Quality of Earnings by Thornton L. O’glove

The book starts by making a case for not trusting analysts. One of the main reasons offered is their incentives are aligned towards the corporations, brokers and the banks — not the individual investors. The book is not very kind to auditors and the accountants either. They get paid by the company and may be inclined to get away with as much as possible “legally”.

He moves on to the shareholder letters. Although written by the media relations, it still gives a color to the bland legal language of the rest of the reports. It is possible to find inconsistencies here, compared to the rest of the report. In such cases, one should tread carefully.

Differential disclosure refers to finding contradictory information or different information in different documents. Legally the management is required to provide all the relevant information. They do so by hiding across documents and in the footnotes. Investors must be wary of such situations and behave accordingly.

Then there is the case of non-operating/non-recurring income. Many a times, a high EPS is a result of non-recurring incomes like tax benefits, sale of assets, favorable exchange rates etc. Unless careful attention is paid, one may classify non-recurring income as income and face the consequences by paying higher for the company than what is safe. Investors should also pay particular attention to increasing expenses, tax reporting, inventories, accounts receivable. and accounting changes. Each of these are dealt in a different chapter.

Of particular interest to me was the inventory and account receivable chapter. Inventory management may have significant short term effects on the stock. For example, if the revenues rise, the company builds up inventory in anticipation of rising sales. But if overdone, the inventory will have to be written down — decreasing earnings in later quarters. The is especially relevant in case of companies who are involved in fashion, computers, or products which become out of fashion pretty fast. Particular attention must also be paid to accounts receivable. Increasing accounts receivable means that the company is extending payments to the dealers — not a good sign for the business.

Similarly, attention must also be paid to accounting changes. Is the depreciation used is straight line (less conservative) or accelerated (more conservative) ? Is the inventory practice LIFO or FIFO ? Pensions and incentives also make noticeable changes in the earnings of the company. Special attention must be paid if the company changes its policies. This generally does not bode well for the shareholders.

All in all, a very informative and enjoying read.

Think Twice by Michael J. Mauboussin

A much better book than More than you know — which I fell asleep reading. But this might be because the subject matter of Think Twice interests me more.

Whenever I read one of these book — books where our biases are laid bare for us to see — I riddle the reasons. Most of the time I get them right. But here there were two interesting ones which are a keeper.

The first one is what he calls “the outside view”. Crudely, this is when people don’t recognize that their situation — as much as they find different — is not unique. Many people before them have had to make similar decisions or predict the success or failure of their enterprise with similar kind and amount of data. It is imperative that one switches its view from “inside” to “outside” and recognize that something can be learned from thinking about the problem as if you are not participating in it.

The second is how playing accordion music boosts sales of Burgundy. This amazingly is because of what Kahneman calls “priming” in his excellent book “Thinking fast and slow”.

All in all, a very enjoyable book. Definitely one of those which are going into my to-buy list.

How we decide by Jonah Lehrer

If the game is simple or obvious, then you’ve made a mistake. The game is never simple. You’ve always got to wonder: what am I missing ? – Binger

Instead of cursorily  looking at *all* the wisdom this book imparts, I will like to mention an amazing experiment described in the book.

The experiment was done by a Dutch psychologist Dijksterhuis. While considering a new car for himself, he realised that the amount of information given to him was overwhelming and his conscious brain was not able to come up with a decision. He came up with an experiment to show how our conscious brain is incapable of making the correct choice in such a situation.

The first experiment started by collecting a group of Dutch car shoppers. They were given a description of four different used cars. Each car was rated on four different categories – for example mileage, transmission, sound system etc. The experiment was designed in such a way that one car was objectively ideal with “predominately positive” aspects. After showing them the cars, Dijksterhuis split them into two groups. The first group was given time to consider the pros and cons while the second group was distracted by word puzzles. While playing the games the second group was suddenly asked to make a choice. The result was that the first group performed significantly better than the second. A little rational analysis is better.

In the second version of the experiment, with the same cars but rated them on 12 different categories – resulting in 48 different information pieces. In this case, the first group chose the ideal car less than 25% of the time while the second group did it more than 60% of the time.

A heartily enjoyable and interesting read. Highly recommended.

The checklist manifesto by Atul Gawande

Convinced me to begin with my own checklist while making investment decisions.

The limits of human knowledge has expanded quite drastically, more so in the last century. It is impossible for any man to know everything about a particular field. Be it architecture, medicine, computer science or astronomy. This has lead to specialisations and if that is not enough, super specialisations. Invariably then we need a lot of people to work together to achieve an end. A surgery for example takes a number of doctors, anaesthesiologists, nurses and so on. It becomes imperative to manage information and make sure that people work in a group. It is also very important to keep track of who has done what and if everything important has been done.

In these cases, saying that checklists help is an understatement. Checklists help you get rid of the mundane and concentrate on the important things which require creativity.

