Saturday, May 31, 2008

Q&A: Ask Lloyd a finance or investment question

Questions Answered:
  • How can I win the stock-picking contest at my school?

  • Should we remain renters or buy a house?

  • Should we sell the farm and pay the tax?

  • Real Estate and Leverage: How much is best?

  • Should I buy-and-hold or trade?

  • How will U.S. stocks perform versus foreign equity markets?

  • Can sentiment predict market direction?

  • How can I use the PEG ratio to value stocks?

  • Is Baidu worthwhile buying now?

  • Is the Chinese stock market a bubble?

  • Have you read the new book, An American Hedge Fund?

  • Which should I use, a full-service or discount broker?

  • Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

  • I'm new to investing. Is there a simple place for me to start?

  • Should I use an investment advisory service?

  • Are stocks with high price-to-book ratio worth buying?

  • I'm a kid. What stocks do you recommend I buy? (Momentum and Recovery Picks)

  • How do I get the money to invest?

  • Is buying high earnings-to-price (or low PE) stocks a good strategy?

  • Should a high-net-worth individual take out a mortgage to buy a home?

  • How can small investors invest in commercial real estate?

  • Invitation: Submit your questions about investing, the stock market, finance or other money-related matters, and I will try to provide meaningful responses based on my own research and perspectives. Please post your questions to this blog by clicking on the "COMMENTS" link immediately below. Thanks!

    How can I win the stock-picking contest at my school?

    Reader's Question: I am taking a finance course in college. Our teacher has set up a competition on Virtual Stock Exchange, where students build their own portfolios and the student who has the highest return at the end of the trimester wins. I'm new at this. Which stocks should I buy?

    As you set out to pick your stocks for the contest, I suggest keeping in mind two "facts" about the short-run performance of individual stocks:

    1) It is almost impossible to predict with any certainty today which particular stocks will rise and which will fall tomorrow, and

    2) Stocks that are volatile today tend to remain volatile tomorrow.

    Putting these two principles together, I'll show you how to win the stock-picking contest--at least with greater odds than you might otherwise expect.

    A Stock-Picking Analogy: Numbers in a Hat

    Imagine that you and each of your classmates are presented with two hats holding cards with numbers written on them. The first hat (call it the "low volatility" hat) holds numbers uniformly distributed between -10 and +10. The second hat (call it the "high volatility" hat) holds numbers uniformly distributed between -50 and +50. You may choose one and only one number from just one of the two hats, and the student drawing the highest number wins.

    The million dollar question is: Which hat should you pick your number from, the high volatility hat or the low volatility hat?

    The expected outcome when picking a number from a hat is just the average of all of the numbers in the hat. In our example, this average is zero, because in each of the hats the positive and negative numbers are uniformly distributed. The situation up until this point mirrors Principle 1 above, which is equivalent to saying that your expected return when selecting either low volatility or high volatility stocks is zero (or close to zero) over a short time horizon (and a trimester is a fairly short period of time, so far as investing goes).

    Now, if you and your classmates were actually to draw numbers out of the hats as described, you would find that the winner (i.e., the person who is lucky enough to pick the highest number) will almost always be a student who draws a number from the hat with numbers ranging from -50 to +50, and not the hat with numbers from -10 to +10. The prescription, then, is that, if you wish to win the contest, you should draw a number from the hat with the wider range of numbers, i.e., from the high volatility hat, since the winning number will almost always be drawn from this hat. You might be able to see intuitively why this is so, but for anyone interested in seeing how the probabilities work out, I'll provide a bit more detail.

    Probability Analysis

    (You may skip this section, but it's an informative application of probability if you are willing to put a little effort into following the math, which really is not very difficult.)

