Blessed by the Potato

Cash held beyond simple transactional needs exists solely to deal with fear.

That’s a very loose paraphrasing of John Hempton’s point in a recent post on banks hoarding cash.

Liquidity can be a very important thing, especially if you have to sell something in a hurry (whether that’s due to an emergency in your life, or a margin call). A lack of liquidity is a risk factor, whether individually or in a business. Recently I talked about investing in individual companies and some of the tools to research how to do that. I also mentioned something about efficient markets — the idea that there is a pool of well-informed investors out there buying and selling the same companies you want to buy and sell, so the market price should closely reflect the market’s assessment of the company’s value. That leads down the deductive path to the conclusion that you can’t beat the market, so the best thing to do is focus on reducing your costs when investing.

Now, like I said, I think that indexing is a great idea and is probably the best way to get investing in the stock market. A large portion of my investments are indexed (with TD’s e-series index funds), and that’s also the part of my portfolio where my new savings are going every month. Nonetheless, I try to beat the market with the half of my savings that are not indexed, which are invested in individual companies. Generally, I don’t bother trying to do this with large-cap blue chip stocks: while they are great investments, they’re followed by a lot of people, so I don’t think that’s an arena where I can get a leg up (sure, looking at the charts, especially in these volatile times, it looks like there are some inefficiencies to exploit, but I’m not sure I’m the one to pick them out). Plus, that’s largely what the indexes are made up of.

Instead, I tend to gravitate toward smaller stocks that are ignored. One of the reasons many of these are ignored is that they aren’t liquid enough. That is, there aren’t enough shares traded every day for a large investor to safely get in. If a large investor decided that to make following a company worthwhile they might need to buy say 10,000 shares, but if only 5,000 are generally traded each day then their actions could drastically affect the market. If they had to sell in a hurry for whatever reason, they might have to accept a much lower price for their shares to find the extra buyers. They could be trapped by the lack of liquidity, so they will often ignore smaller, thinly traded companies. Since a lack of liquidity adds to the risk, these companies should trade at a discount to reflect the additional risk. Extra risk (and inefficiency) can also come into play from the actions of insiders, who typically represent a larger portion of the overall float when dealing with small- and mid-caps.

Since I’m pretty much the smallest of the small investors, there are very few companies where the volume of shares I’d be dealing with would affect the daily volume, so I’m more willing to accept liquidity risk.

Of course, “very few” is not zero, as I found out with one particular company when liquidity dried up — it would go weeks without a single trade, and the bid/ask spread was over 100% (e.g.: bid $1.50, ask $3.50) [the company was later delisted, but not before I managed to bail with an impressive loss]. So it is important to be aware of the liquidity situation before you invest in something — not just stocks, but also some mutual funds can restrict your ability to bail (though usually with just a back-end fee if you don’t hold for some minimum period).

Liquidity, or rather lack thereof, is in fact a part of what triggered the collapse of the market last year. Asset-backed commercial paper (ABCP) was all over the news this time last year, and it wasn’t necessarily that all those bundled mortgages to people in torn vests were worthless (though they were almost certainly overvalued by a not-insignificant percentage), but rather that the market seized up: faced with uncertainty (and an inability to leverage) nobody wanted to buy any more, and those that had to sell were forced to accept very low bids. In times of stress and fear, liquidity (different from “liquid courage”, coincidentally also sought out in times of stress and fear) can become very important, and very valuable. This also helps to explain why earlier in the year banks were seemingly driving away their line of credit customers with a stick.

As if the economy and threat of a flu pandemic weren’t enough to inspire fear, the air force decided to do a low-altitude fly-over of New York with a 747 for a photo op.

I’m sure that didn’t trigger a PTSD response in anyone who lives in New York.

Aside: I’m not 100% happy with this draft, and as you can see by the page number I’ve been sitting on it for a while. I was hoping MG would put it up as a Potato Wedges column at themoneygardener — perhaps with some suggestions for edits — but I sent it to him last Friday and haven’t heard anything back all week… Now TMW has a long interview up (with more to come) with Nurse Brad and Preet on analyst research, so the time seemed right!

There are a lot of important tools to tap when investing, especially if you’re going to go about trying to pick individual companies to invest in.

Of course, any discussion about picking individual stocks should start with a reference to efficient market theory, the idea that one can’t outperform the market as a whole with any certainty or consistency, so the best option is just to buy the index and relax. I personally don’t believe in efficient market theory: it’s pretty obvious that the market is not efficient. It’s emotional, with wild swings and overshoots in both directions, and corrections to news events — while quick — are not instantaneous. Plus the record of investors like Warren Buffet are too good to be due to chance alone, so they must be somehow outsmarting the market. However, while the markets may be inefficient in a theoretical sense, that does not mean that you could outperform the market. Indeed, I’ve been trying this, and it has lead to nothing but fail.

Nevertheless, if you think you’ve got what it takes to outperform and are going to try your hand at stockpicking, then you’re going to need a dartboard.

