May 8, 2011

What I Have Learned

What I Have Learned: "

An investment program or a trading system must be specifically tailored to each and every individual. Risk tolerances, return targets and cash flow needs are critical in structuring a program of capital allocation for investors. All programs and systems are unique based upon our own biases and requirements.


I do believe, however, that there are broad-based investing maxims that can assist individuals in navigating the financial markets. These are the investment maxims I follow.


Human nature never changes.


My favourite investment quote is from Jesse Livermore who said


Wall Street never changes. The pockets change, the suckers change, the stocks change but Wall Street never changes because human nature never changes.


Knowing human behavior is a critical to successful investing. It does not matter if one is trading short-term or investing long-term, any trade or investment is an explicit or implicit bet on human behavior.


Understand history.


History is a guide. It is a road-map to the future. It does not predict what is going to happen exactly because structural shifts occur, but the forces of economic history shift slowly over time. I first read Reminiscences of a Stock Operator in 1998, and I was amazed at how accurately Livermore (through Edwin Lefevre) was describing our time. In the same way that officers are taught military history to understand the mistakes of past battles and the evolution of strategy, investors should understand financial history to understand the mistakes and context of financial markets. Mark Twain said history doesn’t repeat itself, but it rhymes. Karl Marx said history repeats itself, first as tragedy than as farce. Twain and Marx could have been talking about financial markets.


Hubris kills.


The words I cringe the most upon hearing are "can't" and "won't." When people say something "can't" or "won't" happen as it pertains to investments, I become very wary. In investing, anything can happen. Do not think in certainties. Think in probabilities. Banish the words "can't" and "won't happen" from your investing vocabulary. People with a high degree of certainty about the future are the ones most likely to get wiped out. Confidence is good. Hubris is not.


Most people cannot invest successfully. You are probably one of them.


You are hardwired to fail at investing. Literally. Your brain and neurological system are wired in such a way to separate you from your money. It is why your feel euphoric when your stocks are rising and why you feel revulsion when your stocks are falling. It is why you feel you have to buy something when it appears to be running away from you, and why you feel fearful when stocks are falling. Learning to deal with your natural instincts may be the single most important aspect to investing success. Fortunately, there have been significant advances in understanding behavioral finance and neuroeconomics over the past decade. I have listed books on the subject in my book log. Read those books ASAP.


This is not a part-time job.


It is difficult to do well investing and trading over the long-run without being dedicated to it. It is difficult to invest profitably by dedicating a half hour of study in the evening. Investing and trading is not a hobby. Investing is a profession, a craft, a systematic pursuit. If you are not willing to put the time and resources needed to be successful, you should not do this yourself. Pay someone else who does this for a living to invest for you. Or give the professional most of your money and invest in small amount yourself.


Protect your capital.


You cannot play the game if you have nothing to play with. For an investor, that means buying a stock with a significant margin of safety. For a trader, that means cutting your losses quickly. An investor can average down if they have purchased a stock with a significant margin of safety, a trader cannot. A trader must cut his losses. An investor must be certain there is a margin of safety in his investment. Otherwise, capital could become permanently impaired.


Be patient. You do not always have to be involved.


I am an impatient person. I do not like waiting for a minute. I get bored easily and want to do something. Plus, I am greedy and feel that if I am not doing something, I am not accomplishing anything. But this works against me. Patience is a virtue when investing. I have found that I have done really well being patient, and I do much less well being impatient. You do not always have to be involved. Sometimes it is best to just step aside and not buy or sell anything.


Do not invest or trade something you do not understand.


Is this not obvious? You do not need to know Microsoft’s code to invest in Microsoft, but you should know what Microsoft does. If you are trading symbols, know your process cold.


Have a process and keep an open mind.


All great investors and traders have a process. Some great investors are great visionaries with nerves of steel. Some great traders flit in and out of markets successfully. However, all have a process. Different processes are often a function of differing emotional temperament and intellectual curiosity. Everyone is different and different processes will appeal to different people. But the important thing is to have a process. Your process will evolve over time. You will not do things perfectly. Thus, keep an open mind on what works for you and what does not. If there is a weakness in your process, be willing to change it.


Process and strategy are a function of time.


