Tag: investment

Investment Analysis: Struggling industries and prospective short-sell candidates

Posted on by fqzhang

As 2015 is starting, many in the investment circle are looking at what new industries and companies are presenting opportunities. While this is important, it is just as important to note what industries not to pick for this upcoming year. Here is my short list (no pun intended) of what industries are facing some significant headwinds and is good to avoid in this coming year. (If you are long (i.e expecting the value to go up), that is. But if you are looking for shorts (trying to profit by a falling in stock price), feel free to be as aggressive as you like; but be warned, as the great the economist John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent”.)

  1. Small Oil and Gas companies with high fixed costs

Oil and gas are among the largest industries in the world (with an estimated 5 trillion dollars in revenue, rivaling the tech industry). Due in part to the massive stock market boom in the last few years, many small oil and gas companies emerges in the public markets. They range from extraction companies to oil exploration to small manufacturers of drilling equipment. With a falling oil price that is not likely to rise any time soon, these small producers with limited resources will likely falter. Moreover, natural resources extraction is a highly capital intensive industry and the firms will likely take on massive amounts of debts to finance its projects. It is estimated that drilling each oil well costs about 3 to 4 million dollars and small companies with a highly leveraged structure and few prospects for growth will be the likely victim in 2015. (Interested in Big Oil and corruption? click here For more on how the falling oil prices are affecting nations around the world, see here)

  1. Small tech companies that have no prospects of being bought up by the big guys

In this category, the companies that come to mind will be the small software development firms, such as app-makers that makes their business around a single app. For example, Zynga, the maker of the popular app game “Farmville”, is one such company. The company is involved in the social gaming category and have not expanded by much in the last couple of years, and are instead are trying to monetize its existing products. For a company involved in app-development, if no new apps are introduced continually, then the firm will simply wither away when demands for the current app disappears (as it most certainly will since consumer tastes are constantly changing). Monetization will be difficult, since a majority of the company’s revenue still comes from selling of advertising space and the market is increasingly saturated by the amount of advertisings out there, and increasing diminishing rates of return. Of course, the best that these tech companies can hope for is to be bought up by the larger players such as Facebook. However, with the proliferation of software companies, larger tech companies have more options to choose from and will take care to only add firms that adds value to the company’s operations.

  1. Small biotech or pharmaceuticals purporting to have “wonder drugs” or new “breakthrough technologies”

For those of you who subscribes to some form of investment newsletters (it doesn’t matter if they are free or charge you hundreds of dollars per year), you have no doubt saw a number of different promotions that talks about how a certain company is on the verge of growth. With a booming biotech sector, a lot of less credible companies have been swept up as well. These companies can have the following traits in common:

  1. Involving cancer-curing or purporting to cure multiple diseases at once with a single drug. These are often simply scientifically unsound, and investors should do some basic research on the subject and use common sense in sorting some of these issues out.
  2. Often in the early stages of the clinical trials, often Phase I and II. The early trials is to simply establish the safety of these medicines and their efficacy; these can often be subjected to statistical manipulation. (ex. in a trial for breast cancer treatment intended for women, the results show that no significant results have been found. However, the company claimed that the results work for a sub-group of that population. The population becomes much smaller and perhaps is simply the results of random chance.)
  3. Long clinical stages and delays in pushing forward to the next stage or toward FDA approval. If a company is a scam or have a drug that is on the verge of failure, the company will likely take as long as possible to “test” the drug. They will take their time for as long as possible in order to reap profits for insiders. Sometimes, some of these companies will even “retest” their drug once more for a certain stage, claiming insufficient data. This is a huge red flag, for a successful drug company will want to rush forward to start monetizing the drug by getting FDA approval. Delays to do so could suggest that the company is nothing but an elaborate promotion.

Note, I am not suggesting the biotech sector as a whole will do poorly this year; after all, the biotech sector, as measured by NASDAQ Biotechnology Index (ETF), is up around 30% from over a year ago and there is no reason to think such a trend will not continue, albeit at a slower pace.

