Tag Archives: A Random Walk Down Wall Street

(REVISED) Tesla: Another Castle in the Sky Valuation Case Study

In light of my recent post about Facebook’s valuation of WhatsApp, I wanted to explore another relevant case study in valuation: Tesla Motors. Tesla has gained notoriety as an electric car manufacturer in the US. Founded by the eccentric entrepreneur Elon Musk (who formerly founded PayPal), the company has developed several models of fully electric vehicle that some observers believe will transform the automotive industry. Last month, Morgan Stanley released what the WSJ called an “ambitious” research note that sent the stock surging. As the article goes on to describe:

How ambitious? Put it this way: when a research report from Morgan Stanley uses the word “utopian” 11 times — each of them in a sincere, non-ironic way — when describing the future of your company, it’s an ambitious endorsement.

The Morgan Stanley research note points towards a “utopian” society in which fully automated automobiles completely dominant the market and Tesla is at the forefront. They illustrate their potential vision in the graph below:

BN-BR447_Utopia_G_20140225160506

It is hard not to be skeptical about any valuation that relies on visions of utopia to justify its claim. As Malkiel describes in A Random Walk Down Wall Street, sell side research analysts in particular, are prone to conflicts of interest. Tesla would be a coveted investment banking client for a firm like Morgan Stanley and since the automakers stock is all the buzz right now, the bank may want to cash in a PR boost by making an aggressive prediction.

The point remains, however, that the stock is trading near all time highs. The company is worth almost $30 billion dollars, which makes it more valuable than some long standing conventional automakers such as Renault, the French auto company. I consider myself a firm foundations theory believer, so I decided to do some quick off-the-cuff calculations to see what metrics would make Tesla’s current valuation reasonable.

For starters, I looked at Tesla financial statements to determine the market capitalization and added the firm’s debt, which gave an enterprise value or a total value of the firm of about $27.5 billion. Then I assumed a (very rough) cost of capital for the firm of 15%, which is based on the fact that the firm is capitalized primarily with equity a more expensive form of capital than debt. Based on this discount rate, the steady state earnings that Tesla must generate to be worth $27.5 billion are around $4.2 billion annually. Next, I looked at traditional margins for the automotive industry – Ford and GM hover around 3-3.5% operating margins over recent years, however, I factored in that Tesla may be able to sustain higher margins because they sell a more premium product and maybe be able to produce more cheaply once they attain sufficient scale. Let’s say they can sustain a 5% operating margin in the long run then. Based on this assumption, their annual revenue must be around $83 billion. Compare this now to total annual US auto sales, which I found through IBIS World report. The annual US auto market is around $102 billion, so at Tesla’s current valuation, its steady state revenue would be approximately 80% of the current market!

As I discussed in my WhatsApp post, fundamental analysis may not be very useful if you are a trader in this company. As Keynes said, “the market can stay irrational longer than you can stay solvent.” I will not deny that the growth prospects for Tesla appear bright and there is always the potential that the company will truly prove revolutionary enough to justify its valuation over the long run. For now though, as a firm foundation believer, I would stay away from an investment in Tesla Motors.

EDIT: When I published this post on March 26, Tesla was trading at $218 per share. Since then, the stock has traded down considerably, falling below $200 for over a week and just recently crossing back above that level. The market seems to share many of the concerns that I mentioned above. There has also been pressure on the direct sales model that Tesla employs to sell its car, with a high profile legal move by the state of New Jersey, which prohibits direct auto sales. Tesla has the potential to become the next great American auto maker but still has many significant obstacles to overcome, which is why I would continue to recommend any investment in the upstart company.

MPT and retirement planning

In a previous post, I questioned how diversified a portfolio of just three assets could really be.  This wasn’t really fair, since the whole point was to avoid such an analysis.  To provide a fairer test, I will use 15 assets for this analysis, all of which are choices taken from an actual retirement plan. The 15 securities listed here consist of 14 mutual funds and a stock.  Choices are predominately focused on US equities, though is a REIT fund (FARCX), two international funds (RERGX, VTRIX), a bond fund (PPTRX), and a money market account.  Given this expanded universe of choices, what will theory tell us is best?

