Senate ends ethanol subsidies of $6B

Because I was involved in MIT's electric vehicle team, I have been receiving the team emails, even after I left in sophomore year for another research project. It is one of the only "spams" I continue reading even if most of the day-to-day miscellaneous tasks vaguely matter much to me. But I prefer to stay on the mailing list because the projects the team has been undertaking are very interesting.

Today, I received an email from the president of the team, Radu Gogoana, an extremely motivated individual who is truely passionate about building electric vehicles. I remember voting him as the president after he gave a speech to the team on his mission and plans. His email  titled "Senate ends ethanol subsidies. I am providing the content below:
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Radu Gogoana to evt-crew
73 to 27 vote, ending $6B in subsidies for automotive ethanol – see ya E85. The Wall Street Journal advised lobbyists to update their resumes and send them to EV companies. For those who subscribe: http://online.wsj.com/article/SB10001424052702304186404576388113046850414.html?mod=googlenews_wsj Also – I was surprised to see that about half of the scooters and bikes in Shanghai were electric, standing on a random street corner in one of the more industrial areas. Always nice to see things take off at the lowest end of the market. Things are getting interesting!

-Radu
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For those of you who do not have a subscription, here we go: http://www.knoxnews.com/news/2011/jun/18/ethanol-subsidies-take-hit/

The first thing I thought of is how this congressional vote would change the electric vehicle market. Then I proceeded in searching on Google "American electric vehicle company" to see who are the players in the market. One company showed up in a blog, ZAP. Google Finance soon showed me its ticker ZAAP along with a few competitors, including TTTM, ELCR, LMCO, etc. Most of these companies are trading in the down trend, but I expect to see it trending up. I have been following biofuel makers and oil prices, so I paid more attention in learning about electric vehicle developers.

It's known that developing and marketing electric vehicles in U.S. have been unprofitable business and the government used to subsidize ethanol by sending checks to corn farmers. Ending ethanol subsidies means that the price of ethanol would go up, which would drive down consumers' propensity to buy ethanol-mixed gasoline powered cars, drive up oil price if OPEC keeps the supply constant, and drive down the profitability of biofeul makers. This could also mean that electric vehicle developers might turn loss into profit in the median term. 3-5 years? I have no idea.

The second thought that came into my mind is how can U.S. compete in the world market as its debt increases in a unsustainable level. While Chinese have been sugar with its cheap labor to build electricity powered bikes and motorcycles, our government has been subsidizing corn farmers $6B per year with its made believed theory that corns can be turned into ethanol in a profitable manner. Is this more of an effort to support research and development in the area to drive down our expensive oil import, or more of an effort to keep those farmers employed? Regardless what the answer is, the funding is over. More importantly, research and development in the area would decline or even cease to exist, while Chinese start to lead the market.

I still recall how my sister took home the heavy electricity box from her electric motor bike to charge every night and reinstalled it every morning when she went to work. She just let it sit in our living room overnight with no extra work other than the one minute reinstallation every morning. The bike was about 2,000 RMB (~$300) back then, in 2005. It was very cute. Since then, her car mostly just sits in the garage.

With China started innovating, U.S. has been struggling to keep its unemployment rate down, debt sustainable, and consumption level high. I am afraid Jim Rogers's prediction of China being the 21st-century world leader would come true. I see it coming. So here I am, waiting in the Logan Airport, heading to Hong Kong, where the motion is.

Value Investing

Starting a deli on the street corner is investing.  Buying a house is investing. Studying at a college is investing. Depositing money in the bank is investing. Holding stocks is investing. We have always been looking for ways to invest our time in the most productive manner. We also aim to invest our savings to cope with inflation and grow our wealth. But what is the best way to invest? To answer this question, we have to limit the definition of investing to commitment of money or capital in order to gain a financial return in the capital market. This is because we are not interested in discussing issues such as the cost and return associated with higher education or watching television all day long. Instead, we are concerned with the realization of monetary return provided by commitment of capital in purchasing, holding, or selling securities in the capital market.

