Tag Archives: stocks

Peter Lynch Drops The Bomb: Don’t Just ‘Invest In What You Know’

Summary The idea of “invest in what you know” is misunderstood. Using the products of a company doesn’t preclude you from doing more work. The financial implications must be understood before you can say that you “understand” the company. If you are an expert in an industry, use this knowledge as an edge to help you spot opportunities earlier than anyone else. Invest in what you know, but only if you truly “know”. I recently came across an article on Peter Lynch on WSJ where he clarified what he really meant by his trade mark saying of “invest in what you know.” If you are not familiar with Peter Lynch, here’s a brief introduction. He was the iconic manager of Fidelity’s Magellan Fund between 1977 and 1990. Turing his tenure, he averaged an annual return of 29.2% . Keep in mind that the Magellan Fund was not a special hedge fund of some sorts, it was a plain vanilla mutual fund. So despite a lack of more sophisticated financial instruments at his disposal, Peter Lynch was still able to churn out extremely impressive returns. What was his secret? His investing philosophy is commonly (mis)quoted as “invest in what you know.” Don’t Just Invest In What You Know Peter Lynch’s investment philosophy was lauded by the investment industry and his influence even extended to small-time investors. Speaking from personal experience (some of which I’m sure you can relate to as well), amateur investors often believe in their stock picks because they “know what they are buying.” But do they really understand the company? For example, how many of your friends own Facebook (NASDAQ: FB ) but have no idea how to read a balance sheet or an income statement? How many people buy Exxon (NYSE: XOM ) just because they use its gasoline? During the interview, Peter Lynch stated: “I’ve never said, ‘If you go to a mall, see a Starbucks (NASDAQ: SBUX ) and say it’s good coffee, you should call Fidelity brokerage and buy the stock.'” Similarly, just because you enjoy using Twitter (NYSE: TWTR ) or Facebook, it doesn’t mean that those are good stocks to buy. During the post-recession bull market, those who bought into the popular stocks made a lot of money, further perpetuating this false idea that “invest in what you know” is all that is needed to be a great stock picker. Unfortunately, just because you “know” the company, it doesn’t mean that you don’t have to do the hard work. For every stock that I own in the V20 Portfolio (which you can learn more about here ), I do thorough research before investing even a penny. With the market awash in “easy money” these days, particularly with the surge of FANG [Facebook, Amazon (NASDAQ: AMZN ), Netflix (NASDAQ: NFLX ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL )] investing, getting rich quickly has never been more simple. While those who rode the gravy train have made a lot of money (at least on paper), the end result does not necessarily indicate that they made the right decision initially. Stocks can only go up or down, much like how a ball can only land on red or black in a fair game of roulette. I think we can all agree that gamblers who claim that they “beat the system” by winning at the game of roulette are certainly delusional. Yet the success of FANG investing is celebrated. In Peter Lynch’s words, “People buy a stock and they know nothing about it. That’s gambling and it’s not good.” What he means by “know nothing” is that investors use the products and services, but know nothing about their financial impact. Next time ask your friend what Facebook’s ARPU is, or what Starbucks is earning on a cup of coffee, and more likely than not, their look of bewilderment will betray their “knowledge” about the company. And this is a dangerous thing. What Peter Lynch Really Meant To Say Was… … That you should use your specialized knowledge of a certain industry to augment your analysis. If you operate oil rigs, you understand the core operations of the industry better than anyone outside of the industry , and this gives you a unique edge. But this doesn’t preclude you from doing actual work. Can the company pay off its debt in time? How profitable is the backlog? Is the management selling off assets just before the industry swings back to a boom phase? These are all questions that you likely cannot gain from your typical work without you putting in extra effort. With metal prices reaching multi-year lows, Peter Lynch gave a specific example. He said, “If you’re in the steel industry and it ever turns around, you’ll see it before I do.” That person can then use this knowledge to predict the company’s revenue, earnings, cash flows, etc., and spot an opportunity before anyone else. How I Apply Peter Lynch’s Philosophy Funnily enough, Peter Lynch doesn’t specialize in any specific industry. Where he lacks in real industry experience, he makes up for it with intense research. Similarly, I am not what you call an aviation expert (or even a fan), and I am invested in Spirit Airlines (NASDAQ: SAVE ). I’m not a subprime borrower and I’m invested in Conn’s (NASDAQ: CONN ). I don’t use VoIP phones (in fact I use Skype) and I’m invested in MagicJack (NASDAQ: CALL ). I have confidence in these stocks not because I particularly enjoy their products (for the above cases I’m not even a user), but because after thorough research, I concluded that these stocks were attractive enough at the prices that I bought them at. Ironically, I don’t invest in a lot of things that I do use every day. I’m the owner of multiple HP products yet I don’t own any HP shares. I use Google all the time and I never bought a single share. I don’t own these stocks because I know that just because I’m a user, it doesn’t make me anymore “in the know” than Joe across the street. In addition, the prices that these stocks were trading at were simply not very attractive to me. Notice how this is the polar opposite of “invest in what you know at any price” kind of mentality that is so prevalent in today’s markets. Takeaway It may be quite shocking to hear that “invest in what you know” isn’t all that you need to be a good investor, but I hope that this article clarifies what Peter Lynch really meant to say. Now one thing I want to make clear is that I don’t mean to discourage you from investing in what you know, it’s just that the threshold of “knowing” is a lot higher than what everyone thinks it is. Thankfully, Seeking Alpha has a wealth of information available for you to discover. From small caps all the way to mega caps, there is an expert covering virtually any stock that you can think off. I encourage everyone to read some of the analysis on their favorite stocks, and I’m sure that you will discover something new. From “not knowing,” you can slowly build up your knowledge, and be confident enough to say that you truly “invest in what you know”. Why Follow Me I personally invest a ton of time researching every single company that is in the V20 Portfolio (+43% YTD). It’s not a model portfolio, it’s a real money portfolio where you can see the real impact of portfolio decisions and their long-term consequences . Investing is straight forward (though not easy) if you know where to look. If you are looking for a place to find some ideas that could complement your own portfolio, you can click the ” follow ” button and be updated with my latest insights.

