Buying Cheaply Works

When we talk about value investing there is a lot of evidence that value investors have been on the right side of the trade. The statistical studies that run against or contradict market efficiency almost all of them show that cheap portfolios—low market-to-book, low price-to-book—outperform the markets by significant amounts in all periods in all countries—that is a statistical, historical basis for believing that this is one of the approaches where people are predominantly on the right side of the trade. And, of course, someone else has to be on the wrong side of the trade.

Those studies were first done in the early 1930s; they were done again in the early 1950s. And the ones done in the 1990s got all the attention because the academics caught on. There is statistical evidence that the value approaches—buy cheap securities—have historically outperformed the market. Buying Cheap works.


http://csinvesting.org/wp-content/uploads/2012/06/greenwald_2005_inv_process_pres_gabelli-in-london.pdf

The 7 classes of arbitrage and special situations that Warren Buffett has invested into.

Warren Buffett has focused on seven classes of arbitrage and special situations.

Classic Arbitrage 

1. Friendly Mergers
2. Hostile Takeovers
3. Corporate tender offers for a company's own stock

Special Situations

1. Liquidations
2. Spin-offs
3. Stubs
4. Reorganisation

Time Arbitrage

Example to illustrate "time arbitrage":

Company ABC's stock is trading at $8 a share.

Company XYZ offers to buy company ABC for $14 a share in four months.

In response to the offer, Company ABC's stock goes to $12 a share.


How can you arbitrage on this situation?

The simple arbitrage play here would be to buy Company ABC's stock today at $12 a share and then sell to Company XYZ in four months for $14 a share, which would give a $2 a share profit.

Unlike the normal everyday stock investment, this is a solid offer of $14 a share in four months.

Unless something screws it up, you will be able to sell the stock you paid $12 a share for today for $14 a share in four months.

It is this CERTAINTY of its going up $2 a share in four months that separates it from other investments.

Once Company XYZ's offer is accepted by Company ABC, it becomes a binding contract between Company ABC and Company XYZ with certain contingencies.


What is the risk of this arbitrage?

The reason that the stock does not immediately jump from $8 a share to $14 a share is that there is a risk that the deal might fall apart  

In this case, we won't be able to sell the stock for $14 a share and Company ABC's share price will probably drop back into the neighbourhood of $8 a share.



Understanding Time Arbitrage

We are arbitraging two different prices for the company's shares that occur between two points in time, on two very specific dates.  This kind of arbitrage is thought of as "time arbitrage".

This kind of arbitrage is very difficult to model for computer trading. 

It favours the investors who are capable of weighing and processing a dozen or more variables, some repetitive, some unique, that can pop up over the period of time the position is held.


In Summary

1.  The arbitrage opportunity arises because of a positive price spread that develops between the current market price of the stock and the offering price to buy it in the future.

2.  The positive price spread between the two develops because

• of the risk of the deal falling apart and 
• the time value of money.

The work of the arbitrageurs (Market arbitrage)

A particular commodity, e.g., gold,  trades virtually at virtually the same price in different markets in the world.

This is the work of the arbitrageurs.

The arbitrageurs will keep buying and selling until the spread in the prices in the two markets is eliminated.

The arbitrageurs will be pocketing the profits on the price spread between the two markets until the price spread finally disappears.

These transactions today are done with high-speed computers and very sophisticated software programs, which are owned and operated by many of the giant financial institutions of the world.

Arbitraging a price difference between two different markets, usually within minutes of the price discrepancy showing up is known as "market arbitrage".

Arbitrage is Warren's secret for producing great results

Professors Gerald Martin and John Puthenpurackal's studied the stock portfolio's performance from 1980 to 2003 of Berkshire Hathaway.

Their findings:

• Portfolio's 261 investments had an average annualised rate of return of 39.3%.
• 59 of those 261 investments were identified as arbitrage deals.
• Those 59 arbitrage deals produced an average annualised rate of return of 81.28%!

Their study brought to light the powerful influence that Warren's arbitrage operations had on Berkshire's stock portfolio's entire performance.

If those Warren's 59 arbitrage investments for that period were cut out from the portfolio, the average annualised return for Berkshire's stock portfolio drops from 39.38% to 26.96%.