Investing in the capital market involves two major methodologies: momentum investing and value investing. The financial sector has evolved over the past fifty years to include technological advances that made the following possible: algorithmic trading, online exchange, and distal transaction. These technological advances also help analyze data and graphs in seconds rather than days. This empowers momentum investors to invest by using technical analysis. Technical analysis is “the study of relationships among security market variables, such as price levels, trading volume, and price movements, so as to gain insights into the supply and demand for securities…Technical analysis attempts to determine the market forces at work on a certain security or on the securities market as a whole (Scott).” The volatility—defined as the variance of price levels,—creates patterns in prices, trading volume, and correlation between one security to another. These patterns are fascinating to technical analysts. By recognizing these patterns and betting on their repetition, technical analysts could potentially earn handsome profit. However, technical analysis involves frequent transactions and ignorance to the economics of a business.

Value investing, on the other hand, does not have these restrictions. It is primarily driven by fundamental analysis. Fundamental analysis is an “analysis of security values grounded in basic factors such as earnings, balance sheet variables [including debt-to-asset ratio, inventory turnover rate…], and management quality… [It] attempts to determine the true value of a security, and, if the market price of the stock deviates from this value, to take advantage of the difference by acquiring or selling the stock (Scott).” Value investing focuses on generating long-term returns from buying underpriced securities. Value investors believe the fundamentals of a business including industry outlook, cash generating ability, management expertise, and pricing strategies would eventually be reflected in the stock price. They are always trying their best to define value, find the value they defined, and purchase the value at a bargain. Some investors define value as the liquidation value of a company which is the total worth of the company’s physical assets if it were to go out of business. Other investors define value as GARP, or growth at a reasonable price, which involves looking for companies that are showing consistent earnings growth above broad market levels. After identifying the values in the market place, value investors only purchase these values if they were underpriced to minimize risk.

Unlike momentum investors who wager their wealth on many assumptions, value investors wager their wealth on only one assumption: although the market is volatile and unpredictable in the short run, it reflects the performance of underlying businesses in the long run. The two investing methodologies are opposite because value investors look for assets that are underpriced because of momentum investors’ over-reliance on patterns.

In fact, an investor would be better off being a value investor than a momentum investor for four reasons. Firstly, value investing entails bottom-up research for fundamental analysis and bottom-up research is usually more manageable than top-down research. Secondly, value investing does not incur frequent transactions. Thus, value investing helps investors save on transaction cost. Thirdly, value investors do not have to deal with the volatility of the market. Although value investing requires substantial ability to stand discomfort and patience, the focus on intrinsic value allows value investors to stay away from those uncertainties. Lastly, value investing encourages buying at a discount to the intrinsic value of the security. This creates a “margin of safety” or a cushion that allows price to drop slightly further without realizing a loss. This safety net, in combination with strong fundamentals of a business, is the best way to protect and develop wealth in the long run.

“Generally, investors begin their search for attractive candidates [for investment] in one of two ways: top-down and bottom-up (Brandes).” Top-down investors start broadly and narrow their search gradually. They first gauge the strength of the economy in a particular region and identify an industry of strongly positive prospect. They then study the economy’s historical performance to help find a promising sector. Factoring in expectations of macroeconomic dynamics such as interest rates, political climate, and foreign exchange rates, top-down investors then determine specific stocks that will fit their investment thesis. This approach involves a series of assumptions. If any of these assumptions is slightly inappropriate, the investment would be unappealing (Brandes).

            Bottom-up investors, on the other hand, evaluate thousands of individual business simultaneously. They analyze the earnings and cash generating ability of each company as a ratio of its market price in order to find the most attractive candidates. Less consideration is given to macroeconomic factors. Clearly, this is more manageable than top down research. Neither expertise of investing nor confidence in forecasting is needed. Seth Klarman, president of The Baupost Group, stated in his book Margin of Safety, “in reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is speculative undertaking (Klarman).” Seth Klarman is a legendary fund manager for The Baupost Group. Since its inception in 1982, the fund has returned over 20% per year on average and manages $22 billion as of 2010.