I used Matlab and it’s financial toolbox to retrieve four years of monthly prices for each of the funds.  Since one of the funds is a target date fund, data was not available for it before then.  The data was provided free of charge by Yahoo Finance.  These prices where used to calculate monthly returns, which were in turn used to get means and covariance of the assets.  Once this was done, Matlab’s financial toolbox was used to find the optimal weights.  If you really want to get in to the details of such a calculation, this book explains it well, but be warned:  linear algebra and calculus is required, so in practice, this problem is best left for software.  Below is a screen capture of the results, as well as a graph of the efficient frontier.

 efrontierweightsAndNames

The results of the analysis show that fewer assets are better, but raise a few questions as well.  Efficient portfolios generally consist of 3 assets.  This seems to support the idea that a few assets will do.  Yet while these portfolios are efficient with respect the risk reward trade off, they take no account for where the return comes from.  In this case, the funds are for the most part positively correlated over the time period, so funds that would provide diversification are ignored for the higher yielding choices. This points to the period being too short, or more importantly, the number of choices is too small.  The needed number of assets to consider may be close to 100! This seems to indicate that for retirement planning, MPT may be a nice theory, but it’s real value is as a lesson about the value of diversification.

But what’s this say for our choices? There is no substitute for true diversification.  Getting exposure to assets that are uncorrelated is key.  Considering the 15-asset universe, almost every portfolio on the efficient frontier consisted of 3 assets, but a truly diversified portfolio consisting of the choices offered may be better off with a couple more funds.  In this case, examining the top holdings of the funds would provide as much insight as this analysis did!

In search of diversification

In this past weekends Wall Street Journal, I came across an article entitled Funds Investing:  Make More Money and worry less.   At first glance this article seemed to be stating the obvious.  However, after reading it, I began to wonder.  Can one really get diversification from as little as 3 assets?  After some rough analysis, it seems people may need to worry a little bit more then the article suggests.

The article is actually a summary of ways “lazy” people save for retirement.  Lazy, here does not indicate sloth, but rather to retirement ideas named “the margarita”, “the coffeehouse” and “the no brainer”.  The idea of these “lazy” portfolios is that they don’t require a lot of attention or financial know how to set up.  Given the state of most people’s retirements, lets compare the ideas of these retirement plans, requiring little more then your contributions, to conventional wisdom about what it takes to have a solid retirement.

But suppose we have some time, as well as a computer with Matlab or Excel installed on it.  The question I want to ask is:  given these small quantity of assets that make up these lazy portfolios, what do other philosophies about portfolio management say about theses savings ideas?

What follows is based Modern Portfolio Theory, as told in Burton Makail’s “A Random Walk down Wall Street”.   The mathematical analysis, carried out in Matlab, can be done by hand using a general optimization technique called the method of Lagrangian Multipliers.

Modern Portfolio Theory says that the best portfolios lie along the efficient frontier.  This is a line representing the portfolios that invest all the available funds lie on a hyperbola.  The top half of this hyperbola represents what is called the efficient frontier.  These are the portfolios that invest all money, and receive a higher return then the one that lies on the bottom half.  The portfolio located at the “point” is called the Minimum variance portfolio.  The efficient frontier for a portfolio consisting of the 3 mutual funds is shown below.

effcientfrontier

Taken from Matlab 2012

So consider the portfolio mentioned specifically in the article.  It is a portfolio of 3 vanguard funds, (40% VTSMX (Total Stock Market), 40% VGTSX (Intl. Stock Index), and 20% VBMFX, a bond fund). Using Matlab to calculate things like mean, variance, and covariance of the three assets, using data from Morningstar, we can optimize the weighting of the assets to get the optimal combination.  The weights of the portfolios that lie on the efficient frontier are listed below.

Capturedaweights

Using the Vanguard funds listed in the article, as well as data on historical returns from Morningstar, I computed the efficient frontier for the 3 assets given in the article.  This analysis shows that while the portfolio may provide exposure “…to every major equity offering in the world”, it is not exactly efficient.  The second asset (the international stock fund) seems to have very little place in this portfolio despite the unique exposure it brings.  Clearly blindly quantitatively optimizing your portfolio may not leave you diversified, but being lazy may not get you there either.

