Investment

Posted by Inya Ivkovic

These are the guys who are supposed to be internal watchdogs, ensuring that the financial institution does not get carried away too much with its favorite game—Russian roulette. Understandably, once-burned-twice-shy policy applies here. It makes both financial and ethical sense to police those individuals within the firm who have the power to make or lose substantial amounts of money for them.

I find these positions very attractive. It is fun to trade, I should know. But a risk manager, now those are the guys that are there to stay. No burnout effect. The stress level versus the payout factor is outstanding. Plus, the intellectual reward is excellent, for the job goes way beyond buying and selling securities.

Nassim Taleb, however, is not exactly sold on risk managers. He perceives their job as inherently undoable because the reality of traders is not readily observable. Hence, it may be impossible to stop traders from taking on risks in pursuit of profits. And he might be right: just consider the story of Société Générale’s rogue trader, Jerome Kerviel. For most who followed that story, it seemed as if risk managers were only good at covering their respective behinds when the smelly stuff hit the fan.

On the other hand, if there were no watchdogs of any kind, what else does the ordinary Joe Schmo has to look forward to? Hoping that the anarchy of the security markets will go his way once the Pandora’s Box gets opened? Well, good luck with that!

Posted by Inya Ivkovic

Prior to discovering vast heavy oil resource in Alberta’s oil sands, there was not a significant new discovery of oil for good three decades. Also, the world has changed so much in the past decade or so. Wars are still sprouting everywhere, economies have grown terribly dependant on finite sources of energy, the planet has become overpopulated, developed world is slowly drowning in debt, etc. To make matters fundamentally worse, the world’s richest sources of fossil fuel are located in geopolitically unstable areas.

Thankfully, then came the oil sands; the new, rich-beyond-anyone’s-wildest-dreams, source of fossil fuel, and in Canada of all places; a stable, developed, G8 country. Naturally, moments after extraction technologies had improved, the area was swarmed by oil exploration companies, searching for the Holy Grail of the 21st century.

Just in the past year or so, five oil and gas companies found new dance partners for this shindig. More importantly, each time a new acquisition target was named, its stock skyrocketed almost instantly.

Predicting who may be next is potentially a difficult task. The number of potential takeover targets is getting smaller and smaller. It is almost as if oil sands have become like a beachfront property—rare and pricey, but worth every dime.

For starters, there is EnCana, Husky Energy, and Canadian Natural Resources, all three still all alone on the dance podium and still the oil sands “takeover virgins.” Then there are veteran players that have been known to sell bits and pieces for handsome chunks of money, such as Suncor, Canadian Oil Sands Trust, UTS Energy or Western Oil Sands. Basically, anyone having a stake in the oil sands may soon be courted by “Johnny(s) come lately(s).” Because, who knew high oil prices would eventually justify high exploration costs in the oil sands—duuhhh!

Posted by Inya Ivkovic

True, buying ethanol IPOs potentially offers a perfect exit strategy to investors, what with all the government support programs, tax breaks on both sides of the border, and soaring oil prices. In the U.S., the line-up of IPO ethanol producers has become quite long. But in Canada, well, not yet!

There are few things investors should know about the ethanol market. Firstly, it would not even exist if it were not for governments of both countries footing most of the bill. For example, U.S. refiners that use ethanol in their products receive a $0.51 tax break per gallon. At the moment, subsidies and tax breaks deliver billions of dollars in free money to refiners.

As far as Canada’s ethanol policies are concerned, the country has gone a step further, providing ethanol producers with not only endless subsidies, but also with a guaranteed market. Justification for such a move is partly based on ethanol‘s alleged environmental benefits, although any such benefits are dubious at best. And still Canadian ethanol producers are avoiding IPOs.

Why? Perhaps the thought of being responsible to shareholders once they go public does not sit well with producers that are used to being pampered and operate unquestioned. Here is one more crazy idea—it looks to me that everything about ethanol market in North America is artificially created, including demand and supply. And what artificial markets often do? They crash! Perhaps ethanol producers in Canada are simply afraid investors would see right through them!

Posted by Inya Ivkovic

As a result, young men with only a high school education have been enjoying a rising rate in earnings. In contrast, their university educated counterparts saw their paycheques mostly shrink, not increase.

