How the investment industry sees advice

A few weeks ago I had the opportunity to speak with John Wilson, CEO of Sprott asset management. We were both attending an alumni dinner, I was there as an alum and he was there as the headline speaker. We bumped into each other during the pre-dinner mingle and took immediate mutual interest due to each other’s name tags. I would have never guessed who he was, so his title of “CEO Sprott Asset management” piqued my interest; John noticed my title of “Investment Advisor” and enthusiastically asked if my firm uses Sprott funds. I almost felt bad telling him that we would never consider using Sprott funds. I explained the idea of a market based investment philosophy and mentioned Dimensional funds and he proceeded to laugh that I had drank the kool-aid. He asked me why I would would want to buy index funds when there are managers that outperform the market? I rebutted that it is next to impossible to consistently determine which fund manager is going to outperform. The conversation went on and finished with John’s final point that it is the job of the investment advisor to find the fund managers that are going to outperform the market. If a client is with a good investment advisor, they will consistently be in the funds that perform well. If their advisor doesn’t pick winning funds, they are not good advisors.

It is not uncommon for advisors to pitch their value as their ability to pick the winning manager ahead of time. Is that investment advice? As a client, do you want the person that you are paying to manage your money to spend their time picking which mutual fund manager is going to be able to beat the market in the future? In reality, investment advice is not about picking the next hot stock or the winning fund manager. Investment advice is about applying an evidence based approach to markets to help people achieve their financial goals while managing their concerns. An advisor that is focused on researching fund managers or picking stocks is only fuelling the emotions that lead to poor investment decisions.

The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

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Why a robot will never take my job

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor.  These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost.  Two of the largest providers are Wealthfront and Betterment.  Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k).  Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement.  If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing.  A financial advisor should know your personality, your family situation, your dreams, and your frustrations.  This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields.  When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized.  The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication.  When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that well trained professional financial advisors do for their clients.

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High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

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Does Canada need more investor education, or more advisor education?

At the end of a recent meeting, a client asked me if I ever wonder why everyone in Canada isn’t investing in low cost index based funds.  The conversation usually goes that way when people hear the story of a passive investment philosophy and fee based business model, but it isn’t something that I wonder about.  The vast majority of Canadian investors use a financial advisor to invest, and about 75% of Canadian financial advisors are only licensed to sell mutual funds.  Getting mutual funds licensed is much easier than getting securities licensed, and finding a commission based job selling mutual funds is much easier than finding a job with an independent fee-based brokerage firm.  I started my career in financial services as a commission based mutual fund salesperson.  I will be forever impressed by the quality of sales and financial planning training that was given to newly recruited financial advisors, but there was a massive disconnect when it came time to make an actual investment recommendation. 

Advisors with next to zero knowledge of financial markets are expected to choose from thousands of available funds while under pressure to make commissions.  Making it worse for the client is the fact that only high-fee mutual funds pay the commissions that new advisors need to make a living.  With strong sales skills and a knowledge of financial planning the product becomes less important and being a financial advisor becomes a matter of managing relationships, something that people with little to no knowledge of financial markets can do successfully.  A highly skilled and motivated sales force that does not always fully understand what they are selling, and an investing public with minimal financial education, make it obvious to me why Canadians have been relatively slow to adopt low-cost tools like index mutual funds and ETFs.  I meet plenty of people who are fed up with the fees they have been paying and the service they have been receiving, but the market is still slow to get away from high fee mutual funds sold by commission hungry financial advisors.

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Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

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Searching for yield in all the wrong places

The current low-yield environment has made it very easy for investors to question the value of holding bonds in their portfolios.  With interest rates staying low as long as they have, concerns have surfaced around frustratingly low yields, and the fear of rising interest rates decimating the value of bonds.  If bond yields can be matched by GICs, and GICs won’t lose value if interest rates rise, why would anyone hold bonds at all?  Let’s consider this question while ignoring the interest rate environment altogether. 

Bonds reduce volatility in a portfolio and provide an asset class that does not move in lock step with equities; they are not added to a portfolio to produce higher expected returns, but to allow investors to weather the inevitable swings in the equity markets.  When an investor looks at their fixed income allocation as a source of yield rather than a source of risk reduction, they are looking for yield in the wrong place.

In a strong economy with low yields, some investors begin to feel that they can simply replace their bond allocation with dividend paying stocks.  This strategy eliminates the risk reducing effects of a fixed income allocation and leaves the investor fully exposed to fluctuations in the equity market.  When investors begin searching for yield in their fixed income portfolio, they end up taking on additional risk rather than managing it.  Looking at bonds strictly as a risk management asset class changes the nature of the yield discussion.

Nobody can predict the future.  It is obvious that interest rates are low today, but nobody knows what they will be tomorrow.  When you are building a portfolio, it is important to focus on taking risks that have proven to have higher expected returns on the equity side while keeping a bond allocation in place to manage overall portfolio volatility.  By getting your mindset away from chasing yield in bonds, it becomes possible to construct a bond allocation using investment and higher grade short-term bonds.  These securities will have lower yields than low-grade or long term bonds, but they also carry less volatility.  Implementing this fixed income strategy allows investors to reduce interest rate risk in their bond allocation while also maintaining the liquidity that is necessary to systematically rebalance - something that is lost with GICs.

Every investor should appreciate the effects of exposure to riskier asset classes with higher expected returns, but it is important to understand that regardless of their yield there is no replacement for bonds in a robust portfolio.  So what do you do if interest rates rise and the value of your bond allocation goes down?  Rebalance by buying more high quality short-term bonds at the new, higher rates.

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12 Entertaining Finance Movies that will Teach you Finance

Finance is a broad subject with many facets that make learning it a large undertaking for anyone.  These films, watched in order, will lead to a relatively comprehensive understanding of what finance is, how it works, and how it affects our society.

Foundations of money, finance, and the corporate structure:

  1. The Ascent of Money: A Financial History of the World (2009)
    This is literally a full history of how finance has developed through time.  From the first currencies ever used, to financing wars with bonds.  Watching this film beginning to end really does create a strong foundation for understanding how finance has developed through time.
  2. The Corporation (2003)
    One of the most important concepts that drives modern finance is the corporation.  Understanding how the corporate structure influences business decisions is fundamental to grasping the general ideas of finance.
  3. Capitalism: A Love Story (2009)
    The social effects of the corporate structure on a capitalist society are examined in this film.  Widening income gaps have often been attributed to finance.  This film furthers the ideas introduced by The Corporation and applies them directly to a real financial crisis.

    Failures in the financial system, fraud, greed, and regulatory issues:
  4. Enron: The Smartest Guys in the Room (2005)
    A comprehensive look at how a corporation was able to defraud thousands of people with its accounting practices leading to massive changes in the regulatory systems for financial reporting.
  5. Too Big to Fail (2011)
    Understanding the actual finance behind finance is only half of the battle in truly understanding finance.  This dramatization of the fall of Lehman Brothers, and the beginning of the financial crisis, shows how personalities, government decisions, and personal relationships all play a massive role in driving the financial markets.
  6. Margin Call (2011)
    When the US financial institutions began to crumble, they began to unload their worthless securities to other institutions and clients to avoid their own collapse.  This film gives further insight into the decisions that nearly collapsed the financial markets.
  7. Inside job (2010)
    Further reflection on the 2008 financial crisis with insights from global policy makers and academics.  This film further reinforces the concepts introduced in Too Big to Fail and Margin Call, but it is not a drama.

