Katrina and the Quants

Interesting article in the NYT this Sunday about disaster insurance. Specifically, the articles discusses quantitative analysis of catastrophic events, and how investors and quants can profit from this analysis.

I find the timing of this article interesting, given the disastrous performance of many quant funds over the past month or so. Nonetheless, the article does a good job of explaining how quantitative analysis can generate significant trading profits if applied to a problem that's hard to price using conventional methodology.

I was also particularly amused, (and pleased,) to note the disdain that article subject John Seo has for the Efficient Market Hypothesis.

“These academics couldn’t understand the fact that they couldn’t beat the markets,” he says. “So they just said it was efficient. And, ‘Oh, by the way, here’s a ton of math you don’t understand.’ ”

Couldn't agree more.

Value

One of the most difficult times a value investor can experience is when the market is bullish but confidence is low. Speculators pile into popular names, chasing the buck, and sell out of longer-term value plays. Those of us who see these depressed value names as opportunities suffer twice - first when our stocks drop in value because so many other holders are selling, and again when we watch overvalued investments trade even higher as the crowd struggles to buy in.

I've been taking it on the chin this past month and, even though I have a nice cushion from the early half of the year, it still hurts. It's not so easy to keep repeating my mantra of "in for the long term" when the short term pain intensifies. In particular, I like to time my trades such that I can be regularly rolling out of successful positions to reinvest in new opportunities. With nothing to roll out of, I have less incentive to research other trades. It's even worse, of course, when I watch trades I rejected because of specific timing issues or because I wanted to buy slightly lower. Naturally, they're all outperforming. The grass is always greener I suppose.

Just a quick point. Despite the impressive performance of the US equities markets in 2006, after adjusting for currency losses the S&P 500 was only up 1.6% last year in Euro terms. Given that the British Pound just hit $2 for the first time in about 2 decades, I'm sure that the Euro is not an outlier.

So what to do? I'm not feeling completely confident about US equities on the whole, but pulling out of the market exposes me to both inflation and currency devaluation. Looks like international is the way to go. I suppose I'm just as guilty of home bias as the next investor, although I do believe there is some degree of advantage in investing in one's home country - quite simply, I have a better idea of the legal, social, and economic framework that exists in the US than, say, Japan. Nonetheless, I definitely think there are times when one must look beyond perceived advantages and execute on behalf of a larger global strategy.

Since I don't really have the insight necessary to pick undervalued, underfollowed foreign equities, I'm going to have to defer to the markets as a whole and go for ETFs. As for what countries to actually invest in, that will take plenty of analysis and thought, although I'll say right now I'm leaning towards Japan...

Book List

I recently saw a list of the (supposedly) 100 best books of all time. I'm definitely not sure what the criteria were for that list, but given that The DaVinci Code was #1, it's obviously not gauged on literary merit. While I was thinking I'd respond by highlighting the ones I had read, the list is just so utterly bad that I simply can't bear to do it. Any list where Tuesdays With Morrie significantly outranks The Great Gatsby just doesn't deserve a response.

Instead, I've posted the Modern Library top 100 Readers' Choice, and hilighted the ones I've read. Their "expert panel's" choices seemed a bit too dense for my tastes, and I do want to give some credence to popularity as opposed to critical acclaim. Here goes:

