Matt Levine on shareholder value

Matt Levine discusses:

  • Traditional and progressive views of the role of corporations
  • How a narrow desire to raise shareholder value keeps frauds from capitalizing on investors who appeal to higher causes.
  • Compartmentalizing your job from your personhood as a necessary convenience

https://www.bloomberg.com/view/articles/2018-09-27/shareholder-value-could-be-worse



Primacy of Corporate profits

Friedman, along with Michael Jensen and William Meckling, is probably the person most associated with the theory that—as his famous article put it—“The Social Responsibility of Business Is to Increase its Profits.” In this theory, managers of a corporation have a singular duty to the shareholders to maximize their economic return as far as possible (while complying with the law), and if managers pursue any other objective—treating workers well or being good environmental stewards or standing up for what they believe in—at the expense of shareholder value, then they are misbehaving. Of course, there is plenty of room to argue that pursuing those other objectives actually enhances shareholder value. And there is much to be said for Friedman’s view—which is also after all Adam Smith’s view—that by focusing on economic profits, a company will maximize the amount of social good that it does, simply because the normal way to maximize profits is to figure out what people want and then sell it to them.

Including More Stakeholders

It is popular, these days, to criticize that view. The corporation is a political construct, embedded in a society; it has many stakeholders whose interests it needs to consider, not just shareholders. You see this criticism everywhere, from attacks on stock buybacks to Elizabeth Warren’s call for “accountable capitalism.” In its more extreme form, you can see shareholder-profit-maximizing corporations compared to science-fiction robot villains, or to psychopaths: If you value only profit and nothing else, then there is something inhuman about you.

Compartmentalizing

That probably overstates matters. If you come to work and focus on maximizing the profits of your company, that probably doesn’t mean that you’re a psychopath. It probably just means that you have a job. You compartmentalize things a bit; your work does not contain the entirety of your personhood; it’s a thing that you do because you need to make a living. In this sense, a company whose philosophy is “we will sell products that people want for more than it costs us to make them so that we can make a profit and increase our share price” is rather psychologically healthy. That is a good goal to work on during business hours Monday through Friday, and then leave. It is a modest, reasonable, businesslike goal. Obviously there are large contested margins, and you shouldn’t do psychopathic things to pursue that goal, and some people do and that’s bad, but for the most part “shareholder value” is the sort of mission that inspires people more or less the right amount. If you go around murdering people to maximize shareholder value then, yes, you are a psychopath, but most people aren’t.

The Difficulty of Accounting for Intentions

But there are other goals. Those goals are bigger, and you can wrap your whole personhood up in them, and you can believe that those goals are so important that they can justify anything. If Facebook’s goal is to maximize revenue by selling targeted ads to clothing companies, and you find out that it has features that enable genocide, then you shut down those features because the ads just aren’t worth it. If Facebook is about the “noble mission” of “connecting people,” then the tradeoffs are murkier. If “Facebook is truly the only company that’s singularly about people,” then … what even … how do you measure how about-people it is being? If you’re the singular company whose focus is people, then whatever you do is sort of necessarily good; your end is so vague and noble that it can justify any means. And for all that Facebook’s meddling with Instagram and WhatsApp seems to be driven by straightforward ad-revenue-maximization considerations, it’s worth saying that Facebook isn’t really answerable to shareholders and that its explicit ideology rejects shareholder value as a goal. “Facebook was not originally created to be a company,” Mark Zuckerberg wrote when it went public. “It was built to accomplish a social mission.” Okay!

Grand Visions Can Be Weaponzied, But Shareholder Value? Not So Much.

I am late to it, but I just finished reading John Carreyrou’s “Bad Blood,” the story of the fraud at Theranos Inc. and his work to uncover it. Theranos—in Carreyrou’s view, and the view of federal prosecutors—issued tens of thousandsof blood-test results to real patients using technology that it knew didn’t work, endangering those patients’ lives. There are a lot of passages in the book about Theranos founder Elizabeth Holmes inspiring and cajoling her employees to work harder, to get with the mission, to override their moral objections to faking the technology and push ahead. None of those passages mention shareholder value or profit maximization. They mention Holmes’s vision of revolutionizing health care to save lives and treat cancer patients. If you want to inspire people to do terrible things, it is very useful to sell them on a grand vision, a higher purpose, a noble mission. Shareholder value is nobody’s idea of an inspiring mission. That’s what’s good about it!”

How much to wager when you have edge? (Hint: median not mean outcomes!)

Link: Rational Decision-Making under Uncertainty: Observed Betting Patterns on a Biased Coin


  • Optimal bet size as a fraction of bankroll is 2p-1 where p is the probability of winning1. You will recognize this as the edge per trial reported as a percent. So a 60% coin has 20% expected return or edge
  • The formula is a solution to a proportional betting system which implicitly assumes the gambler has log utility of wealth

Imagine tossing a 60% coin 100x and starting with a $25 bankroll

Arithmetic Mean Land

The mean of one flip is 20% positive expectancy

Optimal bet size is 20% of bankroll since you have .20 expectancy per toss

Increase in wealth per toss betting a Kelly fraction: 20% of bankroll x .20 expectancy = 4%

Expected (mean) value of game after 100 flips betting 20% of your wealth each time

$25 * (1+.04) ^ 100 = $1,262

Median Land

The median of one flip betting a Kelly fraction is (1.2^.60 * .8^.40 – 1) or 2%

Median value of game after 100 flips betting 20% of your wealth each time

25 * (1.2^60) * (.8^40) = $187.25!

Things to note

  • The median outcome by definition is the increase in utility since Kelly betting implicitly assumes the gambler has log utility
  • After 100 flips, the median outcome is only about 1/10 of the mean outcome! The median outcome gives an idea of how much to discount the mean payoff. If your utility function is not a log function (ie does quadrupling your wealth make you twice as happy) then a different Kelly fraction should be used

Refactored “When the Culture War Comes for the Kids”

This is a 10:1 compression and refactoring of George Packer’s When the Culture War Comes for the Kids


There is a deep sense of inequality prevailing in America. 

