Refining The Capital Asset Pricing Model for Practical Investment Use

The capital asset pricing model is a great display of academic prowess in financial theory. However, it does have its limitations. Mainly, the criticism it receives is that it makes a number of assumptions that do not necessarily hold true in market conditions. The biggest one I feel is is the beta coefficient, or β.

To break it down the capital asset pricing model (CAPM) is a way of determining the cost of equity for a company. This is often also referred to as the investor's expected rate of return for investing in a security. The formula is as follows:

where:

E (Ri) = expected rate of return of investment i
Rf = the risk free rate of return (usually the 10-year bond return)
βi = beta coefficient of investment i (the individual price volatility of the investment relative to the market as a whole).
E(Rm) = expected return of the market as a whole


The biggest concern is with β. The capital asset pricing model as it stands alone assumes that the riskiness of an investment is based upon the past price volatility of the investment. This is HUGE assumption, because future prices cannot be accurately extrapolated from the past prices. Market prices of a security are determined not only by supply and demand from investors, but also the profitability and growth prospects of a security. The beta coefficient is assuming that market prices are efficient and that all information is known to all investors.

However, we know that not all information is known to all investors, and not all information is important to all investors. Also time horizons for investors differ (another huge assumption of the model), therefore even if all information was known, some information may disregarded by short term investors if it does not serve their time horizon. The information that a trader will be looking at may affect his view of the price, while a long term value investor may see information that reflects his view of the price.

In present circumstances, the current market prices are the averages of investor perceptions. Therefore, if most investors are arguably short term oriented, the price of that stock will more favorably reflect short term prospects. For example, if Ford stock has low upwards movement prospects in the short term because Ford is taking non-cash charges (thus reducing current earnings) , the majority of investors may be uninterested in that stock, and the price of the stock will reflect there lack of demand for it.

This is why it is important to have a somewhat longer investment horizon. You want to account for short term prospects and long term prospects. Yeah, Ford may be taking short-term non-cash charges and reducing their earnings, but is a non-cash charge really a reflection of a change in business value, especially if the company is still making adequate capital expenditures to improve the business for the long term?

The market is not perfectly efficient, which gives the individual investor an edge if they are willing to resist the temptation of short term sentiments.

So how do we adapt CAPM for reliably determining the cost of equity? Simplistically, an investor can expect the market to return 11% on average over time. Therefore, it is reasonable to say that an investor should expect no more than an 11% return on average from their portfolio (this is supported by the latest indexing fad).

Even though the expected return may fall short of what an investor's actual return may be, it is fair to say that a prudent and rational investor should expect no more than what the market will return (unless of course the risk free rate were to exceed that, in which case the last thing anybody would be concerned about is their return on investment when the whole market is collapsing!).

With the cost of equity set to be at a value of 11%, the discount rate for a security can thus be figured out by the company's weighted cost of capital, utilizing the borrowing rates of a company after taxes and our constant cost of equity. Thus we have a maximum discount rate for a public company to be no more than 11%* (if the company is 100% equity financed).

This figure to me seems fair, considering Warren Buffet discounts utilizing only the risk free rate.





*This discount rate only can be comfortably applied to non-controlling shares of publicly traded companies of a reasonable size (excluding micro caps) without getting into liquidity discounts, size discounts, and control premiums.

Benjamin Graham Was Wrong

I was doing some equities research and I ran across this from Benjamin Graham's classic 1934 edition of Security Analysis:

This was one of Ben Graham's examples of calculating the Net Current Asset value for a stock, by using a discount rate to calculate the true liquidation value of various types of assets on the balance sheet. The only thing is that Ben Graham's White Motor Company example was actually incorrect.

If you look at the liquidation value of the Total Current Assets, he only subtracts Current Liabilities to arrive at the Net Current Assets Result of $16,300 when in fact he should of subtracted Total Liabilities.

In practice, if a company goes bankrupt, all creditors go to the front of the line because the assets are collateralized by debt. That would mean that ALL creditors go to the front of the line, not just the ones who are due in one year or less. If long term creditors were left out, how would they receive their repayment if the shareholders got what's left way before the creditor's debt needed to be serviced?

The answer is it would never happen. That would be the equivalent of the owners of a house in foreclosure receiving the rest of the sale price of the house after only the first year of debt had been paid for on a 30 year mortgage. What about the other 29 years worth of money the bank forked up so the owners could buy the house? The same is true for a company. The long term creditors are due their piece of the pie and will always get theirs well before the shareholder even see the leftovers.

The funny thing is that Benjamin Graham knew this and stated on the page before this example:

"The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score."

However, its clear in the example that he only deducted current liabilities. Perhaps this was just a flub up, but the conclusions he derives are based upon the erroneous fact of subtracting current liabilities. The funny thing is that people like Buffet, Ruane, and Graham himself based the majority of their investing decisions on this calculation when it is in fact wrong. Talk about luck!

Home Depot Your Next Great Investment

Say you have to buy some paint to add some pep to your livingroom, where are you going to go?

