CFA Institute

Financial Statement Analysis for Value Investing. 2025. Stephen Penman and Peter Pope. Columbia University Press. The discipline of value investing has had a tough time of late. The relentless ascent of passive investment strategies, the prolonged outperformance of growth stocks since the Global Financial Crisis, and the soaring overall valuations in developed markets (where time-tested valuation principles no longer seem to apply), to name but a few, have all contributed to its struggles. As a result, the heirs of the Graham and Dodd tradition are numbered these days and relegated to deep-value strategies in emerging markets or Japan. Is this merely a temporary aberration, or does the tradition need some refinements to remain relevant in today’s financial landscape? Against this backdrop, Stephen Penman, the George O. May Professor Emeritus at Columbia Business School, and Peter Pope, Professor Emeritus of Accounting at the London School of Economics, have published a 432-page tome entitled Financial Statement Analysis for Value Investing, a work firmly rooted in the Graham and Dodd value investing tradition. The book also expands on the framework developed by Penman in his 2011 work, Accounting for Value. In both books, readers will encounter classic value investing concepts, such as negotiating with Mr. Market or the importance of a margin of safety, and some insights from modern portfolio theory, such as the neutrality of dividends or a company’s capital structure in creating value for shareholders. Practitioners will find this surprising and eclectic combination of ideas refreshing and enlightening. As the authors succinctly state in the introduction: You will find the book contrasts with many investment books. The ubiquitous beta is not of highest priority by far. The common discounted cash flow (DCF) is put aside. Indeed, the book is skeptical about valuation models in general. Perhaps surprisingly, the book takes the position that it is best to think that “intrinsic value” does not exist. For a value investor that sounds like heresy, but intrinsic value is just too hard to pin down. That requires an alternative approach to be put on the table, one that challenges the market price with confidence. Some investors see the alternative as trading on multiples, smart beta investing, factor investing, and more. The book brings a critique to these schemes. So, what do the authors propose? The cornerstone of the book is the residual income model. First formalized in the 1980s[1] and 1990s[2], much later than other valuation frameworks such as the dividend discount model, the residual income model was popularized in the 1990s by the consulting firm Stern Stewart and briefly adopted by the management teams of several large U.S. corporations to gauge whether their investment decisions were creating value for their shareholders. However, despite numerous academic papers on the model, its adoption by practitioners has remained limited, lagging behind more widely used approaches such as valuation multiples and the free cash flow model. As a quick refresher, the residual earnings model instructs us to think about valuation through the lens of the future residual (or economic) earnings that a business is expected to generate. Residual earnings are simply accounting earnings after taking into account a cost of capital charge. These future residual earnings must then be discounted back to the present and added to the company’s current book value to arrive at a valuation for the equity. Notably, if a company’s return on equity matches its cost of capital, it will generate accounting earnings but no residual earnings, meaning that its shares should trade at book value. The elegance of the model lies in the seamless integration of business fundamentals with accounting figures, which in turn produce a valuation for the investor. Although the three valuation frameworks (dividends, free cash flows, and residual income) are mathematically equivalent, the residual income stands out for its ability to capture the true sources of value creation for shareholders. Companies that do not pay dividends or reinvest in profitable growth opportunities would be hard to value using the dividend discount or the free cash flow model, respectivel, but they do not obstruct the residual income framework. The reason this model captures value creation more accurately (and earlier) is rooted in the accruals that govern current accounting systems. While so-called “cash accounting” is often favored by practitioners over accrual accounting on the oft-touted premise that cash is closer to “hard and cold facts” whereas unscrupulous management teams can easily manipulate accruals, Penman and Pope show that this conventional wisdom is simply misguided. First, cash flows themselves can also be manipulated by management teams. Second, there are a plethora of transactions that do not involve cash flows yet still shift value between stakeholders, with stock compensation being probably the most prominent example. But most importantly, earnings are usually recognized earlier than cash flows under the “realization principle.” For instance, sales on credit are recognized before the company gets the cash, capital investments are depreciated over time (increasing earnings at the onset of the investment), and pension obligations are accounted for immediately, even though cash will not flow out of the company to pay the promises until decades later. The important implication for investors valuing stocks in the real world, where the future is uncertain, is that “[w]ith this earlier recognition of value added, there is less weight on a terminal value in a valuation.” In summary, an accounting system based on accruals and the realization principle inherently reflects sound thinking about how firms create value for investors, as well as some guidelines for understanding risk and return. Value is capitalized on the balance sheet only when the certainty of the investment is high, and subsequent earnings are added to book value only when they are realized. From this standpoint, alternative forms of “carrying” the accounting book, such as fair value accounting, fail to uphold these principles. Throughout the book, Penman and Pope criticize fair value accounting for encouraging speculative behavior by placing uncertain values on the balance sheet, which ultimately contributes to investor speculation — as was exemplified during