The parents on the fortunate ledge 0f this chasm gaze down, vertigo stuns them. Far below they see a dim world of processed food, obesity, divorce, addiction, online-education scams, stagnant wages, outsourcing, rising morbidity rates—and they pledge to do whatever they can to keep their children from falling…By kindergarten, the children of elite professionals are already a full two years ahead of middle-class children, and the achievement gap is almost unbridgeable.

The need for equality and the role of merit.

The claim of democracy doesn’t negate meritocracy, but they’re in tension. One values equality and openness, the other achievement and security. Neither can answer every need. To lose sight of either makes life poorer. The essential task is to bring meritocracy and democracy into a relation where they can coexist and even flourish.

In 2014 the front line of social advocacy hardened

This new mood was progressive but not hopeful…At the heart of the new progressivism was indignation, sometimes rage, about ongoing injustice against groups of Americans who had always been relegated to the outskirts of power and dignity…Over time the new mood took on the substance and hard edges of a radically egalitarian ideology…its biggest influence came in realms more inchoate than policy: the private spaces where we think and imagine and talk and write, and the public spaces where institutions shape the contours of our culture and guard its perimeter…You could almost believe they spoke for a majority—but you would be wrong…The new progressivism was a limited, mainly elite phenomenon.

“For better or worse, it’s all identity now.”

The battleground of the new progressivism is identity…progressive politics meant thinking in groups. In politics, identity is an appeal to authority—the moral authority of the oppressed: I am what I am, which explains my view and makes it the truth. The politics of identity starts out with the universal principles of equality, dignity, and freedom, but in practice it becomes an end in itself—often a dead end, a trap from which there’s no easy escape and maybe no desire for escape. Instead of equality, it sets up a new hierarchy that inverts the old, discredited one—a new moral caste system that ranks people by the oppression of their group identity. It makes race, which is a dubious and sinister social construct, an essence that defines individuals regardless of agency or circumstance—as when Representative Ayanna Pressley said, “We don’t need any more brown faces that don’t want to be a brown voice; we don’t need black faces that don’t want to be a black voice.”

De Blasio’s schools chancellor, Richard Carranza, has answered critics of the diversity initiative by calling them out for racism…Carranza has mandated anti-bias training…One training slide was titled “White Supremacy Culture.” It included “Perfectionism,” “Individualism,” “Objectivity,” and “Worship of the Written Word” among the white-supremacist values that need to be disrupted.

Witchhunt?

At times the new progressivism, for all its up-to-the-minuteness, carries a whiff of the 17th century, with heresy hunts and denunciations of sin and displays of self-mortification. The atmosphere of mental constriction in progressive milieus, the self-censorship and fear of public shaming, the intolerance of dissent—these are qualities of an illiberal politics.

[In Jared Dillian’s Daily Dirtnap, he recounts “I’m not sure if you heard about the spectacle at the Des Moines Register, but here goes. Guy goes to a football game and holds up a sign asking for beer money over Venmo. He gets some money. He gets more money. Then more money. He has $1 million! He donates it to a children’s hospital. Reporter at the Des Moines Register digs up old racist tweets from him when he was 16. The guy who saved the children. Outrage mob forms, digs up old racist and homophobic tweets on the reporter. Pandemonium ensues. Thousands of people canceling subscriptions from the newspaper. Newspaper editors stonewalling. Now death threats. This is where we are. Every day is worse than the last. Tomorrow will be worse than today. Yesterday was worse than the day before. This will continue for the next 20-30 years.”]

[Dave Chappelle, in his Netflix special Sticks and Stones, calls out the prevailing ‘cancel culture’: “If you do anything wrong in your life and I find out about it, I’m gonna try to take everything away from you!”]

It struck me that this would punish kids whom the movement was supposed to protect…

In the name of equality, disadvantaged kids were likelier to falter and disappear behind a mist of togetherness and self-deception. Banishing tests seemed like a way to let everyone off the hook. This was the price of dismissing meritocracy.

The middle-school scramble subjected 10- and 11-year-olds to the dictates of meritocracy and democracy at the same time: a furiously competitive contest and a heavy-handed ideology. The two systems don’t coexist so much as drive children simultaneously toward opposite extremes, realms that are equally inhospitable to the delicate, complex organism of a child’s mind.. Wokeness prettifies the success race, making contestants feel better about the heartless world into which they’re pushing their children. Constantly checking your privilege is one way of not having to give it up.

Our goal shouldn’t be to tell children what to think. The point is to teach them how to think so they can grow up to find their own answers.

There is no answer to this

I can imagine the retort—the rebuke to everything I’ve written here: Your privilege has spared them. There’s no answer to that—which is why it’s a potent weapon—except to say that identity alone should neither uphold nor invalidate an idea

“The legacy of racism, together with a false meritocracy in America today that keeps children trapped where they are, is the root cause of the inequalities in the city’s schools. But calling out racism and getting rid of objective standards won’t create real equality or close the achievement gap, and might have the perverse effect of making it worse by driving out families of all races who cling to an idea of education based on real merit. If integration is a necessary condition for equality, it isn’t sufficient. Equality is too important to be left to an ideology that rejects universal values.

 

 

Tradeoffs in tax policy

Excerpts from Howard Mark’s memo: It’s All Very Taxing

The concept of “paying a fair share” is nebulous at best. It’s very contentious because everyone has a horse in the race. Mark’s memo is my favorite reference for the complexities and competing goals when designing tax policy.

Mark’s published the memo in November 2011 so the specifics are outdated but this doesn’t negate the reasoning. In fact, the changes actually highlight how our tax code evolves to punish or incentivize certain behavior.


