Saturday, August 9, 2008

Value Investors and Cockroaches

In an extremely interesting book “A demon of our Design” author Richard Bookstaber , a Wall street quant with over 20yrs of trading experience explains the behaviour of the participants in the financial markets. While the academic community craved for physics like precision and complicated mathematics in economics and finance. Mr.Bookstaber came up with an interesting biology analogue for the economic behaviour of the participants in the financial market. He wrote a paper with his fellow MIT graduate student, Joe Langsam, entitled “On the Optimality of Coarse Behavioural Rules”.
He explains that the best measure of adaptation to unanticipated risks in a biological setting is the length of time period a species has survived. One that has survived for hundreds of millions of years is considered to have a better strategy to adapt to unanticipated events than the one that has survived for short time period. A species that is prolific and burgeoning but then dies because of some unanticipated event may be considered as having a good strategy for dealing with expected events but not with the unexpected ones.
From that point a cockroach is a prime example because it has survived numerous unanticipated changes in the ecosystem – from jungles turning to deserts and facing different predators and countless other unforeseen changes. But what is extraordinary about cockroach is that it has survived all these unanticipated changes with a simple defense mechanism of moving away from slight puffs of air, puffs that might signal an approaching predator. He refers to this mechanism as a “coarse and sub-optimal behaviour”. This mechanism ignores a wide range of information and risks but still survives for a longer period of time than the other highly adaptable and sophisticated species such as furu, a perch like fish of lake Victoria in Africa which was finely tuned to its environment and developed numerous skills and evolved into a number of species each with its own special skills. however they became extinct when a Kenyan game fisheries officer introduced nile perch into the lake. Its extinction was just a result of dumb luck that someone had introduced an alien species into the lake. This situation seems similar to the LTCM debacle where the default of Russian bonds an unanticipated event became a cause of their demise.
According to Christopher Browne, Managing Director of Tweedy Browne Funds true value investors are cockroaches of the investment world with a simple strategy of eschewing leverage, staying within one’s circle of competence and eventually demanding a substantial margin of safety whereas furu is akin to today’s highly leveraged hedge fund investor seeking to eliminate risk by adjusting his portfolio with the help of numerous complicated probability models at his arsenal

Friday, August 8, 2008

Accounting for Stock Options

One of the most elusive accounting concepts for me has been stock options. How does one account for stock options? Should it be expensed from the income statement as a cost? Or should we only increase the number of shares and thus dilute the earnings for the shareholders. Mr. Marty Whitman, Chairman of Third Avenue Funds suggests that from a creditor’s and company’s standpoint stock options should not be expensed as it is not a cash charge and has no effect on credit-worthiness of a company. He certainly believes that stock options are compensation from a stockholders point of view but given that stock options result in dilution, their effect is best reported in the dilutive effect of the earnings per share rather than as an expense for the company. According to him, Mr. Buffett’s view about stock options is an over generalization and that stock options are not a cost to the company.
He believes that it is a fallacy to consider cost of options to the company as equal to the value of the options to the recipient. To drive home his point he even cites an example where a sales clerk buys a $100 sweater for a 40% discount from her department store for $60 and the store incurs $100 as cost because that is what the sweater is worth to the sales clerk even though the actual cost for the sweater might be $35.
But I don’t agree with Mr. Whitman. The above situation is not analogous to stock options.
Options are given with intention of retaining talent and are the cost of retaining talent. So they must be definitely expensed as a cost in the income statement. Its similar to the cost of labour and cost of capital, the cost the company must bear to recruit labour and capital. Even when the store sells sweaters at 40% discount its is incurring a cost of $40 to retain its sales clerk and if it becomes a industry wide practice it would become compulsory for the store to give discounts to its employess and would eventually become a necessary $100 cost to retain employees beacause that is the value of the sweater to the company also. Mr. Whitman has explained his views from two perspectives, one of the creditor and other of the stockholder but from neither standpoint he believes stock options to be expensed as a cost from the income statement. But I believe atleast from a shareholders standpoint its a cost which must be expensed from the income statement.
By the way I read this matter about stock options from Martin Whitman’s letter, 2002