A Brief Example of The Limitations of Algorithmic Investment Selection

Earlier today, I came across this interesting piece of “research” identifying Jos. A. Bank as a compelling long opportunity. For those out of the loop, JOSB is in the process of being acquired by Mens Wearhouse for $65/share. As you can see, since MW made its most recent offer (raising the price to $65, that is), JOSB hasn’t exactly been a great stock to trade, to put it gently. To wit:

+3% and change since JOSB filed the press release announcing the higher takeout price, raised from $63.50 on 3/11 of this year, which was just the most recent bump in the long road that has been the MW-JOSB journey (which, if you’ll recall, started with JOSB offering to buy MW back in September of last year, a brilliant strategy in my humble opinion). The odds of the bid being raised from $65 at this point are, in my fairly well informed opinion, lower than the odds that MW’s board will change its mind after conducting due diligence (itself unlikely, but non-zero). Put simply, any trader/investor can do 5 minutes of work, 15 tops, to realize there’s little upside, and a lot of opportunity cost, not opportunity, getting long JOSB at this point.

TheStreet’s QuantRatings system, available for the bargain price of “less than $1 per week!” touts, among other things, “In-depth analysis of the stock’s most important fundamental and technical factors…”
One would hope that, among the many factors this or any system “analyzes” the existence of a tender offer (easily found in SEC filings, press releases, etc by man or machine) would be one of them. Alas…

With novice and professional traders/”investors” alike increasingly relying on any “new information” in the market to inform their decisions (or, too often, confirm their preexisting views), such garbage systematic “research” is as much, if not more a source of risk than a source of opportunity.

Making money investing/trading is not easy; assuming for even a moment otherwise is a surefire way to shoot oneself in the foot.

As always,


Stone Street Advisors LLC Equity Research Performance Analysis, 2011-Present

When I started Stone Street Advisors, I hadn’t yet developed the full business plan, mission statement, or anything along those lines; I just wanted to do research and consulting differently, and had a general plan for so doing. Over the past few years I’ve refined my approach and my thinking to the point where today, I can be very clear about what the company does, why, and how we add value to clients.
Simply put, our philosophy is that given finite resources and a finite amount of very high-return, high-conviction equity opportunities available at any given time, our effort is best spent identifying only the very best investment ideas, even if that means coming up with a few per year. We believe generating a handful of great ideas is far more valuable to our clients than several handfuls of ok-to-good ones. To be clear, we don’t presume to replace our clients’ existing research capabilities, but rather seek to complement them. We do not manage money, nor maintain a portfolio (actual or virtual), allowing us an unbiased perspective to focus solely on identifying long and short opportunities that we expect will return 50%+ over the next 12-24 months. While we do not explicitly make allocation or risk management (entry/exit/limits) suggestions, we try to convey all relevant risk factors to clients, especially for short and contrarian ideas.

Since we’ve yet to have a client ask to see our track-record, I never kept anything more than a mental accounting of our stock picking performance, that is, until this week. Below are the results of the long & short ideas that we have published (the dozens of high-level analyses we’ve shared have been excluded) since 2011, both in absolute terms and relative to the S&P 500.

Some highlights:

- Long ideas returned, on average, 237% from initiation to their high price or 222.8% relative to the S&P500
- Long ideas have returned, on average, 124.7% from initiation to their current price or 104.0% relative to the S&P500
- Short ideas have returned, on average, 56.2% from initiation to their low price or 71.4% relative to the S&P500
- Short ideas have returned, on average, 26.5% from initiation to their current price or 66.8% relative to the S&P500

For inquiries, please contact us via information@stonestreetadvisors.com.

Jordan S. Terry
Founder & Managing Director
Stone Street Advisors LLC

The Greatest Trade Ever

A few weeks back Bob Treue the president and founder of Barnegat Fund Management was kind enough to upload his November 2010 presentation at Oxford University. Here he explains at length and answers questions about his 2008 TIPS trade which became famous thanks to an academic paper and some coverage from the FT and Barrons.

I personally believe this was the greatest trade of all time. The trade idea itself was a rather straightforward arb opportunity brought about by the massive imbalances that arose during the period directly after the Lehman bankruptcy, but what made it extraordinary was the actual ability to execute.

The keys to the trade, as outlined here, were holding at least 50% of the fund in cash and equivalents as collateral for margin calls during periods of increased vol, selecting and educating a client base that was comfortable with the risks and rewards of a relative value fixed income fund, and hoodwinking desks like mine by negotiating the best ISDAs possible during times when dealers were less concerned about risk management.

Since it only had 25 views when I found it I thought it would be criminal not to share it. Enjoy.

Claims Rule Everything Around Me C.R.E.A.M.

Last week Bloomberg’s Michael McKee was interviewing one of my favorite economists, Neil Dutta of Renaissance Macro, and asked him whether he thought initial jobless claim deserved such a wide following or if it might be an overrated indicator. I was pleased to hear Dutta confirm its importance.