Whether a trade or investment is right or wrong is often a function of time. I both trade and invest. When I trade, I look out a few months. When I invest, I look out a few years. How each strategy plays out is dependent upon time. In the short-term, what matters most is momentum. In the long-term, what matters most is economics. In the short-term, news flow, sentiment and emotion are all the matters. In the long-term, what you pay for a stock relative to the long-term prospects for a stock is all that matters. If you are an investor, the crowd is usually wrong in the long-run. If you are a trader, the crowd is usually right in the short-run.


Time frames matter.


Wall Street tells its retail clientele that stocks are for the long-run. This is true, over generations. If you start methodically and systemically investing in stocks when you are 20 or 25 years of age, you can weather the volatility of the market and buy at almost any valuation and end up with a nice nest egg when you retire. But this is not necessarily true for most people. Most people do not start saving significantly until their mid-40s or later. If someone starts a saving plan at 45 with the goal of retiring at 65, plowing money into the stock market expecting to earn the historical return to equities of 10%, the results can be devastating if stocks bought at the wrong valuation. A 10% annual return over 10 years equates to a 159% gain compounded. But the US stock market has declined since the beginning of 2000. For the 55 year-old who started investing in stocks a decade ago, this is a huge hole in his retirement account compared to what he expected.


Do not base your actions on the opinions of others.


There are a lot of smart people doing stupid things in the world. Simply because someone sounds smart does not mean they are necessarily correct. I can remember just starting out as a portfolio manager, reading an extensive industry analysis by a well-respected Wall Street analyst, thinking “That doesn’t make sense.” I liked the thesis but could not get around this aspect regarding inventory that kept nagging me which the analyst had brushed off. I thought “Well, he knows more than I do,” and invested despite my reservation because everything else sounded good. Turns out, I was dead right, and I lost money because I trusted someone else's argument rather than my own instincts.


Take more risk when you are younger. Take less risk as you get older.


When you are younger, you rely primarily on income from your job. When you are older, you rely primarily on income from savings. Thus, you can take more risk with your savings when you are younger and less risk when you are older. When you are older, a sustained dip in the value of your savings can significantly alter your lifestyle. Thus, your primary goal should be to avoid losses. Conversely, a mistake many young people make is not taking enough risk. The corollary in investing is that, over time, higher risk means higher returns. Since younger people have more time before needing to draw on retirement savings, they should take more risk, and vice-versa.


Risk is however you define it.


Risk is usually defined in two ways – volatility and loss of capital. Academics, quantitative investors and consultants tend to define risk solely as volatility. Investors, usually value investors, tend to define risk solely as the loss of capital, particularly the permanent loss of capital. In truth, the answer depends upon your own circumstances. Some people do not want to see their capital fall, ever. To them, they do not care if an investment they purchased is worth 60 cents on the dollar that falls to 30 cents on the dollar. They care that it fell, period. To someone living off savings, volatility can be devastating, given that a fall in savings means relatively more capital is drawn down when savings are being tapped. This same affect occurs with an endowment or a pension fund that is required to disburse funds at periodic intervals, whereby volatility in itself can result in the permanent loss of capital to the fund. However, if one does not need to draw on capital for an extended period of time, and one has the fortitude to withstand the ups and downs in the market, volatility is irrelevant, and the only thing that matters is the permanent loss of capital.


The only thing that matters is how much money you make. Or, the only thing that matters is how much risk you take.


We do not trade nor invest to test dogmatic philosophies. We trade and invest to make money. In the end, what matters is the size of your account. Having the most logical or most elegant system means nothing if you cannot make money from it. Making money, however, is a matter of taking risk. Over time, the more risk you take, the more money you will make. At times, you want to take lots of risk, at other times, you want to take no risk at all. Understanding your risk profile and managing risk is perhaps the most important aspect of all in money management.


The only (other) thing that matters is price.


You invest and trade to make money. You should not invest or trade for any other reason. For example, you do not invest or trade a stock because it is a great company. I do not know how many times I have heard an investor say that they were investing in a stock because it was a great company. Cisco was a great company in 2000 when it was trading at 118x earnings. It was a great company when it was trading at 7x earnings. Investors who bought at 118x earnings lost 90% of their money top to bottom. A great company can make you great losses if you buy at the wrong price. For traders, if the price is working against you, get out! Get out now! If the price action is poor, the market is telling you are wrong. In the short-term, arguing against the market is a losing proposition. Do not do it.


