Sharpe Investing

Key Lessons from the Paulson & Co. - Third Quarter (3Q) Investor Letter

Matt — Tue, 02 Feb 2010 06:05:58 +0000

This article focuses on the important investment lessons from Paulson & Co. 3Q investor letter. Paulson & Co. is a New York based hedge fund managed by John Paulson. With over $29 billion under management, Paulson & Co. is one of the largest global hedge funds.

Paulson notably earned a record $3.7 billion pay day in 2007 from extremely profitable bearish trades executed during the financial crisis. Paulson’s latest funds include a Gold fund and a Financial Recovery fund. Paulson & Co.’s latest third quarter investor letter provides a unique insight into the hedge fund’s underlying investment philosophy. A copy of the letter is embedded below.

Merger Arbitrage
Although rising merger activity increases merger arbitrage opportunities, more activity reduces spreads. Pfizer’s $64 billion acquisition of Wyeth was the fund’s most profitable merger arbitrage deal. Interestingly, Paulson explains that because the deal had such a large market cap, the merger arbitrage community was simply not large enough to close the spread. This inefficiency presents an opportunity. Paulson cites the importance of evaluating closing risk and antitrust approval risk in merger arbitrage. In the Pfizer Wyeth merger, Paulson viewed both risks as minimal which made the investment more attractive.

Paulson also profited from PepsiCo’s acquisition of it’s bottlers, Pepsi Bottling Group and Pepsi. The fund viewed a high probability of the transactions closing because of the following key reasons:

The large size of PepsiCo relative to the bottlers.
The low initial offer price.
The initial offer was lower on a relative multiple basis to comparable historic bottler acquisitions.
The transaction had had strong strategic merit for PepsiCo. The company needed to improve it’s North American distribution system and streamline operating costs.

Credit

The credit fund benefited from the following fundamental factors:

Credit spreads contracted from the historical highs during the height of the credit crisis.
Paulson Funds capitalized on low Fed Funds borrowing rates to add leverage to the credit portfolio to the increase returns of less risky credit investments.
The fund’s highest return expectation was for defaulted debt. Paulson Funds purchased defaulted debt and then exchanged the securities for a combination of cash, new debt securities, and equity. Highest anticipated returns were from the new equity securities issued for newly reorganized companies emerging from bankruptcy.
Debt restructuring was another profitable area. In these situations, the fund provided liquidity for distressed firms to restructure debt. There is substantial return potential if the capital structure of these distressed firms is stabilized. For example, Paulson Funds purchased $200 million of convertible debentures to refinance a $293 existing convertible. The investment thesis was that the market was discounting the company because of concerns about the ability to refinance the existing convertible. By purchasing these convertible debentures, Paulson Funds could the reduce the market’s refinance concerns, increasing the company’s value. The convertible debt security Paulson Funds purchased provided equity upside with the protection of a senior debt security.

Event Arbitrage
Event arbitrage encompasses merger, distressed, corporate restructuring, and other arbitrage events.

Bank restructuring was a key area of focus. Part of the bank analysis focused on forecasting the need of banks to raise equity capital to create additional cushion for future expected losses. To estimate capital issuance, Paulson Funds forecasted core bank earnings, estimated losses, and then projected the capital whole.
Paulson Funds participated in many non-bank restructurings, including the recapitalization of HeidelbergCement, the third largest cement maker. The recapitalization alleviated problems that were depressing the company’s value. Before the recapitalization, the firm was highly levered, faced an upcoming debt maturity, and the stock was not very liquid because of a concentrated family ownership. The recapitalization raised shares that were used to reduce debt, enabled a successful high yield bond issuance, and increased the stock’s liquidity. These factors made the company more attractive to institutional investors, increasing value.
Gold was another area Paulson Funds was bullish. The fund made investments in Gold mining firms that it believed had catalysts for improvement independent of gold prices, and would thus perform well even if the price of gold remained flat. The biggest position was in AngloGold Ashanti. The general investment thesis was that the miner was trading at a steep discount to peers, but that highly experience new management could improve the company and increase the valuation. Paulson Funds also invested in Gabriel Resources. The company controls the largest potential gold mine in Europe, but was prevented from mining by the inability to secure an environmental permit. The investment thesis was that there was a strong probability of the permit being approved and the approval would be a catalyst for substantial price improvement.

