Robots, Buybacks and Golfers
Humans will always play an important role in investment management, say humans who work in investment management, and while I am inclined to agree with them (disclosure: I am a human), I always find myself a little unconvinced when people try to articulate exactly what it is that humans can do and computers can't. For instance, here is Jordi Visser at Weiss Multi-Strategy Advisers:
“The good thing about computers is that they don’t have emotions,” Visser said in a phone interview. “The bad thing about computers is that they don’t have emotions. Computers can’t detect human sentiment. They can’t identify the usual suspects who typically attend crowded conferences when markets are at a top.”
Those things seem very trivial! Identifying those usual suspects is just a matter of cross-referencing lists of attendees to previous tops, and is probably easier for computers than for humans. "Computers can't detect human sentiment"? Sure, in some literal sense that is probably true. (Though computers are, like, analyzing facial expressions these days.) But you don't really care about "sentiment" per se. You care about "sentiment" as it translates into future price action, and it is plausible that this can be inferred from past price action, which is why most humans who talk about "sentiment" are actually talking about charts, not feelings. "More stocks are up on high volume than are down on low volume," some guy will say on TV, "indicating bullish sentiment." And he's the human, with his nuanced emotional depth and his intuitive understanding of human feelings.
Meanwhile here is Muhammed Yesilhark, formerly of SAC Global Investors and Carmignac Gestion SA, who has started a new firm called Q2Q Capital and is building computer models to do his investing for him:
“They never sleep, do not go to toilet, have no girlfriends or boyfriends,” says the 37-old, who was born and raised in Germany. “I think artificial intelligence and investing is a big opportunity."
Ah yes but how can the computer models really invest well if they have never known love?
What happened at Nestlé SA? Dan Loeb's Third Point LLC announced on Sunday that it had invested billions of dollars in Nestlé and wanted it to do a bunch of stock buybacks (and some other stuff). On Tuesday, Nestlé announced that it would do a bunch of stock buybacks. That was ... fast? The buybacks aren't quite as much as Loeb wanted, and Nestlé has ignored some of Loeb's other ideas, but still, it's a quick result for Loeb:
“It’s extraordinary,” Russo said. “There’s a huge amount of concession to the proposals. Historically Nestle would have been considered really impregnable. The world no longer offers management the ability to say, ‘Just go away.’”
Or is it?
“Nestle’s value-creation model might be seen as a response to recent activist overtures, though the company insists its comprehensive review took place in early 2017,” Charlie Mills, an analyst at Credit Suisse, wrote in a note.
There are two stereotyped ways to think about corporate managers and stock buybacks. The old way to think about it is that managers dislike buybacks, because the goal of a manager is to increase the size of her empire, and every dollar that she hands back to shareholders is a dollar that she no longer controls. The new way to think about it is that managers like buybacks, because buybacks increase earnings per share and the manager's compensation.
But the reason that this has become the standard way to think about buybacks is because manager compensation is now so share-based. The old worry about managers -- that they were unaccountable empire-builders -- is what has traditionally motivated activist investors, and it has completely conquered corporate-governance thinking and compensation practices. Managers are paid based on stockholder return, so their old empire-building goals have been eclipsed by a new simple goal of making the stock go up. Which is also what the activist wants.
The activists have, in a structural sense, won. So now you get this strange sight of an activist showing up at a company, throwing down the gauntlet, and demanding a big increase in stock buybacks -- and the company responding "oh hey great idea we were just thinking about that ourselves."
Golf and insider trading.
I do not subscribe to Golf Digest, but I like to imagine that it is renowned for its insider trading coverage and devotes an annual special issue to the subject. After all, as far as I can tell, the big concerns of the average golfer are like (1) equipment, (2) swing mechanics and (3) insider trading. Exchanging stock tips on the golf course without going to prison seems like at least as important a topic for a golf magazine as, like, getting out of sand traps or whatever.
Anyway here is Jeffrey Toobin at Golf Digest on how Phil Mickelson avoided being charged with insider trading in the Billy Walters case, in which Walters was convicted of insider trading on stock tips from Dean Foods board member Tom Davis:
According to the Second Circuit decision in the Newman case, a tippee (like Mickelson) could only be found guilty of insider trading if he knew that the tipper (Davis) benefited in some way from giving the information to Walters. Because there was no evidence of what Mickelson knew about Davis' motivations, Mickelson could not be charged, under the law of the Newman case. "There is no question that the Newman case hurt the chances of a case being brought against Mickelson," said a government investigator involved in the Walters prosecution.
