Risky Returns

...for not publishing...really good surf. Did I mention holidays are off limits?

Wow, okay, so whipping up formulas in HTML can get quite complicated. I was doing fine until I tried to create two dimensional fractions. I guess the way to go, is to get away from code by creating an image of the formula, and then to source the image into your doc. Or if you are a pro with css, you can use style sheets to create the fractions........either way, this is about finance, not html...nor am I about to spend all my time on this (although the challenge made it entertaining).

So we turn to commentary (known as, my 2 cents):

Is CAPM worth learning? yes and no. Folks at firms like Barra and RiskMetrics will put any pure CAPM derived cost of equity to shame. At the same time, none of these firms will truly capture the future risk of stock. The trick is how to apply CAPM in a practical, value added way...

The best example I have seen (warning: I have not been around the investing block) of applying these risk management tools in an active management context is Richard C. Grinold and Ronald N. Kahn's book fittingly titled, Active Portfolio Management. What Grinold and Kahn do is modify our beloved CAPM to allow for the premise that markets are not efficient. I could write forever on these topics, although I'd rather hear what my informed readers have to say (anyone out there??:) (side note: I would probably add more value to myself by finishing that book over writing this entry...)

σ²= variance
σ= standard deviation
ρ= correlation coefficient
β= beta
α= alpha
r_f= risk free rate

CAPM

r_i = r_f + α + β_i(r_m - r_f) + ε_i

Systematic and Specific Risk

σ_i² = σ_ε² + β_i² σ_m²

Portfolio Variance

σ_p² = w_a² σ_a² + w_b² σ_b² + 2w_aw_bρ_abσ_aσ_b

portfolio variance = (squared weighting of stock a, times, variance of stock a) + (squared weighting of stock b, times, variance of stock b) + (2, times weighting stock a, times weighting of stock b, times correlation coefficient, times the stnd deviation stock a, times the stnd dev stock b)

Enough formulas for now....

Mr. Risky Returns

Part of the process of studying for CFA level II involves rehashing some of the basics from round one. This works out great, with my work today bringing me straight to Study Session 10, section C: Leases and Off-Balance-Sheet Debt.

First the textbook lesson, second my commentary....

There are 2 different types of leases, capital and operating.

Capital leases are treated as sales (purchases) by the lessor (lessee). The asset is carried on the lessee's books and the capital lease is rightfully treated a debt on the balance sheet. Furthermore, the lessee makes interest and principal payments to the lessor which accordingly records incoming interest and principal payments. The payment of principal is key because when it comes to the cash flow statement, a principal payment is a financing CF, not operating. The effect is to make capital leases favorable to operating leases, from an operating cash flow and free cash flow perspective.

Operating leases on the other hand result in NO balance sheet liability, nor a corresponding asset. The periodic lease payment is considered a rent expense and thus has the effect of depressing operating margins (whereas capital leases, with interest payments, have no negative effect on operating expenses). Just because no on-balance liability is recorded, this doesn't mean that a real liability does not exist. In the footnotes (generally only found annually in 10ks), the liabilities are recorded in the form of a schedule of future required minimum lease payments (MLPs). Actual prior year rent expense is also provided; actual rent expense generally is always larger than the MLP schedule would suggest.

Now, from an accounting perspective, firms would generally prefer not to record a liability on the balance sheet. For this reason some crafty tinkering of lease contracts occur so as to ensure a lease is classified as operating rather than capital. You may ask, "what are the criteria for classifying a lease as capital?" Well, I am glad you asked!

Four criteria (thanks to SFAS 13):

1. The lease transfers ownership of the property to the lease at the end of the lease term.


2. The lease contains a bargain purchase option.


3. The lease term is equal to 75% or more of the estimated economic life of the leased property (not applicable to land or when the lease term begins within the final 25% of the economic life of the asset).


4. The present value of the minimum lease payments (MLPs) equals or exceeds 90% of the fair value of leased property to the lessor.

The basic idea is that if looks like a purchase, smells like a purchase, then account for it like a purchase.....and put that debt on the balance sheet!

Time for Commentary:

But wait a minute, what about the fact that capital leases result in higher cash flows than operating leases? Do investors employing a discounted cash flow based valuation not use these very cash flows to value a business? Yes, yes they do. However, it seems that companies are more concerned with making their leverage ratios pretty than they are worried about cash flow. Its the accounting stupid, not the cash flows...

In my last job in the treasury of the ole fortune 500 company, I completed several lease versus buy calculations for the treasurer and in each case the purchase decision made the most economic sense, yet in each case we went with the lease. Our cost of capital through our credit facility was soo cheap that not a single third party leasing company could offer us a cheaper implied interest rate. Used to drive me crazy...the damn savings to be had were multiples over my measly salary!! Part of the problem came right down to bureaucracy. The division for which the equipment was needed had fixed operating budgets. In order to authorize an adjustment to the budget for the clearance of a purchase, way too many people had to sign-off...I think the CFO even needed to touch it.

Anyways, today at work I was analyzing a few companies that all had substantial operating leases....come on folks....we know what game you are playing!! I capitalized all the leases and threw the assets back on the balance sheet. One of the unnamed companies likes to also include proceeds from sale-leaseback in its free cash flow calculation....puuuuulease.

An operating lease is just another option of several financing alternatives for a company...albeit often times the most economically expensive option...but a favored option nonetheless.

additional source:
Aswath Damodaran is the man

Anything to add??