ATLAS SHRUGGED by Ayn Rand
THE FOUNTAINHEAD by Ayn Rand
BATTLEFIELD EARTH by L. Ron Hubbard
THE LORD OF THE RINGS by J.R.R. Tolkien
TO KILL A MOCKINGBIRD by Harper Lee
1984 by George Orwell
ANTHEM by Ayn Rand
WE THE LIVING by Ayn Rand
MISSION EARTH by L. Ron Hubbard
FEAR by L. Ron Hubbard
ULYSSES by James Joyce
CATCH-22 by Joseph Heller
THE GREAT GATSBY by F. Scott Fitzgerald
DUNE by Frank Herbert
THE MOON IS A HARSH MISTRESS by Robert Heinlein
STRANGER IN A STRANGE LAND by Robert Heinlein
A TOWN LIKE ALICE by Nevil Shute
BRAVE NEW WORLD by Aldous Huxley
THE CATCHER IN THE RYE by J.D. Salinger
ANIMAL FARM by George Orwell
GRAVITY'S RAINBOW by Thomas Pynchon
THE GRAPES OF WRATH by John Steinbeck
SLAUGHTERHOUSE FIVE by Kurt Vonnegut
GONE WITH THE WIND by Margaret Mitchell
LORD OF THE FLIES by William Golding
SHANE by Jack Schaefer
TRUSTEE FROM THE TOOLROOM by Nevil Shute
A PRAYER FOR OWEN MEANY by John Irving
THE STAND by Stephen King
THE FRENCH LIEUTENANT'S WOMAN by John Fowles
BELOVED by Toni Morrison
THE WORM OUROBOROS by E.R. Eddison
THE SOUND AND THE FURY by William Faulkner
LOLITA by Vladimir Nabokov
MOONHEART by Charles de Lint
ABSALOM, ABSALOM! by William Faulkner
OF HUMAN BONDAGE by W. Somerset Maugham
WISE BLOOD by Flannery O'Connor
UNDER THE VOLCANO by Malcolm Lowry
FIFTH BUSINESS by Robertson Davies
SOMEPLACE TO BE FLYING by Charles de Lint
ON THE ROAD by Jack Kerouac
HEART OF DARKNESS by Joseph Conrad
YARROW by Charles de Lint
AT THE MOUNTAINS OF MADNESS by H.P. Lovecraft
ONE LONELY NIGHT by Mickey Spillane
MEMORY AND DREAM by Charles de Lint
TO THE LIGHTHOUSE by Virginia Woolf
THE MOVIEGOER by Walker Percy
TRADER by Charles de Lint
THE HITCHHIKER'S GUIDE TO THE GALAXY by Douglas Adams THE HEART IS A LONELY HUNTER by Carson McCullers
THE HANDMAID'S TALE by Margaret Atwood
BLOOD MERIDIAN by Cormac McCarthy
A CLOCKWORK ORANGE by Anthony Burgess
ON THE BEACH by Nevil Shute
A PORTRAIT OF THE ARTIST AS A YOUNG MAN by James Joyce
GREENMANTLE by Charles de Lint
ENDER'S GAME by Orson Scott Card
THE LITTLE COUNTRY by Charles de Lint
THE RECOGNITIONS by William Gaddis
STARSHIP TROOPERS by Robert Heinlein
THE SUN ALSO RISES by Ernest Hemingway
THE WORLD ACCORDING TO GARP by John Irving
SOMETHING WICKED THIS WAY COMES by Ray Bradbury
THE HAUNTING OF HILL HOUSE by Shirley Jackson
AS I LAY DYING by William Faulkner
TROPIC OF CANCER by Henry Miller
INVISIBLE MAN by Ralph Ellison
THE WOOD WIFE by Terri Windling
THE MAGUS by John Fowles
THE DOOR INTO SUMMER by Robert Heinlein
ZEN AND THE ART OF MOTORCYCLE MAINTENANCE by Robert Pirsig
I, CLAUDIUS by Robert Graves
THE CALL OF THE WILD by Jack London
AT SWIM-TWO-BIRDS by Flann O'Brien
FARENHEIT 451 by Ray Bradbury
ARROWSMITH by Sinclair Lewis
WATERSHIP DOWN by Richard Adams
NAKED LUNCH by William S. Burroughs
THE HUNT FOR RED OCTOBER by Tom Clancy
GUILTY PLEASURES by Laurell K. Hamilton
THE PUPPET MASTERS by Robert Heinlein
IT by Stephen King
V. by Thomas Pynchon
DOUBLE STAR by Robert Heinlein
CITIZEN OF THE GALAXY by Robert Heinlein
BRIDESHEAD REVISITED by Evelyn Waugh
LIGHT IN AUGUST by William Faulkner
ONE FLEW OVER THE CUCKOO'S NEST by Ken Kesey
A FAREWELL TO ARMS by Ernest Hemingway
THE SHELTERING SKY by Paul Bowles
SOMETIMES A GREAT NOTION by Ken Kesey
MY ANTONIA by Willa Cather
MULENGRO by Charles de Lint
SUTTREE by Cormac McCarthy
MYTHAGO WOOD by Robert Holdstock
ILLUSIONS by Richard Bach
THE CUNNING MAN by Robertson Davies
THE SATANIC VERSES by Salman Rushdie

Seems a little heavy on the Ayn Rand and Sci-Fi, no? Guess this list was written by a 16-year old male high school student who's more likely to be in the computer club than on the football team. (Not that I was on the football team either. Hey, when I was 16 I'd have loved this list.)

