Wednesday, September 23, 2015

Jack Schwager's interview with John Bender

Stock Market Wizards is the third installment in Jack Schwager's series of interview books. Many people consider it the series's worst book. That may be true if it's judged by its average interview, but Stock Market Wizards also has the single best interview that Schwager has done: his conversation with an options trader named John Bender.

Bender argues that the Black-Scholes formula for valuing options is flawed because it assumes that price moves are normally distributed. Bender believes that a) price changes usually don't adhere to the normal distribution and b) there is no alternative model for pricing options that applies to all securities. As he says:

[There's no] one-size-fits-all model that is better than the standard Black-Scholes model. The key point is that the correct probability distribution is different for every market and every time period. The probability distribution has to be estimated on a case-by-case basis.

Estimating the probability distribution requires knowing who the market participants are and understanding their psychology, how they finance themselves, etc. Bender describes one instance when, contra Black-Scholes, a large price decline was more likely than a small price decline:

[I]n 1993, after a thirteen-year slide, gold rebounded above the psychologically critical $400 level. A lot of the commodity trading advisors, who are mostly trend followers, jumped in on the long side of gold, assuming that the long-term downtrend had been reversed. Most of these people use models that will stop out or reverse their long positions if prices go down by a certain amount. Because of the large number of CTAs in this trade and their stop-loss style of trading, I felt that a price decline could trigger a domino-effect selling wave. I knew from following these traders in the past that their stops were largely a function of market volatility. My perception was that if the market went back down to about the $390 level, their stops would start to get triggered, beginning a chain reaction.

I didn't want to sell the market at $405, which is where it was at the time, because there was still support at $400. I did, however, feel reasonably sure that there was almost no chance the market would trade down to $385 without setting off a huge calamity. Why? Because if the market traded to $385, you could be sure that the stops would have started to be triggered. And once the process was under way, it wasn't going to stop at $385. Therefore, you could afford to put on an option position that lost money if gold slowly traded down to $385-$390 and just sat there because it wasn't going to happen. Based on these expectations, I implemented a strategy that would lose if gold declined moderately and stayed there, but would make a lot of money if gold went down huge, and a little bit of money if gold prices held steady or went higher. As it turned out, Russia announced they were going to sell gold, and the market traded down gradually to $390 and then went almost immediately to $350 as each stop order kicked off the next stop order.

The Black-Scholes model doesn't make these types of distinctions. If gold is trading at $405, it assumes that the probability that it will be trading at $360 a month from now is tremendously smaller than the probability that it will be trading at $385. What I'm saying is that under the right circumstances, it might actually be more likely that gold will be trading at $360 than at $385.

He argues that the same dynamic occurred before and during Long Term Capital Management's collapse:

Last year [1998], it was my belief that stocks were trading on money inflows rather than their own intrinsic fundamentals. IBM wasn't going up because the analysts were looking at IBM and saying, "Here's the future earning stream and we predict the price should rise to this level." IBM was going up because people were dumping money into the market...

A market that is driven by inflows can have small corrections, but it has to then immediately recover to new highs to keep generating new money inflows. Otherwise, money inflows are likely to dry up, and the market will fall apart. Therefore, this type of market is likely to either trend higher or break sharply. There is a much smaller-than-normal chance that the market will go down 5 or 6 percent and stay there. Based on this assumption, last year I implemented an option strategy that would make a lot of money if the market went down big, make a little bit if the market went up small, and lose a small amount if the market went down small and stayed there. The market kept up its relentless move upward for the first half the year, and I made a small amount of money. Then the market had a correction and didn't recover right away; the next stop was down 20 percent.

Most of the abnormal probability distributions he mentions involve positive feedback loops. A rising market attracts inflows, and the inflows make it rise further, or selling begets selling and prices quickly fall. George Soros was one of Bender's investors, and his emphasis on feedback loops is reminiscent of Soros's ideas in The Alchemy of Finance. The emphasis helped Bender earn a 269% return in 2000 when the Internet bubble burst:

[The Internet bubble involved] the distortion of a positive feedback loop-- higher Internet stock prices influenced more buying of Internet stocks, causing still higher prices and so on. This can only go on for so long before a negative feedback develops. Consider what happened with IPOs during the latter stages of the bull market. Companies with $10 million of computer equipment and an idea that had no barrier to entry were selling at capitalizations of $4 billion. The day when somebody pays billions for a company that takes millions to set up is the day you are going to see twenty smart people start twenty more companies that look exactly the same.