    For the idealized case of uniformly distributed numbers in each hat, suppose you draw a number from the (-50,+50) hat, while everyone else in your class picks from the (-10,+10) hat. Three outcomes are possible:

    a) If the number you draw is between -50 and -10, you will lose the contest, and this will occur 40% of the time;

    b) If your number sits between +10 and +50, you will win, and this outcome also has a 40% chance of occurring;

    c) The remaining 20% of the time, your number will be between -10 and +10, and you will typically lose, since the expected value of the highest number drawn by your classmates from the (-10,+10) hat approaches +10 as the number of your classmates drawing from the (-10,+10) hat becomes large, i.e., the best draw from the (-10,+10) hat will typically beat your middling draw from the (-50,+50) hat.

    Overall, when you are the only one drawing from the (-50,+50) hat, you have a 40% chance of winning the contest, which is much better than the odds of winning you would have (e.g., 1/30 or about 3.3%, if there are 30 students) if you, along with everyone else, were to "follow the herd" and pick from the (-10,+10) hat.

    Now, what happens if some of your classmates also decide to draw from the (-50,+50) hat? Suppose that N students, i.e., you and N-1 others, pick numbers from the (-50,+50) hat. The probability that at least one of these N students (including you) draws a number exceeding +10 is equal to one minus the probability that all of these N students draw numbers between -50 and +10, which is (1 - 0.6N). Also, since your draw is just one among N from this high volatility hat, we need to divide by N to arrive at your probability of winning the contest. The result is:

    P(N) = (1 - 0.6N)/N

    For N = 1, P(1) = 1 - 0.6 = 0.4, which represents the 40% chance you have of winning when you are the only one drawing from the (-50,+50) hat. For larger N, i.e., when some of your classmates also follow the high volatility strategy, your probability of winning declines:

    P(2) = (1 - 0.62)/2 = (1 - 0.36)/2 = 0.32 = 32% chance of winning
    P(3) = (1 - 0.63)/3 = (1 - 0.22)/3 = 0.26 = 26% chance of winning
    P(4) = (1 - 0.64)/4 = (1 - 0.13)/4 = 0.22 = 22% chance of winning
    P(5) = (1 - 0.65)/5 = (1 - 0.08)/5 = 0.18 = 18% chance of winning

    In the limit of large N, your probability of winning will fall to 1/N, which is another way of saying that any strategic advantage you have disappears when everyone else learns about and decides to copy your superior strategy (so, keep quiet about how you go about picking your stocks!).

    Picking High Volatility Stocks

    Based on the above logic, you can generally enhance your chances of winning the stock-picking contest by selecting stocks with the highest volatility possible. You may not be able to determine with certainty whether a particular stock will rise or fall (Principle 1 above); however, because stocks that have recently risen or fallen a large amount are likely in the near future to move a large amount one way or the other (Principle 2 above), you have both greater upside and greater downside when playing the high volatility game. High volatility investing tends to produce large stupendous gains as well as shocking losses.

    In following the high volatility strategy, you should realize that the chance you will end up performing the worst in your class equals the chance you will end up being the top performer. However, in stock contests like the one you are participating in, the benefits of winning first place usually far outweigh the drawbacks of being the last place finisher, since kudos and recognition go to winners, while everyone else, no matter how low in ranking, is simply not mentioned at the awards ceremony. Within the context of your stock-picking contest (at least as I am imagining it), you will be better off increasing your odds of "winning big" with risky high volatility stocks than "playing it safe" with more conservative low volatility stocks.

    As a practical matter, you are probably wondering how to identify high volatility stocks. One easy way is to go Yahoo! Finance and examine the daily lists of largest percent price gainers and largest percent price losers. (Although I have not used MarketWatch's Virtual Stock Exchange, I have noticed that their website also provides lists of largest percent price gainers and losers.) On any given trading day, there will typically be a handful of stocks that have moved 20% , 30% or more, up or down. In some cases, the large price movement will have been driven by buyout, earnings or new product announcements, so that the large price move will typically not be followed by another large move--avoid these one-time news situations. Instead, focus on the large percent gainers and losers that have moved on no news.