Paulson & Co. 3Q Letter

Sharpe Investing Top Content - 2009

Matt — Sat, 02 Jan 2010 00:50:10 +0000

2009 was a very unique year in finance. The events of the year demonstrate how the financial markets have a significant impact on all members of society. Below are the top 10 Sharpe Investing posts, in order of page views.

1. Difference Between Basic Shares Outstanding and Fully Diluted Shares Outstanding
Fully diluted shares outstanding provides a better representation of how the market is implicitly valuing the company.

2. Comparable Company Analysis Overview
Comparable company analysis is especially useful when valuing the minority, non-controlling interest of a company.

3. George Soros Theory of Reflexivity MIT Speech
The theory of reflexivity speech by famed hedge fund manager George Soros.

4. When to Issue Debt Versus Equity
Companies face the challenge of determining whether to issue debt or equity for financing needs. Issuance of debt or equity both have advantages and disadvantages.

5. Sortino Ratio
The Sortino ratio is a financial ratio, similar to the Sharpe ratio, that measures the risk-adjusted return of investments or portfolios.

6. LIBOR – London Interbank Offered Rate
LIBOR stands for London interbank offered rate. Banks in London, similar to the United States, can exchange money between banks.

7. Sharpe Ratio
The Sharpe Ratio is a formula used to measure risk/return. The ratio describes the amount of extra return received for the extra volatility of a more risky asset.

8. Retirement Calculators Review
This post reviews a variety of free retirement calculators that are available online that allow users to analyze retirement strategies.

9. Mark Weinstein High Percentage Trader - Market Wizards
Mark Weinstein is a highly successful trader profiled in Market Wizards. This article outlines the trading principals Weinstein shares in Market Wizards.

10. Marty Schwartz Champion Trader - Market Wizards
Marty Schwartz is another rock star trader profiled in Market Wizards.

Mark Weinstein High Percentage Trader - Market Wizards

Matt — Tue, 13 Jan 2009 16:49:41 +0000

Mark Weinstein is a highly successful trader profiled in Market Wizards. After early trading failure, Weinstein diligently studied the markets. Learning from his mistakes, Weinstein eventually became a winning trader in a variety of financial instruments ranging from stock options to soy bean contracts. This article outlines the trading principals Weinstein shares in Market Wizards.

Accepting Responsibility for Losses
One of the turning points in Weinstein’s trading career followed a large soy bean trade loss. After emotionally and financially recovering from the loss, Weinstein realized that his trading results were dictated by his actions, not any form of market luck.

“I don’t believe anyone ever gets wiped out in the market because of bad luck; there is always some other reason for it. Either you were off when you did the trade, or you didn’t have the experience. There is always a mistake involved.”

Waiting for Ideal Trade Conditions
Weinstein’s strategy centers around low risk short term trades. He waits for what he perceives as a “can’t lose” situation to enter the trade.

To control risk, Weinstein trades frequently, selling positions quickly to lock in many small short term profits. Weinstein also pays attention to his gut feeling. If a trade does not feel right he will exit a position.

News
The star trader echoes the belief of other top traders profiled in Market Wizards about using the reaction of the markets to news as a broad indicator.

“A market that is fundamentally and technically poised to move higher is not going to reverse direction because of a news item - even a dramatic one.”

Weinstein’s 7 Trading Rules
1. Work hard and know the important details about the security you are trading.

2. Most successful traders are humble and realize that no one is really above the markets.

3. Understand your personal limits. Knowing your psychological or trading weaknesses, and trading to minimize the impact of these weakness is key to being a winning trader.

4. Have a contrarian mindset, and be wiling to trade against the herd.

5. Be patient and wait for ideal conditions to align before trading. Understanding when to be out of the markets is also very important.

6. Your trading strategy should be flexible and dynamic to change as markets change. Everyday successful traders fight not to become a dinosaur in the ever changing markets. A dynamic strategy that can shift as old inefficiencies evaporate and new inefficiencies appear is very important to trading success.

7. Once a trade is profitable, do not become complacent. Many traders lower there attention to detail once profits are made, but this can be sell destructive.