I recommend this book very highly.

Keynes vs Hayek by Nicholas Wapshott

I start my economics study with Keynes vs Hayek – a book I presume is aimed at the masses as a general overview of the theories and the political/economic backdrops where they were applied. The book does not delve deep into the theories per se but paints a very entertaining and engaging picture of the era and the main players.

Keynes has a talent for showmanship – which results in his participation at the Versailles.   The short sightedness of the leaders, their constant bickering and lack of any compassion for the losing countries disillusions him so much that he ends up writing “The economic consequences of the peace” – a very astute and foreboding book predicting the collapse of Mark and civil upheaval in Germany. The book catapulted Keynes to popularity not only in much of central Europe (i.e., Germany, Austria) but also in the US. He was much sought after in magazines and newspapers for opinions on thorny economic issues of the times.

While Keynes was enjoying the limelight, Hayek was getting his education under Mises in  University of Vienna and lates joined LSE in 1931 – on recommendations of Lionel Robbins. This set the dual with Keynes at Cambridge and Hayek at LSE.

Keynes published The General Theory of Employment, Interest and Money in 1936, which advocated state intervention to ameliorate the sufferings during the low points of economic crises. Classical economist believed in Say’s law, which says that “supply creates its own demand”. Keynes rejected this and claimed that demand, not supply is the key variable. He argued that by artificially increasing demand (say by state sponsored public works) will decrease the sufferings and unemployment at the low points in the economic cycles.

Hayek on the other hand believes that booms and busts are natural parts of economic cycle. A bust comes because of bad allocation of capital and as long as the capital is not correctly allocated, the problem will continues. Spending money by creating artificial demand is not a viable course of action. Left to its own devices the market will come to equilibrium.

I am going to read a serious economics textbook soon. Meanwhile, this is a very worthwhile read.

Inside the black box by Rishi Narang

If you know the enemy and know yourself then you will not be periled in hundred battles – Sun Tzu

This book was recommended to me by a friend as a quintessential “quant” book. Curiosity got the better of me and I decided to read it.

There are two very strong argument for using computers to automate trading. The first is that the computers have no emotions and hence they are not inclined to make emotional/behavioral errors. The second is that once they have a set of rules to follow they never veer outside their limits. Humans or discretionary investors have famously committed both types of errors.

I was surprised at the design of trading models. Overall they are very commonsensical and the aura created around quants is largely misplaced.

A quant trading strategy can be divided into 5 parts i) alpha model, which is the starry eyed optimist trying to find ways to make money, ii) risk model, the pessimist who wants to limit the downside, iii) transaction cost model, which figures out how much the transactions will cost, iv) portfolio construction model, which takes input from all three models and decides what changes to make in the current portfolio, and v) execution model, which executes the trade in the most cheapest way.

The book then treats each part of the trading in some detail. Going into the problems one faces and ways to solve them.

What was surprising to me was the amount of stuff we can already use as a value investor. There are “value” oriented quant strategies which use fundamental data to decide about the quality of a stock. Something similar is done by Vuru. The best use of such a strategy for us is a stock screener.

Many of the strategies that we know are already used by quant trading strategies. In fact, all the observations we have made in our investing life can be tested on data and then implemented. For example Steve Romick has gone long Renault and shorted Nissan. This is called “pair trade” in quant terms and is used to limit the risk while gain from the underlying “fundamental observation”. If you think that XOM is cheap then going long XOM will still make you lose money if the whole stock market goes down. But if you think that XOM is cheap while CVX is expensive then going long XOM and short CVX will remove the risk of market going down. It does still make you lose money if the relative premium continues or increases.

All of this and similar strategies were already in place at Long Term Capital Management and they went bankrupt. Rishi addresses this issue at a few places in the book. He does not think that LTCM was a pure quant based strategy – which is arguably true. In Rishi’s words

They were engaged in a very broad, cross-border and cross-asset class yield game in which they constantly sought to own risky assets and sell safer ones against them. It was, in most respects, a highly leveraged, one-way bet on ongoing stability and improvement in emerging markets and the markets in general.

I would not say that this is a sufficient reason to discount LTCM as a quant firm. Any trading strategy has an underlying philosophy. The “qaunt” part comes because of quantitative ways to measure risk and the amount of leverage one should take. It is quite clear that LTCM’s leverage was based on “quantitative” ways to measure risk.

He then moves on to address the 2007 fiasco, which in his opinion is closer to home. He claims that this was caused by i) the “crowded trade” effect ii) poor year-to-date performance, iii) cross holding of illiquid credit based strategies, and iv) use of VaR based volatility targeting and leverage adjustments.

In my opinion, this is using a lot of words to say that their model was faulty. I don’t see how they have fixed the problem. Is there a way to do so ? In my opinion – No.

The book is excellent. If you want to get a good introduction on quants and what they do – this is a very good book to start with.