Three-Letter Monte

Surprisingly, the first financial statement to get its very own chapter is the Statement of Cash Flows. This is because nobody really understands it. This is by design.

Companies are given two choices for this statement: the direct method and the indirect method. Both methods break cash down into three groupings: operations, financing, and investment. It's in the Operations section that things differ.

The direct method works like your checkbook, beginning with the starting balance and ending with, well, the ending balance. The indirect method starts with Net Income and then backs out cash flow from operations. First of all, it reverses all the signs, so things that cost cash are positive and things that produce cash are negative. Secondly, it means that you may be reconciling with non-existent lines on the income statement. (Many income statements have an net income from operations, but not a cash flow from operations.) Finally, it's working backwards.

So what's with the title of the post? Well, it turns out that there's a certain amount of - latitude - in cash flow categorization. The book notes that a number of companies engage in receivable secrutization, in effect selling their receivables as a security. They have a record of collections, so other companies are willing to pay them now for the hamburger they'll get on Tuesday.

The problem is that the rules are unclear whether the income from that security belongs under the Financing section (because it's basically issuing debt secured by the receivables) or the Operations section (because the income eventually comes from receivables). Because of this, many companies net it our vs. increases in receivables and put it under the Operating Cash Flows. This almost certainly over-values the company, since OCF/NI and OCF/Sales, FCF/Market Cap are commonly used metrics.

Posted by Joshua Sharf at 07:33 AM | Permalink | Comments (0) | TrackBacks (0)

The last four readings are on global econ, rounding out the book. WIth touching thoughtfullness, though, the last lecture is mostly "optional," translated as, "useful perhaps for Level II, so let's wait until after the test to read it."

The first two readings are about trade,. the value of free trade, \Why Tariffs Are Baaaad, balance of payments, that sort of thing.

The second two are about exchange rates, and really could have been condensed into one. It's the return of actual math, with real equations and problems and everything. But if you've made it this far, the only equations that won't be obvious are interest rate (or inflation rate) parity and the bid-ask spread.

Even though the formula isn't obvious, the idea behind interest rate parity is. Basically, if I can get 5% on my dollars and 0% on my yen, by the end of the year, the yen will be worth 5% more vs. the dollar. Figuring out what goes on with exchange rates is about 75% guesswork and witchcraft, But within that other 25%, interest rate parity is about as close to ontological certainty as we can get.

The bid-ask spread is one of those practical things, but they make it much more difficult than it needs to be. Bssically, the rule of thumb is that you use whatever number is most advantageous for the bank, and least advantageous to you. Surprised? I thought not.

Suppose this is the bid-ask table for the dollar vs. the Hungarian Forint. The Forint isn't the most liquid currency in the world, so even though the bank shares office space with the local consulate, the spread's pretty big:

The book would say that the rate that's used is the direct Ask and the indirect Bid. I would say that the bank's going to give you as few Forints for as many Dollars as it can. And vice-versa. For the bank, there's always an arbitrage opportunity. That way, when you get to the test and have to work out which is which, you can reason it out.

Posted by Joshua Sharf at 06:39 PM | Permalink | Comments (0) | TrackBacks (0)

As I round out the Economics studying for the exam, I have to take something back from an earlier reading. The eminent reasonableness that I had noticed in the CFA's official voice seems to stop at the Micro's edge. In macroeconomics, it's replaced by bland conventional wisdom - from about 20 years ago. The Phillips Curve is in, while the Laffer Curve is out. Deficits "crowd out" borrowing and raise interest rates, which effect mysteriously vanishes when they're recruited in support of Keynesian recession-busting. Inflation means both cyclical price increases and monetary incontinence. As a result, the term "deflation" is almost never used.

The Phillips Curve example is more ink-blot dynamics than market dynamics. Take a look at his chart:

I've colored in the dots for his groupings in time, and I've been exceedingly generous, coloring them in for his groupings. And they still don't work! The lines he's got remind me of the imagination that produced the northern constellations. (Yeah, that looks like a lion...sort of...a little....Oh, wait! You say the head's at the other end?) If I really wanted to be mean, I'd say let's lump the yellow, red, and green dots together for an unbroken 20-year run of positive correlation.\

And what's this with lumping 81 and 75 together, ignoring both 1980 and the 1982-83 peregrination? The 70s seem to hang together well enough, until you see that 1975 gets a Curve of Its Own. I suppose the author could claim that the green 1990s dots are the transition from one curve to another, but if so, they're the only one. Every other jump from curve to curve is in one year.

The one curve that really does work is curve A, the 1960s. Which is when the theory was formed, probably why it was formed then. The curve really should just ignore monetary inflation and focus on business-cycle price changes. It would then operate more like a four-stroke engine, as well as actually making sense. There clearly is a short-term negative correlation between price changes and unemployment. But the sort of broad, sweeping general application produced through narrowly-squinted eyes and heavy drinking has long ceased to inform the Fed.

Posted by Joshua Sharf at 04:16 PM | Permalink | Comments (0) | TrackBacks (0)

In studying for the CFA, the Economics section has eight readings (about a week's worth) on Microeconomics, and eight readings on Macroeonomics. It seems to me that while economic illiteracy abounds, especially among the political and journalistic classes, it manifests itself somewhat differently between the two subjects. Most of the juice is around macro stuff, because that's where policy decisions lay. But most of the action is in micro, because that's where businesses actually have to operate.

Illiteracy about macroeconomics leads people to assume that price rises mean inflation. Inflation is a monetary phenomenon. Illiteracy about microeconomics leads people to ignore how poorly gate space is allocated at DIA. Gates are not offered by competitive bid, leading to all sorts of market distortions. Historically, I would guess that micro-illiteracy is dangerous all the time, while macro-illiteracy is mostly dangerous on four- and two-year cycles.

But when politicians talk about 'windfall' taxes on oil companies, then complain about lack of slack in refinery capacity, or when they shut down drilling on the Roan Plateau, then complain about natural gas prices, it's dangerous micro-illiteracy. Or demagoguery taking advantage of it, which amounts to the same thing.

Posted by Joshua Sharf at 07:19 AM | Permalink | Comments (0) | TrackBacks (0)

One of the remarkable things about the economics lessons in the CFA is how reasonable the discussion is. The editors are neither raging Objectivists nor have they been subverted by their relationship with academia. They certainly tend towards the libertarian, ignoring the social consequences of drug use, for instance. But on the whole, you get a pretty solid understanding of human nature along with those pesky supply-demand curves. Two examples.

In discussing the depredations of price caps, they look at the housing market after the San Francisco earthquake. After the quake, there were no rent controls, and there was - voila! - no housing shortage. Owners could charge what they liked, which encourage people to build housing. True, they point out, the government could have imposed rent control, and then passed laws against charging afew hundred dollars for drapes, but the cost of enforcement wouldn't have justified it. Not understanding this sort of thing let Bill Mauldin to wonder why housing wasn't available in postwar NY for the returning soldiers.

Just because they're reasonable doesn't mean they're right. They discuss whether monopolies may actually be more innovative than competitive environments. While they seem to accept the idea that monopolies are less innovative, they also claim that economies of scale make larger companies better at adopting and propagating innovation. There may be some truth to that in certain cases, but only in cases where they're kept sharp by competition. And even then, remember that very Fortune 500 companies from 1980 are still there today.

Posted by Joshua Sharf at 07:24 PM | Permalink | Comments (0) | TrackBacks (0)