If anything this data point is underrated. It is hard data so it is not reliant on estimates (excepting rare examples like California last year when a state fails to correctly collect it). It is released with a six day lag so it’s about as close as one can get to real time. It is subject to an extremely low level of revisions. However, unlike numbers like NFP, durable goods, retail sales, or industrial production it rarely results in market volatility upon its release.

The lack of an upward trend in claims is why I stuck by my guns over the recent data weakness being an entirely weather related phenomenon. My charts below are a testament as to why it is unquestionably the best indicator of the domestic economy.

Let’s start with a comparison to another labor metric: Claims 4WMA (white) vs. Unemployment (orage).

One more labor metric: Claims 4WMA inverted (white) vs. NFP (orange) with recessions shaded red. Claims offers a far less noisy data set.

Overall economic growth: Claims 4WMA inverted (green) vs. GDP growth year over year (blue).

Soft manufacturing data: Claims 4WMA inverted (red) vs. US PMI (blue)

Hard manufacturing data: 4WMA inverted (orange) vs. US auto assemblies (white) with recessions shaded in red.

Sentiment data: Claims 4WMA inverted (green) vs. Consumer Confidence (white)

And the ultimate sentiment indicator: Claims inverted (green) vs. SPX (orange)

Initial Thoughts on Unilife’s New Debt Financing

Since I started looking at Unilife (UNIS), I’ve been extremely concerned with the company’s liquidity and solvency situation. They’ve been burning through cash like it’s going out of style and operating expenses are already very high and have kept growing at a fast pace. Operating losses every year meant the company already has significant negative debt service coverage ratios (i.e. they burn cash to pay debt service rather than using operating income to pay interest/principal). At the end of the last quarter (Dec 31), they were already highly levered with a Debt/(book) Equity ratio of ~0.74, placing UNIS in an elite group of companies — 0.74% of the 6,795 stocks in the Finviz.com database — with such high leverage and negative margins.
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Fisher on Tapering

Over the past few days we have seen a relatively minor selloff in domestic risk assets. A 4% swing peak to trough in equities is not exactly earth shattering, but the onset complacency and lack of volatility in the past year amplified at least the vocal reaction to the move. This coupled with a few mixed economic signals has some under the impression that the Fed might alter its tapering path for QE.

With inflation currently picking up, unemployment significantly below Fed projections, and GDP growth significantly above them, I think the easier case is for more tapering not less. These projections are already so cautiously off the mark that the January unemployment rate is likely to breach the 2014 year end central tendency. That’s an estimate made last month.

Projections which will need to be need to be drastically altered in hawkish directions below.

This situation reminded me of a quote by Dallas Fed President Richard Fisher from his remarks on January 14th. Though clearly the most hawkish member of the Fed, he is a voting member this year, and I found this insight important especially as to why their focus on long term real economic trends is of a great deal more importance than noisy short term market reactions.

“Were a stock market correction to ensue while I have the vote, I would not flinch from supporting continued reductions in the size of our asset purchases, as long as the real economy is growing, cyclical unemployment is declining and demand-driven deflation remains a small tail risk, I would vote for continued reductions in our asset purchases, with an eye toward eliminating them entirely at the earliest practicable date.”

I am confident that as long as the dual mandates of inflation and unemployment are moving in the right direction this, extremely competent, Fed will continue along the path of policy normalization.

Full disclosure I’m a short duration all over town.

Unilife, Or: When A “Growth” Pure-Play Isn’t A Smart Play

I come from the school of fundamental value analysis/investing. So when a client asked me to look into Unilife Corp (UNIS) a few weeks ago, naturally, my first reaction was to look at their SEC filings and financial statements. It became immediately clear (as it should to anyone who’s spent more than 60 seconds looking) that this was not a company on which one could perform a discounted cash flow (DCF) valuation or any other traditional fundamental valuation, since their financials are an absolute and utter disaster of the highest order. DCF won’t work – it’d just be adding an enormous degree of false precision/certainty to an extremely uncertain and unpredictable set of financials – and comps are only useful insofar as they not only exist, but have similar activities, capital structures, etc. Option valuation is just another exercise in futility, especially considering the firm’s financial and operating history is all over the place, making any assumptions/inputs useless.

So how then are we supposed to value this company? Continue reading

Richard Koo on Tapering

In a note this week Nomura Research Institute’s famed chief economist Richard Koo laid out his case for the Fed to start tapering as soon as possible. Most of it focused on liquidity, recent labor market improvement, benign inflation, and the current pace of economic growth through his ever insightful balance sheet recession lens. Most of these factors have been debated to their fullest extent by every research team in finance, and with industrial production and CPI as the only significant data points left before the FOMC meeting, there is little to change any views from that angle.

What stuck out to me was his “personal standpoint” argument. This is especially worth noting because he recently met with both Bernanke and Yellen to discuss monetary policy and presented his case for normalizing policy. As an aside the aforementioned presentation, which I was lucky enough to see later in the month, included one of my favorite chart’s of the year.

Since I did not see any of the usual suspects write up his most recent note I have shared the relevant section directly below.

(A)n objective view of the situation suggests that now—when forward guidance is still in effect and inflation is subdued—is the time to act in order to prevent a premature rise in interest rates under tapering. For that reason, I suspect many FOMC members are arguing that now is the time to make the announcement.