According to a survey of Canadian workforce conducted last year, for the past five years, men between 25 and 34, having only a high school diploma, reported an increase in average weekly earnings of 5.2%. An even more intriguing number was for young men without a high school diploma, who saw their wages rise 7.8% in the same period. All the while, university graduates reported their average salaries shrink 2.8%.

Before kids today take these statistics as a ringing endorsement not to pursue university education, there are two things they should consider. Firstly, whatever goes up must come down. The same applies to anything experiencing a steep growth curve, including blue-collars’ earnings growth. Earnings growth at this rate is hardly sustainable. The demand is likely to reach the critical mass in the near future, implode and drive the earnings growth down eventually.

Also, although wages of university grads shrank, they still earned at least CDN$14,500 more than their high school dropout counterparts. Statistics Canada reported that a high school dropout earned on average $685.00 per week, a high school graduate earned $758.00 per week, while a university grad earned $802.00 per week.

As a parent, all I want for my kid is to be happy. But I also want him to be wise about his career choices. Every statistic has to be taken within a certain context and with all the relevant variables. In case of going after higher education, I’d say that staying in school is a much more profitable decision in the long term, and for all the concerned parties.

Posted by Inya Ivkovic

Many of you may feel that trying to save the planet from global warming is such an overwhelming problem, like world hunger or world peace. What can one person really do?

True, ordinary people, unless motivated and guided en masse by their governments and scientists, are more or less powerless. But socially aware investors may delay, if not prevent, whatever catastrophes may be brought on by significant climate changes.

Governments around the world are already paving the way. New regulations are coming online, supporting financially and otherwise corporations that are manufacturing pro-active, environment-friendly products and/or technologies. No doubt, these companies could represent excellent profit opportunities.

The palette of industries/companies fans quite widely. You could look into the construction and property insurance companies, to manufacturers of biofuels, to power plants that use wind, nuclear or natural gas.

While others are self-explanatory, you may wonder about property insurance companies. Global climate change is held responsible for weird weather events we’ve been having these past few years. Many insurers are refusing to underwrite property insurance policies against hurricanes and other freaky weather events. But there is a growing group of insurers that sees this as an opportunity to underwrite millions, if not billions of dollars in specialty policies.

Then there are environment consulting businesses, crop growers (such as growers of corn and sugar cane used in the production of biofuels), and companies that facilitate something called “carbon credit trading.” Kyoto agreement allowed for accumulating carbon credits, the trading of which protects both the environment and companies’ bottom line. On the list are even car and auto parts manufacturers, with their cars emitting less pollutants or building their engines as hybrids.

Apparently, although the problem of global warming is huge and daunting, there are ways of baking that cake and eating it too.

Posted by Inya Ivkovic

So, what gives? Is there a secret recipe? Is there a secret to successful investing in small caps? Is trading small caps something that only financial gurus can do? Well, the answer is both yes and no, but mostly no.

There is this cute little comparison often used to describe a typical Wall Street money manager. He or she is a person that competes in a game of darts with a blindfolded chimp. The long outstanding joke is that regardless of the blindfold, the chimp outplays the money manager eight out of ten times.

Well, no one can say this comparison is hardly flattering. The real question is, however, could it be true? Considering that most active money managers have difficulty spotting even the basic of market trends at times, it just might be.

The probability of a chimp picking better stocks than a million-dollar money manager covers the bad news. The good news is “Who cares!” Who cares about the stock picking abilities of an expensive money-sitter! It would certainly not be an investor who manages his own portfolio, and definitely not the investor who has a portion of it invested in small caps.

After going through two stock market meltdowns in recent years, there are no excuses for failing to do the necessary footwork. So, what are ordinary investors to look for?

In a nutshell, the first step involves finding out who runs a company and whether the company’s management is invested in the enterprise. The next step involves researching whether the company operates a sustainable business. And the third step is related to the second step; that is, investors should check whether a development-stage company operates within a niche market.

Posted by Inya Ivkovic

Taleb’s discussion on rare events continues with a brief analysis why statisticians cannot successfully detect rare events. He says that statistics “is based on one simple notion; the more information you have, the more you are confident about the outcome.” The only problem is determining the level of that confidence.

Common statistics models are based on establishing the confidence level under an assumption that it will increase in non-linear proportion to the number of observations. In layman’s terms, the larger the sample, the better the statisticians knowledge about the behavior of its variables.

