Designing a cash engine for the company

October 13, 2007

A company is an engine designed to generate cash. The initial seed cash can be paid-in equity. Later it can come from selling shares (common stock, paid-in capital) or from retained earnings. Figure 1-1 in Higgins (This little book was recommended in one of the Morningstar newsletters at some point and I bought it) demonstrates the cash generator well. Squares symbolize accounts which would show up on the balance sheet. Arrows symbolize cash flows between accounts which should be described by verbs. Not all the cash flows show up on the income statement but they are all important too keep liquidity inside the firm.

This reminds me of the C++ coding I have taken on lately. Now I’m a fortran nerd through and through – I have generated compiler errors sufficiently funky to warrant email exchanges with the compiler authors, so shoot me – but object oriented design is really really interesting because it forces you to think clearly about a problem.

For instance, how would you implement an equation of state? I think the best way is to start with a gas (the object) and say it is-a collection of particles that have-a density and a temperature.Summarizing the macrostate like means that individual particles need not be considered. Specifically and fortunately there is no need to … Particle sample[100000000000000000000000];} double Particle::getP_boltzmannstatistics() …🙂 Rather, the density and temperature becomes attributes that the gas has and they can then relate to pressure via a method in the gas class.

How would you implement the company above? Where does the stock price figure into the scheme?

Ethics and integrity in academic research

October 13, 2007

When I became a doctor (not a real doctor, just yet-another-PhD) part of the ceremony was to solemnly swear to be diligent to the best of my ability and not to falsify my research, something like that, I forget the details. I guess moral behavior has always been taken for granted in the physics community and except for a few high profile cases it has survived unscathed. The reason is probably that basic research is not subject to conflicts of interests mainly because there IS no interest, haw haw. Seriously though, aside from the occasional study of toothpaste as sponsored by a toothpaste company, there is one conflict of interest in academia which has been introduced by design. That conflict of interest is between the career of the individual and the thoroughness of his research. Specifically, by design junior scientists (who incidentally do most of the research) are only hired for short term positions. The idea is that this puts pressure on the researcher and provides the best research. I don’t agree with that for many reasons one of which is that a significant amount of research effort (10-15%) goes towards researching new jobs(!). Another problem is that due to the high specialization hiring committees often rely on the quantity of an applicant’s publications rather than the quality. What this means is that research gets published as soon as it is good enough to pass peer review. Such a “good enough” approach can leave much subsequent carnage in its wake. Specifically when another researcher picks up the subject and figure out all the underplayed/unmentioned difficulties of the article e.g. a graph may look continuous but it’s really made out of two discontinuous functions and you just happen to need the derivative, whoops! Also, we all know that data looks much better when it has been log-plotted. Soldiers have a poetic saying for this structural problem: “Shit rolls downhill!”.

Still I must admit that I was quite astounded by the 100+ pages of “Procedures” with sections and subsections. Also they expect one to know them. “Do no evil” is apparently not good enough. In most cases though, one can typically spot the rotten behavior. Good thing we have multiple choice when Legal or the compliance department can’t be consulted. The funny thing is that I actually questioned the ethics of one of the procedures in my day job. So apparently reading “the law” works.

Reading makes you strong

October 2, 2007

In general relativity, there’s a seminal book by Misner, Thorne, and Wheeler popularly known as the apple book because it has an apple with geodesics on the front cover or the “phone book” because of its heft. The book’s actual title is “Gravitation” and it’s a great book. If you make it to the milestone chapter 17, you’ll be quite adept in the ways of GR going “bong” every time you pass through a door frame. Insider jokes aside, if you don’t, at least moving it around is a great workout compared to lesser textbooks … like mathematical analysis. Those books always seemed rather thin.

However, even Gravitation has nothing on the CFA curriculum in terms of sheer mass be it inertial or gravitational! It weighs an approximate 18 pounds and comes complete with its own space time curvature. Its dimensions are approximately 8″ by “letter format”. However, as they mention in the introduction the curriculum it’s “spread over six volumes” for “portability”. Can’t say they don’t have a sense of humor. Adding to it are the included inspirational postcards with titles such as “I have learned to sleep standing up”, “Coffee is a food group”, “I am the worst date ever”, … I am not making this up! Gotta love it🙂

Relevance vs reliability

October 2, 2007

Now here’s an interesting conundrum. In my experience, if something is reliable, it is generally relevant. For instance, if something can be observed and understood well, it is a reliable basis for a theory. A theory connects one reliable facts to other reliable facts and thus from a science perspective where certainty is the name of the game, reliability leads to relevance.

Not so in the real world where the ceiling is an bright blue color with white patches on it. Here one does not tend to discuss things that are reliable. For instance, nobody talks about how the bus shows up on time (unless it doesn’t) or how the coffee machine once again produced some brown water. Rather the interesting or relevant things are those that in fact are not reliable in the sense that they are uncertain. Global warming comes to mind although the certainty of its existence is increasing. Evolution is another discussion, at least for the great uneducated masses.

So for financial markets which are supposed to price in the future e.g. price -> NPV, reliable knowledge is no longer relevant to investors because the value of such information has already been priced in.

Accounting 101 (make that -101!)