Intro

We have a progressive system of taxation, meaning that higher earners don’t merely pay more in terms of dollars; they generally pay a higher percentage of their incomes in taxes. Most people agree that this is fair. But is it? Why should success be penalized through greater taxation? And if the tax rate for those who earn more should be higher, how much higher?

Under the U.S. system, people in higher income brackets pay tax at higher rates. In large part, the question of fairness primarily surrounds whether the higher rates are high enough. Talk about “the eye of the beholder.” There’s evidence on both sides of this debate: The top 1% of U.S. taxpayers pay 38% of all individual federal taxes.

A breakdown of the numbers

The top 10% pay 70% of all taxes, the top 25% pay 86%, and the top 50% pay 97%. The bottom 50% of all taxpayers paying only 3% of the total.

About half of Americans pay no federal income tax, and almost 25% pay no federal taxes at all. The average federal income tax rate for the top 1% of Americans is 23% (and for the top half it’s 14%), while the average rate for the bottom half is 3%.

They pay at lower rates than they used to and it seems progressivity has declined. . . . the effective federal tax rate, including payroll taxes, for the wealthiest 0.01 percent of earners fell to 31.5 percent in 2005, from 42.9 percent in 1979 [for a decline of 26.6%], according to data from the Congressional Budget Office. Over the same time, effective rates for taxpayers in the center of the range fell to 14.2 percent, a decrease of just 4 percentage points [or 22.0%]. (The New York Times, September 21, 2011). Total revenues from income taxes have declined in the U.S. – they “are at a historic low. of 15.3 percent of the gross domestic product, compared with a postwar average of 18.5. percent” (Financial Times, September 25) – and they’ve declined more for top earners. than for the rest. This is because of both specific rate cuts that have been enacted and the fact that the rates applied to dividends and capital gains – which clearly flow more to people in the upper-income brackets – have declined relative to the rates on salaries and wages.

  • On average, higher earners absolutely do pay a higher percentage than those who earn less.
  • But the decision as to whether the differential is just right, too little or too great is highly subjective and certainly a valid topic for debate.

A non-exhaustive list of trade-offs to consider

  • Are some forms of income more desirable to society and thus deserving of taxation at lower rates?

A discussion about investment vs wage income

    • Long-term capital gains are taxed at reduced rates because of a judgment that long-term investment in things like securities, companies and real estate is beneficial for the economy and should be encouraged. Right now, the top tax rate on long-term investment profit is less than half that on short-term gains and ordinary income.
    • What about interest? Why are dividends taxed at preferential rates and interest at ordinary rates? The explanation may lie in the fact that interest is deductible for corporations, while dividends aren’t. Interest is paid out of pretax income, while in theory dividends are paid out of after-tax income – although the existence of corporate deductions and credits means dividends may, in fact, be paid out of income that hasn’t been taxed by the U.S. Alternatively, the difference in tax treatment may be the result of a desire to encourage investment in “risky” equities rather than “safe” debt. But some companies’ dividends are no doubt safer than some other companies’ interest payments, so this distinction is questionable. If the goal is to encourage risk-bearing, is dividend versus interest the right criterion?
    • While on the subject of gains from investments, it’s interesting to note that, not long ago, dividends were included with interest under the rubric “unearned income.” And it was taxed more heavily than wages.
    • But now things have turned 180 degrees, and returns on capital are taxed at lower rates than wages. It’s worth noting that the Democrats – commonly considered the party of labor – controlled the government for much of the period 1928 to 1980, when earned income was favored. On the other hand, the Republicans – the party of those with capital to invest – have been in control more of the time since 1980, and the taxation of returns on capital has declined in relative terms. The definition of virtuous income that should be encouraged through lower taxes clearly is subjective, impermanent and subject to change with the winds of politics.
  • Should we encourage certain expenditures by making them deductible from taxable income?

The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there’s something underhanded
about those provisions. And politicians use the laudatory-sounding term tax incentives to describe tax code provisions that reduce tax revenues in order to encourage certain
behavior. It all depends on your point of view.

Interest on mortgages

    • For as long as I can remember, interest on home mortgages has been treated as a desirable expenditure that should be encouraged. Because homeownership is considered part of the American dream, the tax code subsidizes it by reducing the after-tax cost for those who borrow to buy homes (and are able to itemize rather than take the standard deduction). While everything else may be arguable, certainly this seems fair. But is it? Are homeowners more virtuous than renters? If mortgage interest is deductible but rent isn’t, we’re requiring renters to subsidize owners. Is that appropriate?
    • On average, homeowners are from the middle and upper-income brackets. Is it fair that poorer renters provide a benefit for richer owners?
    • And is it desirable that those able to buy more expensive homes should get more of a subsidy than those consigned to cheaper ones?
    • As with the taxation of dividends, judgments on these matters change over time. Until 1987, there was no limit on the amount of mortgage interest that could be deducted. If you could afford to own ten homes with multiple million-dollar mortgages on each one, taxpayers would collectively share the cost by reducing your income taxes due. Today interest is deductible on only a maximum of $1.1 million of debt, and only on first and second mortgages, and only on a primary residence and a second home. So the tax treatment of owners of many homes and more expensive homes has become less generous. But it’s still better than that of renters. Is that proper?

Charitable deductions

    • As I travel the world visiting with clients, I see that two things about the U.S. are quite uncommon: (a) Americans give a lot of money to charity and (b) donations to charity are deductible in calculating taxable income. Everyone tells me the latter is the main reason for the former. In particular, these things are part of the explanation for the existence of the
      many private, non-state-supported colleges and universities in the U.S.
    • Part of this is true because legislators decided at some point to subsidize non-profits by encouraging contributions through the tax code. That’s certainly understandable. And yet, changes were made in recent years to limit upper-bracket taxpayers’ use of deductions in order to ensure that they pay some minimum tax rate. What about the unevenness of the subsidy?
      • The cost of giving $1 to charity is reduced by the amount of taxes it saves the donor, which is equal to $1 times the person’s tax rate. So today, speaking simplistically, it costs a top-bracket taxpayer 65 cents to give a dollar to charity, while it costs a bottom-bracket taxpayer 85 cents. Is that fair? Should the bigger earner receive a greater reward for a dollar of philanthropy than someone who can afford it less easily?
      • And should those who aren’t inclined to give to charity be required to subsidize those who are?

