Profiting from uncertainty
Posted on August 9, 2007 by Richard Beddard
Filed Under Companies |
Investors hate uncertainty but paradoxically it’s in uncertain situations that some of the best opportunities lie, if you have what it takes to embrace them.
I want to look at Wogen (a company), for a couple of reasons:
- Graeme Pietersz an analyst and blogger recently challenged active investors to demonstrate their skill by explaining the inefficiency they are exploiting. Efficiency is a technical term as well as something I experience, occasionally. Graeme thinks the market is efficient, which, taken to an extreme, means you can’t beat it because share prices, as determined by the investors who buy and sell them, are rational. Why should your view, or mine, be more rational than the combined wisdom of stockmarket practitioners? I don’t think the stockmarket is always efficient, so the trick is to find shares that are cheaper than they should be. That means finding inefficiencies. You can still read the blog Graeme wrote, my reply, and his reply to my reply (and if you follow that, the rest of this post should be a doddle), or you can take it from me the discussion is getting a little abstract. So, I thought I’d bring it back down to earth and add some spice by talking about a current situation, the market in Wogen shares, and how it might be inefficient.
- Like many bloggers, I’ve been fired up by the appearances on the Internet of Mohnish Pabrai, a hedge fund manager, who models himself on the godfather of active investors, Warren Buffett, and our granddaddy Benjamin Graham. Watching him, it struck me that two of his strategies; low risk/high uncertainty situations, and ‘time arbitrage‘, are market inefficiencies that might apply to Wogen. Don’t worry about the jargon, I hope to explain that too.
Wogen deals in industrial metals such as titanium, cobalt, and platinum and demand for these metals drives profitability. The company floated on the stockmarket in October 2005 on the back of rising demand for its metals and rapidly rising profits. In 2006, profits plummeted 92%. Earnings per share in 2005 were nearly 37p. In 2006, they were less than 3p. The price fell 65% from a high of 187.5p to a low of 66p and bounced back up to 83p.
Wogen’s promise is rapid industrialisation in China, India, and elsewhere, secures demand for years to come, perhaps even decades. The problem is it won’t happen smoothly. Supply fluctuates in large increments as companies commission and decommission mines and processing plants. Demand for titanium, for example, depends on the airline industry. I don’t propose to get into the detail. I don’t know it. Managing supply and demand is the job of metal traders like Wogen. My task is to judge whether the company has prospects, and buy the shares at an attractive price.
Judging Wogen by its performance in 2006 would be like writing an athlete off after one bad race. Metal prices are volatile. To get a feel you can explore the United States Geographical Service page for titanium. The abstract from a report by Merchant Research says the titanium market experiences “brief spans of extra-high demand and much more [sic] longer periods of demand downturn”. I’m only using titanium as an example because in its prospectus Wogen said titanium makes the biggest contribution of any metal to its profitability. In fact, Wogen trades ten metals and groups of metals, so it doesn’t have all its eggs in one basket. But the point is you don’t buy shares in a company like this in the expectation of smooth profits growth, and when profits take a dive it’s not necessarily because the business is flawed. Dividing its price of 83p by its earnings per share in 2006 of 2.8p to derive a sweat-inducing valuation of nearly 30 times earnings is, perhaps, a little myopic. That’s what share screens and the Companies & Markets section of the Financial Times will tell you though.
Although Wogen only listed in 2005, it quoted earnings figures back to 2002 in its 2006 annual report. This is the sequence: 1.2p, 6.1p, 15.4p, 36.7p, 2.8p. Clearly 2005 was an exceptional year, perhaps 2002 and 2006 were too. The average earnings per share for the five-year period are about 12p. Divide the current share price by that and you get a much more attractive price earnings ratio of about seven. I don’t know if those five years are the full cycle, or that it will repeat itself in the same way in the next five years, but it makes more sense to me to value the shares of a volatile business on its average earnings than one exceptional year.
There are other reasons for thinking Wogen shares are irrationally low. At 83p per share the market values Wogen at £37m, which by coincidence is the same value as its stock of metal and minerals, as recorded in the consolidated balance sheet for 31 Mach 2007 (see the interim results statement). Simplistically, because it’s free of long-term debt, every pound invested in Wogen buys us £1 of metal and investors get a free share in a business, which, according to its prospectus, was profitable in 29 of its 33 years. Also, the company is still paying a dividend it cannot currently afford out of cash flow or profits, which suggests to me it’s managers are either confident business will pick up (to be specific profit margins will improve, as sales haven’t dropped off much), or they’re suicidal. At 83p, Wogen’s dividend yield is almost 9%, which is exceptionally high and betrays investors’ lack of confidence - otherwise they’d buy the shares for the dividend, and the yield would fall. I could go on, but my purpose isn’t to sell you Wogen, it’s to share an idea: that when investors lack confidence in an apparently sound business, prices fall to irrational lows.
