that has not materialized, it should serve as a wake up call to those who have been cavalier about implicit guarantees.

What is the bottom line? I am not suggesting that implicit guarantees are necessarily bad but they can pose a danger when too large a proportion of the debt in a system is dependent on them. Since none of the parties involved - the lender, borrower and implicit guarantor - make the obligation explicit, it is possible for them to misjudge the extent of their indebtedness and for investors to make the same mistake. I have seen many Asian and Latin American family group companies that have little or no debt on their balance sheets but have unconsolidated subsidiaries with massive debt on their balance sheets (backed up by the implicit guarantee). If we assume that these firms will honor their implicit guarantees, they should be treated as highly levered firms.

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The CRU Scandals: A Reflection on Academia

I am sure that you have been tracking the story of the hacked emails between top climatologists and the ensuing debate about whether those atop the discipline have stifled skeptics in the global warming debate. If you have not, here is a quick review:

http://www.washingtonpost.com/wp-dyn/content/article/2009/11/21/AR2009112102186.html?nav=hcmodule

I do not intend to wade into that debate but the entire controversy has held up a mirror to academic research in general and I don't think the reflected image is flattering.

Let us start with the ideal. Seekers of truth (Scientists, professors, Phd students... the academic research community) come up with interesting and provocative questions to answer, look at these questions objectively (and with no financial interests at stake) and with no preconceptions, develop theories and test them rigorously and then report these results without skewing them. Their research is reviewed by their peers, who bring the same objectivity and fairness to their assessments, and decide whether the research should be published.

As with most ideals, this one is utopian. Here is my more cynical view of how the process works.

1. Research what will be published, not what is interesting: When you first start climbing the academic ladder, the name of the game is to get published. Would you rather publish a ground breaking paper than an incremental one? Of course. But would you rather publish an incremental paper than have a ground breaking paper that does not get published? The answer again is affirmative. It is far easier to publish a paper than nibbles at the edges of big questions than one that asks and tries to answer big questions. If you pick up any academic journal and browse through the contents, you will see the evidence of this marginalization.

2, Bias in, bias out: Researchers are human and come in with biases and preconceptions, some of which are formed early in life, some during their academic experiences and some of which they acquire from their mentors and peers. Those biases then drive not only the topics that they choose to research but also how they set up the research agenda and in some cases how they look at the data.

3. Who you are matters: Where you went to school to get your doctorate, who your mentor is and what school you teach at right now all affect your chances of getting published. If you went to an elite school (and the elite can vary from discipline to discipline), worked with the right mentor (preferably a journal editor) and teach at another elite school, your chances of publication increase significantly.

4. Every discipline has an "establishment" view: There is an establishment view in every discipline. Papers that hew to this view have a much easier path to publication than papers that challenge the view. In finance, the establishment view for decades was that markets were efficient and that any evidence of inefficiency was more a problem with the models we had than with the underlying efficient market hypothesis. It has taken almost two decades for behavioral economists to breach this wall. Now, I sense that they are becoming part of the establishment and don't quite know what to do.

5. Peer review is wildly variable and sometimes biased: When you write a paper in a particular area, it will be sent out to other "experts" in the area for review. Some of them are scrupulously fair, read your paper in detail and provide you with extraordinary feedback that improves your paper. Others are defensive, especially if the paper challenges one of their pet theories, and find reasons to reject the paper. Still others are extremely casual about feedback and make suggestions that border on the absurd. While peer review, on average, improves papers, it does so at considerable cost.

6. Data abuse happens: As the volume of and access to data improves, it has become far easier to abuse the data by (a) selecting the slices of data that best fit your story (b) expanding sample sizes to the point that the sheer amount of data overwhelms the opposition and (c) reporting only a subset of the results that you get with the data.

I think peer review is useful and empirical testing is crucial. However, my advice to laymen looking at academic research is the following.

1. Don't assume that academics don't have an agenda and don't play politics. They do.

2. Don't let "research findings" sway you too much - for every conclusive result in one direction, there is almost always just as conclusive a result in the opposite one.

3. Just because something has been published does not make it the truth. Conversely, the failure to publish does not mean that a paper is unworthy.

4, Develop your own vision of the world before you start reading papers in an area. Take what you find to be interesting and provocative and abandon the fluff (and there is plenty in the typical published paper).