One way to put that is that Mickelson may have known that something was fishy about the stock tips that he got from Walters, but that the Newman court ruled that "fishy" isn't enough for criminal liability: He needed to know that the tips came from a corporate insider who was getting some benefit for giving out the tips, and if there was no specific evidence of that, then he couldn't be charged.
On the other hand, readers of Golf Digest shouldn't put too much confidence in that defense:
In a unanimous decision in December 2016, the Supreme Court rejected the Newman rule and held that recipients of inside information could be prosecuted even if they didn't know what the original tipper received. In other words, Mickelson might have been prosecuted if his case had arisen before December 2014 or after December 2016. But because the Newman case was the law in New York when his case came up, Mickelson dodged trouble on either side—just as he did between those two trees at Augusta.
I am not as convinced as Toobin is that the Supreme Court's Salman decision actually overruled Newman on that point, but it is probably true that prosecutors think it did. So be careful out there on the golf course.
We confirm our interim finding that there is considerable price clustering on the asset management charge for retail funds, and active charges have remained broadly stable over the last 10 years. We agree with respondents who said that, in and of themselves, price clustering and broadly stable prices do not necessarily mean that prices are above their competitive level. However, we also found high levels of profitability, with average profit margins of 36% for the firms we sampled.
Also, the FCA found that investors do not particularly get value for their money:
We looked at whether some investors, when choosing between active funds may choose to invest in funds with higher charges in the expectation of achieving higher future returns. However, our additional analysis suggests that there is no clear relationship between charges and the gross performance of retail active funds in the UK. There is some evidence of a negative relationship between net returns and charges. This suggests that when choosing between active funds investors paying higher prices for funds, on average, achieve worse performance.
In a sense everyone knows that, but it is rather an awkward fact. In most businesses, if you pay more for a thing, you get a better thing. In fund management, generally speaking, if you pay more for a thing, you get a worse thing. That does suggest that there is something wrong with competition in the industry? So the FCA wants firms to compete more on price, for instance by "the disclosure of a single all-in fee to investors" and by "clarifying our expectations around value for money," though all in all its recommendations seem fairly mild.
We talk from time to time around here about whether investment bank equity research analysts inflate their ratings of companies to try to win investment banking business from those companies. I suspect not, these days, because regulation really has cut equity analysts off from opportunities to get paid for bringing in investment banking business, and even from talking to investment bankers.
Debt research, though, who knows? The regulatory settlements limiting conflicts of interest in equity research did not apply to debt, and while there are more recent rules regulating conflicts of interest in debt research, they don't apply as widely as in equities. Here is a paper from Jacquelyn Gillette of the MIT Sloan School of Management on sell-side research in distressed debt. The majority of debt analyst ("DA") reports "reiterate the information conveyed elsewhere and do not interpret the implications of these events on corporate bond prices," and when they do interpret, they don't get very far:
While 54% of the financially distressed firms in the sample file for bankruptcy, DAs predict that only 6% will do so. Furthermore, when a DA’s investment bank is an underwriter or significant investor in the firm, the DA never predicts that the firm will file for bankruptcy (i.e., the predicted bankruptcy rate for these firms is 0%). Finally, for the sample of firms that file for bankruptcy, 89% are covered by DAs that never predict bankruptcy. Collectively, the evidence suggests that a significant number of DA reports piggyback on corporate events and/or perform a marketing role, contrary to recent findings in the EA literature. My results are consistent with the hypothesis that the lack of conflict-of-interest regulations has reduced the information content of DA research.
Distressed-debt research is kind of a niche sample, but, yeah, what is the business case for predicting that a company you underwrite will go bankrupt?
Meanwhile, U.S. and European rules for how research works are about to diverge:
The EU law, which goes into effect in January, will require investors to pay directly for investment research provided by banks’ brokerage arms. The EU measure aims to make research costs more transparent for end investors by breaking them out separately from the trading commissions that investment firms pay.
Yet U.S. law discourages paying for research directly by imposing stricter legal obligations on brokers that accept separate payment for research. U.S. rules have for many years accommodated the current arrangement, which dates to an era when commissions were fixed by exchange rules and brokers competed by offering extra services such as research reports. The extra responsibilities would entail higher legal costs and complicate brokers’ roles as sellers of stocks and bonds, according to industry officials.