Focus on what is going to happen, not what has happened.


This may sound trite but investors are often focused on what has already happened, not what is going to happen. People want to focus on what has made them money in the past. Nobody cared about homebuilders before the housing bubble, but you still see a disproportionate amount of commentary on homebuilders today, even though they have been crushed. After the tech bubble collapsed, investors focused on tech stocks for years and ignored, at least initially, basic materials and industrial stocks. And when the bull market inevitably ends in commodities, investors will focus on commodities for years afterwards.


Do not ignore the macro environment.


One does not have to be a macro trader to understand that the macro environment matters. Self-avowed stock pickers often brush aside macro issues, stating that no one can forecast the economy so you should not pay attention to the macro economy but instead focus on valuation and quality of the company. However, if one looked at the banks in 2006, one would have seen many great companies with stocks that appeared reasonably valued. But the edifice upon which the banks had built their businesses was dependent upon housing prices. Having a view on the banks meant having a view on housing prices. If one was bearish on the banks, one was bearish on housing prices and the concurrent collapse of the financial system, which was a macro call. The KBW Bank Index (the BKX) fell 86% peak to trough, which was greater than the Nasdaq’s decline of 78% after the collapse of the Tech Bubble. High quality banks like Wells Fargo and US Bancorp fell 75% or more. Yes, they have recovered, due in large part to government largesse - a political call even more disconnected from individual company fundamentals - but the volatility has been enormous, and most bank stocks have returned nothing over the past seven years.


It is much easier to make money in a bull market than a bear market.


It should be obvious that it is much easier to make money in a market that goes up 200% over a decade than one that is flat during that same time. For example, you would have been much better investing in commodities over the past decade than stocks, just like you would have been much better investing in stocks rather than almost everything else over the prior two decades.


Things can go on for longer than seems reasonable.


I remember thinking that technology was getting nutty in 1996. I thought housing was getting stupid in 2003. Boy, was I wrong. Both were just beginning. Trends tend to last a long time. Do not underestimate the strength of a trend.


Eventually, all bull markets and all bear markets end.


It is difficult to know exactly when bull and bear markets begin and end. However, they eventually do. You might be late in making that determination but understand that the end is an eventual certainty. Structural bull markets tend to last 10 to 20 years, so you have time in determining whether or not a bull market has begun or ended.

"

May 5, 2011

on Portugal and Spain

Earlier this week, we learnt about the Portugal bailout and the Finnish giving sufficient leeway.
I think that most of the people / parties with a good understanding of the issue argued that Portugal needed a hawkish IMF bailout, not a dovish EU bailout.

By proceeding with the latter, Portugal and the EU decision-makers are buying time and procrastinating on must-to-do measures that would be a win-win for the Portuguese and for all its euro-partners. Some of these measures would include the privatization of stated-owned companies, economic liberalization (winding down subsidies, cutting red tape), deregulation of the labour market, and many more measures aimed to improve Portugal's competitiveness under a no-depreciation monetary system like the euro.

Elsewhere, Spain gave a pretty bad piece of news regarding the employment / unemployment measures. Surprisingly, the former were worse than the latter. Let me explain myself: 7110 people were added to the unemployment list in April (cyclically adjusted) adding up to 4,746,552 unemployed people in Spain ... which is 'rumbo a los cinco millones'.
But to make things worse, the number of employed people by the public administration rose significantly.

Take a look at these figures:
+ Pasive population: 23,5m
- Under 16: 7,900,000
- Above 64: 7,800,000
- in between, not listed / not searching: 7,700,000

+ Active population: 23m
- Civil servants / funcionarios: 3,185,900 (12 months before they were 3,088,000)
- Unemployed: 4,746,552
- Self-employed: 2,830,000
- Employed by private corporations: 11,935,000 (12 months before: 12,165,000)

It is quite clear that the Spanish workered is being cornered, suffering the heavy toll of the worse-ever political class seen in this country. This load, and the anticipation of heavier future loads as the deficit is reduced draws a rather ugly painting both for employers and especially for employees.