  1. Restaurants and related services that are heavily dependent on consumer cyclical spending

Last year, several newly IPOed restaurants have taken a hit following the miss in expected earnings (ex. Potbelly’s, El Pollo Loco). The struggles in the restaurant industry is not lost upon many professional investors; in fact, some of the most heavily shorted stocks (as measured by short interests) in the US are in the restaurant sector. Restaurants in general are low-margin, with high fixed costs, with tremendous competition, and susceptible to variances in consumer sentiments. All of these makes them good companies to avoid investing in at any given time. But in 2015, there are macroeconomic factors at play here as well. Even though the US economy have outperformed its peers in the developed economies, consumer disposable incomes have not risen appreciably over the past year or so. Americans simply aren’t spending as much on restaurants as before, and the growing competition for healthy food options left many traditional restaurant chains and fast-food restaurants little options but to change what they are offering to clients. These changes will take a long time to implement, and will be extremely costly, even if they are successful at all. (McDonald’s recent advertising campaign is a good example of a restaurant trying to reshape their brand image).

Then there are these companies that have certain characteristics that makes them a bad investment in any scenario, but especially so with the bull market that we have been having for the past few years.

Among many economists, the longer the bull market runs, the more likely the crash in the market will be severe. Therefore, the companies that have been swept up in the bull market ride will be the first ones to fall.

  1. Companies in industries with low barriers to entry and no competitive edge that cannot be replicated

A name that comes to mind in this case is GoPro. The company essentially does one thing, which is to produce cameras that are frequently used by outdoorsman. This sole area of operation is inherently risky in itself. However, with the passage of time if the business is successful, there is no reason to suspect why larger companies with significantly more resources will not pursue a similar line of business and crush the competition. Companies that are reliant upon a single product or service are extremely vulnerable.

  1. Foreign based companies with obscure operations

The stock market boom not only attracted bad domestic companies to IPO. Many foreign companies are also taking notice of the market and want to raise money as well. Some of these companies may indeed have good intentions of raising money to fund their operations. Or they may simply be a fraud and simply want a piece of the actions in the market and enrich themselves. These companies can have names that sound grand, invoking their national titles and inflate their own importance. (They may have a naming structure like “‘name of country’ – ‘industry’ corporation”. i.e. Sino-Forest Corporation). Many of these companies claimed that they have great growth potential in their respective home country and it is next to impossible to ascertain what they are saying is true. A few years back, there was a huge wave of Chinese reverse mergers (i.e. a private company is taken public by purchasing a public shell company) that IPOed in the United States. Many of these companies banked on the investing public’s optimism in the economic growth of China and cooked their books to paint a rosy picture for themselves. Eventually, the frauds were eventually exposed. Many of these companies have complicate structures with unclear relationships with their parent company or its subsidiaries. Sometimes, it is also unclear how the companies make their money or the level of their debt obligations (often disguised as other business segments).

One of the things you might have noticed is how many times I have used the word “small” in the preceding passages. This is key. Smaller companies in all the industries mentioned have a much higher chance of going bad or simply being fraudulent that the large ones. I believe that the market is efficient for the large-cap companies that have been carefully scrutinized, and the prices are likely where they should be. (Of course, there are cases like Enron, but in that case, the business is so indecipherable that it is bad idea to be even thinking about it). So when investing, remember to keep the company’s size in mind.

Note: The above article expresses solely my personal opinion. This is a blog, after all. Please do not utilize the articles as investment advices; or if you do (I will be sincerely flattered that you would listen to a sophomore in college), please do your own due diligence before investing. I do not hold any stocks or any form of investments whatsoever.