Mr. Risky Returns

I am well aware that changing the long established tone and direction of this commentary may alienate my massive and loyal readership (I am often told by readers that they would, without hesitation, risk their life in defense of this blog). However, it has become apparent that the time required to maintain this voice to the world, will leave zero remaining time to study for the June CFA level II exam. With intentions to knock the freakin socks off that test, I must be prepared to devote every waking (and sleeping) second to embodying the test material.

In short, this blog is now the "learn a new CFA related item daily" blog. Everyday I will post some interesting (or not) lesson pulled from my daily studies. My hope is that this created publishing obligation will in turn actually result in me studying everyday. So, under that premise, I now promise my servants, err, loyal readers, that from now until the exam, I will try to post at least one CFA item daily (of course barring any extraordinary circumstances such as death, or hospitalization (of the near death type)(or really good surf)(experience has proven the daily post unlikely).

Yours Truly,
Mr. Risky Returns

This site is presented for general information only. It should not be read as investment advice. Any opinions expressed here are mine (or those of the commenter or advertiser, if applicable). I do not represent, warrant, or guarantee the completeness, accuracy or timeliness of the data or information provided, and I shall have no liability to any of this site's users, or to any other party, arising out of any incompleteness of, inaccuracies in, or untimeliness of such data or information. I expressly disclaim all warranties of the fitness of the data and information, and computations and analyses thereof, for a particular purpose or use. In no event shall I have any liability of any kind for any damages, even if notified of the possibility of such damages. There are no express or implied warranties of any kind with respect to the data provided. This is a personal blog only and is not associated in anyway with my current employer.

Thanks to Reflections on Equity Research for the above language.

I want to thank the folks (folk?) over at Abnormal Returns for introducing me to this great interview with Leon Cooperman and Steve Einhorn of Omega (past heads of Goldman Sachs Asset Management and Goldman Sachs Global Research, respectively (or so I think...)).

Sure enough, in the next chapter of Payback, insider trading, referred to by the author as "informed trading," is defended and its punishment is attacked. As a staunch critic of insider trading this defense took me back a bit, although in doing research I learned that many in fact oppose a crackdown on insider trading. Some quotes from the book:

"During the entire decade of the 1980s, the government never developed a theory of why insider trading was harmful or even a rationale for deciding whom and when to prosecute-or even of what, exactly, insider trading was. Neither the SEC, Congress, nor the courts have yet, up to the present day been able to define what constitutes insider trading."

"Insider trading is pervasive because it is frequently beneficial. Sometimes corporate executives want to disclose information but cannot do so directly. Disclosure can cause the information to lose its value. A firm may not be able to disclose the details of a promising new technology, for example, because it does not want to share this information with competitors. If corporate executives in possession of this information purchase shares and make a vague or partial disclosure ("we have good news but can't say just what"), stock prices will move in the right direction. Investors who see corporate executives putting their money where their mouths are more likely to believe what they say."

Fischel brings up an interesting point regarding the ambiguities surrounding the who, what, where, when and why of insider trading. However, difficulty defining an activity, does not render it acceptable. As an analyst, I take personal offense to insider trading. To take its hypothetical acceptance to the extreme, a world in which insider trading is rampant would render my honest efforts useless. Why would I spend weeks diving into the details of a company only to have some plant manager, or lawyer, or confidant trade ahead of me? Focus would switch away from detailed analysis of available public information and instead become a game of payoffs and the race to get the scoop. It is not a stretch for me to imagine "paparazzi photog" and "established international spy" as replacing "CFA" and "CPA" on the resumes of investors. With the now marginalized importance of historical fundamental information, there will be less scrutiny of public filings, which will lead to more abuse of those informational outlets, and more fraud on the part of executives.

The prohibition of illegal insider trading is a core principle that bounds together the self interested participants of our system, with the end result being generally efficient markets that the public generally has faith in.

Insider Trading Pros and Cons:

"What’s Wrong with Insider Trading?", Stephen Moore

"The Peculiar Prosecution of Frank Quattrone", John Tamny

"Insider-Trading Prohibitions Should Go out of Style", Donald J. Boudreaux

"Insider trading: It's a good thing", Jascha Hoffman

Thomas C. Newkirk - Associate Director, Division of Enforcement, SEC

"Why Regulate Insider Trading?", Stephen Bainbridge


"Daniel Fischel is Dean of the University of Chicago Law School. He is an economist, a partner in the preeminent law and consulting firm Lexecon, and co-author, with Frank Easterbrook, of THE ECONOMIC STRUCTURE OF CORPORATE LAW. He graduated from Cornell, Brown, and at the top of his class from the University of Chicago Law School, and served as law clerk for Supreme Court Justice Potter Stewart."

I recently came across Daniel Fischel's Payback at a local Library and had to grab it. The book is a defense of Milken and his '80s money machine. It's always interesting to get the other side's perspective, although so far I am less than impressed (perhaps why I had never heard of this book in the first place).

Fischel lays out the standard argument (largely accepted by yours truly) about the systemic competitiveness and efficiency achieved when micro level participants are self interested, etc (ala Milton Friedman). However, so far Fischel mentions nothing in defense of the accusations of the misuse and abuse of insider knowledge (insider trading is indefensible). It's been a while since I read Den of Thieves and thus I can't completely recall the details of the criminal activity or at least accusation thereof. Perhaps finishing the book will rekindle the brain...