A Look at Lego: A Firm Foundation Analysis of Our Favorite Toy Company (Part 2)

This is a continuation of my previous blog post about Lego. Using some of the information provided in a recent Economist article and Malkiel’s four fundamental determinants of stock prices to structure my analysis, I am performing a qualitative analysis of Lego’s intrinsic value. In the previous post I concluded that, based on its past revenue and employment growth, Lego’s efficient management practices, and its potential to enter industries outside of the physical toy space, Lego is likely to sustain its current earnings growth. In this post, I will focus on the final two of Malkiel’s four determinants of stock prices: degree of risk and level of market interest rates.

Determinant #3: Degree of Risk

The degree of risk is considered by many to be the single, most important factor that determines whether or not one should invest in a particular stock. As Malkiel highlights in his book, there are many ways that investors try to measure risk. The capital-asset pricing model that Malkiel discusses in chapter nine, for example, provides one rigorous, mathematical way to measure the riskiness of an asset. I could, in theory, attempt to find an estimate for the beta, or, systematic risk associated with an investment in Lego’s stock, but due to a lack of both data and proper tools, it would be difficult to do so. So instead I will perform a more qualitative analysis of the riskiness of Lego stock by discussing some of the factors that I expect would go into calculating an accurate risk estimate for Lego. In other words, I will be analyzing some of the factors that contribute to the unsystematic risk associated with an investment in Lego stock:

Slowing Growth: Although I argued in the previous blog post that I expect Lego to sustain its current growth if not surpass it, it is important to take note of some of the pitfalls of such a claim. As the article points out, “Lego’s net profits grew by 9% in 2013 compared with 35% in 2012, and its revenues rose by 10% compared with 23% in 2012… Mr Knudstorp suggests that harder times are ahead: “When the company is getting bigger and the market isn’t growing, it’s a pure mathematical consequence that growth rates will have to reach a more sustainable level.” Mr. Knudstorp is touching on a point that Malkiel made in his discussion of expected growth in chapter four: the life cycle of a firm. It is quite possible that Lego is reaching the end of its period of rapid growth and entering a period of stability. Although this should not be a huge worry for investors, it is something to pay attention to both when projecting expected earnings growth and when determining the risk of a Lego stock investment. The maturity of Lego as a company may actually lessen its stock volatility/risk because stable earnings tend to imply more stable stock prices.

Expansion and Globalization Risks: In an effort to curb doubts of slowing growth, Lego has recently began an effort to expand its production into new markets like Hungary and most notably, China. Although this may seem like purely good news for Lego’s future growth, expansion into new markets comes with a significant set of risks. Entering a new market requires a large amount of initial investment in order to set up both production and distribution methods. Sales in the new market could turn out to less than projected, unexpected costs could be faced when setting up the production facilities, or bureaucratic costs could increase significantly as a result of expansion. All of these factors could have a potentially damaging affect on Lego’s stock price in the future, and therefore increase Lego’s unsystematic risk. Note, however, that as the CAPM model suggests, these unsystematic risks could be eliminated through diversification.

Determinant #4: Level of Market Interest Rates

Malkiel emphasizes that, generally speaking, lower interest rates should justify a higher share price. The low interest rates during the past five years may justify a higher share price for Lego stock, but it is important to consider what will happen to interest rates in the future. Although the Fed has promised to keep interest rates low for the time being, an investor expecting to buy and sit on Lego stock for a long period of time should be aware of the possibility of a share price decline due to an interest rate increase.

In summary, this analysis has used Malkiel’s four fundamental determinants of stock prices to better understand the intrinsic value of Lego. As Malkiel mentions, it is important to take such an evaluation and the conclusions made from it with a grain of salt. Although a fundamental analysis of Lego is useful, its stock price is still susceptible to the state of market psychology and therefore a measure of Lego’s intrinsic value may not always determine its current or future market value.

A Look at Lego: A Firm Foundation Analysis of Our Favorite Toy Company (Part 1)

After finishing Burton Malkiel’s A Random Walk Down Wall Street a couple of days ago, I’ve been trying to apply some of his insights to things I’ve been reading in the news. A recent article in the Economist, “Unpacking Lego,” gave me a perfect opportunity to take a closer look at the Firm-Foundation Theory and apply it to a company that I’m sure holds a warm place in all of our hearts- Lego. The article discusses the company’s origins, its initial growth, and then goes on to examine Lego’s potential to sustain its extraordinary growth in the coming decade. In this post, my goal is to provide a qualitative evaluation of Lego’s intrinsic value. Using Malkiel’s four fundamental determinants of stock prices to structure my analysis, I will highlight some of the main points the article brings up and then evaluate these points to achieve a better understanding of Lego’s value.

