THE WIZARD OF LIES

AM | @agumack

"It's been a total disaster" — Harry Markopolos

In our course on Ethics in the Financial World BSF211 we study the Bernard Madoff case [VIDEO]. From a teaching standpoint, it is a gold mine because it illustrates the role played by custodians and asset managers, the differences between broker-dealers and investment advisors, and much more. The case also allows us to show the Sharpe ratio in action—it was one of the tools used by whistleblower Harry Markopolos [see]. I then ask students to apply the Sharpe ratio to a number of hypothetical investment funds. The first student to spot the 'too-good-to-be-true' scenario (a Sharpe ratio > 4) is awarded ... a whistle.

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HBO Movies is now releasing The Wizard of Lies, a Madoff biopic starring Robert de Niro and Michelle Pfeiffer. We are lucky to have lots of movies to illustrate different aspects of financial markets. Let us see how this one goes (*).

(*) Back in February, the FT's John Authers had lunch with Edward Thorp, one of the superstars in the world of quantitative asset management: "In 1991, Thorp did some due diligence for a consultancy that asked him to look through their hedge fund investments. Madoff’s returns instantly looked too good to be true, he says." (See John Authers: "The man who beat the casinos, then the markets", Financial Times, 4/5 February 2017). And what about this recent scam?
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QUICK VALUATION NEWS No. 2

AM | @agumack

"On ne demande pas son âge à une jolie femme" — Frédéric Mazella

[1] Start-up valuation. The French weekly business magazine Challenges reports on the « radar des valos », a survey of more than a hundred French start-up tech companies with a valuation above the €20 million mark (*). BlaBlaCar is still the only Unicorn—defined as a private company valued at more than €1bn. There is little on the valuation methodology; we are told, however, that Challenges worked in tandem with boutique investment bank Cambon partners. The companies are presented in five categories: software/adtech, biotech, objects connectés, fintech, and services et e-commerce.

(*) Laure-Emmanuelle Husson: "La valorisation des start-up reste un tabou", Challenges, 31 May 2017.
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[2] William Sharpe. Barry Ritholz defines William Sharpe as "the man who figured out how to price portfolios via the capital-asset-pricing model, and how to measure risk via the 'reward to variability ratio', or what has come to be known as the Sharpe ratio". We use the CAPM in all of of our DCF valuation cases in class. Now Mr. Sharpe is turning his attention to ... retirement planning (*).

(*) Barry Ritholz: "Tackling the Nastiest, Hardest Problem in Finance", Bloomberg, June 5, 2017.
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[3] Infinite cash-flows. Last week in Security Analysis BSF313 I stayed a few minutes after class with a student to show that our calculations were OK (it was an old case from Prof. Damodaran on Procter & Gamble with the two-stage growth Dividend Discount Model). In the end, we agreed on the valuation. By throwing cash-flows for a ridiculously long number of years —something that Excel allows you to do in a matter of seconds— you can check your calculations. This is very useful when discount rates change, and when there are doubts about the discount rate that applies to the Terminal Value (TV) and to the PV of the TV. Remember to use discount factors when discount rates change!
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[4] Amazon'stock price. And Amazon [NYSE: AMZN] hits $1,000. Chapeau! Warren Buffett recently acknowleged what a miss it had been. But he added that it was too late to buy the stock now. Analysts, though, remain quite bullish:

Analysts on Wall Street are overwhelmingly bullish — only one brokerage has a hold and none have "sells", according to Bloomberg terminal data, and some of the most optimistic see shares hitting $1,250 in the next 12 months. Few want to miss out on one of the Internet's biggest stock runs. Amazon shares are up 38% from a year ago and 14 times more valuable than they were a decade ago (*).

I am currently reading Prof. Damodaran's latest book Narrative and Numbers. The Value of Stories in Business, which contains his most recent valuation of Amazon. I plan to review it here. Spoiler: even his most favorable scenario yields a value per share that is well below current prices.

(*) Elisabeth Weise: "Amazon stock hits $1,000. What will keep it from $2,000?", USA Today, 30 May 2017.
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JPM & THE YIELD CURVE

AM | @agumack

At the start of last semester's course on Bank & Treasury Management (BSF222), I told students that I would gladly buy them (individually!) a cup of coffee at Via Café if, by the end of the course, the stock price of JP Morgan [NYSE: JPM] was higher (lower) and the yield curve flatter (steeper) compared to the levels seen the first day of class. I should have been more prudent, as I was caught off-guard by the initial euphoria on bank stocks after November 4. Yes, the yield curve became steeper —which justified higher valuations— but other factors were contributing to the surge in the stock, such as the expectation of lighter regulation ahead, a possible end to the annual stress-tests, and even a rumored withdrawal from the BIS and its pesky capital adequacy rules.

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The yield curve, as measured by the yield difference between 10- and 2-year notes, peaked at 1.31% in mid-December, sharply up from its pre-election level of 0.99%. It then began to flatten, surely but slowly, as the Fed thightened while inflation expectations were being kept in check. JPM, however, continued to surge, closing at $93.30 on March 1. By that time, I would surely lose my bet —as I did in the end. (No student, however, has claimed his/her right to a cup of coffee). But see how things have changed in just a couple of weeks! With the yield curve down again (now at 92 bps), JPM closed yesterday at $82.15, a 12.6% decline from its intraday high of $93.98.

An investor could make a living by trading the stock of JPMorgan off the changes in the shape of the yield curve. The sheer size of its balance (north of $2.5 trillion) makes it naturally sensitive to changes in interest rates. Could we build a model for that?

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