More on Short Selling

For students in my Financial Management class (FINM2401) - Alan Kohler has written an editorial on the current short sale restrictions here in Australia (The Blind Leading the Naked, on Business Spectator). In a nutshell: Short selling is an important part of price discovery in markets, but the securities lending business in Australia should be more transparent.

Asset Pricing 101

Peter Wallison has an opinion piece about valuing bank assets in the Wall Street Journal. A quick summary:

Both taxpayers and banks could come out well -- and so would our economy -- if the government were to buy the assets at their "net realizable value," which is based on an assessment of their current cash flows, discounted by their expected credit losses over time.

The article is a real world confirmation of the basic principle underlying all introductory finance courses: assets are worth the present value of their expected cash flows. This is what market value should be if the market is functioning properly. Clearly, the market for mortgage-backed securities isn't functioning at the moment.

Debt and Corporate Control

Robert Gottliebson has an interesting article over at Business Spectator about Centro. For those of you who haven't been following it, Centro is a high profile Australian casualty of the US credit crisis. Centro Properties (ASX:CNP) manages retail properties in Australia and the US. The properties themselves are owned by various trusts, the largest of which is Centro Retail Trust (ASX:CER). In December it became clear that Centro was going to have trouble re-financing a large portion of its debt, and the price plummeted. Clearly the underlying assets (management contracts for CNP and real estate for CER) have not dropped nearly as much in value as the share prices have. Gottliebson points out that the way the debt is structured (unsecured loans to CNP) makes it difficult for the banks to foreclose because CNP's management contracts are written to require shareholder approval in the event of a change in control. The banks will collect much more if they work with Centro to re-finance the debt rather than force Centro into administration.

For my students, this is a good illustration of the effects of debt on corporate control, and how clever structuring can change the usual dynamics between debtholders and shareholders.

(Disclosure: the author has a small financial interest in CER)

Portfolio Construction

The Australian Stock Exchange provides a podcast for investors. The latest item to show up in the feed (though not listed on the ASX podcast page) is a talk on Portfolio Construction by Dale Gillham, Chief Analyst at Wealth Within.

I listened to the podcast the other day while commuting and found it quite interesting. Mr Gillham makes some good points about diversification, but also seems to confuse some of the basic theory taught in finance courses. The basic Capital Asset Pricing Model (CAPM) assumes that market prices are efficient -- that is, that you can't consistently beat the market by choosing individual securities. If this is true, then your best course of action is to replicate the market portfolio. And the cheapest way for individual investors to replicate the market portfolio is to buy index funds or ETFs.

Any investment strategy designed to beat the market is implicitly assuming that the market is NOT efficient (probably not a bad assumption in smaller markets like Australia's). These strategies will beat the market to the extent that they are able to consistently identify undervalued investments. Such a strategy requires assuming a reasonable amount of company-specific risk -- the more you diversify, the closer your portfolio is to the overall market and the closer your return is to the market return.

So, when constructing your portfolio you need to be clear about your assumptions. Do you believe the market is efficient? Then go with index funds. Do you believe the market is inefficient? Then you need to decide whether you can consistently select undervalued companies. If you can't (or if you don't have the time), then index funds are still your best bet.

Welcome to a new academic year

Don't know if anyone is still checking this feed -- it's been months since I last posted.

Down here, January means school holidays and summer vacation. Most of my non-academic friends assume that means I'm on holidays too, but this is not the case. I did take the first two weeks of January off to pursue my creative hobbies, but now it's back to work. I have two research papers to revise and resubmit, and I need to get ready for semester 1, which starts on 25 February.

This semester I'm teaching half of three courses (I've divided my teaching load with a colleague so we can pick and choose topics that we are interested in). FINM1401 is an introduction to personal financial planning for non-business students. No finance background is assumed. FINM2401 is the introductory finance course for business undergrads. Many of the students will not take another finance course, but others will major in finance. It's a huge course with 600 students each semester. We break that into two lecture streams (and countless tutorial streams). FINM7065 is introductory finance for MBAs. The content is similar to FINM2401 with a more applied/managerial slant.

I've set up some shared tags in Google Reader so I can tag new items relevant to these courses. For FINM1401 you'll find the shared items here. For FINM2401/7065 they are here.