Pair Trading Opportunity – AGL Resources And Piedmont Natural Gas

Summary Two deals in the same sector with similar conditions and similar payment methods — the perfect situation for implementing a pair trading strategy. Because of regulation, this will be a very long process. So the pair trading strategy is more profitable than a classic merger arbitrage. In my opinion, if the authorities block one of the transactions the other merger will automatically have a lot problems. This risk should be hedged. I have to admit it: I hate mergers with a lot of regulatory conditions and economic intervention . I’m not a lawyer, so I’m not an expert in terms and conditions and I avoid these transactions. However, we can sometimes see very good opportunities in the M&A markets because of similar deals pursuant to the same antitrust approvals. On Aug. 24, 2015, Southern Company (NYSE: SO ) and AGL Resources (NYSE: GAS ) announced a merger agreement. Sometime later, on Oct. 26, 2015, Duke Energy (NYSE: DUK ) and Piedmont Natural Gas (NYSE: PNY ) approved another merger agreement with similar terms and conditions. Both transactions will be paid in cash, and their size is comparable: $12 billion and $6.7 billion, respectively. In this article, I will only assess the terms and conditions of both mergers. If you want to understand more about the financial performance of the companies, check our these articles: Buyers Duke is the largest electric utility in the United States. It serves 7.3 million customers, located in the Southeast and Midwest. It has an enterprise value of $88.01 billion and $1.38 billion cash on the balance sheet; its ROA is 2.83%. You can check some more numbers here. Source: I nvestor Presentation . It is a mature company, with an interesting dividend yield as well as a high payout ratio: Source: Investor Presentation. You can only see this type of payout ratio in mature industries. Merger arbitrage analysts might say that they like this transaction or not, but the fact is that the sector is in a phase of consolidation and mergers will occur. Southern serves more than 4.5 million customers, and it is the leader in the southeast portion of the United States. It has an enterprise value of $67.48 billion and $1.12 billion in cash; its ROA is 3.74%. You can check some more numbers here. Source: Investor Presentation . I would like to mention that the buyers are very big players. Their size is comparable, and the only difference is that they operate in different areas. The negotiation process with the authorities will be the same. Because of this fact, the merger spread should be similar. Targets and Transitions Benefits Piedmont has one million customers in portions of North Carolina, South Carolina, and Tennessee. It has a better ROA than its acquirer (3.54%), and it is also more than 10 times smaller than Duke. The transaction is an interesting move. Duke’s objective is to enhance its regulated business mix. What’s more, this merger creates a strong platform for future growth. AGL is based in Atlanta. It provides energy services to 5.5 million utility customers (including over one million retail customers served by the SouthStar Energy Services joint venture). Its ROA is 3.84%, which is better than that of the buyer. This transaction is a little better than the other one. It is accretive to ongoing EPS in the first full year, and it will create a strong credit profile. Source: Investor Presentation . Overall, the targets are very similar. It looks like a copied transaction, both in size (“same customer base”) and in value. As mentioned earlier, because of this fact the merger spread should be approximately the same. Terms, Conditions and Timing If you are interested, you can read the merger agreement of Duke’s transaction here and that of Southern here . Both mergers are pursuant to the shareholders’ approval. I did not read about any shareholders complaining about the price paid. So, I’m not worried about these conditions. It is more important, in this case, to assess the regulatory conditions. Southern’s transaction is subject to the following regulatory conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – The approval of the FCC – The approval of the California Public Utilities Commission, Georgia Public Service Commission, Illinois Commerce Commission, Maryland Public Service Commission, New Jersey Board of Public Utilities and Virginia State Corporation Commission and other approvals required under applicable state laws. Source: Merger Agreement. Duke’s transaction is subject to the following antitrust conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – “The merger is subject to the approval of the NCUC. The Company and Duke Energy expect to file in or around January 2016 a joint application for approval by the NCUC of the merger. Section 62-111(a) of the North Carolina General Statutes provides that no merger or combination affecting a public utility may be made through acquisition or control by stock purchase or otherwise