    How financial markets actually work, the buying and selling of securities, and the retail environment:
  8. Floored (2009)
    This documentary looks at floor traders, the people buying and selling securities on an open outcry trading floor.  Although this film gives plenty of insight into this part of the financial markets, floor traders have been replaced by electronic trading.
  9. Money and Speed: Inside the Black Box (2011)
    The level of influence that automated trading has on the financial markets today is intimidating.  This is an area that is constantly evolving and will continue to evolve.  Eugene Fama argues that the algorithms used in this type of trading make markets more efficient.
  10. Boiler room (2000)
    This movie does not by any means depict every stock broker.  It does, however, give insight into the way that the business works at the retail level, and shows how sales driven the industry can be.
  11. Wolf of Wall Street (2013)
    Similar to Boiler Room, this film shows an extreme case of how sales driven financial markets are.  The film is quite wild, but it does offer another opportunity to see how securities are created, bought, and sold.
  12. The Retirement Gamble (2013)
    From the perspective of an investor, this film is the most important.  It shows how all of the pieces fit together to make the investment climate for retail investors extremely difficult to navigate.

Understanding the Stock Market

Why People Invest

I already explained what a stock is, so I should have the foundation to go ahead and discuss what the stock market is in some detail.

Before I do that, I need to explain why we want to invest in the first place.  In the chart below you can see some different lines.  The ones to focus on for right now are the orange line, which is a representation of a dollar invested in the US stock market, and the light green line, which is a representation of a dollar invested in US treasury bills.  It is obvious that a dollar invested in the stock market will grow more than a dollar invested in a treasury bill, but why is that?  A treasury bill is issued by the US government and is what is referred to as a risk free investment because it is very unlikely that the US government will fail to pay someone holding a treasury bill.  Being invested in the stock market is riskier because you are owning pieces of companies which can go down in price, even go to zero if the company goes bankrupt.  Investors need to be compensated for taking risks when they are investing in companies, otherwise they would only invest in the treasury bills.

The difference in returns between the treasury bills line and the stock market line is called the market premium, or the amount of investment return over and above a risk free investment that can be expected for investing in stocks.  So when you are saving for a long-term goal, it can make sense to invest in stocks because they will give you a higher expected return over time.  The chart below shows the returns of the total US stock market minus the returns of US treasury bills every year from 1927-2012.  On average, the market premium was 8.05%.  This means that on average, being invested in stocks meant that you could expect a return 8.05% higher than the return from being invested in treasury bills.  Notice that the red bars are years where stocks had negative returns; that is the risk of being invested in stocks rather than treasury bills.


The Market

We know stocks are pieces of ownership of companies that allow individuals to partake in the company's growth and losses.  Partaking in the growth and losses of a company by buying an ownership stake is called investing in the company, and investors receive higher expected returns for being invested in companies because of the risk involved.  All of the investors that buy stocks need a place to buy and sell their stocks, and that is where the idea of the stock markets becomes important.  If there was not a stock market, people that wanted to buy and sell stocks would have to find each other manually; it would be like Craigslist for stocks.  Having consolidated public stock exchanges makes it much more certain that a stock will be available to buy when you want to buy, and you will be able to sell when you want to sell.  This makes stocks much more liquid, or much easier to convert back into money.  If stocks became illiquid they would go down in value drastically because people would not be able to convert their ownership in a company into money when they need to.  The integrity of the stock market is a very important part of investing, and there are safeguards built into public exchanges to ensure that the markets remain liquid.  So it's easy enough to understand that the stock market is just a big public marketplace where investors can buy and sell stocks, but what are people talking about when they say the market is up or down?  Or when they talk about beating the market?  There are different stock markets around the world, and within different markets there are different stock exchanges.  So what is the market that people talk about in the media?

To explain this further I need to explain what an index is.

How an Index Works

You might have heard about the S&P 500, or the S&P/TSX Composite.  These are indexes.  An index is a grouping of stocks that has been selected to represent a particular market.  The S&P 500 is one of the best known indexes in the world; it is 500 stocks that have been selected by Standard and Poor's (a financial research company) to represent the US stock market.  When you hear that the S&P 500 is up, it means that the overall value of all of the 500 stocks included in the index is up.  It is important to keep in mind that although the S&P 500 has been selected by the very smart people at Standard and Poor's to represent the US market, it only contains 500 of the largest, most well known companies that are traded on public exchanges in the US; overall, there are about 5000 companies with stock that trades on public exchanges in the US.  One of the major uses of an index like the S&P 500 is benchmarking.  Benchmarking is using the performance of an index as a tool to compare the performance of other groupings of stocks, or individual stocks.  When you invest in a mutual fund, or have a broker tell you that they will build you a portfolio that will beat the market, they are saying that they will pick a stock or a grouping of stocks that is different from their benchmark index that they think will allow your investment to perform better than investing in the companies in the index.  If a fund invests in American companies it will likely use the S&P 500 as a benchmark index, and a fund that invests in Canadian companies will likely use the S&P/TSX Composite as a benchmark index.  The whole idea here is that if someone has the ability to predict which companies within a market will perform well, they can buy those companies instead of buying the companies in the benchmark index so that their fund will perform better than the index.  Now, because there is a lot of research involved in deciding which stocks will do well and which ones will do poorly, there are fees that have to be paid to the investment manager if they are going to try and beat the market for you.

Investing in the Market

You can choose to invest in an index that has been built to represent a given market for a very minimal cost, or you can choose to pay a significant cost to invest in a fund that is going to try and do better than the index.  It is very easy to invest using both of these methods.  You can buy something called an Exchange Traded Fund (ETF) which will track an index, or an index mutual fund which will do the same.  Companies like Vanguard and iShares allow people to invest in an index of their choice for a very low cost; you can choose to invest in the S&P 500 which we know is 500 of the largest companies listed on US exchanges, or the Russell 3000 which is an index that is designed to represent all  of the companies in the US market, or the MSCI EAFE which represents all developed markets outside of the US and Canada, and the possibilities of indexes to invest in go on forever.  Investing in a fund that will try and beat the market is equally easy to do, companies like Fidelity have plenty of different funds with different strategies designed to outperform a given index.  To illustrate the difference in cost of these two strategies, the Vanguard Total Market Index which invests in 3000 American companies designed to represent the total US market costs you .05% of your investment account to hold, and the Fidelity US All Cap fund which is designed to "seek the best in US equity opportunities" costs you 2.4% of your investment account to hold.  Both of these funds allow you to invest in the American market, but one is designed to do whatever the market does, and the other is designed to beat the market.

Remember Efficient Markets?

