Friday, October 17, 2008

Recent thoughts on crisis

"If you jump off the top of an 80-story building, for 79 stories you can actually think you're flying. It's the sudden stop at the end that always gets you." - Thomas Friedman on the financial crisis, 15 Oct 2008

On explaining the credit crisis:

It feels surreal to watch as events unfold in the financial world over the past year. In a way, I feel fortunate to be back from studies just in time to start work during arguably the best year (thus far) for the company before experiencing what is now deemed as the worst financial crisis since the Great Depression. The contrast makes the experience all the more startling. I remember taking this US economic history class in college and feeling quite detached from the course material which was describing a world based on gold standard and a worsening depression due to the monetary expansion in the earlier years in 1920's and subsequent inaction of the central bank. I find it hard to comprehend without a reference or anchor to a modern day equivalence which I can relate to. (Un)fortunately, I guess I'm living through such a transition. It really hit home the idea that this is truly a crisis when I was passing through an AIA branch, after the announcement of the Fed's US$85 bil loan to AIG, where throngs of folks (mostly moms and pops) were crowding around, waiting to surrender their insurance plans. In fact, my parents were considering seriously to join in the line as well. Not a bank run yet, but certainly feels like one!

I suppose it's easier to watch on the sideline when I have nothing substantial at stake, in terms of direct personal wealth exposure, to begin with (that is until last week when I finally bought the first stock in my life). That way, I don't have the mental bias and the psychological angst when I am looking at say the widening TED spread or the plunging stock indexes. Being afforded this by-stander privilege, it has become rather "entertaining" to begin reading all the "special reports" that are making the rounds in magazines and newspapers, which inevitably make comparisons with past bear markets and attempt to provide a coherent "ex-post" explanation to the current crisis. Most of them "sound" quite reasonable, in fact probably too much so! It won't be very hard to imagine the Economist producing an equally eloquent editorial describing the success of the earlier bailout measures in rescuing the financial markets, versus what they are now reporting in their latest issue, proclaiming vague-and-hence-non-debatable terms like "there is certainly progress, but it is certainly not enough". Indeed there'd always be a theory that can fit past data, and because such theory provides a "coherent" framework that can explain "intelligently" our past experience, many of us will take that as a confirmation of the theory, without realizing that this theory surfaces (or resurfaces) because of what had happened. This self-referencing mechanism, coupled with our innate preference for confirmation instead of anti-evidence and our gullibility in the face of narrative fallacy, makes me very very hesitant to venture another "intelligent" version of how we got here.

For now, I'd say that I buy the Austrian school view, that credit expansion fueled by the loose monetary policies, and the many levels of conflict of interest in the financial-related institutions (for instance, it's in the interest of rating agencies to maintain an overall healthy expectations of new innovative products such as CDOs) causes the spiraling effects of businesses misjudging the ultimate consumers' time preference (which supposedly should have been reflected in the interest rate, except in this case central banks in a fiat money world can "target" that rate) and in turn making misguided investment decisions....blah blah blah. Seriously, looking back, it all seems so logical.

Most people recognize that "hindsight is 20/20", but not that many see the other dimension of prediction: forecasting backward can be as difficult as forecasting forward! Put it differently, say given the present situation that "S&P500 has nosedived ~40% this year", what could have been the previous happenings that lead up to such an outcome today? Possible worlds exist, and can be interpreted in both time directions! At the risk of appearing overly philosophical (which some might equate as impractical), I'd stress that whatever explanations that we give ourselves today of this credit crisis, we should take it with a much bigger pinch of salt than what is being presented in the press today and probably ingrained in our brains eventually. In the Karl Popper's tradition, (translated in Nassim Taleb's words) "you know what is wrong with a lot more confidence than you know what is right". Especially in cases where the variables are (to quote Taleb again) from Extremistan (eg. most econometric data such as interest rate or inflation really have no theoretical upper or lower limits; just ask the folks from Zimbabwe), the potential impact from a misjudgment of probability could be huge. Adding on top our uncanny ability to mistaken "known unknown" probability (like the probability of hitting straight 6s when rolling dice) for "unknown unknown" probability (like the probability of me marrying my wife), we have to be much more humble in our own ability to forecast or predict economic trend than the level of confidence that seems to be exuded by reports or articles (often written eloquently by economists, journalists or academics).

On a company's intrinsic value:

Having presented such a grim picture that luck seems to play such an important role in our own destiny, I'd say though that there're still many components in life that are consistent and fundamental; with variables that are from Mediocristan land where application of Gaussian distributions actually makes sense. Even for parameters that are scalable with no inherent limitation (think stock prices), there're ways to protect and even gain exorbitantly (think writing put or call options) from the occurrence of a "outlier".

Incidentally, as I was half-way reading through Black Swan, I started reading up on Benjamin Graham's Intelligent Investor, at the suggestion of a buddy of mine. Graham's description of Mr Market seems to me the perfect analogy of Nassim's idea of preparing for a Black Swan. Sometimes, Mr Market may come around with a ridiculously low price for selling his stock, an obvious outlier compared to recent "trends" (which is something we're witnessing today). But how do we know that the price is low enough? This requires a comparison with a reference point (ideally at a high margin of safety), a level which many value investors have come to call a firm's intrinsic value.