In 1987, the S&P 500 delivered a 5% return, while Warren's arbitrage activities earned an amazing 90% that year.

Arbitrage is Warren's secret for producing great results when the rest of the stock market is having a down year.

Certainty of the deal being completed is everything.  The high probability of the event happening creates the rare situation in which Warren is willing to use leverage to help boost his performance in these investments to unheard-of numbers.

Terms: Arbitrage,  Leverage, Compounding

Arbitrage and Special Situations

In the past, these have been the domain of professional investors, who have access to lower brokerage rates.

In the world of arbitrage and special situations, the high retail brokerage rates formed an almost impassable barrier of entry for lay investors.

Simply their brokerage costs often exceeded any potential profit in the trade.

With the advance of the Internet and with the lower rates now available, the world of stock arbitrage and other special situations are opened up to the masses.

Aggressive investors can learn how to identify the bet with the least risk, which can enable the investor to take very large positions and produce results that can be spectacular.

Investing has a whole new set of rules.

If we are to be successful, we need to play by these new rules.

Why the average equity fund investor underperforms the market?

From 1993 to 2012, the S&P Index 500 averaged a gain of 8.21% per year.

However, during that same 20 year period, the average equity fund investor had an average annual gain of only 4.25%.  

Had the average equity fund investor just bought a low-cost S&P 500 Index fund and held it, he/she would have almost doubled their rate of return.

The underperformance was due to investor behaviour such as market timing and chasing hot funds.

Had these investors been long-term, buy-and-hold investors, they would have earned close to the market's returns.

When the average investor underperforms the index by such a significant amount, it is clear that most are playing with a bad set of guidelines or none at all.

A one-time investment of $10,000 invested at 8% compounds to $46,610 in 20 years.

The same $10,000 invested over the same period at 4.25% compounds to only $22,989.

Short-run performance of the stock market is random, unpredictable and very volatile

The short-run performance of the stock market is random, unpredictable and for most people, nerve-racking.

The next time you hear someone saying that he/she knows how the stock market or any given stock is going to perform in the next few weeks, months, or years, you can be sure they are either lying or self-delusional.

The long-term trend of the stock market is up and its performance consistent

There is more than 200 years of U.S. stock market history and the long-term trend is up.  

Over the long term, stock market performance has been rather consistent.

During any 50-year period, it provided an average after-inflation return of between 5 and 7 percent per year.

If you invested in a well-diversified basket of stocks and left them alone, the purchasing power of your investment would have doubled roughly every 12 years.

Stocks over the long-run offer the greatest potentials return of any investment

Although long-term returns are fairly consistent, short-term returns are much volatile.  

Stocks over the long-run offer the greatest potential return of any investment, but the short-run roller-coaster rides can be a nightmare for those who don't understand the market and lack a sound investment plan to cope with it.  

The 1990s were stellar years for stocks but the 1930s were a disaster.

Applying these principles to investing is destined to leave you poorer!

• Don't settle for average.  Strive to be the best.
• Listen to your gut.  What you feel in your heart is usually right.
• If you don;t know how to do something, ask.  Talk to an expert or hire one and let the expert handle it.  that will save you a lot of time and frustration.
• You get what you pay for.  Good help isn't cheap and cheap help isn't good.
• If there's a crisis, take action!Do something to fix it.
• History repeats itself.  The best predictor of future performance is past performance.

Explanations:

As an investor, you can be well above average by settling for slightly less than the index returns.

Listening to your gut is the worst thing you can do.

Although it sometimes pays to hire an expert, you may get less than you pay for.

Trying to fix a perceived investment crisis by taking action is usually a recipe for poor returns.

Using yesterday's results to pick tomorrow's high-performing investments or investment pros is another losing strategy.

Porter's Five Forces Framework - the implications of the industrial environment on corporate strategy

Porter's Five Forces Framework

1. Threat of substitute product
2. Bargaining power of customers
3. Bargaining power of suppliers
4. Threat of new entrants
5. Intensity of rivalry.

Market Share Stability determines the competitive environment in an industry

Stable market shares indicate less competitive industries.

Unstable market shares often indicate highly competitive industries with little pricing power.

Market shares are affected by the following factors:

• Barriers to entry
• New products
• Product differentiation.

Industry Capacity determines the competitive environment in an industry.