    More often than not, the "no news" movers will be stocks of small companies, so-called microcaps or "penny stocks," which are highly volatile, trade in small volume (or at least small dollar volume) and most institutional investors stay away from. Have you ever heard of RXI Pharmaceuticals (RXII), Aristotle Corp. (ARTL), ULURU Inc. (ULU), or I-Many Inc. (IMNY)? Most people probably have not, since they are by no means household names. However, these four stocks were among those that moved more than 20%--two of them up and two of them down--in Friday's trading, on no significant news. Your job will be to do the research and identify stocks whose volatility is likely to remain high, and, if you are lucky, you'll pick stocks that will actually rise (or fall, if you are allowed to go short in your contest).

    So, while your classmates are holding Google (GOOG), Apple (AAPL), Microsoft (MSFT) and other such popular stocks in their portfolios, you will be off buying and selling shares of small companies that no one has ever heard of. Due to their high volatility, the stocks of these microcap companies are the venue of daytraders, stock promoters and others "gambling" for a quick profit. As you are engaged in your game with your classmates, the short-term traders will be the ones doing all of the heavy-lifting, causing the stock prices to ramp up and down, allowing you to ride the opportunity for potential profit within the safe harbor of your stock-picking contest.

    Best of luck paper-investing or paper-trading, as the case may be. I hope you win the contest!

    P.S. Over the weeks ahead, could you please post a comment to let us know how you do in the stock-picking contest compared to your classmates? Thanks.

    Important Note: The strategy I outline above for your stock-picking contest is not the strategy I would recommend following when you actually invest your own money in the real world outside of the classroom. Within the confines of an in-school contest, even the worst case outcome of a dismal investment return will probably not drag down your grade (but check with your teacher to make sure before entering your trades), since educational environments generally adhere to a philosophy that "it doesn't matter whether you win or lose; it only matters how you play the game" (yet it is nice to win, and that's why you've asked for my opinion, right?). When you are using real money, the potential downside inherent in trading extremely high volatility stocks, namely, the miserable prospect of losing all or most of your money, is just too damaging financially, psychologically and emotionally, and should be avoided. For a strategy I suggest following in any real-world investing you do in the future, please read a five-part series of articles on long-term investing I have written, accessible through the last part in the series here.

    Wednesday, May 28, 2008

    Should we remain renters or buy a house?

    Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own. Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?

    Rent vs. Buy Analysis

    As with many financial decisions (e.g., invest in stocks or bonds?, use leverage or not?, continue to hold a stock or sell it now?), much can be said about the choice between renting and buying a house, but we only really find out tomorrow if we truly are making the right decision today. I'll go through an example using the U.S. real estate market, and then return the discussion to a broader perspective.

    Back in 2000, just after the stock market had peaked and the dot-com crash was beginning, my family and I arrived in the city we currently live in. At that time, the local residential real estate market was firm with median-priced homes around $400k, and prices were rising at a solid though moderate mid-single digit annual rate. Being new to the area, we initially rented, paying $1,700 per month for an average-size house on a quiet street in a good school district. While renting, I occasionally would run through a quick rent vs. buy analysis, similar to the one I imagine you are now doing. Assuming no mortgage, the pre-tax calculation is simple, at least in principle (income taxes and a mortgage complicate matters but the main variable remains the relative investment performance outlined below):

    Renting: As renters, we were paying 12 x $1,700 = $20,400 per year in rent, and the owner was responsible for all property tax, homeowner's insurance and necessary repairs on the house. Since the $20,400 annual rent was about 5% of the estimated $400k price of a comparable house at that time (in the year 2000), we can write:

    Annual cost of renting = 5% of price of house.

