Quotes:
1. To be greedy when everybody is fearful and to be fearful when everybody is greedy. – Warren Buffet.
2. In business, it pays to be a cynic and a skeptic.
I remember this quiz I had in my Controllership class during my years in business school. The quiz was actually the first one in the said class. It was basically a sort of a review of our basic accounting knowledge, i.e., return on equity, leverage ratios, current ratios etc and our professor at that time gave us the previous year’s published financial data of the top 5 corporation in the Philippines as our test case. However, that particular quiz had a very interesting twist. I remembered that the last question asked in the quiz was which of the top 5 corporations we want to lend money to. I also remembered that the number 1 corporation at that time was Petron Corp which at that time is hemorrhaging badly and is deep in the red. The number 2 company at that time if my memory serve me right was Texas Instrument and MERALCO was like number 3. Anyway, all our financial analysis indicated that the number 2 company, Texas Instrument was the best choice to loan money to but guess what did I picked? I picked Petron! At the following session, the professor brought out the topic of our quiz and she frankly admitted that she was in a bind as to how to grade two particular answer sheets, mine and another guy’s paper. According to her, the correct answer was Texas Instrument (TI) which was quite obvious from our financial analysis but why in the whole wide world would 2 guys answer differently from the obvious? The other guy picked MERALCO and he reasoned that although MERALCO’s number were less than stellar compared to TI but her financial statement was by all means strong and furthermore, MERALCO has the stronger cash flow than TI, i.e., it is cash rich. So instead of crowding up at TI, a loan to MERALCO could prove to be more of a bane. Nice answer indeed! On my turn to defend my choice of Petron when I was asked the same question, my answer was relatively simple. Petron was and is still is partly owned by the government and it carries an express guarantee of the state on its debt obligation. Therefore, who cares if Petron was in the red, the government would simply pay the debtor regardless and from the state coffers. Although my answer was by and large practical, my professor rejected it and I scored the lowest at that quiz though I didn’t fail (at any rate, it was a minor setback; I eventually passed the subject with flying colors, 3.5/4.0; not bad for a non – accountant in an accounting subject). What was missing in the question at that time however was how much would we charge for the loan to our respective choice of company? For all practical purpose, Petron would probably be charged more for their weak balance sheet and if that were part of the question, I’m pretty sure that my answer would be the best one. Looking at hindsight, I can say that most of my classmates (99% of them are accountants by profession) at the controllership class are good accountants and auditors and nothing more. The other guy who answered differently is an example of a good value investor while I am the archetypal maverick Wall Street trader that everybody loathes nowadays. And this is my point, why would a guy like me (back then) and rest of the many who got “burned” in the latest subprime crisis would skirt the “obvious” safe choice and invest in high risk securities and end up in the mess that we are seeing right now? By the way, I didn’t get “burned” at all, I simply end up with the lowest score in that quiz taken years back but the great many lost their hard earn savings in this recent financial debacle. So what really is the cause? The answer is because of the need to maximize the return on investment. Put it simply, it is the “how much more could I get from the dollar or peso that I had invested be it in a financial instrument or in a business or in an asset?” It is human nature to want more “profit” for the little that we own. Nobody can blame anyone for wanting to maximize their return on investment. However, one had to remember that though almost everybody handles finance, very few do actually understand what finance is. Finance is not simply about managing returns. It is as much of managing risk as well (and allocating funds and managing cash flow). Finance is not just getting more bucks from what we have or maximizing return. It is also making sure that that buck is safe or in short, minimizing risk. Taken in this light, it puts the very idea of maximizing return in jeopardy. How we could maximize return if we are constrained by risk? For how could we be sure of getting that much money given the risk? And this is where the “magic” of Wall Street comes in. That “magic” is called pricing models, the pricing of human behavior and the human behavior in this particular case is Greed. Most people have a “healthy” appetite for risk, i.e., for a certain limited range of risk, people are willing to take their chances (if that didn’t happen, you won’t see people