In the meantime ... the EUR is soaring and Spain, despite its dozens/hundreds of international pro-trade offices around the world (ICEX for Spain, IVEX for Valencia ...), is still unable to export anything but sun.


How is this translated to the stock markets?
... keep shorting Spanish-based assets like real estate.

JPM gave a call earlier this week about some peripheral-countries companies.
The buy list included these companies:
Spanish: abengoa, bbva, campofrio, inditex, tecnicas reunidas, telefonica,
Portuguese: cementos de portugal, semapa
Elsewhere: BIOX GA, DCC ID, GLB ID, ICON ID.

The sell list included:
Spanish: ACCIONA, ALMIRALL, SABADELL, B. VALENCIA, B. POPULAR, BANKINTER, BME, Corp Fin Alba, FCC, Gas Natural, Prisa. Sol Melia.
Portuguese: BCP PL, GALP PL
Elsewhere: TPEIR GA, EUROB GA,
OPAP GA, TT GA, GCC ID,

My favorite 'buys' are
1) Santander (san.mc) at around 8+eur/share. It has a very diversified business portfolio; a stable Tier 1 capital (9+%), and very attractive dividend yield (7 / 8%)
2) Grupo SOS (sos.mc). Now suffering selling pressure from the 'cajas', which became shareholders at 50cent/share in the last debt restructuring deal and seem to be selling their stakes. I want to believe (and have some info to back it up) that the price is depressed below its fair value, reflecting that supply/demand imbalance.
3) Telefonica, good dividend yield, international exposure (including LatAm, WE, ...

On the sell side, during the last year I was a keen short-seller of ...
1) Popular (pop.mc) based on the previous arguments regarding the spanish labour market, and its consequences over the purchase power of society overall, and of the real estate prices in particular. Now that euribor is higher I would keep short-selling at around 4.5eur/share; and the same for the rest of national banks (not international).
2) BME seems cornered: the electronic venues will probably prove to be quite harmful in the long run; no international or diversification opportunities ... so keep collecting dividends but I also see a sell when it's lurking / hovering around its previous peaks.
3)Prisa is in this list for 'meritos propios'. Imo, a firm candidate for the worse company in the spanish investment market.

May 4, 2011

Arbitrage M&A: Talecris & Grifols

The M&A arbitrage arises as an opportunity to benefit from the spread between the bidding price, and the market price. The biggest risk associated with this strategy is that the bidding firm would withdraw its offer (which is not in the interest of the investment bank); and the biggest opportunity would be associated with a bidding war, in which third companies bid above the previous offer.

Research has shown higher stakes in the target firms on behalf of the investment banks advising both the bidder and the target firm (especially the former); but I do not remember how developed is the research about the profitability of the arbitrage opportunities.

One book covering the issue is Warren Buffett and the Art of Stock Arbitrage, from which this is an excerpt:
In professors Gerald Martin and John Puthenpurackal's study of Berkshire Hathaway's stock portfolio's performance from 1980 to 2003, they discovered that the portfolio's 261 individual investments had an average annualized rate of return of 39.3%. Even more amazing was that out of those 261 investments, 59 of them were identified as arbitrage deals. And those 59 arbitrage deals produced an average annualized rate of return of 81.28%! Warren's arbitrage performance not only beat his regular portfolio's performance, it also stomped the average annualized performance of every other investment option in America by a mile. No one - be it individual or firm - even came close...

... good to know.

Elsewhere, the M&A deals covering companies listed in different currencies will have attached a 'currency risk', for which investors should ask a compensation.

For all these reasons, I have become interested in the Grifols bid for Talecris.
Grifols is bidding $19/share and 0,6485 own shares/talecris share.
With the former trading at around 14 eur/share, the latter could be priced at around 32,5 usd/share (assuming the bid would be successful).

I think it is a good risk/return opportunity and I have bought today some shares,
TLCR (nasdaq) @ 27,5usd/share.
More info about this deal can be found in the web, e.g.: bloomberg.
... will see how it ends.


Here there are some raw-sources for arbitrage-driven trades: sinletter, mergerinvesting, theonlineinvestor and here the required due-diligence and storytelling: dealbook, reuters.