Disclaimer

Do your homework before you invest. I am not a professional. I just enjoy investing. I am often wrong.

Tuesday, March 20, 2012

Measurement

To maintain a prediction's integrity, the variable used to predict must be harder to change than than the thing it is predicting.

The very act of measuring something changes the thing being measured.  You must measure something big or unusual to get it to stick. To preserve the integrity of your measurement.

One of two conditions must be met: (1) The people who control the prediction must not know about the measurement. or (2) It is nearly impossible for the prediction to be changed based on the measurement, or there is no reward for them to do so (this is rare).

Here are a couple of examples:

Example One
Let's say I want to predict a student's grades. The output is GPA. I believe I can predict a student's GPA in any semester by taking the weighted average of his course grades. This is an unchangeable fact. The integrity of the prediction is preserved, because it is impossible that the prediction could be changed by me or the student.

Say I want to break down the prediction further: I can predict a student's grade in an individual course based on the number of hours he spends studying over the semester. This measurement is not unchangeable. Its integrity is in question. If (1) the student does not know about me tracking his hours, then the prediction is ok. But if (1) is not met, neither is (2): The student, knowing that his GPA can be predicted by his hours, may start to put empty hours into studying, not fully concentrating on the material, thinking that he will get an A by putting the minutes in. The integrity of the prediction has been compromised. Over time, the prediction will become less accurate.

The prediction becomes much more muddled when compensation comes into play. Let's say I pay a student per hour studied, thinking that will improve his GPA. Bad idea! Further hypothesis: each student has a stock price tied to his grades. I invest in the students whom are undervalued based on the hours they have put in this semester. Ok. I succeed as long as my method is accurate. Now the market finds out about my prediction method. No good! The market will adjust, incorporating my method, and students with high hours will no longer be undervalued.


Example Two - A Stronger Measurement

I believe I can predict a nation's Olympic Medal Count based on its GDP. Props to Colorado College Prof. Daniel Johnson. It is harder to change a nation's GDP than it is to add to the medal count, so this is a strong predictor that cannot be compromised.

But Professor Johnson found that communist, centralized governments are more likely to get gold medals.  If capitalist nations find out about the study, the prediction can go bad because those capitalist nations can mimick the training programs of other types of governments to increase the medal count.


A weak measurement

Any formula for picking stocks is predominantly luck. Say you invest in stocks that have crossed their 50-day moving average. Say you invest in stocks with low P/E only. No single formula to pick stocks has the strength and integrity to withstand the market once the market finds out the method is profitable.  There are two ways to go about this: one, you have a small window of opportunity when the market does not realize it is overvaluing or undervaluing a particular formula. So, for example, generally a good time to invest in high-Beta stocks is after the market has gone down a lot. Because people get sick of losing money, and the market moves out of those guys unnecessarily. But if the market were to realize this arbitrage existed, it would disappear. The most sustainable predictor of stock price is to buy assets for less than they are worth. You must analyze the current assets and project the future cash flows of a company, and invest in what is most certain to bring you the most cash for your investment. That is a measure that cannot be corrupted by the market, because that is the heart of a business's value.

Sunday, March 18, 2012

Some trading action

Sold BAC.

Added to NYT, YHOO.

BAC still has room to go up potentially. But I sold it because it is a position that I followed somebody into. I don't know much about the stock, other than it was beaten down and cheap. Then Warren Buffett took preferred shares with a conversion at $7. So when the opportunity came to buy at $6.50, I said yes. I only do that for investors who I am confident know what they are doing. But my general rule is that when I merely follow someone into a trade, without fully understanding the business, I sell after a 20% gain. So out goes BAC with a nice, but small, profit.

In goes NYT. I really like them. They are differentiating themselves from the rest of print media. The paywall is genius. The writing is superb. The quality of research is excellent. The company is making money. It has a $1 billion market cap, and they own about.com (worth maybe $50 million), shares in the Red Sox (worth about $100 million), and the Boston Globe and International Herald Tribune (worth maybe $150 million). So the underlying business is selling for $700 million. They have about $550 million in employee pension liability. $3 billion in annual revenues. Profits are rising because of the paywall, and advertising is starting to bounce back. When you look at the newspaper industry, the Times stands at the top of all papers in the world, without a doubt, along with the Wall St. Journal and a couple others. They are well-managed. Trading at a 11x forward earnings. Large growth prospects if the paywall is managed correctly. I like it.