Diseconomies of Scale

Investing might be one of the few environments where participants can easily experience diseconomies of scale. In other words, bigger is not better. Specifically, small hedge funds and, when they're knowledgeable and have adequate resources, individual investors, can often put up better returns than the multi-billion dollar behemoths. Evidence for this claim is mixed, but I believe that as time goes on and the big funds get bigger, we'll see some more proof of this claim.

Fundamentally, there's a very simple reason for this assertion: the bigger a fund gets, the smaller the pool of potential investments becomes. A $50 million fund has a very large pool of potential investments to choose from, the only restriction being securities reserved for QIBs and other high-net worth entities. On the other hand, a $10 billion fund can't realistically put money into, say, a stock with a $300 million market cap. The fund simply can't buy enough of the investment without significantly affecting that investment's price. Any investment the firm could make simply would't "move the needle" as far as returns go, and thus doesn't justify the time and effort of the fund's analysts.

Similarly, large banks and research firms on the street aren't interested in analyzing small securities because their clients, the big funds, can't or won't invest in them. Why do the work if you won't get paid for it? To focus specifically on the equity markets, (my primary area of expertise and interest,) small-cap stocks are generally neglected by the larger banks. Many companies are covered by only a handful of analysts, and quite a few are simply not covered at all.

There are currently over 5000 publicly traded companies in the US, (probably closer to 8000 if you include bulletin board stocks, the NASDAQ SmallCap Market, and various other less-liquid listings.) I'd guess that at least one third of these companies are severely under-followed, if even covered at all by any research firm or bank. That's a huge pool of potential investments that the banks won't cover and the funds won't trade. If even one half of one percent of them are mis-valued, that's approximately 12 securities you could potentially buy. Remember, according to modern portfolio theory, more than around 15 stocks in a portfolio and you're really not getting any marginal benefit.

What's important here is that the small guy can profit in areas where the big guys can't. My belief is that there are plenty more than just 12 mispriced names out there. Take a look at some of the blogs on the sidebar - the value investors out there focusing on small cap names seem to put up some pretty good returns. I'm not as knowledgeable as most of them (yet,) and I don't have quite as much time as they do to do the research, (CFA is still eating up all my free time,) but even I've found a few huge pricing errors over the past year or 2. People - the opportunities are out there. You just have to dig a little.

Offshoring

Here's an excellent, thought provoking working paper written by Princeton economics professor Alan S. Blinder on the subject of free trade and offshoring. His thesis, that information technology will allow a much larger number of service jobs to be offshored to places like India, is one I completely agree with.

Assuming Blinder's theory is correct, how does an investor respond? Does the American equity market suffer at the expense of India as more Americans lose jobs, lowering consumption and hurting the economy as a whole? Or, do American corporations profit due to lower labor costs and a larger global market for their services? I think it depends on the rate of the shift of jobs from the US to poorer countries, and how quickly those poorer countries develop and modernize. A sudden shift in jobs offshore would probably allow the US companies to move aggressively into foreign markets before local competitors could grow large enough to capture the market. A slow drift, on the other hand, would give local businesses the time to mature.

Of course, we're ignoring any possible barriers to trade that the US government may erect in the meantime. Given yesterday's announcement of new tarriffs on Chinese paper products, the Bush administration appears to be leaning toward making trade more difficult. My suspicion is that the US government, pressured by labor unions and voters in middle-class districts, will enact more and more barriers to trade, but will concentrate on protecting the farm and manufacturing industries and will generally ignore service jobs. This will probably allow foreign service industries to grow and gain market share both in the US and overseas. Perhaps going long some Indian equities would be an ideal core portfolio holding for long-term time horizons.

