Tag Archives: university
For The Love Of The Game: How To Keep Learning In The Market
Summary This is a philosophical piece intended to help young aspiring analysts. I will share my mistakes and lessons learned on the buy side. I will briefly discuss Cheniere Energy. This is a philosophical piece with two goals in mind: To inspire young aspiring analysts, and to share the multitude of career mistakes that I made. With the benefit of hindsight and reflection, I know others can benefit from my self-inflicted missteps. Given the significant amount of time I spend engaged on the Seeking Alpha website, I am noticing more and more talented authors. For some of the folks more junior in their careers ascents or for aspiring analysts trying to make it into the research arena, I think my experience and unique observations may benefit them. So, in the spirit of trying to help others, I sincerely hope to pass the baton and impart some insights that may benefit them as they progress in their careers. The Power of Mentors For context, I will provide my brief background and relevant professional investment research experience. During my undergraduate days, I attended the Isenberg School of Management at the University of Massachusetts at Amherst. I was passionate about investing since middle school, as my dad sparked my intellectual curiosity. While at UMass, I gained access to an alumni list and then emailed as many people in the industry as possible. After getting a response, I would then call them, usually early in the morning, before their hectic day’s beginning. So here I was talking quietly in the dorm room hallways (trying not to wake up my floor at 7 am). As I had virtual no industry contacts, this was the best strategy. However, long on confidence, I was convinced that I was the next up-and-coming star analyst and I only needed to be discovered. From that point, I would land a junior analyst role. Not only I was incredibly naïve, but I had an exalted sense of self, which was unwarranted and unhelpful. However, nice alumni looked past this misplaced arrogance and focused on my passion. Through these calls, I was able to connect with many smart and talented UMass alumni who were actual market participants on the buy side. One individual was, and still is, a portfolio manager at prestigious Wellington Management. He is piercingly bright, very generous with his time, and passionate about helping UMass alumni learn about investing. Although I haven’t been in as close contact with him lately, he was extremely influential in my progress and evolution as an investor. I have one other mentor, whom I originally connected with on LinkedIn in 2004. This was a period between jobs, and I was still questing for that elusive foothold on the buy side. This individual is currently an equity portfolio manager at Alpine Funds. Yes, he has the shiny credentials of a top MBA and CFA, but more importantly, he is a great investor and extremely hardworking. He and I have been friends through email since 2004, and we constantly trade investment ideas via email. Over the course of thousands of email exchanges, my writing and thought process continued to improve. Specific investment lessons from these two mentors For context, my mentor at Wellington is a portfolio manager at Wellington, and manages international equity growth funds with approximately $4 billion in assets under management (AUM). Over the course of our friendship and multiple email exchanges, he explained (using the Socratic method) how growth stocks work. He said that the only thing that matters is consensus earnings estimates. In order to take a position in any equity, you need to qualitatively and quantitatively understand how the market arrived at current consensus estimates. If, and only if, you deeply study the company and build your high-level models that capture the major drivers of revenue and earnings can you have an opinion. Never, never, never have a strong opinion on a stock unless you have really done the work. The fastest way to get dinged during an interview on the buy side is to come across long on opinion and short on analysis. It is always better to say “Here is what I have read, and here is how I think about it, but perhaps I am missing certain angles.” It is much better to informed and humble than arrogant and overly confident, especially when speaking with actual market participants. He then taught me that many people fall into the trap that a stock is overvalued because it has a high P/E ratio compared to the market or its sector. With the supercomputers of today, crunching ratios is a waste of time, as it is fully reflected in the stock price, given that the market is very efficient at incorporating actual events. Again, you have to understand consensus estimates better than the Street. If your model and work are materially different from the consensus, only then should you make a bet. For a concrete example, over the course of a few emails, he walked me first-hand through