3 ms·

"For example, what risk is a residential REIT taking, especially one whose properties are all insured? By contrast, you can look at a business like a casino (or

"For example, what risk is a residential REIT taking, especially one whose properties are all insured? By contrast, you can look at a business like a casino (or a catastrophe reinsurer), where it is legitimately the case that operating income is predominantly the result of risk-taking." If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors. FWIW, REITs face a lot of significant risks, eg. a regional downturn could lead to all the workers becoming unemployed and vacating or not paying rent, or a rise in interest rates could increase financing costs, or rent control might be enacted and prevent the property management from raising rents as much as financial models predict. And casinos are actually much less risky than assumed: most gambling games have statistical models for how much they pay out, and with millions of games played reality tends to approximate the models very closely (due to the central limit theorem), and they tend to take out insurance on extreme black swan events anyway. I don't know the ROICs on either of these industries in detail, but I suspect that if it's similar, it's because the actual risks to them are similar.

nwiswell 4y ago
> If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors. No, the return on an investment security (in this case, a share of publicly traded stock) is different from the return on a dollar actually invested in the underlying business (i.e., ROIC). This has a lot to do with the price action that you outline. The rest of your comment deals with why these are bad toy examples, which is fine but not really all that interesting in context.
- nostrademons 4y ago
  The security reflects how investors expect the ROIC of the underlying business to change over time, hence the "risk" aspect. They're forward looking over the life of the security's cash flows, while the company's financials now are a snapshot in time.
  - nwiswell 4y ago
    You're still confused. The EMH is understood to imply that securities prices are the NPV of future cash flows (or more specifically their best estimate, using all public information), but that has nothing to do with ROIC. (As an aside, the EMH is obviously false and you don't need to look any further than meme stocks for evidence, but anyway) For example, suppose you have two businesses, both of them have a future cash flow NPV of $1 billion. However, one of them was started in a garage with $1 million of angel money. The other one is a "fallen unicorn" that got $500 million of VC money before it finally IPOed. The ROIC of the first company is obviously going to be something like 500x the second, but this is irrelevant to their market caps, which should be the same in textbook-EMH-land, ceteris paribus.

nwiswell 4y ago

> If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors. No, the return on an investment security (in this case, a share of publicly traded stock) is different from the return on a dollar actually invested in the underlying business (i.e., ROIC). This has a lot to do with the price action that you outline. The rest of your comment deals with why these are bad toy examples, which is fine but not really all that interesting in context.

nostrademons 4y ago
The security reflects how investors expect the ROIC of the underlying business to change over time, hence the "risk" aspect. They're forward looking over the life of the security's cash flows, while the company's financials now are a snapshot in time.
- nwiswell 4y ago
  You're still confused. The EMH is understood to imply that securities prices are the NPV of future cash flows (or more specifically their best estimate, using all public information), but that has nothing to do with ROIC. (As an aside, the EMH is obviously false and you don't need to look any further than meme stocks for evidence, but anyway) For example, suppose you have two businesses, both of them have a future cash flow NPV of $1 billion. However, one of them was started in a garage with $1 million of angel money. The other one is a "fallen unicorn" that got $500 million of VC money before it finally IPOed. The ROIC of the first company is obviously going to be something like 500x the second, but this is irrelevant to their market caps, which should be the same in textbook-EMH-land, ceteris paribus.