I write about markets being efficient often.  Remember that if markets are efficient, all available information is included in the price of a stock.  With that in mind, let's look at the idea of trying to pick which stocks will be the best ones to invest in.  The people that are picking the stocks that will be included in a portfolio that is trying to beat the market are using massive amounts of information to make their investment decisions.  These people will know everything that there is to know about a stock before they select a company to invest in.  But think about all information.  That's a lot of information, and there's new information coming out all of the time.  Even if an analyst does know everything about a stock before they buy it, it is impossible to predict all new information, and all new information will be included in the price of the stock as soon as it becomes available to the public.  So, we should try and get information about stocks before the information is public? No.  That is insider trading which is illegal.  Point is, all information is included in the price of a stock, and new information is random, so stock prices are random.  Still want to try and pick the stocks that are going to beat the market?  Good luck.  My opinion is that if you can't beat them, join them.  Indexes are beautiful tools that should be taken advantage of when constructing a portfolio.  Which indexes?  That will have to be another day's post.

Explaining Stocks

I write because it helps me to understand concepts.  I do think it's neat to have a blog so that I have a medium to share my thoughts, but the main purpose is to give myself a reason to write stuff.  I didn't think anyone really read the things I post.

I have now had multiple people tell me that they read my blog posts, and that they actually enjoy reading them.  Too many of the people that told me this said that they enjoyed reading my writing despite not knowing what I'm talking about.  After hearing that feedback, I took it as a challenge to explain the things that I write about in terms that people can comprehend.

I won't stop writing about heavy finance things, but I want to try to bit by bit explain the fundamental concepts of finance to the non-finance people that grace my website with their presence.

Where to start?  I will first give my rendition of what a stock is.  Establishing what a stock is will give me the foundation to go into detail about lots of other things.

What is a Stock?

A stock is a piece of ownership of a company.  When we say that a stock is publicly traded, it means that the pieces (shares) of that company are able to be bought and sold by anyone in the public marketplace, something that we refer to simply as the market.

Understanding that a stock is a piece of a company should be easy enough, but how and why a stock comes into existence is a little bit more complicated.  It all comes back to money (capital).  Companies need capital to do business.  If a company sells coffee they need money to buy coffee beans, cups, machines, and pay employees and rent space.  That capital can come from lots of different places (which I will have to discuss in another post), but once things are going the company should eventually be able to make enough money selling coffee to pay its expenses and buy more supplies to sell more coffee.  If this business decides that it wants to open another location, the capital that the first location is producing by selling coffee might not be enough to open a second location; they need more capital.  To get this capital, they can choose to sell part of their company on a stock exchange.  When a company chooses to do this, they are going public.  A company consisting of two coffee shops would not likely go public, but for the sake of the example they do decide to go public.  When a company decides to go public they have to be underwritten to determine the price that the public might pay for their shares.  This is where an investment bank comes in; so our coffee company would approach Goldman Sachs and tell them that they want to issue shares to the public in an initial public offering (IPO).  Goldman Sachs will examine the company very closely to try and determine how much the public will pay for shares of this company, and then they will either buy all of the share themselves with the intention to resell them to the public (a bought deal), or they will do their best to sell as many of the shares as they can to the public without giving our coffee company any guarantee that all of their shares will be sold.  This initial sale into the market is referred to as the primary market.  Once these shares have been sold into the market for the first time, they can be bought and sold by anyone in the market.  The market after the first sale is called the secondary market, and that is where most people buy and sell stocks.

So now we have these shares, these pieces of a company, that can be bought and sold by people very easily.  As they are bought and sold by people, the price of these shares will move based on a bunch of factors.  It's like  anything else that can be bought and sold, the more people want to buy it, the more the price will go up.  There is an infinite amount of information that can affect the price of a stock, and there are people researching as much of the information as they can all the time to try and predict where the price of a stock is going to go so that they can make money by buying it at one price and selling it at another.  It is also possible to make money by betting that a stock will go down in price, but that is another story.  I often write about efficient markets, and when you understand how stocks get their prices the idea that markets are efficient makes a lot of sense.  If markets are efficient it just means that all available information has been taken into account in the price of any stock at any given time.  This happens because of all of those people that are out there researching stocks to try and make money; they collectively influence the price of a stock until it ends up at a value that reflects how much all of the people in the market will pay for it based on all of the information that is available.

I feel like that was harder to explain than I wanted it to be.  If you read this explanation and have questions, please ask me,  I love answering questions about this stuff.

What's going on with Twitter?

By special request, I am going to discuss my thoughts on Twitter and the volatility of its share price.

As anyone that reads my writing will know, I believe that markets are efficient.  The price of a security reflects all available information.  Practically, the price of a security is governed by the bid-ask spread that develops when people buy and sell it.  The collective knowledge of the people buying and selling securities is what makes markets efficient.  With that in mind, why is Twitter's share price so volatile, and why has its price appreciated so much since its IPO if it hasn't turned a profit?

To answer this, I would first like to discuss where share value comes from.  The value of any asset stems from the cash flows generated by the asset, the lifespan of the asset, the expected growth in the cash flows, and the risk associated with the cash flows.  In the case of Twitter, we are really only concerned with the expected growth rate in cash flows.  If we say that the price of a stock rises based on the feelings of investors, it is really rising because investors feel that cash flows will see significant growth in the future.

Based on the preceding information, the answer to the question regarding Twitter's volatility is obvious; the price is based on the opinions and ideas that a bunch of analysts, traders, and fund managers have regarding the company's expected growth in future cash flows, and their consensus is subject to change.  If Twitter had years of stable financial information that could be used to forecast future cash flows, these people would likely arrive at a stable price consensus because less imagination would be involved.  As for why its price has shot up so much, I would call it speculation.  There are two types of people involved; people thinking that the company will become profitable and the share price will appreciate, and people thinking that they will buy the stock today and a greater fool will buy it for more tomorrow.  The firm has not changed, it is the excitement around the firm's potential to generate cash flows in the future that has changed.  This excitement around future cash flows is what makes investing in companies like this such a poor bet.

I previously wrote about a paper that discusses the idea of investing in growth companies.  It is a dangerous game when many people are speculating on growth due to the effects that speculation has on the P/E ratio.  Even if this company increases its earnings dramatically and becomes a stable performer, the price has to increase relatively with the earnings to make this a good investment based on growth potential.  As actual earnings increase, it is not likely that the P/E will increase with them; the price will remain stagnant or grow at a fraction of the rate of the company because those future earnings are already priced in today.

To summarize, I think that it is possible that Goldman and friends had lower earnings growth built into their valuation model than what the market was willing to accept, I missed the IPO, and I would be hard pressed to believe this stock will be a sure bet.  Its price is not based on the growth of real cash flows, it is based on the guesses and estimates of the collective body of information that makes up the market.

The paradox of actively managed funds

A recent paper by two Wharton professors and a colleague at the University of Chicago discusses the effects that the size of a mutual fund, the size of the fund industry, and fund manager skill have on the performance of actively managed mutual funds.  Historical data trends in these areas were studied to gain information on two hypotheses: as the size of an active fund increases, its ability to beat its benchmark decreases; and as the size of the active fund industry increases, the ability of any given fund to outperform the market decreases.  This study finds that fund size does not have a significant correlation with performance, but the size of the active fund industry does have a significant and negative correlation with performance.  A 1% increase in the size of the active fund industry was associated with an almost 40 bp decrease in the annual performance of the sample of funds examined.  This goes along with what we know from the Grossman-Stiglitz paradox; the more people that are trying to beat the market, the harder it is to get an information edge to beat the market.

