Strategy Archives


April 20, 2017

The Problem With Proxy Ballots

Vote With Money Instead

by Garvin Jabusch

Many people assume that engagement with public companies through proxy voting and resolution filing is the best — if not only — way to see positive environmental, social, and governance outcomes from your investments. For me, this approach misses a fundamental point of market-based solutions: you make in investments in the most compelling ideas that reflect what you think is likely to grow, where you think the economy is headed, and yes, outcomes you support. That means using investments to favor firms that are already making innovative sustainable contributions to the global economy — not trying to Frankenstein aging, destructive, legacy companies into healthy new citizens.

Consider the recent case of a major advocacy victory with ExxonMobil. After years of effort, a shareholder advocacy coalition in January succeeded in persuading the company to place prominent atmospheric scientist and climate change expert Susan K. Avery on their board of directors. The theory is that surely Dr. Avery’s appointment signifies a change in attitudes at Exxon, and her expertise will encourage the company to incorporate climate change into its corporate strategies. Meanwhile, Exxon Mobil Corporation announced in February that its “proved reserves were 20 billion oil-equivalent barrels at year-end 2016.” That’s 20 billion barrels of oil they fully intend to extract for purposes of being sold and burned. This is what Exxon is; no new board member is going to change that. Speaking to Inside Climate News, Jamie Henn, spokesman for said, "It's hard to believe this is little more than a PR stunt meant to pave over the decades the company spent deceiving the public about the crisis." A cynic could conclude that shareholder activism’s largest victory to date vs. ExxonMobil adds up to a PR coup for the firm under fire.

Further, a lot of advocacy is ineffectual. For example, State Street Global Advisors has recently made news with a plan to use their proxy voting power to encourage Russel 3000 companies to place more women on their boards. What’s the plan, and will it work? Slate Money’s Felix Salmon explored this from the perspective of a Russel 3000 company with zero women on the board: “In a year’s time …if you still have zero female board members and you can’t persuade State Street that you have made moves to get more female representation on your board, then, if and when the chairman of your nominating committee gets re-nominated for a board seat, they will vote against that individual. I mean, come on.” State Street then seems to be engaging in a symbolic form of advocacy, and not seriously expecting to effect change in corporate behavior.

I’ve written elsewhere that “[r]eal impact depends upon voting with your dollars for the future economy, for the actual catalysts of change, for the viable growth areas where we can reasonably expect to earn good equity growth in this era of rapid change. This means a higher level of due diligence that avoids the trap of thinking public equities are ‘set it and forget it’…it's not that public equity portfolios can't have impact, it's just that they usually don't” (emphasis added).

So how do we measure the impact of a portfolio if not by activism? I say it’s about looking at the economic impact of your investments. Invest in the firms that are earning more revenue from creating environmental and social solutions, employing more people, and gaining market share from riskier and less efficient competitors. While this may be harder to quantify than tallying up shareholder proposals, these business and economic factors have dollars behind them, and that means they equal impact at scale. At the end of the day, an economy driven by products and services that address the environmental and social risks confronting the global economy has much greater positive impact than an economy of ExxonMobil’s touting their lone climate scientist board member. The traditional metrics of business are the metrics for a reason: they measure real results. Investing in solutions providers exhibiting the best of these metrics is simply the most powerful message we can send.

Clearly, it’s more environmentally, socially, and economically meaningful to vote with dollars rather than proxy ballots, but it also has greater financial potential. Today, business-as-usual investing in S&P 500 companies means buying a flat 12 month forward earnings per share (EPS) estimate average, paired with a high average price to book valuation. On the other hand, many solutions –like renewable energy, organic farming practices, and water management are growing EPS more rapidly, yet many of them remain undervalued. Investors can send the market a powerful signal about which investments matter and have quantitatively better odds at superior returns by opting for these solutions-creators, rather than the overvalued companies of the old economy. Faster growth at a cheaper price? This is what investment managers are supposed to be seeking, but is almost absent from major benchmarks.

It’s easy to keep investing in stalwarts of the old economy like the S&P 500, then reassure ourselves that shareholder engagement will solve our problems. But it won’t. Let’s be honest with ourselves: we know it is time is stop making lazy and, ultimately, destructive investment decisions based on the inherited wisdom of indexing or for fear of not tracking our benchmark, and then justifying those investments by citing engagement. Addressing systemic risks – like climate change, resource scarcity, and widening inequality – means buying companies that are solving big risks and avoiding firms contributing to risk. This sends the markets a strong signal about the economy’s evolution, and also means that there’s a lesser need to engage these companies in the first place.

Shareholder advocacy can certainly have positive impact, but there’s an important caveat to remember. In the end, companies only care about shareholder proposals when they identify ones that already align with the firm’s self-interest and end goals. Limiting fossil fuel use and climate change is not in ExxonMobil’s self-interest, and no number of resolutions, proxy votes or polite letters is going to change that. As such, shareholder engagement can initiate positive change within the existing goals and structures of a company but not in a company’s fundamental reason to exist. Thus, advocacy is most effective when practiced on firms already engaged in a business that lends itself to the goal favored by the activist. You can work with a solar company to help them improve their supply chain or to have more minority representation in leadership, but you can’t persuade an oil company not to drill. Shareholder advocacy can and does have positive impacts around the periphery of big issues like climate change, but its power is trivial next to the power of the underlying economics. And the brightest signal of the economics is markets and returns.

To illustrate, join me in a short thought experiment. Imagine you’re the CEO of an oil major, say ExxonMobil. What concerns you more: a world where everyone keeps buying index funds that bump your stock price every time they do, but occasionally people file resolutions that you largely ignore, or a world where everyone has decided simply to skip that and invest instead in what’s next, eschewing fossil fuels altogether? I know for sure which of these worlds the CEO of Exxon most fears, and that tells me all I need to know about how to have impact.

An version of this post originally appeared on

Garvin Jabusch is cofounder and chief investment officer of Green Alpha® Advisors, LLC. He is co-manager of the Shelton Green Alpha Fund (NEXTX), of the Green Alpha Next Economy Index, the Green Alpha Growth & Income Portfolio, and of the Sierra Club Green Alpha Portfolio. He also authors the Sierra Club's green economics blog, "Green Alpha's Next Economy."

February 08, 2017

What Good Is Shareholder Advocacy?

By Marc Gunther. 

Last week, ExxonMobil added Susan Avery, a physicist, atmospheric scientist and former president of the Woods Hole Oceanographic Institutions, to its board of directors.

Shareholder advocates, led by the Interfaith Center on Corporate Responsibility (ICCR), which has been organizing shareholder campaigns at ExxonMobil for nearly two decades — yes, two decades — welcomed the appointment.

Tim Smith, the director of environmental, social and governance (ESG) shareowner engagement at Walden Asset Management, said in a news release: “This action by the board is encouraging for shareowners and we want to commend Exxon for this prudent and forward-looking decision.”

For shareholder advocates — investors who represent public pension funds, socially-responsible money managers, unions and church groups, and exercise their rights as owners to try to influence corporate behavior — this is about as good as it gets. ICCR and its allies have for three years called on ExxonMobil to elect an independent director with climate change expertise. They’ve won.

But will the planet notice? Of course not. No new director, not even a climate scientist –and there’s a difference between being a scientist and an advocate — will persuade the board or top executives of ExxonMobil to turn a company that says it is “committed to being the world’s premier petroleum and petrochemical company” into, say, a wind or solar firm. In a long profile of ExxonMobil published just this week, Steve LeVine of Quartz concluded: “Exxon is, and will long continue to be, foremost an oil company.”

Shareholder advocates will continue to push ExxonMobil, and the company will continue to do what it chooses to do, a dynamic that underscores the problem with shareholder advocacy: It’s all about persuasion. Those hundreds of shareholder resolutions that are filed every year with big companies? They are all precatory — a fancy legal term that means expressing a wish or request — and so corporate managers are free to ignore them, and often do, even in the exceedingly rare cases which a majority of shareholders vote for a resolution.

I say this not to disparage shareholder advocates. I’ve long admired such titans of the shareholder advocacy movement as Robert A.G. Monks (who I profiled in 2002 for FORTUNE) and Nell Minow, as well as Tim Smith, who led ICCR for many years, and their allies at nonprofit As You Sow, . But in these times, it’s important for social-justice advocates, nonprofit groups and those who fund them to take a hard-headed look at their strategies, to see what’s working and what is not. As Kevin Starr, who heads up the Mulago Foundation, argued recently:

That means that you get absolutely clear on what you’re setting out to accomplish, identify the outcome(s) that would signify impact, connect the dots from your work to all the way to impact, and strip away all the stuff that doesn’t get you there. You measure what’s critical to delivery, behavior change, and eventual impact, and you continually iterate based on what you measure.

How many social-justice advocates, nonprofits and foundations do this? Not enough, I’m certain. Which brings us back to shareholder advocacy.

It’s hard to measure the impact of shareholder advocacy, or any advocacy, for that matter. Often, shareholder advocates work on issues that also attract attention from politicians, regulators, activist groups, business-friendly NGOS, corporate social-responsibility insiders and consumers. When change happens, it’s hard to tease out cause and effect.

Some notable achievements

That said, shareholder advocates have notched some notable achievements. In the 2000s, first at Dell, later at Apple, and eventually through much of the computer industry, they persuaded companies to take back and recycle electronics. According to The Shareholder Action Guide, a new book from Andrew Behar of As You Sow, the group wangled a meeting in 2007 with Steve Jobs, then Apple’s CEO. Jobs was, no surprise, caustic and negative at first, but he eventually conceded that Apple did not want to be seen as an environmental laggard. Not long after, Apple announced a broad set of environmental commitments known as “A Greener Apple.” Score one for engaged owners.

More recently, Natasha Lamb, who leads shareholder engagement at Arjuna Capital, a sustainable investing firm, led a series of successful engagements with technology companies, including Apple, Intel, Amazon, Expedia, and eBay, around the issue of gender pay equity. All have promised to close the gap between what they pay men and what they pay women. This year, Arjuna will take the campaign to finance and consumer products firms. “There’s a critical mass of companies that are doing it, and the other companies see the writing on the wall,” Lamb told me.

Such victories have led As You Sow’s Behar to declare, with some exuberance:

We believe that most of the world’s environmental and human rights issues can be resolved by increased corporate responsibility and that shareholders are the single most powerful force for creating positive, lasting change in corporate behavior.

Say what? Shareholders are “the single most powerful force” for changing companies? More powerful that governments, activists, consumers and workers? Forgive me, but I’m skeptical.

Having paid on-and-off attention to shareholder advocates for years, my impression — and yes, it’s an impression, not a peer-reviewed study — is that they have been stymied more often than not. For much of the mid-2000s, for example, shareholder advocates pushed Coca-Cola and PepsiCo to use more recycled content in their plastic bottles. They got some tepid commitments, but as oil prices fell, so did the interest in using recycled instead of cheaper virgin plastic. US recycling rates have been flat for years. Shareholder persuasion can’t overturn economics.

On the issue of CEO pay–long the No. 1 agenda item for many shareholder advocates–there has been scant progress. Just the opposite, in fact: The left-leaning Economic Policy Institute reported last year that from 1978 to 2015, “inflation-adjusted compensation of the top CEOs increased 940.9 percent, a rise 73 percent greater than stock market growth and substantially greater than the painfully slow 10.3 percent growth in a typical worker’s annual compensation over the same period.”

Nell Minow, who has worked on corporate governance issues since the 1990s, says: “Every effort to contain CEO pay has been (throwing) gasoline on the fire.”

Making the business case

There’s a pattern here, as Arjuna’s Natasha Lamb explained:

Shareholder engagement works when the change requested by the investor is in the company’s self- interest. In the absence of that, if it’s only about the right thing to do, that’s not enough. It’s got to be the smart thing to do. There’s got to be a business case.

To be more specific, there’s got to be a business case that appeals to corporate managers, who have an annoying but predictable tendency to pursue their own self-interest, even when it conflicts with the long-term interests of the company. This is key. You may be able to make a very good business case for curbing CEO pay, but try making it to a CEO. He or she is unlikely to be persuaded.

So what are the chances that shareholder advocacy can move the needle on the all-important issue of climate change? The advocates argue that climate change creates risks to oil companies like Exxon or Chevron, citing global efforts to curb carbon emissions. Says Lamb: “If a cap is put on the amount of carbon we can burn as a planet, and they can’t sell two-thirds of their assets, that’s a detrimental risk to their business.” This is a legitimate worry for long-term investors, particularly pension funds such as CalPERS or CalSTRS that are investing today on behalf of workers who will be collecting pensions a half century from now.

The trouble is, the executives who run ExxonMobil or Chevron don’t operate with a 50-year time horizon, even though they invest capital in oil and gas infrastructure that may be around for nearly that long. They’re thinking about the next five to 10 years, for obvious reasons. (The average tenure of a FORTUNE 500 CEO is about five years.) Boards don’t seem to be any better. And while Shell, Total and Statoil have all invested in renewable energy, they are driven by near-term market opportunity, not shareholder pressure. Short-term thinking may be the biggest obstacle to effective shareholder advocacy.

The other obstacle is that the world’s biggest institutional investors vote no or abstain on the vast majority of the environmental, social and governance resolutions filed by the shareholder advocates. BlackRock, Vanguard, Fidelity all support management, and not the advocates, just about all the time.

This may come has a surprise because Larry Fink, the CEO of BlackRock, which the world’s largest asset manager, loves to pontificate about corporate sustainability and long-term thinking. What’s more, in a recent report, the BlackRock Institute recommended that “all investors should incorporate climate change awareness into their investment processes.” Yet, as The Times recently reported, Block Rock “voted against every shareholder proposal relating to diversity, environment, governance and social concerns over the last year, according to Proxy Insight.” Every single one.

Resolutions about resolutions

Shareholder advocates have taken notice, so they are now filing resolutions at Black Rock (as well as at other big asset managers) that accuse BlackRock of putting its reputation at risk because of its “perplexing and troubling” votes on environmental and social issues, as the Financial Times reported.

Resolutions about resolutions, in other words. It brings to mind a cat chasing its own tail.

[BlackRock’s behavior is perplexing only if you overlook the fact that big-company CEOs are among its big customers. BlackRock manages corporate pension funds and 401-K plans. When there’s business to be done, why annoy a customer or potential customer over a trivial matter like global warming?]

In fairness, the new set of shareholder resolutions at asset managers won’t do any harm, and they could do good. If BlackRock worries about its reputation, it may begin to align its proxy voting with its sustainability rhetoric. And then, the fossil fuel companies may pay more attention to shareholder resolutions. And then? Well, I’m not sure what is supposed to happen after that.

Someday we’ll find out, I suppose. It could be a long wait.

Marc Gunther writer for Fortune, GreenBiz and Sustainable Business Forum co-chair, Fortune Brainstorm Green 2012 and a blogger at  His book, Suck It Up: How capturing carbon from the air can help solve the climate crisis, has been published as an Amazon Kindle Single. You can buy it here for $1.99.

February 07, 2017

The Trump Trade

by Garvin Jabusch

The first two weeks under the Trump administration have been a shock to the system. With the change in administration, how will you approach your stock portfolio(s)?

For starters, your fundamentals should remain unchanged. For me, that means looking for great companies in expanding markets that are enabling long-term economic growth, and reducing systemic risks. Of course, this also means buying these stocks at low valuations. Benjamin Graham and Warren Buffett were right about ‘wonderful companies at fair prices.’ That is never going to change.

With that said, let’s look at what has changed and what to do about it.

Unpredictability -- that’s the first quality worth noting about the new White House team’s leadership style. Trump’s comments and actions concerning topics such as open global trade, immigration and the US-China relationship will cause uncertainty, to which markets usually do not respond well. George Soros recently emphasized this point, adding, “Uncertainty is at a peak, and actually uncertainty is the enemy of long-term investment. I don’t think the markets are going to do very well.” 

It is true that in the short time since Trump’s election, markets have rallied. Traders perceive that uncertainty has actually decreased because the election cycle is over, and they believe a Trump administration will benefit business by removing regulations. The possibility of fiscal stimulus via infrastructure -- something a Republican Congress never let Obama do -- has also rallied markets. But as we witnessed on 1/30 and will likely continue to see, uncertainty's retreat will prove to be an illusion. 

For example, markets have largely appeared to accept the positive business aspects of Trump’s rhetoric but equally, so far, to discount the negatives, such as the possibility of a trade war. Trump also promises to roll back financial oversight and regulations such as Dodd-Frank, which raises the specter of possible asset-bubble deflation, a la 2008. Good markets should not be confused with a stable investing environment.

Beyond Soros, other qualified observers, such as Eliot A. Cohen and Ruth Ben-Ghiat have noted that there is enough personal and political capriciousness swirling within this White House that the consequences could extend far beyond market implications. We should not make the mistake of not taking seriously the administration’s actions over its first two weeks.

So, portfolio defensiveness is clearly warranted. What that means for an individual investor’s portfolio, I leave to your best judgement.

Yet the inevitable market volatility will present opportunity, both in buying oversold securities as opportunities arise, and also in making investments that benefit from volatility itself.

Trump’s worldview often contradicts global momentum, and this can present buying opportunities. Energy policy is a prime example of this. The global transition away from fossil fuels toward renewable energies is now clearly underway. Nevertheless, the Trump administration's attempts to prolong the fossil age a few more years may meet with some success. It is possible that gas and oil may be about to enter their last, large bull run. If this is the case, some investors may see this as a short-term opportunity, before the much bigger opportunity in being short fossil fuels indefinitely (or until it’s time to cover). For those looking to grow their portfolios beyond the next couple of years, a much larger opportunity appears -- companies that are trailblazing toward the interconnected, sustainable economy.

Trump’s actions also spell out the need for diversification in light of U.S. political risk. While Trump has removed all references to climate change from, approved the Keystone XL and DAPL pipelines, canceled all EPA grants, and caused the CDC to cancel its climate change and health conference, he can’t stop the global momentum of renewable energy (worth a post on its own -- stay tuned).

So, how does an investor respond? As a fund manager, this looks objectively to me like any other case of political risk in a given country, underscoring the importance of a diversified portfolio. Saudi Arabia has policies against beer? Vatican City has ethical restrictions on imports of contraceptive devices? Maybe place less weight on companies trying to sell those products into those markets. Obviously, these examples are extreme to the point of absurdity, but they illustrate my point about political risks and diversification, because both beer and condoms have huge markets in other geographical areas that can be exploited for investment return. My examples are also less than apt in that there is today a booming market in the U.S. for both wind and solar but, considering both the words and actions of Trump and his administration, it seems only prudent to capitalize on renewable energies’ opportunities in companies with large global distribution networks and thus are not overly reliant on U.S. distribution. Canadian Solar (CSIQ), Vestas Wind Systems (VWDRY), and JinkoSolar (JKS) come to mind. Renewable energies worldwide are booming, and if the U.S. chooses not to participate fully in these industries, at least our portfolios can.

There may be opportunities in renewable infrastructure under Trump’s watch, as he pushes to develop transmission capacity from windy middle America to the coasts.

We are now, as much as at any time in recent memory, embarking upon an uncertain landscape, both culturally and economically. More than ever, investing requires a long view into how the economy is most likely to evolve, regardless of short- and medium-term gyrations, wild and scary as those may become.

In short, that means figuring out what’s next. What’s next in energy? In tech? In consumer goods? The way to earn returns over the long term entails investing in firms that are leading the way to the future, holding and accumulating shares through volatility, and looking for value.

Note: A version of this post appeared previously on

Garvin Jabusch is cofounder and chief investment officer of Green Alpha® Advisors, LLC. He is co-manager of the Shelton Green Alpha Fund (NEXTX), of the Green Alpha Next Economy Index, the Green Alpha Growth & Income Portfolio, and of the Sierra Club Green Alpha Portfolio. He also authors the Sierra Club's green economics blog, "Green Alpha's Next Economy."

November 09, 2016

An Investor's Reaction to a Trump Victory

See my response here: Tom Konrad

March 21, 2013

Your Portfolio is Hooked on Fossil Fuels

Garvin Jabusch

Oil addiction photo via BigStock

You are drilling for oil and natural gas, and you probably don’t even know it.  What, you say you’ve never been near a drilling rig, and aren’t even sure what one looks like?  You’re still drilling, because companies you own are drilling.

Many financial advisors and asset managers routinely assume that broadly diversified stock portfolios will have holdings in fossil fuels companies.  Even most stock mutual funds that identify themselves as ‘green’ funds contain natural gas and even oil holdings.

This is not only morally questionable, it’s also likely to lead to disappointing returns.  If the goal of investing is to grow assets, accrue wealth, and prepare for our futures, then it’s key to invest in companies, industries and sectors that will still be there and growing in that future. Similarly, our collective macroeconomic goals shouldn’t be to keep the economy ticking along for the next quarter or current political term, but to keep it healthy so we may thrive for decades if not centuries. Fossil fuels companies fail on both these fronts: they face an uphill battle trying to grow into the medium and long term, and, for many reasons, they also hinder our chances of achieving economy-wide long-term economic growth, which limits your and my chances of positive portfolio returns.

We at Green Alpha believe that fossil fuels have no place in portfolios designed to capitalize on the emerging, sustainable, green, thriving next economy. We picture and model, rather, a next economy comprised of enterprises whose technologies, material inputs, and/or practices have not proven deleterious to the environmental underpinnings of the global economy; and, equally important, those whose businesses have a better than average probability of keeping economic production running close to capacity (meaning close to full employment and therefore causing sufficient economic demand to keep economies healthy). Healthy, innovative economies made up of healthy companies have always proven better for portfolio performance. Next economy companies are innovation leaders in all areas, not just in the energy industries; they exist now and will continue to emerge in all economic sectors, providing all products, goods and services required to have a fully functioning, even thriving global economy. And we believe that next economy companies will continue to win market share from legacy firms, and that they therefore provide superior odds of delivering long term competitive returns.

There are several key reasons this should be the case. As a global economy, we can no longer afford to wait for our basic economic underpinnings to break before we fix them. Too many issues, economy wide, from agriculture to water to warming, all damaged by fossil fuels, have been ignored and left to degrade. By now it’s clear that fossil fuels, including natural gas, do not result in us growing a thriving next economy. Between greenhouse gas emissions, toxic emissions (such as mercury), accidents, spills and contamination of soil, groundwater and oceans, to say they have proven deleterious to our environmental-macroeconomic underpinnings is an understatement. We need to make sure the earth’s basic systems - which global economies rely upon - keep on functioning. And the time to do that is now, while they’re still working.

Fortunately, as a global economy we are now (for the first time since the beginning of the industrial revolution) in a position to begin transitioning to methods that will allow us to run sustainably using advancements like far cheaper and more beneficial sources of energy. As inexpensive, unlimited renewables gain more market share, fossil fuels by definition will be losing market share, meaning stocks of companies providing the most economically competitive renewables will be in a better position to deliver superior stock performance than will oil, coal or even natural gas. Indeed, Shell Oil has recently projected that renewables will eclipse oil as society’s primary source of energy, making up as much as 40% of all energy used within the next 47 years. Considering the booming growth of renewables in recent years (particularly solar), I wouldn’t be surprised if this occurs much sooner; but in any case the writing is now officially on the wall. Fossil fuels have already begun to lose market share to renewables. In 2012, most new electricity generating capacity brought online in the United States was from renewables, and in January 2013, all new U.S. electrical generating capacity was provided by renewables. If these trends are even close to future outcomes, Shell’s prediction will have proven far too optimistic for the future of oil.

Further, from a stock valuation point of view it has also become clear that shares of fossil fuels companies have become far more risky as an asset class than they were even a few years ago. Most policy observers believe that within a few years there will be a worldwide price on carbon via some combination of carbon taxes, cap-and-trade schemes and/or requirements to sequester carbon via ‘capture and storage’ technologies. When these emerge in large ways, they will represent new systemic costs of business for fossil fuels companies that will potentially badly damage their margins. In addition, in a potentially more financially perilous risk, there is the ongoing specter incredibly expensive damage from accidents associated with fossil fuels. For example, look at BP’s management’s and shareholders’ objections to settlements and potential further judicially mandated costs and penalties relating to the 2010 Deepwater Horizon spill (above and beyond the $20 billion trust already established by BP). BP's tortured arguments and huge efforts to avoid further financial liability for an accident for which they clearly are partially responsible reveals the devastating risks the oil industry will be facing as it reaches ever further for product. BP’s continuing potential liabilities from this one incident, including “uncapped class-action settlements with private plaintiffs” and “civil charges brought by the Justice Department” and “a gross negligence finding [that] could nearly quadruple the civil damages owed by BP under the Clean Water Act to $21 billion” among others, show, more than anything, that oil as an asset class is becoming a subprime investment.

All this being the case, why are fossil fuels companies’ stocks considered mandatory holdings by many professional money managers and investment banks? The primary answer is ‘modern portfolio theory;’ that body of knowledge regarding how to build diversified portfolios of stocks taught at MBA and finance departments all over the world and considered sacrosanct by most practitioners. There are good reasons modern portfolio theory (MPT) is so widely practiced, mainly that its underlying goal, to maximize return for a given level of financial risk, is any portfolio manager’s ultimate duty. MPT asserts that the way to achieve this is to have appropriate portfolio exposure to various asset classes like cash, bonds, stocks, commodities, and from there to follow the proscribed allocation to specific sectors and industries within these groups in order to achieve the most “efficient frontier” mix of securities. The sectors proscribed by modern portfolio theory, as it is typically practiced, include fossil fuels such as oil and gas. But let’s recall that this theory was pioneered in the 1930s, and was considered more or less perfected by Harry Markowitz in the 1950s, culminating in his 1959 book “PORTFOLIO SELECTION EFFICIENT DIVERSIFICATION OF INVESTMENTS.” For Markowitz and his predecessors, fossil fuels were the only visible source of energy sufficient to power society, and by requiring portfolio allocations to these industries, they were effectively making sure investors got in on the profitable business of what was really the only energy available. Modern portfolio theory’s asset allocation models were made for and reflect a world where fossil fuels were the only imaginable primary power source. Moreover, in the 1950s, there were fewer material resource constraints, a far lower global population, the word ‘scarcity’ did not apply to the natural world, and no one had heard of climate change or global warming, so there really were no reasons to think twice about fossil fuels or to imagine reasons their returns could be at risk. But we don’t live in that world anymore.

Building a Fossil Fuels Free Portfolio

Next economy portfolio theory differs from MPT by recognizing that we live in an economy that no longer resembles the world of the 1950s. Where modern portfolio theory defines risk as financial risk only, next economy theory is also concerned with the risks of earth’s support systems failing. Where modern portfolio theory says to invest in oil and coal, then, next economy theory says to look for primary energy replacements that have not proven damaging to the environment to a degree where they disrupt economics and even society.

And in realizing that energy now means far more than it did in Markowitz’s day, and by observing that many if not all economic sectors from transportation to agriculture could be run in a sustainable fashion, largely using current technologies and approaches, we build portfolios comprised of next economy companies. This in turn helps the green economy to continue to accelerate, and provides clients with opportunity for competitive returns.  Investing in the growing technologies of the future just makes better common sense than investing in the riskier, slowly shrinking technologies of the past.

Where modern portfolio theory says, ‘buy all these 1950s economic sectors,’ next economy theory says ‘look for all the ways there are to keep the economy going such that we, as a global economy, can thrive indefinitely.’ In that sense, we argue that current portfolio theory is upside down. So-called “Modern” Portfolio Theory is backward looking, but wise investors look forward.  We must think very carefully about asset allocation in the modern economy, and start to make changes. Traditional asset classes must evolve (“critical power sources” rather than “oil and gas”, for example), and our portfolios must reflect that and begin to invest in fully functional enterprises that are both environmentally and economically sustainable far farther into our future than current MPT could foresee. But if MPT is all we know, how do we accomplish that? The only answer to that can be that we have to develop new processes. Green Alpha’s attempt at that, in some ways representing a reversal of traditional models of asset management, works like this:

  1. Begin at the highest macroeconomic and ecological levels and make an objective assessment regarding the most pressing issues confronting world economies
  2. Having identified key issues, the next step is to rigorously research scientific consensus and new approaches to the technologies, ideas and business practices best positioned to and most likely to successfully drive growth while aiding in mitigation of and/or adaptation of issues (such as climate change and resource scarcity)
  3. Of these approaches, then, we ask in the third step which can practically be deployed or practiced – that is, used in the real world
  4. Then, of these working, functional, practical approaches, we fourth ask which can also be aligned with economic interests such that they can attract market capital and inspire both entrepreneurs and established companies to engage. In other words, which can be deployed as profitable businesses
  5. Only now, at this point, do we in our fifth step identify specific companies that come as close as possible to meeting these criteria
  6. Looking at granular company-level financial data comes last for us, and is only applied to qualified next economy companies, as identified via the five-stage methodology above. In the final step then, we apply quantitative, rigorous, bottom-up financial analysis to identify stocks of next economy companies that offer the best financial positions with minimized risk, with particular focus on growth potential and market liquidity and bankruptcy risks.

The tools applied in the final step are universally known and practiced and do not bear describing here. And in any case this is not the piece of portfolio management we're redefining. Suffice it to say that from a bottom up fundamental quant perspective, we don't believe one can improve much Graham-Dodd valuation methodology.

Practicing this methodology, we arrive at innovative, fully diversified portfolios comprised of firms that are working now and are positioned to keep working far into the future as the next economy emerges to displace the fossil fuels economy.

