30th September 2010: Corporate Finance and Investment 101

DangerousMinds.net‘s Richard Metzger recently commented on U.S. wealth disparity. I noted to Richard that reading CFA Institute material on investment and wealth management was like stepping into one of Robert Anton Wilson‘s reality tunnels: it’s a different way of seeing financial realities.

Here’s some of the advice I reflected on in an email to Richard:

1. In approaching a new field or skill consider an overview and/or intellectual history. Burton Malkiel’s (Wikipedia entry; Princeton homepage) A Random Walk Down Wall Street (W.W. Norton & Co., New York, 2007) remains an influential, multi-edition guide to Wall Street, investment, fundamental versus technical analysis and mutual funds. The late Peter Bernstein covered the intellectual history of corporate finance and investment in several books: Against The Gods (John Wiley & Sons, Hoboken NJ, 1998) on risk management; the revised edition of Capital Ideas (John Wiley & Sons, Hoboken NJ, 2005) on asset pricing and risk-return models such as the capital asset pricing model; and Capital Ideas Evolving (John Wiley & Sons, Hoboken NJ, 2009) on the past decade’s developments for derivatives and investment funds. Throw in a behavioural finance book by Robert Shiller (Wikipedia entry; Yale homepage) or an essay by Nassim Nicholas Taleb (Wikipedia entry; homepage) on high-impact low-probability events and uncertainty, and you’ll have the basic concepts and context. The intellectual history will often provide you with an innovation pathway of ideation-to-market and the barriers and challenges that were overcome. It also highlights how differences in moral philosophy and risk-seeking versus risk-aversive behaviour can shape the biases and decisions of financiers and investors.

Investigative journalists such as Philip Augar, Connie Bruck, Bryan Burrough, William D. Cohan, Charles D. Ellis, Roger Lowenstein, Andrew Ross Sorkin, Alice Schroeder, James B. Stewart and Gillian Tett have also covered this in their reportage about the 1980s boom in leveraged buyouts, and the 2007-09 global financial crisis. Their reportage is anecdote rich with an eye for the little details about how investment fund managers, corporate financiers, policymakers and financial institutions and intermediaries actually work. As I observed in 2009 with Barry Saunders: many of these investigative journalists had corporate finance and investment experience (conference paper and presentation slides).

2. Isolate the particular skills you want to know and actively use the best resources to cultivate them. Yale’s David Swensen offers solid advice about personal investment in his book Unconventional Success: A Fundamental Approach to Personal Investment (The Free Press, New York, 2005). Malkiel’s Random Walk above popularised index funds: low-cost funds that track a stockmarket index or sector. Hedge fund manager David Einhorn explains his research process in Fooling Some of the People All of the Time (John Wiley & Sons, Hoboken NJ, 2008). The reportage above will still remain current — even when it deals with events from 20 or 30 years ago — for several reasons. Investigative journalists with a background in corporate finance and investment will have access to skilled individuals and be able to observe them. They will also spend an ‘immersive’ time period — 8 months for a ‘crisis’ story to 3-5 years in some cases — exploring specific contexts from multiple perspectives, background interviews, and historical records. It’s a small price to pay — in terms of time and money — to access their reflective expertise.

3. You don’t necessarily have to go to college. If you can get into an MBA, finance, investment or mathematical finance course at Yale, Chicago, Insead, Harvard Business School, London Business School or Cass then by all means go. If not, you can still learn a lot from Shiller’s Yale course on financial markets which features Swensen and ‘corporate raider’ Carl Icahn as guests, or Aswath Damodaran’s course on valuation. Damodaran’s NYU Stern homepage features a wealth of pre-publication book excerpts, Excel spreadsheets, and lecture recordings.

If you want to learn Microsoft Excel and finance then most courses combine Damodaran’s third edition of Applied Corporate Finance (John Wiley & Sons, Hoboken NJ, 2010) with a Simon Benninga textbook. Carol Alexander‘s four volume Market Risk Analysis (John Wiley & Sons, Hoboken NJ, 2009) and Satyajit Das’ four volume Swaps and Financial Derivatives Library (John Wiley & Sons, Hoboken NJ, 2006) are both ‘standard’ shelf texts for capital/financial market practitioners, and are for advanced research purposes. There is also a lot of good, free material:  MIT’s OpenCourseWare has a wealth of lecture slides on many topics and other universities are following this initiative with their own OCW sites or posting lecture recordings to Apple’s iTunesU and @Google Talk’s YouTube channel.

Increasingly, colleges rely on similar textbooks: derivatives courses often feature competing textbooks by Don M. Chance and John Hull, for example. Or they begin with a introductory guide like Bernstein, Malkiel or Shiller above and then build up to the more advanced material via a subject matter expert like Swensen or a skills-based approach. Textbooks’ tone may also change dramatically: Donald M. Chew’s third edition of The New Corporate Finance (McGraw-Hill, New York, 2000) still retained the Gordon Gekko-style focus on derivatives and leveraged buyouts of its earlier editions, whilst Chew, Joel Stern and Lisa Jacobs’ fourth edition The Revolution in Corporate Finance (Wiley-Blackwell, New York, 2003) reflected the surge of post-Enron interest in corporate finance and growth in international equities markets. In some ways Chew’s even earlier editions are a more Machiavellian and Thucydidean reflection of their time and thus also interesting for Gekko fans, historians and sociologists.

The key isn’t to buy a lot of books: it’s the ‘bootstrap’ process and pathway to return on capital employed. (Diversifiable income streams such as licensing and protected intellectual property are a separate issue).

For a couple of hundred dollars or less you can cover the overview/history of an area and a college level textbook, and either augment or replace this with the free material above. (Textbooks are expensive so you’re really buying the subject matter expert’s view and the ‘screening’ value of a publisher’s editorial team.) If your investment strategy involves ‘passive’ index funds, equities and bonds then you may find all of the information you need online or in a community/university library and a low-cost provider like Vanguard. For a couple of hundred dollars more you can get the advanced practitioner material to begin your own experiments with the much-maligned derivatives, securitisation, experimental economics and market risk tools. Start with Excel and VBA, add a software license for a  developmental platform like Palisade or Matlab and you have ‘inhouse’ quantitative finance capabilities. This can be expensive at several thousand dollars and the software is probably worth only the time and money involved if you want to become an active investor, experiment with market microstructure models or to develop an algorithmic or high frequency trading capability for a fund.

My suggestions above doesn’t guarantee you success in the capital and financial markets: it’s difficult enough for the fund managers, market-makers and other finance professionals. Malkiel, Shiller, Swensen and others are appropriately skeptical of the dotcom era trend in ‘day-trading’: keep any risk capital separate from investment/superannuation funds and don’t over-trade. Also remember the time value of money and the trade-offs involved in any study or commitment to becoming familiar with a new area and acquiring skills.