why in mid-2003 Research in Motion, now BlackBerry (NASDAQ: BBRY ), was his largest holding. I think BBRY’s stock ultimately ended up increasing by 5,000% from 2003 to 2007. If any reader cares to do some searching on Google, they will find that the vast majority of then-leading experts thought BBRY was going to zero. They saw that they were losing money and also saw the company’s cash burn, and erroneously assumed that BlackBerry had nothing noteworthy in its pipeline. Now, my mentor will freely admit that he happened to have met with management (that is a major advantage of being a professional money manger – access to management teams to kick tires). During his visit to BBRY’s corporate HQ, he was able to work out first-hand how technologically advanced the company’s products were, and envisioned their appeal to chief technology officers in the Fortune 500. He also understood the huge addressable market, the potential margins on the handsets, the security features of its product, and that BBRY was really a great software company. Had I known then what I know now, I would be retired at age 35 if I had put on a concentrated long bet on BBRY and simply held it for four years. Clearly, I wasn’t wise enough to understand that I was handed a lottery ticket with winning numbers on it. (click to enlarge) My mentor from Alpine Funds has also taught me a great deal. Once a new investor gets up to speed on the core blocking and tackling, like being able to read financial statements and the basics of accounting, the best way to make money is to develop a great imagination. Stock prices will rise or fall past on their future cash flow and revenue growth relative to consensus estimates. For another vivid example, in 2004, this mentor of mine walked me through his largest holding in his personal account, Silver Wheaton (NYSE: SLW ). If I recall, SLW was then a $4 stock. He explain to me that he was very bullish on silver, and that this was the best vehicle to participate in silver’s ascent. He explained how silver was a by-product, and mining is extremely CAPEX-intensive, so producers who are targeting gold or copper are willing to sell their silver by-product production (or silver streams) for an upfront payment and then for a low price of $4 per ounce. The producers would then use the upfront payment to fund their CAPEX. Silver Wheaton eventually traded as high as $50 in May 2011, though it was a bumpy ride, with the stock dropping down to $2.50 during the 2009 equity crash. My mentor also emphasized the importance of being willing to take a contrarian stance if you have enough conviction in your idea. When he was traveling the hedge fund circuit, as he had two stints as a hedge fund analyst, he learned the importance of managing your downside risk, but also that betting big when the risk/reward was greatly in your favor. Although he was capable enough, he determined that the hedge fund world didn’t suit his personality and investment process. This is my long-winded way of stating that mentors are invaluable. They will encourage you, push you, and if you put in the effort, they will help you become a better investor. I am still in constant contact with my friend at Alpine Funds. I distinctly remember when he once told me, “My wish for you is that you greatly surpass my as an analyst.” That illustrated to me that he was invested in my success, and he was humble enough and had had the benefit of mentors while he was in his formative stages. Don’t get into fights with your boss My next piece of advice is that if you do make it to the buy side, know your role and keep your ego in check. Although the barriers to entry are very steep, just because you made the team doesn’t mean you can’t get cut. Despite an insatiable curiosity and undeniable passion for investing, my ego and poor semantics while expressing my investment ideas wrote proverbial checks that I couldn’t cash. The collective bill came due when I couldn’t meet the proverbial margin call. My five years of solid performance and exemplary annual reviews were marred by aggressive and arrogant interactions with senior analysts. No one want to be told they are wrong and that their thesis is wrong, especially from a 29-year old. You can’t tell your boss that you think you are a better investor than him. This is a career-limiting move, trust me. So the takeaway is that if you can surmount the incredibly high barriers to entry, take it slow, listen, observe and ask questions. Investing isn’t like the NFL, it isn’t a pure meritocracy. You have to work hard, learn, be likeable and keep your head down. If folks sense that you are not a team player (however misplaced this label may be), your career at that shop is effectively over. Know yourself Beside the fact that I didn’t have the right temperament for Liberty Mutual, you have to know yourself. Reflecting upon my five years at Liberty, I probably knew it wasn’t the right cultural fit in year three. However, don’t do the impulsive Jerry Maguire