Determinant #1: Expected Growth Rate

lego_growth1lego_growth2

The first determinant Malkiel emphasizes when discussing a firm’s intrinsic value is the expected growth rate of dividends and earnings. Looking at Lego’s past revenue and employment data, its current management team, and its recent efforts to enter industries outside of the physical toy space, one can make some educated predictions of Lego’s future growth:

Revenue/Employment Data: In the past ten years Lego has been experiencing massive growth. As seen by the graphic above, while other toy companies like Mattel and Hasbro have been stagnating, Lego has steadily increased its revenue each year and has added over 148,000 employees from 2007 to 2012.

Management Practices: Much of Lego’s success in the past decade is a product of a change in management in 2003. Having diversified into too many areas, Lego was producing an unmanageable amount of different products in 2003 and was struggling to keep afloat, but with the appointment of former McKinsey management consultant Jorgen Vig Knudstorp as CEO, the company began to show signs of growth. Knudstorp refocused the company’s production and marketing efforts to only target its core products. He sold Lego’s theme parks and “reduced the number of different pieces the company produced from 12,900 to 7,000”.

Presence in the Film Industry: The new management was also able to revamp Lego’s efforts to play a larger role in the film/virtual media industry. Lego had dabbled in the film industry in the past, but its partnerships with films like Harry Potter and Star Wars were largely fruitless due the dim spotlight these films cast on Lego’s actual products. Recently though, Lego’s partnership with Warner Bros has given rise to “The Lego Movie,” which was ranked number two at the box offices in early March after spending three weeks at number one. The Lego Movie puts viewers’ attention directly on Lego’s products, which not only serves as an effective marketing strategy, but it also opens the door for more involvement on the virtual media front. I would not be surprised to see more Lego video games and perhaps even applications that allows kids to construct Legos on their computer to come out in the near future.

Given Lego’s recent success, its superior management practices, and potential for future growth in the virtual media industry, I would argue that Lego will sustain its current earnings growth, if not surpass it. In my next post I will continue my analysis of Lego by looking at two of Malkiel’s other determinants of stock prices: degree of risk and level of market interest rates. Note that due to a lack of data/information about Lego’s dividend payments I will not analyze Malkiel’s second determinant– expected dividend payouts.

(Revised) Owning Bonds Despite a Bearish Perspective

During the financial crisis, the Federal Reserve (Fed) cut the federal funds rate from above 5% to below 1% and has not raised rates since.

fredgraph_effectivefedfunds

As seen above, the grey shaded area represents the recent financial crisis. After reaching the zero lower bound (ZLB) in late 2008, the federal funds rate target has remained at 0.00-0.25%. With interest rates unable to go any lower due to the ZLB, the only way interest rates can move is upwards. The only question is – when will the Fed decide to raise rates?

Although I have been bearish on bond prices for some time, I have not traded on this perspective because I did not know when rates would rise. I am bearish on bond prices because bond yields and bond prices have an inverse relationship (ex. when interest rates rise, bond prices fall). As the economy improves, the moment that interest rates rise (and bond prices subsequently fall) approaches. Following the march FOMC meeting, I have come to believe that rates will rise in 2015. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation that helps reduce the variance of expected returns through decreasing (and potentially eliminating) unsystematic risk from one’s portfolio. In a well-diversified portfolio, only systematic risk remains. On the one hand, systematic risk is correlated among all securities (i.e. macroeconomic news). On the other hand, unsystematic risk is uncorrelated among all securities (i.e. industry or company specific news). Traditionally, stock prices and bond prices have demonstrated a negative correlation. Adding bonds to my portfolio, which consists entirely of large cap U.S. equities, would offer me meaningful benefits through diversification. Recently, irregularities in the relationship between stock prices and bond prices (i.e. a positive correlation) due to quantitative easing might lead one to think that the benefits of diversification are lessened or eliminated. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). Although Malkiel was not referring to quantitative easing, he makes a useful point. As long as two securities are less than perfectly correlated (i.e. less than 1), then there will be benefits from diversification. With my portfolio consisting entirely of large cap U.S. equities, I could reduce the variance of my portfolio’s expected returns through diversification.

