Author Archives: John Boylan, CFA

St. Paul Book Club Notes: “Dark Pools” by Scott Patterson

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The book received uniformly positive reviews from the group. Despite the title, the book had little to do with dark pools—private trading centers that allows certain investors to avoid placing orders on centralized exchanges. Rather it had to do with the evolution and growth high frequency trading and artificial intelligence on investing. Each of the book club members had personal experience with high frequency trading, artificial intelligence or both—some even had friends that personally knew people in the book. This made the “Dark Pools” more enjoyable for the group. Some of the time was spent discussing the impact on markets from the book’s subject. Most agreed that in the short-term it’s hard to beat the electronic traders, but the group’s opinion was “trading strategies work until they don’t” and that “information is not the same as knowledge.”

What people liked about the book:

  • It did a good job distilling how high frequency trading works.
  • People appreciated the fact it went into detail how high frequency trading evolved and that there were “heros” in the book; somewhat unusual for non-fiction.
  • It’s a classic Wall Street story about how a new concept evolves into widespread practice; investor denial, gradual acceptance, and then investors piling on and mercilessly beating what was a working strategy into oblivion.
  • People liked that the author mostly reported, and did not offer grandiose opinions.
  • There was an interesting science angle to the book and it made some wonder if Wall Street firms were becoming tech firms.

What people did not like about the book:

  • Most commented more on what the subject of the book was doing to investing rather than the book’s shortcomings. Again, the book got uniformly good reviews.

Our next meeting will be on May 14th in St. Paul and our book will be “The Panic of 1907” by Robert Bruner and Sean Carr. Email Kris if you are interested in joining the discussion support@cfamn.org.

SWEEEEEEPPPPPP HAAAARRRDDD!!!!!!!

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Originally we were going to write about a disappointing Chinese PMI in conjunction with an improving US manufacturing situation and their macro ramifications, but watching Olympic curling changed our mind. Why? Because curling made me think about how investors may respond to changing macro conditions.

Unlike other ice sports, Curling does not have a Zamboni cleaning the ice between periods (i.e. ends). Therefore ice conditions change during a match affecting the stone’s speed and curl (direction). While changes in the ice are noticeable (often dramatically so) as the match progresses, this is just part of the game. As a result you try to predict how a shot will react in a particular condition. However, strategy—looking for opportunities for good stone placements—never changes.

This is a lot like investing.  There are a lot of changes to the macro playing field occurring constantly; but we usually have no idea to what extent those changes will impact the market in aggregate. Therefore how do we investors adapt to all these changing crosscurrents on our playing field? By ignoring them in the macro and paying close attention to them in the micro. It’s exceptionally hard to predict what a decelerating Chinese manufacturing situation may do to the US economy, but it is far easier to adjust one’s earnings estimates for companies that do or wish to do business in China, such as Emerson Electric, Yum Brands or Apple. If those estimates end up being outside your risk tolerance you can adjust your positions in those names accordingly, likely leading to aggregate changes in your portfolio that reflect these changed circumstances. This often leads to a better decision making process than a top down approach–trying to divine how a perceived macro change will impact a portfolio. Therefore I’ll leave the dramatic macro calls to the talking heads on financial networks.

So like curling, its better that we pay attention to our portfolios one shot at a time than trying to predict how playing conditions will alter the game in total. Conditions in curling ice, and markets, do change but you can make adjustments to your “game” so your tactics change but not your goal—making good shots.

Whether or Not Weather Matters

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Last week January retail sales numbers were released and were below consensus. Some market prognosticators pointed toward bad weather as a factor in the retail sales drop. There is no doubt we have had a tough winter, but are severe weather events enough to change investor strategy?  I don’t think it does.

Why? Part of it perhaps is the media strongly reacting whenever there is a notable weather event in the Northeast, where most reporters reside. This may have an impact on how data is analyzed by investors in the short-term as a good portion of which also live in that region. Plus with weather becoming more of scientific debate with points/counterpoints surrounding global warming, adverse weather often gets more ink than it once did.

Being a Midwesterner, I have always been astounded at the attention that weather events in the Northeast get, especially when it pertains to snowfall. The fact of the matter is that while we in the Midwest get on average more inches snow in total per year, certain major cities in the Northeast usually get on average more large snow accumulation days per year than certain major cities in the Midwest.

Considering the Northeast does get on average many sizable snowstorms, conceptually the market should discount a range of potential severe weather events as many typically happen each year. However this winter arguably has seen worse weather than most, especially here in Minnesota, and some companies have guided numbers down due to weather. But there is also some danger into looking too closely at weather related data points, especially since there were also a large number of consumer discretionary companies that did not guide down due to snowstorms. Additionally, many would say retail sales were somewhat lackluster before January and internet sales, which are arguably weather independent, were also not as robust as earlier months.