As businesses advance the better, cheaper, more efficient technologies that do not result in further warming, increased resource scarcity, deadly pollution, and soil and groundwater contamination, we can only imagine the productivity, lifestyle and well-being surges that will be unleashed. So enough with traditional, oil based economic models. 

We live in a new world, and it’s time we acted like it.

Garvin Jabusch is cofounder and chief investment officer of Green Alpha ® Advisors, LLC. He is co-manager of the Shelton Green Alpha Fund (NEXTX), of the Green Alpha ® Next Economy Index, and of the Sierra Club Green Alpha Portfolio. He also authors the Sierra Club’s green economics blog, "Green Alpha's Next Economy."

February 21, 2013

The Catholic Church Shouldn't be Investing in Abortion Clinics

Tom Konrad CFA

Jesus Saves, but where does he invest?
Photo via Bigstock.

This article is not about the Church, or abortion.  As far as I know, the former does not invest in the latter.

This article is about investing, and morality.

Since began its campaign to get endowments and pensions to divest from fossil fuels, I've heard two basic criticisms of the movement from my colleagues in the investment management profession.

  • Endowments selling their fossil fuel investments won't stop us from using fossil fuels.
  • Morality has no place in investment decision making.

Both these arguments fail to pass the sniff test, and the point of my title and subtitle were show their failings in a stark light to those who don't necessarily agree with the need to transition away from fossil fuels.

The Effectiveness of Divestment

Starting with the first argument, that divestment will not be effective at combating climate change.  While there may be some question about the effectiveness of divestment, its effectiveness or ineffectiveness is beside the point.  If you doubt me, try to imagine trying to persuade His Holiness the Pope that the Church investing in abortion clinics would be all right, since abortions would continue to be performed with our without the Church's money.  You may not agree with the Pope's stance on abortion, but I'm sure you'll agree that you'd be unlikely to get out of that conversation without having to say more than a few Hail Marys.

Since the Church's stance on abortion is a moral one, the effectiveness of abortion divestment is irrelevant compared to the hypocrisy of any such investments.  As is the hypocrisy of institutions whose mission is to ensure our future well-being when they invest in companies which undermine that well being.

Morality and Investing

The second argument, that morality has no place in investment decisions, is equally specious.  Just ask His Holiness (assuming you still have a voice left, after all the Hail Marys.)  If you think this only applies to religious institutions, consider the following investment:

You are traveling in a country where murder is perfectly legal on Fridays.  A trustworthy man of your acquaintance has been hired to feed a dozen children to starving lions for the amusement of his wealthy patron, for which he will be paid $100,000.  Unfortunately (for him, if not for the children), your acquaintance lacks the funds to acquire the necessary starving lions, and he turns to you.  If you invest the $10,000 he needs to purchase the lions today, and he will repay you with half of his fee ($50,000) after he is paid next week.  In order to emphasize the moral aspects of the investment, we are assuming that all this is perfectly legal, and, because of both your acquaintance's reputation and the legal documents which have been drawn up, you have no doubt you will be paid.   As an investment, feeding children to hungry lions would be rock solid,  and would result in a five-fold return on your investment in less than a week.

Low risk, high reward: Sounds like a great investment. Except for the feeding children to lions part. You wouldn't have to be religious to want to avoid this lion-feeding investment.


There are still valid arguments that Endowments and other such institutional investors should continue to invest in fossil fuels.  If it it is their considered belief that the profits from such investments can be used to more than offset the harm done by those investments, then they might consider it moral to invest anyway.  Yet even this decision would be morally questionable.  Is it right to feed a dozen children to starving lions, even if the funds will be used to save two dozen children from similar fates?

In any case, this is not an argument that morality has no place in investing.  Rather, it is about what is the best way to serve the institution's mission.  In short, it is about taking a moral stance with investments, both the institutions' and our own.

Is there a cost to investing with out morals?  Perhaps.  There is also the possibility of financial gain.  If governments ever decide to get serious about climate change, they will take actions which make it less profitable to extract and burn fossil fuels.  Less profitable operations would hurt the stock prices of such companies.  That's why oil and coal companies are so adamant about opposing any sort of climate legislation.  Companies which provide alternatives to fossil fuels, or enable us to use less of it will benefit from the same legislation.

When regulators enforce regulations which reflect a moral principal, moral investors will benefit, and amoral investors will be hurt.  This brings us to another reason to apply our morality to our investment decisions: it aligns our financial interests with what we know to be right.  In a democratic society, this frees us to push our lawmakers to act in a moral fashion, without having to worry that the reforms we are pushing for will harm our financial interests.

There may or may not be a cost to investing in fossil fuels, and divesting from fossil fuels will not stop the economy running on them.  But if you believe that burning fossil fuels is harming our current and unborn children, why are you investing in them? And why is your college or pension fund?

Update: Although this article was published at shortly after Pope Benedict XVI announced his resignation, it was written before the news came out, and has nothing to do with the resignation, which was apparently due to poor health.

This article was first published on the author's blog, Green Stocks on February 11th.  Forbes' editors felt the headline would be offensive to some, and a reworked version is now posted here.

DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the current opinions of the author and such opinions are subject to change without notice.  This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

November 20, 2012

With the Cleantech Hype Gone, the Real Investment Opportunity Begins

David Gold

The bubble has burst. The hype and euphoria of 2008 and 2009 is a distant memory. Fueled in part by the externality of the handouts from the stimulus package, and the (now fleeting) spike of natural gas and oil prices, cleantech has experienced its own mini dotcom era now followed by a dot bomb phase.  

The politicization of Solyndra, the fracking revolution (that has dramatically increased U.S. fossil fuel reserves) and the realities of what it takes to build successful cleantech companies have all brought the cleantech venture capital space crashing back to earth. Available venture capital for cleantech companies has declined dramatically as some diversified funds pull out of making cleantech investments and cleantech-focused funds find it challenging to raise new capital. But this is not the beginning of the end for cleantech venture capital. Rather, it is the end of the beginning. While the cleantech hype has been fueled by a focus on global warming and the anticipation of government policies on carbon, the true underlying dynamics that will drive the explosion of clean technologies in a variety of sectors remain largely unchanged -- the impending extraordinary growth in demand for commodities of all types.

In the 1960s, there was a widely held belief that world population growth would lead to the demise of the human race. In fact, based on the thinking of those experts, many of us should be dead by now. Back then, experts believed the world could not possibly supply the anticipated population with the necessary food for survival. But a wonderful thing occurred -- the thing that separates humans from animals. The necessity of rapidly increased food supplies lead to the invention of disruptive advanced agricultural technologies. The result? In spite of population growth, today the world generates more food per capita than ever before.

It is that same type of dynamic that will be the true underlying driver behind cleantech innovation. Over the coming decade, the world will add about 1.5 billion people to the ranks of the middle class. That’s approximately a 75 percent increase from the number today. Such an increase will mean 1.5 billion more people who will buy cars, electronics, improved housing, higher protein foods, demand clean water and consume more energy. A Brookings Institute study estimated that this will yield a comparable increase in the world population’s overall consumption.           

The authors of the doom and gloom books of the 60s would look at this and forecast extraordinary increases in the prices of all types of commodities, which would lead to global disruption and unrest. I do believe we will see increased volatility in a variety of commodity prices, but I also believe that this dynamic will drive innovation just like it did in agriculture. Rapid increases in demand for commodities, enormous markets and the ability for new technologies in certain segments to provide disruptive advantages will create an environment for compelling venture capital opportunities.

commodity price chart

The New Global Middle Class:A Cross-over from West to East: Brookings Institute

Many cleantech venture capitalists have focused on CO2 as the driving force for innovation. But I have always looked at cleantech as way to drive increased efficiency, reduce waste and create less expensive alternatives -- the things that drive bottom line benefits in the free market. In other words, creating Gold by being Green (hence the name of my blog). The combination of the natural gas boom and the political reality of the unlikelihood of a price on CO2 emissions in the U.S. (or just about any nation that doesn’t already have one) has caused those with a CO2-focused investment thesis to face a very challenging environment.

If cleantech is viewed as synonymous with carbon emissions reductions, then the segment will be challenging from an investment perspective. But through the lens of GreenGold, where cleantech is about reducing the consumption of all sorts of non-renewable commodities, there will be many compelling investment opportunities yet to come. Undoubtedly the devil is in the details of which markets and areas of innovation will hold the best venture potential (ahh… fodder for a future post). But I believe that investors who run from anything remotely cleantech today will find themselves looking back and feeling like those who ran from investments in the Web in 2002. Now that the hype is gone we can focus on building real businesses. The next decade will be the one where real value is created in a number of segments of clean technologies and I, for one, plan to be making money by investing in some of those winners.

David Gold is an entrepreneur and engineer with national public policy experience who heads up cleantech investments for Access Venture Partners (  This article was first published on his blog,

November 03, 2012

Six Simple Steps to Protecting Your Portfolio With Puts

Tom Konrad CFA

Storm Sailor

Storm Sailor (Photo credit: Abaconda)

Sailing into a Storm

Despite the unresolved European debt crisis and America’s fiscal cliff, stock markets remain buoyant.   With politicians bickering, that is mostly due to aggressive action from central banks.  Yet despite the Federal Reserve’s third (and largest) round of quantitative easing (QE3) and the European Central Bank‘s unlimited bond buying program, politicians still have the capacity to throw a monkey wrench in the world economy.  Worse, doing nothing is all they have to do to mess things up.  Doing nothing is what politicians do best.

An even worse prospect would be short term fiscal tightening in the name of reducing budget deficits, something which Mitt Romney says would be high on his administration’s priority list if he were to be elected.  While the US Government spends far too much compared to its revenues, correcting this imbalance should not be tackled abruptly or we risk sudden economic contraction which will make the debt even harder to pay off in the long term.

How to Invest

It’s a market truism that it does not pay to “Fight the Fed.”  That is, when the Federal Reserve is pumping out the monetary stimulus, the market tends to go up, despite risks elsewhere in the economy.  This implies that the place for investors to be is in the stock market: the most likely direction of the market is up.  Yet there remains a significant risk that one or more of the uncertainties which currently worry investors will blossom into a full-scale panic.  If that happens, selling will beget more selling, and falling stock prices will  cut investment, consumer spending (via the wealth effect), and tax receipts.  Such a market panic may be less likely than a slow cruise to new market heights on QE3, but the market ship may be more Titanic than Queen Elizabeth.

Cautious investors will prepare for any such disaster by investing in life boats big enough for their whole portfolios, but not so expensive that they would be better off just staying on the dry land of cash and money market funds.

The remainder of this article is a step-by-step guide to building those lifeboats in the simplest way possible: using puts on a broad market ETF.  Unfortunately, there is a limit to how simple I could make it, and I had to assume that readers have a basic familiarity with what puts and calls are, how they work, and the risks involved in using them.  If you do not already have this knowledge, I suggest you read one of the many Options Primers available in print or online.

Beta Hedging

The Ballad of Beta-2

The Ballad of Beta-2 (Photo credit: Wikipedia)

One of my most enduring articles has been Five Hedging Strategies for Stock Pickers, written over three years ago but still producing feedback from readers today.  While that article touched on a number of ways to hedge (short positions, short calls, short and ultrashort ETFs, and puts), the focus was on constructing a long-short, market neutral portfolio.  That strategy is not the best one when the market is likely to go up, since it removes the chance of gain from a rising stock market.

Today’s market will probably continue upward as central banks on both sides of the Atlantic continue to pump out monetary stimulus, but it contains significant risks of an abrupt and large market decline.  In this context, hedging with put options is a more appropriate response.  The technique detailed in “Five Hedging Strategies” article focuses on reducing portfolio beta to zero.  Beta is a measure of how much a portfolio follows market moves; a beta of zero implies that portfolio moves and market moves are completely uncorrelated.  Beta hedging works well when the hedging tools are short positions or in-the-money options, but fails with out-of-the-money options (including put options).  If followed blindly, beta hedging would lead to overspending on too big a life boat.

This is  how to figure out just how many puts you need.

Step 1: Get Options Permission

If you use an online brokerage, you generally have to apply for permission to trade options.  There are various levels of option permission, but since buying options such as puts limits your risk to the price of the option, getting permission to buy puts is usually fairly simple.  Nevertheless, it may take a week or two for your broker to process your application, so you should do this as soon as you start considering a option based hedging strategy.  There is generally no cost to apply for options permission, even if you later decide this strategy is not for you.

Step 2: Select a Market Index ETF

It’s possible to hedge a portfolio by buying puts on each of the stocks in that portfolio, but the strategy has several drawbacks.  First, not all of the securities in your portfolio will have options available (options are usually only available for widely held securities.)   Even if options are available, they may be too illiquid to purchase in the quantity needed.

Instead, you should choose an index ETF that is a good match for the stocks in your portfolio.  For instance, if you have mostly large-cap U.S. stocks, a good choice might be the S&P 500 SPDR (NYSE:SPY).  A “Dogs of the Dow” portfolio would use the Dow Jones Industrial Average SPDR (NYSE:DIA), while a portfolio focused on solar and wind stocks might use the Powershares Wilderhill Clean Energy ETF (NYSE:PBW.)

If you have an international portfolio, you might consider the Vanguard International Equity Index FTSE All World Ex U.S. ETF (NYSE:VEU).  Although you might want to use the iShares MSCI World (NYSE:URTH) because it also contains U.S. equities, this is not possible, since options on URTH are not available.

In addition to having options available, you should makes sure that the options on your chosen index are fairly liquid, and that some long-term options (called LEAPS or Long-Term Equity Anticipation Securities) are available and liquid.  You will want to see active trading in the puts you plan to buy, otherwise you are likely to end up paying over the odds (or have to wait a long time for a limit order to execute, if executes at all) for your protection.  For this reason, it’s often best to settle for an index ETF which is an imperfect match for your portfolio in order to be able to trade liquid options.

I use a combination of SPY and the iShares Russell 2000 Index (IWM), which tracks small capitalization stocks, to hedge my portfolio, but using multiple ETFs  adds a degree of complication which is beyond the scope of this article.

Step 3: Portfolio Statistics

A proper hedge requires understanding how much your portfolio will be expected to move when the market index moves.  This will allow you to determine how large your hedge needs to be.  For example, if your portfolio is fairly stable, and is expected only go down around 40% when the index you are using goes down 50%, you’ll need a one-fifth (1/5 = (50%-40%)/50%) smaller hedge than you would need if your portfolio moved in tandem with the index.

Using a spreadsheet, you don’t need to understand statistics to do the necessary calculations.  I’ve put one together for you here: ODF format/ XLS format.

Using the spreadsheet

While the spreadsheet can calculate the number of puts you’ll need to hedge you portfolio, you will need to gather a fair amount of data for it to work.  The sheet works by calculating how much your portfolio and chosen ETF move together, and uses that measure to calculate how many puts will be needed for a 100% hedge of the portfolio against market movements.

To do this, you will need to monitor the value of your portfolio and the ETF on a daily basis and input the values into the green columns on the sheet.  Don’t worry if you miss a day here and there; this should not throw off the calculations significantly.

Start by deleting the data I’ve entered into the first 5 columns of the sheet, which are for an example portfolio consisting of 1000 shares of General Electric (NYSE:GE).

Each day, start a new row with the date in the first column (A), enter value of your portfolio in column B, and the value of your chosen ETF in column D.  If you have transferred money into or out of your account since the last entry, enter the amount in column C, using a positive number for money added to the account, or a negative number for money withdrawn.  If your chosen ETF pays a dividend, enter the amount to be paid per share on the ETF’s ex-divided date in column E.

Leave column C blank if you have not transferred money into or out of your account.  Leave column E blank on all but the 4 days a year that the ETF does not go ex-dividend.  If more than one trading day has passed since your last entry, sum all the transfers you’ve made in the interim when entering column C, and enter the per-share dividend in column E if the ETF went ex-dividend in the interim.  Technically, column C should also account for the lag between stocks going ex-dividend and the dividend payment, but this should not significantly effect the calculations unless the dividend in question is a significant part of the change in your portfolio value on any given day.  If you do wish to account for this, enter the value of the dividend payment with a negative sign on the date a stock goes ex-dividend, and add the number back in when the dividend is received.

After you have entered 30 trading days worth of data, the spreadsheet will begin to show estimates of the number of puts on your chosen ETF you will need to fully hedge your portfolio against large moves of the ETF.  To continue entering data beyond the last row I filled in my example, copy columns F through O from the previous row each time you add a new row.

The example portfolio of 1000 shares of GE  would need to be hedged with approximately 1.6 puts, which is the result of the aggregate calculation shown in column O.   There is also a chart on the second sheet of the calculator which displays this calculation graphically in green (example to the left).

Since you can’t buy fractional put contracts, you will need to decide if you want to use 1 or 2 put contracts.  A single SPY put will not provide full protection for this example portfolio, but it will get you more than half the way there, and cost a little more than half as much (after commission) than full protection with 2 puts.

Step 4: Choose an Expiration Date or Dates

Generally, you will want to protect yourself with long term puts, since short term puts, while less expensive, have to be renewed more frequently.  Generally, the longest term puts available have a duration of approximately two years.  For my example SPY, the longest dated puts currently available expire on the 19th of December, 2014.

Step 5: Choose a strike price

With puts, you need to choose a level below which you want to protect your portfolio.   If you want to protect yourself against small moves, you will have to pay more for protection, so it generally only makes sense to buy protection against large drops in the index.

Using my example of SPY, the ETF is trading around $141 as I write.    To protect against a 10% drop, the appropriate strike would be $125 (this is actually a 11.5% drop, but strike prices are only available in $5 increments.)  The ask for SPY Dec 19 2014 $125 puts was $12.99, or $1,299 per contract.  So for a little over two years of full protection (2 contracts) against a greater than 11.5% drop, you would have to pay about 24% of your portfolio, or about 11% per year, which would likely eat up any gains you hope to make.

Hence, you’ll generally want to protect yourself only against much larger drops of over 20% or more.  Protection against drops of over 22% can be had at a strike price of $110, where the ask for December 19, 2014 $110 puts is $8.45, or $845 per contract.  Partial protection for the portfolio (1 put) can be had for $845 for 25 months, making the average cost of protection a little less than 2% per year.  This is still expensive, but no more than a small investor might pay for advice from an investment advisor combined with the management fees of the mutual funds that advisor would likely recommend.  And, in my experience, few investment advisors know how to provide downside protection for their clients’ portfolios.

In a year like 2008, when SPY fell 37%, a single put contract like the December 19, 2014 $110 put discussed above would have paid out approximately $2,200 against probable losses in the portfolio of $8,030.  My $21, 700 example portfolio would have fallen to $15,871 rather than $13,671.  Perhaps more importantly, you would have had cash to invest in early 2009, when the best investment opportunities since 2001 were available.  Two put contracts would have prevented more than half of the losses, but maintaining a hedge like that would cost $1700, or almost 4% of the portfolio’s value per year.

Step 6: Purchase the Puts

Through your broker, enter an option order to buy the number of the specific puts you selected.  I recommend using limit orders, since even the most liquid option orders have wide bid-ask spreads, and I generally place my limit well below the ask and wait for the market to come to me.  If you place your limit at the midpoint of the bid and the ask, you will often find that your order is executed almost immediately, so even if you are worried that the market will move against you, it’s worth giving this a try.


At best, the spreadsheet calculator I’ve provided is an approximation.  Even the most sophisticated calculations often fail to reflect  future market behavior during a crisis, when historical relationships frequently break down.  In particular, just because your portfolio has been moving in a particular way with SPY before a market crisis, does not mean it continue to do so.  You may end up needing more or (with luck) less protection than expected.

There are also a number of systematic flaws in the methodology, which you may need to correct for.

If your portfolio contains illiquid securities that don’t trade very often, the calculator will most likely understate the number of puts you will need to use.  In this case, you are likely to notice that the columns that are based on 3-day and 5-day changes (K and N) will generally be higher than column H (1-day changes.)  If that is the case, you will probably need more puts than shown in column O.

If your portfolio already contains options such as calls and puts which have non-linear return characteristics, the calculations will also be thrown off.  Long puts or short call positions will usually cause the amount of protection needed to be overestimated (i.e. you’ll need less protection than the spreadsheet predicts) while short put and long call positions will lead to underestimates of the amount of protection needed.  These effects will be greater for in-the-money calls and out-of-the-money puts.


Without a doubt, hedging your portfolio with puts can be an expensive proposition.  It works best when your portfolio already has fairly low volatility, and produces a decent income (perhaps from dividends or selling covered calls) to pay for the ongoing cost of protection.  If you are a passive index investor, protecting yourself with puts is probably not worth the expense over the long term; you would probably be better off keeping your money out of the stock market.

English: Tyne Lifeboat. Second ever lifeboat i...

Tyne Lifeboat. Second ever lifeboat in existence. (Photo credit: Wikipedia)

On the other hand, investors who feel that they have some sort of investment edge such as superior stock picking ability might consider protecting themselves with puts in order to reduce their overall market risk.  If puts seem too expensive, they might want to consider one of the four other hedging strategies I outlined in my 2009 article, or consider using short call spreads.  Such strategies tend to have lower ongoing costs (some even produce income), but they either provide less protection in the case of large market declines, or they potentially produce large losses when the market rises.

Just yesterday, Marc Faber told CNBC that he “would not be surprised” if the S&P 500 and Dow Jones Industrial Average plummeted 20% from their recent highs.  I would not be surprised either.  Nor would I be surprised by a decline of 30-40% if the recent bad earnings numbers are aggravated by renewed problems in Europe and/or a failure in the US to deal with the looming fiscal cliff.

I also won’t be surprised if the ominous storm clouds on the horizon produce no more than a sprinkle.  But just in case, I’ve bought a lifeboat.

Disclosure: Long Puts on SPY, IWM, QQQ

This article was first published on the author's blog, Green Stocks on October 24th.

DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the current opinions of the author and such opinions are subject to change without notice.  This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

September 13, 2012

The Difference between Reality and Pandering

Garvin Jabusch

Innovation and increasing economic efficiency have always been the keys to profits and wealth. Getting more value out of systems without commensurate increases in inputs is the definition of growing efficiency, and it has been the engine of human economies since someone figured out how to use energy from a water wheel to grind grain instead of doing it by hand with a stone bowl and pestle. With that development (to simplify), a couple family members could run the wheel, freeing up everyone else for other pursuits. This kind of gain is the hallmark, to greater and lesser degrees, of new economies. Many times, the extra bandwidth is used experimenting with the next innovation, and in due course, old tech is replaced with new. When James Watt came up with the steam engine, a few individuals could grind the grain for a whole village, and innovation really began to boom. Trains, internal combustion, electricity, chemicals, and thousands of other efficiency-gaining technologies and techniques emerged in rapid succession. In our own time, the pace has only increased. The advent of computers and more importantly networks means we can in weeks or even days develop, test, share, refine and actualize new tech and ideas that would have taken years or even decades as recently as our grandparents’ time.

These efficiency leaps, with their ever increasing power to do more, faster, with less, are the causes of excess output. They come from real-world observation, trial and error, cause and effect. Applied science, in short, is the source of wealth. 

At Green Alpha, this is where we start the process of building portfolios, by seeking the new drivers of efficiencies and wealth. Our approach asks, ‘what are the key, game changing innovations emerging now? Of these, which will be in the most demand? Which will be instrumental in addressing our emerging challenges around resource constraints, 9 billion people in the next 28 years, and a warming climate with far more extreme weather events? Which are being deployed most profitably and with the best growth rates?’

We look for companies whose businesses live at the intersection of all these. Because one thing is certain: capital flows – as it always has throughout history – to the best new innovations creating greater economic efficiency. This is especially true when there are overriding needs in addition to wealth creation driving new innovation.  We believe our portfolios have outstanding chances of very competitive returns over time because they benefit from the two most powerful tailwinds in human economies: efficiency driven innovation and a critical need for solutions to pressing issues. It’s about identifying solutions and seizing opportunities.

‘Gains in economic productivity’ speaks for itself; the technologies may be new, but the process is ancient. For the other driver, ‘solving key problems’, we identify three key subtopics that are the major, global, macroeconomic conditions currently prevailing:

1) sustainable restructuring for reinvigorated growth of the U.S. and world economies,

2) energy and national security, and

3) economy-threatening climate change

Together, these make a strong case for investing in the best companies leading the way to a next, eco-sustainable, minimal-carbon future economy. By 'next economy,' we refer to the economy as it can function to minimize emerging risks. Our models reflect an economy that maintains security and comfort for society while remaining within the boundaries of what earth’s systems can both provide and tolerate. Far more than investing only in renewable energy solutions, this means looking for opportunities throughout the economy such as in water, smart grid technologies, basic materials research, agricultural improvements, forestry, sustainable commerce, zero-carbon transportation, and so on.  All these things are connected; solving for one issue type doesn't make sense when confronted with multi-part problems. Eco-efficiency has become an inherent part of risk and return for businesses regardless of enterprise size or economic sector of activity, and transition to an eco-efficient economy is the only viable path for global financial health. Investing in companies of this next economy is the clearest path to long-term capital appreciation and competitive portfolio performance.

This may all seem obvious. But there are some in this world, primarily those who make fortunes running the old, inefficient technologies of the 19th century (fossil fuels are the prime but by no means only example) who’d like us to believe that we live in the best of all possible worlds, that our technologies are great as they are, that any new innovations should be limited to new, expanded uses and dissemination of their products (e.g., development of the Keystone XL Pipeline). Further, they’d like us to believe there are no climate, population or resource issues on earth today, or, to the extent that there are, that they can be solved with some increase of their old timey technology.

Unfortunately for the people who promote this point of view, it flies in the face of science and objective reality. So, they’re playing the only card they have: a campaign to discredit science and even reality itself (here’s just one of thousands of good recent posts on this). Then, to make it appear that their anti-science position is credible, they portray that position as a legitimate side that must be considered by anyone who thinks of themselves as a reasonable, open-minded centrist.

To be truly centrist is to take the best of both sides, define your philosophy and make your own (as opposed to an authority figure's) decisions based on what you think is right. It's a reasonable approach to living an honest life on your own terms. But in the world we live in now, to claim we need more debate on topics like global warming, scarce resources, income inequality and the policy prostitution resulting from Citizens United is to be complicit in burying the truth. To meet liars, thieves and oligarchs half way is, in the U.S. plutocracy, nothing more than pandering. Or call it fear to speak truth to power, or going along to get along. The problem is that it's a lie. Meeting a lie half way validates it. If someone tells you it’s nighttime at noon, agreeing to debate the subject doesn’t make you centrist or fair, it perpetuates their delusion. There is no reality now wherein warming can be debated or where unlimited burning of fossil fuels can be ‘centrist.’ I understand it can be hard to see positive innovation when there are those who believe that doubting the word of our plutocrats is anti-American, scary and dangerous to our way of life. But, strange as it may seem to some, authority sometimes only has its own best interests in mind. And yes, Citizens United, allowing as it does unlimited contributions to policymakers, is fundamental since policy now follows dollars rather than the best interests of citizens. Parties in America rarely discuss climate because most politicians are afraid to contradict their paymasters, and fossil fuels are the big gorillas when it comes to super-PAC donations. As the richest companies in history, they would be. 

But there is a growing crowd, led by some of the most successful businesspeople alive, who see a better world and who are not afraid to invest in it. The myth that the next wave of human innovation has to wait until later while we continue to enrich the fossil fuel bosses is just that, a myth. And it’s stalling progress.

Facts matter. Global warming is real. Evolution, to bring up another doubted fact, is real. If even one of the tens of millions of fossils formed over the last 3.5 billion years of evolution was out of place in its developmental sequence, we could have the ‘it’s just a theory’ conversation, but not one ever has been. Genetic relationships between species prove evolution’s reality even more convincingly than fossils do. All rational evidence one can cite point to the truth of evolution. Common, everyday horse-sense observation shows us that. I’m amazed that some anti-science folks have no problem understanding that wolves and Chihuahuas are related, but fail to see chimpanzees and humans could possibly have had a common ancestor.  

The ‘observe, verify and repeat’ approach of science works to explain the world. It's the only thing ever to adequately, reliably and repeatedly help us understand our surroundings and allow us to make more of them. To reject what are by now the basic, undeniable, repeated, objectively demonstrable truths of global warming and evolution is to deny reality. To hold a conviction that repeated scientific conclusion is fraud also means rejecting manifestations of science such as medicine. Evolution is the grand unifying theory of biology, and much of what we know of human health care is the result of what we've learned in the realization of how life takes shape. Yet rare is the ideologue that rejects medicine.

Science now tells us that it is earth’s systems that provide the underpinnings of the human economy. Civilization has now reached a scale where it has begun to threaten the stability of those underpinnings, and we need to adapt. Our economies must evolve to be able to provide us a high standard of living without risking dangerous disruptions from climate and depleted resources.

Similarly, global macro economics informs us that global warming, resource scarcity and all their attendant problems are real and looming, and that running our economies while cooking ourselves and recklessly depleting our ultimate economic underpinnings is not going to work. You go to the doctor if you’re ill, and we change our economics when our economies are threatened.

Fortunately, to greatly improve our means of economic production we need merely embrace the next, now emerging wave of human innovation. Improving efficiencies - getting more out of less - is what people do. From the time we domesticated fire right up through today we've been getting more and more out of less and less. Today is no different. We don't need to rely on things like coal and natural gas electricity plants any more than the developers of the first coal plant needed to rely on their old water wheel. We've moved on. Let's act like humans and capitalize on it.  