Interestingly, the study found that the returns attributable to fund manager skill have increased over the period 1979-2011.  This increase in skill can be attributed to experience, education, or better use of technology. Increasing skill has not been evident in returns because returns have been hampered by growth of the active fund industry.  The study also found that the performance of a fund suffers as it gets older due to constant industry growth and the consistent introduction of more skilled competition.

This paper confirms what we already know about how competition drives the efficiency of markets.  As more entrants compete for alpha, it becomes more difficult to generate it.  It also tells us that although new funds may have increasingly skilled management, the positive effect of this skill decreases quickly in the first few years of the fund's existence.

If growth in the actively managed fund industry decreases the performance of actively managed funds, why would any investor continue to contribute their assets to actively managed funds?

"I want to invest in actively managed funds so that I can beat the market, but by investing in actively managed funds I am decreasing the chances that my actively managed fund will beat the market." It's a new paradox.

(Link to the paper)

Blinded by growth

This article focuses on the idea of investing in growth.  People often get excited about companies or geographies that are growing rapidly, and their excitement leads them to invest in securities representing these growing entities.  The first point that the author makes in the article is that there does not seem to be any correlation between economic growth and equity returns.  Why doesn't this seemingly intuitive correlation exist?  The three main reasons posed in this article are:

  1. Companies benefiting from the economic growth of one country are often based in another country.
  2. The largest companies in most countries tend to sell their goods and services in the international market place, resulting in isolation from local markets.
  3. When growth prospects seem high investors are willing to pay a premium, and they may be over paying.

The idea of buying growth securities is explained by the greater fool theory; a person may realize they are a fool for buying a stock with a P/E of 100, but they expect that a greater fool will buy the security for more at a later date.  To illustrate the dynamics of investing in a growth stock we can look at the following equation representing the return for an investor of a company that does not pay a dividend:


g is the growth of EPS.  This relationship shows us that positive earnings growth will have a positive impact on returns, but if the P/E changes in the opposite direction, this positive effect will be neutralized.  The example of Google between 2006 and 2010 is used; the company had earnings growth of 358.8%, but investors only received a return of 7.3%.  The reason for this disparity is the decreasing P/E.  In 2006, the P/E was 82.6.  This high value reflects the market's high growth prospects for the company - it comes back to all available information being reflected in the price of a security.  In 2010, the P/E had dropped down to 19.3, a reflection of much of the expected growth having been realized.  The problem for investors is that the price was so inflated with excitement in 2006, that it ate away much of the opportunity to partake in the growth of earnings.

The moral of the story here is that although growing companies can offer great prospects for investors, it is extremely important to assess how much is being paid to partake in the growth.  If the premium is too high, returns will be diminished.

The direction of the article is clear, and in line with my own beliefs on investing.  There is an inherent disadvantage to investing in growth stocks and an inherent advantage to investing in value stocks.  Growth stocks tend to be well known in the media and are companies trading with high P/E, P/B, or P/CF multiples due to their potential for growth, and value stocks are less interesting and exciting and have modest potential for growth resulting in them having low multiples. Historically, it has been shown that value stocks produce superior returns to growth stocks, a phenomenon known as the value effect.

It would make sense that the value effect is just an expression of the increased risk investors face when investing in value stocks, but the author argues that value stocks are historically less volatile than growth stocks.  Other arguments are also made by the author in favour of value investing, but he goes on to discuss that it is easier said than done to invest in out of favour securities.  This comes back to sentiment and psychology.

In conclusion, although it is more glamorous to invest in well-known and exciting companies with great growth prospects, the investor has been historically proven to be better off investing in less glamorous value companies.

(Link to paper)

The theory and practice of corporate finance

This paper is a discussion of the findings of a survey that received responses from 392 CFOs.  The survey allows the surveyor to gain insights into subjective areas of interest in corporate finance, including the methodology used by these practitioners for Capital Budgeting Methods, estimating Cost of Capital, and Capital Structure.  I will discuss the survey’s finding in each category and how they relate to the theory that I have learned.

In gaining an understanding of how practitioners approach capital budgeting, the survey asked participants about their usage of net present value, internal rate of return, adjusted present value, payback period, discounted payback period, profitability index, and accounting rate of return.  The results showed that 74.9% of CFOs always or almost always use NPV, and 75.7% of CFOs always or almost always use IRR.  Large firms, firms with high debt ratios, dividend paying firms, and public companies were more likely to use NPV and IRR.  After the NPV and IRR, the payback period was most widely used; it was found that CEOs without MBAs, Mature CEOs, and CEOs with long tenure were more likely to use this method.  It is inferred that the use of the payback period method is caused by a lack of sophistication.  This data is consistent with what has been taught in the business courses that I have taken.  NPV and IRR tend to be strong methods for capital budgeting as they take the time value of money into account and they both allow the project to be compared to other available investments.

The next survey section asked participants three question about how they calculate their cost of capital.  The first question asked how firms calculated their cost of equity; CAPM, average historical returns, or dividend discount model.  The second question asked about the risk factors used, and the last question determined how these models are used once they are constructed.  It was found that CAPM is the most common method of estimating the cost of equity capital with 73.5% of respondents stating that they almost always or always use it.  The next most common methods were average stock returns and a multibeta CAPM.  Large firms are much more likely to use the CAPM, and small firms are more likely to determine their cost of equity directly from investors.  Public firms are much more likely to use CAPM which makes sense as it is difficult to accurately determine a beta for a private firm.  Additional risk factors that are used in calculations include interest rate risk, exchange rate risk, business cycle risk, and FX risk.  Large firms are more likely to adjust for FX risk, business cycle risk, commodity price risk, and interest risk.  Small firms are more affected by interest rate risk.  Interestingly, most firms with overseas sales would use a single company wide discount rate to evaluate a project. (58.7% of respondents), and 51% of firms said that they would use a risk adjusted number.  Large firms were found to be more likely to match their discount rate to the appropriate risk of the project than small firms.  The likelihood that a firm with foreign exposure will use a company wide discount rate is surprising as they are more likely to have projects with varying risks.  The use of CAPM as the main method for determining the cost of equity is interesting after learning about the three factor model.  The differences in the way that firms behave could be attributed to them not fully understanding the risks that they are exposed to when they are selecting projects.  It is also important to note that firms are often not aware that it is dangerous to select projects or evaluate divisions using a company wide cost of capital.

The final section of the survey discusses capital structure; there were numerous questions in this section and I will only discuss the ones that I found to be most salient.  The participants were asked about the corporate tax advantage of debt and it was determined that it is only moderately important in capital structure decisions.  The tax advantage was considered most by large, regulated, and dividend paying firms.  It was determined that firms do not see it as important to maintain a target debt/equity ratio; firms will use the most beneficial form of financing at a given time rather than trying to maintain a set ratio.  Firms do tend to issue stock when prices are high and they will delay issuance in the event that their stock is undervalued.  If a firm knows that they have a high credit rating, but are currently labelled with a low rating, they will not issue short term debt to bridge the gap as was hypothesized by Flannery, Kale, and Noe.  To the contrary of this finding, it was found that firms do try to time the market by timing beneficial interest rates.  When considering issuing new equity, earnings dilution was the most important factor affecting the decision by participating firms which is contrary to what is often taught in business school.