Resistance Money: A Philosophical Case for Bitcoin. 2024. Andrew M. Bailey, Bradley Rettler, and Craig Warmke. Routledge. “Bitcoin is for criminals. It’s a tool for terrorists, drug dealers, and hackers, and a plaything for degenerate speculators.” “Compared to physical cash, bitcoin enables some wrongdoing more easily over longer distances.” “Perhaps in the long run, bitcoin could destroy the international order by making sanctions less effective.” “Even if bitcoin intrinsically has no serious problems, it is surrounded by a culture rife with scams.” “Bitcoin does involve significant carbon emissions. This is bad.” “…bitcoin benefits North Korea’s totalitarian government. This is bad.” “…bitcoin does not automatically provide users with significant financial privacy.” “Throughout its history, bitcoin has shown enormous volatility.”   “It might even go to zero.” The preceding excerpts from Resistance Money will likely strike readers of this review as puzzling in view of the book’s subtitle, “A Philosophical Case for Bitcoin” (emphasis added).  In reality, authors Andrew M. Bailey (Associate Professor of Humanities, Yale-NUS College, Singapore), Bradley Rettler (Associate Professor of Philosophy, University of Wyoming), and Craig Warmke (Associate Professor of Philosophy, Northern Illinois University) are forthrightly stating the case against bitcoin in the course of arguing that on balance, one should prefer to live in a world with bitcoin rather than one without it. The book’s evenhanded approach is a welcome contrast to the extreme comments regularly heard from both bitcoin’s zealous proponents and its frequently ill-informed opponents.   High among the positives that, in the authors’ view, outweigh bitcoin’s negatives is its users’ ability to defend themselves against financial censorship. They point out that people with dissident political views who depend on conventional finance are vulnerable to shutdown of their bank accounts, blocking of their transactions, and even seizure of their funds. Bailey, Rettler, and Warmke note that such tactics are not employed solely by dictatorial governments.  From 2013 to 2017, the US Department of Justice and Federal Deposit Insurance Corporation’s “Operation Checkpoint” pressured banks to deplatform individuals and companies involved in fully legal businesses, including ATM operators, coin dealers, dating services, pawnshops, and payday lenders. In 2022, 22 rights groups including the American Civil Liberties Union and the Freedom of the Press Foundation asked PayPal to stop shutting down accounts under a new user agreement which gave the company sole discretion to confiscate up to $2,500 from customers it deemed to be publicly spreading misinformation. Bitcoin is not censorship-proof, say the authors, but it is censorship-resistant.    Resistance Money also pleads on behalf of the world’s billions of unbanked individuals. Bitcoin requires no minimum balance, charges no fees for opening an account, and does not exclude people with problematic credit histories. It is accessible to immigrants who lack documents to verify their identities and financial histories and the poor who lack the resources to obtain them. Bitcoin users need not worry about being surprised by a hidden charge, being discriminated against on the basis of their ethnicity, or living too far from a branch bank to obtain access to banking services. All they need to enter the bitcoin network is a mobile phone or a laptop. Eighty-five percent of Americans currently own smartphones, up from thirty-nine percent 10 years ago.  Masters of argumentation by virtue of their training as philosophers, the authors also tackle in a reasoned manner such standard objections to bitcoin as its high price volatility and the sizable quantity of energy consumed in mining bitcoins. Happily, the scenario presented by a 2017 Newsweek headline, “Bitcoin Mining on Track to Consume All of the World’s Energy by 2020,” did not come to pass. Bailey, Rettler, and Warmke even address several criticisms of bitcoin that many well-informed financial practitioners have probably never previously heard. These include complaints that bitcoin is divisible into unduly small subunits (one bitcoin equals 100 million satoshis, each of which was worth about $0.00025 when the book was written), the objection that bitcoin is very unequally distributed (about 7.9 billion people on earth own none), and the allegation (disputed by the authors) that although bitcoin is purposely designed to operate without makers, mediators, or managers, bitcoin miners are in fact mediators. The last point touches on a problem that many readers are likely to encounter in reading Resistance Money: Following certain of its arguments requires a deep immersion in the technical details of bitcoin’s design and operation. Nonspecialists may, for example, find the lengthy description of bitcoin’s failed predecessors a slog and somewhat beside the point. Along with most other books that Enterprising Investor reviews, Resistance Money is not completely free of error. The text refers at one point to the “Great Recession of 2007-2009.”  In reality, the National Bureau of Economic Research dates the beginning of that economic contraction to January 2008.  None of these difficulties or imperfections should deter practitioners from reading this authoritative examination of a controversial asset with a current aggregate value of $1.3 trillion. The book comes much closer to a CFA Institute-style ideal of rational, evidence-based analysis than most comments on bitcoin’s merits, or lack thereof. With clients asking their advisors either to add bitcoin to their portfolios or to provide a good reason for not doing so, Resistance Money will immensely help advisors reach a firmly grounded decision on which way to go.     source

Artificial Intelligence (AI) and big data are having a transformative impact on the financial services sector, particularly in banking and consumer finance. AI is integrated into decision-making processes like credit risk assessment, fraud detection, and customer segmentation. These advancements raise significant regulatory challenges, however, including compliance with key financial laws like the Equal Credit Opportunity Act (ECOA) and the Fair Credit Reporting Act (FCRA). This article explores the regulatory risks institutions must manage while adopting these technologies. Regulators at both the federal and state levels are increasingly focusing on AI and big data, as their use in financial services becomes more widespread. Federal bodies like the Federal Reserve and the Consumer Financial Protection Bureau (CFPB) are delving deeper into understanding how AI impacts consumer protection, fair lending, and credit underwriting. Although there are currently no comprehensive regulations that specifically govern AI and big data, agencies are raising concerns about transparency, potential biases, and privacy issues. The Government Accountability Office (GAO) has also called for interagency coordination to better address regulatory gaps. In today’s highly regulated environment, banks must carefully manage the risks associated with adopting AI. Here’s a breakdown of six key regulatory concerns and actionable steps to mitigate them. 1. ECOA and Fair Lending: Managing Discrimination Risks Under ECOA, financial institutions are prohibited from making credit decisions based on race, gender, or other protected characteristics. AI systems in banking, particularly those used to help make credit decisions, may inadvertently discriminate against protected groups. For example, AI models that use alternative data like education or location can rely on proxies for protected characteristics, leading to disparate impact or treatment. Regulators are concerned that AI systems may not always be transparent, making it difficult to assess or prevent discriminatory outcomes. Action Steps: Financial institutions must continuously monitor and audit AI models to ensure they do not produce biased outcomes. Transparency in decision-making processes is crucial to avoiding disparate impacts. 