Wesley R. Gray, Ph.D.

Professor Novy-Marx does some really great research. We’ve highlighted his work on a few occasions. His specific work on the gross profits factor has influenced a lot of my own research.

Novy-Marx has a really interesting piece discussing “data-mining:”

Ferson, Sarkissian and Simin (2003) warn that persistence in expected returns generates spurious regression bias in predictive regressions of stock returns, even though stock returns are themselves only weakly auto correlated. Despite this fact a growing literature attempts to explain the performance of stock market anomalies with highlypersistent investor sentiment. The data suggest, however, that the potential misspecification bias may be large. Predictive regressions of real returns on simulated regressors are too likely to reject the null of independence, and it is far too easy to find real variables that have “significant power” predicting returns. Standard OLS predictive regressions find that the party of the U.S. President, cold weather in Manhattan, global warming, the El Nino phenomenon, atmospheric pressure in the Arctic, the conjunctions of the planets, and sunspots, all have “significant power” predicting the performance of anomalies. These issues appear particularly acute for anomalies prominent in the sentiment literature, including those formed on the basis of size, distress, asset growth, investment, profitability, and idiosyncratic volatility.

 

Some of the more intriguing time series that apparently predict when anomalies will perform the best (I highlighted the titles for effect):

Wow.

Anyway, in the end Fama is probably going to end up being right and all of us will go down in flames trying to trade crazy quantitative strategies or value strategies that are supposed to make us 15-20% a year. But at least we’ll have fun along the way!

The "I can beat the market" waterslide. Fun on the way down, but potentially dangerous!

 

Reinhart (and another Reinhart) and Rogoff have another paper in their series about “Why debt sucks.”

The title of their newest work is “Debt Overhangs: Past and Present.”

Fun times ahead

Headline:

We identify the major public debt overhang episodes in the advanced economies sincethe early 1800s, characterized by public debt to GDP levels exceeding 90% for at least five years. Consistent with Reinhart and Rogoff (2010) and other more recent research,we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative short fall in output from debt overhang is potentially massive. We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.

Money Shots:

First, a table outlining what happens before debt overhang (<90% debt/gdp) and after debt overhang (>90% debt/gdp). Yuck!

And to state the obvious, if debt is killing potential GDP by a certain % each year (even if it is small), the magic of compounding KILLS the economy over the long haul.

Keynsian Beatdown?

God knows I love a great rebuttal. I really do think there is an excellent argument that allowing government to fill a demand gap can be an effective way to prevent the world from going into a negative feedback loop and eventually a depression. Fine, Krugman and his cat deserve credit. But, in the end, the Keynsian economic “miracle” really depends on the assumption that people are too stupid to realize that money borrowed by the government today will have to be paid back at some point in the future (ie., if government moves to fill the current demand gap, the people simply offset that demand by pulling back even further, so on net no new demand was created)…and if government is an inefficient method of filling a demand gap because of bureaucracy, corruption, etc., the people are going to be real pissed when they eventually have to pay back the government debt.

Okay, so I’m the first one to admit that “the people” are not always perfectly rational and the idea that “the people” are going to cut their personal budgets to perfectly offset the increased government spending to create a net-zero demand situation is kinda insane. But at some level, people can only be fooled so many times (take a gander at some PEW polls http://pewresearch.org/pubs/2001/poll-concern-raising-debt-limit-higher-spending). Moreover, as this paper highlights, too much debt can cause some serious issues over the long-term for an economy–Keynsian magic is not a free lunch.

contemplating more government debt

Of course, a great depression, which would follow if we cut budgets and let the whole enchilada take its natural course, can also cause some serious gdp potential growth issues. D’oh!

So what is the answer? Well, I simply don’t know and have too many things on my mind these days, but I do know that there is probably no definitive answer such as “stimulate forever” or “austerity forever.”

In all likelihood, the common sense answer is that after many years of spending more money than you’ve earned you gotta take a pain pill in the form of a depression, or a long drawn out debt-hangover induced slug of multiple years of less-than-potential GDP growth. I prefer swift and fast pain, but that’s just me.

Pain is weakness leaving the body!

Why does too much debt suck?

I’m not an expert on all things macroeconomic. I’ll admit it, I started taking Tom Sargent’s macro class at Chicago when he taught his course to the economic PhDs; however, I quickly decided that was a bad idea after every class began with the following:

Typical Macroeconomic lecture

So without thinking too hard about why debt sucks, I came up with a few intuitive reasons that are related to what Reinhart, Reinhart, and Rogoff discuss, but in terms I understand:

Loss of Freedom: With a heavy debt burden, the typical choice is no longer “How am I going to spend my hard-earned dollars today?”, but “How in the heck am I going to pay off my debt???”

Interest Payments: Compounding can work for…or against you.

Loss of Flexibility: Related to point on freedom. With a heavy debt burden, your ability to absorb short term shocks is highly limited.

Exciting to see what happens next….

Our new Turnkey Analyst Screening tool is back in action after a battle with our old data provider.

Turnkey Analyst Redistribution Data Agreement Battle (circa 1850)

We fought long and hard and came up with a solution: Keep It Simple Stupid (KISS).

