July 2007 Archives (Continual Evolution)

July 2007 Archives

Welcome

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... to my investment blog.

I'm a scientist by training and enjoy the process of continual evolution that I think is needed to adapt to the continually adapting market. Both science and investing seem to discount all knowledge that is already "published". We need to know what is out there but this in itself is not enough. We then have to find something new and be right in our hypothesis to be rewarded in either fields.

Overall Strategy

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Academic research has suggested that while the market is mostly efficient, there do exist pockets of inefficiencies due to either structural or behavioural reasons. Examples are:

Incorrect discounting of future earnings:

-- misperceived systematic risk sets high risk premium but actual risk is low due to moat
-- high level of uncertainty but low downside is incorrectly valued as high risk
-- moated companies have competitve advantage that slows the usual reversion to mean
-- incorrect risk premium due to investor diversity breakdown (herd mania/panic)
-- true return on capital obscured due to accounting conventions for goodwill and R&D

Incorrect extrapolation of earnings due to some non-linearity in actual earnings:

-- recent earnings too depressed/elevated due to non-recurring event
-- unusually "lumpy" earnings cycle makes earnings extrapolation error prone
-- a transition point such as tornado of acceptance causes linear model to fail
-- when a small action has a large effect, e.g. when a merger creates an monopoly

Structural inefficiencies:

-- forced selling due to institutional min/max holding limits in restructuring situations, e.g. spinoff
-- short term traders need liquidity premium in small stocks to overcome bid/ask spread.
-- foreign stocks seem underrepresented in indexes compared to their GDP weights
-- market diversity breakdown e.g. when analyst estimates are herded too close to each other
-- volatility is the usual proxy for risk; but this may be wrong in high uncertainty scenarios

My strategy will be to focus stocks which might be underpriced due to such inefficiencies, and minimize risk by trying to choose companies with good fundamental prospects (e.g. moat). I will try to hold for long enough to arbitrage away noise traders (i.e. take advantage of overreaction reversal).

I will avoid linearly growing non-moated companies (in such cases, one should buy an index instead). I will sell once the earnings stream of a stock becomes predictable and hence probably has become properly priced.

Trade: Buy HNR

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It is an oil company whose primary holdings are in Venezuela. Chavez has nationalized all American oil companies recently and made HNR a 33% owner of its old fields along with some new undeveloped fields it threw into the mix as compensation. Due the political uncertainty, Wall Street coverage was essentially dropped, pending the final approval of the newly nationalized company.

I think the reality is that there is very little downside and a pretty big upside as soon as the formal approval comes through. Chavez needs the oil revenue from his fields and HNR has the expertise, so I think he will sign the deal. The company plans to buy back stock; the CEO feels that the street has overreacted to the risk. He thinks the Chavez signing should happen pretty soon since the previous 15 of 17 such applications have already made it through the pipeline.

While uncertainity still exists about various possible outcomes, the stock price seems to be mainly assuming low likelihood bad scenarios. I expect a series of confidence inducing steps that are likely, such as Chavez signing the agreement with HNR, the crediting of backdated revenues, the re-issued statements of earnings, the re-energized resumption of field work, etc.

This is a kind of situation where I think market efficiency often fails since standard economic theory equates risk with uncertainty (proxied by volatility, regardless of whether its downside or upside) and hence this stock is undervalued even though the actual downside is limited.

Trade: Buy LQDT

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Liquidity Resources is a web based marketplace for wholesale liquidation of scrap and surplus mainly from the government and large retailers. Sort of like eBay except that they are targeting wholesale buyers and not consumers. They compete primarily with local liquidators. Their initial government contracts were large enough to give them good liquidity to jumpstart their marketplace and now 50% of the business is coming from large commercial businesses (like retailers dumping the excess to wholesale purchasers). The eBay-like network effect (buyers go where sellers are and vice versa) should provide them with a robust moat and leverage in their margins.

It feels a bit like eBay in its early days in the sense that the stock does not seem to have fully priced in their moated growth potential.

Trade: Buy ALNY

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Alnylam is a biotech company specializing in RNA interference based drug development. This is a new way to target a cellular bottleneck which is easier to access than genes which reside within a cell's kernel. It also has the advantage that it can disable bad proteins from being manufactured rather than targeting them after lots of copies have already been made.

The major risk with biotech lies in the drug not getting FDA approval. To mitigate this, I try to find "platform" companies as opposed to single shot "application" companies. The idea is that the company will have more than one application to monetize its platform technology even if a particular drug trial fails, thus providing a better risk/reward situation. I expect ALNY to get lucrative partnerships with several major pharma companies (it announced another such deal just last week). This tilts the overall risk/reward to be more favorable than a typical biotech early stage company.

Trade: Buy SLT

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Sterlite has the leading market share of Copper, Zinc and Aluminium mining in India. The Indian goverment and industry plans to spend heavily on its basic infrastructure buildout to keep up with its fast growth. They claim to be one of the lowest cost producer for these metals in the world.

SLT also seems to have plausible diversification plan to expand their inhouse competency in captive power generation to sell power to the national grid, given the mismatch between limited supply and heavy demand for power in India. They had to develop this inhouse precisely because of the extreme paucity of power availability in India.

The stock seems significantly undervalued given its lost cost position as well as potential growth; the major risk would be if the metal prices collapse. I also bought this stock to diversify my otherwise tech and healthcare heavy portfolio.

Trade: buy FMCN

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Focus Media has an effective monopoly on electronic billboard advertising in China. Most of their buildout cost is now behind them so I expect the margins to expand rapidly as prices remain firm due to lack of competition. This makes their forward PE and EBIT/EV ratio cheap in light of their robust moat.

They have Fortune 10 companies as clients as well as the 2008 Olympics as a possible catalyst for growth. The major risk, as usual with any Chinese stock, is possible government interference.

Continual Evolution

Arun Garg

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