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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In one of the best TED talks I’ve seen, here is Barry Schwartz:

The talk applies to everything we do but (staying on subject) I’m going to talk about its relation to business.

In my post The Real Causes of the Financial Crisis, I talked about how misaligned incentives led the system astray. But even if you properly incentivize people to do the right thing, that doesn’t mean everything is going to work out. In my previous post, I left it at “However, there’s no perfect solution.” But now I’d like to elaborate.

Dick Fuld, Jimmy Cayne and other financial execs had significant share ownership relative to their personal net worth. In other words, their interests were strongly aligned with shareholders. But that didn’t stop them from making bad decisions that were not only harmful to their company, but bad for society as a whole.

Optimally, you want management that doesn’t need incentives to do the right thing. Good incentives can help, but they aren’t going to cut it. Financial managers in particular need risk aversion ingrained in their personality. They need to be willing to stray from the herd and not follow the crowd. They need to have the wisdom, as Barry Schwartz described it, to do the right thing.

In looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you. … If you hire somebody without the first, you really want them to be dumb and lazy.
— Warren Buffett

In terms of business and finance, you can’t find a better example of a wise person than Warren Buffett.

As an investor or an employee, you want a business leader who is passionate about their company and the product they are selling—not about the money.* Qualities like this can be very difficult to determine. Buffett not only shares them, but he’s good at seeing them in others (one of the major reasons he is so successful).

In business school, you’re not taught to have character. You’re given the numbers, the statistics, the “how to” in a step-by-step fashion. But sometimes, its better to focus on common sense instead of what the figures say. Wisdom, virtue and common sense: all things that can’t be taught, no matter how prestigious the school.

* One last note – if I were the shareholder of a company that has received TARP funds, and will now have salary/bonus caps at $500k, here’s what I’d think: 1) if management gets paid a little less while we’re receiving a safety net from our government, that’s fine. 2) If one of my managers wants to jump ship so he can get paid more somewhere else, then great. It turns out I didn’t want him at the company in the first place.

Warren Buffett talks a lot about competitive moats and franchises. However, I think he most succinctly describes his entire philosophy in this short passage:

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. [From the 1991 Berkshire annual report]

The first sentence basically lays out—in only a few words—the definition of a competitive advantage. So a company can be either a franchise or a business. But the separation between the two doesn’t have to be that clear cut.

Some franchises can be much more lucrative and powerful than others. Both Coca-Cola and Pepsi have moats, but Coke has the upper hand when it comes to customer mindshare. Because of this, Coke has always maintained higher worldwide and domestic market share than Pepsi.

Some companies can have both qualities: they are in extremely competitive industries (where lowest-cost wins), but also share some of the benefits of a franchise. The sit-down restaurant business is extremely difficult to operate in—but chains like In-N-Out and Steak ‘n Shake have created a brand that holds a special place in the minds of customers.

One more thing: I think when Buffett talks about mis-management, he really means short-term mis-management. A long period of poor management can have significant impact on any franchise—even one like Coca-Cola. And even with a strong economic franchise, every investment needs to be monitored just in case the moat starts to shrink (like newspapers over the last few decades).

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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