GAA Logo Blog (2)

Garvin Jabusch is cofounder and chief investment officer of Green Alpha ® Advisors, and is co-manager of the Green Alpha ® Next Economy Index, or GANEX and the Sierra Club Green Alpha Portfolio. He also authors the blog "Green Alpha's Next Economy."

December 04, 2011

Navigating the Clean and Bloody Streets of Europe

Tom Konrad CFA

Blood In the Streets

Walter Rothschild, 2nd Baron Rothschild
Image via Wikipedia

Baron Rothschild was an 18th century British nobleman who supposedly originated the phrase "Buy when there's blood in the streets, even if the blood is your own."  Although accounts differ, Rothschild was a successful banker, and supposedly made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon.

True or not, the tale of Rothschild buying when everyone else was panicking is an excellent illustration of contrarian investing: the notion that the best bargains are to be had when nobody else wants them.  As a contrarian investor myself, the Eurozone turmoil and accompanying declines in European stock markets have piqued my interest.

Clean and Bloody Europe

Europe, with its high energy prices and early acceptance of the science of climate change has for many years been growing industries with the technology and skills to confront peak oil and climate change.  These stocks have been falling along with most other European stocks as a break-up of the Euro zone has begun to look increasingly likely.  If the Euro zone were to fall apart, it would likely be disastrous for all European economies.  Many companies in debtor nations leaving the Euro would be unable to repay  their Euro-denominated debt and have to declare bankruptcy, while companies in stronger economies such as Germany would find it increasingly difficult to compete because of a rapidly appreciating currency.

The coordinated action of six central banks led by the US Federal Reserve on November 30th gave European leaders some breathing room to work out a way to deal with the spiraling cost of financing peripheral economies' debt.  But they must come up with something much more decisive than previous deals if a crisis is to be averted.  If a deal can be reached, now could easily turn out to be one of the best buying opportunities for European stocks at extremely attractive valuations for years.  A deal would also likely lead to a short term rally in the US as well.   If not, it may simply be a good way to lose a lot of money. 

My Strategy

Over the last few months, I have bought a handful of European stocks at what appear to be very attractive dividend yields, but I am also maintaining puts against major stock indexes which should cover my losses if the crisis worsens.  I'd be a lot more cautious about buying European stocks at this point without a hedge.  The stocks I've bought recently are:

  1. Environmental services firm Veolia (VE), which I wrote about in Trash Stocks Trashed.  At $12.69, VE yields over 12% on trailing dividends, although I expect the dividend in 2012 to be significantly lower than the $1.47 paid this year.
  2. Denmark-based global insulation manufacturer Rockwool (ROCK-B.CO/RKWBF.PK).  At the recent price of $88.22, Rockwool has a 2% yield, and Rockwool's global operations should shelter the company somewhat from the fallout in Europe, especially since the global insulation market seems to be rebounding.
  3. German inverter manufacturer SMA Solar (S92.DE / SMTGF.PK), which at the recent price of $56.70 yields 3%.  I most recently wrote about SMA in A Value BOS Play on Solar, although I inadvertently doubled the dividend yield in that article.
  4. Dutch bicycle and e-bike manufacturer Accell (ACCEL.AS / ACGPF.PK) is yielding about 7% at $17.47. I recommended buying Accell last week.

I normally follow North American stocks, and this eclectic group are simply European stocks which have caught my interest over the last few years and currently seem fairly cheap.  Since the Euro crisis is making stocks fall across the board, I polled my panel of green money mangers to see what they thought of the current opportunities across the Atlantic, and to see if they had any specific picks of their own.

Robert Wilder

Dr. Robert Wilder is the CEO of Wildershares, and co-founded and manages the WilderHill Clean Energy Index (ECO) which underlies the largest clean energy ETF, PBW.  He also co-manages two other Wilderhill indexes, WHPRO and NEX.  As an indexer, he was not willing to pick stocks, but he did have some thoughts to share on the situation in Europe:

On Solar:

Overcapacity from China taking poly[silicon] costs near $25/kg and c-Si solar modules under $1 on top of low prices, has been very painful for all European listed (and American) competitors. 
That fact depressed many solar stocks on European markets in 2011, and some consolidation is expected in 2012. A few higher-cost firms have already failed.
Whether that means it's time to buy, is a different matter. Many believe more solar firms with fail ahead and shares have still further to fall.
On the broader market:
Macro-level debt risk too in Europe is adding to woes there. Financing has become more difficult, and Eurozone subsidies are uncertain.
So there is 'blood on the streets' in Q4.
[T]here's no certainty, but one thing for sure is renewable energy is trading far below where it was just 6 months ago, as November 2011 concludes.
[Some] feel clean tech and solar in particular has still farther to fall in 2012. Others contend that to some extent, bad news is already priced into stocks on European markets, and optimism about fixing the Euro crisis along with return to the risk-assets like clean energy could possibly turn things around in a hurry. Especially since this sector has been quite beaten down the past 3-4 years.

Jim Hansen

Jim Hansen is an investment consultant at Ravenna Capital Management in Seattle.  He publishes the weekly Peak Oil focused newsletter The Master Resource Report.  Hansen does not reccommend any European alternative energy stocks, and he does not have any on his "list of near buys."  He prefers "to go at the alternative energy producers from the infrastructure side... [so] we don’t have to pick the best on the cutting edge technology side or determine who is going to be able to produce PV or Wind Turbines at low enough cost to stay ahead of the price decline curve."  Hansen's clients hold a few infrastructure companies such as ABB (ABB) with exposure to alternative energy.

On the overall situation in Europe, he thinks "There will come a day [to buy] but not yet. Reminds me a something read recently on LED lights: 'Overall, I think it's currently safer to be an LED consumer than an LED stock investor.' In this case we may need to see some bodies in the street."

Garvin Jabusch

Garvin Jabusch CIO of Green Alpha Advisors, and manages the Sierra Club Green Alpha Portfolio.  On the overall situation he says:

The short term situation in Europe is pretty brutal. It looks increasingly likely that the single currency may not survive much longer, and the short term volatility if and as they go through the process of reverting to respective national currencies will be pretty scary.

That said, there are good macro reasons why this could present good buying opportunities in cleantech and renewable energy. First, as national central banks regain control of their monetary policies, the stronger nations will be more insulated (not to say immune by any means) from Euro-contagion. So, for example, Germany may be a little better off with D-Marks than with Euros, but Greece will have to swim more on its own. Imagine if U.S. states had their own currencies and monetary policies. Do we like the opportunities offered by the economy and industrial base of an Ohio or Pennsylvania, or do we want to buy bonds from Arkansas or Mississippi?  Nothing against those states, but there is regional variability being masked by the Euro.

The second factor is that cleantech and renewable investing is the one bright spot in global growth today. Bloomberg captured the trend perfectly with this quote: “The progress of renewables has been nothing short of remarkable,” United Nations Environment Program Executive Secretary Achim Steiner said in an interview:“You have record investment in the midst of an economic and financial crisis.”

We believe that combining the rapid growth in renewables with an eye for the Euro nations with competitive economic advantage, and then looking for companies that within this context become very undervalued in the continuing if not accelerating euro volatility, will likely be a source of good returns over the long term. 

If this sounds like a lot of contingencies, it is. But given the complexity and changeability of the situation, I'm happy to feel like there's any path, even one strewn with caveats, through the 'bloody streets.'
For particular stocks he likes Aixtron (AIXG):
It's an upstream, manufacturer agnostic play in both energy (solar) and efficiency (LEDs), it has cut forecasts recently but is still comfortably profitable going forward and has good growth prospects as renewable continue to thrive. It also rests on the relatively strong German industrial base.  If the Euro crisis causes a large dip in AIXG, we'd have to look very seriously at increasing our position there.
After he saw this draft (and my mention of Veolia (VE) above) he added, "I almost mentioned VE in my comments instead of AIXG.  I mean, double digit dividend yield on a water play? Fantastic."


It's difficult to overstate the seriousness of the Euro crisis, and the universal caution of my panel of experts bears that out.  On the other hand, that near universal caution could be a contrarian indicator.  If Europe's political leaders do work out a deal with substance when they meet on December 8th. 

Is a European fiscal union on its way?  If so, investors who are buying European stocks now will be able to not only congratualte themselves for their bravery, but also have some tidy profits to walk home with.  If not, there will be even more blood on the streets when the time to buy comes.

Some of it will be my own.  And I'll be buying.


DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

July 19, 2011

Money Managers See Value in Clean Energy Sector, but Hesitate to Call the Bottom

Tom Konrad CFA

Three green stock specialists see individual stocks at attractive values, but think it's too soon to call the bottom for the sector as a whole.

Last month, I wrote that I'm again finding clean energy stocks that I think are bargains, and listed ten.  I was not ready to call a bottom for clean energy, and in fact said I expected the market to get worse before it gets better, so investors should keep some money on the sidelines to wait for more opportunities to emerge.

In a little over a month since then (June 16 to July 18,) those stocks are up, on average, by 5.6% in dollar terms, while the largest clean energy ETF, the PowerShares Wilderhill Clean Energy Portfolio (PBW) is down 1.5% over the same period.  The top performer has been Alterra Power (MGMXF.PK), which is up 24% and the biggest loser has been Ambient (ABTG.OB), which is down 10%.  It's far too soon to declare victory, and I continue to feel all those stocks are cheap today, and that there is plenty of room on the downside for clean energy as a whole. 

But given that I can only follow a small fraction of the hundreds of clean energy stocks out there, I thought it would be interesting to see if other money managers who specialize in clean energy see the current market the same way I do, and what bargains they are finding, in the spirit of my article looking at clean energy money manager's top picks in the wake of the Fukushima disaster.  I intend to continue to do articles like this one based on other money managers' views, so if you are a professional money manager or analyst specializing in green stocks and would like to participate in the future, send me an email and I'll add you to my list.  You can also reply to the questions here by leaving your comments at the bottom.

This article is the first of a two part series looking into what they had to say.  This first article is about where they see the clean energy sector as a whole, and the second one will take a look at their picks. 

I corresponded with three money managers for this article.
Sector and Market Outlook

All three agree that it's too early to call a bottom.  They raise two basic concerns. 

First, it's simply very difficult to ever time the market.  As Jabusch puts it, "Even when industries become very undervalued, they can remain stubbornly low for some time," while Coven finds it hard to say due to "volatile overall market conditions." 

Coven went on to say "The correlation with global equity markets is still the [strongest driver] of stock performance and I certainly don’t think that global markets have bottomed nor are cleantech stocks as a whole independent from overall macro economic conditions." 

I think Coven's latter comment is interesting because we really have not seen a lot of correlation between the overall market and clean energy over the last couple years, with clean energy trending flat to down even as the market as a whole has risen.  If the overall market heads down from here, will clean energy stocks follow suit, or will they remain mostly decoupled?  I'm inclined to agree with Coven, which is why I have been focusing my picks on small and microcap stocks.  Recent research has shown that portfolios of small and microcap stocks have been better behaved during broad market declines than larger capitalization stocks, so I hope my move towards smaller stocks will somewhat insulate me from an overall market decline.

Healey echoes Coven's concerns about how the larger economic picture might affect cleantech.  He said many cleantech subsectors "have revenue generation that is tied in one way or another to government spending/incentives.  Until investors have better clarity as to what the government spending/incentive picture will look like after the European debt Crisis and US deficit plans have been worked out I can not confidently say any equity that benefits from government actions, either policy or financial incentives, has bottomed."

Finding Value

Despite the cautious tone, all three seem enthusiastic about the values now available in specific stocks and subsectors.   

Jabusch said, "we do believe that just as surely as all bubbles must eventually burst, all unreasonably oversold stocks must some time come back to their fair valuation. By "fair valuation" we mean at least to the old-school Benjamin Graham definition of net present value of the probable future stream of cash flows discounted at a reasonable rate, plus the property plant and equipment. We understand that this valuation method seems very conservative and even quaint by current thinking, but surprisingly, there are a lot of cleantech companies that look very cheap right now, even against this standard."

Coven went into more detail about how he would pick stocks in the current climate. 
We are also much more comfortable with well-capitalized companies, with broad product lines and strongly prefer those that can flourish with diminished government incentives which are bound to fall further.  This of course has us steering clear of all fuel cell and most biofuel companies for the moment.

We continually are reminded how fast certain sectors have product commoditization.  Where intellectual property isn’t strong enough to differentiate products sufficiently, prices have been collapsing  even faster that we had anticipated.  This is true for smart power meters, solar panels, wind turbines, and most lighting products – especially LEDs.  The LED market is going to be massive, but the number of new entrants and (particularly in China) and increased production capacity (mostly in China) has grown so much faster than demand, that prices are falling faster than they did for solar panels.  This will be good for adoption, but the LED market for general illumination (non-consumer electronics) is still nascent and won’t really takeoff until LED prices drop further.   Sector growth doesn’t necessarily mean that many companies will make economic profits in LED lighting or solar PV, but probably those with really great I.P. or the lowest cost manufacturing will.  The rest will die or struggle to survive.
Stock Picking Guidelines

Which clean energy stocks will
  • have strong intellectual property or other advantages that help them avoid commoditization of their products,
  • have great net present value of future cash streams, and
  • aren't tied to government spending/incentives? 
Stay tuned for these three managers' stock picks later this week. 

DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the current opinions of the author and such opinions are subject to change without notice.  This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

June 14, 2011

An Elephant Hunter Explains Inflection Point Investing

John Petersen

In "An Elephant Hunter Explains Market Dynamics" I discussed the two basic types of public companies; earnings-driven companies that are “bought” in top-tier weighing machine markets and event-driven companies that are “sold” in lower-tier voting machine markets. Today I'll get a bit more granular and show how "sold" companies usually fall into one of two discrete sub-classes that have a major impact on their stock market valuations.

As a starting point, I'll ignore the China-based companies that are listed in the US because their quirky metrics would only confuse the analysis. Then I'll break my tracking list of 14 public companies down into three sub-classes as follows:
  • Established manufacturers that have earned a competitive position in their target markets and are or have been stable and consistently profitable;
  • Transition stage manufacturers that have progressed beyond the R&D stage and are increasing revenues, but have not turned the corner to consistent profitability; and
  • Technology developers that are still in the R&D stage and have not completed a credible product launch or started to develop a predictable revenue stream.
In the following graph from Osawa and Miyazaki that summarizes the business dynamics underlying valley of death analysis, the established manufacturers are all beyond the crossover point between the valley of death and success as a business; the transition stage manufacturers are all between the product launch and success as a business; and the technology developers are all between research and product launch.

1.11.11 Valley of Death.jpg

The following table presents summary valuation data on each of the companies included in the three sub-classes. Dollar amounts are expressed in millions.

6.14.11 Peer Valuation.png

Established Manufacturers

When you consider the five first-tier companies including Johnson Controls (JCI), Exide (XIDE), Enersys (ENS), C&D Technologies (CHHP.PK) and Ultralife (ULBI), you'll note that all of them have long histories and established competitive positions in their target markets. While C&D and Ultralife are currently losing money, they have been profitable in the past.

In general, the members of the established manufacturers class trade on the basis of earnings, have an average price to book value ratio of 1.6 and have an average price to sales ratio of 0.5. While companies in the established manufacturers class usually trade within a reasonable range of their peers, you can occasionally identify special events in the past that are not likely to be repeated in the future. Examples include $48 million in nonrecurring charges reported by C&D for the year ended January 1, 2011 and $53 million in nonrecurring charges reported by Exide for the year ended March 31, 2011. Since both companies are emerging from their own versions of a rough patch, they merit special attention and have a good shot at substantially outperforming their peers in the established manufacturer class.

Transition Manufacturers

When you get into the transition stage manufacturers including Maxwell Technologies (MXWL), A123 Systems (AONE), Ener1 (HEV), Active Power (ACPW) and Valence Technologies (VLNC) the valuation multiples jump abruptly and the price to book and price to sales ratios are also far more variable than they are in established manufacturers class. For transition stage manufacturers, I've found that a far more useful metric is a measure I refer to as blue-sky; the difference between a company's reported book value and its total market capitalization.

Using the blue-sky metric, you'll see that the blue-sky premiums for all five companies are clustered around an average of $190 million. Once you know what thee blue-sky premium is for a peer group of companies you can use it to help select outliers that are significantly over-valued or under-valued compared to their peers. In the peer group of transition stage storage manufacturers, Maxwell is trading at a relatively rich valuation compared to its peers, but the premium seems to be justified by growth. In comparison, Valence is deeply under water from a book value perspective but maintains a high market price in spite of the ugly fiscal realities. The differences lead me to believe that Maxwell is a hold while Valence is a sell or even a short. At the low end of the spectrum, Ener1 is trading at a deep discount until you consider possible future impairment charges that would bring it into line with its peers by reducing reported book value and increasing blue-sky.

Technology Developers

The third class, technology development companies, includes Altair Nanotechnologies (ALTI), Axion Power International (AXPW.OB), Beacon Power (BCON) and ZBB Energy (ZBB). These companies have not reached the point of a credible product launch, although all of them are approaching a point in their development where a significant revenue ramp over the next couple years seems likely. Like the transition manufacturers, the price to book and price to sales ratios are far too variable to provide useful guidance, however the blue-sky premium which averages $20 million for the class can be a very useful tool and help in identifying outliers like Beacon which currently trades at a significant discount to the peer group.

Inflection Point Investing

At some point in their development, all companies either move up the food chain or drift down. I've found that the inflection point between being a transition manufacturer that's valued on the basis of expectations and being an established manufacturer that's valued on the basis of earnings can be a difficult and painful time for investors as management strives to meet the quarterly expectations in order to maintain or grow their stock price. While I don't foresee short-term inflection point for any of the transition stage manufacturers I track, Maxwell and Active Power are the closest and over the next couple years they will experience increasing pressure to meet profit expectations in addition to revenue expectations.

As an elephant hunter, the inflection point I've always liked best comes during the months immediately before and after a credible product launch. During this period the only things that matter are revenue and the market's expectations for future ramp rates. It's generally the time when blue-sky premiums climb from an average of $20 million to something closer to $200 million. It's usually hard to pinpoint a specific revenue level that marks the inflection point, but it's also safe to assume that the magic will happen somewhere between $10 million and $40 million in annual revenue. In my experience there's no other time in the life cycle of a company that offers higher medium-term appreciation potential.

Of the four technology developers I track, the two with the clearest visible paths to a substantial revenue ramp are Beacon and Axion. Beacon recently commissioned its Stephenstown frequency regulation facility and is planning to build a second facility in Pennsylvania later this year. The two facilities should generate annual revenues of $12 to $24 million, depending in large part on the final disposition of a pending pay-for-performance tariff proposal. While $12 million in revenue would likely keep Beacon in the technology development class for a while, approval of the pay-for-performance tariff would probably be enough to move it up into the transition class. Once Axion completes the validation and certification of its automated second generation electrode fabrication line and begins shipping products for demonstration testing by several first tier manufacturing customers, it should be well on the way.

Disclosure: Author is a former director of Axion Power International (AXPW.OB) and holds a substantial long position in its common stock.

June 04, 2011

An Elephant Hunter Explains Market Dynamics

John Petersen

Friday afternoon was a strange time for Axion Power International (AXPW.OB). After trading 200,000 shares early in the day, Axion filed $28 million mixed shelf registration with the SEC at about one o'clock and the fly on the wall reported the filing within minutes. It seems that some stockholders were spooked by the news and assumed that Axion would sell stock right away instead of waiting for the fall deal season. Their knee-jerk selling shoved another 1.1 million shares into the market in three hours and made Friday the second heaviest trading day in Axion's history.

When I saw the news I was pleased to learn that Axion plans to do its next funding round as a public offering instead of a private placement and is taking the necessary steps to make that vision a reality. I guess the big difference between me and the street is that I understand that filing a shelf registration statement is a lot like applying for a hunting license. It's the beginning of the financing process, not the end. Since I've never seen a financing transaction go from start to finish in less than 90 days, I don't believe a transaction is likely before September.

All in all, yesterday reminded me of a Norville Barnes line from the Coen Brothers comedy, The Hudsucker Proxy:

– "Relax, it's only natural in a period of transition for the more timid element to run for cover."

Elephant hunters live for times like these. They instinctively know that sellers make themselves irrelevant when they hit the sell button and from that point on the only thing that matters are the buyers because they're the ones who'll determine the future stock price. Since Friday afternoon was such a crazy time, I'm going to step out of my normal comfort zone, try to explain how markets for individual securities develop and function, and offer a bit of advice from a professional with 30 years in the trenches. I can only hope that somebody besides me will find the discussion interesting.

Stock markets are simple creatures that always obey the laws of supply and demand. Each trade has two sides – a willing seller and a willing buyer. When sellers outnumber buyers prices fall. When buyers outnumber sellers prices rise. When sellers and buyers are balanced prices remain stable. No matter what direction a stock is heading, the root cause always boils down to the balance between buyers and sellers.

There are two basic types of public companies; earnings-driven companies that are “bought” in the top-tier "weighing machine" markets and event-driven companies that are “sold” in the lower-tier "voting machine" markets. Bought stocks are well covered by analysts, trade on the basis of earnings, offer moderate to high levels of security and have predictable trading ranges that approximate fair value. Sold stocks draw little attention from analysts, trade on news and events, offer little or no security and tend to have volatile and unpredictable trading patterns. Both types of companies are essential to a healthy economy but they're not necessarily appropriate for every investor.

There are also two basic types of stock market investors; hot money and patient money. Hot money buys a security with a relatively short investment horizon and relatively modest performance goals. The archetype of hot money is the day trader who buys in the morning and sells before noon to pay for his lunch. Patient money, on the other hand, buys with a longer investment horizon and more ambitious goals. The archetype of patient money is Warren Buffett who takes forever to make an investment decision but almost never sells. Every investor needs to know his own style and pick his investments accordingly because the surest way to lose money is to invest patient in a hot stock or invest hot in a patient stock.

The most useful mental image I've found to describe a market for a particular company is three barrels sitting side by side. The barrel in the center represents willing sellers. The barrel on the left represents the hot money buyers. The barrel on the right represents the patient money buyers. Every time a sell order is placed, new shares move into the center barrel. Every time a buy order is filled, those shares move out of the center barrel and into either the right or the left hand barrel. Market makers will theoretically buy stock and hold it in inventory, but those inventories are rarely substantial.

6.4.11 Barrels.png

Elephant hunters are by definition patient. We buy stocks that are fundamentally sound, but unknown or unloved, and hold them until something happens that changes the market's perceptions and expectations and creates new buying demand. We avoid stocks that are favorites of the hot money crowd. Over time, as elephant hunters congregate in a particular stock, the patient money barrel tends to get very full while the hot money and willing sellers barrels tend to run dry. When those two cheap and easy supply barrels run dry and an event occurs that drives new buying demand, the market price must rise to a level where some of the elephant hunters are willing to lighten up and take a profit.

It takes years to learn how to screen stocks and figure out whether they appeal primarily to hot money or patient money. It can take decades to learn how to trade intelligently. Some tricks and tools that I've found useful over the years include:
  1. Divide the public float by the 3 month average trading volume. This calculation tells you the number of days required to trade the entire float. Companies that trade their entire float more than six times a year are usually hot money favorites. Companies that trade their float less than four times a year are usually patient money favorites.
  2. Track moving average volumes. Everybody watches moving average prices. In my experience a more useful tool is a medium- to long-term moving average volume analysis. My favorite periods are 50-days, 100-days and 200-days because they tend to eliminate the spikes, clarify the trends and isolate cases of consistent accumulation over time. If you can find a stock that has a relatively stable price and steadily increasing volume it's a sure sign that the elephant hunters are doing their thing.
  3. Look for upcoming events that will matter to outsiders. Between bulletin boards and financial websites investors can drill down into detailed information on almost any stock or sector that interests them. Unfortunately blogs like mine appeal to a very limited audience and the events that move stocks are ones that are important enough to draw the attention of people who've never heard of the "thought leaders" in a sector.
  4. Don't buy a stock unless you can write a full page on why you want to own it. Far too many investors fall into the trap of the hot tip or the neighborly advice without understanding what they're buying. If you can't write a detailed explanation of why you own a stock, you shouldn't own it.
  5. Don't buy more than you can sleep with. It's easy to fall in love with a story or an idea and we all develop odd emotional attachments to our favorite stocks. No investment is worth an hour of lost sleep.
  6. Take little profits on the way up. Nobody ever lost money by leaving something on the table for the next buyer. Some of my most painful losses over the years have come from reaching for the brass ring on my whole position. There is no better feeling in the world than buying a position, selling enough to recover your out-of-pocket cost, and swinging for the fences on the house's money.
  7. Devote as much effort to selling decisions as you do buying decisions. The financial press is full of stories about how a $10,000 IPO investment in WalMart would be worth a bojillion dollars today. The reality is that there are very few WalMart bojillionaires because most of the IPO investors sold too soon. The reason is people don't spend enough time analyzing selling decisions. Even if you have a big gain on a stock, profit for its own sake is the worst reason to sell because then you'll be left with a wad of cash that you have to put to work somewhere else. Making a pile on Company X and then losing it all on Company Y is a far more common story than most will admit.
  8. Remember Warren's Wisdom. "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful."
Disclosure: Author is a former director of Axion Power International (AXPW.OB) and owns a substantial long position in its common stock.

July 26, 2010

The Big Short and Picking a Money Manager

If you're going to have someone else manage your money, consider their incentives carefully.

I just finished reading Micheal Lewis's excellent book The Big Short: Inside the Doomsday Machine on the Wall Street's role in the subprime mortgage meltdown and the few investors who saw it coming.The Big Short Cover

I began with a low opinion of the effectiveness of the vast majority fund managers and advisors who manage other people's money for a living, but the the highly-paid gross negligence and/or incompetence of the people running the CDO operations of the big Wall Street banks in the years leading up to the crisis shocked me anyway.  I may be cynical, but perhaps not cynical enough.

Incentives and the Crisis

Micheal Lewis makes the case that these people behaved the way they did because of their incentives.  In the concluding chapter he writes:

Greed on Wall St. was a given---almost an obligation.  The problem was the system of incentives that channeled the greed.

The few foresighted people Micheal Lewis writes about who shorted Collateralized Debt Obligations (CDOs) based on subprime mortgages made tens of millions of dollars for themselves, but the people who took the much larger long side of the bet also made (and were allowed to keep) tens or even hundreds of millions for themselves, even after their companies went bankrupt or were bailed out by the government.  Many are still running those same companies, and still being paid tens of millions of dollars to do so.  Back to Micheal Lewis:

What are the odds that people will make smart decisions about money if they don't need to make smart decisions---if they can get rich making dumb decisions?  The incentives on Wall Street were all wrong; they're still all wrong.

The financial reform package tries to address a few of these perverse incentives.   Unfortunately, any benefits of the package are likely to be short lived.  Rather than addressing the underlying structure of compensation and incentives for financial professionals, the reform bill attempts to micromanage a few details.  This may prevent the same problems from recurring in exactly the same way, but the great complexity of the bill makes it inevitable that perverse incentives will remain; they will just be different from the old ones, and lead to financial crises which appear different.

The People Managing Your Money

Perverse incentives may underlie financial crises, but their damage is not limited to a few spectacular banking implosions.  They can also cause slow, steady drains on investment returns that are so common that most people assume they are normal, and don't even notice their effects.

Last month, I was hiking with an angel investor who had just read The Big Short.  He came away from the book feeling that the market is rigged against the small investor.  I agreed with him, and asked what he was doing with the part of his portfolio that wasn't in his private Angel deals.  He told me it was being managed by an advisor at a large Wall Street bank, and he seemed comfortable with that.  I was shocked, but I should not have been.

How could a relatively sophisticated investor, who does not trust Wall Street banks, use those very same banks to manage his money? 

To answer my question, we first should try to understand the investing landscape open to small investors.  They have two choices to make.  First, they can try to beat the market, or adopt a passive investing strategy.  In this context, I am using a passive investing strategy to refer to portfolio allocation.  Within any possible portfolio allocation, it is possible to use a passive or active approach to stock selection, but for the purpose of simplicity, I will focus on passive vs. active asset allocation only.

A passive allocation will be the same regardless of market conditions; it depends only on the investor's needs.  An active allocation strategy considers the investor's needs, but also takes into account market conditions.

With a passive investing approach, portfolio selection involves choosing a sector selection to match the investors risk profile.  The use of a questionnaire and the ability to use simple software is enough to come up with an appropriate assets allocation.  Given the ease of designing passive portfolios, a passive investor should focus on keeping fees and expenses as low as possible.  An individual investor can find an appropriate allocation by using free web based software offered by most mutual fund families and discount brokers, or by paying an advisor to do the same.  Since most advisors charge 1% to 2% of Assets Under Management (AUM) annually, or will place the client in equally expensive mutual funds if they are paid by commission, the clear choice for a passive investor is to avoid the advisors, and use the least expensive index funds available.

Incentives Again: Why Most Advisors Advocate a Passive Approach to Asset Allocation

If passive investors should avoid advisors, do most advisors focus on active investing approaches?  They don't.  Most advisors will provide an investor with a passive portfolio allocation, and will in fact believe that this is the best choice for their clients.  While I believe this is far from the best approach for their clients, there would be a lot less employed advisors if most people agreed with me.  In other words, advisors' belief about the best way to manage money has more to do with advisors incentives than their client's best interest.