YHOO I am mostly following Dan Loeb into this trade. They own parts of Yahoo! Japan, Alibaba, and other international web sites worth more than their market value. He bought at $15, and the chance to buy months later at the same price is a nice opportunity. There are some tax regulations they would have to avoid if they were to sell the shares of their international companies. But he has a large position and a seat on the board and I trust his due diligence that he will be able to unlock the shareholder value. Like most of my "follow in" trades, if it gets to $18 (20% gain) I'll sell it. Another reason I like Yahoo! is because of the phenomenal research the Yahoo! Sports department does, which shows there is some value in the American branch of the company's operations. Yahoo! Finance is also a nice web site.

[Note - this was originally posted in March 2012.  I am editing it in January 2013.  It is interesting how far off I was on the value of About.com.  The Times recently sold About.com for $300 million.  If I had paid better attention to the quarterly reports I would have been able to value the About group better.  Sometimes it helps to be lucky.]

Sunday, March 11, 2012

Smart investing, not just results


If a hedge fund investor chose a basket of the highest-priced tech stocks stocks in December 1999, then tragically died, and his fund had to be liquidated in March 2000 at a large profit based on inheritance laws, he was not a smart investor despite his profits.

If a Dutch basket weaver traded all of his machinery and inventory for a tulip bulb in January 1637, then was forced to sell it a month later in a dire need for cash, and he received a 25% profit, he was not a smart investor despite his profits.

To determine if an investment was good, one should examine reasoning behind it to see if it was sound and if it is repeatable. This means some money-losing investments were actually good, and some money-making investments were poor. Over time, if you make good investments, you will make money.

Computer running out of batteries. More on this later.

Keith Foulke - not just value.

Thursday, March 1, 2012

Timeline for an investment opportunity

I am reading a Joel Greenblatt book about the profits to be made in spinoffs, and I thought of this:

Each investment thesis has only a finite time when it is profitable. The market becomes more efficient as time goes on. I suspect that Greenblatt's spinoff methodology (look for illiquid, low-cap spinoffs with management continuing to hold shares) is not as profitable today as it was when he was a fund manager. That's because he publicized his ideas and strategy in a way that's easy to mimic. Therefore, smart traders did mimic it, and the arbitrage opportunities probably do not exist anymore.

The ultimate, unbeatable strategy is to compare the assets and cash flows you will receive to your investment price today. The investment that maximizes your future cash flows is the best investment. But even that has caveats: human error. The market gets more efficient with time. So what worked in the 1930s to 1960s (asset arbitrage - buying companies with more assets than their market cap, a la Ben Graham) is not as easy to find today. As the market gets harder to beat, individual investors have to be more precise in their predictions. The more precision required, the more chance for error and losses on investments.

That brings us back to the original post: there is no eternal competitive advantage, in investing or in business. You always have to innovate, and you don't know when you're going to lose your edge.

I still believe profits can be made in the stock market. It's just harder. Here are a few ways:

- Find market misconceptions, stocks that have been overshorted, or are too unpopular for no reason.
- Act on news that the market has not been able to digest yet.  For example, there was a Kentucky bill last week to give Churchill Downs (CHDN) a near monopoly on in-state casino gambling. The stock price did not react that much to the bill, which was ultimately defeated. But that might have been a good purchase had the bill passed.
- Buy after a string of bad news that is not that bad (recency bias is in effect)
- Buy stocks that you are more familiar with than the rest of the market
- Know the rules: tax rules, rules for mutual funds and hedge fund investment. Find areas where the rules make some stocks unnecessarily cheap and make it so that they can't be purchased by a segment of the market.


Always know the reason why you are making profits. If you can't explain why, you can't repeat it, and it was probably luck rather than skill. Luck is never a good investment.