Final Advise
Weinstein’s final advise is to learn how to lose and quickly cut losses. This advise is also stressed by countless traders in Market Wizards.

Special Note: In the Market Wizards chapter, Weinstein stated that he had no losing weeks that he could remember since 1980 to the date the Market Wizards interview occurred. For full disclosure, many are skeptical that this is possible. The author of Market Wizards, Jack Schwager, talked with a trusted close mutual friend of Weinstein and Schwager, who somewhat verified Weinstein’s performance claims. However, they would release no official performance records.

Overview of Traditional Investment Banking Groups

Matt — Tue, 16 Dec 2008 17:40:21 +0000

A traditional investment bank is composed of multiple divisions, including sales and trading and investment banking. The investment banking division is an intermediary between companies that need capital and clients wanting to invest capital.

Bankers advise clients that need capital or are planning a strategic action, such as a merger or acquisition. Bankers also help execute these strategic actions. Normally, the investment banking division is divided between industry, product, and capital markets groups.

Industry Group
As the name implies, industry groups are divided by sectors. Examples of traditional industry groups are financials, industrials, and energy. Bankers in a specific industry group have specialized knowledge and expertise for the sector.

They try to win business from clients in their specific industry that are seeking to raise capital or execute a strategic action. Bankers in industry groups are exposed to multiple products such as mergers and acquisitions (M&A).

Product Group
Working in partnership with the industry groups, product groups primarily help execute transactions. Normally, M&A is the largest product group. The M&A group, for example, may provide valuation and deal structure services. The other product groups include leveraged finance and restructuring.

Capital Markets Group
Bankers in the capital markets group assist clients in raising capital. The capital markets group is traditionally divided by financial instruments. Capital markets groups include equities, high yield, fixed income, and structured finance.

Bankers in the capital markets groups also frequently work with members of the industry and product groups. For example, bankers in the mergers and acquisitions product group may help structure and execute an acquisition, and the capital markets group would assist the client in raising capital for the acquisition.

While most large bulge bracket investment banks are structured as outlined above, not all investment banks are the structured this way. The interactions between groups frequently differs between investment banks.

Also, smaller boutique investment banks frequently specialize in one area of investment banking. For example, a boutique healthcare investment bank would only provide investment banking services to clients in the healthcare industry, and thus not need multiple industry groups.

General Overview of Investment Banks

Matt — Tue, 09 Dec 2008 16:27:16 +0000

Investment banks are frequently discussed and anlyzed in the financial press, especially during the current credit and financial crunch. This article reviews the structure and normal functions of typical investment banks.

Primary Functions
Investment banks primarily have two functions. The first function is to raise and invest capital. The second is to advise clients on strategic actions, such as mergers and acquisitions. Investment banks primarily serve as intermediaries between companies that need capital and companies wanting to investment capital.

In addition, investment banks have been increasingly employing their own balance sheets to generate profits without directly serving clients through groups such as proprietary trading and internal alternative investment funds.

Typical Investment Bank Divisions
There are multiple division within most large bulge bracket investment banks. These divisions include investment banking, sales and trading, private wealth management, equity research, and more. Thus many investment banks provide more services than simply investment banking.

The investment banking division is generally divided into two groups, corporate finance and capital markets. The corporate finance group primarily attempts to win business from clients and execute strategic transactions. The capital markets group assists clients in raising money, generally through debt or equity markets. Capital markets groups are generally divided by the capital product, such as high yield debt.

Different Investment Bank Structures
The structure outlined above is typical of the large bulge bracket investment banks. Smaller middle market or boutique banks may lack part of this traditional structure, instead specializing in a specific area or a different target client.

David Ryan Stock Investment as a Treasure Hunt - Market Wizards

Matt — Wed, 12 Nov 2008 12:01:21 +0000

David Ryan is an extremely successful investor profiled in Market Wizards. He worked closely with famed investor William O’Neil, and eventually became a professional money manager. In addition, Ryan won the stock division of the U.S. Investment Championships in 1995 and 1995, posting 161% and 160% returns respectively. Ryan has a detailed stock selection process that he outlines in Market Wizards.

Stock Selection Process
1. Ryan only buys stocks within a few percent of their base to control downside risk.