Consider the incentives shaping most investment advice.  For a start, SEC rules prohibit investment advisors and mutual funds from charging performance based fees, with only a few exemptions for rich or sophisticated clients.  If advisors could charge performance based fees, they would probably focus on performance: if the investor made money, the advisor would make money; if the investor lost money, so would the advisor.

In practice, most fees are a percentage of Assets Under Management (AUM) ("fee-based"), or based on commissions (again a percentage of assets invested) for mutual fund transactions.

Commission based advisors are the lowest rung, and are generally only the best choice for those with small portfolios.  Their incentives often lead them to place investors in high-fee mutual funds, and trade far to frequently.  The incentives of fee-only advisors with flat fees or fees based on a percentage of assets under management are just less bad, rather than good.  First of all, it's mathematically impossible for the average advisor to produce above average performance on a consistent basis.  And even the few who can produce above average performance have great difficulty demonstrating that ability, since it's near impossible to distinguish investment skill from a long run of good luck.  This is why mutual fund disclosures always have to include the phrase "past performance is no guarantee of future results."

"Model" is a Fancy Word for "Excuse"

Both fee and commission based advisors can increase their income more by acquiring new clients than by working hard to achieve a percentage or two more of extra return for existing clients.  So most advisors focus on attracting new clients, while working to persuade them that active portfolio management is either unnecessary or does not work.   Modern Portfolio Theory (MPT) is both the tool for passive portfolio allocation, and the theory used to back up the arguments that active portfolio allocation does not work.

MPT is an asset allocation model that has three very attractive characteristics to your average investment advisor who is more interested in gathering AUM than achieving good returns.
  1. MPT sounds impressive and scientific.  The very name tells us it's "Modern." "Theory" sounds very scientific.  How many advisors do you know who choose to use the more sophisticated and accurate Arbitrage Pricing Theory (of which MPT is a special case) instead?  I'll wager the answer is "none," and I think a large part of the reason is that the word "Modern" is more attractive to the general public than the word "Arbitrage."
  2. MPT relies on the assumption that markets are efficient.  The consequence of the efficient markets assumption is that no one can beat the market on a risk-adjusted basis, and so this leads to the conclusion that the best investing approach is a passive approach.  This is a very convenient assumption if you are an advisor with a mediocre track record trying to persuade a prospective or current client not to look for someone better.  The main problem with the efficient markets assumption is that it's completely contrary to the evidence.  If markets were efficient, Micheal Lewis wouldn't have had anyone to write about in The Big Short, and no one would have ever heard of Warren Buffet.  In fact, if markets were efficient, we would not have had the financial crisis in the first place, because CDOs would have traded for a fraction of the price they did in reality, and lenders would not have had incentives to make $750,000 mortgage loans to California strawberry pickers (an actual example from the book.) 
  3. MPT is easy to use.  While understanding the intricacies (and flaws) of MPT is beyond your average investment advisor, readily available software makes it very easy to implement: just interview the client to determine his or her risk tolerance and return requirements, and Voila! out pops a portfolio.  This leaves the investment advisor plenty of time to go about the business he is actually paid to do: finding more clients.
  4. Regulation leads to conservatism.  In a regulated industry, where every security in a client's portfolio has to be "appropriate," it's very convenient to have a widely accepted model to measure what is "appropriate."  The more widely accepted the model the easier it is to argue that it produces results that are appropriate to each client.  This is also about incentives: if an advisor is being audited by the SEC or his state regulator, they're very likely to ask if the advisor is recommending appropriate securities to clients.  They're not at all likely to ask if the advisor is actually making money for those same clients.  The stock of a large, well-regarded bank like Citigroup (C) would have probably been considered appropriate for a conservative investor at the start of 2008, while a speculative put betting the same stock would fall 50% by the end of the year would generally not be considered appropriate.  But Citigroup started 2008 at $30, and was down to $8 a year later.  The appropriate, conservative investment would have been down almost 75%, while the inappropriate, "risky" investment would have been up something like 600%.  While it's certainly possible to defend a long put as an appropriate part of a conservative portfolio, it takes real thought and work.  The path of least resistance is to do what everyone else is doing, and use MPT to explain the mediocre returns that result. 
In other words, Modern Portfolio theory is a pretty-sounding excuse that provides mediocre investment advisors reasons not to do the very difficult work of trying to outperform the market.  In a sense, it's a lot like the models described by Micheal Lewis used by the rating agencies Standard & Poors and Moodys to rate CDO tranches when they did not even have all the data that would be needed to perform an accurate assessment of the riskiness of the underlying loans.  Traders at the big Wall Street banks knew the weaknesses of the rating agencies' models far better than the people who used them, and they gamed them to get investment grade ratings on CDOs which would end up being worthless.  Because these CDOs were highly rated, nearly everyone felt safe buying them, including many traders at the same banks which were gaming the rating agencies' models in the first place.  

Using a Passive Investing Approach

That brings us back to the money-management options for a small investor.  Above, I made the case that unless you're going to try to beat the market, you should avoid investment advisors.  The self directed investor can replicate the results of the risk-adjusted passive portfolio allocation approach using free, widely available, portfolio analysis tools.  You can get yourself a MPT-based portfolio by using any of the portfolio analyzers on discount broker or mutual fund websites, and not have to pay for it.  You don't have to understand MPT to use it.  MPT's very good at producing average results, with tweaks to make your portfolio appropriate to your risk tolerance and investment goals.  I use Charles Schwab for most of my trading, and I've looked at their "Portfolio Analysis Tool" (sorry, the link only works if you are logged in to a Schwab account) and it will give you the same sorts of results you will get from your standard MPT-dependent investment advisor, without the hand-holding or the fees.

Attempting to Beat the Market

An investor who wants to beat the market has two options: attempt to do it himself, or find an investment advisor who has the skill to do it for him.

Managing your own money in an attempt to outperform the market  requires the most time, effort and skill.  I only advise it to people who are willing to and interested in spending a great deal of time and effort learning the necessary skills.  To successfully manage your own money, you'll need to find a mix of investing and analysis skills suited to your aptitude and emotional make-up.  Far more people try than succeed. 

Finding a Skilled Investment Advisor

If you want to take an active approach, but have decided that you don't have the time or dedication to invest your own money, you should look for a skilled advisor.  This will take considerable time and dedication, but it can be done, and if you do it right, you'll only have to do it once, while active investing is a never-ending process. 

Here is how I would go about finding a skilled advisor:  I'd begin with a process of elimination.  I'd want someone who at least attempts to analyze the market or securities he's investing in, and not just run them through a widely accepted model.  The main purpose of market models is not to produce superior returns, it's CYA for money managers. 

If an advisor utters any of the phrases "Modern Portfolio Theory," or "Efficient Markets" with anything other than derision, I'd leave immediately. These are signs that the advisor prefers a passive investing approach.  The rare advisors who follow active approaches do exist, despite the incentives.  I've met a few, although they have been far between.  But finding an advisor who does real analysis is just the first step. Next, you must determine if he or she is any good at it.

Looking at the advisor's track record is unlikely to help distinguish luck (good or bad) from skill.  Probably the smartest investment manager profiled in The Big Short was Mike Burry, and he suffered three years of negative performance from 2005 to 2007, right before he made incredible sums of money in 2008.

The only way I know to decide if an analyst is any good is to understand his or her methods.  Here are some positive signs I would look for:
  • Does he or she knows more than 99% of other investors about his or her specialty, without being reliant on some model from a third party.  In-house models are potentially okay, but I'd want to talk to the person who invented the model, and make sure they have an edge over all the other model-makers.
  • Has the advisor often been wrong before being right?  Ask the advisor to give an example of a time when they took a position, based on their analysis, that was contrary to market consensus and the position moved against them for an extended period.  If the position has since paid off spectacularly, you might have found a Mike Burry.  If the position is still moving against him, you may have found something even more valuable: you may have found a Mike Burry in 2007, right before his gigantic bet against the mortgage market paid off. 
Neither of these is a guarantee of competence.  Rather, I'm saying that knowledge is a much better sign of competence than ignorance, and always following the herd is another way to produce average results.  The reason to ask about trades that started off bad is to test if the trade was lucky, or based on astute analysis.  It's much easier to spot a profit opportunity than it is to predict when that opportunity will pay off.  Mike Burry got into his CDO bet three years too early because he could not believe that other investors would not soon be piling in to the same bets as the ones he was in, pushing the price up.  Investors who get into a position too early but are ready and able to stick with it still make money.  Investors who get in too late don't.

Final Thoughts  
Will it be easy for you to trust your money to an advisor who speaks candidly about times the market has moved against him?  It almost certainly won't be.  That is why such advisors are few and far between: despite their skill, they often have trouble gathering and keeping assets under management.  Mike Burry was particularly bad at handling people: he so annoyed his investors during his down period from 2005 to 2007 that nearly all of them abandoned him as soon as they could, even though he had just produced gigantic returns as the market imploded on nearly everyone else.

None of the three options I recommend is without flaws.  Managing your own money using a passive approach will produce average results.  Managing your own money with an active approach can be very risky, and takes more time, effort, and skill than most people have.  Finding a skilled active money manager is a good deal of work because there aren't very many of them, and it's often difficult to distinguish skill from luck.

Given these unpalatable options, many people who read this article will probably ignore my advice and decide to work with an MPT-touting investment advisor anyway.  To those who are tempted to do so, I ask: "What are your incentives?  Are you more interested in avoiding putting in effort today, or in achieving your investment goals?"


DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

July 16, 2010

My #1 Rule of Investing

Tom Konrad CFA

Rules of Investing

Warren Buffett says "The first rule of Investing is don't lose money; the second rule is don't forget rule #1."

Jim Hansen at Ravenna Capital Management and publisher of the Master Resource Report about oil and other energy news has a "prime directive" (a la Star Trek) about oil prognostication which is "never predict prices."

These rules have to be taken metaphorically, not literally. 

Buffett's rule is too general to be useful.  I take his message to mean that care to avoid losses is more effective than chasing gains.  That's sage advice.  Last year I showed how a stock market investor gains more by being out of the market on the worst months than he gains by being in the market on the best months

What Buffett's rule does not tell us is how not to take losses.  "Don't lose money" is a great bumper sticker or pithy saying to keep on your desk, but not of much practical value taken alone.  All investments hold risk, and you might lose money in anything.  If we took him literally, we'd never invest in anything.

As for Jim Hansen's "prime directive," I agree with the subtext: If you predict the oil price, you will be wrong.  In fact, I think this prime directive applies to a lot more than just oil: if you try to predict price in any somewhat efficienct market, you will be wrong.  But again, the directive is far from useful in investing practice.  Investing is all about making predictions.  If I buy any security, be it a stock, a bond, a commodity such as oil, or a mutual fund, I've made a prediction about price.  I've essentially predicted that the price of the security (plus any income from it) will go up fast enough to meet whatever goals I have for the investment. 

A Rule You Can Use

As an investor, I have to predict price or stop being an investor.  Yet I know that my prediction will be wrong, and I want to be careful not to lose money.  So my rule is:

Be Prepared to be Surprised

Any time you make an investment, you're making a prediction about price.  You can be surprised in a good way (your stock goes up 200% when you only thought it would go up 50%), or you can be surprised in a dangerous way (the company goes bankrupt).  We don't need to prepare for the good surprises, but we do need to prepare for the dangerous ones.  Investors who tell themselves that something bad isn't going to happen may be right a few times, but the more times they are right, the more confident they become that they can ignore risks.  Usually sooner, but sometimes later, they are surprised, and they lose everything because there was no contingency plan.

Surprises Everywhere

The market is not the only place where this rule applies. 

For example, if you are single, and want a date, be prepared to be surprised.  Suppose you do find that tall, dark, and handsome doctor or blond bombshell who always laughs at your jokes and who seems to have every item on your wish-list.  The tall, dark and handsome doctor might not be forthcoming with the fact that he's a mini-Tiger Woods: i.e. he has two kids, a wife and a few other women on the side.  The blond bombshell could be laughing at your jokes because she is sizing up your paycheck and calculating her future alimony payment.

When anything seems too good to be true, it probably is. 

Preparation beats Prediction

Dating may be complex; but investing is simpler.  There's only one type of bad surprise: surprises that lose you a lot of money.  Be prepared for the catastrophic event even though you're certain that there is no way it could happen.  

You did not need to predict the 2008 stock market meltdown to be prepared.  When the Dow was over 12,000, you could have bought puts betting it would fall below 10,000 for pennies on the dollar, enough to cover all your losses when the Dow hit 9,000, and even have a net gain when it fell below 8,000.  Buying those puts is preparation.  A stop-loss order that automatically sells a position if it falls to far is also preparation, although they open you up to liqidity risks during market turmoil, as we saw when the Dow fell 9% and then rebounded on May 6th.  A watchful eye on the market and a willingness to sell at a small loss can also protect you from much worse losses, but only if you are a dedicated market watcher and have thought through what a disaster might look like before it happens.

How do you know what a disaster might look like?  The exercise I did in February is a start: Try imagining what it would take to make you lose all (or most) of your money over the next year.  Once you've dreamed up as many such doomsday scenarios as you can, you can change your portfolio to reduce your vulnerability to the most worrying scenarios.  If you've already considereed what a potential investing disaster might look like before it happens, you'll be much more ready to sell and cut your losses while it's still developing than if you had never given a second thought as to what it might look like.  You won't think of everything, but if the news or market action does not fit with a scenario you've thought of, it's time to start expecting the worst.


The most important way to prevent market surprises from becoming large portfolio losses is to keep an open mind.  While we can't think of everything that might go wrong and cause our stocks to tank, a prudent investor remembers that there are always dangerous possibilities.  Expect to be surprised, and plan defensive strategies.  If we don't expect to be surprised, we're much more likely to ignore the early warning signs of a catastrophic market move, thinking that they are just momentary aberrations that will soon correct themselves.

We must predict price to invest, so we need to recognize quickly when our predictions go wrong.  Being prepared to be surprised will help keep us in compliance with Buffett's first rule: "Don't lose money." 

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

May 23, 2010

A Year Later: Market Up, Clean Energy Down

Tom Konrad, CFA

When I called the peak a year ago, it was too soon for the broad market, but not for clean energy stocks.  I think both have room to fall, but clean energy may bottom first. 

Almost a year ago at the start of June, I wrote saying "we're near the peak" of the stock market.  I was too early, and admitted it in August.  But I also said that it was a bad time to be in the market: the risks of a decline far outweighed the potential gains of remaining in an overvalued market.

Since the start of May, investors are once again realizing that not all is right with the economy, and the market can go down as well as up.  I'm willing to go out on a limb again and say I think the market has a lot farther to fall from here, and I expect the S&P 500 to be below where it was when I made my call (at 945.)

What Was I Thinking?

When I made my call, it was based on the feeling that all the stocks I watch (almost exclusively clean energy) had come too far, too fast, and were overvalued.  My mistake, it seems, was extrapolating from what was going on in my sector to what was going on in the market as a whole.

Consider this chart comparing the performance of a domestic clean energy ETF (PBW), a global clean energy ETF (ICLN), and the NASDAQ and S&P500 broad market indexes (click for full sized chart):

Perfomance Chart

While the broad market indexes continued to rise until late April this year, the S&P Global Clean Energy Index (ICLN, in red) peaked at $26.00 shortly after my call.  The Powershares Wilderhill Clean Energy Index (PBW, in blue) had a minor peak at $11.37  at the same time, but went on to scratch out another 5% gain by early January 2010 before turning decisively down.

ICLN is now down 31% from its peak, while PBW is down 22% from its minor peak following my market call. 

What Went Before

You'll also note that in the three months leading up to my call, clean energy had been strongly outperforming the broad market indexes.  I became nervous as I saw stock valuations rise too far, too fast in my own sector, and I made the mistake of generalizing that personal experience to the market as a whole.

Over the last year, I have become increasingly bearish about the broad stock market.  In August of 2009, I wrote that I had shifted my portfolio into a market-neutral stance.  I've had an overall short position since September 2009, and have encouraged readers to get out of the market or take short positions since then.  Most recently I wrote at the end of April that it was time to "double down" on puts to hedge against market exposure or gamble on a market decline.

The Future

I still believe that the market is overvalued.   However, because of the declines in clean energy stocks, I am starting to see individual companies that are decent values.  On May 16, I profiled one such example, CVTech Group (CVT.TO, CVTPF.PK.)  I think it's still too early to begin buying even these reasonably valued stocks.  If we have the broad market decline that is looking increasingly likely, reasonably stocks are likely to get caught in the downdraft, and fall further until they are incredible bargains.

Those bargains, I feel, are now just a matter of months away.  (Time will show the accuracy or inaccuracy of that prediction, too.)

DISCLOSURE: No positions.
DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

March 08, 2010

Green Energy Investing For Beginners: How Many Stocks Should You Own?

Tom Konrad, CFA

In stock portfolios, deciding how many stocks to own involves weighing a trade off.   A smaller portfolio can be built (and sold) with fewer commissions, and also requires less time to research.  On the other hand, a portfolio with fewer stocks will gain fewer benefits of diversification, and likely be both more volatile and harder to sell in a crisis.  These trade offs are also affected by the size of the portfolio, and the market capitalization and liquidity of the companies in the portfolio.

Diversification is widely accepted as a nearly costless way to reduce the risk of a portfolio.  Diversification averages out the idiosyncratic risk that arises from unexpected events at particular companies, but it does nothing to remove market risk.  When the market falls, nearly all stocks fall with it.  The benefits of diversification from each new stock added to a portfolio are smaller than the diversification benefits of the prior one, but the costs of adding each new stock are nearly constant: transaction costs, and the cost of your time to do the research you need to decide this is the stock you want.

Most investors try to get the best of both worlds by buying mutual funds or exchange traded funds.  I discussed the relative merits of these approaches in Part I of this series on Green Investing for BeginnersGreen energy mutual funds are substantially more expensive than either green energy Exchange Traded Funds (ETFs) or stocks.  The ETFs are much better than the mutual funds when it comes to costs, but brokerage commissions have fallen so low that stocks often have lower costs after just a few years.

Hence, the only good justification for buying a green energy mutual fund is because you believe the manager has superior skill, and the only good justification for buying a green energy ETF is simple diversification. 

Where Mutual Fund Investors Go Wrong

If you are going to buy a mutual fund because you believe the manager possesses superior skill, you should buy just one.  Countless studies have shown that the average actively managed mutual fund under-performs the similar index fund, and determining if a manager's track record is due to skill or luck is so statistically difficult that the only thing nearly everyone can agree on is that "past performance is not a reliable guide to future results."  And, after they agree on that, most people go right back to studying past performance... because it's the only apparent indicator of a manager's skill that is easily quantifiable.  Numbers make us feel like we know something, even if they are the result of completely random processes.

To make matters worse, most green mutual fund investors I have talked with about their holdings own small stakes in several mutual funds, so their money is being managed (very expensively) by the chronically-underperfoming "average manager."  This is clearly taking diversification a couple steps too far.

Where ETF Investors go Wrong
In contrast, investors in green energy ETFs know that they cannot discern investment manager's skill, and so they opt for passively managed ETFs instead of the actively managed green energy mutual funds.  (There are not yet any green energy index mutual funds I'm aware of.)  Using ETFs is a much more internally consistent approach, and makes sense, especially in small portfolios where the investor does not want to take the time to research individual stocks.  The problem with this approach is that the green energy sector is still very immature, and the indexes are dominated by growth companies with little or no earnings.  In such an immature sector, the largest market capitalization firms (which dominate the ETFs) are not necessarily the most successful businesses. Rather, they are the companies which have caught investors' attention: the flavor of the moment.  Buying and selling such companies may make sense for a speculator, but is probably not the best approach for a small investor who wants to invest money that will grow with the green economy.

When You've Eliminated Everything Else...

In short, investors in green energy mutual funds almost always under-perform, and investors in green energy stocks subject themselves to excessive volatility, the very thing that diversification was meant to protect against.  That makes the best strategy in my mind to build a portfolio of green energy stocks that are not the minimally profitable or unprofitable flavors-of-the-moment that dominate ETF portfolios, but are instead profitable companies doing green work that has not yet caught investors' imagination.  In Part IV, I discussed the green energy sectors where profitable but untrendy companies are most likely to be found, and at the end of last year I gave you a list of ten such stocks to consider. 

But is ten stocks really the right number for a green energy portfolio?  There's no reason to think so, since the number owes more to David Letterman than to financial theory.

How many stocks is the right number?  The answer depends on the market capitalization and liquidity of the stocks in question.

Liquidity and Return Volatility

I decided to write this article after reading Has the U.S. Stock Market Become More Vulnerable over Time?, by Avraham Kamara, Xiaoxia Lou, and Ronnie Sadka in Financial Analysts Journal.  The article looks at the trends over time for systematic risk (the tendency of stocks to move in the same direction as the market) and systematic liquidity risk (the tendency for the liquidity of all stocks to dry up or increase in a correlated fashion.)

Diversification.pngThis chart shows how excess liquidity volatility, and excess return volatility of equal-weighted portfolios of small and large companies have changed over time.  Here, "small companies" are those with market capitalization in the lowest 20% of the researchers' sample, and "large companies" are the 20% with the highest market capitalizations. 

The clear trend over time is for portfolios of small companies to have lower excess volatility, while portfolios of large companies have mostly higher excess volatility.  The authors hypothesize that this trend is the result of greater institutional dominance of the markets, especially in the form of ETFs, other index funds and basket trading.   These institutions have predictable and correlated trading patterns that create greater correlation in both liquidity and return among the stocks they trade. Since most indexes are dominated by large companies, these have seen the greatest increase in correlation.  Meanwhile, small companies have become less correlated with the market as a whole.

Given that the trend towards greater indexing has continued since 1985 and has not yet reversed itself, I think it is likely that the trends shown have continued.  If this guess is correct, then excess volatility for portfolios of small stocks in 2010 will fall somewhere below the dotted lines, while excess liquidity for portfolios of large stocks will be mostly above the dashed lines, except for small portfolios (less than 20 stocks) of large companies.

According to these charts, portfolios of large companies rapidly reach a point of diminishing returns, at around 10 stocks for return volatility, and 25 stocks for liquidity volatility.  Small companies continue or show benefits of added diversification for the largest portfolios shown, and these portfolios become less volatile than the market as a whole (i.e. achieve negative excess volatility) when they contain more than 33 companies.

An Ideal Green Portfolio

Even for a full-time market watcher like myself, I find it impossible to keep track of more than 20 to 30 companies at one time.  For part-time investors, I expect the maximum is no more than 5 or 10 companies.  Yet even 30 companies is too few to gain the full benefits of diversification available with portfolios of small companies. 

One solution is to meld indexing with a small portfolio of actively managed small companies.  The index fund (either an index mutual fund or ETF) should provide similar volatility reduction as a portfolio of about 25 stocks.  If we combine the index fund with a our individual companies so that the investment in the index fund is 20-30 times the investment in each of the individual stocks, we should have a less volatile portfolio than if we had invested in the index fund alone, something which we probably would not be able to acheive without the individual small stocks.

I've shown three examples below, with five, ten, and twenty small stocks.  Note that the amount invested in any one stock falls as you add more stocks, but the total proportion invested in stocks rather than the index fund increases. 

Low Volatility Portfolios.png
This method should always be superior to using the index fund alone in order to reduce volatility because of the greater diversification benefits of small stocks compared to the ones used in index funds.

This type of portfolio also works well if you only want to devote part of your portfolio to clean energy.  The index fund could be a mix of a Renewable Energy ETF and a general market index fund.  The research suggests that the best choice for a general market index fund would be one that focuses on small stocks, such as IWC or FDM.  You could then adjust your exposure to clean energy by changing the proportions of the index funds in the portfolio. 

Earlier parts of this series, Green Energy Investing for Beginners, provide ideas about how to select the individual companies in your portfolio and and other aspects of green energy investing.

Beyond Beginners

Note that this is a long-only stock portfolio.  I personally combine my long positions in green energy with short positions and option hedges against broad market indexes and non-green companies.  In this framework, the shorts and option hedges on index funds would slot in to the index fund portion of the portfolio, while the options in individual non-green companies would fit into the individual stock portion of the portfolio.  Allocations to bond funds and other asset classes may also make sense in the "index fund" part of the portfolio if they are baskets of securities, while they should go into the individual stock part of the portfolio if they are securities of a single issuer.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

February 13, 2010

Down and Out in 2011: Headlines from Possible Futures

Tom Konrad, CFA

If you don't know what could go wrong in 2010, it could still hurt your portfolio.

In Nassim Taleb's Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, he describes an exercise at one of his early jobs.  In order to become aware of risks they otherwise might have overlooked, they were to assume that they would lose all the money under their management in the coming year, and they work backwards to figure out how that might have happened.

This struck me as an excellent idea, which investors such as myself who are focused on the risks of Peak Oil and Climate Change should should find doubly useful. As we saw in 2008 and 1999, it's not the risks you are focusing on that are most likely to bite you. In 1999, the big scare was Y2K, but we should have been more worried about dot-com valuations. In 2008, I was most worried about peak oil, and while I was aware of the overpricing in the housing market (I'd been warning people about it for years,) I had not realized how the mortgage-backed securities and credit default swap markets could turn a housing bubble into a financial crisis. In my defense, I was up to my eyeballs in studying for the Level III CFA® exam, but that is more of a reason than an excuse. Life, and financial markets have their own agenda, and you can't expect them to wait on you when you are exceptionally busy.

In short, if I had taken the time to go through this exercise in February 2008, I probably could have saved myself a good deal of money. I don't have patience for investors and analysts who say “No one could have known what was going to happen” in any financial crisis. It's our job to know about future risks, or, at the very least, to know that there are risks out there that we don't know about, and take precautions. How do you take precautions against unknown risks? By asking what could happen to devalue the securities in your portfolio, and buying insurance (or put options) against these contingencies.

How I lost all my money in 2010

My own portfolio is currently aligned through a combination of hedging and speculative puts so that I should make money from a market decline.  I'm also holding a large percentage of my assets in FDIC insured bank accounts. Hence, talking about what might make me go broke in 2010 will not be useful to most readers.

The most dangerous possibility would be a massive speculative stock market boom resulting from falling oil prices and increased supply. I currently have an overall short position in the market.  So far my gains in individual companies and sectors have offset my losses due to the rising stock market.  Those sector bets would probably turn against me if energy prices were to fall significantly.  I have some long calls which protect me somewhat from this eventuality, but probably not enough for every eventuality.  My losses could be compounded buy my temptation to follow a strategy of "selling on the bumps" (as opposed to buying on the dips) if I did not think that the oil price drops would be long term.

The lesson for me from this exercise is to watch the drivers of a continued boom in the stock market, and to restrain myself from taking an even more bearish position than I already have as the stock market rises, especially if that rise is fueled by low oil prices driven by increases in oil production. 

As a result of this exercise, I bought several calls on SPY with a strike price of $150 expiring in December 2012.  These calls will effectively reduce my bearish position as the stock market rises, without any further action on my part.  I can't imagine the S&P 500 surpassing 1500 by the end of 2012.  Nevertheless, if that inconceivable event occurs, my losses should be manageable. In the markets, as well as life, the inconceivable does happen.  The inconceivable only only appears plausible (and occasionally inevitable) in retrospect. 

I did not do anything to protect myself against long term low prices for oil arising from new sources of supply, that's too inconceivable even for me.  While stock markets can go up on a wave of optimism that has nothing to do with the underlying reality.  Crude oil, however, is a real asset.  The price might fall if demand were to collapse, but I can only see that happening if the collapse in oil demand resulted from a collapse in the real economy.  An economic collapse would lead to a stock market collapse, which would help my portfolio.  Crude prices might also fall from a surge in supply.  Where would such a supply surge come from?  I'll watch for it, but I probably won't believe it even if it happens.  There's no need to buy insurance against the sun coming up in the West.

How you lost all your money in 2010

For those of you with more conventional portfolios, I will write a series of possible newspaper headlines that bode ill for some of the alternative energy sectors my readers care about. If you are invested in these sectors, you should ask yourself if you think such headlines are possible. If so, what have you done to protect yourself against this sort of event?

Spray-on Photovoltaic (PV) Paint Commercialized: Solar Stocks Plummet!

Solar bulls often point out that solar is the only renewable resource that can provide power at the terawatt level that is needed to run society. True, but that does not mean that today's solar technologies are the ones we'll be using to exploit it. If we develop a photovoltaic paint that can be applied by a house painter for pennies per square foot, what would happen to even low cost crystalline PV companies such as Suntech Power (STP), or even thin-film sellers such as First Solar (FSLR)?

In other words, the great hope for solar energy, a new technology that allows PV to be sprayed on like paint at pennies per watt, could easily spell the end of the current crop of solar companies. I personally don't expect to see such a technology emerge in the next decade, but many solar investors talk as if they do... yet they invest as if the future of solar is gradual, incremental improvements in cost.

Danish Blackout Causes Governments to Withdraw Wind Subsidies

Wind power is cost competitive with fossil fuel generation on a per-kWh basis. The problem has always been that current electric grids were not designed to accommodate variable power supplies. Our current state of understanding is that better power dispatch over broader regions should be sufficient to allow wind integration up to somewhere between 20% and 30% penetration. Denmark has already passed the 20% number. This high penetration is working well because they have strong interconnections with Germany and Norway. Germany provides a large additional market when wind supply exceeds local demand, and dispatchable hydropower and pumped storage in Norway help to counter the variability of Danish wind.

What if our wind integration models are more rose-tinted than we think. Wind skeptics already claim that wind power actually adds to carbon emissions because it makes natural gas turbines work harder to compensate for the variability. I think that claim is untrue, except in very special circumstances, but I also know that the models are imperfect.

