Why Finance? A need for a financial brain in any kind of business

Innovative and unique firms serving different interest areas of customers are being conceptualized and executed everyday. From Uber for airplanes to Airbnb, entrepreneurs are exploring new ideas, unexplored before. They create needs, unfelt before. But the theme of all those firms serve a common purpose, making your customers life easy.

However, firms must not just be limited to this purpose. Firms serve another important group of people – their own shareholders. After all they are the people who provided the company with money when it was in need. And after all, shareholders own the company. So how do we serve interest of the shareholders – A large group of people representing different income group in addition to including institutional investor?

One thing I can tell you, being a finance major, we the finance people have differing variables, conflicting theories and own personal assumptions. It will be rare to find two finance people agreeing on a given model. But I can assure you one thing that we all agree upon. That is all company should have a goal to “maximize the wealth of a shareholder by maximizing the long term intrinsic value of the company”. Yes, this is one of the rare areas in textbook that holds true in practical world. And this gives answer to the question previously raised, “How do we serve interest of the shareholders?”.

Now not all entrepreneurs have done a finance coursework and not all know that “Maximizing the long term intrinsic value of the company” will be an all-inclusive goal that serves every purpose that an organization believes in and thereby keep all stakeholders contented.

This is one of the reason activist run campaigns against corporation that they should get a seat on the board. And I see this as a fair demand because having an activist in the board, in addition to bringing all the positives (with few negatives), they bring concepts of finance with them.

And why do we need concepts of finance in the board? Let me explain this with a simple example. Currently I am working on a project about a Fortune 500, industry leading company. I can tell you with a good confidence level that the company should increase its debt to increase its long term intrinsic value. Although the percentage of debt in relation to its equity that I would suggest can be argued, but I can assure you that increasing debt from its current level is more than likely to increase the firm’s intrinsic value. In addition, I can give you names of few companies that can add value by repurchasing shares. And what purpose does increasing debt or repurchasing share serves? The all-inclusive purpose of creating wealth to the shareholders.

My point is being someone, who has relatively few years of experience in finance can come up with such conclusion, how beneficial would it be for every board to have a finance expert that has wealth of finance expertise. Not just that. To all those young entrepreneurs thinking of running your own venture, always keep a seat open for a finance mind, as finance is not just about collecting and paying money.

Can decacorns retain its attractiveness?

Ten years ago, a startup being valued over a billion dollar was a rare event. But now unicorns have become so common that to regain an exclusive status for a startup, people came with a new buzzword – Decacorn – A startup valued at ten billion dollars or more. Uber, Xiaomi, Pinterest, Snapchat, SpaceX are few names that have been valued over ten billion dollars. These firms may seem as, or in fact are big names with big prospects. But from an individual investor’s perspective, are those firms worth investing: through mutual funds or in an IPO?

To analyze this scenario, let’s understand how startups are valued. Take a hypothetical example that Uber is looking for funding and a venture capitalist decides to give Uber ten million for a 1 percent stake, thereby valuing Uber at a billion. The amount of investment and the percentage of stake is decided by a series of negotiation between the founders and venture capitalist. The key determinants of the outcome of negotiations are growth potential, founder’s expectations and earnings of the company (if any). Even if the company may have negative earning, positive future earnings are expected along with supernormal future growth. Thus, a unicorn or maybe a decacorn is created. This paper value, the higher it is, the favorable reception it will receive during its IPO or during its further valuation rounds, thereby rewarding early investors at the cost of later investors.

Another perspective to look into it is the difference in the value per share of these startups. A recent WSJ article, “Mutual funds flait at valuing hot startups like Uber”, states how mutual fund firms vary in the valuation of private stocks. As per WSJ, tech unicorns had 12 instances where a same firm was valued differently on the same day. So which value should an investor look at? Closely related with this perspective is the recent IPO of Square, a mobile payment platform by Jack Dorsey – CEO of both Twitter and Square. Private valuation for Square was 6 billion, but then its IPO placed its value at $3.9 billion. Seriously? A difference of 1.1 billion!

IPOs are a window of opportunity for the founders to cash in on their idea/s. No one knows the firm and its perceived value better than its founders. Hence, founder can choose a time whereby they can receive the highest possible price for its stocks to maximize their returns, thereby reward the time and effort they have put in for the firm. But on the other hand, the loser is the general investor who buys its stock in the IPO.

Given how well tech stocks are performing after its IPO, the idea of those stocks being overvalued may seem absurd. But, it was absurd to believe that holding “dot-com” stocks was a bad idea, during late 90’s and early 2000’s.

Do hedge funds serve their purpose?

“…Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.” – SEC, Hedging your bets: a heads up on hedge funds and funds of hedge funds.

“A hedge fund is an actively managed investment fund that seeks attractive absolute return…. Hedge fund managers are active managers seeking absolute return.” – Robert A. Jaegar, All About Hedge Funds (2003)

“Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” – Investopedia

To summarize, the ultimate purpose of hedge fund is to earn attractive return, preferably seeking positive alpha and that’s how the hedge fund managers market their fund – making positive alpha. But are the funds serving this purpose? Do they really make above market returns every year? Have these funds been able to beat the market in the long term, say 5 years, 10 years?

To come up with an answer requires some study since hedge funds are mostly limited partnership and free from all the regulation that mutual funds are subject to, Hence there is limited information about the short/long term performance of the funds.