The new turnkey screener does only 1 strategy. We visually depict the strategy in the figure below:

Why 1 strategy? Because it’s easy and because it works!

If you want details on how the strategy works, click here:

http://turnkeyanalyst.com/about/

And if you want to check out the new system, click below:

Jack and I are working on a new research paper that addresses a very simple question:

Can investors improve their screening process by eliminating frauds, manipulators, and financially distressed firms?

Answering this question appears easy, but as Cliff Asness and Andrea Frazzini point out in their recent paper, “The Devil in HML’s Details,” the devil is REALLY in the details.

• How does one identify frauds?
• How does one identify manipulators?
• How does one identify financially distressed firms?
• And most importantly, how does one identify frauds, manipulators, and financially distressed firms BEFORE the market has already priced in the risks of fraud, manipulation, or distress?

Luckily, we can stand on the shoulders of academic research (and create our own!) and take a stab at addressing our original question. The academic literature describes techniques that help identify frauds, manipulators, and financially distressed firms before the market.

Here is a helicopter tour of the literature we enjoy most:

Frauds and manipulators:

Beneish (1999): The Detection of Earnings Manipulation

Sloan (1996): Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?

Hirshleifer et al. (2004): Do Investors Overvalue Firms with Bloated Balance Sheets?

Financial Distress:

Campbell, Hilscher, and Szilagyi (2008): In Search of Distress Risk (Discussion Piece that is more “Barney Style”)

Campbell, Hilscher, and Szilagyi (2010): Predicting Financial Distress and the Performance of Distressed Stocks (similar to above but with data out to 2008, see Table 2 and compare to Table IV in older version)

Preliminary Chart Porn:

First, a look at the entire distribution of firms’ 1-year Buy-and-hold 1-year returns from 1973 through 2011.

Click to Enlarge

Next, a detailed look at the left tail.

Click to Enlarge

Next, a simple robustness test: Here we present the same analysis as above, but only for stocks that are greater than the NYSE 40% market cap benchmark at a given point in time (this benchmark was ~$1.4B as of December 31, 2011).

Click to Enlarge

How did we create this?

In short, it’s complicated.

We calculate scores on all the fraud, manipulation, and distress factors outlined in the papers above, and eliminate any firms in the bottom 5% (the real scum of the earth).

If you want a a more detailed overview of the process, check out the following link and look at the details of step 1: Avoid Permanent Loss of Capital Firms.

Charlie Ergen, the billionaire founder of Dish Network Corp., is not shy about pursuing the holy grail of the telecommunications industry.  Over the next ten years, he wants DISH to become a provider of three major services, Internet, video and voice service, both on mobile devices and in the home, which is something no other firm has been able to do effectively.  DISH has been laying the groundwork for this quest over the past few years through such efforts as the purchase of Blockbuster out of bankruptcy, as a path into the streaming media business, and through the acquisition of two satellite operators, in order to acquire the spectrum necessary to create a wireless broadband business.  If DISH can succeed in this aggressive strategy it would transform the company into something much more than a satellite pay-TV provider.

DISH is the nation’s third largest subscription-based television service provider, with 14 million customers, which represents approximately 14% of total pay-TV subscriber market in the U.S.  The firm offers a variety of local and national programming, is a technology leader in its industry, and aims to provide outstanding customer service.  The company owns or leases capacity on 13 satellites, and subscribers receive programming via a satellite dish and receiver.  The company is based in Englewood, CO and has approximately 34,000 employees.

DISH is quite cheap, especially considering its sizeable market capitalization, and resides comfortably within our universe of the top 10% cheapest stocks, with an EBIT/EV yield of 18.3%.  Below are some additional summary statistics for the company.

Franchise Power

Developing a satellite pay-TV business is a highly capital intensive process, requiring investment in numerous assets, including satellites, scarce transmission bandwidth, programming content, subscriber equipment and its installation, advertising, customer call centers, and FCC and other government licenses.  The high initial fixed costs associated with the creation of such a complex content distribution network serve as a deterrent to new startup entrants.  Many argue that due to this dynamic the satellite pay-TV industry has effectively evolved into a duopoly, consisting of DISH and its larger competitor, DirecTV.

DISH’s approach to the market has been to be the low cost provider of satellite TV service, which it promotes through its “everyday value” branding message, with monthly packages starting at $19.99.  It seems reasonable to attribute these low prices to significant economies of scale.  Additionally, the company’s customers have lower levels of disposable income, and tend to be value conscious; thus, switching costs are high for these customers, which has the effect of stabilizing the company’s customer churn rate.  Finally, DISH boasts an established and recognized brand, which it supports and enhances through customer service and advertising.

Within the satellite pay-TV market, which has high barriers to entry due to the heavy investment required, DISH is a large, low cost service provider with significant market share and a customer base with low turnover.  These appear to be the ingredients of a franchise with an economic moat.  Next we turn to our quantitative output to assess DISH’s economic moat, and reduce its franchise power to a single number.