So what if there is a Danish Wind Emergency, causing a blackout of large portions of the European grid for several days, and it turns out the culprit really is wind? I think it is a pretty safe bet that many governments would quickly start to re-evaluate any support they currently give wind, and perhaps even require more integration studies before allowing more to be built. Wind stocks would almost certainly plummet.

EEStor Unveils Long-Awaited EESU, 10x Faster and 1/10th the Cost of Lithium Ion Batteries:

John Petersen says: “EV's Make Sense.”

My readers often chide me for calling electricity storage “expensive” in comparison to long distance transmission and demand response technologies for grid-based storage. But my cautious approach towards electricity storage is nothing compared to John Petersen's skepticism of the viability of using expensive batteries for electric vehicles. While we both think that the battery market is likely to expand greatly, we don't see electric cars as becoming mainstream anytime in the next couple decades simply because of the extreme high cost of battery packs on a per kWh basis. Like solar, a break-through technology, such as the one that secretive EEStor is working on (with endless delays) could change all that. ZENN Motor (ZNNMF.PK) seems to think so.

If EEStor does deliver a faster, cheaper, lighter, more durable way to store electricity at a fraction of the cost, it won't be good for current battery stocks, especially if the new technology can be produced quickly and in large quantities.

French Nuclear Accident Covers Paris With Radioactive Plume!

If you're expecting a Nuclear Renaissance, you might get one, or you might not. But it's not hard to imagine things getting a lot worse for Nuclear power. If a major Western city had to be abandoned because of a nuclear accident, I don't think that the nuclear industry could recover from the widespread panic for a generation. Even newer, safer nuclear technologies would be tarred with the same brush; no one would want anything to do with anything nuclear, let alone own any nuclear company stocks.

Further Thoughts

What is your favorite Alternative Energy sector? If I did not write a disastrous headline for it above, it's not because such a disaster is not possible, there are a lot more such headlines where these came from, and many more I have not thought of. Furthermore, it does not take a disastrous headline like the ones above to hurt clean energy as a whole. Clean energy companies typically are younger and usually have not yet achieved profitability. Such companies are less well equipped to deal with financial crises than profitable companies.

Are your investments “Alternative” or just “Alter-Naïve”?


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

January 07, 2010

Green Energy Investing for Experts, Index and Wrap-Up

Tom Konrad, CFA

My Green Energy Investing for Experts series looked at ways shorting could both protect your portfolio against market decline, and make it greener by shorting decidedly non-green companies.  This is an index of the entries, plus one more industry for you to consider.

Green Energy Investing for Experts, Part I made the case that shorting stocks that are particularly vulnerable to peak oil or climate change is a good way to hedge a portfolio of green stocks against a market decline while making the whole portfolio greener.

Green Energy Investing for Experts, Part II looked at shorting Mexican stocks.

Green Energy Investing for Experts, Part III discussed using puts in case shale gas is not as big a game changer as the industry would have us believe.

Green Energy Investing for Experts, Part IV looked at shorting airline stocks.

Green Energy Investing for Experts, Part V looked at using puts on coal miners, because the muddle in Copenhagen and "climategate" are unlikely to be the end of the coal industry's woes.

I don't know about readers, but after writing these, I find this series formulaic.  I'm not an expert on any of these industries, so my analysis doesn't go into much depth beyond pointing out each industry's vulnerability, and then finding a few stocks or an industry ETF to short.

I'm not out of ideas for industries that are unprepared for peak oil or climate change. Preparedness is still much more the exception than the rule.

My best ideas were air travel and Mexico.  I'll leave the rest as an exercise for the reader.  One such is the trucking industry.  I personally have sold a short call spread on JB Hunt (JBHT.)  Take a look at my article on Newsweek's Green Rankings for a couple more.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

December 06, 2009

The Short Side of Clean Energy

Green Energy Investing For Experts, Part I

Tom Konrad, CFA

You don't have to be long Renewable Energy stocks to have a green portfolio.  Shorting, selling calls, or buying puts on companies and industries which are heavily dependent on dirty and finite fossil fuels not only makes a portfolio greener, it can protect against the effects of a permanent global decline caused by peak oil.

Nate Hagens presented this slide at the 2009 International Peak Oil Conference:


It shows his conception of the different schools of thought among those of us who understand peak oil.  Those represented in the top two green circles believe that the economy can continue to grow, either through Alternative Energy or the more efficient use of resources, or both.  The bottom two groups think our economy has grown so far beyond a sustainable level that it must shrink or collapse.

Nate thinks that any of these outcomes could happen, with differing probabilities.  I agree, with the caveat that the chances of renewable energy technologies being effective enough to allow us to continue on our current growth path (the Alternative Energy/Environment option) is exceedingly unlikely due to limits in energy productivity (EROI and EIRR).  

Market Consequences of No Growth

There are many speakers and writers far more eloquent than I who discuss the reasons and possible shape of a steady state, declining or collapsing economy.  I'm not going to try to convince anyone that we're near the end of economic growth.  If you think it's a possibility, you should consider what it will mean for your investments.  If you still need convincing, try watching Chris Martensen's Crash Course

If the economy ceases to grow, or even declines or collapses, the stock market will do the same, only in an amplified fashion.  The most concrete advice on what to do with your money usually involves taking some cash out of the banking system, and perhaps acquiring some physical gold.  If there is a genuine financial system collapse, it probably does not matter what you did with your portfolio: what I'm going to talk about here is preparation for the Technology/Efficiency or Anti Growth/Steady State scenarios above.  

If we do have a shrinking economy but our financial system does not totally collapse, it will be very important not to have a net-long position in the stock market.  While I expect my favorite sectors to do relatively well in no-growth scenarios, even the most promising companies see earnings multiple contractions when markets fall as a whole.  For centuries, stock markets have been priced under the implicit assumption of continuing economic growth.  If investors begin to re-evaluate their investments under a new assumption of no growth or negative growth, we are likely to see average P/E ratios fall from the high teens where they are today well into the single digits.  Even promising sectors will have to fall in sympathy to the lot, because they will need to attract capital that has many other suddenly more attractive opportunities.

 How to Protect Yourself

If you see a substantial market decline as a real possibility, it makes sense to reduce your exposure.  This is true even if you run the risk of missing out on substantial upside gains.  The easiest way to do this is to sell stocks. While selling stocks is an excellent way to avoid losses, it will prevent you from profiting from your insights.  The most valuable insights are those that are not yet widely shared.  If you see changes in the economy coming, but most investors do not yet see them, you have a profit opportunity that need not be wasted even if it means that the stock market is headed down.

Instead, you can hedge your market exposure.  By buying companies and sectors that are likely to do well during the transition, and taking short positions in companies that will probably be hurt, you should be able to profit if your predictions are correct.  In future articles in this Green Energy Investing for Experts series, I will take a look at specific sectors and stocks that I expect to fare particularly badly.  

In September, I wrote an article on hedging strategies, which included a simple technique for using a spreadsheet to monitor your overall market exposure, using only daily values and market index data.  This technique is rough, and will only tell you your approximate exposure to market moves, but precise measurements of market exposure are unlikely to be much better.  Markets tend to change over time, as do the relationships between them.  Hence more sophisticated techniques are likely to give you more precise measures of your market exposure, but they are not likely to be much more accurate especially in times of market turmoil when you need them the most.  Worse, the precision of such calculations can lend them an air of mystique, leading us to trust their accuracy much more than we should.  In other words, to quote Warren Buffett, "It is better to be approximately right than precisely wrong."

Hedging Instruments

In the same article, I discuss a variety of ways to hedge.  I'm not a great fan of pure shorts on individual companies because unexpected news events can cause any company to leap in price when you least expect it.  My preferred approaches are:

  • Buying puts.  This is the only option in retirement accounts such as IRAs, and has the advantage that losses are capped at the amount of money you pay for the put.  Buying puts is especially useful if you feel a company could be badly hurt in some future scenario, but may do quite well (or at least not badly) if that scenario does not materialize.  Unfortunately, the hedging technique I mentioned above does not work very well with out-of the money puts, because the protection given by such puts is much higher than would be implied by their Beta.
  • Short stock plus long call.  By buying a long term, out-of the money call when you short a stock, you are protecting yourself against unforeseen large price rises.  This technique is most appropriate if you expect the value of a company to erode slowly over time.  New calls should be bought when old ones expire.
  • Short call spread.  This technique is similar to the short stock + long call option, but has the advantage that both positions can be chosen to expire on the same date.  Further, if the short leg of you call spread is near the money, and the long leg is far out of the money, you will end up making money even if the stock does not fall.  You still will lose money if the stock goes up, however.

I tend to use a mixture of all three of these, depending on my expectation of the probability distribution for the particular underlying security.  I will go into this in more detail when I discuss specific sectors.

About the Jargon

If you got lost in the jargon of the last section, please recall that you're reading a series called "Green Energy Investing for Experts."  None of these techniques are for the casual investor.  If you got lost, and still think you want to try these techniques, you will need to get options trading authority from your broker, as well as learn the ins and outs of your chosen option strategy.  The safest and easiest strategy to start with is buying puts.

To learn more, get yourself a comprehensive book on options and option strategies, or commit to spending a good chunk of time with several of the web option primers.  If you are just learning, start small.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

December 01, 2009

Green Energy Investing for Beginners: A Small Investor's Perspective

This is a guest post by Brad Wright, who felt that my "Beginners" series was a too high level to really live up to the name.  He's probably right about that, so here is his effort to bring it down to basics for the small Canadian investor.  The links and section headers are mine.   Tom Konrad.


The goal of this article is to assist with your future investments by explaining investment options, how they work and potential alternatives that may be of interest to you. The take away I’m looking for is with a little research you can empower yourself to make more socially and environmentally responsible investment decisions.

There are long term financial advantages to investors who identify and invest in current and future clean and green companies. Recent developments in technology and the world we live in have allowed opportunities for us to invest in companies that can make a difference – and make a profit for themselves and their shareholders. For most people, the stock market is a foreign concept, but a little research can alleviate most concerns. Here are a couple of stories that may help to see where we’re trying to go.

In a recent book I read, the author described this interesting story: He and his friend ran into a ‘biker’ at a bar. The biker asked what they did for a living. They replied that they were investors. The biker elaborated on how he once received some advice on stocks, invested and lost all his money. The author went on to say how this is such as typical notion of the stock market – people get bad advice and lose their money. The author went on to say that the biker should have purchased stock in a company that he actually knew something about such as Harley Davidson. It turns out that assuming the biker had purchased stock in Harley Davidson 5 years ago, his investment would have multiplied by 5 times.

Another example is my friend who went to speak to her registered retirement savings plan (RRSP) manager. When she went in to discuss her investments, she asked what the top 3 holdings of her portfolio were. The manager replied that he didn’t know but that he could find out. A few minutes later he returned with news – the top 3 companies were oil, diamond and uranium companies. Now, this may be commonplace considering the resource extraction based economy known as Canada. When you look at the companies that are listed on the Toronto Stock Exchange the majority are mining companies. Anyways, my friend who is environmentally conscious didn’t feel comfortable that she was investing in these companies. The next question is how she can invest in companies that are more inline with her ethics.

Investment Options

Well, first let’s just provide a quick overview of the investment options that are out there. First off, there are bonds and GIC’s that are generally fixed interest rates that may or not be locked in for long term investing. They are generally around a 4% annual interest rate and can be held either inside or outside of an RRSP.

The "Registered" part of RRSP means you have agreed with the (Canadian) government that you will leave your money in the account and not take it out until you retire. This is similar to a US 401(k) plan. The government in turn does not tax you on those investments until you make a withdrawal. Now the most common entities held within RRSP are mutual funds. A mutual fund is a conglomeration of numerous companies (let’s say about 50) that the fund invests in. These mutual funds are generally invested in larger companies and may give personal rates of return of less than 0 to more than 20% per year, depending on the volatility of your mutual fund. In general, it is assumed that mutual funds provide a 10% annual rate of return. You can talk to your investment manager and select conservative, balanced or aggressive mutual funds depending on your situation, age and comfort with investing – or more specifically, comfort with fluctuating annual rates of return. My last point with RRSP’s and mutual funds is that they come with a manager who monitors and adjusts the fund over time. They generally charge 2-3% per year for this management.

An investment vehicle which takes a further step into the stock market is called an exchange traded fund (ETF). It is identical to a mutual fund in that there are normally 50 to 100 companies you can invest in. The differences are that you purchase the ETF like you would for a stock, not just sign some papers that your investment manager gives you for a mutual fund. Also, the management fee is less, usually less than 1%. Finally, some have said that the advantages of ETF’s are that they are actively traded when the markets are open while mutual funds are adjusted when the markets are closed. The advantage is that the ETF may get better deals during the day. The disadvantage of ETF’s could be that they are more closely linked to the stock market and may depreciate more when the market is doing poorly. [Note: You can find a list of the available Clean Energy ETFs here, and a discussion of the relative merits of each ETF here.]

The final investment vehicle is buying stock from one company at a time. When you do this, the only fee is to a broker, either in person, over the phone or over the internet. In person and over the phone is generally $50 to $100 to buy or sell stocks, whereas competition on the internet lowers these broker fees to the $10-$30 range. With respect to fees, the advantage of stocks, especially if they are held for 5-10 years is that you may have to pay a total of $100 to buy and sell a stock, you don’t pay a 3% management fee over that time period. For example, with $10,000 in RRSP’s over a 5 year period with a management fee of 3% would cost you $1500!

Investment Goals

So, that is a summary of common investment vehicles. [Note: this series also discussed the choice between stocks, mutual funds, and ETFs in Part I.] Other factors that you need to consider when investing are: what are you saving for, how much can you save or allocate, and how comfortable are you with risk?

So the next couple paragraphs will deal with steps to help you move away from investing in oil, diamond and uranium companies.

It just so happens that the first step is to say, hey, what if I just invest in the best or most environmentally or socially responsible oil, diamond and uranium companies. Well, you can.

The first step towards making more ethical investment decisions is researching and finding more ‘ethical’ mutual funds. Some mutual funds use social, economic and environmental criteria to select companies for their fund. For example, ethical mutual fund companies are quite similar to Environment Canada’s EcoLogo program (which is an environmental criteria program which provides its logo on approved products, for example, green cleaning products) in which the top 20% best performing companies that meet the criteria are selected for the fund. For example, most ethical mutual funds invest in PetroCanada, Royal Bank and Research in Motion. It just so happens that these are some of the largest companies in Canada, so first, your investments are relatively safe, and second, you will likely have a good rate of return.

With exchange traded funds, the exact same principles apply. For example, the Jantzi social index (JSI)is traded on the Toronto Stock Exchange and invests in companies like Royal Bank, PetroCanada and Research in Motion. Also interesting, if you visit the Jantzi website, they list companies that are included in the ETF and mention companies that were kicked off the list because of bad company practices such as buying-out other companies with poor performance. The issue with Canadian ETF’s is that there are very few or are relatively new. For example, the Jantzi social index just came out this summer.

What I find problematic of both ethical mutual funds and socially responsible exchange traded funds is that they still invest in large companies. Large companies in every industry sector, even sectors that you may not want to invest in such as oil and gas exploration. These investment vehicles need to provide investors with a sense of security and competitive rates of return compared to the traditional investment types. So for most people, these options are definitely a step in the right direction.

Finding Companies You Believe In

There is one final option where you can invest directly in an organization that you believe in, such as buying stock in an individual company. This is where, with a little research you can find an organization doing interesting things that you can truly get behind. The reason more people don’t do this is because of the word diversification. Most are not willing to invest in one organization or one industry sector. If you are a small investor (< $10,000), most experts say that you are unable to diversify your portfolio enough and you are at greater risk when there are fluctuations in the stock market. This is why many like the idea of mutual funds or ETF’s – the work is done for you, and you don’t really have to worry.

But what if you did a little work, what’s the advantage, what would you need to do and what could you find out? The best place to start is the Toronto Stock Exchange. There are lots of companies in many different industry sectors. Here are a few industry sectors that might be of interest to you:

This is just an initial list of the types of industries where there are Canadian companies that are publicly traded on the Toronto Stock Exchange. Personally, I was originally interested in wind, solar and hydro power, but realized that I needed to diversify from the renewable energy field. For example, what if the Canadian government decided not to give tax incentives to the renewable energy industry or what if oil prices drastically reduced? What would be the repercussions to a stock portfolio based on just renewable energy companies? You could take the chance, but it would probably be best to diversify. Therefore, although the above list is mostly renewable energy fields, organic food or energy efficiency and other industry sectors could add to your portfolio. Also, there are likely many socially responsible companies in other industry sectors that I have not listed above.

Risk and Reward

Now the risk here is that the majority of companies in these industry sectors are small, new or not making any money. Most invest in companies that are large cap or blue chip companies (i.e., Microsoft, Apple, Google, etc.,) – these are generally large companies. There are really three types of companies on stock exchanges – large, mid and small cap. The word cap means market capitalization and it is calculated by multiplying the price of the stock by the number of shares that are available to be purchased. Large cap companies are generally over 1 billion dollars, medium cap range from several hundred million dollars to 1 billion dollars, and small cap are generally less than 500 million.

Most stock investors like the idea of small cap companies because of growth and that they could be the next Microsoft company. Also, once companies such as Research in Motion mature, there is less growth over time. However, most people shy away from small cap companies since there is more risk involved.

My answer to this is that depending on your age you are able to allow for more risk because if you do lose your money you can still make it back over time. For example, most retired people are very conservative with their investments since they are dependent on those savings. Also, as I’ve mentioned previously, with the world we live in and the rate of developing technologies it’s possibly a very good time to risk investing in clean and green companies.

So where do you start looking? I started with internet searches. I find companies that sound interesting or have a neat product and I check to see if they are publicly traded. You can also order investment magazine subscriptions or find investment advice websites.

These interesting companies that I look at are ones that are providing a new product or is in a new field, has a market advantage, has a vision for the future and is generally making the world greener or cleaner with their work. In additional it’s good to see the experience of their board of directors, overall financials, and the outlook for the industry, etc.

So I hope this has helped provide some insight into the crazy field of investing. There are some interesting companies out there. It is easy to find out what is going on and see for yourself what you think that your hard earned dollars should be invested in. After all, these companies use your money invested in stock to do things like build solar panel plants or buy land to build wind farms. Wouldn’t it be great if you could invest in a company that was doing good things for the planet while making you some money? Sounds crazy, but it just might work. Maybe I’m optimistic, or maybe I just want to be smart with my investments.

Brad Wright holds an Environmental Science degree from the University of Guelph and a Masters of Environmental Planning from the University of Waterloo.  He is currently a municipal stormwater planner and has an interest in sustainability issues.  He has been researching and investing in green companies for the past three years.

November 29, 2009

Green Energy Investing For Beginners, Part IV: Model Portfolio

My target sector allocation for Green Energy Sectors: How much to put in Solar, Wind, Geothermal, Biomass, Biofuels, Energy Efficiency, Alternative Transport, and enabling technologies such as Smart Grid and Transmission.

In Part I of this series on green energy investing (see also Part II and Part III), I suggested readers "structure your portfolio to reflect the technologies which are actually going to make a difference."  This is not the same as investing in a market portfolio, because the market tends to overemphasize the most exciting or familiar (as opposed to the most useful) technologies.  This is true for all-too-human venture capitalists, as well as public stock investors.


Real advantage in investing comes from doing better analysis than the majority of other investors.  By understanding the mistakes or biases of other investors, even small investors are capable of beating the market.  For each green energy sector, we should ask ourselves:

  1. How big a role will this sector play in our energy future?
  2. How big a role do stocks in the sector play in the market currently?
  3. Can we buy stocks in companies which will profitably play this role, or is the current industry likely to be disrupted by new entrants and technologies?
  4. If we can't invest in the companies which will make a difference, can we invest in enabling technologies?

If the sector's role will be large, but it plays a smaller role in the current stock market, and we can buy companies today which are likely to play a significant part, then that is a sector which should be prominent in our portfolio. 

Assessing Sectors

There are countless studies and reports detailing what our energy future will or should look like.  One that I think takes a fairly unbiased view of the available technology is the Gigaton Throwdown.  The Gigaton Throwdown looked at technologies' potential over the next 10 years and asked if they could make a difference in job growth, energy independence, and climate change.  Another reference I've used in the past is the London Accord, which used modern portfolio theory to assess the effectiveness of many technologies towards mitigating climate change.  Because most of these studies focus more on climate change than peak oil, which I consider to be a more immediate threat, I also consider strategies such as mass transit, biking, and road pricing which will help us cope with transportation fuel scarcity.  I lump these strategies together as Alternative Transport.

To get an idea of the market's view of technologies, I obtained a report from BofA Merrill Lynch Global Research.  Below is a chart of the market capitalization of the CleanTech sectors they cover:

BofA Merril Lynch does not consider Alternative Transport to be Cleantech, but they do cover most of the other technologies I think are important.  

Industry Disruption

In terms of industry disruption, I look at what reports have to say about what is required to achieve scale in the industry.  For instance, Geothermal is an extremely economic form of renewable electricity with relatively low environmental impact.  In order to achieve scale, Enhanced Geothermal Systems (EGS) will have to be developed, a technology which is not currently being worked on by publicly traded industry players.  EGS is unlikely to displace the current set of companies, whose profitability depends on extracting energy from existing resources and owning the mineral rights to those resources, but neither are they likely to be able to take advantage of the opportunities of EGS.

Solar needs technological innovation in Photovoltaics (PV) or Concentrating Photovoltaics (CPV) in order to be cheap enough to be brought to scale quickly, and such innovation is likely to be harmful to many existing industry players working on incremental improvements to current PV.  Concentrating Solar Thermal have few established players and is already in the midst of industry technological disruption.

Efficient lighting is in the midst of rapid technological change, but many efficiency technologies, such as geothermal heat pumps have been around for years and have established and profitable players.  The insulation industry is even more staid.  Advancing energy efficiency requires much more cultural and political change than technological change, so efficiency investments are likely to be very profitable if concern about climate change and energy security drive the needed cultural and political changes.

Putting these sources together, here are my assessments of the four questions I outlined above for each sector.

Sector Role Current Market Cap Chance of Disruption Enabling Technologies
Wind Large Large Low Transmission, Smart Grid
Solar Large Large High Transmission, Smart Grid, Storage
Efficiency Very Large Small Low or Ongoing Political and cultural change
Plug in Vehicles Small Small High Smart Grid, Storage
Biofuels Moderate Small Moderate to High Cellulosics, use of Waste Streams
Geothermal Moderate Small Req. to achieve scale Transmission, EGS
Alternative Transport Large Medium Low Political support, Smart Growth
Nuclear Moderate Moderate Medium Safe disposal of radioactive waste
Waste Small Small Low none needed
Transmission Enabling Medium Low n/a
Smart Grid Enabling Small Ongoing n/a
Storage Enabling Small Ongoing n/a

Of the nine technologies  listed, only Efficiency and Alternative Transport (Mass Transit, Biking, etc.) strongly meet my criteria.  Among enabling technologies, only Transmission is a well-established industry not prone to disruption.

Smart Grid and Storage technologies also appear frequently as enabling technologies, but both of these industries currently are undergoing rapid technological change, and so investments should be chosen carefully.  Finally, Wind, Geothermal, and Waste show current market capitalization of a similar scale to their likely future, while Waste has the added advantage of being an enabling technology for biofuels.

My Target Portfolio

Target Portfolio.PNG

Putting all of this together, the majority of my target portfolio is composed of Energy Efficiency, Alternative Transport (such as mass transit), and Electric Grid sectors.  The balance goes to Wind, Geothermal, Electricity Storage, and Biomass/Waste to Energy.  In contrast, Modern portfolio Theory would suggest that your Green Energy Portfolio should look very much like the market cap breakdown I obtained from BofA Merrill Lynch Global Research.  Yet Modern Portfolio Theory is designed for people who are trying to match the market, not beat it.  

If you disagree with my judgments here, you should now have the tools to incorporate your own thoughts on our energy future into your own table, and use the result to allocate your portfolio.

Building Your Portfolio

If you'd like to achieve a portfolio like this yourself, Alternative Energy ETFs can get you about half-way.  As I discussed in my recent comparison of Green Energy ETFs, the Powershares Global Progressive Transport Portfolio (PTRP) is a good way to invest in Alternative Transport, and the First Trust Global Wind Energy Index (FAN) serves the same function in the wind sector.

In November, First Trust launched their Nasdaq Clean Edge Smart Grid Infrastructure Index Fund (Nasdaq: GRID).  When I analyzed GRID's portfolio holdings, I found that it was much more of a general grid infrastructure ETF than a narrowly focused Smart Grid ETF, but that it addresses the sector I'm most interested in much better than it would have if it only focused on Smart Grid stocks.  

The other sectors still need to be addressed with stock-picking, but stock picking is likely to be more effective (and take less time) if you can focus on a narrower range of companies.  I discussed some simple approaches to stock picking in Part I.  For those looking at the battery sector, an excellent place to start is John Petersen's series Battery Investing for Beginners, the popularity of which was the inspiration for the more broadly focused Green Energy Investing for Beginners series you are now reading.  

If you have suggestions for further articles in this series, leave a comment.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

November 16, 2009

Green Energy Investing For Beginners, Part III: Before You Invest

Before you consider green stock market investments, invest in yourself.

A reader of my article on asset allocation for green energy investors brought up an important point: we may have green opportunities in our own lives, such as improving the energy efficiency of our homes, which will return much safer and higher returns than green stocks, especially when the market as a whole is as overvalued as I currently believe it is.

Homeowners typically have a large number of high-return energy efficiency investments they can make.  Since energy efficiency reduces energy use, it both produces returns and is very green, since pollution from fossil fuels is reduced.  Even reducing the use of renewable energy is green, because all energy production has some impact on the environment and uses resources.  Furthermore, energy efficiency reduces financial risk, because you are less subject to fluctuating energy prices if you use less energy.  

If you are considering investing money that is in an IRA or other account that is difficult to access without tax consequences, you should probably go ahead with your green investment plans.  But if you have money that is easy to access, here are a few steps you should take first.

Assess Your Opportunities

Most homeowners have countless opportunities to invest in energy efficiency or renewable energy that they don't know about.  An energy audit is a good way to discover your opportunities.  Many utilities have programs to give customers free or subsidized energy audits.  

Check with your utility (gas and electric) first to see if they have such a program.  If not, and you are a do-it-yourselfer, visit a website dedicated to helping you improve your home's efficiency, such as the EnergyStar site. If you're not a do-it your selfer, look for a RESNET certified energy auditor and pay for an energy audit.  Prices for audits vary a lot, but I've heard that $200 - $300 is a good ballpark figure.

You will be amazed, or even shocked, at how many opportunities for savings you find, even in a brand-new home. The improvements you make usually qualify for federal tax credits, as well as (possibly) rebates from your utility or state tax credits.

Any energy efficiency or renewable energy measure with a payback of less than 10 years is likely to be a better investment than green stocks or funds, especially in today's overvalued markets.  Here are ten that almost always have great financial returns, many of which are good enough to perform even if you rent and plan to stay in one place for a year or two.

  1. Keep your car tires inflated to the proper pressure.  
  2. Change and clean your air furnace filter regularly.  Take a hose and get the dirt off the coils in the outside heat exchanger as well.
  3. Caulk air leaks
  4. Use CFLs.
  5. Install a Water Heater Blanket.
  6. If you have an old fridge in the garage or basement, unplug it.
  7. Install low-flow showerheads.
  8. Use an intelligent Power Strip to turn off standby mode.
  9. Get a power meter to hunt for energy hogs around the home.
  10. When replacing electronics, computers, cars, and appliances, get energy efficient ones, especially anything that's often on or in standby when plugged in. (cordless phones, TVs and set-top boxes, clocks, etc.)

Lists like this abound on the internet. Consult several for ideas.


Paying off debt causes no environmental harm, and increases your financial security.  Since I think the market is overvalued, if you have any debt, including credit card debt, car loans, and even tax-deductible mortgages, you'll probably be better paying those off than investing in the stock market.  As everyone who didn't already know it learned in 2008, all investments are risky.  On the other hand, if you pay off debt, you get a guaranteed return equal to the interest rate you're paying off, and your investment can't fall in value.  That debt won't be there no matter what happens in the stock market.

There are times when stock market investments make sense even if you have low-interest debt.  It made sense to invest in March 2009.  Now, in late 2009, I fell the markets are quite overvalued, so paying off any debt makes a lot more sense to me than buying stocks or mutual funds.  Even green stocks and funds.


If you've paid off all your debt, and taken advantage of your efficiency investing opportunities, then it's time to consider green stock market investments.  If you have not read them already, here's where I discuss how much to invest, and what to invest in.

I don't currently have plans for more articles in this Green Energy Investing for Beginners series.  If you feel there's something I still need to cover, please leave comments here.

DISCLOSURE: The author will receive referral payments for purchases through the Amazon links.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

November 12, 2009

Green Energy Investing For Beginners, Part II: How Much To Invest

In Green Energy Investing for Beginners, Part I, gave information to guide the choice of green investment vehicles (mutual funds, ETFs, or stocks.) This article is intended to help investors decide how much of their money to put into those vehicles.