In fact, rationality depends on your perspective. What can appear rational to one group of investors is completely irrational to another. I’m very grateful to Michael G for reminding me of this. He’s a reader, a pensioner, and a pension fund trustee. In a comment on this blog, he wrote:
…A pension scheme should be investing to provide a stream of income to pay pensions in 30 years time. Yet, all we look at are quarterly reports on the market value of our investments. Are these correlated in any particular way with our objectives? If the FTSE100 fell back to 3000, I would be delighted because the pension contributions we invest today would buy twice as much future income. If it rose to 12,000, I would be worried for the future of the scheme.
This all seems common sense to me, though investment professionals smile gently, and think I am somewhere between eccentric and deluded (they are careful to be polite to pension fund trustees). One of the largest passive investment managers in the world can’t tell us what the overall dividend yield, price/earnings, cash flow and book value are for the FTSE100, or any of the other indices they track. They can’t understand why anyone should consider such information relevant.
I’m dividing the investing universe into two to make the point, which is a generalistion, but despite the fact that we’re repeatedly told it’s no guide to the future, the fund managers who dominate the market are judged by their recent past performance. Whether it’s pension fund trustees, financial advisers or Joe Schmo that’s the customer, nobody likes a loser. So the main risk facing a fund manager is the risk to his reputation posed by falling prices or volatility. That makes Wogen a very risky company because volatile markets are hard to anticipate. I’m no fund manager, so I’m theorising, but with your reputation on the line over the next six months, would you buy if there were a significant chance the price might fall further?
Now, listen to Mohnish Pabrai for a different take on risk. In this interview (it’s long, but worth it) he describes an investment in Frontline, an oil shipping company that resembled Wogen insofar as it is in a cyclical industry and it appeared to be financially sound, and undervalued:
We actually started buying the stock at about $7 a share. Then we saw our holdings cut in half when it went to $3 odd a share. Then the [shipping rates] came back up, in fact they went to $100,000 and then $200,000 [a day] and the stock went to 7 and then 14 and I exited at 14. And then it went to 60 after that.
So with Frontline the uncertainty was when will this situation turn? When will oil-shipping rates come back up, when will oil demand go up and how much will they go up? And how many new ships will come on stream by then? How many ships are going to be scrapped by then? All of these are not clearly known and I don’t think any analysts could have answered these questions. But you knew general trends and you knew the way it was likely to play out over a period of time.
It’s impressive how casually Mr Pabrai mentions the halving of his investment, especially as he maintains a ten stock portfolio, and how he embraced all that uncertainty. The risk he fears most is not uncertainty, or volatility, but the risk of ruin; that Frontline might have gone bust before it recovered. His research said it wouldn’t, which gave him the confidence to buy and just as importantly not to sell at a loss. It seems Mr Pabrai is immune to short-termism, which gives him an inefficiency to exploit. He calls it time arbitrage (arbitrage being a risk-free trade). I call it patience.
I don’t know which metal prices will recover, or when, but if I’m right about Wogen, it will reward patience too, but only for a certain kind of rational investor. Most investors won’t look beyond the uncertainty, and given their position, that’s rational too. I’m going to leave the last words on this not to the celebrated Mr Pabrai, but the uncelebrated Michael G:
There is a fallacy right at the start of efficient market theory. The market can ONLY be completely efficient if all the players have EXACTLY the same needs and objectives. If different players have different requirements, the market CANNOT be efficient for everyone…
….I don’t claim to be a skilled investor, but I do believe that if you identify your objectives correctly, you can quietly beat the market while it thinks it is beating you.
Footnotes:
- Found on Value Quest.
Comments
10 Responses to “Profiting from uncertainty”
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I do not think the markets are as wonderfully efficient as all that.
What I do think is that few investors are sufficiently good at finding inefficiencies to active investment worthwhile, given the extra costs and risks.
I disagree with Michael G, but I have already partly explained why on a comment on the post he left that comment on.
For more detail I (quite disinterestedly, of course!) suggest reading the relevant entries on Moneyterms….