I was quite fascinated by the ideas in Graham's book and started digging through writings by Warren Buffett, Graham's most famous disciple. There're certainly numerous ways to analyze a company, and coming up with a company's intrinsic value is at best a wild guess. I won't even regard the endeavor an intelligent undertaking because that'd give it a false sense of certainty (which is why Graham emphasize so much on margin of safety). However, such a guess can be made with much higher level of confidence if given more relevant information.

Which leads me to this following thought: every company's management should be regularly evaluating the company's intrinsic worth. Compared to shareholders or external analysts, the management always (at least for a well-functioning organization) has the most up-to-date info about many aspects of the company. With that intimate knowledge, the "internal analyst" will be able to arrive at an estimate of the firm's intrinsic worth with a fairly high confidence level (not to mention that the enormous exercise could also potentially be a great "learning journey" for management to really think through the various risk elements in the company and where true value lies). Only when armed with a sense of such an estimate would a firm be able to analyze and justify the benefits to the shareholders its use of share repurchase, issuance of stock options (for employees or in lieu of management fees or to raise capital) and using its stock in a M&A situation. Perhaps more importantly, a focus on increasing intrinsic worth (which is fundamentally a long-term concept) will draw true investors instead of speculators as shareholders. By providing the information necessary for shareholders to evaluate the intrinsic worth of the company (this could mean reporting financial statements as per accounting standards but showing the appropriate adjustments in the management discussion section for better reflection of economic reality just as the "internal analyst" would), this will give rise to a natural selection of like-minded investors as shareholders such that the market price will mostly trade on parity with the firm's intrinsic worth. This way, shareholders stand to gain from the long-term success of the company, instead of gaining at the expense of another fellow partner in the business (ie. the new shareholder).

On "Mismatch" problem and fair value accounting:

I can understand why this is seldom practiced (Berkshire's Hathaway's annual report being a noted exception) in reality. Gathering the necessary info for reliable analysis may be an extremely laborious and complex endeavor (pity the guy given the job analyzing a behemoth like AIG) and in a setting where management live and die for the next quarter's earnings, it could be a wasted effort which speculators (disguised as shareholders) may not appreciate (especially when this work against their trade directions). But more importantly, I suspect the reason this is usually not on the management's agenda is because of the inherent fuzziness of the concept of intrinsic worth. The exercise itself is highly subjective; even Buffett readily admits that his view often differ from Charlie Munger's (Buffett's alter ego at Berkshire) when given the same set of company data.

Indeed, what cannot be measured with certainty will often be deemed useless. This in turn leads to the deception of confidence when we are presented with evidence that seems measured with certainty. This is the "mismatch" problem that I wrote at length previously. The Michael Jordans who initially fail NBA draft tests, the kids who fail SAT who go on to publish breakthrough papers etc. Recently, I came across 2 other such incidences that highlight the darker side of such reliance on "tests".

One was the milk scandal in China. Evidently, melamine was added intentionally to give a higher score during protein testing! An over-reliance on standardize test to examine level of protein ends up with thousands of children with failed kidneys! This really saddens me and serves as a powerful reminder that our innate inclination for binary decision (yes-this-is-safe/no-this-is-dangerous) can lead to disastrous consequences.

I also see parallels with the recent fervent debate on fair value accounting. Banks are arguing for a suspension or "flexible" interpretation of the business of marking to market its assets. (Funny they never bring this up during the good times when they keep "marking up".) Many forget that the role of accounting is to provide a means to "record" a company's current standing, based on a highly arbitrary set of rules. It is a means, but certainly not the ends! Actually, I am totally fine whether the accounting community chooses to adopt mark-to-market or cost-based or held-to-maturity methodologies (so long I know what rules they're using) because in the end, how the numbers are recorded have very little to do with how the company is doing fundamentally. What they're arguing about is like a book publisher deciding whether the best way to present a book is by either its front cover or back cover, when really both are just snapshots of the same book. What truly matters is the book's content, which takes time and effort to digest and it's entirely possible that you still will only have a vague idea of the concepts written in the book. Making mechanical decision to say dump a stock because a certain ratio calculated from the accounting statements drop below a certain threshold is akin to judging a book by its cover; you cannot have good judgment consistently unless you've done the tedious work of evaluating the firm's intrinsic worth, however flaky this practice may seem.

Once again, some wise men out there sums it up much better than I ever could. In this case, Warren Buffett gave the following insight: "I'd rather be approximately right than precisely wrong." How true!

PS: It feels great that the company's library has finally come online! It's been over a year since I first had the idea of having a "click-and-you-shall-receive_on-your-desk" library system. I must confess I really did not do much (the company college and IT did all the work; all I did was talk) but I'm glad that the books in the library will finally see some "action"! (Btw, I would treat books like land if I'm an accountant. They should not be depreciated! This should in my opinion reflect the real economic reality.)

1 comment:

Marcus said...

I think this article, albeit simplistic, does a good job at summing up why the next crisis is just around the corner.

That such financial crises happen time and time again might be reason for us to reconsider our unconditional worship of the Invisible Hand and the values it promotes - greed and self-interest.