An informed decision of how much to invest in green energy is at least as important as how you make the investment.  The choice between green Exhange Traded Funds (ETFs) and green Mutual funds rests on a difference of about one percent per year, caused by differences in fees.  Yet in the first three quarters of 2009, the S&P 500 (general stocks) returned 17%, ICLN, a green ETF returned 21%, and my ten green stocks for 2009 returned 41%.  With differences between performance as large as 20-30% a year (green stocks did much worse than the market as a whole in 2008,) the decision between investing 10% of your portfolio or 60% of your portfolio in green stocks will make a large difference (8% to 12%) in your total returns for the year, far more of a difference than how you invest.  The other important factor will be sector selection within green energy.  I believe that the main reason my Ten Green Stocks for 2009 have done so much better than the benchmarks is because I emphasized sectors I believed would benefit from the stimulus package.  At that time, the stimulus was  only something that I (and other green commentators) were predicting as part of Obama's response to the financial crisis (He had not yet been sworn in.)

Your Allocation Decision

How much of your savings you put into green energy will depend on two things:

  1. Your risk tolerance and market expectations.
  2. Why you are investing in green energy in the first place.

Market Expectations

Most people should not try to time market moves.  Endless studies have shown that small investors tend to put their money into the market near market peaks (1999 or 2007, for instance) and withdraw that money near troughs (2002 or early 2009.)  The economics of supply and demand make this inevitable: the more people want to buy stocks, the higher demand for stocks is, and the higher prices rise.  The more people who want to sell stocks, the larger the supply of stocks is, and the lower stock prices will fall.  

This may sound like circular reasoning (do stock prices peak because buying peaks, or does buying peak because stock prices peak?), but circular reasoning is the only way to understand stock prices. The price-setting mechanism itself is circular.  George Soros called this "reflexivity" in his classic book on market trends, The Alchemy of Finance. Most people want to buy when they see prices rising, causing prices to rise more.  Most people want to sell when they see prices falling, causing prices to fall more.

Hence, most people will get market timing wrong, and that is why your investment advisor is always telling you not to time the market.  However, understanding the psychological mechanisms which cause most people to be wrong about market timing can let a minority of investors take advantage of these predictably irrational decisions.  

Since June, I have felt that we're near a market peak, and have not changed my mind because of the market advance since then.  If you are reading this in late 2009, and the market has not fallen significantly since the writing (the S&P closed at 1042 today), I feel it would be irresponsible to suggest that anyone buy green stocks today, without a suitable market hedge.  Hedging is beyond the scope of this discussion, but I have outlined five simple hedging strategies here.  If you want a portfolio that is greener even than the green stocks, ETFs, or mutual funds, you might consider hedging with shorts on some of the least green companies.

All further discussion in this article assumes that either:

  1. You have chosen not to time the market.
  2. You have faith in your own predictive ability, and believe the market will continue to rise, OR
  3. Your portfolio will be hedged against major market moves.

Risk Tolerance

Many green energy investments are more volatile than other sectors.  This is because the majority of green energy stocks are not yet profitable, and do not have the internal cash to see them through hard times.  This can force companies to raise money from the financial markets when those markets have fallen, and will cause the stock prices to fall further in market declines.  Such stocks are especially concentrated in the domestic and specialty green ETFs, such as PBW, TAN, and KWT.  Most of the green energy mutual funds, and the international green energy ETFs such as ICLN and PBD are less volatile due to a higher concentration of established companies.

Investors can deal with the greater volatility of green energy in several ways:

  1. Stick to the less volatile green energy investments.
    1. Stock investors can emphasize profitable green companies over unprofitable ones.  Almost all of my 10 for 2009 picks referenced earlier are profitable companies, and those that are not currently profitable had a history of profitability prior to the financial crisis.
    2. Stick to the less volatile ETFs that contain a broad base of profitable global companies, instead of the more volatile domestic ETFs.
  2. When hedging your portfolio, use a larger market hedge than you would otherwise.  The method I outline in my hedging strategies article automatically incorporates this adjustment.
  3. If replacing an allocation of normal stocks with an allocation of green stocks in a larger portfolio,
    1. Replace an equally volatile sector allocation with your green energy allocation, or
    2. If replacing an allocation to ordinary stocks, replace part of that allocation with less volatile bonds, and part with green energy stocks.

Investment Motivation

It makes sense that the more confident you are that green energy will outperform other sectors, the more money you should allocate to it.  Keep in mind, however, that almost everyone has a strong overconfidence bias.  That is, we believe we are going to turn out to be right a lot more often than we actually do.  This bias persists even when we are aware of overconfidence bias.  Even when we tell ourselves, "I feel that X has a 95% probability of happening, but I know I'm likely to be over-confident, so I'll act as if the probability is only 80%," it usually will turn out that the real probability of X was even lower than our 80% revised estimate.  

Hence, we should only let our confidence in green energy have a small influence in our overall allocation decision.  Like market timing, this is another rule that I honor in the breach: my entire stock portfolio is in some way related to green energy.  In ten or twenty years, we'll find out if I actually know what I'm doing, or am just overconfident like most everyone else.

    Motivation: Doing the Right Thing

If your main motivation for investing in green energy is to be more environmentally responsible, you are faced with a trade-off: the more you invest in green energy, the more volatile your portfolio will become.  However, feeling better about your investments may make you more comfortable with the added volatility.  This may allow you to hold more green energy because of your increased risk tolerance. 

However, if you don't believe that green energy will outperform, there are less risky ways to do the right thing.  You could instead replace your stock holdings with companies that are more green than most companies in their sector.  In a recent paper by Meir Statman and Denys Gluskov entitled "The Wages of Social Responsibility", the authors found that socially responsible investment managers were able to achieve higher returns by favoring "best of class" companies in each sector, a process they described as socially responsible "tilt."  In contrast, they found that completely shunning sectors such as alcohol and firearms led to lower returns over time.  Based on theses results, there is a win-win available for environmentally responsible investors who want to do the right thing: they can rebuild their entire stock portfolio by keeping the same sector allocations they had made before the change, but replacing the stocks in each sector with the greenest stocks from lists such as Newsweek's rankings of the 500 largest US Corporations that I wrote about in September.

    Motivation: Fighting Climate Change

If your motivation for investing in green energy is to fight climate change, you must balance the trade-off of increased risk from concentration in one industry, with your expectation that that industry will produce higher long-term returns because of increasing regulation of greenhouse gasses, and support for alternative energy.  In general, I find it very difficult to predict which companies are going to benefit from climate change regulation.  Will politicians choose to subsidize solar, wind, biofuels, or energy efficiency?  Will carbon credit giveaways create a windfall for utilities and other large emitters of greenhouse gases. 

Not being able to predict politicians, I instead choose to focus my investing based on the (clearly false) assumption that politicians will do (roughly) the right thing. While I know this assumption is wrong, I also know I don't know in which direction my assumption will be wrong: the idea is that the ideal political action averages out all the likely errors that politicians are likely to make along the way.  How do we know what the ideal actions are?  We look at reports from relatively unbiased sources that recommend particular actions.  I recently wrote two articles based on an article from two economists that looked at what Modern Portfolio theory has to say about the best technologies for climate mitigation (here and here.)

In terms of how much of your portfolio you should devote to fighting climate change, if that is your motivation, it should depend on how quickly you expect the effects of climate change to occur.  The biggest gains from a climate change focused portfolio will occur as more and more political leaders stop being able to ignore the urgency of responding to climate change.  I personally feel that this will be triggered by the increasing frequency of climate-related disasters, caused by the increasing severity and frequency of unusual and dangerous weather events such as hurricanes, droughts, floods, and blizzards.  This is something that I already see happening, but I don't expect it to be obvious to the many people who want to ignore the effects of climate change for another 5-15 years.  

Based on your own belief of when you expect this political transition to occur, you should only allocate money to climate change mitigating investments if you do not need to withdraw that money before the expected political change is likely to occur.  In some ways, this political change has already begun, and money is being awarded to deserving green energy firms.  However, investors should not ask what has already happened, but what unexpected changes are likely to occur.  The unexpected (by most other investors) change that I expect is the realization that Climate Change will not only be a serious problem, but that it will be a serious problem in our lifetime, and that it's worth risking damage to the economy by devoting massive resources to the project of combating it.

In my case, my investment horizon is about 20-30 years, which is longer than the 5-20 I expect for the political change, so I consider fighting climate change as a good motivation to increase my portfolio's allocation to green energy.

    Motivation: Peak Oil

The connection between fossil fuel prices and the performance of green energy stocks is tenuous at best.  Investors should not expect their solar stocks to go up or down with the oil price.  After all, we do not yet have a fleet of plug-in vehicles which might let us substitute electricity from solar for gasoline from oil.  Hence, investors motivated by peak oil should stick to green energy sectors which reduce the need for liquid transportation fuels.  These sectors include biofuels, hydrogen fuel cells, technologies which make transportation more efficient, and technologies such as batteries which enable the electrification of transport. 

Like climate change, how soon you expect to see the effects of peak oil should affect how much money you invest.  I feel that the effects of peak oil in terms of the reduced affordability of gas and diesel are already upon us.  This does not just mean high oil prices (which we have), but decreasing ability to purchase oil due to the economic disruption and contraction caused by those prices.  Low oil prices make our economies vibrant, which provide the money needed to buy oil.  High oil prices cripple the economy, which in turn means that we're less able to buy oil at any price.  This is what I mean be "reduced affordability."

In a recent report, "The Peak Oil Market," Deutsche Bank predicts that post peak, both oil prices and oil demand will fall due to the introduction of disruptive technology: plug-in vehicles (Thanks Nate Hagens.)  If they're right, investing in oil or oil companies is not the best way to profit from peak oil, but rather the potential disruptive sectors.  Of the sectors I mention above, efficient transportation, hydrogen, and electrification are the only ones that can possibly scale to replace a significant portion of our fossil fuel demand.  Biofuels are limited by the available supply of biomass.  Biomass can more efficiently power a vehicle when burnt to produce electricity to charge an electric vehicle's battery than when converted into liquid fuels for an internal combustion engine.  A similar efficiency argument applies to hydrogen, although breakthroughs in electrolysis and fuel cell technology could change this.  However, I don't consider betting on possible technological breakthroughs a sound investment strategy.  After all, even if a breakthrough occurs, it's at least as likely to come from a new player than an industry incumbent.

Batteries will need some technological breakthroughs in order to make plug-in vehicles economical enough to displace gasoline.  However, the needed improvements to the electric grid needed to accommodate electrified transportation (as suggested in the Deutsche Bank report) can be accomplished with existing technology.  Hence, investors motivated by peak oil should be looking to investments in transport efficiency, transmission and smart grid stocks.

In terms of how much to invest in these strategies, it probably should be a lot (at least if you believe as I do that the peak in oil production has either already happened, or will happen soon), and it should probably be accompanied by a hedge using shorts in oil intensive industries such as airlines.  The hedge is necessary because a peak in oil supply will hurt the world economy, and is likely to make stock prices as a whole fall, quite possibly even the stock prices of the companies which are working to displace oil with disruptive technology.  However, it is a good bet that these companies are likely to fare better than companies whose economics depends on the large scale consumption of cheap oil.


Your goals, expectations, and risk tolerance will affect both how you invest in green energy, and how much you invest.  Before you make any decisions, answer these questions for yourself:

  1. Do I believe investing in green energy is the right thing to do? Will this help me bear the pain of declines in my portfolio?
  2. How soon will Climate Change reach the top of the political agenda?  Do I have the time to wait for the expected investment returns?
  3. How soon will oil production peak?  Do I have time to wait for the expected returns?
  4. How confident am I about my answers?  Do I have reason to be confident, or is my confidence based on self-delusion?

Knowing the answers will help guide your investment allocation.  

I don't currently have plans for more articles in this Green Investing for Beginners series.  If you feel there's something I still need to cover, please leave comments here.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

November 06, 2009

Green Energy Investing For Beginners, Part I: Stocks, Mutual Funds, or ETFs

Investing in green energy can be good for both the climate and your wallet.  How good depends on choosing the right investment vehicles (mutual funds, ETFs, or stocks) and sectors to invest in. This will get you started.

More and more investors are investing in green energy.  According to the Cleantech Group, the Cleantech sector is now the largest sector for venture capital investment.   Green Energy is not just for venture capitalists.  Small investors have done well in 2009.  Since the market bottomed at the start of March, the average green energy mutual fund topped the S&P 500 by 13%, while the average clean energy ETF beat the S&P 500 by 18%.  

Knowledgeable investors will scoff at that last statistic because, of course, most green energy companies are riskier than the tried-and-true companies of the S&P500, and what out-performs in an up market will under-perform in a down market.  That is true, but only to a point.  When I investigated it this Spring, I found that green energy stocks had outperformed the rest of the market even on a risk-adjusted basis

Nor are all green energy companies risky.  While the sector has more than its share of profitless startups, there are also established companies which have been making the planet a greener and safer place for a long time, but now have the opportunity to benefit from rising public awareness of the need to do something about climate change. By knowing what to look for, an investor can be green without taking on excessive risk.

Stocks, Exchange Traded Funds, or Mutual Funds

The small investor has three basic options:

  1. Green Energy Mutual Funds,

  2. Green Energy Exchange Traded Funds (ETFs), or 

  3. Individual Green Energy Stocks.

Green Energy Mutual Funds

Mutual funds will be the most familiar option to the small investor.  The available green energy mutual funds are all actively managed, which means they try to choose the best green companies.  Mutual funds charge high fees for this service, but I have been unable to find evidence of skill among green mutual fund managers which would justify the cost.  Numerous studies of the mutual fund industry also find that manager skill is very rare and difficult to distinguish from (much more common) manager luck.  Green mutual funds are not the best way to gain exposure to the sector: even compared to most actively managed mutual funds, the green energy mutual funds are quite expensive, and so they make sense only for investors who have no other option.   

I took an in-depth look at the available green energy mutual funds here.  

Green Energy ETFs

The second option is green energy Exchange Traded Funds, or ETFs.  ETFs are like mutual funds in that they allow an investor to own small stakes in a large number of companies with a single investment, but, unlike mutual funds, they do not have managers who try to pick the best investments.  Instead, their goal is to gain exposure to a wide range of green energy companies by buying the companies in an industry index.  Investors buy ETFs from other investors on a stock exchange, much like they would by individual stocks; the ETF manager seldom deals directly with individual investors.  This hand-off approach means that they can charge investors much smaller fees for their services.  Furthermore, since there is little evidence that active mutual fund managers add value, the ETF investor benefits from cost savings, but probably does not lose any benefit from active management.

ETFs are an appropriate investing strategy for a hands-off investor with a few thousand dollars or more to invest.  I published an in-depth look at the available green energy ETFs here, which includes recommendations of the best ETFs for different types of investors.

Green Energy Stocks

The final option is investing in green energy stocks.  This can deliver significant cost savings relative to investing in green ETFs (and almost certainly will deliver cost savings relative to mutual funds), but typically requires considerably more investment of time than does using the green ETFs.  This must be weighed against the additional work required to select individual stocks instead of ETFs, but carries the advantage of access to green energy sectors which the mutual funds and ETFs neglect, better control of both sector and stock selection..

In order to give readers a relatively simple option to invest in green energy stocks without a lot of work, I have published a list of 10 stocks on January 1st for the last two years.  My ten green stocks for 2008 lost 55% that year, but this was still better than all the ETFs and all but one of the mutual funds in 2008.  Most of these lost between 60% and 70% of their value in 2008.  In the first three quarters of 2009, my ten picks returned 41.5%, handily beating the green ETF I chose as a benchmark (by 20%).  (I have not looked into the performance of all the ETFs over the same period.)  As with mutual fund managers, it's impossible to say if my 1 3/4 year track record is skill or luck, but at least the costs are low.

I'll publish a new list of ten on at the start of 2010.

Four Articles on Sector and Stock Selection

No matter which investment vehicle you use, understanding a little about the clean energy sectors can lead to a stronger, safer, and more profitable portfolio.  It can also lead to a greener portfolio, in the environmental sense of the word.

I've published a series of articles to help investors make the right decisions.  Two are based on research into which technologies would be most effective against climate change.  The first looked into those technologies which would have a significant impact on climate change, and the second looked into those technologies which were not going to make significant contributions.  I  believe it makes sense to structure your portfolio to reflect the technologies which are actually going to make a difference.  People who want to do the right thing will know that the companies they own are doing the right thing about climate change.  People who want to make money will know that rational investments to fight climate change will also benefit the companies they have invested in.

The third article looked at the types of questions investors should ask when selecting stocks or sectors, as part of a basic framework for investment decision-making.  We are currently inundated with information about companies, but most of it is useless when trying to predict stock returns, because it is already reflected in market prices.  Knowing the difference between useful information and useless information can dramatically reduce research time and lead to better decision-making.

The final article in this series looked at psychological factors which can lead incautious investors to invest unwisely, and how investors who are aware of this tendency can do better.  The article also includes a list of twenty green energy stocks and sector ETFs that I think have the best prospects in their sectors.

Stock Selection Shortcuts

Individual stock selection is also more complex than selecting a few companies from stock lists, even my lists.  Selecting stocks requires a level of due diligence when looking into each company.  However, for investors who would like a shortcut and don't want to use my lists, another trick would be to choose stocks from the portfolios of the green mutual funds to match your intended sector allocation.  Even if we can't be sure that the mutual fund managers are good at stock picking, we can be fairly confident that they have looked into the companies in their portfolios and avoided the obvious scams.  

I tried such an approach by using stocks from the mutual funds' portfolios when I constructed my Quick Clean Energy Tracking Portfolio earlier this year.  The purpose then was not to outperform the mutual funds by better sector selection, but instead to match their performance at lower cost.  It didn't work out that way.  The portfolio vastly out-performed, which turned out to be due in large part to an unexpected bias towards riskier stocks than those in the funds, in combination with a strong upward trend for the overall market over the period in question.  

Even though that particular experiment did not work, the portfolios of the green energy mutual funds and ETFs are good places to start when selecting green stocks, and I will continue to do so myself.

For investors following the mutual fund or ETF routes to green portfolios, I give breakdowns by sector of each fund's portfolio in the linked articles on Green Energy Mutual Funds and Green Energy ETFs.

Part II of this series will attempt to help you decide how much to invest in green energy. (Link will be broken until publication.)


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

October 28, 2009

Why Do Green Energy Experts Buy Solar Stocks? 

Green energy experts accept that solar panels are one of the least cost effective ways to reduce your carbon footprint.  Nevertheless, many buy solar stocks.  They should rethink their investment strategies.

I recently spoke on "Stock Selection in the Era of Peak Oil and Climate Change" at the ASPO 2009 International Peak Oil Conference.  Whenever green energy enthusiasts find out that I analyze green energy stocks professionally, they react in one of two ways.  Many want to know my top stock pick in general (New Flyer Industries NFI-UN.TO/NFYIF.PK) or in their favorite sector (see below.)    Others tell me about their own green energy investments.  

My guess is that the latter group hopes I will stamp some sort of stock guru seal of approval on their portfolio.  If so, they usually go away disappointed.  This is not only because I have not yet been issued with a special seal by the stock guru union.  It's also because, even if I had such a stamp of approval, I would seldom need to use it. 

I find that even industry experts who know more than I do about green energy fail to apply that knowledge when it comes to investing.  Enthusiastic amateurs are often worse.  The typical green stock holdings of a brilliant cleantech engineer are a couple solar stocks, like First Solar (FSLR) and Sunpower (SPWR.)  People who will lecture tirelessly on the need to improve the efficiency of buildings before slapping solar on the roof don't walk the walk when it comes to their investment portfolios.  Instead, they take whatever portfolio they have, slap on a couple solar companies.  They forget all about the efficiency stocks and other, more cost-effective renewable options such as wind, geothermal, and biomass that they would recommend if they were asked about what we needed to decarbonize the economy.

Invest In What You Know, Use What You Know

To be fair, none of these people are professional investors. They cannot be expected to make the same sort of decisions that a professional would.  On the other hand, many are extremely knowledgeable when it comes to green energy.  The old adage "Invest in what you know" does not mean that a pilot should buy airlines.  It means that that a pilot will have more knowledge of the airline industry than an industry outsider, and my be able to use this knowledge to either choose between well-run and poorly run companies, or to have a better understanding of industry cycles, and buy when industry fortunes are on the upswing, and sell before a decline in profitability.  The key to successful investing is not depth of knowledge, but knowledge that other market participants lack.

Likewise, an energy rater will know that efficiency improvements will deliver much faster paybacks than solar PV.  Yet, based on my informal survey, energy raters are more likely to own a solar stock than an energy efficiency stock  Dedicated greens know taking mass transit or biking to work is much greener than any private car, even an electric one.  Yet these same greens are more likely to have investments in electric vehicles or battery stocks than investments in mass transit or bicycle companies.

"But I Don't Know any Energy Efficiency Stocks"

When I ask these people why their portfolios don't match their lives, they usually tell me they don't know what stocks to buy.  Ignoring the fact that people who aren't willing to do several hours of research for every stock they own should not be venturing into the Wild West of individual stock investing (don't say I didn't warn you) here are a few of my favorite investments in each of the major green energy sectors.

Sector Investments Related Articles
Energy Efficiency Waterfurnace, Cree, Flir Heat Pumps, LEDs, Infrared
Clean Transportation PTRP, New Flyer ETFs, New Flyer
Wind FAN Wind ETF, ETFs,
Transmission/Grid Quanta Services, ABB, General Cable Transmission shopping list
Batteries / Energy Storage Enersys, Exide, A123 Irrational Battery Investments
Solar Solar Millennium, Satcon Solar Shopping List
Geothermal Ormat Geothermal & the ARRA
Smart Grid Echelon, Telvent Smart Grid Shopping List
Biomass/Biofuel Aracruz, Plum Creek, Potlatch Forestry Stocks and ETFs

Note that this is not intended as a list of companies to buy now.  I currently consider most stocks to be overvalued, and am waiting for a market decline before buying again.  But, if you have an urge to buy a glamorous solar stock today, or are reading this article after the market has descended to more reasonable valuations, I hope you'll use this list to buy stocks in the sectors you know are greener, even if they're not as sexy.

The Right Questions

Using your knowledge from the real world to help choose your investments is another variation on the theme of Asking the Right Investment Questions I recently discussed.  The easiest way to gain an advantage over other market participants is to zig when emotional investors zag.  Solar has a lot of appeal because it lets anyone with a rooftop generate electricity, and emotional green energy investors tend to buy solar stocks.

It's difficult to underestimate the emotional appeal of the personal energy independence photovoltaics seem to promise.  Nevertheless, few rooftop solar installations do add to our personal energy security: They are grid-tied, and stop producing power whenever the grid goes down.  While solar panels can be a good investments with sufficient subsidies and tax breaks, or where electricity is extremely expensive, government subsidies and small markets with expensive electricity are not good foundations for the explosive growth that solar stock speculators are betting on.  

Financial modeling shows that solar will only be a significant part of the most effective carbon mitigation strategies if prices fall quickly and dramatically.  Such cost improvements are possible, but will come with the risk of extreme disruption for the current crop of solar stocks.

Investors swept up in the emotional appeal of solar stocks are providing those of us who pay close attention to the economics of green energy an opportunity to profit at their expense.  Taking advantage of the opportunity is not only likely to benefit the investor, it will also help the companies we do invest in raise capital.


DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

October 22, 2009

Asking the Right Questions: Why Invest in Clean Energy?

Often, knowing more about a company is less useful than knowing just a few of the right things.  Knowing the right questions to ask can help investors wade through a sea of mostly irrelevant information.

Take a moment to answer the following poll:

The key to this question was the stated goal of "outperforming other solar stocks."  An investor who is only hoping to achieve returns equal to the average solar stock would most likely choose to invest in an index of such stocks, most likely by purchasing shares of one of the Solar ETFs.  Hence, the assumption that an investor considering individual stocks is most likely looking for out performance.

Achieving out performance requires finding market inefficiencies.  In general, the market is efficient, meaning that most publicly available information is already incorporated into stock prices.  Information which is useful in achieving out performance, in contrast, is either not broadly available, or not broadly acknowledged.  Information may be available but not acknowledged because most investors have some behavioral or emotional reason for not seeking it out or believing it.

Hence, the best answer to the poll is "C. The most-followed analyst of MySolar made a mistake in his calculations, without which his estimate for next year's earnings would be 5% higher."   Although a 5% earnings mis-estimate is relatively small, all of the other answers refer to information which is likely to already be incorporated in the stock price.  The other answers refer to information which is likely to be broadly available, and hence will already be reflected in MySolar's stock price.

Ignoring the Obvious

While the example given above would be useful information, it would also be extremely difficult for a small investor to discover.  This is information which has not been incorporated into stock prices because only investors who have spent hours or days combing over analyst reports are aware of it.

Fortunately, it requires much less work to uncover useful information that other investors are ignoring for emotional reasons.  In other words, the astute investor can take advantage of others' denial.  As Upton Sinclair said, "It's difficult to get a man to understand something if his salary depends on him not understanding it."  More generally, we tend to deny the truth of facts that, if acknowledged, would require action we find costly or unpleasant.

I believe that the inconvenience and cost of dealing with the looming crises of climate change and peak oil are the main reasons that there continues to be a broad segment of the population intent on denying that they exist, despite the evidence to the contrary.  As a human being, I find this endlessly frustrating.  We're likely to continue burning coal and driving Hummers until some disaster forces us to reconsider the implications of our actions, even though the costs of dealing with the problems we are creating continue to escalate in the meantime.

The Fruits of Denial

As an investor, Climate denial and Peak Oil denial are the source of endless opportunities for investment out performance.  I may be forced to live on a planet that is being ruined by our collective denial, but at least I can console myself with profits arising from that same denial.

This, of course, is the main reason I focus my investing and writing on clean energy.  I don't have the patience to spend hours and hours looking for mistakes in analysts' stock reports.  Denial, on the other hand, will end slowly over time, as the defenders of the old order look increasingly more ridiculous.  As denial recedes, the facts, which have been obvious for at least a decade to those who were willing to see them, will continue to be incorporated into market prices, broadly helping companies whose business reduced net carbon emissions or oil consumption.

Clean energy investors would find themselves laughing all the way to the bank, if it were not for the fact that we're going to need every penny of profit to deal with the enormous mess we're likely to be in.  But that will be a lot better than being broke and in the same mess.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

September 30, 2009

Better, or Beta?

My Quick Clean Energy Tracking Portfolio has produced unexpected out-performance.  Is it because of high beta (β) in a rising market?

I recently asked why two portfolios which I had designed to track green energy mutual funds ended up out-performing them by a wide margin.  

This is the first of a short series of articles looking into possible causes.  Could the portfolios be outperforming because the stocks they contain rise more when the market rises (and fall more when the market falls) than do the mutual funds they were designed to track?  In other words, are they out-performing because of high beta (β) in a rising market?

A Beta Definition

From Wikipedia,

In finance, the beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole.[1]

An asset with a beta of 0 means that its price is not at all correlated with the market; that asset is independent. A positive beta means that the asset generally follows the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up and vice versa.[2]

That's a basic definition.  It's worthwhile to note that β changes for any stock or portfolio over time (usually slowly, but sometimes quickly in times of market turmoil.)  Measured β will also vary depending on the time increment used (are we interested in daily, weekly, monthly, or even hourly changes of a stock with respect to the market,) and it will also vary depending on which market index is used as a proxy for the market as a whole.  In my recent article on hedging using beta, I showed a graph with three measures of beta for my portfolio against various market indexes.

Mathematically, if S is a stock (or portfolio) and M is the market index, then

β = correlation(S,M) x /


β = covariance(S,M) / variance(M).

Either formula can be calculated with standard spreadsheet functions.  I gave an example using the first formula in my hedging article, and a spreadsheet using the latter formula is available here.  In both cases, the change in S will be β times the change in M, plus an error term which is uncorrelated to the change in M.

Why High Beta Would Explain Out-Performance

I created my tracking portfolios at the end of February, which was, co-incidentally, right before the stock market began its recent rise.  From this graph,


you can see that both tracking portfolios have out-performed nearly every possible benchmark.  In the first article in this series, I attributed the difference between the two tracking portfolios to "winner-loser" effects (hence the names of the portfolios.)  In theory, without these effects, those portfolios should have produced returns approximately equal to the average of the two.

Since the S&P 500 (my proxy for the market) gained 43% over the period in question, while the mutual funds gained 56% on average, and the tracking portfolios gained 80% on average, if β were the sole reason for the out-performance, we would expect that the average mutual fund β would be about 1.3 (=56%/43%) while the average tracking portfolio β would be about 1.9 (=80%/43%.)  There will be significant errors in these calculations (recall the random error term and other caveats from the definition of β), but we should at least expect that the β of the tracking portfolios is higher than the β of the mutual funds.

In fact, I do not expect that the out-performance of the mutual funds over the S&P500 will all be due to β.  In April, I argued that clean energy in general was outperforming the market due to the greater political support shown by the Obama administration compared to previous administrations, something I dubbed the "Obama Effect."  If this is true, then the β for the mutual fund portfolio will be less than 1.3, but β could still explain the out-performance of the tracking portfolios if their β is approximately 0.6 greater than the β for the mutual fund portfolio.

Calculating β

β for a portfolio is the weighted average of the β's of the portfolio's components.  Furthermore, Yahoo! Finance provides some pre-calculated β's (from Capital IQ, a  division of Standard & Poors), but not for all securities in my portfolios.  Furthermore, I was unable to determine the market index used to calculate the Yahoo! β's.

