Ep37 Five Common Finance Mistakes

[MUSIC] Hi, I'm Jules van Binsburg and a finance professor at the Wurnd School of the University of Pennsylvania. And I'm Jonathan Burke, a finance professor at the Graduate School of Business at Stafford University. And this is the All Else Equal Podcast. [MUSIC] Welcome back everybody. Today we're going to do something a little bit different. If Jules and I were good friends and we often get on the phone and we complain about the mistakes people make. And we thought to ourselves, last time we were shooting the breeze, why don't we just do a podcast on it and we've decided let's do a podcast on the five most common mistakes in finance. So that's what we're going to do today. So Jules, what mistakes should we start off with? Well, actually, Jonathan before we start with that, I think we should give a little more context in the sense that obviously in the capacity of our job, we talk to a lot of people all the time. Right? We talk with students at various levels, undergraduate students, MBA students, PhD students, executives in our executive education programs. We talk with university administrators, we talk with corporate executives. And so therefore, we just came to the conclusion that there's a certain set of mistakes that we're seeing across the board. And so really, we don't want to focus here on the mistakes that an individual at some point makes. We really want to look at structurally what seems to go wrong every single time. And I think that the reason why these things go wrong every single time is that after you understand them, they may seem simple, but certainly before that, they're actually quite complicated. They're very deep insights. And so one thing that I've always appreciated about the field of finance is its internal logical consistency. And so a lot of these things that we're going to talk about relate to each other one way or the other. Yeah, I mean, your FC rituals. I call it the professors mistake. We've studied this for so long. And then everything looks so obvious to us. And when the students don't get it, we go, what morons they are. But in fact, when we were in the position, we didn't get it either. Right? We're just completely forgotten. How hard and how deep these concepts are. And so anyway, since you planted it and didn't want to pick the first one, I'm going to pick the first one. Sounds perfect. Why do we start with the mistake of mixing up return measures and value measures? Yeah. So I think that in finance, and I think this actually holds also across our profession, John. And I think that we got really used to focusing most of our analyses and evaluations and performance evaluations on return measures. Meaning there is some percentage change in the investment value. And we're going to compare that percentage change with some benchmark percentage change, say what the stock market did as a whole. And then we're going to say that we did a good job or a bad job relative on that percentage measure. But the problem, and I think this is the easiest way to explain the difference is percentage just don't pay any bills. I cannot buy data or pay salaries or pay bonuses or do anything with percentages. The only thing that I can pay bills with is actual dollars, actual value that I have created. And so making fantastic returns on small investments that generate no dollars, what I'm supposed to do with that. Yes, George. This is a huge common mistake that we see, which is people focus on returns instead of the dollar. So you know, simple example. Would you rather make five percent on a hundred dollar investment or one percent on a million dollar investment? Obviously, you're better off one percent on a million dollar investment than five percent on a hundred dollar investment. Whereas the bragging rights of course are on the five percent. You might ask, why are we in this? I mean, when people talk about investments in the stock markets, they only talk about the terms. And so you might say, are they all making mistakes? The answer is no. And the reason why is the underlying assumption, everybody implicitly makes when they talk about stock market investments, which is that when you make the investment, you do not affect the price. In other words, you're so small that any amount you trade doesn't affect the price. And if that's true, then the percentage measure is a good measure because you choose how much you want to invest. The problem is that is a very exceptional case. It only applies to individuals investing in the stock market. If you're a big institution, you definitely do affect the price. So even there returns on a great measure. Then when you step away from public markets, you step into private markets, the measure is completely wrong because every investment you make is going to be at a particular scale. And then you have to worry about that scale and how much data is you make? I think that Peter Lynch's career is the perfect example of exactly what you just described, which is when he started as the manager of the Magellan fund. He was not managing that much money. It was in the millions of dollars. And so he made very high double digits returns and alphas on the investments. And so therefore in percentage terms, he looked like an absolute star. And then later in his career, when his fund had grown into the billions of dollars, suddenly the returns are much lower. And people started to conclude that he must have lost his mojo or that he must be a worse manager today than he was before. But obviously, once we start to talk about the dollars that he created through his investments in the second half of his career, it was what was it? A factor 20 higher than it was in the beginning of his career. He was just much more impactful dollar wise in the later part of