getting married). And for every risk, there is a commensurate return. The bolder ones getting rewarded with better pay offs. However, for huge risks, 99.99% of the people are avoiding it even if the return “commensurate” with the risk involved and one doesn’t need financial analysis to come to that decision. However, Wall Street has managed to skewer the risk appetite curve towards risk taking bordering on gambling and they do this by simply offering “bigger” return on investment, much bigger than the “commensurate risk” which in essence is stoking greed. Such is the case of the current sub – prime mortgage financial crisis wherein investment banks package mortgages with poor credit quality into a high yield debt instrument and resell it to investors looking to maximize their return. And as these sub – prime mortgages fumble under the weight of a falling economy, the debt papers backed by these mortgages became essentially a worthless piece of paper. This has in turn, triggered the massive selling of these debt instruments or calling in of these debts issued by some of the most venerable Wall Street institutions resulting into their bankruptcies and eventual demise. Alas, Wall Street has done what behavioral scientists had failed to do, that is to quantify or more specifically, to put a price on a human behavior – greed. Essentially, this is the same mechanism employed in pyramiding schemes. Greed however is not the only human behavior that is explicitly witnessed in these turn of events. Panic is one. Panic is the extreme fear that defies logical reasoning. By logical reasoning, it refers to logical financial reasoning and this is quite funny because how does one expect people to be logical and reasonable along the established rationale of a financial analysis when the rationale of their decision has turned from one of maximizing return to that of preservation? Interestingly, unlike greed, no one has priced panic yet. Perhaps somebody already did if one considers the bailout package as the ultimate price of panic. But then again factoring panic into the price decision could very well prove to be useful. I mean in regular appraisals of assets to be mortgage, most lender would only lend out a portion of the total value of the asset in question. The difference between the actual value of the mortgaged asset and the loan amount is the buffer that lenders seek in order to protect them against a devaluation of the mortgaged asset in case of a default and the ensuing fire sale. However, in times of panic wherein the price of the assets in a defaulted mortgage would precipitously dropped below its reasonable fair market value, lenders stand to lose because they wouldn’t be able to recover their money through the sale of the asset in a defaulted mortgage. Henceforth, pricing “panic” is essential if one is to stay afloat in times of market hysteria. However, there is an inherent difficulty in pricing panic since the rationale is no longer that of obtaining a return on investment but on securing the investment. Would somebody buy a $1000 asset for just $100 in a panic market especially when that person has been “burned”? Most likely not. After all, a dollar in cash is better than a dollar in a risky security. But what if the same $1000 asset is sold for say $10, would somebody buy? What about if it were sold for a dollar? If one can determine the discount from the fair market price of an asset that would entice a jittery investor to purchase the said asset, we would have our price on panic. Opposite panic, we have euphoria which in a not so long ago time, is the prevailing mood of the market. I remember before during my early days in business school, the fair valuation of a corporation’s common stock trading in the market was 15 times the projected future earnings of the said company. By the time, I’m halfway through MBA, that multiple has jacked up to 22x average with some valuation going as high as 30 to 50 times (that is during the internet bubble era). Furthermore, the valuation then is no longer based on projected earnings, which is properly defined as net income from operations after tax and interest and after deduction of one time charges. Instead, the market back then was talking about pro – forma income, which was accordingly defined as income from operations before tax before interest charges and before deducting other charges which was a very “creative” way to define profit. At any rate, how do we valuate euphoria or in the former Fed Chairman Alan Greenspan’s word, irrational exuberance? But before we could price euphoria, we have to define what a fair valuation is. Is 15x, 22x fair? This is aside from the fact that each analyst employing different methodology has their own forecasts and projections, which then should be used for valuation? So many questions, so little answers and this is basically why market swing and swoon. This is also why some people make money and some people lose money. All because of the volatility of human behavior and our inability to accurately price them for our own sake.