letter and then quit, as this is terrible career mistake that has to be explained away in future interviews. There are exceptions, but the buy side generally requires a CFA, Ivy League education (at least on the equity side), lots of networking, and even more luck to find your foothold. Although I made it into the industry, I only advanced to the bottom rungs of the ladder. There is an alternative pathway. There are excellent open source sites like Seeking Alpha, and different ways to make a living. However, this is the path less traveled, and it will invariably take years of building your brand, developing a portfolio of great research as evidence, and getting the marketing aspect right. There are members of the Seeking Alpha community who have successfully done this, so they would be a much better resources. I only write articles in my free time as a hobby. The Power of Redemption Moving along, let me power down my philosophical side of my brain, and let’s talk about one of my recent investment ideas written here on Seeking Alpha that seems to be playing out. I want to specifically highlight two investment pieces that I wrote recently on Cheniere Energy (NYSEMKT: LNG ). The point of bringing this up is that through the comments section of my first article, the Seeking Alpha community inspired me to improve upon my first article that some labeled incomplete. I viewed this as constructive criticism and an opportunity to dig deeper and write a follow-up article. Incidentally, my original thesis seems to be playing out, as Mr. Chanos disclosed a new short position in shares of Cheniere. However, I am not spiking the football on the one-yard line, as the stock has now become a battleground stock between the bulls, including investing greats like Seth Klarman and Carl Icahn, and the bears, like Jim Chanos. I have done a lot of research on the company and have shared my bearish view on the site. Again, I’m not writing to gloat, but simply suggesting that if we are passionate about our craft, we can make good investment calls. Of course, the buy side has its advantages of access to management team and access to many research publications. However, with the power of Google and some intellectual curiosity, you want produce compelling work. I can’t tell you the last time I read a sell side report. As a general rule, I completely ignore sell side research, as I like to do my own research. Moreover, when an idea finally works and it gets recognized by the market, it brings a great feeling of satisfaction and even redemption for hobbyists like me. To sum up Mr. Chanos’s bearish arguments: There will be massive global overcapacity in the LNG space. LNG is priced based on Brent prices, and Brent has collapsed from $110 to $50, so incremental new long-term supply agreements will be less lucrative. The industry is plagued by massive cost overruns (look at Chevron’s greenfield projects). Cheniere’s contracts aren’t sacrosanct. The company is way too promotional and has yet to sell any LNG. Its capital structure and executive compensation polices leave much to be desired. Concluding Thoughts Investing is more of an art than a science once you understand the fundamentals. For aspiring analysts: Find great mentors, don’t get in fights with your boss and know yourself. Investing is an extremely humbling pursuit; therefore, savor your victories, because they can be fleeting. Good luck, and thanks for reading. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Tetraphase Pharma Offers A Lesson In Risk Management
Summary Limit sell orders wouldn’t have protected investors from Tetraphase Pharmaceutical’s 78% plunge after hours Tuesday. Two ways for investors to limit downside risk from stock plunges like this are diversification and hedging. We examine the pros and cons of both of those methods of risk management. Tetraphase Tanks After Hours Shares of Tetraphase Pharmaceuticals (NASDAQ: TTPH ) closed up 3.54% on Tuesday, to $44.78. Less than 40 minutes later, TTPH was trading for under $10 per share after hours, as the dramatic graph below from YCharts shows. (click to enlarge) What tanked the stock, as Seeking Alpha news editor Douglas House reported , was the failure of its leading drug candidate, a broad spectrum antibiotic called Eravacycline , in a stage 3 clinical trial versus another antibiotic called Levofloxacin in the treatment of complicated urinary tract infections. Limit Sell Orders Don’t Limit The Loss A painful lesson some Tetraphase longs may learn here is that limit sell orders don’t protect against these kinds of drops. Consider, for example, a hypothetical investor who owned Tetraphase on Tuesday and didn’t want to see his position value drop by more than 20%, so he set a limit sell order at $36. The problem with this sort of limit sell order is that it won’t get you out of the stock at $36 per share, if the stock never trades at that price on its way down. Whatever price the stock opens at the next day is the price an investor would be offered for selling the stock then. Two Ways To Limit Stock-Specific Risk Two ways to limit stock-specific risk of this kind are diversification and hedging. Both have their advantages and disadvantages. The big advantage of diversification is that it doesn’t cost much.