The results of this survey were enlightening as they offer insights from practitioners into the academic theories that are posed by the people that study behavior and data.  Often times, academic theory will not agree with what is true in practice; one of the most interesting parts of this study was that it offered reasons as to why the theories did not hold true in practice.  In many cases, outdated models or methods were used by executives of small companies, older executives, and executives that did not have MBAs.  This shows us that when best practices are not followed, it may be due to a lack of knowledge rather than the academic theories being incorrect.

(Link to paper)

Commentary on the CSA's recent status reports (CSA Staff Notice 33-316 & 81-323)

The Canadian Securities Administrators have been reviewing two different, but related issues for over a year now.  Both of the topics receive a significant amount of coverage in the media; they are Mutual Fund Fees and the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients (making it the law for advisors to act in the best interest of the client).  I just want to express what I feel were the highlights of both of these papers, and offer my commentary.  I have been on three sides of this equation (investor, mutual fund salesperson, and fee based investment advisor), and as such I think that I can offer some unique insights.  The stakeholders in this discussion have been identified as the mutual fund industry, and the investors.  Their points of view are summarized below.

The Mutual Fund Industry

  • There is no evidence of investor harm that warrants a change to the mutual fund fee structure in Canada
  • A ban on embedded compensation will have unintended consequences for retail investors and the fund industry, including:
    • a reduction in access to advice for small retail investors,
    • the elimination of choice in how investors may pay for financial advice, and
    • the creation of an unlevel playing field among competing products and opportunities for regulatory arbitrage; and
  • We should observe and assess the impact of domestic and international reforms before moving ahead with further proposals.

The Investors

  • Embedded advisor compensation causes a misalignment of interests which impacts investor outcomes and should be banned;
  • Investors should at a minimum have the true choice to not pay embedded commissions;
  • We need to implement a best interest duty for advisors; and
  • We need to increase advisor proficiency requirements and regulate the use of titles.

The statement that there is no evidence of investor harm that warrants a change to the mutual fund fee structure is just about the worst reason that I have ever heard to allow a regulatory policy to remain the same.  A practice should not be allowed to continue because no harm has yet been caused by it.  My point here is especially salient when we consider that other countries across the globe are changing their mutual fund compensation structures because they have had problems in this area.  The UK and Australia have prohibited conflicted advisor remuneration "in response to unique consumer protection gaps and situations including mis-selling scandals causing harm to investors, which are not present in Canada."  So despite serious problems with the exact same thing in other countries, we don't need to change it in Canada because nothing has happened yet...seems like a good idea.

I do agree that changes to the regulations could have ramifications beyond the scope of their intentions, but I do not think that these ramifications would be a bad thing.  There is some merit to the statement that unbundled mutual fund fees would reduce access to financial advice for people with small (less than $100K) portfolios.  It would not be beneficial for either the client or a fee for service advisor to enter into a relationship with only a small amount of capital to invest.  As it stands today, small retail investors are in a situation where they are limited in their options beyond investing in mutual funds with high expense ratios if they want financial advice - the only reason that financial advice is affordable with the current embedded commission model is due to the existence of the deferred sales charge (DSC).  The DSC is exactly what it sounds like; instead of paying a bunch of money (5-6% of the account) up front, you pay it behind the scenes over five or six years and never even notice that the advice you received cost anything.  This is a great idea for the advisor as they receive remuneration at the time of the sale.   It also seems to make sense for the investor because they never see the money leave their wallet, until they want to move their account or withdraw their funds before the six years is up.  If the money does not stay invested for the full deferral period, the client is on the hook to pay the fund company back for the money that their advisor received at the time of the sale.  Another issue in this area is that not all mutual funds have the DSC option; in my experience, funds with low fees that do not involve predictive management or large amounts of trading cannot be purchased in this manner.  So... small investors that want advice are likely to have their money invested in expensive funds that allow their advisor to apply the DSC to make it worth their while.  Knowing that information, I'd say that  although small investors can afford advice in the current environment, the advice that they are getting is highly biased towards funds that can be sold with the DSC.

The industry has stated that they do not think that there are conflicts of interest with the embedded fee structure because all types of mutual funds in Canada have comparable trailing commissions.  On this topic, I can speak from direct experience.  When I was operating on the MFDA platform I was very limited in the funds that I was able to offer.  Yes, there were hundreds upon hundreds of mutual funds with high expense ratios claiming to be able to beat the market available to me and the people in my office, but as I started to shift my thinking towards the use of ETFs and index tracking mutual funds I learned that I could not access them.  I remember discovering TD's index funds and being told I shouldn't use them because I couldn't make any money, and I wasn't able to use Dimensional Fund Advisiors because my dealer did not acknowledge them as a supplier.  It is true that most equity mutual funds with high fees have the same trailing commissions, but I would argue that when advisors are limited to using these funds it is difficult to act in the best interest of the client.  Based on my experiences I can safely say that the clients' best interests are not being put first.  Of course, this shouldn't come as a surprise.  In the current regulatory environment investment recommendations only have to be deemed suitable for the advisor to be legally off the hook.

This lack of a requirement to act in the best interests of the client, or lack of a fiduciary standard, is an issue on more than one level.  To open the discussion of the lacking fiduciary standard I first need to explain the educational requirements in place for an advisor to begin operating in this industry.  In order to sell mutual funds, and call yourself an advisor, it takes one exam requiring a 60% to pass and a 90 day supervised training period.  The exam is designed to take between 90 and 140 hours to prepare for.  So with that said, how is someone supposed to know if they are acting in the best interests of their client when they barely know what they are selling? During the 90 day training advisors aren't even trained to put the interests of the client first, they are trained to make suitable investment recommendations. Using the UK as an example, when they prohibited embedded commissions and increased regulations there was a drop in the number of advisors because some of them could not meet the proficiency standards put in place.  To compound this issue, the CSA cited a study stating that most investors already think advisors have a legal duty to act in their best interest.

The fact that there is a debate around whether or not advisors should have a legal duty to act in their clients' best interests is a little bit silly right?  How is this even a question?  The industry argues that the cost of an investment product should not determine suitability; although an advisor may place their client's investments in a more expensive fund they may have done so because the more expensive fund is expected to perform better in the long run...what?  I don't even want to touch that one.  History tells the story of expensive funds outperforming the market better than I can.  The industry also poses that the introduction of a fiduciary standard will give people less incentive to educate themselves on investments and place more reliance on their advisor.  We certainly wouldn't want clients to forgo educating themselves in favour of taking advice from their professional advisor.  I of course say that in jest, but it may hold more truth than it should with proficiency standards at their current level.  

Another argument that the industry poses against implementing a fiduciary standard is that it would be expensive, and these costs would be passed to the client.  To this I say that clients are better off paying more for advice when the advice has their best interests in mind than getting cheap advice that quietly pads the pockets of their advisor.

One of the biggest problems the mutual fund industry would face if a fiduciary standard and unbundled commissions were implemented is that they only funds.  If the most suitable product for a client was not a mutual fund, or like in my experience the most suitable product was a mutual fund without embedded commissions, how can the client's best interests be served?