    Buying: If we were to buy a comparable house, we would need to sell $400k worth of investments (mostly stock), foregoing whatever future return we might realize, and use this money to buy the house, which itself would show some rate of price appreciation. The financial burden of 1) paying property tax and insurance (about $4,000 annually on a $400k house) and 2) performing repairs or at least putting money aside into a reserve account for major repairs (e.g., roof replacement or painting) to be performed at some point in the future (estimated at another $4,000 annually), together add up to $8,000 per year. So, in approximate percentage terms, we have:

    Annual cost of buying = 2% for property tax, insurance & repairs + (S - R),

    where S is the estimated future annual percentage return on investments (mostly stocks) to be sold in order to buy the house, and R is the anticipated future annual percentage price appreciation of the house (real estate).

    From an investment point of view, renting should be preferred over buying when the annual cost of renting is less than the annual cost of buying, i.e., when 5% <> R + 3%. In other words, as a rough rule of thumb: If stock market returns exceed house price appreciation by more than 3% (i.e., 300 b.p.) per annum, one can expect be better off renting a house (and owning stock) instead of (selling the stock and) buying a house.

    The graph below shows how stock market returns (S&P 500) have compared to house price appreciation (for the Seattle area where I live) for the eight years between 2000 and today.

    (click graph to enlarge)

    During 2000-2002, when the stock market fell sharply, I expected the sell-off in equities to exert noticeable downward pressure on local real estate prices, but the correlation between the stock and real estate markets was weak. When the stock market turned around in late 2002, initiating an extended five-year bull run, real estate price appreciation accelerated as well. Currently, amidst fallout from the subprime crisis here in the U.S., the housing market seems softer than the stock market, which itself is largely moving sideways as the economy flirts with recession.

    In my family's case, after an extended house search, encompassing a few years but focussed on a small neighborhood with very little available inventory, we finally found the right house, liquidated other investments and closed escrow, switching from being renters to homeowners in early 2005. in retrospect, we managed to capture the bulk of the rapid price appreciation our local real estate saw in 2004-2006, and have ended up being on the correct side of the rent-vs.-buy dichotomy for each of the past three years.

    Assessing the Future

    Like you and everyone else, I wish I had a crystal ball to predict the future. If I could correctly forecast the relative performance of the S&P 500 versus my local real estate market, I would always know whether to be a renter or homeowner. Short of knowing the future, however, I look to "softer," more qualitative factors--such as being partially "hedged" through having exposure to both the stock and real estate markets, the freedom to replant a garden or repaint a room without consulting a landlord, peace of mind from having neither rent nor a mortgage to pay, and so on--for assurance that owning a house and allocating much of the balance of our investment portfolio to the stock market is the right decision, at least for now.

    For a comparison to other markets, you might wish to read the Global Property Guide article here covering the state of housing markets around the world, giving both price appreciation and rent figures for many countries. Some highlights, with emphasis on the Pacific Rim (including both Australia and the U.S.), are:

    House Price Appreciation (2007, in local currency):

    Shanghai 28%
    Singapore 28%
    Hong Kong 11%
    Australia 11%
    UK 10%
    South Korea 9%
    Japan (6 major cities) 8%
    New Zealand 7%
    Canada 6%
    Japan (nationwide) -1%
    U.S. (average of indices) -2%.

    Rental Yield (gross rent as percent of house price):

    Shanghai 7.8%
    Sydney 5.9%
    London 5.4%
    New York 5.0%
    Tokyo 4.7%
    Hong Kong 4.2%
    Singapore 2.8%

    Offhand, I would guess that at some point during the next couple of years a few of the hotter real estate markets around the Pacific Rim will see declines similar to what the U.S. (particularly the submarkets like California, Florida and Las Vegas, Nevada, which rose fastest on the way up) is now experiencing. How your neighborhood real estate market in Australia is impacted is really something you, being local, should have a better handle on than I do.

    When making your decision, keep in mind that a) the future is hardly ever crystal clear, and b) it is the relative future performance between whatever particular investments you will sell (the "S" above) and the specific house you will buy (the "R"), that will allow you (and only retroactively!) to determine conclusively if you made the correct rent vs. buy decision in prior years.