[i] As the Nobel laureate economist Harry Markowitz famously put it, “diversification is the only free lunch”. If you owned Tetraphase as part of an equal-weighted portfolio of 20 stocks on Tuesday, the worst impact it could have on your portfolio value going forward would have been -5%, because it would have comprised 5% of your portfolio. Of course, the flip side to diversification is that if a particular stock does very well, its impact to your portfolio would be similarly limited. Diversification limits the harm caused by your worst investment, but it also limits the benefit provided by your best ones. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998, If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Unlike diversification, hedging allows you to concentrate your assets in a handful of securities you think will do best, because your downside is strictly limited. Consider, for example, hedging with put options. Put options (or, puts) are contracts which give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). An investor who owned 1,000 shares of Tetraphase on Tuesday and 10 put option contracts (each contract covers 100 shares) with strike prices at $40, would have been able to sell all of his Tetraphase shares for $40 on Wednesday, regardless of what price the stock was trading at then. The main drawback with hedging, though, is its cost. At Portfolio Armor , we look for optimal puts (as well as optimal collars) when hedging. Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. A Tetraphase investor scanning for optimal puts on Tuesday against a greater-than-20% drop over the next several months, would have gotten this message, The reason he would have seen that message is that the cost of protecting against a greater-than-20% drop on Tuesday was itself greater than 20% of position value. The smallest decline threshold against which it was possible to hedge TTPH over the same time frame with optimal puts on Tuesday was against a greater-than-27% drop, and, as the image below shows, the cost of doing so was prohibitively expensive – equivalent to nearly 27% of position value. Note that, in the image above, the “cap” field is blank. If an investor had entered a figure in that field, the app would have attempted to find an optimal collar to hedge Tetraphase. A collar is a type of hedge in which an investor buys a put option for protection, and, at the same time, sells a call option, which gives another investor the right to buy the security from him at a higher strike price, by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest price, while not capping your possible upside by more than you specify. In a nutshell, with a collar you may be able to reduce the cost of hedging, in return for giving up some possible upside. It was possible to hedge Tetraphase against a greater-than-20% drop over the next several months with an optimal collar on Tuesday, if an investor were willing to cap his possible upside over the same time frame at 20%. The cost of that protection would have been 8.26% of position value, which would still have been fairly pricey. Using Security Selection To Reduce Risk (and Hedging Costs) Another way to reduce risk, and to hedging costs, is to avoid stocks like Tetraphase in the first place. That may sound like hindsight at this point, but remember the hedging cost shown above was calculated using data from before the stock tanked. Hedging cost that high can be a red flag. By way of comparison, look what the cost of hedging Gilead Sciences (NASDAQ: GILD ) against the same percentage drop over the same time period with optimal puts was on Tuesday: As you can see at the bottom of the image above, Gilead cost 2.1% of position value to hedge. Tetraphase was 12.6x as expensive to hedge in the same manner. By limiting your portfolio to securities that are relatively inexpensive to hedge, you will end up avoiding some of the riskiest ones. How much should you be willing to spend to hedge? That depends, in part, on how high you estimate the potential return of your underlying securities. One approach is to calculate both hedging costs and potential returns for your best ideas, then, subtract the hedging costs from the potential returns, rank them by potential return net of hedging cost, and buy and hedge a handful of the highest ranked ones. That’s the essence of the hedged portfolio method, which we detailed in a recent article (“Keeping A Small Nest Egg From Cracking”). —————————————————————————– [i] To be precise, this isn’t quite true if you buy individual stocks rather than a low-cost index fund. All else equal, the more you diversify, the more trading costs you will incur. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.