So why do momentum investors favor top-down research? They believe that “bottom-up investing is poorly suited to the current era, as it fails to equip investors with the many tools they need in order to spot opportunities throughout the globe…[it is] for those who want to think small and prefer to shun the extraordinary investment opportunities created by the spread of market capitalism. Top-down investing is for those desiring to think big, and it is for profit (Crescenzi).” We have to recognize that bottom-up investors might lack the tools they need to pinpoint attractive investments because in the globalized village, we have to account for different accounting standards and legal implications in different regions in order to find the most attractive businesses. Moreover, we need to understand different languages ahead of everything else. However, we could overcome these difficulties through outsourcing and hard work. Bottom-up investors do not prefer to “shun extraordinary investment opportunities.” They are simply more risk-averse. Unlike top-down investors who trust their gut feelings and have faith in their abilities to “think big,” bottom-up investors only depend on hard work to analyze all investment opportunities. Top-down investors’ accusations do not make value investing any less attractive if an investor is willing to work hard.

Bottom-up research is a better method to make investment decisions because it is more pragmatic. To answer the yes-no question of whether we should invest in a company, we only need to analyze its business and compare it to its competitors. On the contrary, top-down analysis requires assumptions that could falter. Therefore, bottom-up research-based value investing is better than top-down research-based momentum investing.

Value investing has a long-term focus. Its disciplines “focus on long-term fundamentals and reject all technical charist approaches… [It has] long-term investment strategies and short-run operating results in analyzing companies (Whitman).” The long-term focus leads to fewer transactions.

Momentum investors focus on being the first movers. They would buy a security before everyone else does if they believe the prevailed market perception indicates the security would increase in value. Similarly, they would try to sell a security before the momentum of selling accumulates. Since the market continuously drifts up and down, momentum investors have to transact with brokers very frequently. Each transaction comprises a direct transaction fee to compensate the broker-dealer and an indirect cost that is reflected in the bid-and-ask spread. The transaction fee ranges from 0.5% to 5% of transacting value. In very rare cases the fee lands on the lower end because there is a lower bound on the fee. Therefore, unless you buy or sell a multi-billion-dollar block of shares, your transaction fee would be high. The bid-and-ask spread is the difference between highest price a broker is willing to buy and the lowest price a broker is willing to sell. This translates to an immediate loss if you were to buy and sell a share simultaneously. The spread ranges from one cent to a few dollars per share. It exists simply to protect brokers from market volatility. High market volatility is associated with wider spread. In other words, if stock A traded between $10 and $20 in the past year, stock B traded between $14 and $16, and both have fair price at $15, the bid and ask for stock A might be $14.2 and $15.8 while the bid and ask for stock B might be $14.9 and $15.1. The bid-and-ask spread creates an indirect cost for investors. Thus, if an investor were to buy 100 shares of stock A at $15.8 and pay his broker $10 dollars for the transaction, he would have to wait for the stock to increase 6%1 and reach $15.92 per share before realizing any positive return.

Robert A. Korajxzyk and Ronnie Sadka conducted research to “test whether momentum strategies remain profitable after considering market frictions induced by trading (Korajxzyk).” Their study showed that returns generated by momentum strategies decline with portfolio size. In other words, the return to capital deployed in momentum investing has diminishing returns to scale.

Value investors, with a long-term focus, neither need to face the frequent transaction costs nor do they need to face diminishing returns to scale. Value investors often hold a stock for years unless the underlying business undergoes an imperative negative clause. The low frequency saves value investors transaction costs.

Value investors also do not need to deal with the volatility of the market. The focus on intrinsic value allows investors to stay away from most of the uncertainties. Numerous researches showed that short-term price movements are similar to random walks. French mathematician Pioncare “found that each period’s price change was not significantly correlated with preceding period’s price change nor with the price change of any earlier period, at least as far as he tested, up to twenty-nine periods (Alexandra).” This means the change in price of a stock cannot be explained by any previous changes.