State and local deductions (SALT)

    • Deductibility on the federal tax return somewhat evens out the burden and ensures that (a) the states get first crack at taxing income and (b) the federal government can only tax
      what’s left, in line with federalist principles.
    • This raises a number of questions. Is the deductibility of state and local taxes fair? As with other deductions, the key question is “fair to whom?” Some people pay more state
      and local taxes than others, meaning they get greater deductions than others. As a result, while a person with a given income who lives in a high-tax state pays higher total taxes,
      he or she pays less federal tax than someone in a low-tax state. Is that fair?
    • Should the federal government subsidize spending on the part of high-tax states? That is, should residents in low-tax states bear part of the expenses of high-tax states?
    • While the source of an exemption rather than a deduction, what about interest on “municipal bonds” issued by states, counties, cities and local agencies. This is exempt from federal taxation, under the legal doctrine that the federal government mustn’t tax the operations of the states. But here again, we’re talking about a federal benefit (in the form of a lower cost of capital) for the biggest-spending local governments and their citizens, and a tax break for people who lend to them.

Property and sales taxes

    • Property taxes deductible without limitation. Thus the owner of a mansion – or ten mansions – receives more of a tax benefit than a low-income earner. And it’s another subsidy for homeowners versus renters. Is this right, or should it be changed?
    • Sales tax used to be deductible, too (meaning the buyer of a Rolls Royce got assistance from the federal government). Now it’s not. More fair?

The biggest exclusions of all: employer-provided health care and the deferral of taxation of contributions to pension plans

    • In both cases, those receiving these employer-paid benefits enjoy a substantial benefit not shared by those not fortunate enough to participate. For instance, is it fair that many better-paid workers get thousands of dollars a year in untaxed health-care benefits, while other workers enjoy no such subsidy?
  • Just think of how complicated the argument is on “fair” ways to raise taxesThere’s an argument that for the deficit solution to be equitable, all citizens should contribute to it. Though some government spending benefits all citizens alike, such as national defense, national parks and the administration of justice, much spending disproportionately benefits lower earners, in the form of public education and transportation (which are supported by the federal government), unemployment insurance, food stamps, Medicare and Medicaid, etc. Thus the effect of the coming spending cuts will fall more heavily on the poor. Some argue that since they receive less in benefits and are therefore less likely to experience their loss, the wealthy should share the burden of reducing the deficit through increased tax payments.
  • Keeping taxes low in general
    • Reduce wastefulness
    • Laffer curve
    • Encourage growth

Notes from The Rebel Allocator

The Rebel Allocator
by Jacob L. Taylor


Summary

Using a Socratic device, the author creates a Buffet/Munger composite doppelganger named Mr X to help guide Nick, a young left-leaning journalist turned investor. Nick is disillusioned by the business world from his seat at Big Rock, a cartoon of a private equity firm whose short-term, scorched earth practices give capitalism a bad name. Through his regular lessons, Nick learns the principles of sound capital allocation and sees them applied within billionaire Mr X’s nationwide burger chain. The book covers a broad array of ideas that underpin business and strategy, while its narrative structure makes the lessons more enjoyable and practical than the dry texts that typically teach these topics.

The Profit Constraint

Apply this: revenue – profit = expenses aka pay yourself first.

  • Yarak: “hungry but not weakened”
    • A bird in this state is the purest expression of its genetic capabilities.

3 Key qualities in employees

Integrity, intelligent, energy

  • 2 out of 3 will do so long as you have integrity!

A compass for what to focus on

4 hours a day spent on something that will make other things easier or unnecessary

Zero-based budgeting

Every year budget items are subject to a ‘delight’ test. If the expense doesn’t delight the customer it’s non-strategic and subject to trimming. Don’t paint the (unseen) fourth wall.

Effect of compounding improvement

365 days of 1% improvement is 37x return

Iron Law of Economic Survival

Cost, price, value triangle (straws model introduced in ch 19)

  1. Cost is true economic cost not accounting cost.
  2. Price can be based on lifetime revenue.
  3. Value is subjective,context dependent, and variable.
  • Trade-off between profit (price minus cost) and brand (value minus price).
  • By flying under the radar with lower profits you may be able to store brand in your customer’s mind.
    • Profit would alert competitors and regulators! Brand is poorly measured.
    • Me: Interesting to think of underpriced companies as those storing economic value in their brand which exists in the customer mind.
    • Net promoter score surveys compare the percent of people who are superfans vs those who are ambivalent or detractors

Customers don’t want a quarter-inch drill bit they want a quarter-inch hole

A business should consider its competition broadly with the criteria of who else fills the need. (ie Southwest airlines early on was competing with Greyhound for short trips).

Understand your edge

​Franchise model allows parent company to do what it does best: source ingredients, craft customer experience, marketing. The franchisee is really in the real estate business. (in the 4 seasons model this is same). Real estate unlevered returns are close to inflation while the fictional McDonald’s is closer to 12%

Effective capital allocation requires evaluating all options

Mr X looking at an empty plot poses the question, how many ways could we build a restaurant?