2. FCRA Compliance: Handling Alternative Data The FCRA governs how consumer data is used in making credit decisions Banks using AI to incorporate non-traditional data sources like social media or utility payments can unintentionally turn information into “consumer reports,” triggering FCRA compliance obligations. FCRA also mandates that consumers must have the opportunity to dispute inaccuracies in their data, which can be challenging in AI-driven models where data sources may not always be clear. The FCRA also mandates that consumers must have the opportunity to dispute inaccuracies in their data. That can be challenging in AI-driven models where data sources may not always be clear. Action Steps: Ensure that AI-driven credit decisions are fully compliant with FCRA guidelines by providing adverse action notices and maintaining transparency with consumers about the data used. 3. UDAAP Violations: Ensuring Fair AI Decisions AI and machine learning introduce a risk of violating the Unfair, Deceptive, or Abusive Acts or Practices (UDAAP) rules, particularly if the models make decisions that are not fully disclosed or explained to consumers. For example, an AI model might reduce a consumer’s credit limit based on non-obvious factors like spending patterns or merchant categories, which can lead to accusations of deception. Action Steps: Financial institutions need to ensure that AI-driven decisions align with consumer expectations and that disclosures are comprehensive enough to prevent claims of unfair practices. The opacity of AI, often referred to as the “black box” problem, increases the risk of UDAAP violations. 4. Data Security and Privacy: Safeguarding Consumer Data With the use of big data, privacy and information security risks increase significantly, particularly when dealing with sensitive consumer information. The increasing volume of data and the use of non-traditional sources like social media profiles for credit decision-making raise significant concerns about how this sensitive information is stored, accessed, and protected from breaches. Consumers may not always be aware of or consent to the use of their data, increasing the risk of privacy violations. Action Steps: Implement robust data protection measures, including encryption and strict access controls. Regular audits should be conducted to ensure compliance with privacy laws. 5. Safety and Soundness of Financial Institutions AI and big data must meet regulatory expectations for safety and soundness in the banking industry. Regulators like the Federal Reserve and the Office of the Comptroller of the Currency (OCC) require financial institutions to rigorously test and monitor AI models to ensure they do not introduce excessive risks. A key concern is that AI-driven credit models may not have been tested in economic downturns, raising questions about their robustness in volatile environments. Action Steps: Ensure that your organization can demonstrate that it has effective risk management frameworks in place to control for unforeseen risks that AI models might introduce. 6. Vendor Management: Monitoring Third-Party Risks Many financial institutions rely on third-party vendors for AI and big data services, and some are expanding their partnerships with fintech companies. Regulators expect them to maintain stringent oversight of these vendors to ensure that their practices align with regulatory requirements. This is particularly challenging when vendors use proprietary AI systems that may not be fully transparent. Firms are responsible for understanding how these vendors use AI and for ensuring that vendor practices do not introduce compliance risks. Regulatory bodies have issued guidance emphasizing the importance of managing third-party risks. Firms remain responsible for the actions of their vendors. Action Steps: Establish strict oversight of third-party vendors. This includes ensuring they comply with all relevant regulations and conducting regular reviews of their AI practices. Key Takeaway While AI and big data hold immense potential to revolutionize financial services, they also bring complex regulatory challenges. Institutions must actively engage with regulatory frameworks to ensure compliance across a wide array of legal requirements. As regulators continue to refine their understanding of these technologies, financial institutions have an opportunity to shape the regulatory landscape by participating in discussions and implementing responsible AI practices. Navigating these challenges effectively will be crucial for expanding sustainable credit programs and leveraging the full potential of AI and big data. source

Few people have managed to avoid noticing the increasing popularity of cannabis consumption. However, if you walk down the street and catch a whiff of that grassy, pungent smell, you are witnessing a dying breed of cannabis users. While more people consume cannabis, they are increasingly shifting away from the raw flower. For investors in the space, the changing cannabis consumption landscape opens challenges and opportunities in product creation, marketing, and targeting new consumer groups. Cannabis is Becoming a Commodity While cannabis is famously a weed, its connoisseurs will let you know if you get your strains mixed up. Different strains have varying amounts of THC, the cannabinoid that gets you high, as well as other non-psychoactive cannabinoids and terpenes, several of which have been found to have beneficial effects on inflammation, stress, and more. Cannabis strains all have their own individual look, smell, taste, and experience. Cannabis is becoming increasingly commoditized, however, and consumption is moving farther away from the raw flower. A growing segment of consumer products are infused with THC and other cannabinoids, thus removing the experience of a flower strain and its characteristic cannabinoid and terpene combinations. Cultivating cannabis is increasingly a large-scale commercial affair, with the size of cannabis “grows” limited in part by their market size because the United States does not allow interstate commerce of the crop. Many larger operations belong to so-called multi-state operators — companies structured to operate in multiple states. If you have ever invested in a cannabis exchange-traded fund (ETF), these are the companies you bought. Because of their wide reach, their market capitalization is large enough to make it into cannabis ETFs. Yet, no cannabis company can ship across state lines. What you grow in a state is also