1. To be greedy when everybody is fearful and to be fearful when everybody is greedy. – Warren Buffet.
2. In business, it pays to be a cynic and a skeptic.
I remember this quiz I had in my Controllership class during my years in business school. The quiz was actually the first one in the said class. It was basically a sort of a review of our basic accounting knowledge, i.e., return on equity, leverage ratios, current ratios etc and our professor at that time gave us the previous year’s published financial data of the top 5 corporation in the Philippines as our test case. However, that particular quiz had a very interesting twist. I remembered that the last question asked in the quiz was which of the top 5 corporations we want to lend money to. I also remembered that the number 1 corporation at that time was Petron Corp which at that time is hemorrhaging badly and is deep in the red. The number 2 company at that time if my memory serve me right was Texas Instrument and MERALCO was like number 3. Anyway, all our financial analysis indicated that the number 2 company, Texas Instrument was the best choice to loan money to but guess what did I picked? I picked Petron! At the following session, the professor brought out the topic of our quiz and she frankly admitted that she was in a bind as to how to grade two particular answer sheets, mine and another guy’s paper. According to her, the correct answer was Texas Instrument (TI) which was quite obvious from our financial analysis but why in the whole wide world would 2 guys answer differently from the obvious? The other guy picked MERALCO and he reasoned that although MERALCO’s number were less than stellar compared to TI but her financial statement was by all means strong and furthermore, MERALCO has the stronger cash flow than TI, i.e., it is cash rich. So instead of crowding up at TI, a loan to MERALCO could prove to be more of a bane. Nice answer indeed! On my turn to defend my choice of Petron when I was asked the same question, my answer was relatively simple. Petron was and is still is partly owned by the government and it carries an express guarantee of the state on its debt obligation. Therefore, who cares if Petron was in the red, the government would simply pay the debtor regardless and from the state coffers. Although my answer was by and large practical, my professor rejected it and I scored the lowest at that quiz though I didn’t fail (at any rate, it was a minor setback; I eventually passed the subject with flying colors, 3.5/4.0; not bad for a non – accountant in an accounting subject). What was missing in the question at that time however was how much would we charge for the loan to our respective choice of company? For all practical purpose, Petron would probably be charged more for their weak balance sheet and if that were part of the question, I’m pretty sure that my answer would be the best one. Looking at hindsight, I can say that most of my classmates (99% of them are accountants by profession) at the controllership class are good accountants and auditors and nothing more. The other guy who answered differently is an example of a good value investor while I am the archetypal maverick Wall Street trader that everybody loathes nowadays. And this is my point, why would a guy like me (back then) and rest of the many who got “burned” in the latest subprime crisis would skirt the “obvious” safe choice and invest in high risk securities and end up in the mess that we are seeing right now? By the way, I didn’t get “burned” at all, I simply end up with the lowest score in that quiz taken years back but the great many lost their hard earn savings in this recent financial debacle. So what really is the cause? The answer is because of the need to maximize the return on investment. Put it simply, it is the “how much more could I get from the dollar or peso that I had invested be it in a financial instrument or in a business or in an asset?” It is human nature to want more “profit” for the little that we own. Nobody can blame anyone for wanting to maximize their return on investment. However, one had to remember that though almost everybody handles finance, very few do actually understand what finance is. Finance is not simply about managing returns. It is as much of managing risk as well (and allocating funds and managing cash flow). Finance is not just getting more bucks from what we have or maximizing return. It is also making sure that that buck is safe or in short, minimizing risk. Taken in this light, it puts the very idea of maximizing return in jeopardy. How we could maximize return if we are constrained by risk? For how could we be sure of getting that much money given the risk? And this is where the “magic” of Wall Street comes in. That “magic” is called pricing models, the pricing of human behavior and the human behavior in this particular case is Greed. Most people have a “healthy” appetite for risk, i.e., for a certain limited range of risk, people are willing to take their chances (if that didn’t happen, you won’t see people getting married). And for every