Despite my bearish view on bond prices, there are still ways for me to purchase bonds and gain the benefits of diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to diversify, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase (and the credit rating remains fixed). Although the prices of short term bonds will still fall as rates rise, there will still be benefits from diversification.

As I attempt to adjust my portfolio’s asset allocation, I will consider both diversification and my bearish perspective on bonds. On the one hand, I will purchase bonds with short maturities. On the other hand, I will sell (i.e. sell short) bonds with long maturities. As a small investor, I will use ETFs in order to implement my strategy because it is more cost effective.

ABC for Investing in Stock Market from Malkiel

Having no prior basic knowledge of how stock market is driven and how investors make decisions in the Wall Street, I must say I enjoyed reading “A Random Walk Down Wall Street” by Burton Malkiel. The most interesting and eye-opening part of the book is when he talks about two type of analysis of stocks: technical analysis and fundamental analysis.

How I briefly explain them to someone who has little knowledge of the stock market is following:

Technical analysis: a way of choosing a certain stock to buy or sell based solely on the recent movements of the stock price on the chart. Technical analysts would suggest you to buy a stock if the stock has recent history of upward price movement and sell it if the stock has already started declining.

 

Technical analysts believe that there is momentum in stock price movement and if you can get in and get out of the momentum at the right time, you can make profit by trading stocks, They rationalize their strategy by followings:

-crowd instinct of mass psychology sustains started momentum

-first movement in price often results from insider getting information about the company before the market

-investors tend to be initially less responsive to new information

On the other hand, critics of technical analysis  would say that history of stock price cannot tell you how it will behave in the future. In other words, they claim that the stock price movement is a random walk. A random walk means that  you can’t predict future returns based on past returns.

Malkiel gives examples of technical trading rules such as the filter system, the Dow theory, the relative-strength system. and others. But one thing to take away from his this section is that, according to his research, all of these techniques are showed to be not more profitable than just a buy-and-hold strategy.

However, we can see prolific investors who made wealth out of stock market by using technical analysis approach. These names include James Simons of Renaissance Technologies, Ray Dalio of Bridge Water Associates and Steve Cohen of S.A.C Capital. Of course, they are few of technical analysts who managed to beat the market with their secret technical trading strategies. Above article writes down what these famous managers have common:

  • Mechanical trading models were used my many of the most successful.
  • They all used clearly defined systems and stuck to their rules.
  • Many of them back tested their ideas before implementing them in the real market.
  • Most of them surrounded themselves with exceptional people who had the expertise they needed.
  • Many of them lost money for the first few years before hitting their stride.
  • Each trading system suited their personality.

Fundamental analysis: an approach to choose which stocks to buy and sell based on whether a stock’s foundation value is higher or lower than the market price. When they value a stock, they study how the companies will perform in the future, how much will earnings and dividends be, and how long this sustained growth will continue. In other words, unlike technical analysis, fundamental analysts actually do hand-on research on a company and an industry it is in to forecast its earning and growth for coming years. The fundamentalists focus on four main determinants to get real value of the company:

-the expected growth rate

-the expected dividend payout

-the degree of risk

-the level of market interest rates

The last determinant, the market interest rate, is interesting for current period since the market interest rates have been at their historic low levels. Therefore, according to the fundamentalists, the value of stocks should be increasing.

As there were critics of technical analysis, critics of fundamental analysis say that:

-the information on which the fundamentalists base on could be incorrect

-analysts calculation of the value of the stock could be wrong

-the market value of the stock may not converge to its estimated value

Regarding the first point, when there is too much economic uncertainty, firm’s future earning and other related information is very volatile. For this reason, some fundamental analysts changed their approach to technical analysis after 2008.

On the following chapters, Malkiel gives sufficient amount of advice and suggestions for creating a good portfolio for not only beginners but also others. But to me, as a beginner for stock market investing, I learned ABC of investing in stock market in these chapters where he writes about these two ways of analysis.