5. Learn statistics. It is amazing how much of what you see reported as the truth fails the "standard error" test.

One final note on the CRU email story. For the most part the faults of academic research create no significant damage because so much of the research is inconsequential. The scandal of the data manipulation and stonewalling of critics in this case is that it is so consequential, no matter what you think about global warming. If there is no global warming and the data has been manipulated to show that there is warming, the academics at the heart of this affair should be forced to answer to the coal miners, SUV assembly workers and others who lost their jobs because of warming-related environmental legislation. If there is global warming and the numbers were being cooked to make the case stronger, there is the real possibility that people will turn skeptical about warming about revert back to old habits. In either case, it behooves those involved in this mess to step down.

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A tax on financial transactions: Good or Bad Idea?

In recent days, we have heard talk from Congress about imposing a tax on financial transactions. While there has been heated debate on the topic, there seems be more smoke than substance in most of the arguments. This morning, Paul Krugman, who seems to have made a speedy and seamless transition from economist to polemicist, has an article on why such a tax is a good idea:
http://www.nytimes.com/2009/11/27/opinion/27krugman.html?ref=opinion
As always, Krugman sees the villains here (the speculators, who else?), decides that this tax will not have much effect on the good guys (a group of long term investors, into which he puts himself and his readers) and sees potential benefits to markets from the action.

Very convenient, but not very balanced!!! I would like to provide a counter, by first examining the motives for a transactions tax and then considering the laws of unintended consequences.

Motives
As I see it, there are three motives for a transactions tax.
1. Revenue generation: As government budgets get squeezed and deficits mount, legislators are flailing around for ways to raise revenues in fragile economies. Given the sheer volume of trading volume in financial markets, even a small tax seems likely to raise huge revenues. (In a classic example of how governments compute potential revenues from taxes, the estimated tax receipts are computed by taking the existing dollar value of trades in a market and multiplying by the tax rate.... If only we lived in a static world...)

2. Punish bad behavior: As a bonus, the tax will fall most heavily on those who trade short term or in derivatives markets. If we assume, as Krugman has, that these trades are for the most part speculative, the tax punishes that "bad" behavior. (It is the same rationale that allows governments to raise taxes on tobacco and alcohol...)

3. Target the "right" entities: The perception on the part of many is that the biggest traders in derivatives markets are investment banks and hedge funds. The billions of dollars that these entities are reporting in profits, in conjunction with their absence of suitable remorse for their role in creating the banking crisis of last year, has made them easy targets. (I am quite surprised that legislators have not proposed a windfall profits tax on just the bad guys, at least as they see them... they would probably call it the Goldman tax!!)

So, what can go wrong?
1. Motives are internally inconsistent: There seems to me to be a direct contradiction between motives 1 and 2. Put another way, the only way in which this transactions cost will raise revenues is if the bad behavior in question (short term trading) continues in the future. I think legislators need to specify what their primary objective and not try to argue out of both sides of their mouths. (I know little or no chance of this happening, but no harm hoping..)

2. Speculation versus Investing: As I have argued before, I am very uncomfortable drawing the line between speculation and investing. While I might not see much benefit to short term trading, I can see how others might. To label myself as the investor and the others as speculators is self serving and wrong. Furthermore, the notion that derivatives trading is driven primarily by speculation is fantasy. I can see plenty of reasons why a long-term, value investor may use derivatives to protect and augment his returns.

3. Liquidity costs: Even if we accept the premise that short term investors create noise and pricing bubbles, long term investors benefit from the liquidity they bring to the system. In fact, the markets where long term investing is most difficult are markets where there no short term investors. (Consider the market for fine art or even real estate.... Transactions costs inflate for everyone and insiders end up dominating the market)

4. Market mobility: As trading moves of exchange floors into ether space, it is difficult to visualize how a transactions tax will work, unless it is globally coordinated. All you need is one rogue player for the system to start coming apart at the seams. Krugman argues that the clearing systems for many of these markets are centralized and that the tax can be therefore collected at these locations. While this may work in the short term, how long will it take for an offshore location (say the Cayman Islands) to set up a competitive system? (It will cost money but the potential benefits from the system will be huge.) Once that happens, any chance of regulating these markets, even in sensible ways, becomes remote.

All in all, I think this is a dumb idea that should be throttled early in the process. I am sure that you will hear variants of the concept, and they will all share a common feature. They will try to focus the tax on what they view as the markets or securities that they view as most speculative and argue that only the entities in these markets will be affected by the tax. I don't think so. Ultimately, we will all bear the cost.

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Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?

The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?

If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?

The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.

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The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.
http://online.wsj.com/article/SB125823321386948789.html?mod=googlenews_wsj

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:
http://www.amazon.com/Greatest-Trade-Behind-Scenes-ebook/dp/B002UBRFFU/ref=sr_1_1?ie=UTF8&s=books&qid=1258333719&sr=8-1

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.

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