    Overall, seeing that you and your husband are entrepreneurial, hardworking, persistent in your saving habits, self-directed in your investing, and debt-free, I am optimistic that either path, i.e., renting or buying, will lead you to the comfortable retirement you are targeting. Best of luck in the years ahead!

    Wednesday, May 14, 2008

    Why Successful Traders Are So Secretive

    I set out to explain why successful traders are so secretive, by stepping through a logical argument of how a trader, if he publicizes his trading decisions, will almost certainly sooner rather than later undermine his own success. For many reading this, secrecy among successful traders may be a truism not requiring elaboration. However, for anyone wishing to hear the story, here it is:

    Let's call our (hypothetical) young trader Mr. Bright. Assume that Mr. Bright either has an innate and remarkable ability to discern patterns in stock price movement or, alternatively, has developed a sophisticated computer program that can correctly forecast price action. Using his uncanny ability or his financial technology, Mr. Bright buys and sells stocks, typically taking positions for only a few hours, and achieves a highly favorable track record, soon vaulting him to multi-millionaire status.

    One sunny morning, driven by apparent altruism camouflaging a layer of megalomania, Mr. Bright wakes up and decides to "share the wealth" with others by publishing his trading decisions via a website, announcing his buy and sell targets for particular stocks, and detailing his actual trades real-time.

    Now, the media, always looking for a good story, is quick to pick up on young Mr. Bright's impressive track record and his openness and willingness to educate anyone who will listen. However, the public, including numerous "little guy" investors, who have only painful memories of losing too much money on rumors, hearsay and not-so-sound "advice" from "experts," is more skeptical. At first, only a few people take Mr. Bright and his predictions seriously enough to put their own hard-earned money at risk mimicking his trades. However, the success of the bold early adopters soon attracts a small army of followers, who are eager to partake of the "easy money," free for the taking simply by copying Mr. Bright's trading actions--buying when he buys and selling when he sells.

    For quite a few months all is well. Mr. Bright's trades, along with those of his army of copycats, are profitable more often than not. He and his followers are on track to realize a 100% return during the first year. To the surprise of all skeptics, Mr. Bright is consistently putting money into the pockets of every little investor in his army and quickly becoming a popular hero.

    By this time, as success tends to generate its own publicity, Mr. Bright and his uncanny forecasting system have caught the attention of professional investors (hedge funds, proprietary trading desks at investment banks and others). Since Mr. Bright makes a habit of publishing his trades real-time, he and his army of followers are an easy target for deeper-pocketed pros.

    The strategizing in the pros' minds goes like this: Seeing that the stocks that Mr. Bright and his army buy rise so predictably, why not kick in a few dollars and join them on the way up? Then, instead of waiting for Mr. Bright's typical 10% rise before taking profits, how about front-running Mr. Bright and his army by selling out a little sooner, say at 9% profit, and proceeding to go short in significant size? As the stock starts to fall due to our short, Mr. Bright and his army will have little choice but to cut their profits and join us in selling, thereby pushing the stock down further and faster. As Mr. Bright and his army go into rapid retreat, the corresponding surge in trading volume and collapsing stock price will provide us pros with an opportunity to buy back shares to cover our short for a quick profit. As is easy to see, Mr. Bright and his army, with their well-publicized trades, will inevitably fall right into our trap!

    In essence, Mr. Bright's system breaks down when more money is put into play. While the system initially succeeds in predicting price movement and generating profits for Mr. Bright and a small army of followers, the forecasting ability of the system vanishes when deeper-pocketed pros toss more money into the game. The very actions of Mr. Bright and his followers become a significant part of the overall market and, ultimately, the predictability of their behavior becomes a target of the pros.

    Ironically, Mr. Bright's uncanny forecasting ability, when publicized to allow everyone free access to his trading decisions, itself becomes a predictable aspect of the market. In other words, the very act of revealing the predictions of a successful trading system predictably undermines its own ability to predict!

    Moral of the story: Mr. Bright wasn't so bright after all.

    Corollary: The brightest traders keep their systems secret.