REVISED: Facebook’s WhatsApp Deal is No Value Investment and That’s Ok

Last month Facebook announced that it was acquiring the messaging application WhatsApp for a whopping $19 billion. While the deal has been picked apart over the last several weeks by financial commentators, I wanted to revisit it in light of our reading of A Random Walk Down Wall Street. Malkiel spends the entire first half of the book introducing (and subsequently arguing against their validity) the castles in the air and firm foundation valuation perspectives – how would the WhatsApp deal look when viewed through the two valuation lenses that Malkiel describes?

Interestingly enough, one of my favorite bloggers – corporate valuation expert Aswath Damodaran a Finance professor at NYU – provides an analysis that presents a perspective that echos some of the principles Malkiel presents in his book. Damodaran presents the two valuation viewpoints:

There is the pricing process, where the price of an asset (stock, bond or real estate) is set by demand and supply, with all the factors (rational, irrational or just behavioral) that go with this process. The other is the value process where we attempt to attach a value to an asset based upon its fundamentals: cash flows, growth and risk. For shorthand, I will call those who play the pricing game “traders” and those who play the value game “investors”, with no moral judgments attached to either.

The trader perspective is a castle in the air approach and the investor perspective is the firm foundation theory. Professor Damodaran goes on to say that from the investors/firm foundation perspective the deal is almost impossible to justify. From a traditional discounted cash flow valuation perspective:

To justify a $19 billion value for a company in equity markets today, you would need that company to generate about $1.5 billion in after-tax income in steady state.

WhatsApp is currently making no where near this amount – according to the WSJ’s MoneyBeat blog they are making just barely $20 million in revenue annually. They charge $1 to users after the first year, which according to Damodaran, would require them to have over 2.5 billion users in order to reach the break even net income (they current have almost 500 million). They could also raise the price to about $5 or begin selling ads, but either of these moves would risk slowing the growth of their user base and turning away already loyal customers. On fundamental analysis grounds, this is a trade that hardly makes sense.

The only way this deal makes sense is looking through a castles in the air lens. According to Damodaran’s terminology this is a “trader’s” acquisition – Mark Zuckerburg in this case is the trader buying companies. Facebook acquired Instagram for $1 billion over a year ago, offered Snapchat $3 billion (which the rapidly growing start up rejected), and just last month announced this $19 billion acquisition. Zuckerburg and company appear to see acquisitions as their best growth strategy considering growth in Facebook’s own platform has slowed around around 1 billion users. Because the company is looking for outside social networks to integrate into its own, it might make sense for Facebook to pay a premium price in order to bring new users into its ecosystem.

The other thing to consider is that social networks are a hot trade right now and because the investors have optimistic beliefs about their future potential, they do not trade based on traditional fundamental metrics. Many observers point to valuation per user as a useful comparison metric that the market seems to price companies based on. According to the below chart from the WSJ, this metric makes WhatsApp look somewhat more reasonably priced at around $42 per user.

BN-BP502_WhatsA_G_20140220070328

Damodaran points out – and I agree with him – that if Facebook believes that the market is valuing their firm from a castles in the air perspective based primarily on their number of users, it makes sense to acquire a company with a very large user based (like WhatsApp) for a lower value per user multiple than your own. From this perspective Zuckerberg and company may have made a genius trade. Only time will tell if the trade works out or if social media stocks in the early 21st century will make their way into the chapter on bubbles in some future edition of A Random Walk Down Wall Street.

ARWDWS: The Professional’s Hidden Veil

In A Random Walk Down Wall Street, Burton Malkiel argues that even investors have trouble making accurate stock forecasts and more often than not underperform the market as a whole. Throughout the book, he gives countless examples of how a lack of information to investors and unique jargon was used to build a “castle-in-the-air.” These stocks are perceived by the public to have an unrealistic level of growth and often can lead to bubbles. And while Malkiel gives many historic examples, he also points to how these castles can be build today. To avoid the risk of losing on individual stocks, Malkiel recommends investing in indices rather than using analyses or market information to make specific picks. Malkiel suggests that neither the at-home investor nor the professional can beat Wall Street’s “random walk” and names five reasons why professional security analysts have a tough time picking winners in the market.

1. “The Influences of Random Events” – The first and most obvious challenge to all investors, professional or not, is the occurrence of random events. Unpredictable and unavoidable, a negative event or discovery can doom a company and its stock. Malkiel is conservative but correct when naming this an obstacle.