risk, there is a commensurate return. The bolder ones getting rewarded with better pay offs. However, for huge risks, 99.99% of the people are avoiding it even if the return “commensurate” with the risk involved and one doesn’t need financial analysis to come to that decision. However, Wall Street has managed to skewer the risk appetite curve towards risk taking bordering on gambling and they do this by simply offering “bigger” return on investment, much bigger than the “commensurate risk” which in essence is stoking greed. Such is the case of the current sub – prime mortgage financial crisis wherein investment banks package mortgages with poor credit quality into a high yield debt instrument and resell it to investors looking to maximize their return. And as these sub – prime mortgages fumble under the weight of a falling economy, the debt papers backed by these mortgages became essentially a worthless piece of paper. This has in turn, triggered the massive selling of these debt instruments or calling in of these debts issued by some of the most venerable Wall Street institutions resulting into their bankruptcies and eventual demise. Alas, Wall Street has done what behavioral scientists had failed to do, that is to quantify or more specifically, to put a price on a human behavior – greed. Essentially, this is the same mechanism employed in pyramiding schemes. Greed however is not the only human behavior that is explicitly witnessed in these turn of events. Panic is one. Panic is the extreme fear that defies logical reasoning. By logical reasoning, it refers to logical financial reasoning and this is quite funny because how does one expect people to be logical and reasonable along the established rationale of a financial analysis when the rationale of their decision has turned from one of maximizing return to that of preservation? Interestingly, unlike greed, no one has priced panic yet. Perhaps somebody already did if one considers the bailout package as the ultimate price of panic. But then again factoring panic into the price decision could very well prove to be useful. I mean in regular appraisals of assets to be mortgage, most lender would only lend out a portion of the total value of the asset in question. The difference between the actual value of the mortgaged asset and the loan amount is the buffer that lenders seek in order to protect them against a devaluation of the mortgaged asset in case of a default and the ensuing fire sale. However, in times of panic wherein the price of the assets in a defaulted mortgage would precipitously dropped below its reasonable fair market value, lenders stand to lose because they wouldn’t be able to recover their money through the sale of the asset in a defaulted mortgage. Henceforth, pricing “panic” is essential if one is to stay afloat in times of market hysteria. However, there is an inherent difficulty in pricing panic since the rationale is no longer that of obtaining a return on investment but on securing the investment. Would somebody buy a $1000 asset for just $100 in a panic market especially when that person has been “burned”? Most likely not. After all, a dollar in cash is better than a dollar in a risky security. But what if the same $1000 asset is sold for say $10, would somebody buy? What about if it were sold for a dollar? If one can determine the discount from the fair market price of an asset that would entice a jittery investor to purchase the said asset, we would have our price on panic. Opposite panic, we have euphoria which in a not so long ago time, is the prevailing mood of the market. I remember before during my early days in business school, the fair valuation of a corporation’s common stock trading in the market was 15 times the projected future earnings of the said company. By the time, I’m halfway through MBA, that multiple has jacked up to 22x average with some valuation going as high as 30 to 50 times (that is during the internet bubble era). Furthermore, the valuation then is no longer based on projected earnings, which is properly defined as net income from operations after tax and interest and after deduction of one time charges. Instead, the market back then was talking about pro – forma income, which was accordingly defined as income from operations before tax before interest charges and before deducting other charges which was a very “creative” way to define profit. At any rate, how do we valuate euphoria or in the former Fed Chairman Alan Greenspan’s word, irrational exuberance? But before we could price euphoria, we have to define what a fair valuation is. Is 15x, 22x fair? This is aside from the fact that each analyst employing different methodology has their own forecasts and projections, which then should be used for valuation? So many questions, so little answers and this is basically why market swing and swoon. This is also why some people make money and some people lose money. All because of the volatility of human behavior and our inability to accurately price them for our own sake.
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