But what about truly significant weather events like Hurricane Sandy? Don’t they have an impact on retail sales? Perhaps in the short run, but looking at the chart below one can argue that statistically significant changes in retail sales correspond more toward economic cycles and events (e.g. dot com bust in 2001 and 2008-9 financial crisis) than any weather event in particular.

Data source: US Census Bureau

Therefore I usually figure I am better off from an investment strategy standpoint determining valuations of retail companies, where we are in the cycle, and trying to discern retail trends than trying to predict short-term weather impacts.

Or perhaps as one famous Minnesotan, Bob Dylan, put it “You don’t need a weatherman to know which way the wind blows.”

Catching a Buzz—Bees and Investor Sentiment

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OLYMPUS DIGITAL CAMERAOne of my joys is beekeeping. In fact, I have learned a great deal about human investing behavior from observing bee behavior. For example many people believe that bees hop from one flower to the next, be it a dandelion, snap dragon, petunia, or whatever flower happens to be around. Actually bees are very particular about what flowers they visit. They usually focus solely on what is blooming in force at the moment such as a grove of apple trees or a large field of clover. Investors, for better or worse, are very similar—“the swarm” congregates to whatever is currently blooming in the market.

Investment styles come in and out of season, much like flowers. Most investors focus on the business cycle—certain sectors work at certain times in the cycle. We believe this is true, but we also think that we can break it down even further. Since most of us have a financial background, often times how investors focus attention on certain financial statements (i.e. income, cash flow and balance sheet statements) can work better as a guide to collective investor sentiment than analyzing individual sectors.

For instance when we are in the middle of a market upturn, investors often focus on income statements as they struggle to ascertain what to pay for future growth. Cash flow and balance sheets in this phase may not tell the whole story in the short-term as increased leverage and lower cash flows as companies increase sales forces, capacity, head count and other expenses associated with potential growth. Therefore accurately forecasting revenues on the income statement in this phase may be the most crucial task especially if investors believe that operating leverage on the income statement follows.

As the market matures and goes into a downturn, usually this is when we see cash flow statements take center stage. Investors may become preoccupied with the sustainability of results. More predictable free cash flows mean more potential earnings streams, more cash flows to shareholders and likely a less volatile stock. Additionally the ability to deleverage with free cash flows not only strengthens the financial outlook of the company; it also should give it a better ability to refinance debt as often interest rates decline at this phase of the cycle.

Finally as the market bottoms, this is often when balance sheets get their love. This is when investors focus on inventory levels, working capital management, debt ratios, potential goodwill write-downs and the like to determine how well the company is positioned to come out of a downturn financially. If the company has a strong balance sheet, it should have the ability to be more nimble than its peers to make timely growth investments in the future.

Therefore we likely can learn a lesson from our furry black and yellow friends. Don’t look at what individual bees are doing (although they are fun to watch). If one wants to determine which direction the market is going, watch the swarm. It may tell you where the cycle is if “the buzz” is focusing on one particular financial statement.

If you are interested in bees and beekeeping, I recommend “The Beekeepers Lament” by Hannah Nordhaus.

Learning from our Most Painful Successes

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I think that every investor dreads the end of the quarter portfolio review—even when your quarter was successful.  Why? Because even in the best of quarters there are always the zombie stocks of your portfolio stumbling around for all to see.  We all struggle with defending these stocks to our peers and clients after they failed—even if the stocks were sold and it was the right decision to sell them at the time.  And we spend a lot of time analyzing these undead. All too often our successes go unanalyzed in these reviews because we attribute success to our intelligence, foresight and ingenuity of our investing process.  Unfortunately lots of avoidable future failures can be learned from our investment “successes”.

The Holy Grail of investing is developing a winning process that is unique, repeatable and sustainable. Achieving that goal means asking tough questions about success as well as failures. Investor hubris often comes from mistaking your intelligence for stumbling upon a bull market or your investing style coming into vogue for one’s clairvoyance. The key question, which rarely if ever gets asked, is what did you do differently this time that you did not do last time and is it repeatable? Equally as important is what insight drove you to that successful decision?  Why did others miss that insight? Will that insight continue to be overlooked? If an investor cannot answer those questions, success probably didn’t have anything to do with your stock picking skill. It probably had everything to do with luck.

Don’t get me wrong, luck is great as long as you can identify a particular success as such. It makes exiting out of a lucky position much easier of a decision. But again, achieving this takes some tough self-analysis and self-questioning, and not being afraid to admit to one’s weaknesses and misjudgments openly—even in the face of “success”.  Not always the easiest thing to do! Therefore long-term success means asking difficult questions about our winners as well as our losers. If they are truly winners, we can learn from them, incorporate what worked into our investment process and have (hopefully) even stronger results in the future.

We know how to question ourselves in our failures. They are there for all to see. Honesty is required in these situations. But good results don’t lie do they? Yes they do. Therefore brutal honesty is required here as well.

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