his career than in the first. Yes, absolutely. And when people are valuing private equity, invest the capital, they invariably talk about the IRRs of the investments and never talk about the scale at which they were able to invest. It's a fundamental mistake. The good investors, of course, realized this. But a lot of investors are focused on returns, and it's just not appropriate to do so. No, in particular, because these return measures, particularly to equity holders, are going to be manipulable by one of the other big mistakes that we're going to talk about later, which is the amount of debt financing that you use. When you can control the leverage, there's a lot you can do to manipulate these IRR measures. We're asked manipulating the value measures, the amount of dollars that the whole investment generates is much harder to do comparatively. So therefore, I think that focusing on returns, while many people do it, I think you should always be careful to interpret it in the right context. One of the foundational principles in economics is that good ideas are not an infinite supply. They're hard to find. And so how does that translate to finance language? That positive NPV opportunities are not an infinite supply. And so the assumption that you can just scale up a project as much as you want at the same return is the same as making the assumption that positive NPV opportunities can just be generated all over the place at that same return level. Or as the reality of course is that as you scale up the projects, something that what we call decreasing returns to scale will kick in. And that makes it hard to scale it up to any level that you like. And so once we start to assume that return measures can just be scaled up infinitely, we are not properly taking into account that there are decreasing returns to scale. We're not taking into account the idea that positive NPV opportunities are not that easy to find. And so therefore that logic just doesn't work. And so focus when you evaluate, for example, mutual fund managers or private equity managers or any institutional investor, focus on the dollars that they generate, not the returns that they make. >>Jules, I just want to make sure everybody knows what we mean when we talk about a positive NPV opportunity. A opportunity to invest in markets, zero NPV, zero net present value. So a positive NPV opportunity is an investment opportunity that's better than an investment opportunity available to anybody. In other words, it is a good deal. So when we say there are few positive NPV opportunities, we're really saying there are few good deals in the world. When I joke about it, I say to students, Marx was right. What do I mean by this? Marx was right. What I mean is Marx lived in a different age. And in that age, there was a shortage of capital. Capital providers were able to make economic rents. His argument was no, no, no, no, capital doesn't deserve rents. Labor deserves rents. Well, that's the modern world today. Nobody earns rents on capital. As I like to tell my students, capital is an infinite supply for positive NPV investments. When you have a good deal, many people will line up to invest in your good deal. And so the price of that gets bit up to the point and we'll talk about this in a second so that the return on the capital is just defined by the riskiness of the investment opportunity. What's in short, surprise, good ideas, good ideas, common scale. Yes. And who gets the benefit of the good ideas? Labor. It's exactly what Marx said. Labor gets the rates, not the capital. What's so funny about that, Jonathan, is that the irony is, of course, that those students are sitting in front of you, exactly because they realize that by learning a lot and having a skill in short supply, as part of the labor force, that's how they can make the rents, not as part of the capital. And so why are people investing in education as much as they are? Because once you have high school. skilled labor that allows you to make a lot of money because that is something in short supply, not the capital. This is when capitalism is delivered. It's a much fairer world. Back in the world, when it was hard to find capital because the financial markers were knocked to the end of it, capital providers got rent. So if you were born rich, you just got rents. It's highly unfair. Today, since capital markers are very competitive and it's easy to find capital for positive and pb opportunities, then if you're born rich, you just get the return for putting your capital at risk. But if you develop your skills and you work hard and you come up with an idea that nobody else has, then you become rich. Ironically, capitalism has delivered the fairness that Marx wanted to do by fiat. That is probably one of the biggest ironies ever indeed. All right, Jonathan, so the next topic that we should talk about is the difference between returns that have realized in the past. So returns that you have made as an investor say and returns that you should expect to make going forward. So the difference between what we call realized returns and expected returns. And I think that the thing that people are most confused about is the following. If the world doesn't change and so we're what's called in a stationary environment, then what will happen is that the average return that you made in the past is indicative of the average return that you will make going forward. But the question is, what is the difference between expected returns and realized returns when the world does change? And I think there are two scenarios that we should discuss. The first scenario I think is most easily explained by a bond investment. So if you buy a bond at a certain interest rate, and then if that interest rate changes, then the change in the interest