what you sell in that state. More People in the US Now Consume Cannabis Than Alcohol The commoditization of cannabis parallels an important trend that sees cannabis use spreading across age groups and social spheres. More cannabis consumers are now college kids and middle-aged women, as opposed to your traditional “potheads.” We see more distilled and infused products, such as gummies, drinks, and vapes, and less flower for examining, grinding, and smoking. Surveys of consumption in the United States reveal that cannabis consumption has surpassed alcohol drinking. This has long been the case among younger cohorts. Among Millennials and Gen Zs, alcohol consumption has been on a slow and steady decline while cannabis use has been increasing. This is partly due to a realization of the damage that alcohol does, and partly because of the softer effect of cannabis. Cannabis is now recognized as a more benign drug than alcohol and has lost the heavy stigma it previously carried. Growing Product Categories For investors, a wider demographic of cannabis use opens a field of new investment opportunities. Product categories are broadening, creating opportunities for expanding branding, and marketing. Smoking is increasingly recognized as unhealthy and unappealing. Familiar products that do not require inhalation such as chocolates, cookies, and drinks are becoming more popular. There are powders and concentrates for making cannabis cocktails. Edibles such as gummies and drinks are particularly popular among consumers aged 55 and over, according to a report by New Frontier (2023). The same report also finds that those aged 18 to 24 are the least likely to smoke cannabis exclusively, pointing to the trend of a new generation of cannabis users replacing alcohol and not wanting to smoke. Smoking in some form, flower or vape, is still the dominant form of cannabis consumption, but the trend toward other types of products creates opportunities for new entrants to claim niche spaces. There is an increasing popularity in lower-dose products, according to New Frontier. Their consumer report notes a decrease in popularity and frequency of use of blunts, bongs, and water pipes, as well as dabbing and concentrates. Meanwhile, we are seeing an increasing use of edibles, which is now the most frequently used form of cannabis. Also rising are vapes, drinks, topicals, and to some extent tinctures. While cannabis has become increasingly common at student parties, we anticipate that it will eventually make its way into bars and other social settings. Twelve states currently allow cannabis consumption lounges in some form. Some states allow for purchase of cannabis on site, while in other states, lounges can only offer spaces for consumption. While lounges still mostly come in the form of simple cafes, this category of hospitality establishments may well soon evolve into pleasant speakeasies and dance clubs. This field is wide open for entrepreneurs. New Consumer Groups As cannabis becomes more mainstream, new target groups are emerging. As mentioned, young people are dominant users of cannabis. But the fastest growing group of cannabis users is senior citizens over the age of 65. Another important and quickly growing consumer group is middle-aged women, using it to alleviate symptoms of menopause. Pain relief and sleep aid are common applications of cannabis for all cohorts but especially for these groups. And as with any health remedy, whatever humans use on themselves they also provide their pets, making the pet market an important focus for investors in cannabis. Understanding how to reach these new consumer groups offers great opportunities for novel branding and product categories. Investment Opportunities As weed becomes increasingly commoditized, opportunities emerge outside crop cultivation. Prices of flower are falling in most states, making it increasingly attractive to be a buyer of biomass instead of its producer. By contrast, on an international level, markets outside the United States are increasingly integrated via cannabis trade, opening opportunities to grow cannabis in low-cost and climate-appropriate places for export, with southern Africa and Colombia attracting a growing stream of investments. Cannabis remains underdeveloped as a consumer-packaged goods (CPG) category. Most packaging remains rudimentary and brand building is still in its infancy. This may well be due to entrepreneurs in cannabis not entering from a CPG angle but out of a passion for the plant and its health benefits. While this

1. Fama and French: The Five-Factor Model Revisited How well has Eugene F. Fama and Kenneth R. French’s five-factor model explained returns? Derek Horstmeyer, Ying Liu, and Amber Wilkins share their analysis. 2. Tell Me a Story: Aswath Damodaran on Valuing Young Companies When valuing companies, “You don’t have to be right to make money,” Aswath Damodaran says. “You just have to be less wrong than everybody else.” Roger Mitchell considers Damodaran’s insights. 3. The Elephant in the Room: The ESG Contradiction The inherent conflict between the “E,” the “S,” and the “G” in ESG investing can no longer be ignored. As much as we might wish otherwise, the goals embedded in these initials don’t always align with one another, Andrea Webster, Paul Smith, CFA, and Kübra Koldemir contend. 4. How Long Can Russia Withstand the Sanctions? The toll of the economic embargo on Russia will be enormous, Joachim Klement, CFA, predicts. He goes on to calculate just how enormous. 5. Investing’s First Principles: The Discounted Cash Flow Model Brian Michael Nelson, CFA, explains why the DCF model is not only relevant to today’s market, but remains an absolute necessity. 6. Retirement Income: Six Strategies How can we mitigate sequence of returns risk (SoRR)? Krisna Patel, CFA, shares half a dozen strategies to safeguard clients’ retirement portfolios. 7. Building a CAPM That Works: What It Means for Today’s Markets “The capital asset pricing model (CAPM) is a marvel of economic scholarship,” Jacques Cesar writes. “The problem is that it doesn’t always work in practice. So, we fixed it.” 8. Equity Risk Premium Forum: Don’t Bet Against a Bubble? Cliff Asness, Rob Arnott, Roger G. Ibbotson, and other luminaries explore the nature of bubbles and the momentum factor. Paul McCaffrey provides a synopsis of their dialogue. 9. A Tale of Two Suits: The Three Capitals of Career Success According to Eric Sim, CFA, human capital, financial capital, and social capital helped build his career in finance. Paul McCaffrey considers Sim’s compelling personal story and how we can apply the lessons to our own careers. 10. From No to Yes: Persuading Clients with the 3Ps Method In this adaptation from Small Actions: Leading Your Career to Big Success, Eric Sim, CFA, and Simon Mortlock discuss the 3Ps method — perseverance, perspective, and positivity — and how to use it to transform rejection into approval. If you liked this post, don’t forget to subscribe to the Enterprising Investor. 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: ©Getty Images / RomoloTavani Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

