“The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.”
—William Poundstone, “Fortune’s Formula”

Everyone needs an “edge” in both investing and business. If it were just a matter of finding and purchasing a security below its intrinsic value, anyone could go out and buy “The Intelligent Investor” and become great. In other words, value investing, in and of itself, is not a competitive advantage.

An “edge” is any method that gives an investor a leg up over the market by obtaining higher returns with lower risk. (Risk in this case being the risk of permanent capital loss–or the size of potential loss times the probability of loss.)

From what I’ve seen, there are six basic advantages, each of which can give investors an edge over the market:

1. Psychological - discipline, patience, and the avoidance of common biases and misjudgments. An extremely difficult advantage to have, but is probably the most common among good investors. (Easier said than done.)

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A few months ago I helped put together a PDF of Seth Klarman’s letters to investors of the Baupost Fund from 1995 to 2001. Among many other great discussions, Klarman goes over a few of his individual holdings and Baupost’s rationale for investing.

One interesting aspect of Klarman’s investing style is his allocation into many asset classes. By not limiting himself to one asset class, he is able to hugely increase his universe of investments and also mitigate the risk of a single market class collapsing. If public equities are generally overvalued, corporate bonds, treasuries, private equity or real estate may provide better returns. It is also well known that Klarman doesn’t hesitate to hold a lot of cash when he can’t find any good investments.

In this post, I’d like to examine the investment allocations of the Baupost Fund from both a numerical and qualitative perspective. (Keep in mind that the letters from above are from only one of Baupost’s smaller funds, but my guess is that the allocations are very similar to those in the main fund.)

Let’s take a look at the investment categories:

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Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value: -2.8% (5/4/2009)
Low value: -4.9% (3/9/2009)

Chart: Trailing 10-year return.
Current value: -3.8% (5/4/2009)
Low value: -5.9% (3/9/2009)

Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.

Current value: 16.1x (5/4/2009)
Low value: 11.9x (3/9/2009)

One conclusion from the above charts is that based on the 128-year average, the market (as represented by the S&P 500) is fairly valued. (Data from S&P, Robert Shiller, and the St. Louis Fed.)

See also: Market Valuation Charts: 10/08

The Black-Scholes model does an admirable job at valuing short-term options. If an option expires in a few weeks, the current price of the underlying stock and its recent volatility have a good deal of influence on the outcome of the option investment. A simple Black-Scholes calculation has a lot of flaws (none of which I’ll go over), but in my opinion it does alright on the short-term options. However, the further away the expiration date, the worse it gets.

Value investors know that the historic volatility of a stock has nothing to do with its long-term value, and therefore should never be used when making a purchase. However, when purchasing equities, value investors have the luxury of waiting however long they need until price eventually reaches fair value.

If a stock is worth $30, that doesn’t mean a call option with a strike of $20 is worth $10. The option value must also depend on the duration of the option: the further out the expiration, the greater the underlying valuation should affect the option price (and the less volatility should matter). A lot of value investors purchase LEAPs, or options a year or more out, for this very reason.

The Graham-Olson Option Valuation Model

In honor of Benjamin Graham, I put forth the following equation as the value of a call option:

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The presentation above compliments my previous post on the systemic causes of the financial crisis. Some of the illustrations didn’t translate well on SlideShare, so to download the original in PDF format click here (6.4MB).

(The following is an excerpt from the most recent letter to the partners of Braewick Holdings LP. I’ll be posting a presentation that goes along with this commentary shortly.)

There have been many explanations thrown around of how we got ourselves into this mess. However, I have a slightly different take on what really caused the problem—and what hasn’t been fixed yet.

The public always enjoys finding someone to burn at the stake. Who is to blame for the current mess? Many culprits have been named: greedy executives, The Fed, short sellers, Democrats, Republicans, CDO’s, CDS’s, real estate speculators, and so on. However, the real issues are more systemic. Derivatives and bad mortgages may be where the problem started, but in and of themselves, did not cause this mess.

In my view, there were three problems that led to the collapse of financial markets: misaligned incentives, poor risk management, and needless complexity. All three problems are not specific to the current crisis, but are widespread and must be addressed to avoid future dilemmas.

If You Give A Mouse a Cookie…

He’s going to want some milk. And if you give a Wall Street executive a $30 million bonus, he’s going to want a bigger one (and he’ll use the same methods to get it—after all, it worked the first time, didn’t it?).

Misaligned incentives were pervasive. And because incentives drive behavior, things are eventually not going to turn out as desired.

This occurred on almost every level. Executives were being rewarded for taking risks with only short-term payoffs. Mortgage originators made money based on the volume of mortgages given, not on their quality. Rating agencies getting paid by the companies they have to subjectively rate (causing a huge conflict of interest). Home buyers were incentivized to buy a house they couldn’t afford with low down payments, teaser rates, no-documentation Adjustable Rate Mortgages, and 0% interest.

Many of the asset managers (including banks, hedge funds, and insurance companies) were given incentives to take huge risks with the firm’s capital only because they produced outsized short-term gains. They were given very large bonuses or a cut of the profits with no downside risk (other than a pink slip and severance payment). There was no link between immediate actions and their future consequences.

Business managers and decision makers need to constantly look at how their incentives are structured. People will naturally do things in their own self-interest, and managers need to react accordingly. Some incentives aren’t so obvious—giving a trader a cut of the profits may not sound bad at all. But even if it’s not their intent, people usually end up gaming the incentive in their favor. If traders aren’t punished for taking long-term risks in pursuit of profit, then guess what—that’s what they’ll do.

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