Personally, I think that the fact that there is a debate around these issues at all is ridiculous.  I worked with some great people when I started in this business on the MFDA platform, but it did not take me long to realize that there were many pieces missing if I was going to be acting in the best interests of my clients.  There a lot of good people in this industry that genuinely think that they are doing what is right for their clients; it is an issue of education on the part of the advisor. I look forward to seeing how all of this turns out, though it doesn't make any difference to me.  I am already operating on a fee-only basis within a firm that has a self imposed fiduciary standard.  

Everyone else will get it right eventually.

Value destruction and financial reporting decisions

This article is a discussion of a survey of senior financial executives that was carried out by Graham, Harvey, and Rajgopal.  The survey was administered through multiple media and received an overall response rate of 10.4%.  The questions were designed to probe the executives’ thoughts and opinions on how likely they or their firm would be to destroy value in pursuit of short term financial performance.  The categories that the questions addressed were: the importance of earnings, earnings benchmarks, meeting earnings benchmarks, failure to meet earnings benchmarks, sacrificing value to meet earnings benchmarks, and smooth earnings.  

The cash flows that a company produces are what investors are really purchasing when they invest in a company.  This knowledge is not reflected in the sentiment of CFOs.  The survey showed that nearly two thirds of respondents believed that earnings are the most important metric in the eyes of outside stakeholders.  It was noted from the data that unprofitable and younger firms tended to favor cash flows, and private firms were also more likely to favor cash flows.  The fact that public companies are more likely to see earnings as the most important metric may speak to the pressure that financial markets place on companies to perform.  The authors speculate that earnings, particularly EPS, is seen in the eyes of senior finance executives to be important to outside stakeholders because it is comparable across companies and it gets media coverage.  The use of this one single metric also makes it easier for analysts to make predictions on future performance.

As earnings are the most widely accepted performance metric, there are numerous methods for benchmarking.  The idea of earnings benchmarks allows managers to compare their performance to something; the survey showed that the most important benchmark was same quarter last year with a 85.1% of respondents selecting this.  This answer was unexpected as CFOs also stated that missing the analysts estimates leads to the biggest drop in share price, but it was also noted that current quarter compared to last year is the first item in a press release.  The next category addressed the importance of meeting earnings benchmarks; 86.3% of respondents believed that meeting benchmarks builds credibility with the capital markets, with 80% agreeing that meeting benchmarks helps maintain or increase the firm’s stock price.  According to survey responses, individual managers strive to meet benchmarks to maintain their own personal reputation.  Maintaining employee bonuses and lowering the cost of debt were seen as unimportant. 

When asked about the consequences of failing to meet their benchmark, 80.7% of CFOs cited the uncertainty about future prospects and the perception that there is something unknown wring with the firm as the top two consequences.  The CFOs commented on how businesses ore often run in such a way that they will produce smooth earnings with goals that will be perpetually attained.  CFOs are scared of what the market will infer about their company is a target is missed.  In order to avoid missing a target, it was found that 80% of CFOs would decrease discretionary spending on R&D, advertising, and maintenance to hit their earnings target; this is clearly short term behavior that is destroying shareholder value in the long run.  These actions are a quick hit play to maintain the share price, but will undoubtedly have consequences.  Taking it even further, 55.3% of CFOs would delay starting a project to meet earnings targets, even if the delay was clearly going to destroy value.  This data indicates that managers are willing to sacrifice cash flows for accounting earnings.  It is speculated that these actions are the result of managers preferring real economic actions over accounting games to meet earnings due to fear from previous scandals.

Smooth earnings paths are another area that CFOs tend to be willing to make sacrifices for.  96.9% of respondents stated that they prefer smooth earnings, even though the underlying business may be far more volatile.  The reason for this is to make investors think that the company is less risky than it may actually be which can result in lower costs of capital due to a lower perceived risk premium.  CFOs in the survey stated that they would sacrifice value to maintain smooth earnings.

The fact that executives manipulate their earnings numbers to maintain or improve their stock price is scary in the context of maintaining the integrity of capital markets, but when they are willing to destroy long term value to make their performance appear to be strong, that is detrimental to a market where people feel that they are able to trust available information.  Missing the analysts’ earnings consensus and having volatile earnings are said to have similar effects on share price, and are therefore equally avoided even if real value needs to be destroyed to make that happen.  In the context of building and maintaining integrity of the markets, CFOs do a major disservice by placing retail investors at the bottom of the list when they produce their financial information.  Companies do this because it is thought that analysts are young and they will overreact if they see things like volatile earnings, so they are hidden.  It is also noted that because institutional investors are evaluated against each other, if earnings are missed and one fund begins selling off stock, the other in its peer group will likely follow.  Also, hedge funds may have measures in place to sell a stock if it drops below a certain price, and a missed target could trigger the same and a chain reaction following.

In order to solve these problems, the authors propose that firms change their reporting habits by moving to principles rather than rules based accounting standards, remove quarterly EPS guidance, and less emphasis on quarterly earnings.  They also state that it is important to maintain integrity in reporting, and some major changes in corporate governance.  I think that the most interesting suggestion is that of making institutional investors take a more active role in how management perceives their short term actions will be received.  If major funds confirm that they will not sell off a stock due to a missed target as long as there is a value creating activity behind it, managers would not be so short term in their behavior.  I think that although a good idea, it would be very difficult to sufficiently empower retail investors.

(Link to paper)

What Happened to lululemon athletica?

I don't pick stocks.  I don't really think that anyone can pick stocks.  A lot of analysis can be done to try and forecast stock prices, but it will never be possible to predict all new information (weather, wars, celebrities' actions...all new information).  Nobel Prize winner Gene Fama believes that all available information is reflected in the price of a security.  If we cannot predict all new information, and all new information is factored into the price of a security it is safe to say that success in forecasting will be as random as the development of new information. 

As much as I disagree with the fundamental concept of picking stocks, I do enjoy a good business case.  If I took one single thing away from my MBA (other than the people I met) it is that companies fail when they get away from their core competencies.  In attempts to keep pace with their past growth rates, poorly managed companies tend to stray from the strategy that brought them success in the first place.  I think that over the last few years lululemon has departed from their core strategy.  It is no surprise to me that they are faltering; the original shareholders cashed out, but is that the path to building long-term value?  Is it strategic for a company to create strong core competencies and maintain them just long enough for the original shareholders to cash out in the primary market only to leave the company to be ravaged by the demands of the secondary market?  Studies have been conducted on the willingness of executives to destroy long-term shareholder value in order to achieve short-term financial goals, and I think this is exactly what has happened at lululemon.  I don't blame them.  Chip Wilson is a business man.  Christine Day had analyst expectations to meet.

Dollar signs and ratios overcame the company's original vision; quality was traded for quantity and they began to diversify away from their core products.  I'd like to walk through how the industry environment has changed since the company began.

lululemon currently has multiple suppliers in a handful of developing countries; a far cry from back in 2004 when they first began outsourcing and had one single supplier in China which was merely a foreign extension of the original Vancouver manufacturer.  In 2004, the supplier had a significant amount of power over the price that they charged for the premium, exclusive, luon blend of 85% Nylon and 15% Lycra that Chip Wilson had created.  lululemon and their supplier had a mutually beneficial partnership that allowed both of them to become highly successful while creating high quality products.  It should not come as a surprise that as the company grew, margins and scale needed to increase and more suppliers were employed.  With the current number of suppliers that lululemon has, and the fact that luon can be easily replicated by other manufacturers, suppliers have been rendered powerless.