December tapering would benefit both Bernanke and Yellen
A December tapering would also be beneficial from a personal standpoint for both the current Fed chairman and his successor nominee. As the man responsible for launching quantitative easing, Mr. Bernanke would no doubt like to set a course for the normalization of monetary policy before his term expires.

I suspect he began talking about tapering in May because he wanted to at least put things in motion before his term expired at the end of January. Then, even if the US economy fell into a quantitative easing “trap” during the process of normalizing policy, he would be able to avoid the criticism that he had started QE but left the cleanup to his successor.

Decision by Bernanke would make it easier for everyone else
Ms. Yellen, meanwhile, has strong dovish credentials, and if that was the basis for her nomination by the Obama administration, I think it would be difficult for her to announce a tapering immediately after becoming Fed chair.

For the first few months, at least, it would be better for her to spend time preparing everyone psychologically for the next step given her dovish reputation in the markets and the administration. But this would delay the start of tapering and could push the Fed behind the curve, possibly leading to an undesirable rise in long-term rates.

Her job, therefore, would be made much easier if Mr. Bernanke were able to set a new course for the Fed before stepping down.

In short, if a decision has to be made in the near future, it would be easier for all concerned if Mr. Bernanke were to make it before his term expires.

Dutch again: The parameters for policy normalization have been in place for some time now, and I agree that it is both important and would be far easier for Bernanke to make the call.

Negative Ghost Rider, the pattern is full

This post is little more than a victory lap so please feel free to stop reading now.

Something strange happened yesterday. In the morning I was looking through data from the past two debt ceiling clusterfucks trying to think of an ideal way to structure a trade for a potential impasse. Having remembered that the US sovereign CDS curve had some wild fluctuations the last two times I focused on another possible flare up on the front end. This is a rather illiquid little backwater and a truly useless market for anyone actually trying to hedge risk on a treasury portfolio, but it’s a fun spot for doing some punting.

As it stood this morning 1y CDS were at 13bps with a 6bp spread on the bid ask and 5y CDS were at 24bps with a 4bp bid ask spread. Both of these levels were significantly below their (short) historic averages.

Since I can’t trade these in my PA, my desk doesn’t actively take risk in these instruments, and our clients don’t particularly care for small illiquid trades I thought I would share my thoughts on twitter.

I was happy that a number of people thought it was an interesting trade and got a few follow ups on the matter but most people just thought it was a halfway funny joke about Top Gun.

Then at the end of the day I was going through my pricing rundowns and I saw that this happened.

1y CDS had shot up by 45bps since the morning. Upon further examination I noticed that the aforementioned 1-5y spread went from 11bps to an all time record of -28bps. As shown below this is a 5.9 standard deviation event, and if you believe that derivative pricing follows a normal distribution this is something that should be seen once in every 300 million observations.*

And here’s the one day change for the curve.

I am going to run with the assumption that I just happened to have timed this recommendation perfectly, but I will hold out an inkling of hope that just maybe someone who reads my tweets banged this level and moved the market.

*If you think illiquid derivatives follow normal distribution patterns you should stay away from them, as well as any other assets that might prove too complicated for you.

The Limit of Fundamental Analysis: You

The other day, my friend Eddy Elfenbein wrote a post entitled “The Limits of Fundamental Analysis,” which made some good points (as he most always does), but in so doing, made far too broad and thus inaccurate a conclusion. The premise is (and I welcome Eddy to correct me if I’m off-base) that in some circumstances, fundamental analysis is inappropriate, such as when dealing with transformational businesses like Amazon was (is), cyclical firms, leveraged firms, firms with varying earnings quality, etc. The thing is, we can – and do (try to) – adjust for all of these things – and more – when performing a proper fundamental analysis! I’m going to attempt to show how, by making relatively small changes to a few key assumptions (sometimes even just one number will do!) in a simple DCF framework, we can grossly change not just how much we think a stock is worth, but why it’s worth that price, as well.

Fundamental analysis, by definition, involves examining the industry in which a firm competes, the regulatory/legal environment, the market for a firm’s goods/services, the goods/services themselves, the firm’s financial condition/performance, strategy, capital structure, reliability of financial statements/accounting controls, and several other factors, not only currently, but in the past and, more importantly, the future as well. Fundamental analysis isn’t just looking at a few ratios on Yahoo Finance or Finviz or whatever and concluding a company is a good (bad) investment based on valuation, liquidity, solvency, and/or other metrics. That can be the starting point for narrowing down firms which are more (less) likely to be worth investigating further, given a finite amount of time to allocate to identifying and researching ideas which we hope will help us invest wisely.

A quick tangent: If you’re not in the markets to invest, you are in the markets to gamble. This is not up for debate, it just is; if you find or fancy yourself a gambler, save the trouble and head to your closest casino where they’ll be more than happy to separate you from your presumably hard-earned money quite expeditiously (you may even get some “free” food and drink out of it). If you’re not sure whether you’re trying to invest or gamble, just put your money under your bed until you figure it out, you’ll be doing yourself a favor. If you’re interested in making good investment decisions, this is where the fun starts…

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