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7/11/2005
Victor Niederhoffer: Four Variations on Rates of Return in Commodity-Type Businesses

1. Advances in Behavioral Finance by Richard Thaler, Vol. 2 (published by the Russell Sage Foundation in 2005) seems to go beyond the usual academic tome in that it does not seem to be a direct solicitation for funds to invest in the author's existing or new fund or a way of cementing tenure. The 19 chapters in the book, ranging through arbitrage, stock returns, equity premia, overreactions, underreactions, investor behavior and corporate finance, are quite interesting on their own, and contain many original papers that apparently were not able to find their way into accepted and refereed academic journals.
2. In Chapter 8, "Contrarian Investment, Extrapolation and Risk," by Josef Lakonishok, Andrei Shleifer and Robert Vishny, the authors conclude that "value strategies outperform glamour strategies by approximately 10 to 11 percent per year. Moreover, the superior performance of value stocks persists when we restrict our attention to the largest 50% or largest 20% by market capitalization." Such conclusions could only come out of an ivory tower. The results are based on retrospective Compustat data from April 1963 to April 1990. Biases upon biases are contained in such a study, starting with when the announced earnings data were assumed to be available. Why do such studies capture the popular imagination, when Value Line's prospective studies of similar strategies show return differentials at least as high in favor of glamour? Who is kidding whom?
3. One of the reasonable things that investors used to be taught is that you can't make money by investing in a commodity-type business because competition is based on price. And the return drops to zero. This should be tested empirically, and a categorization of value companies should be based on product differentiation and ease of entry into the field.
4. When I was in the merger business, I had many commodity-type businesses available for sale, and could never sell them for more than book value. The buyer always said, "If I wanted to buy such a business, why not go into it myself? And why should I pay more than cost, for a business that anyone can enter and thereby drive the rate of return to zero?" I have had tens of thousands of company-selling years in the merger business and this conclusion has never been upset. What is it about public companies that creates in the public mind the illusion that the return to a public company in a commodity business should be superior to the return of a privately held firm?

Mr. Ckin comments:

Even the purest of commodity businesses present opportunities for possible returns over the risk-free rate. 

Besides the economics of producing the end product, a company must be able to successfully market its goods in a unique way, such as investing in a brand name (Clorox bleach and Reynolds Wrap are virtually identical to the generic brands, but cost much more) or investing in a distribution scheme. The shareholder return of Alcoa was superior to its peers' over the past decade or so due to its prowess in anticipating price moves, and forward selling on futures markets, not because its aluminum was better, or even distinguishable, from anyone else's.

Moreover, arbitrage opportunities will probably exist in any oligopolistic market in which the participants/investors use different assumptions for risk-free rates of return. Why should we assume that Codelco, or RTZ, or Norilsk, or Phelps Dodge should all use the five-year US Treasury yield as a gauge of risk-free rates (as far as the Capital Asset Pricing Model is concerned)? Further, for metals and energy companies, wouldn't their reserve lives (duration, in fixed-income terms) have some bearing on the risk premium that an investor would pay for those assets?

Of course, the second point assumes that the CAPM is valid in the first place.

Allen Gillespie comments:

A company with continually falling earnings goes bankrupt. A company that fails to grow earnings is a bond. A company with rising earnings is experiencing growth. Thus even value managers rely on earnings growth.

The market cap increases of a few growth stocks is much greater than the assets under management of most firms. The problem, however, is that there is a serious index/benchmark construction issue that is not being addressed. Namely, the growth stocks frequently are not in the index, e.g. GOOG, which has added $50 billion to its market cap since the IPO, or YHOO, which got added on the top tick, or CME). To simply cut a large list of stocks in half and call one half value and the other growth based on price to book hardly measures anything, especially considering that the value of a stock is the discounted future cash flows. Marty Whitman has been successful buying bankruptcy recoveries, which is logical because after bankruptcy the future always has more potential value than the loss-producing past and Brown earns excess as a liquidity provider.

Where the growth funds went astray was in thinking the past would continue in the future. Moreover, in regards to Bill O'Neil, very few stocks really meet his criteria at a given time (generally 30-40) and his style has a market direction component which most mutual funds cannot implement. Furthermore, the stocks that have truly met the CANSLIM criteria the last few years include plenty of value stocks such as the homebuilders and oils.

Andrew West offers:

While I am sympathetic to your skepticism regarding LSV's "Contrarian Investment, Extrapolation and Risk," my perception was that it was their interpretation that was more in doubt than their raw numbers. That paper has been held up to peer review, and I have seen numerous subsequent papers written along the same vein, using different data sets in different countries. There are a large number of finance professors who could make a name for themselves by writing a paper disproving these conclusions by identifying biases or mistakes. Fama and French, who are generally unsympathetic to LSV's interpretations, still find value (or distressed) outperforming growth. Have the Value Line numbers been scrutinized by peers or followed up with out of sample studies?

Victor Niederhoffer responds:

Those problems you mention are true, but the survivorship problem itself is so great that any results of Lakonishok, Fama, or Dreman are totally worthless. And they are superseded by actual results in the '90s. That papers like this are accepted is guaranteed to happen, as detailed in Practical Speculation.

Jim Sogi explains:

One of the criteria in the valuation of businesses for gift and estate tax purposes is marketability. The existence of a large and liquid public securities market gives less of a discount to a minority share in a publicly traded businesses. Whereas a minority block of a privately owned business, whether commodity or not, is subject to various steep discounts for marketability, and additional minority problem of finding a buyer who wants to be under the thumb of the dead owner's son who knows nothing about managing a business, and the son's pushy wife and mother-in-law who know even less but are draining the profits for inflated salaries and perks. This is where the Sage may have gotten some of his returns, preying on the discount factor of distressed family businesses subject to estate taxes. Who exactly does a family turn to when grandpa's seaweed growing business needs to be sold? There is not much of a market, the salesmen take a steep commission, the valuation is always a question, and there is always some exigency involved, all adding up to a discount.

Kim Zussman adds:

Does not the observation of increasing prices for commodities (oil, gold, food) in times of fear prove there is a continuum, or axis of value, beginning with rudimentary supplies and ending with creative intellectual property that parallels Maslow's hierarchy? The assumption and hope that human society is evolving and progressing places value on the top range of the continuum. Zealots, Luddites and primitives value the bottom range and hope to force us to.

Alex Castaldo comments:

in the hallowed textbook "Principles of Corporate Finance" byBrealey and Myers on Page 84 the value of the firm is given as

            P0 = EPS1/r + PVGO

where EPS1 is the next earnings, r is the risk free rate and PVGO is the "present value of growth opportunities".  This shows that theoretically a firm with no growth opportunities is valued as a perpetuity: the annual earnings are discounted at the risk free rate.

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