2. Another early step Ryan initially takes is to \examine charts and identify stocks of interest from a technical analysis perspective.

3. After narrowing his universe of stocks, Ryan employs an earnings per share screen. Ryan compares the previous five year earnings growth record and the last two quarters earnings relative to the previous year’s earnings.

This comparison allows Ryan to evaluate the earnings growth trend. For example, if the previous two quarters of earnings growth were lower than the five year average, that would signal a warning about future stock performance.

The strong relative earnings growth that Ryan seeks is not always discounted into stock prices. For example, if the general market is weak, an individual stock with strong earnings growth may be held down in price. When the general market conditions improve, these stocks that have been held down but have strong earnings fundamentals generally outperform.

4. A degree of institutional ownership is also an important factor in Ryan’s stock selection process. He seeks stocks with 1-20% institutional ownership. Like William O’Neil, Ryan wants a small degree of institutional ownership, so that once Ryan buys the stock and it eventually becomes more attractive to the general market, the demand caused by further institutional buying will increase the stock price.

5. Ryan also selects stocks that have a growth catalyst, such as a innovative new product or service. Having a growth catalyst reduces the risk of investing in a value trap.

6. Volume is also an important part of Ryan’s screening process. For example, if a stock moves to a new high on low volume, that is a negative signal. This volume indicator is used by many of the star traders in Market Wizards.

Also, if volume remains very high for an extended period, that may indicate a top caused by increased selling. “You want an increase in volume when a stock breaks out, but you want a decrease as the stock consolidates.” Increased volume combined with no further price decreases may signal support from buyers, and thus a bottom.

7. Even with this rigoruous stock selection process, Ryan still states that only about 50% of his stocks are winners. The key to his profitability is risk control. He sells individual stocks if the stocks fall more than 7%.

8. Ryan generally advises to buy growth stocks without the premium valuation.“The most profitable trades are when you find a stock with a strong trend that is trading at a P/E ratio in line with the broad market ratio.”

9. Every time Ryan buys a stock he lists the reasons for his purchase.

Listing the buy rationale is an important step that provides guidance for when to sell the stock. If the reasons for the initial purchase are not present after buying and holding the stock for a certain time period, that may indicate a wise time to sell. Also, listing purchase reasons provides a way to learn from mistakes, by comparing results to the initial rationale.

“The single most important advice I can give anybody is to learn from your mistakes. That is the only way to become a successful trader.”

William O’Neil Art of Stock Selection - Market Wizards

Matt — Tue, 14 Oct 2008 18:11:22 +0000

William O’Neil is another star investor profiled in the book Market Wizards. Mixing a unique quantitative and qualitative growth investment strategy, O’Neil achieved dramatic investing success. In 1963 at age 30, he capitalized on this success by launching the brokerage firm William O’Neil & Co, and became the youngest member of the New York Stock Exchange at the time. In 1983, O’Neil launched Investor’s Business Daily, a popular investment publication that incorporates his investment philosophy. In Market Wizards, O’Neil shares some of the keys to his investing success.

O’Neil does not simply buy low priced stocks with low traditional valuation measures, such as a low P/E ratio. He cautions against investing in value traps, stocks that have attractive valuations but flat line in price. Instead, O’Neil employs a growth focused quantitative and qualitative strategy. He uses the acronym CANSLIM to describe this investing strategy.

C
C stands for current earnings per share. O’Neil’s back tested research indicated that the best stocks normally have large earnings increases in the current quarter before the stock price increases. Thus, this type of current quarter earnings increase is a leading indicator. Rising earnings drive fundamental growth.

A
The A stands for annual earnings per share. Again, O’Neil’s back tested research demonstrated that top performing growth stocks had a prior 5 year compound annual growth rate (CAGR) of 25%. Because of this correlation between strong earnings and stock performance, O’Neil seeks stocks that have consistent strong year over year earnings growth.

N
A new innovative catalyst is another key factor that O’Neil seeks in potential investments. Identifying a growth catalyst for a specific company, such as a new product or service, is important. Selecting stocks with potential catalyst reduces the risk of buying a value trap.