Student answers buy a plot, hire a construction crew and build one. But there are more strategies:

  1. Buy land and erect building later
  2. Buy land and wait
  3. Buy competitors store and convert
  4. Buy public stock
  5. Buyback your own stock
  6. Just waiting
  • Your next best option is your opportunity cost. Important to not define menu too narrowly
  • If you were trying to improve the experience of traveling across the country one option is to fly faster. This will cost substantial additional fuel and maintenance. Installing TVs on the planes may provide a better ratio of benefit to cost to the consumer.

2 kidneys for a reason

Tradeoff between efficiency and survival: virtue of cash and less leverage

Trees don’t grow to the sky

There are feedback loops which lead to mean reversion

The virtues of efficient capital allocation

“Good capital allocation means doing more with less to create happier customers. The pressure to continually deliver value is one of the wonders of the free market. Roll up all of those customers into society at large. When you are able to provide value for the least required cost, you free up resources that can go toward adding value somewhere else.

Imagine that inside you are all of these different locks. Each lock represents one of your wants or desires. You have a lock for food, a lock for shelter, a lock for water, a lock for the opposite sex. Now imagine that each capital allocation project creates one key. Ideally, the entrepreneur knows the lock their key will fit beforehand. A restaurant provides you food, a hotel gives you shelter, shoes protect your feet. The role of business is to use the least amount Of resources to create the key that fits a certain lock. Doing a proper job spares resources to create more keys for other locks. In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so. When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.

That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.”

When simple models outperform experts

Simple models thrive when:

  • Problem is ill-structured and complex.
  • The information is incomplete, ambiguous, and changing.
  • The goals are ill-defined, shifting, or competing.
  • The stress is high, due to time constraints and/or high stakes.

Notes on Invisible Heart

Invisible Heart
by Russ Roberts


Thinking like an economist: Second Order

Price modulates supply/demand

Suppose the world has 531 billions of barrels of oil in reserve and on balance consumes 16.5 billion barrels a year. How long before we run out of oil?I’ll give you a hint. You don’t need any more information. If you know the answer it is because you reasoned like an economist. I never said it required more horsepower to think like an economist. It’s just a different lens. 

If you are stumped then consider Robert’s thought exercise.

I gave you a room full of pistachio nuts in the shell. It’s a big room, say the size of a classroom. The room is filled with pistachio nuts up to a height of five feet. There are millions of them. Welcome to the Nut Room. The nuts in this room are yours for the taking. Any time you want to come in here and help yourself, there is no charge. Bring your friends if you’d like. Just wade in and have a pistachio party.

“You’re happy because you love pistachio nuts. Outside the Nut Room, they’re expensive. Inside, they’re free. There’s only one rule in the Nut Room. As you eat the nuts, you’ve got to leave the shells in the room. You can’t take them out with you. At first, that’s no problem. For the first few days and maybe weeks and months, the pistachios are plentiful. But as the years go by, it takes longer and longer to find a pistachio. The shells start getting in the way. You come in with your friends and you spend hours wading through the shells of pistachios you’ve already eaten in order to find one containing a nut. Your friends say, we’ve got to stop meeting like this. ‘Why?’ you ask. ‘Don’t you like free pistachio nuts?’ And what do your friends say in response?”

The nuts aren’t free anymore” In other words, the price of finding the nuts has exceeded the price of just getting them at a store. The price rationed demand. 

So what about the oil?

“Remember the pistachios!”

You will never run out of oil. The price of finding the marginal barrel will become high enough that people will find cheaper sources of energy before they ever extract the final barrel. By thinking like a microeconomist you were able to see that the relative price of substitutes meant the supply of oil was not headed to zero with a slope of negative one. It’s a curved line that never approaches zero.

Being a nanny state

“Children don’t anticipate the future very well, so we treat children differently from adults. But when we start treating adults like children, we start taking away the essential human challenge of coping with uncertainty and making decisions”

  • A life without consequences and costs has no meaningful choices. A life without meaningful choices is the life of a “child, animal, or robot”
  • The connection between choices and rewards is the essence of responsibility

Chapter 13: The Rules of the Game

  • Thought experiment about designing the perfect law highlights the reality that every choice is a trade-off. If you had access to a “Dream Machine” a construct referenced from Nozick’s Anarchy, State, and Utopia then you would fast forward to the goals and prizes but the seeking, trials, failures and risks of the world would never be endured but remember without valleys, there are no peaks.
  • When people are laid off it sharpens our focus on them. What’s blurred is the competition which rose to combat the cost-cutting company. The employees of those competitors get to have jobs.
  • Maimonides thoughts on charity. The giver and receiver must be considered.

On an ascending level, they are as follows:

8. When donations are given grudgingly.

7. When one gives less than he should, but does so cheerfully.

6. When one gives directly to the poor upon being asked.

5. When one gives directly to the poor without being asked.

4. Donations when the recipient is aware of the donor’s identity, but the donor still doesn’t know the specific identity of the recipient.

3. Donations when the donor is aware to whom the charity is being given, but the recipient is unaware of the source.

2. Giving assistance in such a way that the giver and recipient are unknown to each other. Communal funds, administered by responsible people are also in this category.

1. The highest form of charity is to help sustain a person before they become impoverished by offering a substantial gift in a dignified manner, or by extending a suitable loan, or by helping them find employment or establish themselves in business so as to make it unnecessary for them to become dependent on others.

  • A key to the self-regulating property of economies is private property. Regulation can make far more sense when dealing with a common resource that nobody owns. How did Zimbabwe turn such a resource into a form of ownership, thwart poachers and increase elephant populations? Making the villages able to charge to hunt them. This gave villages an incentive to care for the elephant population since elephants were now a source of revenue. While some conservationists found it reprehensible others found it practical. If you care more about elephant populations it turned out to be an effective strategy.
  • “The human heart has its reasons that reason cannot know”. A divorce is complex and its cause is never as simple as one reason (ie infidelity). A divorce is the “product of a thousand misused moments”. The legal system is smart enough to recognize this and not try to determine whose fault it is. This is a good lesson when thinking about using courts to adjudicate discrimination. While some cases may be cut and dry most will not be and the ability of courts to intervene leads to changing incentives and potential for unintended consequences.