Another notable feature of Bender's trading strategy is its complexity. His basic idea-- that there's no single model for pricing options-- is brilliant but simple. Trading on that idea is far less simple: it requires deep knowledge of many different markets, which in turn requires a mix of talent, knowledge, and hard work. (He mentioned working 20-hour days in his interview.) This makes it difficult for other investors to compete away the strategy's excess returns.

Many investors noticed that spinoffs were traditionally undervalued and responded by buying spinoffs. That eliminated their excess returns. Many investors have also noticed that Black-Scholes is flawed, but few of them have achieved Bender's returns because few of them have the same breadth of knowledge.

Tuesday, September 22, 2015

McDonald's: the next Tesco?

A few years ago, Tesco was a popular value stock. It was written up four times on Value Investors Club. Warren Buffett was a shareholder. While the company's recent earnings were disappointing, its historical results were fantastic and bulls thought a turnaround was likely.

Today McDonald's is a popular value stock. It was written up twice on VIC earlier this year. A large hedge fund, Glenview Capital, is a shareholder and has touted the stock. While the company's recent earnings are disappointing, its historical results are fantastic and bulls think a turnaround is likely.

With the benefit of hindsight, we know that Tesco was a value trap. I think McDonald's is another value trap. The arguments that investors have made for buying McDonald's are similar to the arguments people made for buying Tesco.

Bad same-store sales are blamed on loss of focus

When they were written up on VIC, Tesco and McDonald's both suffered from deteriorating same-store sales.The VIC authors argued that this was a result of the companies losing focus.

After Tesco became the largest grocer in Britain, it made an ambitious effort to expand internationally. In June 2012, kevin155 wrote, "I believe that since Tesco was so focused on their growth initiatives, some of the best management talent and resources has been foucused outside the UK."

In April 2015, cmg90 wrote, "In 2013-2014, MCD’s SSS turned negative as a result of strategic misdirection, operational inefficiencies, and disenfranchised franchisees." He added, "Menu proliferation (100 items added over last decade) has hurt order speed (doubled order time in many stores) and order accuracy."

A good investment for the next few years

In 2011, cowboy wrote, "We believe an investment in Tesco plc offers an excellent risk/reward for those with a 3-5 year time horizon."

This past April, gordon703 wrote, "I believe MCD represents a compelling risk/reward investment opportunity over the next 3-5 years."

A wonderful company with scale advantages, etc.

Both the Tesco and the McDonald's bulls are backward-looking: they portray TSCO/MCD as a legendary company and its ongoing problems as a temporary deviation from phenomenal long-term results.

According to the VIC authors, "Tesco is one of the world's great retailers" and "a good franchise with a strong long-term history of growth and returns" while "MCD is a very high quality business with a irreplaceable brand" and "market leading position in a growing, defensive category, significant scale advantages and a highly stable business model."

Each company has economies of scale. Tesco "enjoys significantly lower COGS than its competitors, as well as operational economies of scale" while McDonald's has "a margin of safety provided by its significant scale advantages."

Each company owns valuable property. "MCD's sacrosanct real estate could be worth ~$140B alone," while "Tesco owns ~70% of its real estate. Based on management’s estimate of its properties’ worth, the stock currently trades at approximately that value." Another Tesco bull argued that "According to management this property is worth GBP38bn, which is more that the current enterprise value of GBP33bn."

Each company promoted a promising manager from its international business to the top spot. Tesco's former CEO, Phillip Clarke, "did a very good job establishing new foreign markets as well as growing them to their current sizes today." McDonald's "new CEO Steve Easterbrook is credited with successfully turning around the McDonald’s UK business in the mid / late 2000s."

Concluding thoughts

This is a superficial comparison, and Tesco and McDonald have many important differences: they're headquartered in different countries, they operate in different industries, etc. I don't know if McDonald's will implode the way Tesco has, but I think theMcDonald's bulls are making many of the same flawed arguments that the Tesco bulls made.

Another important difference between Tesco and McDonald's is valuation: Tesco traded at 10-13x earnings before its share price collapsed, while McDonald's trades at 21x this year's expected earnings. McDonald's has all the makings of an undervalued turnaround except that it isn't undervalued.