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Wall Street Lunch

Summary A mid-day update on arbitrage, event-driven opportunities, and value. Details of price changes and progress on POM, TWC, and DTV. In each case, there are still double-digit returns available. Lunch is for wimps. – Gordon Gekko Arbitrage Here are my collected thoughts on arbitrage, wandering from the academic to the practical definitions, with a heavy dose of the middle ground. The definition is indeed a tortured one. However, in both its strong and weak forms, the idea focuses on the key to investing: mispricing. In the recently launched Sifting the World , arbitrage will be a major focus. What arbitrage opportunities are available today? *Available as of today. The word “arbitrage” in academia means “certain profits,” whereas in practical investing, arbitrage often means “a trade we kind of like.” Some in the industry adhere to a perhaps reasonable middle ground: that arbitrage is not riskless, but unlike much of investing, it involves going long and short very similar securities and betting on a price difference. I can live with that. But it is clear that many use it in the loosest sense and, therefore, strip it of its meaning. – Cliff Asness Dresser-Rand / Siemens Update DHR has returned 4% since the last update. (click to enlarge) The buyer completed a $7.7 billion note placement as a component of the acquisition financing. The EU review is going well and is likely to result in approval this summer. Pepco / Exelon Update POM has returned over 8% since I last discussed it. (click to enlarge) Since then, it has remained an attractive long opportunity with a positive expected value. I have not added to my position, but I am holding onto it. From the outside looking in, this situation involves a lot of political noise. From the inside looking out, it is a negotiation like any other. There is a regulatory cost that needs to be paid, and both the applicants and the regulators have preferences on what that cost would be. The difference was surmountable. In the Maryland PSC approval, the commission majority split the difference with an order that was acceptable to both sides. Subsequent to the Maryland PSC approval, the deal was also approved in Delaware. Additionally, EXC completed its five-tranche $4.2 billion senior notes acquisition financing through Barclays (NYSE: BCS ) and Goldman Sachs (NYSE: GS ). Time Warner Cable / Charter Update TWC returned over 30% since I first discussed it. (click to enlarge) It remains a safe position; I still have $13 million of TWC, based on confidence in the current deal. DirecTV / AT&T Update This position is up over 5% since the last update. (click to enlarge) The parties appear to be progressing towards regulatory approvals later this summer. Event-Driven Event-driven, my wife was sorry to learn, is not used in the same sense as event planning. It involves few parties or cocktails in the backyard. Instead, the ones I focus on tend to involve: Mutual conversions Odd lot tender offers Merger securities Squeeze outs Here is how it worked out so far. I am thrilled that Seeking Alpha’s exclusive research program will include several such authors. Value Value is like honesty and fidelity – few people own up to being in the opposite camp. Also, like honesty and fidelity, talking about it a lot does not make it so. The core of value investing is thinking about securities as pieces of a business, valuing that business, and then underpaying for it. The remaining problem involves finding a counterparty with something at stake besides the same value that you are trying to capture. Today, my favorite values include this and this . Conclusion Arbitrage, event-driven, and value are often categorized separately, but I think of them as points on a spectrum. In the case of arbitrage, the investment opportunity has an explicit process for unlocking value. In event-driven opportunities, there is still a catalyst, but it is somewhat less explicit and there is greater variance in the outcomes. Value investing has the greatest range in outcomes. However, successful value investing frequently results in securities becoming targeted by M&A and other corporate events. These events often unlock value, whether or not that was explicitly part of the original investment thesis. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: The author is long TEG, POM, IGTE, HE, TWC, OWW, OVTI, BRLI, ODP, BHI, DTV, PRGO, KRFT. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

Trend Following Doesn’t Work For Stocks

Summary Applying classic trend following models to stocks is very dangerous. If however you are willing to adapt and move to momentum strategies, your chances will greatly improve. Classic trend following will fail on stocks. Stocks have many unique properties that must be taken into account. Momentum strategies provide a solution and a much higher success probability than trend following. There’s a good reason why most professionals who apply models similar to trend following to stocks call them momentum models. It’s not just a clever rebranding, it’s really a very different game. To blindly cling to trend following as a religion, disregarding any real world evidence and attacking anyone presenting ideas that differ to the trend following mantra is not only unprofessional, it’s outright dangerous. I bet you’re wondering about the title of this article. After all, I do employ quantitative models based on trend following logic on single stocks in quite large scale myself in my business. Some models that I’ve been using for many years produce very attractive returns on single stocks. So why am I writing such a provocative title? It’s not only to get you to click on it (though that worked, didn’t it?). It seems as some people stop reading after such a headline, and simply go on an all out counter attack, without bothering to read or understand the rest. Well, I’m guessing they’re no longer reading, so let’s get down to the real deal. If you apply a standard trend following model on stocks, you will lose. The operative word here being ‘standard’. Trend following on futures is quite