Thus, relying on historical price performance to predict future price movement is a gamble. Momentum investors have to buy at lows and sell at highs in the volatile market. Just as a gambler with sophisticated knowledge of probability bets on heads-or-tails on the next coin flip, a momentum investor with expertise in top-down analysis bets on direction of price movement. Contrary to this, a value investor never takes bets. A value investor is armed with almost all, if not complete, knowledge of a company when he makes the investment decision. He knows the company’s comparative advantage, industry prospect, profit margin, leverage ratio, the risks associated with its business... Most importantly, he only invests if it is a bargain. Then, all he has to do is to wait for the market price to reflect the true value of the company.

“Patience is a key virtue for a value investor. As Ben Graham said, an undervaluation caused by neglect or prejudice may persist for an inconveniently long time (Monitier).”  That is to say that price might drop further in the short run simply because the market is irrational. Similar to any individual in an uncomfortable situation who would implement a fight or flight decision, a value investor in price drop would either average-down or sell off. Namely, a value investor would either buy more at lower price after a price drop to lower his cost basis for the stock or sell all the shares he owns because price drop makes him uneasy. Ability to bear low comfort levels and patience to wait for the market to reflect the true value are extremely essential.

Now you might wonder, what is the catch? What distinguishes value investing and leads to handsome returns? “Warren Buffett likes to say that the first rule of investing is ‘Don’t lose money,’ and the second rule is, ‘Never forget the first rule.’” Even though no one wishes to incur losses, the innate compelling urge for free lunch through speculation in every single human being is evident. Some investors believe “risk comes, not from owning stocks, but from not owning them,” or “risk avoidance is incompatible with investment success (Klarman).” These conceptions might sound silly but they are widely believed.

The next question is: how do we minimize losses in investments? “Value investing is the discipline of buying securities at a significant discount from their current intrinsic values and holding them until more of their value is realized (Klarman).” Bargain is the key. For value investors, it is translated to buying a dollar for fifty cents and waiting for others to realize it is, in reality, a dollar.

We all love bargains when we shop for foods, clothes, and electronics. We can easily get excited when we see a poster that says “50% off of everything.” But why are we not excited about bargains in stocks? This is because not following the herd makes us feel anxious. A contrarian is very lonely and uncomfortable. It is much easier to endure losses when everyone else experiences losses than to be value investor and experience disastrous performance when others enjoy gains. That is why patience is needed for true value to be reflected in the price.

The discount in purchase price provides a margin of safety. “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And the same principle works in investing (Willis).” This is the core concept in value investing.

Overall, value investing is a better practice than momentum investing. This is because a more manageable research method,is employed. While momentum investors incur frequent transaction costs, direct and indirect, and cope with the volatile market, value investors seek discounts that provide margins of safety. While momentum investors aim to ride on trends for free lunch, value investors work meticulously to find bargains. Fortunately, all of the hard work could pay off and the long-term wealth value investing delivers is palpable.

The world’ third richest individual, Warren Buffett, a self-made value investor of personal net worth of $47 billion, has once said, “we’ve long felt that the only value of stock forecasters is to make fortune tellers look good… [I] believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children (Altucher).” His analogy between momentum investors and children indicates that trend predictors are believed to be immature. Warren Buffett is only one of many investors who earned their fortunes through value investing.

Bibliography:

Alexandra, Sidney S. “Price Movements in Speculative Markets: Trends or Random Walks.”

Industrial Management Review. May 1961, Vol. 2, No. 2, p7.

Altucher, James. Trade like Warren Buffett. Wiley, 2005.

Basu, S. “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratio:

A Test of the Efficient Market Hypothesis.” Journal of Finance, Jun77. Vol. 32 Issue 3,

p663-682.

Brandes, Charles H. Value Investing Today. McGraw-Hill Companies, 1997.

Crescenzi, Anthony. Investing from the top down: a macro approach to capital markets.

McGraw-Hill, 2008.

Karojczyk, Robert A. “Are Momentum Profits Robust to Trading Costs?” Journal of Finance.

June 2004, Vol. 59 Issue 3, p1039-1082.

Klarman, Seth. Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful

Investor. HarperCollins, 1991.

Whitman, Martin J. Value Investing: A Balanced Approach. Wiley, 2000.