rate will cause the price of the bond to drop if the interest rate goes up. Right, Joseph. The way I like to think about this is if I buy a bond and the interest rate of the bond is 5%. And the next day, interest rates become 7%. Nobody is going to want to hold my bond with a 5% interest rate if they can buy a new bond with a 7% interest rate. The only way to get somebody to buy my bond from me is to lower the price of that bond. And the price of the bond will go down just to the point when at the new price, the effect of interest rate is 7% on that bond. Exactly. So in that particular case, the realization of the return that you make, which is the fact that your bond price drops, actually moves in the opposite direction as what you expected return on the bond from that point forward moves into because that's what the interest rate is. So the interest rate goes from 5 to 7, so it goes up. So your expected return goes up and yet you realize return, the capital loss on the bond is a negative number. Yeah, expect return given the new price of the bond. And this is a more general concept, doesn't just apply to bonds. Anytime there's a change in what we call the discount rate, anytime there's a change in the cost of capital, this effect will occur. If the cost of capital goes up, that causes a loss in value, so a drop in price, but of course going forward at the new price, the expected return is higher because we just said the cost of capital has gone up indeed. And so we just discussed an example where expected and realized returns are actually negatively related to each other. We said that they would be the same if the world doesn't change, well, the world does change, the cost of capital has changed or the interest rate has changed. And if that happens, we have a negative relationship between the realized return and the expected return. So now Jonathan, can we think of an example where there's a positive relationship between the expected return going forward and the realized return in the past? Yes, of course, you'll certainly team you up for this particular issue. Of course. So one good thing about the following, imagine we have a company and there's good news about the company and the company's good news comes out slowly. Right? Yes. One day you find out good news about the company, well, that means the price of the company will go up, right, to affect the good news. And then the next day, more good news comes up. So again, it goes up. So if the good news comes out slowly, then a real positive realiser turn will also lead to another positive realiser turn in the future. But of course, that depends on this idea that the news is coming out slowly. Yeah. Or to say it slightly differently, that the news is slowly incorporated into prices. In other words, why wasn't it the case that when the first piece of good news came out, they realized that that had implications for the more good news coming out and therefore the price already adjusted in the first instance to this higher level. And indeed, the slow adjustment of the price to the good news is what many researchers believe to cause the so-called momentum effect. The momentum effect implies that past winners keep on winning for a bit more and that past losers keep on losing for a bit more. And so that is an effect that has been well documented in financial markets. I would make a small caveat there. I think there's no question that we see momentum in markets whether or not it's caused by slow revelation of positive information or negative information. I think that's less agreed on. But so the important thing to realize there is there's this relation between realized return and future returns and that depends on how news comes out. Now, imagine a world where all the news comes out immediately. People are not fully rational, they fully realize what's going on. Notice that in that world, you'll have a say a good news will occur. You'll have a high return when the news comes out. But then the expect return in that world since the risk of the company hasn't changed would be the same as expect return before the news came out. So in that sense, expect return wouldn't have changed. All right, Jonathan. So the next topic that I think we should talk about is this idea that some people have that you can create quite a bit of value for companies by coming up with clever ways of financing them. Meaning what do you finance them with debt or with equity or with some people also call financial engineering. And I think we should evaluate to what extent that claim is true, that the way that you finance companies and if you do that in a clever way, you can generate a lot of value. Yeah, so Joseph is an interesting topic and I would even say bankers tend to make claims that the way they finance how much equity a debt they have makes a big difference to their business operation. And I think the key insight is that it's hard to come up with good reasons why this is true. So talk about it in a bit, you could think about certain frictions in the world where it could be a little bit true. It could be that financing can make a little bit of a difference. But for financing to make a big difference seems unlikely. And the important insight here was derived by a particularly Arnie Miller. And I think the best way to describe it is to start with a simple example. Yeah, so let's think about the example of financing a house. Suppose you buy a house for a million dollars. You put 200,000 in down payment that's your equity position that you finance to rest with a mortgage for $800,000. And so the key question you should then ask is do you think that the price for which the house sells in the housing market is in any way related to how you chose to finance the house in the past. So if I finance it with 50% mortgage