Volatility Does Not Equal Risk
Posted by Eddy Elfenbein on May 11th, 2010 at 12:36 pm

I don’t easily go about criticizing Finance Blogger King Felix Salmon (especially after he said such nice things about me), but I have to speak up when he equates volatility with risk. Felix says that stocks aren’t a good buy and adds that “when an asset class gets more volatile, it gets riskier.”
Hmmm. Let’s take a step back. Risk is a very peculiar concept in finance. The problem is that we use this one word “risk” to describe many different things. What does risk mean? Well, you can take your pick. There’s the risk of what you don’t know. There’s systemic risk. There’s the risk that you won’t do as well as everybody else. There’s the risk that you’ll lose everything. The list of risks goes on and on.
Gold is a good case study on which to contemplate the meaning of risk. Gold is popular with goldbugs because it’s the least risky investment possible. In this sense, we’re defining risk as an investment losing its inherent value. In other words, gold can’t go bankrupt. Governments? Sure, they go belly up all the time, but even in our Mad Max future, gold will still be around.
But in another sense of the word risk, gold is highly risky. Gold tends to be very volatile. It bounces up a lot each day. On the other hand, gold tends to have a very low, and even negative, beta. So which is it? Is gold risky or not? It really depends on the kind of risk you’re talking about.
My point is that there’s no evidence that greater equity volatility leads to poorer performance. The risk of a market plunge is the kind of risk that matters. Except at very low levels, the historical evidence is that volatility doesn’t much affect future returns. Only when the VIX gets down below 13 does that market show some outperformance.
I know it seems counter-intuitive but volatility does not equal danger.

Gilead Announces $5 Billion Buyback
Posted by Eddy Elfenbein on May 11th, 2010 at 10:48 am

Groan:

Gilead Sciences Inc. (GILD) announced a 3-year, $5 billion stock-buyback effort, with the board and management considering the move “an appropriate and strategic use of the company’s cash.”
A host of companies have been boosting or initiating repurchase plans in recent months as the need to hoard cash recedes. The drug maker, known more for its HIV treatments, announced Tuesday it has completed a $1 billion buyback effort authorized in January, buying 24.1 million shares for an average $41.43.
The stock was up 1.6% premarket at $39.00 and was down 11% this year through Monday. Gilead’s market value is about $35 billion.
The drug maker plans to fund the repurchase program with future profit as Gilead said on Tuesday that the company has made significant progress with its HIV pipeline programs to develop a new treatment regimen, which it expects to file for regulatory approval this year.
Gilead reported last month its first-quarter profit jumped 45% on strong sales of its HIV drugs as well as higher royalties from flu-treatment Tamiflu because of worldwide initiatives to plan for a possible influenza pandemic.

Just give us the money! The buyback works out to about $5.50 per share and Gilead doesn’t pay a dividend. At least, the stock is up today.

Dean Foods Plunges Below $10
Posted by Eddy Elfenbein on May 11th, 2010 at 10:26 am

A few weeks ago, I highlighted Dean Foods (DF) as a good value stock. The market, however, seems to have other ideas. Yesterday, the company missed its earnings estimate by five cents a share (23 cents versus 28 cents; in February Dean gave a range of 25 to 30 cents). The stock responded by dropping 28% and it’s down again today. DF is now below $10 a share. It’s never a good idea to tell Wall Street to expect one thing and deliver another.
Wall Street had been expecting Q2 earnings of 41 cents per share. Instead, Dean said it will range between 23 and 28 cents per share. The problem is that there’s a price war going on in the milk business and that’s hurting profit margins. Dean’s Q1 actually beat Wall Street’s revenue target. The issue is turning those sales into profits.
The WSJ reports:

Dean Foods Co. Chairman and Chief Executive Gregg Engles said gains by private-label producers are accelerating despite an improving economy, noting that in some regions, a half-gallon of his company’s milk costs more than a gallon of an unbranded product. Major retailers routinely use discounted staples such as milk, bread, eggs and meat to drive foot traffic, and private-label food products gained market share as consumers traded down during the recession.
Cheaper private-label products have been gaining food-industry market share for years, but Mr. Engles is acknowledging that the weak economy may have forced a long-term change in consumption that holds ramifications for margins and investment. Milk prices have firmed in recent months after a volatile period, but Mr. Engles said efforts to push through increases at the retail level have failed to stick.