Limited capacity gives companies more pricing power as demand exceeds supply.

Excess capacity results in weak pricing power as excess supply chases demand.

In evaluating the future competitive environment in an industry, we should examine current capacity levels as well as how capacity levels are expected to change in the future.

It is important to keep in mind that:

• If new capacity is physical (e.g., manufacturing facilities) it will take longer for the new capacity to come online so tight supply conditions may linger on for an extended period.  Usually however, once physical capacity is added, supply may overshoot, outstrip demand, and result in weak pricing power for an extended period.
• If new capacity requires financial and human capital, companies can respond to tight supply conditions fairly quickly.

Industry Concentration determines the competitive environment in an industry

If an industry is relatively concentrated i.e., a few large firms dominate the industry, there is relatively less price competition.  This is because:

• It is relatively easy for a few firms to coordinate their activities.
• Larger firms have more to lose from destructive price behaviour.
• The fortunes of large firms are more tied to those of the industry as a whole so they are more likely to be wary of the long run impact of a price war on industry economics.

If an industry is relatively fragmented i.e., there is a large number of small firms in the industry, there is relatively high price competition.  this is because of the following reasons:

• Firms are unable to monitor their competitors' actions, which make coordination difficult.
• Each firm only has a small share of the market, so a small market share gain (through aggressive pricing) can make a large difference to each firm.
• Each firm is small relative to the overall market so it tends to think of itself individualistically, rather than as a member of a larger group.

There are important exceptions to the rules defined above.

• For example, Boeing and Airbus dominate the aircraft manufacturing industry, but competition between the two remains fierce.

Barrier to Entry - A form of Durable competitive advantage

Low barriers to entry mean that new competitors can easily enter the industry, which makes the industry highly competitive.  Companies in relatively competitive industries typically have little pricing power.

High barriers to entry mean that existing companies are able to enjoy economic profits for a long period of time.  These companies have greater pricing power.

However, the above mentioned characteristics of high and low barrier industries are not always observed.

Further it is important to note that:

• Barriers to entry should not be confused with barriers to success.
• Barriers to entry can change over time.

Relationship between Price and Maturity of Bonds

If the yield remains constant:

• A premium bond's value decreases towards par as it nears maturity.
• A discount bond's value increases towards par as it nears maturity.
• A par bond's value remain unchanged as it nears maturity.

Costs of trading, illiquid markets and costs associated with gathering and analyzing information affect security prices.

Two securities that should trade for the exact same price in an efficient market may trade at different prices for various reasons:

1. If the costs of trading on the mispricing (to make a profit) for the lower cost traders are greater than the potential profit.
2. In such cases, these prices are still "efficient" within the bounds of arbitrage.  The bounds of arbitrage are relatively narrow in highly liquid markets (e.g., U.S. T-bills), but wider in relatively illiquid markets.
3. There are always costs associated with gathering and analyzing information.  Net of information acquisition costs, the return offered on a security should be commensurate with the security's level of risk.  If superior returns can be earned after deducting information-acquisition costs, the market is relatively inefficient.

Factors Contributing to and Impeding a Market's Efficiency

Market participants:   

The greater the number of active market participants (investors and financial analysis) that analyze an asset or security, the greater the degree of efficiency in the market.

Information availability and financial disclosure:

The availability of accurate and timely information regarding trading activities and traded companies contributes to market efficiency.

Limits to trading:

The activities of arbitrageurs, who seek opportunities to trade on mispricings in the market to earn arbitrage (riskless) profits, contribute to market efficiency.

Transactions costs and information acquisition costs:

Investors should consider transaction costs and information-acquisition costs in evaluating the efficiency of a market.

Market Value versus Intrinsic Value

Market Value

The market value or market price of the asset is the price at which the asset can currently be bought or sold.  

It is determined by the interaction of demand and supply for the security in the market.


Intrinsic Value

Intrinsic value or fundamental value is the value of the asset that reflects all its investment characteristics accurately.

Intrinsic values are estimated in light of all the available information regarding the asset; they are not known for certain



Efficient Market

In an efficient market, investors widely believe that the market price reflects a security's intrinsic value.


Inefficient Market

On the other hand, in an inefficient market, investors may try to develop their own estimates of intrinsic value in order to profit from any mispricing (difference between the market price and intrinsic value).