…Research! I meant you’re going to have to do some research! Not throw darts, that’d just be silly. You can go about your research in any fashion that you see fit — it’s your money, and I’m not particularly talented or qualified to be handing out advice in this area. That’s not going to stop me from writing about it, but faithful reader, you should be aware at all times of who is giving you your information and how trustworthy it is — and my issue is that I’m still fairly new at active investing and stock research in particular. So that said, your first step is to come up with an investment idea. There are simply too many companies out there to just start researching all of them, so the criteria here can be very loose, but somehow something about a company has got to catch your attention to make you want to look into them further: maybe a mention in the news , or a featurette in a blog you read every day, or just a good consumer experience in your everyday life (which would be the Peter Lynch philosophy). Then you can start looking for resources to make a decision: the economic environment, first-hand experience, the company’s financial reports, and other resources varying from technical analysis to analyst reports.

Odds are, your broker (especially if they’re an arm of a big bank) has some analysts on staff covering the larger, more liquid companies in Canada. They may also (or only) provide access to 3rd party analyst reports, such as those from S&P or morningside. These analyst reports are great things to read for the most part since they often highlight the important numbers in the fundamentals, they give you a sanity check on your own analysis, and they can also give you a summary of the business and the key outside influences. However, the thing they are best known for, the headline buy/sell/hold (or equivalent ranking) rating is, IMHO, one of the less valuable components of the reports. I have been impressed with TD’s record when they go out on a limb to rate something an “action list buy” instead of just a buy or hold, and if I see one of those in a morning report I will often have at least a cursory glance at a company before deciding to not bother… but generally, someone who relies on those ratings alone to make their investing decisions is asking for trouble.

First off, those headline ratings sometimes seem at odds with the detailed analysis. Whether this is caused by an overall sense of bearishness/bullishness at the broker (and RBC seems to suffer from these bouts of rating everything high or everything low in a given month, in my limited experience), or other less savoury factors is unknown. Most analysts do disclose conflicts of interest, for example when their firm is doing business with the rated company, but disclosing bias is not quite the same as being unbaised. Sometimes it’s pure momentum: a stock is hot, so they rate it a buy, even if it’s already overshot the fundamentals they talk about in the fine print.

Note that no where in there did I mention personal finance bloggers. They are actually a good resource to read to get new ideas and new perspectives on things, but for the love of all that is starchy, you must resist the urge to blindly follow their advice (especially mine — go back to my archives and see just how poor my advice has been over the last year!). Of course, my pleas to not blindly follow advice is becoming something of a mantra, so I’ll leave it at that. (Aside: one should read personal finance blogs daily, even if you don’t follow the advice. And click on the advertising links. Twice.) I suppose the important theme here is: can you follow the logic?

The issue of analyst coverage has come up a fair bit lately, which is what prompted me to try to dust off this column and actually get it out. If you haven’t yet heard of the minor spat between the John Stewart show and MSNBC/Jim Cramer’s Mad Money then you should watch at the very least the relevant episode of the Daily Show. I thought that John Stewart had a very good point to make, which was that the financial news shows were not asking the hard questions, they were not digging into the stories, and they were being naive about whether executives they were interviewing were lying to them. That they, like the corporate world in general, were too focused on the short-term movements and didn’t have the interests of the long-term investor (or the stability of the economy as a whole) in mind. If you call in to listen to a conference call for a company’s quarterly results, you often will hear the real analysts asking the hard questions. Sometimes they come out of the gate with an answer in mind, as I seem to recall an RBC analyst in full bearish mode harping on the Yellow Pages management about dividend cuts, how big they’d be, and when they’d come, and if they’d cut it just because the share price was low so the yield would then look more normal, and maybe they could cut, just to give some more breathing room, and the management having to brush all this off… but the analysts should, at some point, be getting the important questions answered for you.

Stock analysis reports were also the topic of discussion recently at Canadian Dream and Four Pillars. Nurse Brad, of Triaging My Way To Financial Success fame has started to sell some of his stock analysis reports, and there was some minor debate on what to charge, and whether they would sell.

Now, I haven’t read one of these yet (I probably should have dropped him a line and bugged him for a review copy before writing this column, but that would deprive me of the ability to make two columns out of the issue), but at the suggested price of $20, I have to wonder how worthwhile they’ll be. Don’t get me wrong, they sound like fantastic learning tools, and I’ve been very impressed by the depth of Brad’s research in the past, in particular his on-site visit to a brewery to uncover inefficiencies. It sounds like you’ll get plenty of content and research to show for your money. However, for a small-time investor like myself, a $20 fee can represent something like 1% of a position in a stock, so to be worthwhile this research would have to improve my returns by at least 1% just to break even*. And of course most analysts’ research comes to a “hold” conclusion — that a given stock doesn’t look like it will drastically over- or under-perform the market as a whole. That’s probably true for most companies, perhaps axiomatically, but that doesn’t make you feel any better if you shelled out $20 for “meh”.

