Archive for Chartered Financial Analyst

Risk Aversion and Pricing Climate Risk

I felt the “Editor’s Corner” article in the most recent Financial Analysts Journal (Sept/Oct 2011) “Pricing Climate Change Risk Appropriately” does an excellent job explaining why the possibility of extreme climate scenarios justifies a considerably higher price for carbon than would be warranted under the most likely or average scenario: Humans are risk averse.

Equities… have low prices (and high expected returns) because their cash flows are discounted by society at high rates. The reason has to do with the anti-insurance aspect of equities: Their cash flows are highest in good states of nature whereby the value placed on the cash flows is low. In contrast, efforts to mitigate climate change by pricing carbon emissions will be most valuable to society if climate change turns out to have catastrophic consequences for society’s well-being. Because of this insurance aspect, society should be willing to pay higher prices for climate change mitigation.

FAJ Executive Editor Robert Litterman goes on to explain the mechanics behind carbon pricing models and their flaws, as well as why equity analysts are uniquely qualified to do these assessments.

I’ve long thought that financial market theory is uniquely applicable to understanding climate and the measures needed to mitigate climate change. what I don’t understand is why I hear so few analysts talking about it, so it was very refreshing to come across this article applying a deep understanding of economic pricing theory to what the greatest challenge the world will confront in the 21st century.

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Six more study tips for the CFA exam.

Although it was off-topic, probably my posting with the most long term staying-power was the 2008 article Six Tips For CFA Candidates

I just read another six study tips from the Finance Professional’s Post (published by NYSSA, the NY chapter of the CFA Institute), which focuses on study habits. Since I still have so much traffic even after 3 years, and the advice is good, I thought I’d share.

Here’s the link.

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CFA Level II Exam results: Two down, one to go

I passed the June 2007 Level II Chartered Financial Analyst Exam. As I said after I took it, this does not come as a surprise, but it’s nice not to have to wait any longer to find out. (it’s been 2 1/2 months since the exam… they like to take their time. )

So far, that makes me 2 for 2.

Pass rates for June 2007 were in line or slightly lower than recent years, although pass the pass rate for level 3 was at an all-time low.
40% for Level I
40% for Level II
50% for Level III

CFA Institure press release on pass rates
Pass rates since 1963 [pdf]

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Top Ten Reasons I’m Glad the second CFA® Exam is over

10. Free T-Shirt from Schweser (They were handing them out as we left the testing site.)

9. Got to use my short-cut for multi-stage dividend discount
model valuation problems. (I admit, I’m a math geek.)

8. Time to catch up on my reading.

7. Going vacation to Glacier National Park in 9 days (after the Colorado
Renewable Energy Conference

6.  More time to blog.

5. New ideas for articles.

4. I got some ideas on good arguments I intend to use that renewable energy
projects deserve to be evaluated at a lower discount rate in the next Least Cost
Plan at the Colorado Public Utilities Commission.

3. Don’t need to study for the next one ’til 2008.

2. Ethanol (not the type they put in cars.)

1. I think I passed (actual results don’t come out until August).

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A Hard Look at the Ethanol Industry

My weekly column for AltEnergyStocks again doubles as part of my study for the second CFA(R) exam.  The Equity valuation part of the curriculum contains a chapter by Michael Porter on analyzing competitive pressures in an industry.  I decided to apply it to the corn based Ethanol industry, and, as often is the case, it changed my way of thinking about the industry.  I’ve never been bullish, because I worry about a classic commodity squeeze: both ethanol and the main feedstock (corn) are commodities, and are subject to forces outside the industry which effect their prices.  For instance, if corn harvests were to be poor because of drought or pests, at the same time that oil prices fell, many ethanol producers would be forced out of business because their costs exceed their selling prices.

I also went on a little rant about the typical measures of Energy Payback and Energy Return on Energy Investment (ERoEI) often used in the industry.  These measures are often used to criticize ethanol, but it is a weak criticism, because they do not take into account the time value of energy: namely that a kWh of electricity today is a lot more useful than a kWh produced 30 years from now.  We should instead be thinking in terms not only of how much energy we have to use to get energy out, but also in terms of how soon we get that energy.

I propose a couple measures, of Energy Net Present Value (ENPV) and Energy Internal Rate of Return (EIRR) which I think would give us a clearer view of the undying energy economics (and hence the potential economic profitability) of various energy production technologies.  But that is a column for another week.

This week, here are my thoughts on competition in the corn Ethanol industry, and how it might affect your investments.

If you have a subscription, there’s also an excellent article in the NYTimes on ethanol in Hawaii.  I think it ties in well to this one, and the one I wrote last July about renewable energy in Maui.