Efficient Market versus Inefficient Market

An information efficient market (an efficient market) is one where security prices adjust rapidly to reflect any new information.

It is a market where asset prices reflect all past and present information.

Investment managers and analysts are interested in market efficiency because it dictates how many profitable trading opportunities may abound in the market.



Efficient market

In an efficient market, it is difficult to find inaccurately priced securities.  

Therefore, superior risk-adjusted returns cannot be attained in an efficient market.

It would be wise to pursue a passive investment strategy which entails lower costs.

In an efficient market, the time frame required for security prices to reflect any new information is very short.   

Further, prices only adjust to new or unexpected information (surprises).



Inefficient market

In an inefficient market, securities may be mispriced.

Trading in these securities can offer positive risk-adjusted returns. 

In such a market, an active investment strategy may outperform a passive strategy on a risk-adjusted basis.

Overview of a Fixed-Income Security (Bonds)

Who are the issuers of fixed-income security or bonds?

• Supranational organizations
• Sovereign (national) governments
• Non-sovereign (local) governments
• Quasi-government entities

Credit worthiness of Bonds

Bond issuers can also be classified based on their credit worthiness as judged by credit rating agencies.

Bonds can broadly be categorized as

• investment-grade bonds or
• non-investment grade (or high yield or speculative) bonds.

Maturity of Bonds

Fixed-income securities which, at the time of issuance, are expected to mature in one year or less are known as money market securities.

Fixed-income securities which, at the time of issuance, are expected to mature in more than one year are referred to as capital market securities.

Fixed-income securities which have no stated maturity are known as perpetual bonds.

Par Value

The par value (also known as face value, nominal value, redemption value and maturity value ) of a bond refers to the principal amount that the issuer promises to repay bondholders on the maturity date.

Bond prices are usually quoted as a percentage of the par value.

• When a bond's price is above 100% of par, it is said to be trading at a premium
• When a bond's price is at 100% of par, it is said to be trading at par.
• When a bond's price is below 100% of par, it is said to be trading at a discount.

Coupon Rate and Frequency

The coupon rate (also known as the nominal rate) of a bond refers to the annual interest rate that the issuer promises to pay bondholders until the bond matures.

The amount of interest paid each year by the issuer is known as the coupon, and is calculated by multiplying the coupon rate by the bond's par value.

Zero-coupon (or pure discount) bonds are issued at a discount to par value and redeemed at par (the issuer pays the entire par amount to investors at the maturity date).  The difference between the (discounted) purchase price and the par value is effectively the interest on the loan.

Currency Denomination

Dual currency bonds make coupon payments in one currency and the principal payment at maturity in another currency.

Currency option bonds give bondholders a choice regarding which of the two currencies they would like to receive interest and principal payments in.

Yield Measures

The current yield or running yield equals the bond's annual coupon amount divided by its current price (not par value), expressed as a percentage.

The yield to maturity (YTM) is also known as the yield to redemption or the redemption yield.  It is calculated as the discount rate that equates the present value of a bond's expected future cash flows until maturity to its current price.

Given a set of expected future cash flows, the lower  the YTM or discount rate, the higher the bond's current price.

Given a set of expected future cash flows, the higher the YTM or discount rate, the lower the bond's current price.

Important Relationships of Fixed Income Securities (Bonds)

Defining the Elements of a Bond

Coupon rates and bond prices

The higher the coupon rate on a bond, the higher its price.

The lower the coupon rate on a bond, the lower its price.


Interest rates and bond prices

An increase in interest rates or the required yield on a bond, will lead to a decrease in price.

A decrease in interest rates or the required yield on a bond will lead to an increase in price.

That is, bond prices and yields are inversely related.


Bonds risks and bond yields 

The more risky the bond, the higher the yield required by investors to purchase the bond, and the lower the bond's price.

Contingent Convertible Bonds ("CoCos")

CoCos are bonds with contingent write-down provisions.

They differ from traditional convertible bonds in two ways:

• Unlike traditional convertible bonds, which are convertible at the option of the bondholder, CoCos convert automatically upon the occurrence of a pre-specified event.
• Unlike traditional convertible bonds, in which conversion occurs if the issuer's share price increases (i.e. on the upside), contingent write-down provisions are convertible on the downside.