* – that’s not quite true, since I could amortize the cost of the report over a few years, in which case I might only need say a quarter of a percent (per year) outperformance to make the research worthwhile; on the other hand if the data became stale in less than a year, then the improvement would have to be better.

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It’s Earth Day, which means later today the pricing for the 2010 Prius should be released! (For the US, at least).

Some other hybrids (and full electrics!) have cropped up recently with actual models on the way, or promises of real soon now:

The GM Volt has always confused me beyond the ability to blog. The concept itself is quite good: a plug-in hybrid electric car with enough all-electric range to cover the daily commuting needs of most people without needing gas, but with a gas range-extender so no one had to feel trapped or deal with the range limitations of an electric car.

However it was sprung on the world in a way that did not suggest there was ever an intention to build one, until it seemed that the GM head honchos accidentally promised they would. It was still a powerpoint pipedream, without even a prototype or autoshow setpiece cobbled together when they actually started advertising it. One has to wonder at the management of a company that spends money it doesn’t have advertising a product that doesn’t exist. The main goal seemed to be a combination of greenwashing and deflecting attention from the Prius: “Don’t buy a Prius” the subtext said “this will be better and you just have to wait a few more years to get it.”

The goofs continued when the autoshow mockup (in my estimation, likely a half-finished muscle car chassis stolen for the moment of need) had a huge, aggressive engine compartment… for the car with the tiny range-extender motor. The saying was that it did so poorly in the wind-tunnel tests that they might as well have put it in backwards. Now they’re less than a year from their promised introduction, and apparently still need billions of dollars to finish the R&D. That seems like a fairly ridiculous number, and there have been reports that the US government is not interested in continuing to fund the Volt…

Ford, nearly 3 years late, is introducing the Fusion Hybrid. This car is a very close competitor to the Toyota Camry Hybrid (in part because of the convergent evolution of the Toyota and Ford systems), but they’ve tuned it a little more towards fuel economy. The big question in my mind is how they arranged the batteries wrt trunk space, unfortunately that’s the one thing none of the preview articles seems to touch on. In the specs on Ford’s website, the Hybrid has the same 467L trunk as all the other models — I don’t know if that’s a mistake or if they actually managed to make a hybrid sedan without sacrificing trunk space. It’s certainly worth checking to see if it’s true if you’re interested in a Fusion.

Honda is also stepping up the heat by introducing a direct competitor to the Prius with its new Insight. The new Insight has the same aerodynamic & practical hatchback body as the Prius, and the two are a little hard to tell apart from pictures alone. The Insight is a little smaller (but not nearly as small as the old Insight), but it’s also going to be cheaper. Honda’s IMA system isn’t quite as efficient as the Prius, particularly in the city, but real-world tests with the Civic hybrid showed that the gap was perhaps smaller than the government testing suggested. While the Insight will certainly draw a few potential Prius buyers away, I think it might hurt the Civic hybrid sales even more — now Honda loyalists can get a car that’s more efficient with a bigger trunk for less money. Of course, for some looks matter more than practicality, and the Civic hybrid is a “stealth sedan.”

But perhaps the biggest news in alternative fuel cars this last little while has been from Tesla motors: the all-electric startup company has actually built and delivered several of their expensive all-electric 2-seater roadsters. That’s given them the confidence and operating funds to move on to the next stage: an upscale all-electric sedan, known as the Model S. Supposedly the S will be able to seat 5 adults and two children, like station wagons of old, but without an interior shot I’m having trouble seeing how the jump-seats will fit in the hatch. Nonetheless, it’s poised to be a real competitor, with a $50k US price tag, which isn’t out of the ballpark for luxury sedans, and a very generous 300-mile all-electric range. I think that the 17″ touchscreen replacing all of the traditional centre console controls is pretty silly, but it’s got to appeal to someone…

What is perhaps most interesting about the now two models of Tesla is that they’re a small company that managed to make these cars from the ground up, without the benefit of government funding or the cobasys batteries. It just sort of makes you wonder what GM is doing.

My car was broken into again sometime yesterday or this morning. The club was on it, thankfully, so the car itself didn’t go anywhere, but the driver’s door was left ajar (with the dome light on and the battery not dead yet) and all my stuff had been rifled through — sunglasses on the driver’s seat, etc. As far as I can tell, nothing has been taken (and I’m getting awfully sick of trying to mentally inventory the stuff left in my car), and no damage was done. Either I forgot to lock the driver’s door (and my last trip was for groceries, so I might have), or they just jimmied it open without blasting through the whole lock.

I just can’t wrap my head around why this keeps happening — we’re close to downtown, and there are a lot of students in the neighbourhood, but I’d be really hesitant to call it a high-crime area. Plus it’s a 12-year old Honda accord. It really doesn’t look like the kind of car that would have valuables in it. I think I’m going to have to get some stickers to that effect made up and put in the window.