The Five Dimensions of Variant Perception
Back in early 2007, an analyst pitched me on Ambac, the bond guarantor. He understood the financial statements of the company exceptionally well. He could quote from memory the details of the company’s financial guarantee book. He also understood how the accounting for the guarantees worked, even the detailed notes in the financial statements, and knew intimate details about the structure of recent deals. The analyst advocated that we hold the stock.
Ambac was a stock that I had inherited when I took over the fund roughly a year earlier. The time had finally come to make a decision about it. But, shortly after the analyst recommended we hold the position, I sold it.
Ambac stock (ABK at the time; now, AMBC) was trading in the low $80s when I sold it. Over the following three years, the stock fell to pennies on the dollar, and the company ultimately declared bankruptcy.
I wasn’t right because I was a genius or had perfect foresight. It’s that I was roughly right about the prospects for the business in terms of the bigger picture, whereas the analyst was right about the fine details of the company but wrong about the story they were telling. Very wrong, as it turned out.
Why was the analyst so wrong? In short, this analyst knew everything about the boat, but nothing about the river. In other words, he held a bias for company-related micro information. And this bias led him to a favorable view of the company’s prospects. And this favorable view was — we now know — consistent with the market’s views. So, how can we learn from this? What exactly is the difference between detailed knowledge of a business on the micro level and understanding a business sector on the macro level? Shouldn’t such detailed knowledge of the company support the ability of long-term investors to make sound decisions? Does detailed company knowledge eliminate the need to know what the market thinks? How did this analyst’s perceptions of Ambac compare to the market’s perceptions of Ambac? These are important questions.
For far too long, the investment industry has failed to recognize the distinction between personal and market perceptions of securities, even though this distinction is at least as important as the fundamental analysis we perform and is absolutely essential to active management. In fact, the role of perceptual analyst should be a C-level position in every investment organization.
Many analysts labor under the belief that the game is about getting the cash flows right. It’s not. Alpha is not in your cash-flow estimates. It’s not in your discount rates. And it’s not in your cheap multiples. The game is about our variant perception — our ability to distinguish our perceptions from the market’s and successfully bet when there is a material difference. Divergence between your perception and that of the market is where you should dedicate the lion’s share of your work. This is where true alpha comes from. Everything else is beta in disguise.
Consider the following graphic, which outlines the five dimensions of variant perception:
Using this framework, let’s look back at what happened with Ambac.
- Micro: As of the first quarter of 2007, the company was profitable and had reported decent earnings growth in the preceding five years. Its return on equity had averaged about 15% and was the best in the industry. Its administrative expense ratio was 15%, also the best in the industry. Its stated capital ratios were adequate. The analyst I worked with even had detailed information on how much money the company was making from each deal. Pretty good, right? The problem was that this analyst had no idea how these numbers might change under alternate scenarios.
- Macro: Up until 2007, flows into asset-backed securities had been robust, and demand for guarantees had likewise been strong. But it was clear that any slowing of growth would change the market dynamics for Ambac. Just as rising house prices reduced the obligations the company might ultimately make, falling prices increased the obligations. As house prices declined, it meant that the capital backing the bonds they underwrote was increasingly at risk. In the event of mortgage defaults, which were rising, the obligations for Ambac would also rise commensurate with supporting mortgage-backed securities.
- Market Perspective: For approximately 12 months, the market price of Ambac stock was still responding to market sentiment and largely ignoring home price declines. In the 2006 10-K, management states, “In order to enter the financial guarantee market certain requirements must be met, most restrictive of which is that a significant minimum amount of capital is required of a financial guarantor in order to obtain triple-A financial strength ratings by the rating agencies. These capital requirements may deter other companies from entering the market.” Not only was this statement true (which was, of course, good for the company in and of itself), it also suggested that the company had staying power, a competitive advantage. It was possible that a certain group of investors would become fixated on this notion of competitive advantage and, perhaps, less fixated on the events unfolding in the business.
- Valuation History: In early 2007, Ambac was trading at about nine times earnings. The S&P 500 P/E multiple was around 17.30, making this stock about half as expensive as the market. Many investors, particularly value investors, considered the stock cheap and were satisfied with the combination of low P/E ratios and what they believed to be a competitive advantage.
- Macro History: Going back 200 years, the United States has experienced a roughly generational real estate cycle. And sharp real estate cycles have almost always ended in recession, where bond issuers, such as local and state governments, struggle financially. In 2007, the most recent real estate crash had been in 1990, and it had been fairly severe. Besides this, 2007 was littered with many other warning signs that a down cycle was beginning. Defaults on mortgage loans were rising sharply, and home prices were declining nationally. In fairness, I had no idea how bad this particular cycle was about to become, but history told me that things were changing and that change would be negative for the safety and soundness of Ambac.