Notes on The Accounting Game

The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
by Darrell Mullis and Judith Orloff


Balance sheet

Assets = Liabilities + Equity

Income statement

The movie that connects a period’s beginning and ending balance sheets which are snapshots.

Sales

-COGS
-Labor

________________

Gross Profit

-Expenses

________________

Net profit

Examples of expenses

bad debt, interest, insurance

An expense like insurance can be prepaid (ie a 10 year policy). So while you may pay cash for it upfront reducing your cash assets, you will expense only 1 year worth of its benefit while booking the remaining value as a “prepaid asset” on the balance sheet

For service businesses:

Sales

-Cost of services

_________________

Gross profits

-Expenses

_________________

Net profit

Cost of services are direct cost of providing service hours. Expenses include items like admin, sales & marketing including commission for leads, and R&D to develop materials, salaries including to owners.

  • Income taxes are deducted on the income statement to compute a net income after taxes.
  • If you sell an asset at a value higher/lower than book value you will register a gain/loss on the income statement

Inventory

  • The inventory from a beginning balance sheet will be part of the COGS in an income statement.
  • Inventory on balance sheet can be divided into raw materials and finished good. It takes cash (for example to pay labor) to turn a raw material to a finished good so there can be cash “locked” up in the balance sheet in the finished goods that can only be realized by making sales.

Valuing inventory

  • In an inflationary business where the cost of materials rises over time, LIFO accounting will value the inventory and COGS higher, in turn, reducing paper profits and taxes.
  • Most businesses start using FIFO which is operationally easier but switch to LIFO for tax reasons. In fact, LIFO records are expensive to maintain and usually only done by companies with large inventories.
  • The IRS must grant permission for your business to switch methods a second time and require any back taxes be paid.
  • Where it was possible to report cash balance sheets to the IRS and accrual ones for investors it is required to be consistent with method used to value inventory (LIFO or FIFO). So accounting statements will usually footnote whether the assets are being under or overstated based on the method used.
  • If it is easy to value the inventory individually (ie each item has a serial number) then some businesses will average the value of the inventory.

Accrual vs Cash Accounting

  • Accrual accounting is more accurate but leads to higher profits than cash accounting so it leads to higher taxes. Companies prefer cash method for IRS but accrual method for investors.
  • Service companies have the advantage of being able to use cash accounting but companies who have inventories as a significant portion of business are required to use the accrual method. Otherwise, they could easily shield profits by spending cash on hand to buy inventory and reduce reported earnings.

By allocating items, we can allocate items in a way that lends economic insight into the business and price services correctly.

Capitalizing an asset vs expensing it

Plants and buildings are fixed assets although costs to maintain them would be recorded on the income statement as expenses.

  • Equipment is also a fixed asset but usually separated from plants and buildings which are stationary.
  • Whether a purchase is treated as an asset or expense really depends on:
  1. duration of its use. If it is many years then capitalize it as an asset. If it’s treated as an expense it will reduce earnings in the current period.
  2. Its cost. You can set a dollar limit, and any item which exceeds it will be capitalized.

Cash Statement

Keeps track of cash flow which is necessary when doing accrual accounting. For example, if you made a sale on credit in a previous accounting period and the cash for that sale comes in we do not adjust the income statement since we already accounted for the sale. However we will update the cash statement.

Depreciation

Shows up as an expense on the income statement reducing earnings. The balance sheet will be kept in balance by reducing the value of the fixed assets by the same amount as the expense.

  • It is a rare Non-Cash Expense allowing us to reduce earnings without losing cash!
  • Buildings must use “straight line” depreciation while equipment can use “straight line” or “accelerated”. There are a few types of “accelerated” schedules and the IRS intermittently changes them. “Accelerated” depreciation uses the updated “base” (ie the asset’s value after the last depreciation period) to calculate the new depreciation amount. The resulting curve will allow you to save taxes near term by taking steeper depreciation expense.

Categorization of Assets

“Current Assets”: assets such as cash, receivables, inventory and prepaid expenses which are probably convertible to cash within 1 year.

“Net Fixed Assets” or “net book value of assets”: gross fixed assets (using purchase price) + accumulated depreciation

  • By breaking net fixed assets into gross + depreciation we can estimate how old the assets are.
  • Assets are typically listed on a balance sheet in descending order of liquidity (ie cash is first).

Understanding the difference between earnings and cash

When you are investing in a business you may find that it has little cash and even if the business is very profitable it is very possible to have high retained earnings but no cash. Retained earnings are not cash! It is not a sum just sitting in a bank. It reflects that the business has been profitable, and also your ownership but it is not spendable like cash. It can be tied up in assets.

  • On a daily basis, cash runs the business!

Flirting with Models: Wayne Himelsein

Link: https://blog.thinknewfound.com/podcast/s2e7-wayne-himelsein/

About Wayne: CIO of Logica Capital

Transcription: Otter.ai


Overview

Every trade is implicitly long or short volatility or optionality

  • There is variability in every asset and its distribution dictates whether you are long or short.
  • Every trade is either a bet on convergence or divergence. Convergence trades are short volatility

Quant vs Discretionary

“There’s good and bad in all of it. So the best you can do for yourself by going with what you know because you’ll be able to ask better questions and be more comfortable with what’s happening day-to-day.”

  • Myth of quants building a black box then “going to the beach”

“The market is always changing. In fact, it’s funny even the idea of factors and categories, if you think of something like value and growth. These two big facets of the market, even those are evolving. [Consider] that you buy a value stock, and it turns around and starts moving in your favor. Well, now it’s a growth stock. So literally, the categories are changing on us. So if you bought a value book, and you leave it for six months, you’re now a growth book, if you were right on your picks.”