2. “The Production of Dubious Reported Earnings through ‘Creative’ Accounting Procedures” – Similar to above, this is an instance where the reveal of dirty accounting can cause a nosedive for a share’s price. Of course, due to rules from the Securities and Exchange Commission (SEC), neither professionals nor casual investors would predict news of accounting fraud and would be at a huge loss if faced with an Enron-like scenario.

3. “Errors Made by Analysts Themselves” – Again, a simple and clear reason – but Malkiel misses the mark to some extent. He acknowledges young analysts to be “well-paid and usually highly intelligent person who has an extra-ordinarily difficult job and does it in a rather mediocre fashion.” (137) While everyone makes a mistake, he fails to acknowledge how experience and day-to-day work give professionals a clear advantage to learn from their mistakes and avoid them in the future – making them much less frequent than that of the average investor.

4. “The Loss of the Best Analysts to the Sales Desk, to Portfolio Management, or to Hedge Funds” – It’s not surprising that after a couple years, analysts are quick to jump to higher paying and less time-intensive positions. There certainly is merit to acknowledging the high level of turnover for security analyst positions.

5. “The Conflicts of Interest between Research and Investment Banking Departments” – The fifth and final reason is by far the most interesting, and the biggest reason why I chose to write this post. It reveals a huge educational gap in how the ratings system of stocks work, and how the interpretation of these ratings differs within the industry and from the outside. Malkiel explains, “When an analyst says ‘buy’ he may mean ‘hold,’ and when he says ‘hold’ he probably means this as a euphemism for ‘dump this piece of crap as soon as possible.'” In fact, these ratings sometimes are solely a way for analysts to please their biggest customers. Malkiel notes that the situation has improved to some extent through SEC policies, but the issue remains that a “buy” rating may not mean what an at-home investor thinks it does.

While reading through this section, I thought of Facebook and its initial public offering (IPO) in 2012. As a huge name and exciting company, it garnered the attention of casual investors looking for the next Apple or Google. Of course, the IPO disappointed many after it quickly dipped to under half its initial price. For those who stuck with it, the stock has recovered and now sits at 50% higher than the IPO price. However, as with many of Malkiel’s examples such as the Biotech bubble and ZZZZ Best, the casual investors were the ones to lose. If the market wants to create fair access for professionals and amateurs alike, the educational barrier through investing jargon and corporate bias must be the focal point of today.

The Rational Investor (Notes on a Random Walk Down Wall Street)

After putting on reading the book A Random Walk Down Wall Street, I finally cracked it open a week ago, and was a little upset I put the book off for so long. The book had a ton of information and quite frankly it was hard to take it all in, in a short period. As a plan on heading into the financial advising industry after college, I think the insights from the book will prove to be very helpful and I definitely plan on spending more time revisiting the book this summer. One of the most interest take aways I found in the book was the psychology behind investing.

First explained toward the beginning of the book with the Castle-in-the-air Theory. It seems that everyone is big on putting their money in solid companies, however as long as the greater fool exists it seems that anyone can make money in the market. Investors can make money on staying in front of the investing curve over holding on to stocks too long. Between 1989 and 2004 for only one  consecutive two year period was the same investment category considered the market winner (EAFE Fund; 1993/1994). Where trained investors know not to invest in the same funds annual, the greater fool will look to the pervious on bet on that market winner. In three separate years, acting as a greater fool would have realized negative returns on investment. (Annual Winners and Losers).

The importance of a rational investor can be seen again in Chapter Four: The Biggest Bubble of All, Surfing on the internet. Again with the investment in the internet bubble, we see investors acting recklessly. They took any information they could get their hands on and bought up as much dot com stock as possible. Eventually a bunch of the companies go under and we see poor investments becoming big losers. Its not that the internet wasn’t profitable, the problem we saw was investors careless putting their money in a wide variety of companies, and when the greater fools ran out the market busted.

One last note on the rational investor comes in Chapter Five. The book spells out the rules of the rational investor and here you see solid financial principles over why one would be interested in paying more for certain stocks. While the vast majority of the population would probably say “Buy low, Sell High”, the book was able to detail situations where “Buying High” may be advantageous.

While the book had many interesting insides on Wall Street, the rational investor was one that definitely stuck out to me. I think the book was very worth while and look forward to revisiting it in the future.