The Financial Crisis of 2008: A History of US Financial Markets 2000–2012. 2021. Barrie A. Wigmore. Cambridge University Press. Barrie Wigmore analyzes an extremely complex topic, the financial crisis of 2008, with wide-ranging and deep analysis. He brings to bear a richly experienced point of view, based on working “in the trenches” as an investment banker over multiple cycles. For Wigmore, shocking levels of leverage sounded the main alarm about the mounting crisis. This was represented most dramatically by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) operating with leverage of 100 to 1. These government-sponsored enterprises had to make subprime loans and hold private residential mortgage-backed securities (RMBSs) because the US Department of Housing and Urban Development (HUD) had mandated that these institutions increase the number of low-income homeowners, beginning with the Community Reinvestment Act in 1992. In November 2004, HUD set additional low-income lending goals for Fannie Mae and Freddie Mac. Fannie Mae exceeded these aggressive goals in 2005 and again in 2006. At this point in the narrative, the author tells the story in such an exciting way that you can smell the credit danger lurking around the corner. Not only do subprime borrowers represent a disturbingly high percentage of total borrowers, but also Wigmore presents astonishing data directly out of Fannie Mae’s “credit book” cited in its 2006 10-K. The data suggested that both Fannie Mae and Freddie Mac were exposed, beyond HUD’s mandates, to the weakest credit sectors. While this was occurring, state and local government pension funds, insurance companies, and the commercial and investment banking intermediaries that serviced Fannie Mae and Freddie Mac continued to fund them despite their unlimited information resources, their attention to financial markets, and their own stakes in the outcome. There was also the parallel challenge of seeking higher investment returns in a declining interest rate environment — not only for retail investors but also for institutional investors, the so-called smart money. This stretch for yield is presented in Table 2.5, which sums up in simple terms the $11 trillion apocalypse to come. Wigmore cogently presents the setting for the crisis. It visibly began in the second half of 2007, with house prices leveling off after huge runs in such places as Los Angeles, Phoenix, and Las Vegas. The US Federal Reserve noted that consumers’ debt servicing capability was deteriorating from traditional levels, even with the low interest rates prevailing at the time. Consumer liabilities rose from 15% to 22% of net worth between 2000 and 2007, due in particular to growth in residential mortgage debt. Yet, the Fed evidenced no major concern at that time, believing that consumer strength would support a further rise in consumer spending. Subprime mortgages were beginning to default at high rates. The value of asset-backed securities and private RMBSs sank. Mortgage originators with large sub-prime exposure, such as New Century and Fremont General, lost their lenders. Countrywide Financial, IndyMac, and Washington Mutual faced unprecedented disruptions. Their published balance sheets did not keep up with the rapid deterioration in the quality of their loans. The institutional collapses that occurred had a common narrative: extreme leverage; complicated, if not unexplainable, real-time balance sheets; and poor-quality assets, in the case of investors, or liabilities, in the case of lenders. The author methodically explains the collapses, with numerous graphs to underscore the severity of the strains, both individually and systemwide. In the chapter titled “Epilogue 2012–2016,” Wigmore cites many instructive indicators of market and economic recovery. Security markets’ recovery preceded recovery in the economy, based on anticipated recovery in S&P 500 Index earnings forecasts. In 2012, equity valuations stretched in a way never before seen, as the S&P 500’s dividend yield and the 10-year Treasury rate converged for the first time since 1957. Housing prices and commercial real estate sales rebounded. Consumer confidence rose. Federal debt to GDP was still high; however, the Fed’s balance sheet was huge, interest rates were artificially low, and the status of Fannie Mae and Freddie Mac remained to be determined. In reading this masterful book, I was initially impressed by its structure in addressing such a complex time in history. It analyzes the market and economic environment preceding the crisis, during the crisis, and over a number of years that followed it. The book delves deeply into the institutions and the securities. The author differentiates opinion from fact, relying on extrapolation from actual reported numbers. I found it impressive that he uses the analyst’s most trusted original sources, corporate 10-Ks and 10-Qs. Neatly rendered graphics and tables assist the analytical narrative. Wigmore cites Federal Reserve Economic Data (FRED) frequently and appropriately. The Financial Crisis of 2008 is essential reading for banking, investment, and insurance firm leadership but also for investors, analysts, economists, and students of financial and investment history. It depicts how widespread risk-taking at the firm level can morph into systemwide near collapse and how the mantra of homeownership for all must be considered in light of the associated financial risks and undisciplined creation of asset-backed securities. The book is required reading for a generation. If you liked this post, don’t forget to subscribe to the Enterprising Investor. 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. Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

What is the current outlook for investors in today’s credit market? Interest rates had been in secular decline since the 1980s. In the aftermath of the global financial crisis (GFC), rates hovered near zero as central banks embraced quantitative easing (QE) and flooded markets with liquidity. Among other effects, these monetary policies elevated the valuations of most assets, including private and public debt. This trend came to an end in 2022 when central banks began to raise rates and tighten credit conditions to tame inflation. Today, investors must navigate this transition. In terms of economic expression — and to take a page from Thomas Piketty — we have shifted from an r > g to an i > g world, from one where the real rate of return exceeds the rate of economic growth to one where nominal interest rates outpace the rate of economic growth. This has significant implications for debtors whose earnings are likely to grow slower than the interest accumulated on borrowed funds. As our parents might say, this is likely to “end in tears.” Simply put, many businesses and investments have not been tested. Since 2009, save for a brief period in early 2020, nominal growth has outpaced