S
S stands for supply and demand. If a stock has limited shares outstanding, more buying will help drive up the stock price. I think this also links to investing in smaller cap stocks with less shares outstanding. Institutional buying in some of these small cap stocks that are not traditionally followed by the large institutional players can dramatically move stock prices.

L
The L symbolizes leader over laggard. O’Neil favors investing in stocks that have strong price performance relative to peers during the previous 12 months.

I
The I stands for institutional sponsorship. Institutional stock investments can be somewhat volatile, or less stable than long-term investors. O’Neil does not invest in stocks that have very high institutional ownership. Instead, he favors purchasing stocks with lower levels of institutional ownership. By buying before institutions potentially do, investors’ can capitalize on stock price increases from this large buying.

M
M stands for market direction. Macro market moves generally dictate the price movement of individual stocks. Buying stocks after a major market downturn is a bad idea according to O’Neil.

O’Neil also shares some general macro strategies in Market Wizards. If stocks that have been leading a specific sector or market begin to break downward, that is an indicator of a weak market. Also, if the Fed raises rates 2-3 times, that is normally a bearish indicator. Last, high volatility indicates directional strength. For example, if a stock breaks to new highs on high volume that is a bullish indicator. If the stock breaks to new highs on low volume, that is a bearish indicator, as there is less demand to support future price increases.

Risk Control
O’Neil incorporates strong risk control into his investment strategy. Unlike Larry Hite, however, O’Neil runs a concentrated portfolio believing that “diversification is a hedge for ignorance.” To control risk, O’Neil uses a strict stop loss policy and sells stocks if the price falls more than 7%.

*Image courtesy of thestreet.com

Michael Steinhardt The Concept of Variant Perception – Market Wizards

Matt — Mon, 15 Sep 2008 16:14:15 +0000

Michael Steinhardt is a legendary investor. In 1967, Steinhardt founded the hedge fund Steinhardt, Fine, Berkowitz & Co. From 1967 to 1995, the hedge fund returned 24.5% annually after fees. After retirement in 1995, Steinhardt became chairman of Wisdom Tree investments, a company providing a variety of exchange traded funds. Steinhardt is profiled in Market Wizards, where he shares keys to his investing success that are summarized and analyzed below.

Contrarian Perception
The star investor first discuses his theory of variant perception that is rooted in contrarian ideas. Steinhardt attempts to develop perceptions different than the consensus market view. He then trades on these variant perceptions until the general market perception aligns with Steinhardt’s opinion.

A tobacco trade provides a great example of the application of the concept of variant perception. Steinhardt shorted a specific tobacco ahead of a pending litigation decision. At the time, tobacco companies rarely lost these cases. Therefore, Steinhardt believed the general market perception would also expect the tobacco company to win the case. Because a victory was discounted into the stock price, if the tobacco company did not lose, Steinhardt expected the stock price to barely increase. The limited price appreciation potential if pending litigation was won caused Steinhardt to short the tobacco company. This was a low risk trade with high upside if the company lost the case, and low downside if the tobacco company won the case. Trading these favorable odds is a strategy echoed by many star traders including Larry Hite.

Top characteristics of successful contrarian investors are also highlighted by Steinhardt. “In order to win as a contrarian, you need the right timing and you have to put on a position in the appropriate size. If you do it too small, it’s not meaningful, if you do it too big you get wiped out if your timing is slightly off. The process requires courage, commitment, and an understanding of your own psychology.” Thus, successful contrarian investing is also dependent on excellent trade execution and commitment.

The Opposite Side of the Trade
Steinhardt stresses the importance of understanding why someone took the opposite side of your trade. For every buyer there is a seller who is making the opposite decision. “The major advice I would give to anybody is to recognize that this is a very competitive business, and that when you decide to buy or sell a stock, you are competing with people who have devoted a good portion of their lives to the same endeavor. In many instances, these professionals are on the opposite side of your trades, and on balance, they are going to beat you.”

I also think this quote about the competitiveness of investing emphasizes my views about small cap investing. For small investors buying individual stocks, I believe it is generally more wise to purchase smaller capitalization stocks that are covered by less professionals. Competing in a small pond is easier than fighting in an ocean full of sharks.