easy in comparison. It’s much more complex to model strategies on equities. Most people simply ignore the difficult parts and hope for the best. That’s not an advisable course of action. Doing really proper strategy modeling on stocks may be outside of the budgets and technical capability of most retail traders. Even if you get your models right, you can’t treat stocks like futures. There are a few key differences, that require you to adjust your expectations and approach. Stocks are cash instruments and need to be funded. You have a clear limit to how much exposure you can take on. You do not have a pool of cash anymore to be placed in govvies. You cannot have your client fund his managed account at 20%, putting up 200,000 for a million notional. Stocks are a very homogeneous group. The internal correlation is massive. They will all go up and down at the same time with some small variation. In a bull market, they all go up. In a bear market they all go down. Diversification becomes much less important. You end up mainly trading beta anyhow. That can be ok, but if you’re under the delusion that you’re a great stock picker for buying high beta stocks in a bull market, you’re in for a nasty surprise when the bull leaves the field. Stocks are prone to rapid vola expansion in bear markets. Your neatly calculated risk measurements goes right out the window real quick. Suddenly all those stocks that were doing so nicely all fall down hard at the same time. As you start entering shorts on new lows, the stocks tend to make huge, albeit temporary, jumps up. As you’re forced to shut down positions not to blow your portfolio up, they fall back down. The short side of the single equity game is a veritable nightmare for standard trend following models. Modelling strategies on equities properly require total return series and dividends details. You need to analyze the total return series, trade the price series and have logic in place for how to handle the dividends when they come in. The potential for survivorship bias in single stock strategies is massive. If you run a strategy on the S&P 500 stocks for ten years back, base on the current S&P500 constituents, you’ll get an extremely distorted picture. Many of those stocks are in the index because they had a massive price increase. They were not in before. They wouldn’t have been on your radar when they had those returns. Check your data. Applying standard trend following models on single stocks is dumb. It doesn’t matter whether you use breakout channels, moving averages or other indicators. Toggling parameters up and down won’t help. People who say that you should apply standard trend models on stocks also tend to be the people who lacks experience with professional trading or quant modeling but don’t let that stop them from selling defunct trading system to unsuspecting retail traders at a few thousand bucks a pop. The most common arguments for applying standard trend following models on stocks is based on anecdotal evidence and classic fallacies. The first kind would be to point out that some hedge fund seems to be doing it with good results, without of course knowing anything about how they have adapted models for stocks, or to point out that someone’s cousin got rich doing it. Hedge funds certainly don’t run standard trend models on single stocks, though the often simplify the marketing pitch by calling it trend or momentum strategies. I can assure you that real hedge funds are a little more sophisticated and are fully aware of the special situation in stocks. As for the cousin, well, going on anecdotal evidence anything is possible. Apparently there are people who made gazillions trading on financial astrology too. The fallacies are usually about mentioning stocks that went up a few thousand percent, and how trend following models totally would have captured this. Disregarding of course the probabilities of having covered that stock when it was a small cap, the many times you would have been shaken out along the way, the allocation to this stock compared to the many that did less well etc. A massive simplification of the real world. This argument concentrates on the position level, and on the pro side we’re just concerned with portfolio level results. Does trend following really not work on stocks? If you’re willing to adapt your models and do something closer to momentum trading, you’ll do just fine. But the return expectations cannot be the same as for futures. Not that it’s necessarily lower, that’s not the point. But you’ll be much more dependent on the overall state of the equity markets. You can’t expect to make a killing in 2008 because you were supposedly short all the stocks. Would be nice if the real world worked like that though. How do I know that standard trend following does not work on stocks? Besides the common sense arguments of having lost the advantages of diversification and leverage, there’s quite a bit of actual, empiric evidence. I do this for a living. I have no reason to say that something works or does not work, unless that’s based on experience and research. I’ve modelled thousands of iterations of trend following models on every major index in the world. I’ve arrived at models that work and models that don’t. Standard trend models don’t. So what can be done to make trend following work on stocks? 1. Don’t go short. Kill the short leg of your strategy. Replace it with a short index overlay if you have to. 2. Take the state of the overall markets into account. You can’t keep going long in a bear market and expect to gain. 3. Build a ranking methodology to pick the best stocks. Don’t trade the stocks you read about in the news or heard about from your friends. Automatically analyze a large number of stocks and have the best ones selected. 4. Single stock vola can change dramatically over time. Rebalance your position sizes. 