nominal rates. Warren Buffett famously said, “You only find out who is swimming naked when the tide goes out.” Well, the tide is going out and as businesses refinance at higher rates, default rates and distressed exchanges are likely to increase concomitantly. When revenue grows more slowly than the cost of financing, especially over an extended period, businesses feel the pinch. Add to this the large amount of US corporate fixed-rate debt coming due in the next couple years and banks and other traditional lenders getting cold feet, among other factors, and many businesses will be left vulnerable. Some are rolling over debt early, even at higher rates, to avoid potentially not being able to do so at all later on. Costs for high-yield borrowers are hovering near 9%. For investors, the risk focus has shifted from the rising cost of capital to refinancing, period. Year to date, total US corporate bankruptcies have been at their highest level since 2010. The pace of defaults is expected to continue if not increase in 2023 and 2024 due to the lagged impacts of higher rates, slower economic growth, and inflation. This is not “business as usual.” Investors’ risk appetite has also changed. While they may have felt compelled to venture further out on the risk continuum to capture yield, as the risk-free rate has increased, investors have less need to do so. The tumult in the US regional banking sector, with the March collapse of Silicon Valley Bank and Signature Bank and the failure of First Republic in May, has cast a pall over lending. A recent report on US economic activity showed a slowdown in job growth and a near-term deterioration of business prospects. Where does that leave asset allocation in public and private credit? Rising rates have pushed bond prices down. Notwithstanding the ongoing love affair with private debt, there is an overlooked and growing opportunity set in the public debt markets that appears mispriced relative to risk and return. In 2020 and 2021, public and private debt was priced at par (or above) with private debt offering a liquidity premium in the form of a fat coupon. Today, the situation is different, with the edge going to the public markets. There are several reasons for this. In the public debt market: Pricing is determined in the open market and adjusted to changing market conditions. There is greater price transparency. This brings more price volatility and more opportunities to acquire assets below par to increase the margin of safety. Greater liquidity makes exiting a position easier should the risk/reward balance change or a better prospect for deploying capital develop. Companies that issue public bonds have proven their business models in the market. There is greater diversification of bonds in the public markets. Public debt has corrected more than private debt in the rising interest rate environment. In every economic cycle, some businesses with solid growth profiles will nevertheless carry some debt. For example, starting in 2015, the energy sector was severely stressed while other areas — hospitality, for example — were not. In 2020, amid peak COVID, hotels, movie theaters, and automobile rental services were struggling, but bakeries were doing fine. At some point, the prices in stressed sectors fell far enough that investors were compensated for the risk. Selective investors could find companies with high quality assets and strong competitive advantages. The occasional price volatility in publicly traded bonds offers the potential to exploit mispricing. In the four previous default cycles, the average drawdown of lower-rated high yield was about 30% and the average recovery approximately 80% over the ensuing two years. With the high-yield bond market down roughly 18% in 2022, investors are beginning to see good opportunities developing in the eventual recovery in lower quality credits. Investors looking to diversify their portfolios and take advantage of the valuation gap between public and private bonds should consider an allocation to public credits. Among an assortment of small to mid-sized companies lies an attractive risk-reward proposition. Due to their size, these companies experience greater capital scarcity and investors face lower competition from other capital providers. Further, as credit conditions remain tight and refinancing costs increase, more quality businesses will need to raise capital. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author(s). 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: ©Getty Images / Tatomm Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

Public pension funds allocate on average 30% of their assets to expensive alternative investments and as a result have underperformed passive index benchmarks by 1.2% per year since the Global Financial Crisis of 2008 (GFC). Large endowments, which allocate twice as much on average to alternatives, underperformed passive index benchmarks by 2.2% per year since the GFC. These unfortunate results typically get little attention because the overseers of public pension funds and endowments often use performance benchmarks of their own devising that give an unduly favorable impression of performance. They should use passively investable benchmarks that reflect the funds’ average market exposures and risks over time. Their “custom” benchmarks are complex, opaque combinations of indexes, often nebulous and invariably subjective in their design, that lower the bar by 1.4 to 1.7 percentage points per year compared to simple, sound index benchmarks.[1] In this post, I examine institutional investment performance from a different perspective. My focus is on whether institutions are meeting their investment goals. For public pension funds, I compare industrywide returns with the average actuarial earnings assumption prevailing since the GFC. For endowments, I compare the return earned by NACUBO’s large-fund cohort to a common goal for colleges and universities. That goal is to enjoy a typical rate of spending from the endowment, increasing over time at the rate of price inflation. In both cases, I seek to determine whether institutions have met their earnings objectives, rather than how well they have performed relative to market benchmarks.