The company boasts solid normalized (8-year, geometric mean) return on assets of 10.9% and normalized (8-year, geometric mean) return on capital of 19.0%, and these results place it in the 90th percentile for each of these categories, within our universe of cheap stocks.  Long term free cash flow (8-year cumulative FCF) / assets is 67.9%, which places the company in the 91st percentile.  DISH has also shown reasonable margin stability, with a normalized (8-yr average) gross margin / gross margin 8-yr standard deviation of 9.3, which places the company in the 51st percentile.  When we take an average of these percentile scores, we find that DISH’s average is 81% – just shy of the 95th percentile breakpoint of our universe – indicating solid franchise power.

In general, it appears that while the company’s margin stability is merely average for our universe, normalized returns on assets and on capital are very impressive, as is the company’s long run free cash flow generation record. It should be noted that these percentile scores are relative to the cheapest decile of our screening universe.  This means that within this smaller universe of already cheap stocks, DISH is demonstrating durable franchise power – not bad for such a large capitalization stock.

Financial Strength

Profitability

DISH is currently profitable, generating a 11.6% return on assets, which exceeds its long run average (see Franchise Power above), and FCF / assets is also strong at 16.3%, although this metric is slightly below its long run average.  Free cash flow exceeded net income, indicating the company is not using accruals aggressively, and this earns the company another point.  Overall, we give the company three out of a possible three points for profitability.

Stability

Turning to our stability measures, our next component of financial strength, DISH’s leverage, scaled by its assets, is increasing versus a year ago, and so we withhold a point.  Its current ratio decreased by 6.4%, which signals a statistical reduction in liquidity, which also fails to earn the company a point.  Finally, we review DISH’s net equity issuances, scaled by assets.  It turns out that over the past year DISH has been a net issuer of equity versus its asset base, which also fails to gain a point.  Our quantitative stability measures give the company a score of zero out of a possible three for stability.  An analyst might review the company’s leverage and share issuance trends, and its liquidity situation to get more comfortable with DISH’s overall stability.

Recent operating improvements

Next we review the company’s recent operating improvements.  Return on assets has decreased versus a year ago, which is a bad sign and fails to earn the company a point.  FCF / assets increased versus a year ago, and this operating improvement wins a point.  Gross margins increased YoY, which causes us to award a financial strength point. Asset turnover has increased versus the prior year, indicating a more efficient use of the company’s assets, which is worth a point.  In the long run, one might hope for continued increases in asset turnover, as the incremental asset base required to service a marginal customer declines, based on leveraging the high fixed startup costs of the business discussed earlier.  Overall, the company scores three out of a possible four points in connection with its recent operating improvements.

On our various Financial Strength metrics, DISH scores 6 out of a possible 10 points overall.  Statistically, DISH appears to be solidly profitable, and is showing multiple statistically important recent operating improvements.  There are some questions around the company’s stability, as regards share count, liquidity and leverage, and these would be areas for an analyst to review.

Summary and Conclusions

DISH is cheap company, with an 18% earnings yield and a single digit P/E.  On this basis alone, the stock merits consideration, but it is the quantitative quality measures that set it apart.

DISH is a large capitalization company that controls almost one sixth of the national pay-TV market, and has made a significant investment in that market, which would tend to discourage new startup entrants due to the significant investment required.  It is the low-cost service provider, which implies high switching costs for its subscribers, enjoys economies of scale, and it operates in what has effectively become a duopoly.  These factors suggest the presence of an economic moat, and the numbers seem to support this.  In particular, the company has shown strong margin growth and solid free cash flows over the past 8 years, and averages a solid score of the 81st percentile across our franchise power metrics. The company is showing solid profitability and is showing a variety of signs of recent operating improvements.  The company’s stability metrics raise some questions; an analyst might want to review recent changes in leverage versus assets, and liquidity ratios, as well as dilution caused by stock issuance to determine whether these trends will continue.

The stock may be cheap since subscriber growth has slowed recently, versus earlier growth rates.  Charlie Ergen, however, has articulated a bold vision for the company, involving its entry into the Internet, video and voice markets at home and on the go, which he has stated could occur over the next 10 years.  This would reinvigorate the franchise going forward, and stockholders would therefore get a call option on this upside potential.  Even if the company does not totally succeed, the assets related to this effort have value, in particular the wireless spectrum.  Some believe that these spectrum assets alone makes DISH a compelling acquisition target, perhaps for a large telecommunications company.  An analyst could explore these themes, for instance by assessing the value of the embedded spectrum as part of a sum-of-the-parts valuation.

Finally, the company passed our screens for manipulation and financial distress, scoring a 3/3 for safety.  The numbers are suggesting that statistically the company does not appear to be showing obvious signs that its equity is overvalued.  Please refer to http://turnkeyanalyst.com/about/ for additional discussion of these metrics. DISH scores in the 81st percentile for Franchise Power, and a 60% (6/10) for Financial Strength, and thus its overall quality score (average of these two metrics) is 70%, which earns it a top 10 finish in our universe of the top decile of cheap stocks.  DISH appears to be a cheap, safe, high quality, large capitalization franchise allowing participation in the satellite pay-TV space, and offers some upside due to the broader strategy it is pursuing.