Monitier, James. Value Investing: Tools and Techniques for Intelligent Investment. Wiley, 2009.

Scott, David. Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor.

Houghton Mifflin Company, 2003.

Willis, Clint. What do I do with my money now? Answers for Any Market from Warrant Buffet.

Da Capo Press, 2003.

Footnotes:

1.         [($15.8*100+10)/ ($15*100)-1]*100% = 6%.

2.         $15*(1+6%) = $15.9

Recruiting and new knowledge!

I had been having a crazy schedule because of recruiting, because I dropped my resume everywhere and got a lot of interviews. What I realized that never came across my mind before is that interviewers really have different agenda in recruiting; some are looking for smart and driven individuals who are passionate about the job/market while others are looking characteristics written on the back of their notebooks. But wouldn’t it make more sense for the recruiter/interviewer to share a matched proportion of a candidate’s bonus so their interests and their employers’ interests are aligned? I guess that’s why it makes sense to have headhunters. 

Now, I’ve got both banking and sales and trading offers so am more relaxed now, after a week’s frenzies. One thing I learned in my superday on last Friday was actually very interesting. I talked the director of prime services and risks in a bulge bracket bank. He used to have his own fund, macro net long, which made him considerably more interesting to talk to. I asked him as director of prime brokerage services how he hedges his exposures to different positions different funds under different circumstances, e.g. Egypt unrest. He answered that he basically had his team screening through all the hedge funds’ positions to see if they were exposed to Egypt, and if so, how concentrated their positions are and how big they are. Then reach out to them if the bank thinks they are in danger. Of course, the bank is not able the think; it’s him who makes the decision. Therefore, it’s still a matter of subjective judgment and decision making, just as in every other aspect of life. I also asked him when would he call margin or kick a fund out of his portfolio. His answer was very vague. He said it was a combination of how “big” the client is and “how are they operating.” I pushed for a more specific answer and he gave me a better one, saying that it’s very hard to quantify the credit of their clients but if they happen to use the liquidity they can access in prime brokerage by setting up a shell fund to support its subordinate PE business, then they might have crossed the line. That was very interesting to learn.

Mr. Hu and Mrs. Watanabe

I’d like to note on President Hu Jintao’s visit to Washington D.C. Of course, he was greeted with questions on human rights, which he remained silent about and was forced to say that a lot is “still remained to be done.” He was also criticized on trade policies, especially the currency manipulation that Americans believe to be one of the bottom-line forces that drive up our unemployment rate. It’s true that United States needs a surge of demand to lift it out of, completely out of, recession, but counting Chinese consumption of goods made in U.S. seems a little out of scope. This is because Chinese fiscal policy also astutely prevents consuming imported goods with high tax on import. Thus, Mr. Hu’s trip to U.S. only accomplished two things: first, China is patient and will be sitting calmly while dealing with all criticisms and questions; second, China can obtain “respect” from a powerful developed country, especially after spending skyrocketed advertising fees showing off its USD 6 trillion GDP in 2010 at Times Square. However, who knows if China is not stepping on the brake to slow down the heat of its “unhealthy” growth? It almost kind of sounds silly to me how growth is “unhealthy” only because it is too high that a government needs to “do something.” But “do something” is easy in China, because it has only one party and wouldn’t have to go through debates and criticisms to design and execute any policies, just as how its CPI was controlled through an effective decrease of vegetables’ prices.

Being vaguely tangible to what was broadcasted on TV yesterday, the stock market decided to go through a decline just for the sake of selling off a new high. There wasn’t any obvious reason why market should experience a dip. Some blamed it on GS’s below-estimate profit; some blamed it on Steve Job’s medical leave; some blamed it on BAML’s clichéd loss on its heavy position in mortgages; and some blamed it on what was discussed by Mr. Hu. But to me, it was just a selling off of new high of technical analysts. Of course, my personal portfolio suffered as I didn’t think there should be a selling off for no obvious reasons. I probably could have been in a better position if I were Mrs. Watanabe, a term that vividly describes Japanese day trading housewives.