[2] Public pension plans generate public liabilities. Actuaries for the plans estimate the value of those liabilities and prescribe an amount of annual contribution that would eventually lead to funding the liabilities. Their work includes identifying an earnings rate on invested funds that makes the pension funding math work over the long run. Public pension trustees often state that their top investment priority is to achieve the actuarial earnings assumption. Doing this affords them peace of mind that they are doing their part to see that pension liabilities do not go unmet. The Center for Retirement Research at Boston College reports the average actuarial earnings assumption of large pension plans. That figure averages 7.4% per year between fiscal years 2008 and 2023. Colleges and universities typically seek to spend a sustainable percentage of their endowment fund in support of the institutional program. Spending percentages vary among schools and over time, recently averaging 4.5% of endowment value among large endowments, according to NACUBO. The cost of conducting higher education has risen faster than consumer prices historically. Accordingly, a separate measure of price inflation, the Higher Education Price Index (HEPI), is typically used to estimate cost increases for colleges and universities. Taken together, a target spending rate plus inflation (as measured by HEPI) is often used as an indication of the endowment earnings requirement. “HEPI + 4.5%” has amounted to 7.0% per year since fiscal year 2008. Investment Policy Choices Investment overseers have an important choice to make when establishing investment policy. They can use index funds (at next to no cost) in proportions compatible with their risk tolerance and taste for international diversification. Alternatively, they can use active managers — including for alternative assets — deemed to be exceptionally skillful in the hope of garnering a greater return than available through passive investment. If it chooses index funds, the institution relies on theory and evidence regarding the merit of active and places its trust in the capital markets to generate sufficient returns to meet financial requirements. If it chooses active management, the institution bets that markets are meaningfully inefficient, and that the institution would be among the minority of active investors that can exploit presumed market inefficiency. And most try to do so with inefficient, clumsy, diversification: many institutions use 100 or more active managers jumbled together. Active versus passive is the most important investment policy choice institutions face in determining how to meet their financial requirements. In recent decades, institutions have opted overwhelmingly for active management, with particular emphasis on private-market assets. How well has the active strategy served institutions during the 15 years since the GFC? As with most studies of this type, the results are sensitive to the period selected. I believe the post-GFC era offers a fair representation of circumstances having a bearing on the evaluation of investment strategy.[3] Exhibit 1 analyzes rates of return for public pension funds and large school endowments from fiscal year 2008 to fiscal year 2023. The return objective in the case of public pension funds is the actuarial earnings assumption described above. For the endowments, it is HEPI + 4.5%. The “actual return” for public pensions is that of an equal-weighted composite of 54 large funds. The “actual return” for the endowments is that of the NACUBO large fund cohort composite. In both cases, the indexed strategy is a combination of indexes with the same market exposures and risks as their respective composites — a kind of best-fitting, hybrid market index.[4] Both types of institutions failed to meet their institutional investment objectives since the GFC: public funds fell short by 1.3 percentage points per year, and endowments fell short by 0.6 of a percentage point. The indexed strategy, however, essentially met the public plan requirement and handily outpaced that of the endowments. Exhibit 1. Actual Returns and Indexed Strategy vs. Objectives2008–2023.   Public Endowment Return Objective 7.4% 7.0% Actual Return 6.1 6.4 Indexed Strategy Return 7.3 8.7 Exhibits 2 and 3 illustrate the results graphically. The investment objective in both cases is represented by the horizontal line with the constant value of 1.00. The other lines represent cumulative earnings for the active and passive strategies relative to the objective. For both types of institutions, the low-cost indexed strategies generated sufficient earnings to meet the objective. In neither case, however, did the actual active strategies do so. Their high cost of investing proved to be too great a drain. Exhibit 2. Public Funds: Investment Returns vs. Actuarial Earnings Assumption. Exhibit 3. Large Endowments: Investment

Last year was humbling for economists and investment strategists alike. It began with an “imminent” recession and ended with equity markets near all-time highs. Historic rate hikes fueled a compelling narrative that, at best, anticipated both a weak economy and disappointing returns. To be sure, legitimate concerns underpinned this narrative. Post-COVID-19, amid resurgent inflation, the world was still emerging from an era of “unprecedented everything.” But the inherent pressure to take a stance on the economic trajectory led many investors to find comfort in collective concern and embrace the prevailing storyline. For many investors, human nature took the wheel. So, what can we learn from this scenario? Investors crave a compelling, rational narrative. Economic data, which is more detailed and accessible than ever, helps us paint those narratives. But with great amounts of data comes great responsibility. We not only have to keep our convictions, goals, and time horizons in perspective; we must also remember that the economy and financial markets are not the same thing. That is easy to forget. In the rational, well-ordered world of economic theory, various pieces of economic data fit together like a puzzle that visualizes the ever-evolving interplay between businesses, consumers, investors, governments, and central banks. Of course, in reality, these pieces of data are often lagged and revised and have varying and evolving impacts on financial markets. Moreover, this data is often cherry picked for clickbait headlines and political talking points. And with economic projections shifting with the wind, investors struggle to identify clear, actionable insights. So, what are we to do? The economy deserves its fair share of attention, but we shouldn’t let it steal the spotlight. The financial markets themselves provide considerable insight. Here are five questions to ask to better understand the markets without having to speculate about the larger economy: 1. How Has Market Composition Evolved? What forces are working beneath the surface and churning the financial markets? How concentrated are market-cap-weighted indexes? How have sector weights adjusted over time? Which stocks are newly listed or jumping across the market-cap and style spectrums? To understand the recipe, we have to understand the ingredients. 2. Which Companies Are Contributing the Earnings? Are the markets giving credit where it is due? Comparing a stock’s earnings weight with that of its market cap indicates what is moving the stock and whether that movement is temporary or sustainable over the long term. Closer examination of earnings trends across sectors, sizes, and factors offers critical context that surface-level data simply doesn’t. 3. Which Stocks Are Contributing the Returns? Stock prices reflect collectively evolving opinions. What are investors rewarding? Fundamentals? Narratives? Narrow or broader segments of the market? Does a 360-degree analysis support these returns into the future? Last year presented quite the riddle for investors. The “Magnificent Seven” lifted the S&P 500 for most of the year. But should we always count on a handful of players to carry the team? Proactive risk management requires that we understand the source of our returns. 