5. Trade fewer stocks with larger positions. Yes, that’s right. Counter intuitive isn’t it? Don’t be fooled into thinking that you’ve got more diversification with 50 stocks than with 20. They’re all beta bets and you just need to get the individual event risk down to reasonable levels. Beyond that, further diversification will worsen your results. Don’t believe me? Run a few hundred iterations of your model and tell me what you find. 6. Expect to have great returns in bull markets and aim to make your strategy lose as little as possible in bear markets. Religious dogma about a trading methodology is not helping anyone but system salesmen. It’s dangerous to view yourself as a trend follower. A much more pragmatic way would be to look at yourself as a systematic trader. Investigate what works and how it works. Trend following is a great concept but be very aware of its limitations. Adapt your rules to reality and overlay satellite strategies where needed. Hard work, quantitative modelling, research and pragmatism will get you to your goal. My new book details how to go about constructing a robust equity momentum strategy and offers a complete methololgy for implementing it. Released in June 2015, Stocks on the Move is now available in paperback and Kindle. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Bargain Energy Funds To Buy As Crude Shows Uptrend

There aren’t many individuals who don’t like a good bargain. Most, or perhaps everyone, loves a great deal and such a bargain is now available in the energy sector. After the rout in crude prices last year, prices have stabilized, and crude is now gaining ground, making the sector a safer investment option. The fundamentals driving the price of the commodity look good, and thus buying energy funds at the current discount would be a prudent move. The word “downturn” fits perfectly for the energy sector. Crude prices had slumped to below $50 a barrel. Thus, the profit margins of several players from the industry have seen massive declines. This has hit stock prices as well. Nevertheless, this has made their stocks inexpensive and a really good bargain. Funds with strong fundamentals owning potential gainers from the energy sector should do well going forward, somewhat illustrated by their year-to-date gains. Before we cherry pick the energy funds, let’s look at other details. Fundamentals Driving Crude Since last June – when oil was trading around $100 per barrel – we saw a prolonged plunge in crude. This was primarily owing to the plentiful North American shale supplies when nobody seemed interested in buying, sluggish growth in China, and a dull European economy. However, the fundamentals are improving now. U.S. Energy Department’s weekly inventory release showed that crude stockpiles fell for the fifth straight week despite domestic production notching up to another record. The federal government’s EIA report revealed that crude inventories fell by 1.95 million barrels for the week ending May 29, 2015, following a decrease of 2.80 million barrels in the previous week. But the real booster should be felt on the demand side. The peak summer driving season in the U.S. – started officially this past Memorial Day weekend – and should fuel up crude consumption. According to the American Automobile Association (AAA) and IHS Global Insight, about 37.2 million travelers were forecasted to have traveled by air and road during the Memorial Day weekend. If the prediction is to be believed, then this Memorial Day weekend might have been the busiest in a decade, with the highest travel volume since 2005. Moreover, we have seen Asian demand for crude increasing. As per Energy Aspects – an independent research consultancy firm in U.K. – notwithstanding a slowing economy in China, the country’s crude import touched a record 7.4 million barrels per day in April. Additionally, according to the Ministry of Finance, customs-cleared oil imports in Japan hiked 9.1% from last April to 3.62 million barrels per day in April 2015. The improving fundamentals – as reflected in growing demand and lower supply – are reflected in the recent West Texas Intermediate (WTI) crude price of $59.72 per barrel, up significantly from the six-year low mark of $43.88 per barrel in March 2015. 3 Energy Mutual Funds to Buy Here we will list 3 Energy mutual funds that either carry a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy). Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. The following funds are rebounding from 1-year loss and have encouraging year-to-date gains. Fidelity Select Energy Portfolio (MUTF: FSENX ) seeks capital growth over the long run. FSENX invests a lion’s share of its assets in companies involved in the energy sector including oil, gas, electricity, and solar power. FSENX primarily focuses on acquiring common stocks of companies throughout the globe. Factors such as financial strength and economic condition are considered before investing in a company. FSENX currently carries a Zacks Mutual Fund Rank #1. Its year-to-date gain is 8.8% as against 12.3% decline over 1-year period. The 3- and 5-year annualized returns stand at 7.9% and 8.5%. The annual expense ratio is 0.79% as compared to category average of 1.44%. FSENX carries no sales load. Guinness Atkinson Alternative Energy (MUTF: GAAEX ) seeks capital growth over the long term. GAAEX invests heavily in domestic and foreign companies from the alternative energy sector. GAAEX invests in companies regardless of their market capitalization and may also invest in developing economies. GAAEX currently carries a Zacks Mutual Fund Rank #2. Its year-to-date gain is 11.7% as against 7.1% decline over 1-year period. The 3-year annualized return stands at 16.7%. The annual expense ratio of 1.98% is, however, higher than the category average of 1.44%. GAAEX carries no sales load. Fidelity Advisor Energy T (MUTF: FAGNX ) invests in common stocks and in certain precious metals. The fund normally invests at least 80% of assets in securities of companies principally engaged in owning or developing natural resources, or supply goods and services to such companies, or in physical commodities. FAGNX currently carries a Zacks Mutual Fund Rank #1. Its year-to-date gain is 8.7% as against 12.6% decline over 1-year period. The 3- and 5-year annualized returns stand at 6.1% and 6.4%. The annual expense ratio is 1.34% as compared to category average of 1.44%. Original Post