September 30, 2007

Accounting will be my nemesis. It is an entirely different way of thinking about numbers. You see, I’m used to negative numbers😉 Thus I would write the balance sheet equation for a company like this

assets + liabilities + equity = 0, where assets are things the company owns, liabilities are things that the company owes (negative) and equity is any (junior) claim (negative again) on the rest.

From a physics perspective this would show several things. First it shows that money is conserved. Taking the differential also tells you that changes always go somewhere e.g. changing one quantity must by construction change another. It also shows that the value of the company to anyone who do not have an interest in the company is 0 (the RHS). Now if you’re a physicist, this equation will make intuitive sense. If you’re an accountant, I suspect it will not make sense?! The funny thing that this is exactly what was initially confusing to me about accounting.

Accountants write the balance sheet equation like this

assets = liabilities + equity

It is now understood that all quantities are POSITIVE! The reason for this is probably historical. Double entry book keeping was invented at a time and place where negative numbers where still eyed with grave suspicion (they were referred to as “absurd” numbers). Hence instead of assigning all claims on the company to negative numbers, they were written on the right (latin. credit) side of the book whereas assets were written on the left (latin. debit) side. Much like counting beans, for after all, what is -1 bean? A negative bean, an anti-bean, absurd!

I expect a lot of my initial trouble will be due to realigning or rather expanding my intuition. Thus in the beginning I will be a focused on technicalities much like newbies in any field seem to be focused in technical skill before deep understanding evolves, hopefully.

The future …

September 29, 2007

Last week I signed up for the CFA level 1 exam next summer (2008). I decided to start this blog for several reasons. First, it might prove helpful to people in a similar situation to mine or at least serve as a bad example. Second, it would help me keep track and provide a record of my studies. Third, it might yield some networking contacts to the finance world, and .. Fourth, it will give me an outlet for discussing some perspectives on financial analysis from someone who was not originally schooled in business. This might be interesting to some people.

Let’s consider some of these points. I decided to sign up for the CFA after much soul searching. The CFA is a self-study that requires one to pass three exams that are considered “hard” and accumulate 48 months of relevant experience. I like the idea of self-study. After having gone all the way through the educational system and acquired a PhD in physics and after having seen it from the other non-student side while teaching and grading students I have a hard time seeing myself back in the class room. Much like Rocky (in Rocky IV) when said he didn’t need a coach anymore since he had done it before whence he could do it again without the need of a coach. The wisdom of Rocky movies!

The CFA is frequently considered very narrow compared to an MBA say, but on the other hand it does not strike me a quite as narrowly focused as an MFE and I have always been somewhat of an integrator/generalist. Another point in favor of the CFA is that I don’t have to give up my day job to study full time. That’s what mornings, evenings and weekends are for! Admittedly the QCF has the same self-study qualities, but that is a very expensive and I think not as widely recognized certification.

I come from a science background. In the scientific community there’s a widespread disdain for business related matters. It is generally assumed that if you don’t have the brains for science, you can always do business. Also, if you do have the brains for science but yet choose to do business, you’re somehow evil or greedy. Now, I’m not sure that spending one’s entire level studying a specific atomic transition level or a particular chemical reaction is a sign of intelligence, but businessmen are as interesting and intelligent as people in science. It’s just another language. Still, science has widespread prejudices in the sense that if you study science you either do so with the goal of eventually becoming a professor or you’re a failure. In that regard it’s implicitly assumed that you spend all your time thinking about science. Although lip-service is paid to being “well-rounded” this well-roundedness often takes time away from all important research and since scientists are generally not the users, we don’t really need to know more about the world than the average Joe although of course many scientist do (but many don’t). This could lead to a long discussion about the ivory tower, but I won’t go there today. Suffice to say thinking through the above was part of the soul searching process.
In deciding whether I could actually complete this or rather whether I thought I could actually do this, I read through the CFA Fundamentals book by Bruce Kuhlman. From the perspective of a physicist the math is quite simple, but there are a lot of rules and facts to learn and in many cases (accounting comes to mind) the rules don’t make immediate sense. However, all areas of study, ethics, quantitative methods, financial statements, capital markets, corporate finance and security analysis seem interesting and doable although there’s a lot of catching-up to do since I don’t have a business degree. Now, I have studied some economics before, especially Austrian economics, and I have also done some security/derivative analysis having worked my own roll for the past couple of years. Speaking of my own investments, this was also part of the motivation to “go for it”. Even if I could only eke out a few percent more in investment returns, especially in under-analyzed issues, the CFA program would certainly pay for itself at least in monetary terms. In terms of time costs, it mainly comes out of more unstructured reading of exactly the same things already + of course TV time😛. In other words the opportunity costs of making it official are fairly small. More importantly studying for the CFA will hopefully put me above the wannabe level and increase my career opportunities whether I stay in science or not, e.g. the potential rewards are high.

So with some trepidation which can be described as a combination of the first time I wrote a covered call on a large position and/or moving to another country, I enrolled in the CFA program. It was fairly painless and involved very little bureaucracy – try registering anywhere else in less than 15 minutes – though I did experience some doubt when I saw the weight of the UPS package they sent me: 18 pounds! It arrives on Monday.