The power of buyers is also a far cry from 15 years ago when the company had just begun and the product was sought after as a status symbol and a fashion statement; women would pay $100 for a pair of Groove Pants without thinking twice, they were powerless against the draw of the brand.  As lululemon became obviously successful, multinational, diversified athletic apparel companies started manufacturing yoga equipment to keep pace with the developing market.  While this was happening, yoga went from being a craze, to a trend, to a mainstream form of exercise.  In the current market, yoga apparel is everywhere and buyers have a huge amount of power over the decision of where to buy.  Due to these developments, the market has become more price sensitive, and it is exceedingly difficult for lululemon to justify selling pants at a premium price point when their quality is no longer a differentiating factor.

Competition in the athletic apparel industry is extremely high.  The industry is fragmented and consists of both small private manufacturers like One Tooth, and huge companies like Nike, Adidas, and Roots.   In their 2013 10-K, lululemon acknowledges that the competitive landscape is not easy to operate in.  They actually explain the competitive rivalry in their industry much better than I can (I have paraphrased):

"We also face competition from wholesalers and direct retailers of traditional commodity athletic apparel, such as cotton T-shirts and sweatshirts. Many of our competitors are large apparel and sporting goods companies with strong worldwide brand recognition, such as Nike, Inc., adidas AG, which includes the adidas and Reebok brands, and The Gap, Inc, which includes the Athleta brand. Because of the fragmented nature of the industry, we also compete with other apparel sellers, including those specializing in yoga apparel. Many of our competitors have significant competitive advantages, including longer operating histories, larger and broader customer bases, more established relationships with a broader set of suppliers, greater brand recognition and greater financial, research and development, store development, marketing, distribution and other resources than we do. In addition, our technical athletic apparel is sold at a price premium to traditional athletic apparel.

Our competitors may be able to achieve and maintain brand awareness and market share more quickly and effectively than we can. In contrast to our “grassroots” marketing approach, many of our competitors promote their brands through traditional forms of advertising, such as print media and television commercials, and through celebrity endorsements, and have substantial resources to devote to such efforts. 

In addition, because we own no patents or exclusive intellectual property rights in the technology, fabrics or processes underlying our products, our current and future competitors are able to manufacture and sell products with performance characteristics, fabrication techniques and styling similar to our products."

If consumers choose not to buy yoga (or run, or dance) clothing at all, there are substitutes.  lululemon is much more than athletic clothing, it is casual wear and fashion; I think that from a strategic standpoint buying jeans or cotton sweatpants instead of lululemon clothing can be a logical substitute.  lululemon clothing has not fully lost its appeal as athletic apparel, but the brand had evolved into something not just sought after for use at the yoga studio or gym.  This clothing was trendy; it was fashionable and normal to wear the stretchy yoga pants out in public as if they were jeans.  Maybe I'm getting older and am not with the times any more, or maybe it's because it's winter, but it seems to me that wearing yoga pants is far less socially acceptable than it was a year ago.  The next time Ocean and Duke have a few bills to blow on clothes, it's my bet that they're looking for something that they can wear in public without looking like they just came from the gym... I remember when tear-away track pants were cool too.

For new competitors to appear, the cost of establishing production facilities would be a hurdle, but so many of the new entrants are existing companies that are diversifying into lululemon's market.  Smaller companies are also able to enter into the market to mop up the segment that wants Canadian made, high quality clothing for use in a yoga class; I think this is a segment that lulu left behind when they began their multinational outsourcing and reduced their quality standards.  New entrants can come from both huge companies that are diversifying, and also small players that cater to the traditional yogi market.

So, lululemon is in a market where suppliers are commodities, buyers have tremendous amounts of choice, competition is cumbersome, their product is becoming less fashionable, and new players can easily enter the market; how did they become so successful in the first place?  They leveraged their core competencies.  An extremely high quality product, and an extremely loyal, culture driven, cult-like customer base.   We all know what happens when you bite the hand that feeds you.  When the "scarcity model" shifted to mass production outsourced to inexpensive manufacturers in India, China, and Vietnam, the cult-like following that had previously felt so privileged to own one of the limited items produced in a particular style and colour started to feel just like everyone else on the street.  As the products became less and less exclusive, they also became lower in quality; it's a lot harder to justify buying a pair of stretchy pants for $100 when it may only last a season and everyone else at the gym has the same pair.  In the beginning, the design was meticulously functional and created with material that was carefully monitored for quality.  More recently, we have seen disastrous items like this:


and had serious problems with the quality of the material.  Now that their loyal customers have been insulted with over-priced, unfashionable, poor quality garments it is no surprise that many of the women (and men) that once praised the company are becoming less interested in the culture, and the products.  With the entrance of a new CEO, lululemon could still change its direction and improve its image, but it will never go back to being the glowing superstar of the retail world that it once was, and the image of the wealthy, sporty, yogi, wearing her Astro Pants to yoga class before going straight to the organic market to pick up wheat grass and lentils is dead.  If it's not dead, it's at least out of style.  People will still buy lululemon clothing, it is still functional, and I'm sure the quality will improve to match the price point, but they had something very special that was thrown to the wayside in order to drive profits.  The way that this company fell from grace is attributable to the pressures that the financial markets put on short term performance rather than accepting periods of under performance in light of building out a long-term strategy.  All of this is interesting, and managers can learn from it, but for investors none of it matters.  The market has already priced in everything that I have discussed.


How To Construct a Portfolio:

The first step in constructing your investment portfolio is determining a goal for the investment.  Setting an objective allows you to create parameters that make it possible to determine the rate of return that you will require.  The return will be the number that is required to bridge the gap between the amount of capital that you will invest, and your ultimate goal.  Once this model has been created, the parameters and the required rate of return can be adjusted in order to arrive at a required rate of return that is plausible, and that fits with your investment style.  As an example, if you begin with a principal investment of $5000, make a $100 monthly investment, have a 20 year time horizon, and a goal of saving $100,000, you will require a compound annual growth rate of 8.7%.  If it is determined that 8.7% is not feasible, or if it does not fit with your preferred investment style, the parameters can be adjusted.  Following the same parameters, if we increase the principal to $10,000 and the monthly investment to $200, we only require a 3.8% annual return to achieve the goal.  In the charts below, the green bars are the invested principal and the blue bars are investment returns.  Take note of how heavily the person on the left is relying on investment returns to achieve their goal, if the market does not perform as expected they will have a much greater shortfall than the investor on the right.

$5000 principal, $100/month, 20 year horizon, $100K Goal

$5000 principal, $100/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

Armed with an idea of the rate of return that you will need to achieve your goal with your given parameters, the next step is to determine your tolerance for risk.  Risk and return are very closely related in that an intelligent investor will not assume more risk than is necessary to achieve a given return, and when more risk is assumed the investor expects to be compensated for assuming it.  If we look at the performance of the S&P 500 since 1950, the general volatility of the equity market can be observed.