4. What Are the “Fundamental Technicals” Saying? Just as doctors render their diagnoses after batteries of tests and exams, so too must investors. A cursory examination of market data is not enough context. We need to know what’s going on beneath the surface. “Fundamental technicals” are critical gauges of the underlying health of financial markets. They measure what’s really going on under the hood. Market breadth, relative strength, put–call ratios, equal-weighted indexes, and volume, among other metrics, can shed light on risks and opportunities alike. 5. Where Are the Asset Flows Going? Expressing a view of the market is one thing, but committing actual investment capital to that thesis is quite another. Do we have the courage of our convictions? Asset flows measure consensus as well as the extremes and outliers. They reflect real choices with real consequences. From a behavioral perspective, the sentiments they uncover can be both entertaining and insightful. Conclusion The economy matters, but it matters differently to different investors depending on their distinct objectives, timelines, and asset allocation. And it’s not the only thing that matters. As humans, we have an innate tendency toward groupthink. The more we follow the headlines, the more our own perceptions will correlate with them and lure us away from our investment process right at the moment when sticking to it matters most. Ultimately, we must exercise the discipline to convert our analysis into actionable insight. We have to relentlessly ask ourselves, “What does this mean in the context of my strategy?” If you liked this post, don’t forget to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center. 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. The opinions expressed are those of John W. Moore, CFA, CAIA, as of the date stated on this article and are subject to change. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Image credit: ©Getty Images / Peter Hansen Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

Default: The Landmark Court Battle over Argentina’s $100 Billion Debt Restructuring. 2024. Gregory Makoff. University of Georgetown Press. In his autobiography, preeminent financier William R. Rhodes notes a phrase inscribed on the gold Cross pen used by Nicaraguan authorities to sign off on their 1980s debt restructuring with private creditors: “Firmar me harás. Pagar jamás.” The phrase translates to “You can make me sign, but you’ll never make me pay” — a prescient warning that proved true. Gregory Makoff continues in the tradition of Rhodes with his book Default: The Landmark Court Battle over Argentina’s $100 Billion Debt Restructuring. He has penned the authoritative take on the most important debt restructuring (other than Greece) in the history of global finance. A physicist by training, Makoff worked as a banker for more than two decades, advising developing nations on debt management policy. He then moved on to scholarly pursuits at the Centre for International Governance Innovation and at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School. Perhaps it took the transactional experience of a banker, combined with a physicist’s training to derive complexity, to establish this historical narrative for posterity. Argentina’s debt restructuring tests the theoretical limits of chaos theory. As Henri Poincaré famously noted, “An accumulation of facts is no more a science than a heap of stones is a house.” Makoff’s feat is to build his narrative as a thriller without losing the detailed facts valued by specialists. I read the book in 48 hours. Readers will inevitably develop empathy for Judge Thomas Griesa, who serves as a central actor in his role overseeing the case for the US District Court for the Southern District of New York. Griesa ultimately broke through a decade of “uniquely recalcitrant” behavior from Argentina with a legal interpretation that prevented Argentina from paying interest on new bonds before settling amounts owed to holdout creditors from its earlier debt restructuring. The author avoids a simplified hero-versus-villain narrative. Makoff demonstrates how court cases were steered by rationalized self-interest on both sides and deterministic properties governed by the initial conditions of international lending agreements. Given this pragmatic and apolitical approach, investors, scholars, and policymakers alike will find value in Default. For investors, Makoff provides a healthy reminder to read the terms of one’s bond documentation. Only by understanding the lessons of history can investors navigate the current generation of sovereign debt distress. The author explains how the regrettable decision to not include exit consents in the original debt restructuring allowed some minority creditors to engage in an eventually successful holdout strategy. For students and professors, Makoff sticks the landing in authoring both a scholarly and practical history. Much ink has been spilt in academic circles on how sovereign debt markets work in theory. It took a practitioner like Makoff to explain how the world is rather than how it is supposed to be. For policymakers, this historical narrative is well timed as newly contemplated reforms are being reviewed in both multilateral (Global Sovereign Debt Roundtable) and legislative (proposed legislation in New York state) forums. The international bond market can be a positive force in developing economics, allowing countries to navigate from their present to their future by pulling forward investment. As scholar Barry Eichengreen reminds us, however, sovereign debt is a “Janus-faced” asset class. If mismanaged, sovereign borrowing can lead to default and an arduous process to manage through an evolving debt resolution architecture (sovereign nations cannot file for bankruptcy). Default is ultimately an origin story for enhanced collective action clauses (CACs), a modernization of international lending agreements that bind majority agreements for debt restructuring onto the minority. This approach prevents a repeat of the contentious holdout creditor dynamic in Makoff’s Argentina saga. As the US Court of Appeals for the Second Circuit stated in its review of Judge Griesa’s ruling, “It is highly unlikely that in the future sovereigns will find themselves in Argentina’s predicament.” Thanks to CACs, one can hope this will be the last book that is necessary to describe a decade-long debt restructuring. If you liked this post, don’t forget to subscribe to the Enterprising Investor. 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: ©Getty Images / Ascent / PKS Media Inc. Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source