Monday, July 22, 2019

Wimpy and private equity - Investors can avoid the worst issues through replication alternatives

Wimpy's motto is, "I will gladly pay you Tuesday for a hamburger today". The concept of long lock-ups in private equity investments without full disclosure of the investments or effective valuation follows the Wimpy motto. Pay us today with cash which will be invested over time with a management fee every year and a 20% carry that is paid when you are given your cash back. There is clear investment uncertainty and illiquidity that requires extra compensation than what would be expected from any public investment. 

Many studies have shown the strong returns from private equity that make it an attractive investment. Still, private equity requires an inherent optimism with a strong commitment of time. There is also evidence that private equity returns can be replicated in more liquid public markets. Private equity may not be as unique as marketed.

Private equity replication requires three components, equities that match the underlying PE investments, leverage, and long-term accounting. See "Replicating Private Equity and Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting" by Erik Stafford of the Harvard Business School for a good study of the differences. See L’Her, Jean-Fran├žois, Rossita Stoyanova, Kathryn Shaw, William Scott, and Charissa Lai. 2016. “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market” Financial Analysts Journal 2016, vol. 72, no. 4 (July/August): 36-48 for another comparison between public and private funds. In both of these cases, looking at some simple criteria such as small cap and value provides the basis for liquid replication of private funds.

Private equity investments focus not on large cap firms but smaller firms with low EBITDA and some leverage. The problem with replication is that the valuation process will show a markedly more volatile investment than what is received with a private equity fund. While valuations will be similar to a public fund, there will be greater smoothing and possible upward bias in private equity valuations. The accounting differences matter. 

Nevertheless, investors can have greater control over their investments and still reach the same return potential at lower costs through replication strategies. However, to realize these gains requires the investor to commit to a long-term investment and accept variation in valuations that will suggest greater risk than a private equity alternative. 

Sunday, July 21, 2019

Stocks Don't Do So Hot - Most equities don't beat one-month Treasury bills

Stocks are risky investments. Let's be very clear, stocks are risky with positive skew. Of course, everyone knows that but some data published about two years really drove that home. (See my earlier post "Most stocks are losers - Median and skew tell an important story" about the paper "Do stocks Outperform Treasury Bills" by Hendrik Bessembinder)That path-breaking work has now been updated for more time and across international stocks, see Do Global Stocks Outperform US Treasury Bills?

This meaningful research again comes from Henrik Bessembinder who found in his original paper that over half the stocks in the US never make more than the risk-free return. Most of the wealth from equities comes from a very small percentage of firms. This research has now been updated and includes 62,000 domestic and international stocks. The results are about the same, but even worse for international stocks.

The long-run performance is highly skewed positive and shows that most of the global wealth from equities comes from a limited set of names. Investors are not compensated for the risk that they take with buy and hold investing with individual equities. Most stocks around the world cannot beat the risk-free rate. An investor can still make money by holding an index which will contain the few winners, but long-run stock-picking by this simple measure is a losers game 

Thursday, July 18, 2019

Hedged Corporate Bonds - Not a good deal over the last year

A corporate bond has two components, an underlying Treasury exposure with risk premium or spread associated with the default risk of the issuing company. Your return will be associated with the performance of each of those pieces. If rates do not change but spreads tighten, the investor will receive a total return gain. The added return will be the spread yield plus the spread tightening times the duration of the bond. 

Investors can buy a corporate and high yield bond index (LQD and HYG). They can also buy LQDH and HYGH which is the hedged version of the same index. The hedge reduces the underlying duration or Treasury interest risk in the portfolio. An investor is only holding the corporate risk exposure. That change in risk can have a significant impact on performance.

In the last year, grabbing for yield has been good for corporate and high yield investors, but the gain has come from the interest rate duration exposure and not from the added yield of holding corporate risk. Over the last year, investors only got 20% of their return from corporate bond spreads and less than 50% from high yield spreads. Buying yield is a two-part decision. Sometimes you want to buy the premia and other times you want to have the duration.

Using alternative yield curves tells the same story of inversion - Recession coming

The yield curve is inverted. Who has not heard about? Who does not expect a coming slowdown given this information? Is there any more information that  needs to be said?  A Fed paper suggests that looking at the short-end of the curve may be slightly more informative than a 2-10 year Treasury spreads or some other Treasury combination like 10-year / 3-month spreads. (See "The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted View" by Engstrom and Sharpe.) Now the yield curve inversion is somewhat of a blunt forecasting instrument. There can be variable lead times before a recession and it has predicted recession that did not occur; however, having alternative looks at the yield curve may provide additional information.

Engstrom and Sharpe find that the focus should be on the 12-18 month part of the forward curve. Their argument is that when the market prices in a monetary easing they are also pricing in an expected recession. The Fed is responding to the threat of a recession. 

Using their work with a simple variation, there is a lot to learn by focusing on shorter-term forwards as opposed to longer-term spreads. Here is the Eurodollar futures curve as forward yields out beyond five years. Notice the inversion that suggests a recession and is also consistent with easing monetary policy expectations. The real economy and monetary economy are closely linked. 

There is less noise from longer rates using the Eurodollar futures data. The long rate by definition is an average of expected short-rates so focusing on the 12-18 month curve is a more direct measure of changes in relative prices. While we still look at the consensus inversion numbers, we agree with the Fed researchers that short rates may provide better information.