Hi Graeme. Thanks for your comments
I know you don’t think markets are perfectly efficient and actually in terms of the big picture we are, as you said on your blog, in agreement. Beating the market is a zero sum game so, once you take costs into account, more active investors will lag it than beat it. If you think you’re not one of laggers, you definitely should be able to explain why, which is why I’ve got you to thank for what will become, hopefully, a steady trickle of posts on inefficiencies I think I’ve discovered!
Regarding Michael G. I’m off to reply on that post!
And Moneyterms is my first port of call when I want to check what something means, so I can genuinely disinterestedly recommend it!
[...] Beddard appears to be willing to agree with me that most active investors will under-perform. We still disagree about how investors’ chances of out-performing are. Richard has focused on [...]
Hi Richard and Graeme, great discussion although I am now getting a headache trying to keep track of the conversation.
It spans two core websites (plus loads of ancillary ones) and multiple blog entries.
How about we just agree you are both wrong?
… just kidding
I look forward to listening to Mr. Prabai’s interview later on.
It sounds like he is a dangerous guy to follow to be honest, although I could say the same about Warren Buffet.
Holding just a few stocks and not being worried about a 50% drop in one of them would be a sure fire way to go bankrupt for most people.
I have to say, I like the idea of investing in funds because
(a) Someone else is doing all the complex research for you and it is their full time job
(b) They are very diversified and therefore have more predictable behaviour and are easier to benchmark
(c) You can check up on them less often
(d) They are forced to follow the crowd, to a certain extent, and this can generate some useful inefficiencies
Hi Robin.
It may come to agreeing to disagreeing! It’s a pretty invigorating debate, although I pity you trying to follow it. It makes me think blogging software has some way to go in terms of tracking conversations that drift across more than one blog.
I agree that a-c are all good reasons people might invest in funds. D’s got me confused, though. That sounds like the point I make - that funds are forced to follow the herd (investment trusts less so perhaps) - so the inefficiencies are there for those of us who don’t invest in them. Look at the hedge funds now. They’re forced to sell at any price because of redemptions. They have to raise cash to pay people pulling out of their funds. That’s an inefficient surely - and one that affects unit trusts too (though to a lesser degree as they’re not (so?) leveraged).
Oh, and before I forget, I wouldn’t follow Mr Pabrai in terms of buying or selling the shares he does. I just like his style
Thanks for the reply Richard. I am really looking forward to listening to those news clips later on
Point (d) is exactly the point you make. You regard it as a bad thing; I regard it as a (possibly) useful thing. If a fund manager went off and did any old thing then they would no longer be predictable and my asset allocation program (which I have mentioned in previous posts) would not work so well!
Also, the fact that they follow the herd means that one aspect of my program, which is to track momentum, would also no longer work.
Also, I am currently looking at certain predictable signs on which would be a good day to switch from one fund to another. One pattern is certainly looking interesting…
Its all related.
One man’s food is another man’s poison, as they say
Indeed! And don’t forget, once you are confident in your system I want to be the first to know
Hi Richard,
After last week (Thurs 16th Aug in particular), it will be a while before I want to talk about my computer program again! All my returns for this year have been wiped out. However it certainly has not dampened my enthusiasm for the basic principles of the system (at least yet) as it is still where I want it to be over one year.
The current recommendation of the program is to move some of the portfolio into money market funds and bonds. However, this is just an expensive way of just moving to cash, which is where I will start to position the portfolio over the next couple months unless there is a recovery.
A recovery now would be interesting as this would reflect the true, ‘non-leveraged’ value of the various sectors (in my opinion). However if there is still a lot of leverage out there, then there will still be more downside on the market, as hedge funds continue to sell-off their debts on the peaks.
If only I had a crystal ball!
I find it fascinating you have a program that can tell you this! My ‘program’ is telling me quite the opposite of course, but that’s what makes a market.
Hi Richard,
I understand what you are saying. If I had a value based investment program I would certainly be running it now. However my program only tracks upward trends and there is currently no strong trend to track. However, the current market performance suggests that there should be something in a couple of weeks when I do my next run.
I found it interesting that the FT ran several articles deriding the performance of some quant hedge funds, saying that they lost X amount of money this month and have only returned about 6 to 8% YTD as a consequence. By my standards this is a superb performance. While it is comparing apples and oranges, my own investments were down to -1% YTD at the time of these articles.
With the recent strong performance in the market (plus a little lucky timing on the sell-to-cash orders
) I am back to about 4% YTD and about 25% in cash.
I am looking forward to investing the cash again quite soon, but there is no immediate rush. I am inclined to agree with you and Ken Fisher that we should see a strong rally. I am happy to wait for it to start and not catch it at the bottom. I hope my program will allow me to track this efficiently. We shall see…