S&P 500 Performance  - 1950 - 2013

S&P 500 Performance - 1950 - 2013

This chart shows the potential for gains, but it also shows the that capital can be lost in large amounts.  If an investor is able to stay invested when the market is in a dip, history tells us that the market will rise again with time.  This idea gets much more complicated when we factor in psychology and the time horizon of the investor.  If you panic when the market is low and liquidate your investments, you will miss the gains when the market recovers and be stuck holding your losses; similarly, if you have a set date where the capital will be needed and the market is low when you need it you will either be stuck with the losses or not be able to access the capital until the market recovers.  The above chart shows the S&P 500 index which is only an example of a group of stocks.  An investor can build a different portfolio of stocks that is subject to less risk, they can invest in bonds, they can invest in real estate - there is no shortage of investment opportunities, the challenge is building a portfolio that fits your individual needs and investment style.  The following chart from Vanguard illustrates the average returns, and the variability of returns for various portfolios consisting of stocks and bonds from 1926 through December 2012.  Selecting a mix of equities and fixed income securities is called asset allocation - asset allocation is how a portfolio is constructed to fit a risk profile.


With the ideas of setting a goal, determining an acceptable level of risk to achieve that goal, and the right asset allocation to meet that risk level, we are ready to begin selecting the securities.  Picking individual securities is like going to the casino, or like flipping a coin.  The prices of securities reflect all publicly available information, and trying to guess at the new information that may affect the price is not a particularly effective practice.  I once had a pension fund manager tell me that even the best analysts are only right 70% of the time.  It is, however, possible to reduce the risk and increase the expected return of a portfolio through diversification.  Historically, returns of any asset class vary considerable from year to year, and combining assets classes in a portfolio can mitigate this volatility.  To further reduce volatility, global diversification reduces the effect of any single asset class or market.  The figure below shows the variability of returns across asset classes and geographies, common sense tells us that by combining securities across these asset classes and geographies in a meaningful we can reduce the overall volatility of that portfolio.

Variability of Returns.png

At this point we have taken the following steps to construct a suitable portfolio:

  1. Determined an objective for the investment
  2. Determined a time horizon and required rate of return to achieve the objective
  3. Determined a tolerance for risk
  4. Established an optimal asset allocation based on, time horizon, required return, and risk tolerance
  5. Diversify away the risks of investing in any single asset class, market, or geography
  6. The final step is determining a management strategy.  There are two ways that a portfolio can be managed; read after the jump.

What the Automotive Industry Can Teach Us About Mutual Funds

Up until General Motors (GM) went bankrupt in 2009, their business practices created a beautiful juxtaposition for the business practices of Toyota.  GM had been able to rely on their size, market share, and Japan's non-existence to remain profitable for many years.  This fostered an environment of complacency in their ability to perform their core activity...creating vehicles.  In 2006, GM's profitability was mostly derived from financing the sale of their vehicles while they lost an average of $2,300 on each sale; their core activity had become financing while they were still stuck with making cars.  They were using inefficient manufacturing techniques to create a wide array of uncompetitive vehicles.

In contrast, it's no secret that Japanese automotive manufacturers have absorbed the market share that GM was slowly giving up; in 1960 GM held 50% of the North American market, while they only held 19% in 2009.  There were some very clear factors that contributed to this shift in the market, and, strangely enough, I believe that the same principles can be applied to the current state of the mutual fund industry.  The principles are very basic; efficient manufacturing practices, and competitive products.

Efficient manufacturing practices were revolutionized by the Japanese with Just-in-Time manufacturing (JIT).  American manufacturing methods employed economies of scale to keep the cost of machine hours down; they would have a large production run of a single part and then change the machinery to produce the next part.  The problem with this was that the time and cost associated with changing the machinery was cumbersome.  In the event that a manager suddenly needed a small run of rear doors when the machines were set up for front doors, they would be paying a premium for those machine hours.  JIT made the manufacturing process flexible by implementing production machinery and a labour force that was interchangeable; managers no longer had to pay a premium for unexpected production runs because multiple machines could be quickly set up for a small production run of any part.  These interchangeable parts in the manufacturing process eliminated the high fixed costs of any single production run.  Parallels can be drawn between JIT in auto manufacturing and the trading done within a mutual fund.  

Active fund managers will conclude through research that it is the right time to purchase a certain amount of a given security.  When they fill this order, they will be paying a premium to obtain the specific amount of securities at a specific time due to the nature of bid-ask spreads; at a given time spreads will vary, and filling the kind of large market order that an active mutual fund would place will result in paying varying prices for different available lots.  In contrast, a portfolio designed with holding diversified across asset classes and geographies would not need to accept an undesirable bid-ask on any individual security because they would not be looking to purchase any particular security at any exact time.  A mandate may require a certain weighting of domestic small cap stocks, but the individual securities could be anything fitting that description.  This approach lowers overall trading costs; trading costs are not something to be overlooked either.  It would not be unusual to see an actively managed small cap fund with a trading expense ratio as high as 1%.

Lowering the costs associated with producing either a car or a mutual fund is beneficial to both the customer and the manufacturer, but if the product is not competitive, the cost savings do not drive any value.  In 2006, consumer surveys about vehicle value showed that people perceived Toyota vehicles as being better designed and built, costing less to own, and lasting longer than GM vehicles.  This higher perceived value combined with lower manufacturing costs allowed Toyota to grow its margins while GM’s margins became negative.  GM boasted a massive portfolio of brands and vehicles, each one with a wide array of available features.  This lack of focus and internal competition made it very difficult for GM to produce any single excellent product; in contrast, Toyota has only two brands (Toyota and Lexus), and the vehicles that each brand produces have fewer options.  Toyota’s focused approach to the continuous development of excellent products combined with their low costs allowed them to surpass GM as the number 1 auto manufacturer in the world.  As GM’s margins were squeezed by high manufacturing costs and competition with Toyota’s low prices, the quality of their products continued to suffer.  Near the end, and since their re-birth, GM has eliminated or sold many of the brands in their portfolio.

In the context of mutual funds, the industry is in a similar state as GM was before they went bankrupt.  Current funds in general are not of a high quality, they are costly to produce and costly to own.  Much like GM, fund companies are managing massive amounts of mutual funds.  On average, mutual fund companies manage 117 funds, a huge contrast to the average of 1.7 funds managed in 1951.  Just as GM had to eliminate many of their brands to pursue a more focused effort, mutual fund companies have been going through the same kind of consolidation.  Between 2001 and 2012 there was a 7% per year failure rate for mutual funds; failing funds would be absorbed into funds with strong records to mitigate the evidence of their poor performance.  If a mutual fund company were to take the same approach to their product portfolio that Toyota has taken in manufacturing vehicles, it would produce a few high quality, engineered, and focused products.

So, I have drawn a comparison between the automotive industry and the mutual fund industry.  Why do we care?  We care because those who cannot learn from history are doomed to repeat it.  If I went back in time and had a choice between investing in GM and investing in Toyota, I think it’s obvious where my money is going.  If I wanted to use this analogy to decide where to put my money today? Dimensional Fund Advisors would be my Toyota.