On the future of Hedge Funds

Posted on by fqzhang

This has been bothering me a while, and I recently found an article online (http://www.businessweek.com/articles/2014-09-15/calpers-has-had-it-with-hedge-funds) that talks about similar ideas, so I think I will simply talk more about it today. I have always been thinking about how is it that hedge funds and other money management firms are earning millions while at the same time having performances that are below that of the market (as measured by the S&P 500). The article talks about how hedge funds currently have 2.8 trillion in assets under management, yet their performance is mediocre at best; and in any case, their rate of return is far lower than the market as whole in the past 2 years of raging bull market.

Of course, the arguments is and has always been that hedge funds aren’t designed to outperform the market. People in favor of the hedge fund industry argued that hedge funds utilizes a number of different market strategies that have different purposes and not every one of the hedge funds have the end goal of maximizing profit all of the time; and some cited that the hedge fund industry actually performed okay during the bleak years of ’08 and ’09, when mutual funds and other large funds that have a wide basket of stock or those that focuses on a particular index suffered enormous losses. In other words, the hedge fund’s returns has been less-negative than the market as a whole. There is a reason, after all, why they are called “hedged” since they try to stay more market-neutral. Some argues that perhaps that hedge funds delivers return in accordance with the risk-tolerance and desires of the investors, while the hedge fund itself simply find a niche market of consumers who have particular wishes. All of these are valid points, and some might argue that hedge funds might not be too bad, and perhaps they reduce some of the risks involved.

However, the key problem with these sorts of arguments in favor of hedge funds is that these funds have a very high fee-structure, which can seriously eat away investor’s return. Most of them have what has been called the 2-20 structure. Namely, charging 2% for their assets under management, and 20% for the profits that they are able to generate. While I do not have any numbers to back that up at the moment (this is a blog after all), we can easily see where the investors might not be making as much money as they might have hoped. Compare this to say a more diversified personal holding, or perhaps an index fund of some sort (having less commissions because they are not actively managed), and we can see why investors might be having second thoughts about giving money to hedge funds. Unless hedge funds can generate enormous amounts of returns to justify the fees they are charging, there is no reason for an investor focused on total return to invest with these funds, since the fee structure would simply reduce their returns.

For me personally, as someone interested in business and who might work in the financial services in the future, I worry about the viability of the industry as whole in the future. Would the hedge fund industry disappear altogether as more people switch to managing investments themselves or perhaps alternative forms of managing money that have a considerably lower fee structure? Or perhaps hedge funds would shrink down to a small size and making them something of a marginal business form?

It is interesting to note that hedge funds have not been around for too long. We credit it to Alfred W. Jones, who came up with the “hedged fund” back in 1949 with its invention. It is not until the 1960s that we see a boom in hedge funds, when people first heard about it. And it was not until the late ‘80s and ‘90s that we see hedge funds as something that takes a significant place in our financial landscape. Men like Paul Tudor Jones, who famously shorted the stocked market crash of 1987, profiting from the market’s spectacular decline, became something of a celebrity in our world. Perhaps, if the article in Businessweek is correct, are we seeing the hedge funds best years behind them? This is an interesting thought. However, I do not think hedge funds will be displaced in its entirety. The past couple of years have been absolutely extraordinary in the returns that the stock market has been generating. This is partly due to the Fed’s quantitative easing program, pumping billions and billions into the American economy while at the same time keeping interests near zero. The reasons and justifications for these measures have been many and subject to debate, but the result is that an enormous amount of money have been made available for investors (who behave increasingly like speculators) to invest in stock market. The low interests made leverage buying of a stock attractive, while at the same time, the safety of the bond market are not attractive since they the returns on their investments are so low. And in such times, the value of a stock have risen beyond all common and logical expectations, deviating from any fundamental reasons for a stock’s growth. This being the case, it will be difficult for any hedge funds to replicate the sort of fantastic returns that the market has been generating by itself. Over the long term, I do believe that hedge funds, with their unique strategies, will find a place in the investment community, although their size and influence might shrink in size, as people began to diversify further into other forms of investment that can generate even higher returns in a bull market.

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