Sunday, May 31, 2009

Why is Small Beautiful?


I was reading something on microsatellites which got me thinking about how in the new era of investing, bigger does not always mean better.

When I was looking for work in Montreal, I stumbled across a group of prop traders that really impressed me. They work for themselves, put up their own capital and trade in and out of futures contracts all day long.

A few of these guys are extremely successful at this style of trading. When I inquired as to how they trade, they told me they move ahead of the big hedgies and big institutions and are able to be nimble and pick their spots.

It's not foolproof and they don't always make money but they got me thinking. I could never trade the way they do and their strategy is not very scalable for institutions to replicate. Moreover, I find it excruciatingly boring going in and out of the futures market hundreds of times a day.

But if you understand the constraints of prop traders, portfolio managers, hedge fund managers and institutional investors, you can use this information to your advantage in your own personal portfolio.

Let me explain. A hedge fund manager or portfolio manager at some pension fund or mutual fund has limits on how much they can invest in one company or sector. For example, they might limit and individual position to 3% of their portfolio and a sector to 10% of their portfolio.

Now, if you know this, you also know that they will start bidding up stocks in sectors that are outperforming and the trend can last longer than you think. Unlike them, you are not constrained by some tight risk rules or stop losses, allowing you to place a higher weighting on some stocks or sectors in your portfolio.

Let me take a step back here to go over my approach to looking at the stock market. In my comment on the investment labyrinth, I wrote that I use a thematic approach which combines top-down analysis with bottom-up technical and fundamental analysis.

I wrote that I track the following funds from MFFAIS website (data is lagged but fairly recent and based on 13-F filings):

AQR Capital Management

Artis Capital Management

Atticus Capital

Bamco

Barclays Global Investor

Berkshire Hathaway

Brevan Howard Asset Management

Bridgewater Associates

Bridgeway Capital Management

Cascade Investments

Caxton Associates

Citadel LP

Clarium Capital Management

DE Shaw and Co

Eton Park Capital Management

Farallon Capital Management

Fortress Investment Group

Fox Point Capital Management

Greenlight Capital Inc

Golden Tree Asset Management

Goldman Sachs Group

Grantham Mayo Van Otterloo and Co

HBK Investments

Highbridge Capital Management

Hussman Strategic Growth Fund

Ionic Capital Management

Jabre Capital Partners

JP Morgan Chase Co

Legg Mason Capital Management

Letko Brosseau and Associates

Leuthold Core Investment Fund

Leuthold Grizzly Short Fund

LSV Asset Management

Morgan Stanley

Kingdon Capital Management

Lone Pine Capital

Maverick Capital

Millenium Management Llc

Moore Capital Management

Paulson and Co Inc.

Pequot Capital Management

Pershing Square Capital Management

Quantum Capital Management

Renaissance Technologies Corp.

Soros Fund Management

Spinnaker Capital LP

Sprott Asset Management


Tiger Global Management

Traxis Partners

Tremblant Capital Group

Tudor Investment Corp.

Viking Global Investors LP


[Note: I added a few funds. Another good source of information on what hedge funds are buying and selling is Seeking Alpha's comments on hedge fund activity.]

The reason I track what top funds are buying instead of what analysts are touting is that actions speak louder than words. You can recommend a stock to me but if I know you are putting your money where your mouth is, then I know you have conviction behind your recommendations.

When I told my friends to buy energy stocks in Q2, especially solar stocks, I was not just saying it, I was putting my money where my mouth is and I warned them it is a very volatile sector but when it moves up, it moves up very quickly.

[Note: Read an earlier comment on solar stocks from last August and more recent articles on the Chinese solar index taking top spot, alternative energy cost parity within reach, and falling silicon prices pressure thin-film solar]

I know because I got nailed buying some of these companies after what I perceived to be an inordinate and steep drop in Q4 2008. But I understood the mechanics behind this decline so I kept buying as much as possible all the way into early March.

There are times to cut your losses and move on, and there are other times when you should be forgetting these trader rules and keep doubling down. That was one of those times.

Let's look at a specific example of a solar stock that I track but did not invest in. Look at this one-year chart of Trina Solar (TSL). If you check out the summary, you'll see a 52-week range of 5.61 - 49.63 in its price.

Why all this volatility? Hedge funds were long but as they delveraged to meet redemptions, they were forced to sell stocks. Long-short hedge funds are typically long small cap stocks and short large cap stocks, so it wasn't surprising to see small cap stocks get decimated in Q1 of this year.

But all stocks got clobbered in Q1. Now, there are currently 1,483 stocks in the Russell 3,000 that are up year to date, 134 are up more than 100%, and 38 are up more than 200%.

Getting back to Trina Solar, you'll see some of the major holders at the end of Q1 were Citadel and DE Shaw, two well known hedge funds. You will see the stock hit a double-bottom (one in November, one in March) and has been trending up ever since.

Let's say you were lucky enough to buy it a $7 and it doubled. Would you have sold? Most people would have sold but as long as a stock makes higher highs and higher lows on a weekly basis, you should be riding it up.

Specifically, for short to intermediate trends, focus on the 10-day EMA being above the 50-day EMA and for longer trends, focus on the 50-day EMA being above the 200-day EMA.

You should be looking at these moving-average trends, weekly high, low, close and volume very carefully. I look at them as a gauge and not just for individual stocks, but for general markets like the Nasdaq and S&P 500.

If you are not comfortable investing in individual stocks, learn all you can about ETFs and ETF trends. Lots of people out there are getting raped on fees by mutual funds that consistently under-perform the markets. WHY?

My final comment in this small post is to tell you that I agree with Toro's Running of the Bulls Market Blog, when the yield curve is this steep, it is usually a good time to invest in stocks. Treasuries could make a comeback or range trade for a long time.

For now, risk trades are back on: long commodities, long commodity currencies, long emerging markets, long high yield bonds, long, LONG, LONG! How much longer will it last? Who knows? As long as they keep buying the dips, this rally has legs.

My thoughts are that all that liquidity is drowning the meaning of inflation but showing up in speculative pockets like oil. And guess who is back buying oil futures? Who else? Pension funds and other speculators are back buying these indexes and now U.S. Senator Bernie Sanders has asked the federal futures market regulator to crack down on speculators whom he blamed for pushing up crude oil and gasoline prices.

But the tidal wave of liquidity has been unleashed. The genie is out of the bottle and to navigate these treacherous markets, individual investors need to use their nimbleness and lack of constraints wisely, increasing sectoral positions when opportunities arise and not be afraid to ride these trends up knowing that liquidity is very favorable.

One final piece of advice: do not be afraid to short pension funds and go long hedge funds. The best hedge funds are typically ahead of the curve and the former are typically late to the game. Interestingly, public pension funds have not invested in solar stocks while the best hedge funds have.

But as I mentioned above, hedge funds and institutional funds have position and sector limits - an extra constraint that you do not have. Use this to your advantage, be nimble, study their portfolio moves and do not be afraid to take on more risk when opportunities arise.

And above all remember that everyone's risk profile is different. If you are not comfortable with investments, consult a few experts and ask some tough questions on fees and their thoughts on markets going forward. Never be afraid to ask as many questions as you need to, after all, it's your money.

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