I used the last 200 trading days of stock market data for the securities in question, and the formula above to calculate β with respect to my market proxy, the S&P 500, using an Excel spreadsheet.  Here are the results:

Stock/Portfolio Beta (β)
CGAEX (Calvert) 0.916
ALTEX (First Hand) 0.912
GAAEX (Guinness Atkinson) 1.117
NALFX (New Alternatives) 0.812
WGGFX (Winslow Green Growth) 1.123
Mutual fund Portfolio 0.974
LSB Industries (LXU) 1.078
Echelon Corporation (ELON) 1.573
First Solar Inc (FSLR) 1.067
South Jersey Industries (SJI) 0.360
American Superconductor (AMSC) 1.675
"Winners" Portfolio 1.151
Citrix Systems (CTXS) 0.979
Echelon Corporation (ELON) 1.573
SunTech Power (STP) 2.186
Cemig (CIG) 0.996
Vestas Wind Systems (VWSYF.PK) 1.318
"Losers" Portfolio 1.410
Average of "Winner" and "Loser" portfolios 1.281

A Partial Explanation

The average β of the tracking portfolios is 0.3 more than the mutual fund portfolio β, but we needed a difference of about twice that to explain all the out-performance.  We also see the Obama effect here, which accounts for the 13% out-performance of the mutual funds over the S&P 500.

My calculated β's, plus the Obama effect on green stocks and funds, can explain an average performance of the tracking portfolios of about 70% over the time period in question, leaving about 10% of the out-performance unexplained. 

As I hypothesized in the previous article, this out-performance could also arise from the way I chose the stocks, which created a bias towards some Cleantech sectors (mostly efficiency stocks  and smart grid stocks) when compared to the mutual funds.  It could also be the mutual fund managers' skill.  In either case, however, an out-performance of 10% during seven months which have been as volatile as these last seven would not be enough for me to reach any firm conclusions.  10% is small enough to be a bias in my β calculations (recall that β depends on the choice of index as well as the frequency of the data used, and it also changes over time.)  10% could also be just luck.  

Since I won't be able to show that any out-performance which remains is not just luck, I see no need to continue this investigation.

An Inadvertent Discovery

It's interesting to note that the β for the "Losers" is higher than that for the "Winners."  In other words, I was wrong to attribute the out-performance of the "Losers" portfolio to winner-loser effects.  "Loser" out-performance is also explained by β.  Why do the "Losers" have higher β than the "Winners"?  Because the "Losers" were the worst-performing of a group of stocks from 2/27/2006 to 2/27/2009, over which period the S&P 500 fell 43%.  Since high-β stocks are likely  to fall more than low-β stocks when the market as a whole is falling, my "Losers" portfolio was biased towards high-β stocks.

None of this explains why the "Winners" portfolio also has higher β than the mutual funds.  While the "Losers" were selected with a high-β bias, the "Winners" were selected with a bias towards low-β stocks.  We would therefore expect that the "Winners" portfolio would have a β lower than the mutual funds from which they were drawn.  

Here are some reasons that the mutual fund β's are lower than the β's of their top holdings.

  1. Mutual funds need to maintain a cash reserve in order to meet redemptions.  Cash has a β of 0, and so an allocation to cash will lower the funds' β overall. For instance, the Calvert fund holds about 4% cash.  Without the cash, the Calvert fund's β would be 0.954 rather than 0.916.  However, the funds would have to be holding about 20% cash for this to be a full explanation.
  2. The greater emphasis of my portfolios on energy efficiency and smart grid technologies does not account for the bias.  The average β for these companies in my portfolios was about the same as the portfolios as a whole.
  3. The funds own a good number of diversified companies with exposure to green energy, but they do not own enough of many of these to put them in the top holdings of the funds.  One example would be Applied Materials (AMAT), a semiconductor firm with growing interests in solar.  Such firms will generally have lower β than pure-play firms, which is why I suggested readers invest in AMAT and nine other large companies with green energy exposure in the spring of 2008: I was concerned about a market decline (not that I had any clue how bad it would be) and low-β stocks are likely to fall less during declines.

Implication: More Bang For Your Buck

The discovery that the top holdings have higher β than the funds has some implications for tracking portfolio creation.  In order to better match the gains and losses of the mutual funds, we will need to invest less money.  By holding some cash, β can be lowered.  Alternatively, by investing the same amount, an investor can get more exposure to the positive trends affecting green energy, such as peak oil and the advent of carbon regulation.  

That's why we're here, isn't it?

DISCLOSURE: Tom Konrad and/or his clients own AMAT, LXU, ELON, and AMSC. The Guinness Atkinson Fund is an advertiser on his website,

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

September 24, 2009

Shorting The Least Green Companies

Newsweek recently released its 2009 Green Rankings for America's 500 largest corporations.  Investors would do well to examine the bottom of the list, as well as the top.

DISCLOSURE: Tom Konrad and/or his clients have short positions in DAL.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

September 08, 2009

The Black Swan and My Hedging Strategy

Nassim Nicholas Taleb's The Black Swan: The Impact of the Highly Improbable changed the way I trade; I can't give a book higher praise.  This isn't a book review; since the book is over two years old, and I did not get around to reading it until this Spring, I direct readers to this Foolish Book Review, which agrees with my viewpoint quite well, and to the New York Times for a detailed critique.  The latter seemed overly nit-picky to me, but then I'm a fan.

Human Biases

Recently, I've been writing that I expect a good sized market decline, and that I've been hedging my market exposure in response.  The Black Swan, however, is not so much about what we expect, but what we don't.  To massively oversimplify one of Taleb's major points, we (humans) tend to place too much weight on likely and easily imagined events, and not nearly enough weight on unlikely, difficult to imagine events.

In market terms, this should mean that we overvalue insurance against relatively likely, easy to envision events, and undervalue insurance against very unlikely, difficult to envision events.  Readers who have not already read the book can get some ideas of why we make these errors by reading the reviews referenced above, but you'll get a lot more out of it if you read the book itself.

For stocks and market indexes, it's generally more likely that the price will not change much than that it will change a lot.  In general, it's also easier to imagine a stock or market index returning to a value that it has reached recently or is at currently than rise or fall rapidly to something else.

In terms of financial options (which can be considered insurance against a stock's rise (calls) or fall (puts), this implies that options with strike prices near the current price or recent prices are likely to be over-priced, and options with strike prices that are quite far from the current or recent prices are likely to be under-priced.

That means that investors who are aware of this bias (which is unlikely to go away, because it is an artifact of human psychology) should prefer to sell options with strike prices near current or recent prices ("near the money") and buy options with strike prices that are far from recent or current values (far out of the money.)


I generally prefer to use options to hedge my positions because I find the margin requirements are less onerous.  Historically, I've reduced my exposure to the market by selling calls on index ETFs such as SPY, IWM and QQQQ.  For more detail, I wrote a longer post on five ways to hedge, and why I prefer selling calls.

 After reading the Black Swan, I've modified this slightly.  Now I

  • Sell calls that are just slightly in the money (according to the rationale above, these should be priced slightly too high, because they are insurance against likely events)
  • Buy an equal number of far out-of the money calls with the same duration at a considerably higher strike price.

This combination is known as a "call spread."   The calls I sell are much more valuable than the ones I buy, so this spread still loses value when the market rises, and gains value when the market falls.  The moves are not quite as large as they would be for just short calls, so I take slightly larger positions to achieve the same size hedge.

The advantage of hedging with this sort of spread is what happens when things go wrong.  The call spread can only produce finite losses when prices rise, while a short call can produce theoretically infinite losses.  Furthermore, the long out-of the money call position is likely to be underpriced (according to the theory above), which means that it should be an effective use of funds to buy this sort of protection.

The one problem with both short calls and short call spreads as hedging strategies is that they become less effective as the index falls.  If only a small correction is expected, this can actually be an advantage, because as the market falls, the portfolio's beta will naturally increase. 

If the market falls and a hedge is still desired, the downside protection can be enhanced by buying back the short call part of the spread, and selling a new batch of short calls at a strike price closer to the index's new value.

In Short

In other words, the main change in my hedging strategy in response to The Black Swan was the purchase of far out-of-the money calls on the same index I was using to hedge.  This does not have to be done as part of a short call spread; the same advantage arising from the under pricing of far out-of-the-money options can be exploited on its own, or as part of a short-based hedging strategy.

So far, my change in strategy has served me well, since the market has been going up when I expected it to head down.

DISCLOSURE: Tom Konrad and/or his clients have short positions in SPY, IWM, and QQQQ.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

September 07, 2009

Five Hedging Strategies for Stock Pickers

Instrument Advantages Disadvantages
Short & Ultrashort ETFs Can use in any brokerage account Sacrifice of upside potential, and loses money over time in volatile markets.
Sell Covered Calls on stocks in portfolio Makes money in flat markets Sacrifice of upside potential; hedge against small declines only.
Buy Puts on index or specific stocks No loss of upside; protects against large losses Works like insurance; has up-front cost.
Short the index Protects against full range of index declines Sacrifice of upside potential; must pay dividends
Sell naked calls on the index Makes money in flat markets Sacrifice of upside potential; limited downside protection.

I list buying Short and Ultrashort ETFs first because this is the option which is most easily available to all investors.  If you can buy stocks, you can buy Short or Ultrashort ETFs based on dozens of market indexes.  If the underlying index rises (falls) by 2% in a day, a corresponding Short ETF will fall (rises) by approximately 2%, and an Ultrashort ETF will fall (rise) by 4%.

Unfortunately, Short and Ultrashort ETFs (along with related leveraged ETFs) have a fatal flaw which makes them unsuitable for long term use.  When the underlying index is volatile, these instruments lose money over time due to the geometric nature of compounding.  To give an example, SH is a short ETF designed to produce the inverse of the S&P500 daily return.  The S&P500 closed on August 4 at 1005.65.  On September 3, it closed at 1003.24, a decline of 0.25%.  Over the same period, SH lost 0.1%, compared to the 0.25% gain you might expect.  Annualized, that's the equivalent of losing about 4.5%.

To show that this is the result of the underlying structure of SH, and not poor execution on the part of the ETF manager, we can see the same effect in a simple example.  Suppose on Tuesday the S&P500 were to go from 1000 to 1100 (a 10% gain), and then fall back to 1000 on Wednesday (a 9.1% decline.)  SH would fall 10% on Tuesday, and gain 9.1% on Wednesday, for a net loss of 0.90 x 1.091-1= -0.018 = -1.8%.  I go into more detail in my article on Ultra ETFs from February, but the result is that these instruments are not suitable for hedging.

Selling Covered Calls on the stocks in your portfolio requires the most basic level of options permission from your broker.  Given the very low risk of this options strategy, however, you do not have to have extensive knowledge or experience with options to get permission to sell (or "write") covered calls.  You can follow the link for a detailed how-to; I'll stick to the advantages and disadvantages of covered calls as a hedging strategy.  

There are two main advantages.  First, covered calls are tools which are reasonably available to most stock market investors with only the hour or so of work which is required to get low level options trading permission from your broker.  Previous options trading experience is unlikely to be necessary, and this is a good way to get options trading experience if your broker requires it in order to start using more sophisticated options strategies.

Second, you only need the market to not go up in order to be better off by selling covered calls.  Ideally, the market will be relatively stable, and you will not lose money on your stocks, but you will make gains on the calls you write.  

The disadvantages of covered calls are that your downside protection is fairly limited, usually to declines of 5-10%, while you give up all the potential of upside gains in the underlying stock.  This is a strategy I use with stocks that I don't think have much potential for outsized gains. Selling covered calls is an incomplete hedging strategy offering no protection against large market declines, and so I use it only in conjunction with at least one of the other strategies listed below.

Buying Puts is very much like buying insurance on your portfolio.  If you want to protect against large declines in specific stocks, you can buy puts allowing you to sell those stocks for a fixed price at a later date.  If you want to protect against a large decline of an index, you can buy puts on that index (or index ETF) which will settle for cash if the index falls below the strike price, or you can buy the ETF at the future reduced price, and sell it at the strike price for a profit, offsetting losses elsewhere in your portfolio.

The main advantages of buying puts are that they offer complete protection against declines past the strike price of your choosing, and there is no loss of upside potential in your portfolio. Puts are one-sided bets.  Like most one-sided bets, they come at a cost.  The insurance puts offer requires paying a premium, and that premium must be renewed when they reach their expiration date.  

Another advantage of buying puts is that it is only slightly harder to get options permission allowing you to buy puts than it is to get permission to sell covered calls.  The strategies which follow both can entail theoretically unlimited losses, and getting permission from your broker to use them is correspondingly more difficult.

Shorting the Index (or index ETF) is the classic way to hedge.  When the index goes up, you lose money on your short position, but your stock portfolio should be rising as well, insulating you from the market move.  When the index declines, the gains in your short position offset the expected losses elsewhere in your portfolio.

The main advantage of shorting the index is simplicity.  Unlike options strategies, you do not need to periodically renew your positions as options expire, or to adjust your exposure as the sensitivity of the options changes with market moves (more about this below).  The main disadvantages are that you will need to pay any dividends declared on the security you are shorting, and you generally do not earn interest on the cash retained in your margin account to cover the short position.  If the short moves against you, you may even have to come up with more cash to cover the short position, or begin paying margin interest.  This is in contrast to selling/writing calls, where you are able to earn interest (or even re-invest the cash received.)

Selling (Writing) Calls on the Index (or index ETF) is a hybrid between selling covered calls and shorting the index.  Unlike shorting, the balance which you need to maintain to cover the position will usually accrue interest, and you will also tend to make money on the premiums for which the calls were written if the index stays relatively flat.

This does have the disadvantage that there is little protection against declines in the index below the strike price of the call you sold.  However, you can sell calls with strike prices considerably below the current level of the index (although this comes at a cost of smaller gains when the index is flat.)  Another strategy is to continue selling more calls dynamically as the index declines, which works so long as the market does not decline so quickly that it is difficult to find call buyers at reasonable prices.

This has long been my primary hedging strategy, but I have recently shifted to a slightly more complex (if related) hedging strategy of selling short call spreads.  I will publish a short article about this strategy later this week, when you can find it at the previous link (which will be broken until then.)

How Much to Hedge

You now should know which market factor you want to hedge against, and which hedging instruments you plan to use.  It's theoretically possible to calculate the precise number of options or shares to use in your hedge in order to achieve a particular exposure.  The calculation depends on the variances and covariances of the various instruments and securities in your portfolio with the index and each other.  These statistics not only require considerable market data and number crunching to calculate, but they are prone to change over time and in different market conditions, making such calculations extremely complex and even unreliable in practice.  

Fortunately, there is a much simpler way to determine and refine the effectiveness of your hedge.  The only data you need is daily price date for the index you have chosen to hedge against, and the daily total value of your account.  The daily historical values of your account are not usually available from most brokers, so this requires logging in each evening and recording the account value.  Fortunately, the method still works if you miss a day here or there.

Set up a spreadsheet with columns as follows:

Date Index Acct Index Change Account Change Beta
A1 B1 C1      
A2 B2 C2 D2=B2/B1-1 E2=C2/C1-1  
... ... ... ... ...  
A3 B20 C20 D20=B20/B19-1 E20=C20/C19-1 =CORREL(D1:D20,E1:E20)*



A4 B21 C21 D21=B21/B20-1 E21=C21/C20-1 =CORREL(D2:D21,E2:E21)*




Once you have the first 20 rows filled in, you can just copy the final 3 columns from a previous row in order to continue the sequence.  Note that corrections will need to be made in the "Account Change" column if you take money out of or put money into your account.

The formula in the "Beta" column uses Microsoft Excel functions to calculate the Beta for your account relative to the index over the last 20 trading days (approximately 1 month).  In other words, for every 1% change in the index over the last 20 trading days, your account changed Beta percent.   A perfectly hedged account will have a Beta of 0. 

Below is a graph of Beta for my largest account for this year against three indexes: The S&P500, the Nasdaq, and the Dow Jones Total Stock Market index.  The magenta line shows the trend for the account itself, while the red line is a composite of those three indexes (click on the chart for a higher resolution view.)


As you can see, I started the year with a Beta of around 0.6. At that time, I was participating in 60% of the gains and losses from general market trends.  I maintained a moderately positive Beta at the start of the year because I was cautiously bullish on the market as a whole.  In April, I began to feel that the market was advancing too far, too fast and I began to increase my hedge by selling calls on market index ETFs.  By early June, I had become increasingly bearish, and published my market call saying "we're near the peak."  Since then, I have continued to hedge, and now the account has a Beta near zero, meaning that changes in the account value will have more to do with my particular stock picks than with general market moves.

By monitoring your own spreadsheet, you can have a good idea how effective your hedge is operating.  If you expect the market to decline, you should keep your own account's Beta at zero, or even negative.  If you're aggressively bullish, you'll want a Beta near 1 or higher.  You can raise your account's Beta by decreasing the size of your hedge or adding to your stock portfolio, and you can decrease your account's hedge by selling stocks or adding to your hedge.  This is what I meant earlier when I referred to "selling more calls dynamically."

A Watchful Eye

The key to hedging is regular monitoring, preferably daily.  The increase in my account's Beta in June was not due to me decreasing my hedge, but to changes in the internal correlations of the market.  You account's Beta will tend to drift over time due to such changes, and effective hedging requires that you make occasional trades to keep it near the desired level.

For most investors, the daily monitoring required to keep a portfolio properly hedged is probably too much work.  If that is the case for you, and you also feel that the market is likely to decline, the best strategy is probably to sell most of your stock portfolio and wait on the sidelines until the market declines to better valuations.  The use of simple hedging strategies such as shorting the index may compensate somewhat for less frequent monitoring, but changing market conditions mean that even this strategy is probably only appropriate for relatively active investors.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

August 04, 2009

When Market Calls are Wrong

Tom Konrad, Ph.D., CFA.

My recent market call now looks premature.  What lessons can we learn?

When we make market predictions, we will inevitably be wrong some of the time.  I stuck my neck out at the start of June, saying "We're near the peak."  I later gave some numbers to allow readers to objectively judge if that call was right or wrong.  I said that we should consider it an accurate call if the S&P 500 fell 20% (to 756) before it rose 5% (to 992.)  The S&P 500 has not yet come near 756, but it closed at the end of July at 987, very close to my upper limit.  Although I remain bearish, I'm getting ready to admit that that market call was wrong, quite possibly before you read these words.

Why did I do it?

Before I made that call, I knew that the market had a good chance of proving me wrong.  At the time, I said "This is mostly a gut feeling, but when it comes to predicting market moves, most methods (including my gut) are pretty worthless."  Knowing that, why did I not just keep my mouth shut, and avoid subjecting myself to potential derision from readers?  Furthermore, why am I now highlighting my probable mistake when I could just as easily choose not to write about it and distract readers with an article about a hot wind or solar stock?

Because I value my own humility.  I write about many stocks to buy or sell, and it would be easy to find examples of outstanding performance, and forget about the calls that did not turn out so well.  One of the more important benefits I get from writing my thoughts about the market is a permanent record of what I was thinking when I made the choices I did.  Writing for an audience encourages me to work through and put down my thoughts at the time in much more detail that I would if I were just writing for myself.  

By reviewing old articles, and conducting regular performance updates, I have a much better idea of when I was right or wrong, and why, giving me an opportunity to learn from my mistakes.  The times I have been wrong also serve the valuable function of keeping me humble.  I believe that an investor who loses his humility will soon lose his money as well.

What can I learn?

I can't say I've learned much from this market call, since I already knew that most methods for predicting market moves (including my own) are pretty worthless.  I'm still bearish, now thinking that the market call was too early, rather than wrong about the direction of the market. But the too-early call (if that is what it turns out to be) has helped keep me in touch with my humility.

One reader recently asked

Why bother waiting to buy? Why not short the market and go long in these companies? Hedge out beta and you can take advantage of any edges these companies have without exposing yourself to the market. No waiting necessary.

The answer is simply because I know I could be wrong.  At this point, I am still bearish, and I have "hedged out Beta" as the reader described; my portfolio as a whole has a Beta of somewhere between -0.1 and 0.2, as well as much lower volatility than the market as a whole.  This means that I am unlikely to make or lose money due to moves in the market as a whole, although I can still make or lose money on my particular stock picks.  But if I were confident in my market calls, I would actually take my Beta negative with additional shorting, and make money as the market fell (or lose money as the market rose.)

I don't have that sort of conviction, and hence I wait in a neutral stance for either a market decline, or some other significant circumstance to change my mind.

The Benefits of Staying Out

Along the way, I talked a little about why it makes sense to get out of the market, even when you know you might miss a large upside move.  I noted that an investor who manages to miss the greatest annual market declines at the price of also missing the biggest annual gains still comes out ahead, and commented that "The same will hold true for potential monthly, or daily  returns."  I thought it might be useful to back up that statement with a decade of monthly returns. 

Standard and Poors provides a spreadsheet of monthly returns for the S&P500 here.  For the ten years from July 1999 to June of 2009, the total return was -20.1%.  The following chart shows the results of eliminating the n best and worst months over that period.

Total returns if an investor were to sit out of the stock market for the n best and/or worst months from July 1999 to June 2009.

Number of months missed Eliminating the best months only Eliminating the worst months only Eliminating both the best and worst months
0 -20.1% -20.1% -20.1%
1 -27.2% -4.0% -12.6%
2 -33.6% +7.7% -10.5%
3 -39.0% +20.5% -7.9%
4 -43.9% +32.6% -6.8%
5 -48.2% +45.6% -5.5%

While I would clearly have lost touch with my humility if I thought I might be able to accomplish the returns possible by only skipping the worst months in the market, it is more reasonable to assume that I might be able to miss the worst months if I were also willing to miss out on the best months.  

The asymmetric nature of stock market returns, with the bad months being worse than the good months are good means that this strategy also outperforms, as seen by the successively smaller negative returns in the last column.  Just to make sure that this is not an artifact of the past decade of lousy stock markets, I also looked at the whole period supplied by S&P:

Total returns if an investor were to sit out of the stock market for the n best and/or worst months from February 1988 to June 2009:

Number of months missed Eliminating the best months only Eliminating the worst months only Eliminating both the best and worst months
0 +482% +482% +482%
1 +422% +600% +528%
2 +376% +718% +569%
3 +334% +818% +583%
4 +296% +927% +598%
5 +263% +1030% +604%

As you can see, the pattern holds true, with the worst months hurting returns more than the best months help returns over the longer period.

In other words, it's worth looking like a fool by missing a really good month in the stock market if it also means that you avoid a really bad month at some other time.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

June 15, 2009

Clean Energy Stocks Shopping List: FAQ

Stocks may be expensive now, and the temptation is to buy before they get even more expensive.  Why patience makes the brokerage account golden.

Tom Konrad, Ph.D., CFA

On Friday, I started a series on stocks I'd like to buy when they are cheaper.  The first was on clean or efficient transport stocks which will benefit from both Climate Change regulation and high oil prices due to Peak Oil. Before I continue on with my Clean Energy Shopping List series, I think it's worth talking about the underlying strategy, since it can be counter-intuitive, and I expect that many readers may have some objections.  So here's a FAQ about my strategy.

Q: Most people think that the stimulus will work and the economy is getting back on track.  Why should I trust your judgment that this is a bear market rally?

Market prognosticators are notoriously bad at predicting the markets.  This is not surprising, since part of what causes high levels of stock market valuation is lots of people buying because they think the market will continue to go up.  I tend to think of what "most people" think as a contrarian indicator.

That's not to say I'm right with any certainty, but I have reasons.  Right now both the consumer and companies are tightening their belts.  Although  the stimulus package may boost Clean Energy, for the overall economy, I feel it's likely only to lessen the blow.  Companies are looking to raise money through IPOs and share offerings, while the US personal savings rate has increased substantially.  Meanwhile, governments are issuing unprecedented amounts of debt to pay for stimulus packages and recession induced budget deficits.

With consumers paying down debt and the government and companies soaking up cash, where is all the new money going to come from to buy stocks and keep driving them up?

Q: What if I miss out on a big bull run?  I need to make back my losses from 2008 in order to retire/send my kids to college/take that vacation.

The stock market does not take your needs and wants into account.  The market is decidedly not fair, and if you make investment decisions based on your needs, you clearly are not paying attention to the true forces that guide the market.  After 2008, unprecedented numbers of retired people are going back to work because they can no longer afford to be retired.  Do you think the market paid any attention to their needs?  Do you think that it is going to pay any attention to yours?

The only one looking out for your needs is you.  Not your mutual fund manager, not Jim Cramer, and quite possibly not your financial advisor.   Looking out for your own needs involves making hard decisions, getting some exercise when you'd rather be eating pork rinds on the couch with your DVR.

Q: I've heard that it makes no sense to time the market, because nearly all the market gains come from just a few short periods.  If I miss those periods, I miss out on all the gains.

See the question above... thinking only about what you're missing out on is a sure way to get into trouble.  Stop an consider what might be gained by missing out on the worst periods.  Consider this chart of the percentage annual returns from 1825-2008.  The six highest returns were all in the 60% range, meaning that if you'd missed those six years, you would have less than 1/16 as much money as someone who had stayed in the market for the whole period.  However, the six lowest returns are two -50% returns, one -40% return, and three -30% returns.  If you'd missed those worst years, you'd have twenty times as much money than you'd have had if you had stayed in the market for the whole period.

We have to assume that we don't have perfect foresight, but even if we miss as many good years as we miss bad years, we still come out ahead.  If we miss both the best and worst year over the period, we end up up 25% over where we'd otherwise have been.  If we miss three each of  such good and bad years, we end up 62%, if we miss all six of each, we end up up 15%.   In other words, the bad years are a lot worse than the good years are good, and we only have to miss the extremes to come out ahead.  If we're even slightly better than that, i.e. missing five good years for every six bad ones, the potential gains are enormous.  The same will hold true for potential monthly, or daily  returns, since most of us are not investing to a 200 year time horizon, but a 200 month (12 year) time horizon is something we might be thinking about.

These returns are more impressive when you consider that the average annual return for the period was significantly positive: Skipping any 12 random years would ordinarily produce worse, not better, returns.  Also, when not in the market, you could place your money in short term treasury bills or a money market fund, and have earned interest, which would also add up over twelve skipped years.

In other words, if the market is likely to be unstable, it makes sense to get out, even if that means you might miss a big rally.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

June 02, 2009

Market Call: We're Near the Peak

Tom Konrad, Ph.D.

The current rally from the March 5 bottom has been breathtaking, especially in Clean Energy, with my Clean Energy Tracking Portfolio up 70.5% since it was assembled at the end of February (as of May 1), 11% higher than it was at the three month update last week, and the S&P 500 is up 41% from its March low.  Even in a better economic climate, gains of this magnitude would have me running for cover.  In the current economic climate, with a gigantic mountain of debt keeping consumers out of the stores, makes me feel this bear market rally does not have much farther to go.

This is mostly a gut feeling, but when it comes to predicting market moves, most methods (including my gut) are pretty worthless.  I've actually felt that this rally was on its last legs for the past month, and it continues to head higher. It's easy to predict the market, and then point back to the times you have been right, which is why I don't generally make calls like this publicly.

On the Sidelines

Why am I making the call?  Because I don't have anything to say about specific stocks.  The recent moves have been so extreme, I can't find any stocks that I'd want to buy anywhere close to these levels, and so I can't get excited about writing articles encouraging anyone else to buy them, either.  Maybe I'll research something to short, like First Solar (FSLR)

Until then, I've been selling covered calls on what I do own, to hedge some of my downside risk.  Unlike selling Cash Covered Puts, a bullish strategy I've discussed in the past, selling covered calls reduces your overall risk, so most investors (even relatively inexperienced ones) can get the necessary options permission from their broker.  US laws even allow selling covered calls in IRAs.


DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

March 28, 2009

Do You Need To Invest In Oil To Benefit From Expensive Oil?

Two months ago, Tom told us how he'd dipped a toe into the black stuff (i.e. bought the OIL etf) on grounds that current supply destruction related to the depressed price of crude oil would eventually lead to the same kind of supply-demand crunch that led oil to spike during the 2004 to mid-2008 period.

If you need evidence that the current price of crude is wreaking havoc in the world of oil & gas exploration, look no further than Alberta and its oil sands. The oil sands contain the second largest oil reserves in the world after Saudi Arabia, but more importantly will account for the lion's share of incremental supply as conventional oil production continues to decline. The province's economy, which had been growing at a breakneck pace for the past five years, has come to a grinding halt: employment insurance claims grew by twice the Canadian average over the past year; personal bankruptcies jumped by 61%; and home foreclosures are on the rise. This is the result of significant project cancellations that will no-doubt limit Alberta's ability to ramp-up output once prices climb back again.

It is thus no surprise that Cambridge Energy Research Associates and others are warning about the economic hazards of curtailing investments into conventional and alternative energy.  

Alt Energy & Fossil Energy

Oil being the most followed of the energy commodities, it is no surprise that it is receiving most of the media attention. Arguably, natural gas and coal prices should matter more to alt energy investors than oil prices: according to REN21, of the $71 billion invested in renewable energy in 2007, 47% went into wind and 30% into solar PV. Both technologies are used for power generation (investments into transportation alternatives are comparatively small) and, in the US, coal and natural gas are the dominant fuels in power production. The relentless focus of the popular press and other pundits on the the economic case for alternative energy being closely tied to the price of crude oil is thus mostly misplaced.

