Investing frameworks I

Trying to beat the market involves predicting the future.  This is not easy.  One needs to find theories that can be applied in the real world to predict the future.  A useful theory makes predictions that can be tested and falsified.  If a theory can’t be proven wrong, then how do we really know that it’s right?  We don’t.  Avoiding unprovable theories weeds out hokey bull**** stuff out there.

The problem with the stock market is that it is run by human beings and human beings often change.  If people get burned by some fad that loses them money, then they probably won’t get sucked into the same exact fad again.  Like .com stocks, tulip bulbs, and so on and so forth.  So sometimes when we come up with theories, everybody will know that theory (or market inefficiency if you want to call it that) and then the theory might not work so well anymore.  A great example would be the classic Ben-Graham techniques of buying stocks below liquidation value and buying stocks with long track records of profitability.  These situations are much rarer than they used to be, since almost everybody is familiar with these techniques.  That being said, human beings often make the same mistakes repeatedly.  Casinos have a lot of repeat customers, there have always been numerous real estate bubbles in the same areas, etc. etc.

That being said, let’s dive into some theories/frameworks about how to make money in the stock market.

Simple math

Yes, in some cases there are almost risk-free ways to make money.  These are generally called arbitrage trades.

One type of arbitrage trade is where a stock trades in two different currencies.  In theory, you could buy the stock in one currency, sell it in the other currency at a higher price, pay for the currency conversion, and then profit.  Nowadays, all sorts of high-frequency trading computers are all over this type of trade.  For the retail investor, there is no opportunity due to higher transaction costs and not having a super fast infrastructure ($$$).

Almost risk-free arbitrage trades

One type of arbitrage trade that is sort of available to retail investors is in special situations where the computer-wielding players aren’t looking.  Companies may announce tender offers to buy back shares (they will buy at a certain price), usually because they think that the shares are undervalued.

There may also be opportunities in stub stocks, where one company (call it the parent) owns shares in another company (call it the child).  If you want to own stock in the child company, it may be cheaper to buy shares in the parent company and get the parent company’s other businesses and liabilities thrown in for free.  You can buy shares in the parent company and short sell shares in the child company.

There may also be odd situations such as Medquist Holdings where you could have bought MEDQ shares and sold MEDH shares short.

In practice, these trades aren’t 100% risk-free.  If it’s a tender offer, there may be a limit as to how many shares get tendered (though I am not aware of any situation where this has happened).  If you are selling stock short, you have to:

  1. Pay interest to borrow the shares (this interest rate can shoot up)
  2. Get bought-in on your shares (other people will engineer buy-ins to profit from short sellers)
  3. You are exposed to margin (liquidation) risks (where you can lose more than anticipated because your broker can liquidate your account however it wants and some try to profit from that situation).

Other arbitrage trades are risky

You may read about other types of trades that are labelled “arbitrage”.  Make no mistake about it, many of these trades are risky.  This includes merger arbitrage and trading futures and derivatives against the underlying.

The stuff we are less certain about

Moving away from situations that only require simple math, we get into the world of:

  • Predicting human behaviour.
  • Valuing businesses.
  • Market structure. / Fleecing retail and institutional investors.
  • Other.

Incentives drive behaviour

Throughout history, this has almost always been the case.  It’s pretty rare to find human beings who go against their self-interest to do the right thing.  Whenever people are faced with the wrong incentives, they usually figure out the behaviour that serves their self-interest.

If a school’s funding is dependent on standardized testing, you will usually find teachers helping their students cheat or cheating on behalf of their students / their school.  When it comes to stocks, you usually find that insiders and the boards of directors pay themselves a lot of money.  They have a mutual interest in keeping their pay high and will usually work together to maintain the status quo, even though they are supposed to be working for shareholders.

When management does not own a significant amount of stock in a company, they don’t really have skin in the game.  If stockholders are getting a raw deal, management isn’t really affected.  So management may do things such as empire building, where they make the company grow even if it doesn’t make money for shareholders.  This increases their social standing and tends to increase their paycheques (because it’s easier to justify higher pay for larger companies).  They may also do deals with investment banks and pay ridiculously high investment banking fees in return for kickbacks.

When it comes to accounting, management will often use overly aggressive accounting to inflate their reported profits and drive the share price higher.  I tend to call this fraud, but I throw the f word around too much.  This increases their pay since it’s usually tied to the share price, especially if they own options.  In rare situations, management will switch to overly conservative accounting to drive the share price down.  This is because they haven’t been granted their options yet and they want to get their options when the share price is low.  And then they switch to overly aggressive accounting.  It’s dangerous to buy into stocks with overly aggressive accounting so it pays to figure out the insider’s incentives.  Some people are really smart and the accounting trickery that they use may be difficult to figure out.

What are the incentives?

Human beings are not always driven by money.  Bernie Madoff committed a massive fraud even though he didn’t really need the money.  He had a profitable market making business (though its profits were declining).  He could have used his smarts and his connections to continue making money legitimately.  I would say that his pride led him down the path of fraud as he didn’t want to admit that he wasn’t making a lot of money for his clients.

On the flip side of this, there are rare situations where management pays themselves too little as a matter of pride/ethics.  Warren Buffett of Berkshire Hathaway is the best example as his salary is $100,000 and the use of the company jet.  He could easily get paid a salary that could buy multiple company jets every year.  As a hedge fund manager he could probably rake in a billion dollars a year, if not more.

Valuing businesses

See my posts on value investing for my opinions.

Market structure

Trading is a zero-sum game.  If somebody is making money, somebody else is losing it.

So let’s play follow the money.

The various stock exchanges derive a lot of their revenue from market makers.  In return, market makers get special advantages that allow them to profit from skimming from investors.  (If market makers add value for an exchange’s customers by “providing liquidity”, then I would expect that the exchanges would pay market makers instead of the other way around.)  This stuff doesn’t go on with the futures exchanges, so you don’t have to worry about this type of skim there.

At the retail brokerage level, some of the retail brokers will sell order flow to companies such as Knight Capital Group (NITE).  Knight then goes on to skim from the retail broker’s customers, and in return the retail brokerage gets a kickback (the euphemism for this is “payment for order flow”).  Nowadays the market landscape has changed as the retail brokers sometimes move this activity in house, or they sent retail orders to Knight’s competitors (sometimes these practices fall under “broker-dealer internalization”).

The whole system is fairly complicated and there are various methods and techniques to stealing (e.g. collecting the spread, NBBO manipulation, NBBO exceptions, opening price gap, market orders, all-or-none orders, stop orders, margin liquidation, etc.).  This makes it difficult for investors to catch on as to how they are being cheated.

But remember to think for yourself

Look, there are exceptions to some of the frameworks I already mentioned.  Sometimes fraud/shadiness works against you, and sometimes it works for you.  Maybe it’s not so easy to figure out where insider’s incentives lie.  Or if they are really smart, then they may be good at concealing their accounting fraud and you will get burned even if the company didn’t look shady (see Cynthia Cooper’s book on Worldcom).  And therefore you have unexpected losses.

And if a particular criteria is subjective (e.g. shadiness), then maybe it’s an unprovable theory that isn’t so helpful in real life.

And even I admit that “incentives drive behaviour” (my favorite framework) is not true for all human beings.  There are whistleblowers and martyrs out there.  And in other contexts, human beings can be incredibly kind and generous.  Most strangers will help you (and/or give you money) if you ask for their help, even if it’s highly unlikely that you will reciprocate.

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