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Where I find my Alpha

This week and next I’m taking a break from my usual analysis of some aspect of renewable energy. I’ve been studying hard for the second Chartered Financial Analyst® exam, and it has gotten me thinking about my investment philosphy. Why, do I, as a lone investment manager feel that I can beat the market, which essentially means making better judgements about stocks than all the other extremely bright an well funded people looking at the same stocks?

My answer is that large money managers are constrained by who they are: They have a lot of money, so they cannot effectively invest in small, thinly traded securities, and I also think that many institutions have a quantitative bias: they tend to use matematical models for valuing stocks. But mathematics has blind spots, and numbers cannot describe every truth about the world, or about companies, so I think that there is more potential for an individual to spot mispriced securities where the big managers can’t look: being a big fish in a little pond, as it were.

Here is Part I on “Beating the Market.”

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Stocks for High Waters

My AltEnergyStocks column this week is about preparing yourself financially for the possibility of rising sea levels due to global warming.

I’ve been rather gloom-and-doom recently, with this and my article from a fortnight ago about preparing for Peak Coal.

Let’s hope that I’m just moody because of all the studying I’m doing for the second CFA exam (which is why entries here have been short and far between.) I plan to get back in the swing of things in late June, after the exam, the Colorado Renewable Energy Conference (there will be a session on “Investing in Renewable Energy”, led by Yours Truly), and a vacation. My wife and I want to see Glacier National Park before it becomes The National Park Formerly Known as Glacier.

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Energy’s Place in Economic Theory

I recently started studying for the second (in a series of three) CFA® examinations (I passed the first one last June.)  The CFA charter is a credential often used by stock analysts and money managers.  In addition to an industry work requirement, there are 3 tests, which are administered once a year, covering a curriculum including Statistics, Economics, Financial Theory, Ethical standards, markets and the like.    

I expect to study about 200 hours for the exam, which is in June. By the way, if there is anyone reading this in Denver who also is studying for the Level II exam, I’d be interested in getting together to work through some of the problems and share study materials.

I just finished a reading on theories of economic growth, a chapter from Economics by Michael Parkin, which is probably one of the best basic Economics text books out there.  It’s been a long time since I took an Economics course, and so I had forgotten how economic growth theory is taught.   

I was disappointed. 

Why?  Because the role of energy use in labor productivity is almost completely ignored. (Labor productivity is simply the sum of all economic activity divided by the number of hours worked.  Since the number of hours worked is relatively easy to measure, growth in labor productivity is the key factor which needs to be understood in order to understand economic growth.)  All three theories covered attempt to explain labor productivity through the interaction of two factors: the ratio of capital to labor employed, and technological change.  As a short aside, the role of energy use is given a slight nod, because the drop in productivity growth in the United States in the 1970s is attributed to the Energy Price Shocks of ’73-4 and ’79-80, in addition to a diversion of effort for coping with environmental problems.  To me, that sounds eerily familiar.  Those are precisely the same problems I expect the world will be trying to cope with for the next decade and beyond.   It’s not that economists as a whole fail to recognize the role of energy use in keeping our economy going.  For example, the effects of the recent rise in energy prices have been widely discussed, and many pessimists (myself among them) have been surprised at how little effect rising energy prices have had on the economy.   The explanation for the lesser effect on economic growth is that our economy has become (partly as the result of the ‘70s price shocks) much more efficient, requiring less energy per unit of GDP. What bothers me is that energy is dealt with as an aside, not as one of the major factors in determining economic growth.  For most of the 20th century, we were blessed with energy supplies which we could increase at will to meet increasing demand, so supply constraints were seldom a factor in determining the growth rate.  In a sense, economist theory is like military strategy: there is too much emphasis on figuring out how to win yesterday’s battles, not tomorrow’s.  Tomorrow’s economic battles, as I see them, will be learning to cope with diminishing supplies of fossil fuels.  Economists, who are the ones who will be helping society plan those battles, should be taught the role of energy in economic growth as part of their framework of understanding, not as an aside or afterthought.  This brings to mind the other aside in the chapter: The other cause given for the slowing of productivity growth in the 1970s was due to the expansion of laws and resources devoted to protecting the environment.  This is perhaps a graver weakness of economic dogma than the minor role for energy.  Because we measure only economic growth, and do not count natural resources like clean air and water among our assets, destruction of those assets is much more likely to be overlooked or minimized by policy makers than it would be otherwise.   This concept is known as Green GDP, and is still very much a fringe theory in economics, in large part because it is fiendishly tricky to measure accurately.  Unfortunately, what isn’t measured is usually ignored, and, like the unmeasured risk of terrorists flying airplanes in to skyscrapers, is likely to come back to haunt us in time.

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