Morningstar Broad Hedge Fund, which encompasses more than 500 hedge funds serves as a useful index for benchmarking and is also a good estimate of performance of hedge funds. Based on annual return starting 2009 through 2014, the historical rate of return for this index has been 4.3%. At the same time, it has been 10.5% for S&P 500.

Year 2014 2013 2012 2011 2010 2009
MBHF 16.46 20.56 1.77 0.14 6.12 11.77
S&P 500 11.39 29.6 13.49 0 12.78 23.45

(Data extracted from Morningstar)

Even when individual years are compared, hedge funds have been able to beat S&P 500 only 2 out of 6 times. So even though investing in the market seems a viable investment compared to hedge fund, still hedge funds are popular and attract investments from accredited investors. The popularity for hedge funds can be associated to these causes: Gains are announced. Out of the many existing hedge funds, there are few standout firms that are earning substantial returns, sometimes even during market turmoil. These are the funds that get media coverages, thereby garnering attention. On the other side, limited regulatory requirement means limited disclosure of information i.e. no need to publicize losses. A decent bet. Hedge fund are essentially a good lottery to bet on. Since its open only for accredited investors, they won’t feel as much financial pain as would a non-accredited investor. On the up side, you have better chance in winning in a hedge fund than in winning a lottery ticket.

In essence, hedge funds do not serve the purpose they are supposed to serve. However, given the limitation of data, it is necessary to further assess this scenario with sufficient data to support this conclusion.

Golden formula for investment – it’s a secret!

Is there a formula that can find out whether a security is bullish/bearish thereby generating trade signal of going long or short? Most probably there is! How do I get access to it? You never will. Or even if you do, it will never be the chicken that lays golden eggs.

Why? Efficient market hypothesis – An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. (Investopedia, n.d.)

Suppose there is an insider information about a company that is exclusively available only to you. What do you do? If the information is positive, you go long and vice versa. Now say that the same information is available to 100 investors. Will you be able to generate same amount of return? NO. Because someone else will bank on it and drive prices up/down, decreasing your return or in some cases you won’t get any return at all because prices already reflect the information.

Same thing goes for an algorithm that you have figured out to generate you returns. If you keep it to yourself, you will earn hefty returns. The moment you leak it out, you are sacrificing your earnings. Or even if you keep it a secret, someone will figure it out as there are plenty of creative brains working day and night trying to figure out on beating the market.

A recent article featured in WSJ talks about how Elements Capital Management LLC is betting on earning handsome returns through arbitrage. If things go as planned, yes it will bring Elements Capital Management and its clients huge return. It might work for other early market entrants looking to follow its footstep. But soon it will become so common that the inefficient becomes the efficient and the arbitrage no longer exist.

Thus if you have the “Golden Formula” that lays golden eggs, keep it a secret. Unless you want to make contribution sacrificing your returns.

The black swan hedge funds – A fund in need?

When non-finance people first read through this title, most of them must have recalled the academy award winning performance of Natalie Portman in Black Swan. Even for finance majors, they might be tempted to find linkage between the movie and hedge funds, like I did when I first came across this term in Wall Street Journal. However, in finance, “A black swan is highly improbable event with three principal characteristics: it is unpredictable, it carries a massive index and after the fact, we concoct an explanation that makes it appear less random and more predictable than it was.” (Taleb, 2007). Although unpredictable, at least in terms of when exactly such event may occur, however, there are funds that can offer protection. And you guessed it right, those are the Black Swan Hedge Funds (BSHFs).

Nasim Taleb first popularized the term “Black Swan” in his book The Black Swan – The Impact of a Highly Improbable, which is a NY Times best seller. The author currently works as an advisor to Universa Investments that sells BSHFs. According to Business Insider, a BSHF suggested by Taleb made a billion dollar last week.

The underlying mechanism of such hedge fund is simple. Buy a put option whose value rises high when the market falls. If the market is stable or increasing, one only pays the price of put option, which is analogous to premium paid to insure against risk. For the inflow of money to the investors,the market has to fall. Eg. 2007/08 Financial Crisis, 2010 Flash Crash. These are times when BSHFs come into limelight as word is spread that certain funds have earned millions of dollar while the rest are losing.

They BSHF can be seen as type of insurance policy to hedge against risk. It basically operates using a person’s emotion of fear and greed. And it is a good bet. It’s a win-win situation for both the parties. The firm gets a hefty fee for its service and the customer is insured against the downfall risk. When the firm is bullish, such firm can utilize public’s emotion of fear. Highlighting the past financial crisis and the amount of money that one can lose when the market turns red, these firms can market itself. It’s even easier when the market is bearish. Firms get a lot of publicity as news about so and so firm making so and so amount of money amid such turmoil. As is the case currently, BSHFs are getting ample coverage that has attracted investors who lost money.

So is it a friend in need? At the moment, yes. With the second largest economy taking a hit, emerging markets slowdown, influential CEO of Bridgewater Associates, Ray Dalio, predicting a round of Quantitative easing rather than interest rate hike and a lack of a clear understanding on the Fed’s stand on the interest rate, BSHF seems a viable tool to hold in the short run. However, in the long run, just as the Black Swan events are unpredictable, so is the decision to invest in BSHF. It all depends on one’s personal preference i.e. how much are you willing to pay and till when?