and 50% down payment versus 20% down payment and 80% mortgage, do you think that that in and of itself will change? The house price, and I think most of us would say it seems very unlikely given those numbers that the house price would be materially affected by it. So that then raises the question, well, if it doesn't hold for a house that you cannot influence the value of the house by the way you finance it, why would it be true for a corporation? And the degree on the Miller proposition, it says to me, says it isn't true. How you choose to finance a company called determine the value of the company, the value of the company is independent of how you finance it. And although the proposition is called the medically on Miller proposition and Miller at least got the Nobel Prize for pointing this out, in fact, they were not the first people to make the argument. The first person to make the argument was a fellow called John Burr Williams who made it in his dissertation at Harvard University. And what's interesting about it is the simple argument he used in that dissertation. The argument he used was imagine a company had any one owner. Why would that owner care if his ownership shares came in either equity or debt? Either case, he gets all the cash flows of the company. So if the company's finance for the 100% equity or 50% debt and 50% equity, either way, he gets exactly the same cash flows. So the ratio of debt directly can't affect the value of his invest. Indeed. And this example of one investor holding both the debt and equity in a particular company in some proportion isn't even so far fetched. Many pension plans today hold for companies to debt and the equity of that company. And so from their perspective, how the company decides to finance itself and what proportion is completely immaterial. And then if that for starters true, Jonathan, why? Is it that so many people are trying to make the argument that financial engineering is this usually value-generating thing? Because, you know, I think there are quite some private equity firms that would argue that the large amounts of debt that they use in the financing of those private companies is a value driver. Well, there are two odds with those questions. Let's start with a frictionless world with no frictions. Then as we just pointed out, you can't increase the value of the company by coming up with a clever way of financing. But people think that you can, and it's because they make the following all else equal mistake. The all else equal mistake they make is they make the following argument. They say, "Well, look, if I finance the company with just equity, I'll have one set of investors. But if I find that there's a company with debt and equity, I'll have a different set of investors and different investors demand different risk premium and therefore demand different prices. So the value of the company is going to vary depending on who's investing in the company. And that does seem like a logical argument. But it ignores an important insight. The inside it ignores is any investor can undo whatever the company does. So imagine the following scenario. Imagine I am an equity investor in an all equity company. And the company management decide, "No, no, no, no. We're not going to be an all equity company anymore. We're going to be a company that's 50% equity and 50% debt." Now, if I just hold the equity of that company, the equity is going to become much more risky because it's going to be levied equity now. And I would say to myself, "Boy, I don't want to hold levied equity. I just want to hold equity. I don't want risky equity like that." And then naive argument says, "Well, then I'm going to try to sell my equity and that will change the price of equity." What's wrong with that argument is that I can always get my old equity back by just holding 50% equity, 50% debt in the same company. That would still be what I had before an all equity company. So I can undo whatever the company does. And because I can undo whatever the company does, I demand no price. There's no price change. So in fact, the price of the company does not change. The price of the end. Indeed. Because investors can undo whatever the company does. The argument that who is holding the stock will affect the value is incorrect because investors can always undo what the company does. Indeed. And so, but the arguments that we just used are perfectly valid within a frictionless world. But there are a few frictions. And that's why at the beginning we said there may be a little bit of value creation that you can do through financial engineering because there are some relevant frictions. I think one of those frictions is the fact that most governments have decided that interest payments, so the money that you give to investors in the form of compensation for debt, is taxed deductible. Whereas paying investors that are equity holders, you tax them. So there is a way to create some value there for the investors of the firm. Because all of the money that you pay to the investors in the form of debt payments, the government can't touch. And therefore, the tax bill will be lower if you finance yourself with more debts. Right. So you can save taxes by issuing debt and a lot of leverage by outs. People think the value they created in leverage by outs is the associate tax shield by issuing a lot of debt. I am not actually so convinced of that. I think a lot of the value that leverage by outs has to do with incentives. And when you incentive us people as people all with leverage by outs, they do a much better job. Well, it's possible to combination of those two things. Yeah, certainly could be. The last two common mistakes we've covered in previous podcast episodes, so we don't have to spend that much time on them, but