Where statistics becomes complicated, and by extension, yields fallacies, is when the distribution is not normal, but asymmetrical. Taleb offers an example. Suppose there is an urn full of red and black tennis balls. We don’t know how many balls are in the urn, only that red balls are significantly outnumbered by black balls. Having that in mind, knowing about “the absence of red balls will increase very slowly,” while “our knowledge of the presence of red balls will dramatically improve once one of them is found.”

In the investment context, assessing performance requires more precise and less intuitive techniques and models. Otherwise, performance assessments will have to be measured independent of how often rare events may or may not occur.

Posted by Inya Ivkovic

Taleb continues discussing rare events by introducing the example of Mexico’s so-called the “peso problem.” Namely, during the 1980s, economists were largely puzzled by certain Mexican variables, which behaved rather oddly, thus skewing their quantitative models. Constituting “odd behavior” were erratic switches between stable periods and volatile periods.

According to Taleb, “Rare events are always unexpected, otherwise they would not occur…They are generally caused by panics, themselves the results of liquidations (investors rushing to the door simultaneously by dumping anything they can put their hands on as fast as possible).”

Interestingly, the second edition of Fooled by Randomness was published in 2004. I’m mentioning this because even back then, Taleb talked about traders buying and hedging mortgage-backed securities within the context of rare and devastating events. Almost as if he had magical powers to predict the catastrophe that subprime lending crisis would have caused in the global markets today.

Part of the reason why rare events catch investors by surprise is their rather amazing “ability” to push “randomness under the rug.” Apparently, psychologists have found that people are generally more sensitive to the presence of a stimulus than to its actual magnitude. For example, if an investor loses a small amount of money, he is likely to be more upset about the mere fact that he did lose money than how much he had actually lost.

Taleb concludes the section saying, “In the markets, there is a category of traders for whom volatility is often a bearer of good news. These traders lose money frequently, but in small amounts, and make money rarely, but in large amounts. I call them crisis hunters. I am happy to be one of them.”

At this point, I have a felling I’m not the only one wishing to join the ranks of “crisis hunters.”

Posted by Inya Ivkovic

In Chapter Six of Fooled by Randomness, Taleb talks extensively about skewness and asymmetry. He starts the section subtitled ‘Rare Events’ with the statement, “The best description of my lifelong business in the market is ‘skewed bets,’ that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur.”

Taleb proclaims himself not to be greedy. He is more interested in hauling in piles of money infrequently, when a rare event occurs, “simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price.” Taleb also believes in taking counterintuitive approach to trading, even though most traders are generally not wired in such a manner.

According to Taleb, rare events are usually incorrectly evaluated for a number of reasons, the predominant one being the psychological bias induced by the herd mentality. If something is said in the Wall Street Journal, it must be true. If a famed financial guru, such as Jim Rogers, says that “Buying options is another way to go to the poorhouse,” well, heck, that has got to be true. Oddly enough, for a while, Jim Rogers partnered with George Soros, who Taleb describes as, “…a complex man who thrived on rare events.”

Finally, Taleb mentions an often quoted statistics that 90% of all option trades lose money, which is also the reason why Rogers stays away from them. But Taleb approaches this statistics introducing the variable of frequency. The secret is not in the 90% of losing options, but in the 10% of the winning ones, which, granted, occur infrequently, but when they do, they are potentially extremely profitable.

Posted by Inya Ivkovic

Believe it or not, the bear and bull analogy was drawn from the way each animal attacks its victims. A bull attacks with its horns by driving it through its victim and up into the air. A bear, on the other hand, mauls its victim by swiping its paws downward over it.

Pretty pictures, and seemingly relevant. But here is what Nassim Taleb thinks about these terms: “I have to say that the notion of bullish or bearish are often hollow words with no application in a world of randomness—particularly if such a world, like ours, presents asymmetric outcomes.”

Taleb then proceeds to describe “discussion meetings, where “…[although] the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street ‘economists’ or ‘strategists,’ who make pronouncements on the fate of the markets, but do not engage in any form of risk taking, thus having their success dependent on rhetoric, rather than actually testable facts.”

I loved every word of this description, particularly seeing it in the current context of every media outlet flushing us with this, that and other opinion. As Taleb says, “…bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no experience in handling risk.

Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant; it is the magnitude of the outcome that counts.”

And, don’t we all with invested assets know it!