  • Using quant to “mechanize” what works vs mining for patterns

“Finance algorithms that developed from logic and experience that simply seek to mechanize what is already well understood, have a chance at success. Those that begin in data analysis, categorization, quantification, or statistical or numerical gymnastics do not.”

Opportunities in volatility trading

Traders have different “assumptions across the volatility surface, the strikes up and down and across the calendar upwards and outwards, There are different prices for every option. Because of all this modeling and people having demand for different options at different calendars in different strikes, there’s going to be cheaper and more expensive….Take advantage of the weirdness and pricing and model variants across the option surface.”

An inverse relationship between signal strength and opportunity size

  • As your signal strength declines you need to diversify more. “To have more probabilities repeated more often, [so] more positions”
  • Hoffstein: “Information ratio is equal to your information coefficient times square to breadth. If you have to lower your information coefficient, but your breadth goes way up, you can actually end up with higher information ratio”

Re-phrasing a bit: expectancy scales with number of trials but volatility scales with square root of number of trials. If your bankroll is large and your business diversified, it follows that your focus should be on hunting for high expectancy games, not minimizing risk.

Evaluating a strategy

  1. Use daily returns to get more data points. Monthly returns mask too much.
  2. Are you achieving your premise?

    “So you’ve said yourself, I know where I want to neutralize, and I know where I want to get my alpha. And if that’s where you get your alpha, you have to know that number one, you have alpha there. So if you look at your growth tilt and measure that against Fama growth factor, do you beat it? If not, you’ve got no edge.”

    • Map the strategy.
      • Compare the exposures to time series of different exposures to see how it behaves. This requires using mathematical tools that do not rely on linearity (ie regressions).
        • “I don’t ever listen to what [the manager] tells me. I just run it versus we have in here about 180 different exposures that we have time series for factors or exposures [to find out] “what is inside this thing?”
      • How intentional are the exposures?
        • Managers will tell you that they’re doing something but don’t even know what they’re exposed to. “Did you know you have a 30% exposure to momentum? Oh, no, I didn’t. I’m actually a value investor.” (Me: sounds similar to performance attribution frameworks behind “hedge fund replication” strategies)

Risk

Beta is a poor quantity to use to balance your portfolio

  • Beta equals correlation times vol ratio
    • It’s easy to compute which makes it popular
    • …but since its inputs are non-stationary, non-linear and themselves volatile it’s garbage in/garbage out.
    • Important to understand if a beta-hedge portfolio will bleed longer or shorter as correlation increases. (Me: This is why gross exposures are important to constrain)
  • How to balance a portfolio without relying on beta?
    • Geometric approaches that account for non-linearity
      • Clustering distance approaches
      • Stochastic dominance

Market neutrality is a “funny” concept

  • What does it mean to even be neutral?
    • “What do you want to be neutral to? Are you directionally neutral? Are you factor neutral? You can [initiate] a directionally neutral portfolio that has equal long shorts, with a complete growth, tilt, or a value tilt or some other factor tilt like a volatility tilt.

Overcrowding

“If we find a good pair trade, rest assured, many others have found it. And there’s just gobs of computing power, and PhDs and all the rest doing the same thing. And so we’re all going after the same edge. When things start to go wrong, the differences between the different groups is that they manage the risk differently. And one of the best means of managing risk in these markets [is to manage leverage]. The overcrowding risk is that everybody’s in this trade, and it’s a good trade. That’s why everybody’s in it. So you’ve done the right thing. But as some of these bigger shops start to unwind, it becomes everything going the wrong way. Others are needing to exit because they have LPs to answer to or they have risk that they’re managing to, so as long as you’re in it, you’re exposed to that. And it’s difficult to manage because at the get-go, you made the right bet.”

Walking away or sticking with a “broken” strategy?

Difficult question since the pricing may be more favorable as anomaly gets stretched but unclear whether the relationship will revert and on what timeline. There’s career risk is sticking with it vs the weight of the historical evidence for the opportunity.

“The more your measure won’t determine whether something’s out of favor, the more time you might give it to try to fix it”

“Comes down to a personal decision. How much time am I willing to spend tweaking and contorting to try to figure out whether I can fix it. And we all have our limits. It comes down to a business question as well. It’s not just tweaking and contorting and trying to fix it. But how much time can you spend defending it? How sticky is your capital? Even if it does come back still be in business?”

An easy example was the trade that shorted both the triple long and triple short ETFs on the same reference asset. The trade was over once the cost to borrow the shares exceeded the edge in the trade. This was easy to measure and therefore abandon when it became too crowded.

Hedging non-linearity or skew

  • “The only way to get rid of the left tail is to balance it with the right tail. And to have that obviously, you have to have the right offset temporarily. You need the time association to match that when this thing goes down, the other thing goes up. So you need to understand the time relationship between the two.”
    • Stop-losses are “synthetic left tail mitigator”. They are not fully reliable because of:
      1. Gaps
      2. Discipline
    • Tradeoffs between hit rate and cost of the hedge. Need to define what type of exposure you are ok with to target the right option hedge. Just like insurance has cost levers like premiums, coverage amounts, durations, and deductibles options portfolios can be custom tailored.
    • Flight to quality assets like gold, USD, treasuries in a permanent portfolio
    • Managers who engineer defensive market-neutral portfolios

Final words on hedging

  • Depending on the nature of the crisis hedges behave differently. Since we cannot predict the nature nor timing of a crisis it’s best to be diversified across hedges.
    • “Back to the larger insurance analogy, you have your medical and you have your dental and you have your vision. And so I don’t know where I’m going to get hurt. But either way it’s covered.”
  • Tolerating the cost
    • “Optionality being potentially the heaviest cost again, to me, it’s not expensive when you get what you want. But since it is more often a bleed than a payoff, perhaps people should have more treasures and gold and a little bit less optionality. But definitely all concurrently.”