If Home Depot even crossed your mind (just in case you said Lowes), you've just realized the hedge to this investment. Right now, Home Depot is severely undervalued in relation to its long term prospects. The reason why its down is because home improvement projects took a dive when the housing market dropped. Why do home improvement if your not planning on selling anytime soon?

The fact of the matter is that Home Depot has a huge market share, contested only by Lowes. Its brand equity serves as a great hedge against long term risk exposure, in addition to the housing market already having been through the worst. And surprisingly, even though earnings are down for HD, free cash flow is at some of its highest levels even compared to years with stronger revenue growth. Management's refocusing on merchandising also will serve to lower expenses and capital expenditures to help that free cash flow figure grow.

As I step down from my soapbox, I will be adding this holding to both my own and my girlfriend's portfolios.

Why nobody has been able to replicate Warren Buffett's success

I'm currently reading Snowball, and I wanted to address the issue as to why nobody has been able to replicate Warren Buffet's success as an investor.

Diana Sonis at UnitConnect pegged it right on the money in her blog (here) as to why nobody has been able to duplicate it: patience. Wall Street is the cross between a mosh pit and a cash register, and its very easy to get caught up in the whirlwind. CNBC doesn't help it with all that Fast Money stuff either. I feel like Pete Najarian sometimes wishes to go back to his heydey as a Minnesota Viking, and sack Rick Santelli: entertaining yes, but insightful, no.

Warren nailed it when he said that the equities market is a voting machine in the short term but a weighing machine in the long term. Common sense would dictate "do as Warren does," but as we know, common sense is not so common.

In fact, our very nature as human beings often prevents us from replicating another outlier's success. Being essentially animal by nature, human beings have a tendency to "herd." There is no shame in this, its actually a defense mechanism. Herding is evolutionary psychology's learned defense that in primitive times, there is safety in large numbers. And it makes perfect sense: if the edge of your herd is attacked and you're in the middle of the pack, you'll probably survive.

Unfortunately, our evolutionary computers are as outdated as Vic-20's. We find ourselves in new world circumstances, using practically prehistoric evolutionary mechanisms to survive. The truth we must face is that our evolutionary development as humans will never be able to catch up to the speed of the information age, because as it whole it takes millions of years to make a change. Quite contrasting to the speed of a stock ticker on the bottom of a TV screen, which can change in seconds.

Which leads us to reframe our initial question. Is it possible to replicate Warren Buffet's success? Without a doubt, yes. However, to do so requires a rebelliousness that contrasts to the standard activity of the Wall Street herd.

And as we see in Snowball, Warren's personality growing up almost lends itself to this certain rebelliousness. He was always different, awkward, and sometimes even annoying. He said himself he felt he never fit in socially, convention just fit him awkwardly. We see this anti-herd personality in Graham as well, which is probably a major reason why Warren looked up to him so much. Here was a man, much like himself, who is quirky and yet, successful by his own means...and is revered for it!

So if you do wish to produce fruitful gains in your portfolio as bountiful as Warren has, it will take a conscious effort to switch off that social calibration. The more socially calibrated you are, the more conscious effort it will take on your part.

A Great Example of an Ideavirus

I just finished reading marketing guru Seth Godin's manifesto Unleashing the Ideavirus (you can download it here), probably one of the most relevant pieces on marketing ever written. While reading it, I thought of a great example of a successful Ideavirus.

I'm sure by now everybody on Facebook is familiar with the application Mafia Wars, an application created by Zynga. The growth of this application has made it one of the most popular on Facebook ever. After reading Seth's thoughts, I understand why.

First, Mafia Wars was without a doubt remarkable (worth remarking about). How many other things do you have going on in your life that allowed you to pretend you are a mafia kingpin- killing, maiming, and extorting money?

Second, the application was incredibly viral. Every time you log in to the application, it gives you a prompt to "invite people to your mafia." This turned its users into promiscuous sneezers spreading the ideavirus for their own personal gain. The more people you invite, the bigger your mafia got and thus the more powerful your mob became. This scalability of Mafia Wars made it so that the more people that joined Mafia Wars, the better the individual user experience became.

Third, it had a hive with a definite vector. It became big with college kids first who then gradually started running out of people to invite, so they started inviting family and friends who were out of college, bringing Mafia Wars across the early adopters chasm to the general public.

Fourth, it had a great amplifier, Facebook. 'Nuff said...

Fifth, it was incredible persistent. People logged on more than once a day (I was one of them) to use their points and check their bank account. Foolish yes, but persistent, definitely.

Sixth, and probably most importantly, Mafia Wars traveled through a virtual vacuum. There were other applications you could download on Facebook, but none that allowed you maim your friends and amass a fake fortune. Utter genius.

Emotional Intelligence

It seems today's corporate cultures often frown upon emotions in the workplace while 'objectivity' is prized. Probably because emotions are some of the most misunderstood things we experience, and where there is uncertainty there is a perceived element of risk. The very essence of emotions is what drives us, gives us passion, and integrity. So why do we as a culture take something that is evolutionarily hardwired into us for granted? Why do we squelch the very things that pervade through all human beings everywhere?