- Analogies of History: At Ambac, their financial position was based not only on their own finances, but also on the financial wherewithal of the bond issuers they underwrote. In the 2008 crisis, they assumed massive liabilities for issues in default. From a historical perspective, many companies have labored through similar situations and failed. One example is how large numbers of banks in Texas went bankrupt in the mid-1980s after the oil patch turned south on the back of geopolitical events. When falling oil prices weakened the financial stability of many energy companies, these firms, in turn, couldn’t pay back their bank loans, creating insolvency among many banks. The market responded modestly to changes in oil prices as they fell, but reacted strongly once these changes became evident in the performance of the banks. The same held true during the financial crisis of 2008. Home prices peaked in July 2006. Ambac stock didn’t peak until March 2007, and didn’t fall below $80 until the company’s pre-announcement of negative earnings on 25 July 2007. That was a full 12 months after home prices began to fall, as is illustrated by the shaded area on the left hand side of the graph below:
- Industry Regulation: From a policy perspective, recent laws and regulations had been enacted that were pushing more and more risk onto guarantors. The banking industry was encouraged to expand into sub-prime mortgages by both threats and rewards. Banks that didn’t meet affordable housing goals were threatened with sanctions, while banks that embraced sub-prime borrowers found a ready market to sell these loans through Fannie Mae, Freddie Mac, and Wall Street, booking immediate gains on sales and removing these loans from their books. Regulations across the credit markets had pushed the envelope in credit extension limits and, in turn, helped push issuers to pursue guarantees to maintain their own credit ratings. The result was that credit standards were lowered and buffers were reduced throughout the system. In many cases, the reduction in buffers simply shifted more of the burden of failure onto guarantors like Ambac.
- Monetary Policy: Artificially low interest rates created by the US Federal Reserve caused an unsustainable spike in credit growth and asset-backed securities, artificially inflating the economy and the markets.
- Trade Policy: The US current account deficit ballooned to nearly 6% of GDP in 2006, making it clear that the incremental growth in trade could not continue very long, as economic imbalances this large tend to get corrected. As the current account deficit ramped up, it encouraged foreign central banks (particularly China’s) to purchase US Treasuries with longer maturity dates and drive down interest rates. Given the prospect of a correction, this phenomenon would reverse itself, meaning interest rates would rise, the US economy would weaken, and foreign capital would (to some degree) flee the United States. With the exception of the massive policy response to the crisis, this is exactly what happened in 2008–2009.
- Incentives: From an agency perspective, lenders had incentives to grow EPS without any reference to the quality or transparency of the whole supply chain, which directly affected Ambac’s obligations. The top five senior executives at the company stood to take home $43 million simply upon termination after a change in control (see the “Potential Payments Upon a Change in Control” section), while rank-and-file employees risked losing their jobs. CEO William T. McKinnon received minimum annual bonuses of $800,000 and $850,000 in 2007 and 2008, respectively. Regardless of the value created by McKinnon for shareholders, he stood to make a lot of money whether the company did well or poorly. Moreover, senior management stood to gain $17 million personally if the company hit its earnings targets over the 2007–2010 time frame.
- News Flow, Propaganda, and Meme Repetition: Alan Greenspan: “Nominal house prices in the aggregate have rarely fallen.” Ben Bernanke: The sub-prime crisis is “contained.” Alan Greenspan: “A ‘bubble’ in home prices for the nation as a whole does not appear likely.” Hank Paulson: “I also said I thought in an economy as diverse and healthy as this that losses may occur in a number of institutions, but that overall this is contained and we have a healthy economy.” We heard it all on the front end of the crisis. We even heard it all the way up until all hell broke loose with the collapse of Lehman Brothers in September 2008. And we didn’t hear these types of bromides uttered by just anyone: We heard them from the heads of the Fed, Alan Greenspan and Ben Bernanke. We heard them from the sitting secretaries of the US Treasury, Hank Paulson and Timothy Geithner. We heard them repeated by sitting President George W. Bush and many other high-profile authority figures. This authority mis-influence, leading to memes that were then repeated ad nauseam throughout the investment industry, made the market slow to respond to the full scope of the crisis.
- Status Quo: Ambac was profitable and growing. This is true. It is natural for many market participants to expect the status quo to continue. This should be a baseline assumption about market perceptions. Looking back, we now know definitively that the market was wrong. The market clearly had been focused on recently reported earnings, which were at their peak. In my experience, the status quo tends to dominate market perception of a stock.
- Mental Model Bias: Many value investors saw the low P/E multiple of 9 on Ambac and viewed the stock as “cheap” compared with the overall market multiple of 17-plus. Ambac stock had “relative value,” and many value investors supported it on that basis.
With the benefit of hindsight, it is now clear the analyst’s perception of Ambac in early 2007 was shaped by the company’s reported financial results up to that time. Just three years later, however, the company declared bankruptcy, wiping out all existing shareholders. In 2007, I didn’t forecast the larger crisis, but I was able to incorporate a more expansive view of the business and identify Ambac as relatively unsafe in contrast to a market that generally viewed the business as safe. If you have a similar view and similar weighting to the market portfolio, you are wasting precious time. Remember, everything interesting in economics and investing happens on the margin.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/Jonathan Woodcock