Risk and Return: Not So Easy
Posted by Eddy Elfenbein on May 11th, 2010 at 9:50 am

Eric Falkenstein is the author of Finding Alpha which argues that, in the real world, risk and return are not related. In fact, if there is a relationship, it’s probably negative. The more risk you take on, the worse you’ll do.
As Eric explains, a good example of this is in corporate bonds. Both the riskiest bonds—high-yield junk bonds—and the least risky—rock-solid AAA bonds—don’t do as well as bonds rated as investment grade but just below top-shelf.
Why is this? Is it that both ends of the risk spectrum unusually crowded? Eric writes:

It may be that individual investors expect high returns when investing in high risk assets, only that this is a mass delusion, the triumph of hope over experience. If so, that isn’t the ‘expected return’ one talks about in academic finance, that is, a statistically rational expected return. It is important to think of a return premium as due to two things: randomness and alpha. Randomness or luck we all understand. Alpha, however, is a little trickier. It isn’t something you can buy, because due to competition, no one sells it for less than cost, meaning, the insiders who structure and sell any alpha idea will take out all the extra return, leaving nothing at best, a mean-mode trade* at worst. To get alpha, you don’t buy something passively, you have to actively negotiate, time, or structure an investment, and while people can help you, no one will singularly present you with an extra-normal return. Further, most alpha attempts are like karaoke ballads, well intentioned but ultimately awful, meaning, after fees most alpha is negative (how else do so many alpha-less brokers afford their nice cars!?).
It is difficult to see how the little risk is priced, the big one not, if risk is to have any consistent meaning. If the corporate spread is a function of risk at one end, why is it not at the other, more intuitive end? This is but another reason I think there is no general risk premium, as explained in my series of Camtasia videos on my book here.

Jon Stewart on the Crash
Posted by Eddy Elfenbein on May 11th, 2010 at 9:09 am

Goldman Sachs: Perfect for the Quarter
Posted by Eddy Elfenbein on May 10th, 2010 at 4:04 pm

DealBreaker reveals this little fact: Traders at Goldman Sachs were profitable every single day last quarter.

Goldman Sachs just revealed in an SEC filing that its traders made money on every single trading day last quarter, a record for the firm. Net revenue for trading was $25 million or higher in all of the first quarter’s 63 trading days with 35 of those days bringing in more $100 million, according to the filing.

That’s one smart squid.

Deep Value at Wendy’s
Posted by Eddy Elfenbein on May 10th, 2010 at 1:07 pm

This Thursday, Wendy’s/Arby’s Group (WEN) will report its earnings. My prediction is that earnings will be seen as either very good news or very, very bad news. (Impressive analysis, no?)
The reason why I’m highlighting Wendy’s is that it’s a good example of what you often find in value investing. I’m not terribly impressed by the business but the market, as evidenced by the share price, is far less impressed. It’s the gap between perception and price that value investors seek out—even if that still leaves you with a mediocre company.
Wendy’s business has not been doing well, but at $5 the stock is well below its true value. The stock is even going less than book value which is $5.16 per share. In September 2008, (Triarc the owner of Arby’s) bought Wendy’s for $2.34 billion. We can now see that the merger isn’t working out. The Wendy’s side of the business has been sluggish but it’s the Arby’s side that’s really hurting things.
The company is investing lots of money in an effort to turn things around. I’m skeptical but at least they’re trying. Arby’s is getting killed at the price level, so management is aiming to expand their value meals. To give you an idea of what Wendy’s/Arby’s Group’s valuation is like, the current price/sales ratio is about 0.62. At McDonald’s (MCD), it’s 3.35.
The arguments in favor of Wendy’s/Arby’s Group is that the company is profitable, albeit barely. They also pay a very modest dividend. I think a good way of looking at the stock price is seeing it as the sum total of two very different outcomes. I’m making up these numbers but I think it will illustrate my point. Let’s say that the market thinks there’s a 25% chance WEN will go to $14 and a 75% chance that it will go to $2. The whole adds up to $5 but you can see that just under the surface are wildly divergent views.
I don’t know if management’s plans will pay off but we’ll get a hint this Thursday. I think the stock is a good, but highly risky, buy.

AFLAC Soars
Posted by Eddy Elfenbein on May 10th, 2010 at 11:02 am

The stock market is having a very strong morning. We’ve basically closely the gap from everything we lost during last week’s panic. The Dow is currently up 360 points and our Buy List is doing even better. Thanks to the European bailout news, AFLAC (AFL) is doing especially well. The supplemental insurer is currently up $5.40 which is over 12%.
I realize I’m beginning to sound like a broken record, but the cyclicals are the key stocks to watch. The Morgan Stanley Cyclical Index (^CYC) is up 5.22% which is well ahead of the S&P 500. This is clearly the “it” index of this market.

Economist Tells Truth, Apologizes
Posted by Eddy Elfenbein on May 10th, 2010 at 10:45 am

J.P. Morgan Economist Calls Senators ‘Ignorant’
The hearings exposed an unnerving ignorance of fundamental principles of market economics by folks who have a hand in remapping rules of finance that will be with us for a while.

We begin counting, now. Three…two…

JP Morgan apologizes for memo trashing Senators

Order Your Federal Reserve Comics Today
Posted by Eddy Elfenbein on May 7th, 2010 at 10:08 am

No, I’m not making this up.