The Importance of Dynamic and Adaptable Investing Strategies
Steinhardt also emphasizes the need for flexible investment strategies. Successful investors normally do not exploit one market inefficiency for the long term. Overtime, a persistent inefficiency will attract more traders who subsequently eliminate the inefficiency. ”As soon a formula is right for any length of time, its own success carries the weight of its inevitable failure.”One of Steinhardt’s keys to success was employing a dynamic investing and trading strategy that capitalized on changing market conditions.

Comparable Company Analysis Overview

Matt — Mon, 08 Sep 2008 21:37:50 +0000

There are multiple methods investment bankers and other financial analysts use to value a company. One frequently employed relative value method is comparable company analysis. Comparable company analysis is especially useful when valuing the minority, non-controlling interest of a company.

Theoretical Basis
Comparable company analysis is rooted in the idea that companies with similar characteristics should have similar valuation multiples. Typically, a group of comparable companies includes companies from the same industry as the company being valued and companies with similar fundamental characteristics.

Multiples Valuation
After identifying the list of comparable companies, the comparable valuation multiples are applied to the company being valued to establish a relative valuation. Common valuation multiples include price to earnings, price to book, and enterprise value to EBITDA ratios. For example, the mean or media price to earnings ratio of the comparable companies would be multiplied by the earnings of the company being valued to establish a relative valuation. By valuing the company using many multiples, a relative value range is established.

Benefits
A key benefit of comparable companies analysis is that the methodology is based on the current market stock price. The current stock price is generally viewed as one of the best valuation metrics because markets are considered somewhat efficient. Also, because comparable company analysis is based on stock prices, the technique is especially useful for valuing potential IPOs.

Drawbacks
Finding true comparable companies that closely resemble the company being valued can be difficult. In addition, comparable multiples based on small companies that are less liquid in public markets provide less reliable valuation metrics. Another drawback is that comparable company analysis only values a minority, non-controlling interest in a company, which is less useful for acquisition valuations.

Difference Between Basic Shares Outstanding and Fully Diluted Shares Outstanding

Matt — Mon, 01 Sep 2008 19:49:34 +0000

Financial statements report the basic shares outstanding. However, when attempting to value a company’s market value of equity, fully diluted shares outstanding is used instead of the basic shares outstanding number. Fully diluted shares outstanding provides a better representation of how the market is implicitly valuing the company.

Basic Shares Outstanding
Basic shares outstanding are the total shares that a company issued and are outstanding. This number is directly reported on the financial statements. Not all shares that are issued are still outstanding. For example, treasury stock reduces the number of shares outstanding. Treasury stock are shares repurchased by the company in the secondary market.

Fully Diluted Shares Outstanding
Fully diluted shares outstanding are the company’s outstanding shares, adjusted for potentially dilutive securities and stock options. Convertible debt is an example of a dilutive security. If the convertible debt is converted to equity shares that increases the total number of shares outstanding.

Calculating Fully Diluted Shares Outstanding
Fully diluted shares outstanding are calculated using the treasury stock method and or the if-converted method. The treasury stock method accounts for the share impact of options, and the if-converted method accounts for the share impact of convertible debt and or preferred stock.

Treasury Stock Method
The treasury stock method includes the impact of stock options by calculating the additional shares created when the options are exercised. Only in the money options are included because out of the money options are anti-dilutive as the options would never logically be exercised. This method also assumes that proceeds from the sale of stock when options are exercised are used to repurchase shares at the current price. This partially offsets options’ dilutive effect.

Fully diluted shares are then calculated by adding the additional shares to the basic shares. Additional shares are calculated by determining how many new shares could be purchased from the profits of exercising in the money options. The calculation is current stock price minus strike price divided by stock price all multiplied by the number of options.

A company’s most recent 10k contains information about all of the current options outstanding. Normally there are multiple options with different strike prices that need to be calculated.

If-Converted Method
The if-converted method is used to calculated the share impact of convertible securities by determining how many new shares would be issued if an in the money convertible is exercised. The end calculation in this process is to multiply the number of securities being exercised by the conversion ratio to determining the new shares.

Also, convertible debt that is converted eliminates interest expense. The after tax interest savings from the conversion is therefore added to earnings per share when calculating the diluted earnings per share.