without written approval from the NCUC. Under this statute, such approval shall be given if justified by the public convenience and necessity. The Company is a public utility under North Carolina law and two of Duke Energy’s subsidiaries are also public utilities under North Carolina law. Source: Merger Agreement. I do not think that any merger arbitrageur will tell you the outcome of these mergers. It is a very technical question that you might only be able to answer if you have worked approving mergers for a while. So I would not implement a classic merger arbitrage strategy here. I do not like gambling. The pair trading strategy that I will explain below reduces the exposure to these regulatory risks. Overall, the mergers will take a long time because of these regulatory conditions. Both transactions are said to close in the second quarter of 2016. Pair Trading Strategy and Conclusion Duke will pay $60 per share in cash, so the merger arbitrage spread is 5.24% ($60/$57.01 (close on Dec. 11, 2015) – 1). What’s more, we have to include four quarterly dividends paid by Piedmont (0.33 per share; I included the fourth quarterly dividend of 2015 but not that of 2016). So, the merger contribution is $61.32, and the calculated spread is 7.56% ($61.32/$57.01 – 1). Southern will pay an amount of $66.00 per share in cash, so the merger arbitrage spread is 5.21% ($66/$62.73 (close on Dec. 11, 2015) – 1). However, if we include the four quarterly dividends that AGL distributes (0.51 per shares), the merger contribution becomes $68.04, and the calculated spread is 8.46%($68.04/$62.73 – 1). The most recent evolution of the calculated spread can be seen in the following figure: Source: Maudes Capital. I would like to mention that the spread of both companies is somewhat correlated. It makes sense because of the facts explained above. In the future, the evolution will be similar so that you can perfectly implement a pair trading strategy. Today, I would buy PNY shares, and use the same amount of money to short sell GAS. You can make more than 1% return in a short period of time. The best thing in this idea is that you eliminate the regulatory risk included in both transactions. If one merger does not close, the other merger will have a lot of issues as well, and the spread will be enlarged. This means that you hedge the loss in one merger with the gains in the other transaction. To make a long story short, these transactions have a lot of regulatory conditions, and the classic merger arbitrage strategy is not a good idea. The pair trading strategy provides a better risk/return ratio. What’s more, both mergers are necessary moves in the same sector, and therefore good M&A ideas. I believe that both transactions will close, but I do not like playing with regulatory conditions. So, I prefer to hedge the risk. Note: At the moment there are some other merger arbitrage and pair trading investments like this one — you can read about them here , here , and here .

How To Avoid The Worst Sector ETFs: Q4’15

Summary The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs. The following presents the least and most expensive sector ETFs as well as the worst overall sector ETFs per our Q4’15 sector ratings. Question: Why are there so many ETFs? Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell. The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs: Inadequate Liquidity This issue is the easiest to avoid, and our advice is simple. Avoid all ETFs with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads. High Fees ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive. To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.54%, which is the average total annual costs of the 196 U.S. equity sector ETFs we cover. Figure 1 shows the most and least expensive sector ETFs. ProShares and Direxion each provide two of the most expensive ETFs while Fidelity and Vanguard ETFs are among the cheapest. Figure 1: 5 Least and Most Expensive Sector ETFs (click to enlarge) Sources: New Constructs, LLC and company filings Investors need not pay high fees for quality holdings. The PowerShares KBW Property & Casualty Insurance Portfolio (NYSEARCA: KBWP ) earns our Very Attractive rating and has low total annual costs of only 0.39%. On the other hand, the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) receives our Neutral rating due to its poor holdings. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price. Poor Holdings Avoiding poor holdings is by far the hardest part of avoiding bad ETFs, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings . Figure 2: Sector ETFs with the Worst Holdings (click to enlarge) Sources: New Constructs, LLC and company filings PowerShares appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. Our overall ratings on ETFs are based primarily on our stock ratings of their holdings. The Danger Within Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. Barron’s agrees . PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.