On the one hand, from the perspective of the overall investment-fiduciary system, the EU approach seems right: People should know what they're paying for, and direct payments should be encouraged. On the other hand, in isolation, you can sort of understand the U.S. system: People should have higher expectations for objectivity from research that they pay for than from research given away free with trading commissions. The problem is that no one really likes to think about the implications of giving research away free with trading commissions, so they prefer to think of it as objective anyway.
There's a weird buyout boom.
The biggest buyout fund in history ($21.7 billion) was raised in 2007 by the Blackstone Group LP, which seems about right, but it's about to be eclipsed:
Apollo Global Management LLC, the private-equity firm co-founded by billionaire investor Leon Black, has raised $23.5 billion for the world’s largest-ever buyout fund.
You might remember 2007 as a year when there were a lot of huge private-equity buyouts. But 2017, not so much:
Faced with increasing competition for assets from sovereign-wealth and pension funds, buyout houses have slowed the rate at which they have deployed capital. The value of deals struck by buyout firms fell 14% in 2016, while deal count dropped 18%, according to Bain & Co.’s Global Private Equity Report 2017.
This, coupled with a strong fundraising environment, resulted in firms accumulating a record $1.5 trillion of dry powder, according to the same report.
And deal value was under half what it was in 2007, back when the previous record was set. The old buyout-fund boom was, there were a lot of buyouts, so investors kept giving money to buyout firms. The new buyout-fund boom is, investors don't have a lot to do with their money, so they give it to buyout firms, who don't have a lot to do with it either.
People are worried that people aren't worried enough.
"It’s Not Just Stocks. Bonds Are Super Calm," and of course people are worried: "Investors could be in for a rude awakening later this year if they engage in excessive risk taking at this time," says a guy. Meanwhile, "If You Think Stocks Are Dull, Look at the Economy'":
Over the past three years, the standard deviation of the annualized change in U.S. gross domestic product—how far it has tended to swing each quarter from its underlying trend—is just 1.5 percentage points, or about as low as it has ever been. It is a trend that is being matched elsewhere, with global GDP exhibiting the lowest volatility in history.
I feel like most of the explanations I read of low stock-market volatility are emotional (investors are complacent) or structural (volatility hedging has dampened volatility). But here's a boring old efficient-markets explanation: As the volatility of economic activity goes down, the volatility of stock prices should also go down. But can you buy GDP volatility products? Can you buy options on GDP volatility products?
People are worried about unicorns.
Erin Griffith suggests that people are more worried about tech startups than is justified by the data:
I recently found myself carelessly repeating a statistic that I’d heard dozens of times in private conversations and on public stages: “Nine out of 10 startups fail.” The problem? It’s not true. Cambridge Associates, a global investment firm based in Boston, tracked the performance of venture investments in 27,259 startups between 1990 and 2010. Its research reveals that the real percentage of venture-backed startups that fail—as defined by companies that provide a 1X return or less to investors—has not risen above 60% since 2001. Even amid the dotcom bust of 2000, the failure rate topped out at 79%.
So why do people repeat the "nine out of ten" thing? Griffith says that it "it comforts failed startup founders who burned through their investors’ money, laid off staff, and shut down their companies." But history is written by the winners, and I suspect that the "nine out of ten" thing is meant not to comfort failures but to exaggerate successes. "Nine out of ten startups usually fail," a totally average venture capitalist will think, "but four of my ten startups succeeded, so I am amazing."
Also, just, you think differently about an activity with a 90 percent failure rate and one with a coin-flip success rate. Picking the one startup in ten that will succeed is a visionary, mystical process. Sorting startups into two roughly equal piles of successes and failures seems like boring old portfolio management.
Elsewhere, my Bloomberg View colleague Noah Smith argues that "the example of Uber demonstrates how the illiquidity of private markets makes them much worse than public markets for communicating information about a company."
If private markets replace public ones, the degree to which financial markets give us good information about companies’ real economic value will be substantially degraded. That would be bad news for the U.S. economy’s ability to allocate capital to the businesses best able to put it to good use.
It is tempting to say well, yeah, that's the point: The reason that companies want to stay private is to avoid the constant discipline of a market stock price, and to be able to raise vast piles of money from investors who do not ask too many tough questions about whether they'll do anything useful with the money. But it's weird to say that about Uber Technologies Inc., which has built its reputation on a frankly somewhat unpleasant commitment to the laws of supply and demand. Uber should really want its stock price to reflect supply and demand. Right now it seems safe to say that there is no surge pricing in effect.
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