As a side-note, Blinder mentions security analysis as a possible industry to be offshored. I think security analysts and investment bankers are at very high risk. The sell-side is very much concerned with pedigree, particularly in i-banking. American banks will be very slow to consider offshoring. The buy-side, however, is much more concerned with results. Put together a bank in India that provides both research and investment banking that's just as good as the American alternative and costs one third as much, and you'll see a titanic shift of commissions and fees. Perhaps I should reconsider my current employment status...

Back to the CFA...

Did Cramer Just Admit to Market Manipulation?

Looks like Jim Cramer's caused a bit of a stir due to some comments made in a recent interview at The Street. I'm not sure if this is an admission of market manipulation, but he's certainly skirting a very very thin line.

Personally, I've never been a big fan of Cramer. I'm not going to speculate on whether he is really trying to help the average investor, or if he's just using CNBC as a platform to pump up stocks that he owns in his "charitable trust." What bothers me about him is that he's teaching people very bad habits about the markets and trading. The fact is that for most people, the stock market is a form of gambling. I'd guess that 95% of the people out there buying stocks have no idea how to value a company, have never read any of the financial data on the stocks they own, and probably just throw away any proxy statements they recieve. In case any of you out there had any doubt, the important part of a company's annual report are all those boring pages of numbers in the back, not the glossy pictures of happy-looking employees and self-congratulatory remarks from the CEO. (Oh, and just so you folks out there know, by the time you get that nice glossy report in the mail, people like me have already had the information sitting on our desks for about 6-8 weeks. The SEC website posts all the corporate filings in real-time, and all of us know how to use it.)

Look, if you want to make money in the markets, you're going to have to do the work on your own. It takes lots of time, tons of reading, and quite a bit of analysis. And even then, after all that, you're still likely to be wrong a good percentage of the time. Your best bet, though, is to invest in small-cap companies that aren't covered by most research firms and I-banks. If you're dilligent, patient, and persistent, you'll find a few companies that are trading at a significant discount to their true value. Find enough of these, invest over a relatively long period, and you'll probably be successful. Trying to trade in and out like Cramer is only going to get you whipsawed and cost you tons of money in transaction costs on top of the losses you'll probably take.

If you're really one of the very few people out there who can day trade well enough to consistently make profits, then go ahead and keep doing what you're doing. For the other 99% of the population out there, just stop. The next time you want to buy a stock, do yourself a favor and go online, download a copy of the company's latest 10-K filing, and read it. The whole thing. Including all the financial data and all the footnotes. Pay particular attention to the part where it talks about prior years' results and the explanation for why the numbers are trending up (or down.) Treat every assumption regarding the future as suspect. Try predicting what will happen to the company's income if you adjust those assumptions lower.

If all this sounds too burdensome, stop immediately. Managing your own stock portfolio probably isn't for you. Put your retirement fund into some index funds, and maybe a few actively managed mutual funds. If you still feel the need for some action, get on a plane and head to Vegas - your odds of making any money are about the same, and Vegas treats you a lot better when you lose. (Try getting your stockbroker to comp you a hotel room and a free meal.)

If, on the other hand, you sit down and read that filing and, to quote Obi-Wan Kenobi, you feel like you've just taken your first step into a larger world, keep going. Start reading all you can about valuation and analysis. Read more 10-Ks, read conference call transcripts, read, read, read. You just might have what it takes...

Study Time

A few months ago, in a fit of frustration about the apparent lack of traction I was feeling along my career path, I decided to sign up for the CFA exam. Despite a warning from my boss that the CFA is "the hardest test you'll ever take" and various foreboding sodomy-related similies, I decided to take the plunge. Right now, sitting on the shelves above my desk, are about 40 pounds of textbook that must be read, comprehended, and fully regurgitatable by the first weekend in June.

Clearly I must have been out of my mind when I came up with this bright idea. The sheer volume of material that must be learned is staggering. That said, none of it seems to be particularly difficult, and a good deal of it, particularly the economics and statistics sections, are primarily review. Nonetheless, reading 3500 pages of dense, poorly written, uninteresting financial text in a span of about 3 months is not my idea of a fun time. In fact, it really sucks. (Especially the accounting part - I hate accounting, and it's the largest section of the test.)

I'm sure I'll have more to say as we get closer to crunch time, but I'm already feeling the pressure. I signed up for a 3-day cram session at the end of April, which will hopefully be enough to get me past this thing.