de·riv·a·tive – something that is based on another source.
an arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset.
One of the noteworthy attitudes of most sovereign countries is they want to control their own destiny. On an individual scale, people typically make it a priority to act in their personal interest, which is usually tied to controlling their activities. As an example of this in the business world, good risk management for companies means not having a dependency on one supplier, customer, financing source, key employee, or business division for profitability. So there is this common idea of being the master of ones destiny across any number of disciplines. Conversely, there is the important idea of derivation, which is applicable in many ways as well. If you are a sports fan of a particular team, you might derive pleasure or happiness when that team wins a game or a championship. Politically, if you belong to a specific party, it might make you pleased when that party wins important elections on the national, state, or local level. In the financial world, as seen from the above definition, derivatives are often thought of as instruments which are based on something else, which can be an asset, a royalty stream, the weather, or any number of things you may have not imagined. Derivatives are often seen as an effective tool for risk managers because they can be used to protect the downside of an asset. For example, if you have borrowed quite a bit of money using a variable rate instrument, that can be swapped into a fixed rate, and vice versa. Bond traders often use futures as a way to protect against interest rate volatility. Still, my focus always revolves around equities, so naturally we have to add our two cents as to why derivation is important to think about in that area, too.
When I was in college, the first math course I took was calculus, and I probably was not ready for it at the time. Later, when taking it in graduate school, no problem as I nailed it, so from a maturity standpoint, some of that might have been related to my approach. Calculus involves learning about derivatives and plugging in one answer to find another answer, so you have to get the first problem right to give yourself any chance to get the entire problem correct. Many investors say, I don’t quite understand how the stock market works? When considering stocks, and options for that matter, they are simply derivatives in that how they perform is a function of the business performance of that specific company. I, like many investors, believe if you pay too much for any business by buying a stock at an elevated price, you will have poor results. However, what you find is over a long period of time, a stock is going to depend on it’s specific business results, which is where the famous comment by Buffet comes in about voting machines and weighing machines. Options are just the second derivative of a stock’s business results, but tied to different time frames and price points. The option price is based on the underlying asset, the stock, which is based on its business performance. Hence the the term, second derivative. At the time I took my first calculus class, I never would have imagined how important learning those ideas would eventually become in my little world. Anyway, when you look at your individual stock holdings and how they perform, you might hearken back to your old calculus days in thinking about their ultimate outcomes.
Turning towards the capital markets, yesterday first quarter GDP came in at much better than expected 3.2% as inventory builds and government spending provided a boost. All week long, earnings reports were the focus as tech heavyweights Facebook, Amazon, Microsoft and Intel went three for four with Intel being the only downer. On a personal note, last week I was in Toronto and met with a CFO and we talked about the fact that if you are a smaller company, it is hard to get attention even if you are a high quality entity. When Amazon grows at 17%, Microsoft similarly, and Facebook at plus 20% (revenues), with those companies being in excess of 50 billion dollars, why would an institutional investor take a chance on a company that grows at the same rate? The answer is they won’t, and it is one reason why stock performance has been concentrated in the big boys for quite some time. Keep in mind, these heavyweights have been posting revenue growth higher than what they did last week. So, maybe the little guys have more of a chance for attention, but they better be growing quite quickly to give themselves a look. In the oil world, Exxon and Chevron had disappointing results because of poor refining margins due to higher Canadian crude prices and infrastructure bottlenecks. Anadarko received a higher bid for its company (valuable Permian basis acreage) from Occidental, so the question becomes how will this play out as a prior offer by Chevron’s was accepted from Anadarko.
In the circus that remains US politics, the big news was Joe Biden officially declared and was immediately given access to New York Governor Andrew Cuomo’s donor base. Elizabeth Warren made a stir by coming up with a proposal to forgive plenty of student debt (over a trillion dollars worth) by taxing those with assets of over $50 million. I wonder about the concept of a government helping students over many generations through the use of student loans, which have helped many people advance their intellectual capital and achieve their professional aspirations, and then forgiving those loans because a politician finds attractive as a strategy to attract votes. It is similar to the concept Mr. Obama used with free phones and other incentives to help him, shall we say, attain the throne. Looked at it differently, what about those that have paid off their loans, or other citizens whose tax revenues help fund those loans. Is there any sense of fairness to those individuals? Or what about the easy target, those with plenty of assets who assume a higher tax burden? If one examines tax revenues and the United States, the highest earners are paying the vast majority of all taxes collected. Maybe at some point Mrs. Warren or AOC would just suggest to tax those people at 100% rates, or just start confiscating their property, kind of what has been proposed in South Africa with land expropriation. It will be interesting to see what the Democratic party elects to adopt as their platform and who the candidate will be to lead them in 2020. Finally, last week I skipped the blog for the first time in ten years, and I am sorry I did not let you know. Perhaps my derivation of pleasure from writing it waned a tad.
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Yale Bock, Y H & C Investments, its clients, and the family of Yale Bock have positions in the securities mentioned in the blog, Investing in securities involves risk and the potential loss of ones principal. Past performance is no guarantee of future results. All investment decisions should be considered with respect to ones risk tolerance, return objectives, liquidity needs, tax considerations, and one’s overall financial situation. The fact that Yale Bock has earned the right to use the Chartered Financial Analyst in no way means or guarantee performance better than market indexes.