Thought experiment

You can only own 1 asset and never trade it again, what do you pick?

SP500. The only reason people underperform the market is they want to control volatility and liquidity needs. But if we remove these concerns the best thing is to just own the market in perpetuity.

Notes from Invest Like the Best: Ali Hamed

Link: http://investorfieldguide.com/ali/

About Ali: Partner at CoVenture fund


His approach

  • He looks at new asset classes that can be hard to value.
  • Alternative financing like asset-backed loans (loans against fruit inventory, app for fast-food chain which allows them to clock employees in and out and allow them to pay employees whenever they wanted for a slight pay haircut)
  • Fee structures depend on the dispersion of manager skill.

Coventure recognized many seed companies never get to Series A

  • Fail to build the planned software to get to market. So Covenutures helps them.
  • Software types who don’t understand the industry they are building a solution for
  • Don’t understand the team they need

How does CoVenture fit into this?

The lesson is that the capital was easier to find than the people who can execute so :

  • Giving young businesses guidance and connecting them to the personnel they need is very valuable.
  • Having a service which serves common needs to many prospective startups is how to scale this idea.

Thoughts on cost of capital

  • If one VC fund can convince its LPs to accept 1/2 the going return because it has the clout to get the best deals that’s another way of saying it has a lower cost of capital. Sequoia can offer lower rates of return because they are less risky than an upstart fund
  • These relative differences in costs of capital sustain significant advantages.
  • A fund may offer a startup cheap financing in exchange for warrants (similar to a convert). This is a bad strategy b/c the performance of the instruments is inversely correlated. If the company takes off and does well, the warrants will perform but a larger fund with a low cost of capital like Blackrock or Apollo will refinance the debt piece for cheaper. In the case where the debt is not refinanced the warrants will be worthless.

Conundrums for seed funds

  • They are expected to “stick to their knitting” and be contrarian. This is practically impossible since being contrarian requires you to exit the seed company in a year or so to a Series A fund which is by definition consensus.
  • Any seed fund of quality naturally wants to raise more money but will find itself capacity constrained so it will drift towards Series A deals which are outside their expertise
  • Pre-seed round is about trying to methodically uncover if you are creating customer value. Revenue can be falsely equated to customer value. For example, you can spend money marketing which will lead to more revenue but this is not the relevant KPI (“key performance indicator”) to test the hypothesis that you are increasing customer value. The seed round is then about trying to find out if the improvements to KPI can scale.
  • Important to have a strong understanding of the role of the round you are in
  • Judgment vs Empathy at the core of a solution
    • Empathy reflects a true understanding of the practical trade-offs that lie within a business problem.
    • Judgment is typically what an arrogant or ignorant outsider looking at the problem prescribes when crafting the solution
  • Technology has made starting companies cheap but scaling is more expensive.
    • Trade-off when raising capital: balancing getting off to a fast start to acquire customers and scale versus discipline and overleverage.

A link to another post with takeaways from this podcast: https://thewaiterspad.com/2018/01/24/ali-hamed/

Notes from Capital Allocators: Tali Sharot

About Tali: Professor and author of The Influential Mind, The Science of Optimism, and The Optimism Bias

Humans have evolved to maximize positive emotion which is a reward for engaging behaviors which promote survival (sex, eating, social acceptance).

We have built-in biases which push us towards maximizing this emotional well being.

Comparing alternatives requires us to put a value on which actions will improve our well-being, but this is a significant task requiring us to continually weigh our immediate happiness vs future happiness. This is difficult comparison since it requires exchanging immediate, visible gratification for longer-term, invisible, and often compounded benefits. The cost of these decisions is not immediately visible, but the benefit is.

Tali’s research seeks to understand the mechanism by which our built-in biases confound these comparisons so that we can make the costs and benefits of our options more readily available or design nudges which push us towards better long term behavior in cases where we reflexively choose poorly for short term benefit in defiance of what we might actually want.

Optimism Bias

  • We paradoxically hold private optimism vs. public despair
    • “Machines are going to take everyone’s job; except mine”
    • “The market is going to crash, but I’ll be ready and willing to buy when they do”
  • We tend to learn less from things which give us negative feelings
    • We ignore them
    • We explain them away more easily rather than attributing our role to them.
  • We seek opinions which agree with our priors.
    • She cites a study where a group is discussing the value of real estate. When people were agreeing the pleasure centers of their brain light up.
These last 2 points conspire to boost the well-documented confirmation bias.

Is the optimism bias adaptive?

Whether it’s adaptive or not depends on the consequences.

  • It’s not adaptive when it encourages you to take reckless risks
  • On the other hand if you are very motivated in a task because you are overconfident it may be a self-fulfilling prophesy.

Home Country Bias

  • Driven by preference for control rather than the uncertainty that comes with investing in the unfamiliar. Sense of control is also shown to independently be a source of positive emotion.

Reducing Bias

The prescription for dealing with biases varies across individuals. How responsive individuals are to social rewards, anxiety-reducing rewards, risk tolerance all lives on a spectrum.

How can we combat confirmation bias?

  • Confirmation bias compels motivated reasoning. To counteract that find outside points of view that don’t share your priors.
  • Be aware of group dynamics especially our preference for agreeing.
    • For example, before a group discussion surrounding a decision, it is good practice to ask everyone to write their opinion down before the discussion.
  • Be aware of our tendency to confuse confidence for competence. [This reminds me of mimicry in nature. For example, several snake breeds are imposters of the venomous coral snake. Just as a true expert will spot an imposter, a coral snake will intimidate their copycat cousins.]
How can we encourage incremental actions whose benefit is unseen or far in the future?
  • Feedback. We can provide rewards for near-term milestones.
    • She gave the example of a display showing how many people at the hospital washed hands so employees are encouraged to increase the score. Seeing the score increase serves as a psychic prize.