it's worth going back and thinking about them. The first one is that good companies are not good investors. Yes indeed. I think that the easiest way to get back to this one is just think about any other purchasing decision that you may. Suppose that you're going to buy a car and you can choose between a Porsche and a Toyota. Now obviously, if you have to pay the same price for both cars, then getting a Toyota is going to be a bad purchase. But as soon as the prices can be different between the Toyota and the Porsche, then it depends on what exact pricing you really get on both cars, which one of the two is a good deal on which one is a bad deal. Maybe I can get the Porsche for $60,000 and that's a fantastic price for that particular product and therefore a bargain and therefore a good investment between quotation marks. Whereas the Toyota, even if you would get it for 30,000, you're still overpaying for it, but if I could get it for 15,000, then maybe it is a fantastic purchase because it's such a low price for what I'm getting. And that is exactly the same thing with stocks. It is about what price are you paying for to stock relative to how good the company is. Yeah, I mean, it's amazing how easy people to get this important lesson. Like I was actually talking to a student today who wants to start an investment firm and he's identified a place where there's going to be enormous growth. There's no question about it. And so there's huge pressure on real estate prices and his idea is to go in there and buy up real estate in a particular sector that he thinks will benefit especially from the growth. And his investment thesis is absolutely correct, but I can't say to him, how do you know the land prices don't already reflect the growth? It isn't good enough to say he's going to be this enormous growth. You also have to say that people don't realize it yet. And what evidence do you have for that? And he was giving me evidence like, oh, no, they don't realize it. What do you mean they don't realize it? What evidence do you have they don't realize? Oh, it's a small market, in a small state, people don't fully realize it in the state. I'm saying really, but you know about it. And again, it's not just good enough to say, look, it's going to be a big opportunity. You also have to be first. The prices should not have changed to reflect the investment opportunity. No, and so I think that on a previous podcast, we had a very clear example of when somebody actually does have a competitive advantage in terms of determining whether an investment is overround or valued. When we were talking about the big short and we were thinking about housing markets, if you actually are going to analyze all the underlying data of the mortgages and make sure that you understand all the paperwork better than everybody else. And therefore you have information analyzed that all the people didn't. And at least you can comfortably say, I have a competitive advantage that I can make money off. But in the vast majority of cases, indeed, I think we should be very careful before concluding just out of the blue that we just know better than everybody else. Anybody can say it at any point in time. What evidence do you have for it? And then the last common mistake is of course the money matter is a common mistake. The idea that just because you're investing with a good money manager means you're going to make a higher return. It's the same argument again, right? If I know a money manager has a ability to pick stocks and I know because of that ability, they could generate a higher return, you've got to assume other people know that too. And if other people know that too, they'll all rush to invest with that money manager. And when they rush to invest with that money manager, they increase the size of the money manager's fund and he has the harder time looking for opportunities that we've discussed at the beginning of this episode. And they have lower zestral turn. And people will keep wanting to invest with him until he's returned, is equivalent to the return that would get investing in the market or in any investment where somebody isn't picking stocks. Again, it's the same argument. And it actually also goes back to one of the earlier problems and the fundamental underpinnings of modern finance because I think the mistake comes from the following. I think most people think that just because they have investable money, they're special. They believe that they don't need any other competitive advantage or any other skill just by showing up with the money. You're so special that you deserve to earn a higher return and they assume that therefore they must be getting that. And I think that as you pointed out earlier when you said Marx was right, in fact, you're not that special if you just have investable money. At this point, there's so many people in capital markets that are constantly looking for investment opportunities that just showing up at money just won't cut it. You need to do something more. You have to think about the competition. Let me just make sure that everybody knows I'm joking if I'm Marxist right. He said a lot of stuff. This is just one little thing and most of his stuff is completely wrong. Right? So it's a joke, okay? While on that joke, Jonathan, this seems like a good place to end the episode. Thanks everybody for listening. We look forward to seeing you in two weeks. Thanks for listening to All else Equal Podcast. Please leave us a review at Apple Podcasts. We love to hear from our listeners and be sure to catch our next episode by subscribing or following our show wherever you listen to your podcasts. For more information and episodes, visit allelsequalpodcast.com or follow us on LinkedIn. 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