A new term being thrown around today in the corporate world is Emotional Intelligence. In fact, some employers are starting to adopt standardized testing to assign an E.I.Q (Emotional Intelligence Quotient) in order to assess their potential employees. However, knowing your EIQ doesn't help you raise it. How do you study for a test that you don't know the content of? There's a disconnect here on what people are being tested on and showing them how to prepare for it.

The fact of the matter is emotions are a biofeedback system. They are a set of neurological electrochemical signals that change our state and resulting physiology. Their sole purpose is to serve as a assessment system as to how we are interpreting our reality. Emotions are not to be squelched because they tell us whether we are moving towards or away from what we want in our lives.

Humans operate off of the simple fact that they gravitate away from things that cause them pain and towards things that cause them pleasure. Our emotions are an assessment as to if we are moving towards our goals (pleasure) or away from them (pain).

In Anthony Robbins' Awaken the Giant, he provides an excellent description about 10 call to action emotions people experience on a regular basis. These emotions tell us valuable information about our actions and how we are perceiving the situation. I thought I would share them here with you.

1) Discomfort - (impatience, mild embarassment, boredom) Message: How you're perceiving things is off or actions taken are not producing results you want. Solution: Change how you think about things or change the actions you are taking.

2) Fear - (anxiety, worry, nerves) Message: anticipation of something that may happen that could cause pain. Solution: Preparation is key. Prepare yourself mentally and physically to deal with the situation at hand. Come up with multiple solutions to increase confidence and diminish the intensity of the fear.

3) Hurt - Message: expectations have not been met and a feeling of loss is at hand. Solution: Ask yourself if something has really been lost and if the person is really trying to hurt you. Know also that your expectations are not the expectations everybody lives by. Change your expectations of others and maybe communicate calmly to the person why you're upset. Try to understand their side.

4) Anger - Message: An important rule or standard you live by has been violated by someone else. Solution: Perceive the situation differently and know that everybody does not hold themselves to the same standards. Communicate your standard to the person and find out the motivation for their actions.

5) Frustration - Message: you believe you could be doing better than you are. Solution: Be excited about the learning that is to come. Find out other possible solutions or seek a mentor. Also know that you are so close to reaching it which is why you are experiencing this.

6) Disappointment - Message: a goal or an expectation that you have is probably not going to happen. Solution: Change your immediate expectations or break the larger goal down to smaller goals. See what you can learn from the situation. Also it may be too early to judge. Develop patience and evaluate your approach and procedure. Helfpul quote: "God's delays are not God's denials."

7) Guilt - Message: you have violated a high standard that you hold yourself to. Solution: Evaluate what standard you violated and commit to not violating it again. Once you have committed, you may release the feeling of guilt, do not wallow in it.

8) Inadequacy - Message: you do not presently have the skills, knowledge, or tools to deal with the task at hand. Solution: Evaluate if the standard you are holding yourself to is too high at the moment. Lower your immediate expectations and begin to search for ways to improve. Untrained or unskilled does not translate to unable.

9) Overwhelmed - (grief or depression) Message: you are trying to deal with too much, too fast, and all at once. Solution: Reevaluate whats most important to you and prioritize what to deal with first. As you begin to conquer one problem, your brain will gain momentum which will make each subsequent task easier and easier. Change your focus from what you can't change to what you can change.

10) Loneliness - Message: you require a connection with another person, often to objectively confirm or reject a belief or attitude. Solution: You can reach out anytime, there are caring people everywhere. Identify what your needs are: intimacy? friendship? To laugh? Recognize that loneliness is the showing of your true belief that you care about people and need them in your life.

The Net Present Value of Integrity

I read in a Yahoo news column today that sports marketing expert Robert Tuchman walked through an airport a few days ago and saw what he calls surreal: an Accenture billboard advertisement with Tiger Woods. Around it, people joking about it and taking pictures. The whole thing Tiger Woods is going through is actually quite remarkable. Not in the sense of infidelity, but in the value of integrity.

The Dalai Lama once mentioned in a book he wrote about the law of interdependency, commonly referred to as "the butterfly effect." Its the idea that seemingly unrelated phenomena are actually inextricably linked together. Its interesting to see how this phenomena is playing out in this situation. Two seemingly unrelated aspects of Tiger Woods' life affecting one another. He cheats on his wife, he loses sponsership. Wow! It seems a butterfly somewhere is flapping its wings...

There is something the rest of us can take out of Tiger Woods' admitted mistake. Its the fact that our integrity does have value (in Tiger Woods' case, his was worth millions) and we should treat it and care for it the way a business coddles its brand. In every decision we make, we need to evaluate how this is going to affect our personal brand and how an outsider may perceive it.

Any business owner knows the hard work that goes into building brand equity. Building a brand is comparable to pushing a boulder up a hill with a cliff on the other side, you need to be careful and calculate your moves because any slip up could send you right back to where you started or worse. We need to calculate our moves in building our character just as precisely as a business builds its brand.

Luckily, Tiger didn't lose everything and will return to greatness soon enough. He just needs some time to get his priorities straight.