Case in point, last November, a reader wrote me with a correlation analysis conducted over a 5-year period (or, where there wasn't five years' worth of data, since inception). The correlation coefficients between the returns on crude oil and those on alt energy securities were as follows: GEX, 0.19; PBW, 0.14; TAN, 0.18; and the index underlying FAN, 0.19. These are, by most measures, pretty low correlation coefficients. Given the reader's reputation, I trusted the numbers. 

Nevertheless, in alt energy investing as in life, perception is often reality. Given the many signs pointing toward a rapid escalation in crude prices - demand can and will rebound far quicker than supply - I decided to re-explore the relationship between fossil and alt energies. If a strong positive correlation can be found between alt energy investments and crude oil, natural gas and coal investments, there may not be a need to dip a toe into the black (or colorless) stuff at all - one can focus on alt energy alone and still enjoy the ride up.

In order to verify this, I ran a basic correlation analysis with the daily returns on the KOL (coal), OIL (crude) and UNG (nat gas) ETFs/ETN on the one end, and the daily returns on the alt energy ETFs on the other. I got the return data from Yahoo Finance using the Adjusted Close prices that include dividends and splits. Given the results above from our reader's analysis, I only went back six months to see if the (lack of a) relationship still held.   

OIL and UNG track the prices of futures contracts in the underlying commodities, so they are pretty decent securities to use to estimate the returns on crude and nat gas investments. KOL, on the other hand, tracks a basket of coal company stocks. It's the closest thing I could find but it's not ideal as stock returns don't necessarily track commodity returns. For instance, large mining firms will often sell a high proportion of their output through fixed-price contracts, preventing them from benefiting from sudden surges in spot prices. 

The boxes delineate general alt energy ETFs (ICLN to GEX), the solar ETFs (TAN, KWT) and the wind ETFs (FAN, PWND). There aren't any notable differences between the ETF categories, with the most significant differences being between the fossil fuel ETFs/ETN and the alt energy ETFs.   

The relationship between alt energy stocks and coal stocks appears relatively strong. However, in the absence of return data on coal, it's hard to tell whether investing in alt energy stocks (or coal stocks for that matter) is an optimal way of playing increasing coal prices. Given the structure of the coal market, with significantly less involvement by purely financial actors than in oil or natural gas markets, this is a hard one to play for retail investors, although data appears to suggest there is a play.

Though the correlation appears to have strengthened somewhat between crude oil and alt energy investments in the last six months, it remains weak enough that if someone wants to play a return to expensive oil they are still better off dipping a toe (or even an entire foot!) in the black stuff. The same holds for nat gas.

This quick and dirty analysis wouldn't withstand close methodological scrutiny. My only intent here was to see whether these relationships were worth exploring further - they are not. If you want to benefit from crude oil and nat gas price increases and have no ethical qualms about it, invest in them directly!

DISCLOSURE: Charles Morand has a long position in TAN.

DISCLAIMER: I am not a registered investment advisor. The information and trades that I provide here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

March 05, 2009

A Quick Clean Energy Tracking Portfolio

Yesterday, I outlined a strategy to approximately replicate the performance of a Clean Energy mutual fund at much lower cost, with only a couple hours of effort.  I gave a cost example based on $5000 invested in 5 stocks, with another $1000 worth of a single stock added in each subsequent year.  

This is the procedure I would use to select the initial five stocks.

  1. Collect all the top five or ten holdings of the available Clean Energy mutual funds.  This data is available from Morningstar, and on fund sponsor's home pages.
  2. A few of these holdings may be international, and not available through your stock broker to small purchasers.  Eliminate them from consideration.
  3. Organize the remaining companies by cleantech sector (we have stocks listed by sector on out Cleantech Stocks page, or you can select sectors yourself by reading the company profile on Morningstar, or the company's home page.
  4. In the top five sectors, rank the companies by recent performance (1-3 year.)  Recent underperformers tend to do better in subsequent years, so choose the worst performers. 

In subsequent years, look at your portfolio, and pick a single stock which you do not yet own from a sector which is relatively underrepresented in your current portfolio.  Such under-representation could occur because your other sectors have been outperforming that sector, or because you have been picking more stocks from other sectors in recent years.

Stocks Green Mutual Funds Own

Here are all the stocks listed in the top 5 holdings of the clean energy mutual funds compared in my recent article: American Trust Energy Alternatives Fund (ATEAX), the Calvert Global Alternative Energy Fund (CGAEX), Firsthand Alternative Energy (ALTEX), Guinness Atkinson Alternative Energy Fund (GAAEX), New Alternatives Fund (NALFX), and Winslow Green Growth Fund (WGGFX), along with CleanTech sector and 3 year performance (obtained from  I have eliminated several which investors would need to purchase on foreign markets.  Many brokers have minimum transaction sizes and higher fees for such transactions.. 

If you were putting together a larger portfolio this way, you might also look at the top holdings of the Clean Energy ETFs, and/or expand the search to the top 10 holdings of each fund.

Stock In Fund(s) Sector 3 yr Annual
ADM American Trust Ethanol -5%
CTXS American Trust Efficiency -14%
WFFIF Winslow Efficiency -10%
LXU Winslow Efficiency 10%
ELON Firsthand Grid -10%
STP Firsthand Solar -45%
FSLR Winslow, AmericanTrust Solar 216%*
CIG Guinness Atkinson Utility -2%
FPL Calvert Utility 6%
SJI New Alternatives Utility 11%
VWSYF.PK New Alternatives Wind -17%*
GCTAF.PK Calvert Wind -6%
AMSC Winslow Wind 10%
* Average annual return based on less than 3 years' data.

Since we are looking for 5 stocks, and 6 different sectors appear in the chart, we have a choice of one sector not to include.  I personally don't feel that most of the utilities listed belong in a clean energy fund, because most of them produce more than half of their power from fossil fuels, with the exception of Cemig (CIG), which is mostly hydropower.  If Cemig were not in the list, I'd drop the utility sector.  However, since it is in the list I choose to drop the Ethanol sector instead, given the questionable environmental benefits of ethanol.  

Note that I am not making this decision based on the sector which I think will perform the best, because I am attempting to do this exercise using only information which a small investor who is interested in clean energy might have at his fingertips, and predicting stock moves is not something that should be tried by someone only willing to devote a few hours a year to their investments.

Taking the stock which has the worst previous 3 year performance from each of the remaining categories, I arrive at this portfolio, based on closing prices on February 27, 2009:

Company Shares* Price
Citrix Systems (CTXS) 48 $20.58
Echelon Corporation (ELON) 165 $5.99
SunTech Power (STP) 162 $6.09
Cemig (CIG) 72 $13.66
Vestas Wind Systems (VWSYF.PK) 22 $44.85
Total portfolio cost: $5,000 including $65 brokerage commissions

My hope is that this portfolio should roughly track a basket of the six mutual funds it is based on, but outperform due to its lower costs and the strategy of picking previous underperformers.  For comparison, here's the mutual fund portfolio:

Fund Shares Price
ATEAX (American Trust)  82.43 $10.11
CGAEX (Calvert) 122.19 $6.82
ALTEX (First Hand) 171.47 $4.86
GAAEX (Guinness Atkinson) 205.76 $4.05
NALFX (New Alternatives) 29.75 $26.68
WGGFX (Winslow Green Growth) 111.71 $7.46
Total portfolio cost: $5000, including $39.58 front-end load on NALFX

A year from now, I plan to take a look at how the two portfolios performed, and choose another stock to add.

Tom Konrad, Ph.D.

DISCLOSURE: Tom Konrad has long positions in  ADM, WFFIF, LXU, ELON, GCTAF, and AMSC.  GAAEX is an advertiser on

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

February 11, 2009

UltraPromises Fall Short

When I first came across ProShares' UltraShort ETFs, I thought they were a brilliant idea.  They seem to promise a multitude of advantages for investors:

  • The ability to hedge market or sector exposure without having to go short.  (Going short requires a margin account, and US law prohibits the use of margin in most retirement accounts.)
  • They should have a better risk profile than shorting.  With an UltraShort, you can't lose more than your initial investment.  With true shorting, the potential losses are unlimited.  As the underlying index rises, each percentage gain creates a smaller dollar fall, while successive declines in the market index should produce successively greater gains.
  • They should tie up less capital than Short ETFs for a similar effect.
  • Unlike with option strategies, there is no need to choose an option expiration date by which the market move will have occurred.

Unfortunately, it's not so simple.  All Short, UltraShort, and Leveraged ETFs under-perform the seemingly equivalent long or short position in the underlying index, and the underperformance will be worse the greater the leverage and the more volatile the underlying index.  This is stated in the prospectus, but the fund sponsors understate the magnitude of the problem.

I'm far from the first person to write about this.  In fact, I made the mistake of including an UltraShort ETF in my 10 Clean Energy Stocks for 2009 as one option for a market hedge, because I feel that the downside risks for the market as a whole this year outweigh the upside potential, and I expect that many of my readers may not be using margin accounts.  The other possible hedge I mentioned was to "reduce the allocation to large cap stocks" elsewhere in the portfolio.   In some ways, my inclusion of SDS in the list was fortunate, because a commenter trashed UltraShorts, and brought the problem to my attention. 

The Bad, The Worse, and the Appalling

Others have done a decent job of explaining why leveraged funds underperform, as well as looking at the evidence in the historical data, but despite considerable time on the subject with Google, I have not seen any quantification of the penalty an investor in these funds will pay.   So I did an experiment.  I put together a spreadsheet which randomly generates a year's worth (200 trading days) of data from an index for which the daily percentage move follows a normal distribution, except the last 10 days which are calculated to bring the index back to its starting value.  

I recalculated my spreadsheet about 30 times each for 1%, 2%, 3%, 4%, and 5% standard deviation of the distribution of percentage changes in the underlying index.  The table below shows the range of percentage losses I observed for each type of leveraged ETF.  I was a bit surprised to note that Short ETFs and Ultra (x2) ETFs had approximately the same underperformance, while UltraShort (x-2) and Triple (x3) leveraged ETFs also seemed to have the same long term underperformance/frictional losses.

Mostly, I was appalled.

Standard Deviation of Daily Index Returns

1 Year Leveraged ETF Underperformance / Frictional Losses

Short (x-1) and Ultra (x2)  Ultrashort (x-2) and Triple (x3)
Min Max Min Max


1% 4% 4% 8%
2% 7% 13% 18% 26%
3% 14% 24% 34% 53%
4% 24% 43% 64% 74%
5% 32% 60% 67% 96%


I feel the need to give examples of how to read the above table, because some readers might suspect that they don't understand the results.  I did the calculations myself, and I can barely believe them. 

Based on data from October 22, 2008 to January 26, 2009, the S&P 500 had a daily standard deviation of 3.62%.  If you were to invest in SDS, an UltraShort ETF which has the S&P 500 as its underlying index, and were to hold it for a year, you should expect to lose between 34% and 74% of your money, if the S&P 500 is flat for that period.  This assumes that there are no transaction costs, and that the expense ratio is 0% (in fact, it's 0.91%.)  My experiment also assumed that daily stock market returns follow a normal distribution.  In fact, the the distribution of daily stock market returns is leptokurtotic (it has fat tails.)  According to my mathematical intuition (the Ph.D. is in math, in case you were curious,) if I had performed the experiment with a leptokurtotic distribution, the losses would have been larger.  Obviously, this could be checked, but the results are bad enough as it is.

To put this another way, if your frictional losses were in the middle of the 34-74% range (55%, including the expense ratio,) the S&P 500 would have to drop 27.5% (=55%/2), for you to just break even.   In 2008, the S&P 500 fell 39%.   If you wanted to make a profit by buying SDS on January 1, and holding it until the end of December, the S&P 500 would have to fall from $903 on January 1 to below $654 by the end of the year.  You would do much better (by limiting your potential losses and making profits on a smaller drop in the S&P 500) by buying December 2009 puts on SPY, an unleveraged ETF which tracks the same index.

It simply does not make sense to hold these funds for anything more than a few days (if that.)  The S&P 500 is one of the least volatile indexes around, so the example above is a mild one.   One reader of my recent crude oil speculation article suggested that I use DXO (an Ultra) or ERX (a Triple) instead of OIL.  Using historical data from October 23, 2008 through January 28, 2009, the daily volatility of OIL was 5.18%, implying a 67% to 96% loss in ERX over the course of a year if crude oil prices do not rise.  Although I expect oil prices are headed up, I'm not willing to bet it will happen in the next couple of weeks (over which time an investor in ERX might expect to lose 1-2% if crude prices did not rise.)  

It is worth noting that current volatility is much higher than it has been historically.  However, volatility always goes up in bear markets, precisely the time I would want to use these as a hedge.

What Can You Do?

Short and UltraShort ETFs are not appropriate for creating a long (or medium) term hedge.  In a brokerage IRA, the only effective hedging option I can think of is to purchase long-term puts, or to sell covered calls on the positions in the account.  Both these strategies require option trading authority, which most brokerages will grant to experienced or knowledgeable investors.   

I have avoided buying puts in the past because they, too, lose value over time.  However, if hedging is important to you, the time-value loss can be minimized by buying deep in-the-money puts, at the expense of tying up capital and increasing your potential losses.  Selling covered calls is a strategy I use frequently, but this is more of an income-producing strategy.  The potential of covered calls to offset a large loss is limited.

If you can, however, it's probably better to create a hedge for the positions in your IRA in a taxable margin account, where many more tools are available.

Tom Konrad, Ph.D.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

February 09, 2009

Why I Sold My Utility Stocks

In times like these of financial uncertainty, regulated utilities have traditionally been considered a safe haven.  But that is changing.  The Dow Jones Utilities Average was down 30% in 2008, vs. a 34% drop in the Dow Industrials.  Not much of a safe haven.

In a recent interview, utilities analyst Daniel Scotto noted, that the utility industry offers "a lot less security" than it used to.  His reasoning is based mainly on the fact that the regulated portion of utility company's business is smaller than it has been in previous recessions, making them vulnerable to lower growth (or even contracting) energy demand.  Scotto forecasts electricity demand growth at "no more than 0.2% this year, and he sees a chance that the U.S. electric utility industry could experience negative growth for the first time since the 1950s.

Because of my work as an expert witness helping clean energy groups with utility regulation, I fear that even the regulated portion of utilities' business may be in jeopardy.  In November, I wondered if utility Demand-Side Management programs could remain effective with the phase-out of the incandescent light bulb, but that may be only the tip of the iceberg.  I was recently asked to advise an anti-coal, pro renewables advocacy group in a rate case.  Looking at the evidence, I expect that utility regulators may begin to slash authorized returns on equity.

Authorized Return on Equity (ROE)

Because they are monopolies, utility regulators cannot rely on the market to keep utilities from making excess profits.  Instead, they set rates calculated to let utilities make returns on equity comparable to what other companies with similar risk profiles make in competitive industries.  Determining what this might be is complex, and analysts use several models to calculate what might have been.  ROEs can be determined using the Capital Asset Pricing Model, Discounted Cash Flow models, Equity Premium model, the method of Comparables, and various Risk Factor models.

All of these calculations have common elements: they are based on historical data and analysts' expectations for the stock and bond markets.  Over the (very) long term, publicly traded companies total returns should be approximately equal to ROE.  Utility regulators turn this simple relationship on its head, and, after performing considerable manipulation to tease out other factors unique to the business of the utility in question, set authorized ROE based on observed and expected long-run market appreciation.


In regulatory practice, "long-run" usually means ten to twenty years of returns.  What happens when the market falls 34% in one year, and the continuing weakness of the credit markets causes analysts to revise their long term expectations for the market downward?  Over a 10 year span, a 34% drop will reduce the average annual return by 3.4%, even without any drop in expected growth.  Over a 20 year period, that same drop will reduce annual growth by 1.7%.

Many regulators may look at these lower "long-run" returns, and cut the authorized ROE by 1-3%, something which would soon pass through to the utilities' bottom lines, and hence impact share prices significantly.

It's Different This Time

While historically utilities have done well in a downturn, the market models described above were not developed until the 1960s and 70s, let alone used in utility regulation.  Hence there is little historical precedent to know how regulators will behave.  Will they look at the need to invest in transmission and renewable energy infrastructure, and decide that current authorized returns will help utilities raise the necessary capital?  Or, will they look at the economic plight of ratepayers, and decide that, if the models say that ROE should be cut, why not cut ROE and let ratepayers keep some money in their pockets?

I'm not intimately familiar with each state regulator's decision-making process, so I don't know which utilities are likely to be impacted, nor when.  I've decided not to take the gamble, and have sold nearly all the utilities in my portfolio. 

The decision was made easier by my unrelated resolution to reduce my total number of holdings, which I mentioned in my article Ten Green Energy Gambles for 2009.  At the time, it didn't occur to me that regulated utilities might also be gambles.

Tom Konrad, Ph.D.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

September 22, 2008

What I'm Selling (and will be Buying) in the Market Turmoil

The market is in turmoil, and it seems like everyone I talk to wants my take on what's happening this week.  So here's my take:

  • I really don't know if the various bailouts and decisions not to bail out made by Paulson et al will turn out to be good decisions or not.  I do know that the mess we're in is due to hard decisions which have been put off for years at the highest levels, and I do know that the American taxpayer is going to be feeling the pain for a generation, if not generations.  
  • Although I predicted that the credit crunch would lead to a bear market, (and was bearish long before that) the intensity of this last week still caught me by surprise. I had expected big problems to emerge sooner, and when they did not, I began to expect that the fall would be gradual, rather than quick. 
  • I do not believe we are at the bottom, so I'm taking the current recovery as an opportunity to unload some of the stocks I expect to be hurt the worst.
  • Long-term, the extra US-denominated debt will have to be either repaid, or inflated away.  Inflation seems most likely, which may be good news for technologies like wind and solar which produce energy at a fixed cost, and probably better for efficiency technologies which do more with less.

Stocks to Sell

What companies are likely to be worst hurt?  Any company which needs to raise new money in the next couple years.  Although I tend to favor established, profitable companies, I have recommended (and own) a smattering of startups with compelling technology, and I'm currently selling many of these.

Many of these companies are thinly traded, and I am still in the process of selling these positions (mostly at substantial losses).  Not wanting to depress their prices, I will not disclose the specific companies at this point.  I also am holding on to some which have fallen so far that the proceeds of the sale are insignificant, especially if they are in accounts such as IRAs where the tax loss would not be useful.

Ten Stocks to Buy

Last February, when it was still fairly early on in this bear market, I brought you a series on stocks to buy when you think we've hit bottom.  Although I do not yet think we've hit bottom, I know that timing the market is very tricky.  I also know we're considerably closer to bottom than we were in February.  Given these uncertainties, I take the approach of selling cash-covered puts on stocks I'm interested in at prices below where I expect them to fall.  This means that I collect the premium if the stock does not fall that far, or I buy the stock at what I considered a very good price if it does. 

I currently like companies involved in energy efficiency, wind, transmission, and government contractors involved in alternative energy, because I expect all of these to be more resilient during what I expect to be years of hard economic times.  Here are my current top ten, with links to the articles where I wrote about them.  Since most of these companies are both large and extremely liquid, I don't expect that listing them here will affect the stock prices materially.  The ranking is based on a combination of how much I like the company itself, and the current valuation, starting with my current top pick. 

  1. New Flyer Industries (NFYIF), $11.00
  2. Johnson Controls (NYSE:JCI), $33.65
  3. First Trust Global Wind Energy ETF (NYSE:FAN), $22.55
  4. Veolia (NYSE:VE), $45.15
  5. Philips (NYSE:PHG), $30.83
  6. Honeywell (NYSE:HON), $45.32
  7. General Cable (NYSE: BGC), $38.99
  8. Siemens (NYSE:SI), $102.42
  9. General Electric (NYSE:GE), $26.62
  10. AECOM Technology (NYSE:ACM), $27.28

DISCLOSURE: Tom Konrad owns or has written puts on NFYIF, JCI, FAN, VE, PHG, HON, BGC, SI, GE, and ACM.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

July 17, 2008

Cleantech Investing For EcoGeeks

by Tom Konrad.  This story is cross-posted on

As lovers of green gadgets, EcoGeeks probably know as much about what's new in clean technology (a.k.a Cleantech) as anyone on the web.  So if you're an EcoGeek thinking about investing in companies which make the technology you know and love, you will probably take comfort in the old adage that you should invest in what you know.  An EcoGeek investing in clean technology companies will have an advantage understanding how a company makes money, and what is a needed innovation with a large  market,  and what is simply a bizarre curiosity.  More importantly, an EcoGeek knows that any maker of EVs will have to cope with endless competitors, and they're the first to know when LED bulbs are bright enough for general use.

While knowledge of cleantech is the great strength of the EcoGeek investor, this knowledge most likely arises from a love of clean technology.  Just as "geek" implies technology expertise, it also connotes an obsession with technology which might interfere with the geek's social life.  Unfortunately, an obsession with cleantech has the potential to blind the unwary EcoGeek investor to the pitfalls of investing in a cool technology which might not turn out to be such a great investment.

Investing in what you know is not the same as investing in what you admire.  People who invest in something just because they admire the brand often find themselves buying at the top.  Our aspirations and wants are in large part cultural, and others will be excited about the same things we are, at the same time.  When many investors are all buying at once, none are likely to get a good price.

To the extent that EcoGeeks are ahead of the curve with fashion, we can get in ahead of the crowd.  The rising popularity which follows can work in our favor, driving the price higher as other investors pile in.  To the extent that we live up to the geek stereotype, and what we think is great turns out to be hopelessly un-cool, we'll find ourselves investing in things which never catch on.  Many innovations which help the environment are also quite unpopular, so it is very difficult to know if we're blazing a path for others to follow (as turned out to be the case with hybrid cars), or simply lost in the woods (think Segway.)

That said, the EcoGeek who decides to invest in cleantech need not end up going EcoBroke. The trick lies in distinguishing between when we're on the environmental cutting edge, and when we're on the environmental lunatic fringe.  Most people on the lunatic fringe think that they're the only sane ones, and the rest of the world is confused.  That may well be the case.  After all, those of us who were worried about Climate Change before 2003 or so were on the lunatic fringe, even though most people now accept that we were right.  But if we were investing in cleantech companies back then, we probably had a lot more losers than winners.  Anyone remember Astropower?  Or, if you're impressed by the recent successes of Capstone Microturbine (CPST), you probably didn't buy it in 2001.

The key to EcoGeeky investing is to know that we're investing out of knowledge, rather than just buying a stock because we're excited about the company's green technology.  In the end, the key to all successful investing is to know ourselves at least as well as we know the companies we're investing in.

DISCLOSURE: Tom Konrad owns CPST.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

April 20, 2008

Stocks We Love to Hate

Investing in clean energy is both an economic and a moral decision.  From an economic perspective, I believe that constrained supplies of fossil fuels (not just Peak Oil, but also Peak Coal and Natural Gas) are leading to a permanent rise in the value of all forms of energy.  From a moral perspective, I know that we and the vast majority of our children are limited to this one planet for generations to come, so we should abuse it as little as possible, so, of all the possible forms of energy to invest in, clean energy (Renewable and Energy Efficiency) is my moral choices.

A Short Walk Down Wall Street

The investing decision does not have to stop there.  In addition to buying stocks we like, we can also sell (short) the stocks we hate.  There's a lot of truth in the caricature that environmentalists are much clearer about what we don't like (cars, mining, coal, pollution) than what we do.  For instance, "organic" is typically defined by the processes which are not used (chemical fertilizers, GMOs, pesticides) rather than those that are.  Smart Growth means "avoiding urban sprawl."  Those of us worried about global climate change want to reduce Greenhouse Gas Emissions.

I may be exaggerating, I also believe there is more than a (sustainable, local, organic) grain of truth in the caricature of the environmentalist as the wild-eyed environmentalist who chains himself to a tree (or runs around naked) in an attempt to stop some blight on the face of the planet.  

Why not embrace the stereotype in our investing?  When even wind turbines can kill birds (if less so than skyscrapers and pollution from coal plants) and solar panels are awfully expensive, it can be hard to agree on the companies or technologies that are truly "green" and which ones are just greenwashing.  Many well-meaning people make the case that we need nuclear power and/or "Clean Coal" to fight global warming, but it's hard to get behind a power source that involves finding someplace underground to store hazardous waste for centuries or millennia at great expense.

If we can't agree on what we like, at least we can agree on what we hate.  So why not short the companies which do the things we hate?

That's a rhetorical question.  Shorting is extremely risky, and should only be done with a careful eye to risk management.  That said, I'm generally bearish on the outlook of the stock market, so in addition to giving some simple rules to help people decide to sell what they already own, here are some ideas for those of you with courage of your convictions wanting to strike a blow for what you believe in.

#5: Meat

It has been claimed that the biggest step you can take to reduce your carbon footprint is to eat less meat.  Some of these claims may be exaggerated, but it's certainly true that the way we currently raise and transport meat, it's extremely energy intensive (not to mention unhealthy for both the animals and ourselves.)

SHORT IDEA: The rush to ethanol (caused by peak oil) is most likely to harm the economics of pork and poultry, so the vegan investor might consider shorting meat products companies such as Tyson Foods (NYSE:TSN), despite their partnership with Conoco-Phillips for Green Diesel.  

#4: Globalization

As well as eating vegetarian, ethical eaters also look at the energy necessary to get their food onto the table, as well as the energy costs of transporting all those Chinese-made gee-gaws.  While the distance of transport is an extremely  poor proxy for the energy needed to get the item there (containerized shipping is so efficient that we're likely to burn more fuel driving to the grocery store and back than we're likely to save by buying local foods while we're there), growing herbs in your own garden is likely to be much more energy efficient than flying them in from South America... especially if it saves you a drive to the grocery store for a singe ingredient.

SHORT IDEAS: Investors might consider shorting country ETFs of highly energy intensive economies with little local energy resources.  China is the first country which comes to mind for me, although the thought of shorting China scares me almost as much as global warming.  A safer anti-globalization short might be airlines (although they seem to be declaring bankruptcy so fast that we may have missed the plane on this one.   Truckers are also feeling the pinch of high gas prices, so if you, like me, feel that there's more where that came from, take a look at long-haul truckers.

#3: Urban Sprawl

Urban sprawl is the unwanted child of our ill conceived love affair with the car, and keeping the brat happy is one of the major factors keeping us together.  The biggest investment many of us will make is a home, so living near where you work is probably more important than your financial investments.  But that doesn't mean you can't strike a blow against sprawl with your brokerage account. 

SHORT IDEAS: Housing developers who slap 'em up cheap in the suburbs and exurbs, and the road construction industry.

#2: Coal & Oil Cos.

I personally loathe the coal industry.  Devastation caused by mining adds injury to the insult of massive carbon emissions.  Some oil companies have been making moves towards biofuels, but it's small potatoes compared to their main business.  Nevertheless, I'd stay away from shorting these two industries no matter how much you hate them... the same rising energy prices that will benefit clean energy will benefit the old fossil fuels.  Although both will have considerably less to sell as time goes on, they should be able to command premium prices.  

Although I can see a scenario where massive carbon regulation actually depresses the price of coal, I don't expect lower coal prices anytime soon.

SHORT IDEA: Don't do it.

#1: Sport Utility Vehicles

I'm convinced that the personal car will never be green.  The most forward thinking car companies, like Toyota, realize this, and are already starting to plan for a day when the personal car is obsolete (at least according to a presentation I saw at a recent conference.)  But it's likely to be too little, too late, especially for companies which seem to believe that an SUV that burns ethanol and gets 22 MPG is the height of greenery.  They may even have to go head-to-head with Wal-Mart.  This is the one short idea here I feel strongly enough about to actually dabble in.  I just took small short positions (actually far out-of the money January 2010 short calls) in Ford (NYSE:F) and General Motors (NYSE:GM.)  Admittedly, these companies have many other problems besides peak oil and global warming, but those are well known, and likely to already be factored in to the stock prices.

SHORT IDEA: If you've ever been tempted to vandalize an SUV, here's a legal option.

DISCLOSURE: Tom Konrad has short positions in F, GM.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.


March 30, 2008

When to Sell: Five Rules of Thumb

A common complaint about investment writers is that we are always willing to tell you the next stock to buy, but we don't always get around to telling you when to sell.  I'm as guilty of this as most: generally, I write about the stocks I'm interested in... which are the ones I'm buying, not selling.  And, although I write the occasional negative article (Petrosun Drilling most recently, but also US Sustainable Energy and Global Resource Corporation), these were more stocks to avoid, rather than stocks which had seen their run.

This is unlikely to change.  For a start, I'm not selling many alternative energy stocks... I'm using the downturn to add to my holdings, and intend to continue doing so even if the downturn becomes a full-blown bear market, as it well may.  What I am selling are stocks I bought in 2001-2004, mostly precious metals mining stocks, and I have not researched any of them for 3 years.  I don't have a lot to say about them, nor would an article fit the Alternative Energy Stocks theme.

In the absence of specific "sell" articles, I thought I'd outline a few rules of thumb I use to know when to sell.

Rule #1: Rebalancing

I have target percentages for both stocks and asset classes, above which I will sell part of my holdings.   For the mining stocks mentioned above, whenever they appreciate to more than 11% of my total portfolio, I sell some to bring the percentage back down.  For individual stocks, the target depends on how risky I believe the stock is.  For large, stable companies this is around 3-5% of my portfolio each, while for more speculative companies, this is less than 1% of my portfolio for any single stock.

Rule #2: Sell Half on a Double

For particularly speculative companies, especially one with negative earnings, I'll typically sell half of my holdings if the stock doubles from where I bought it.  This rule served me well last year with Composite Technology Corporation (CPTC), allowing me to take some gains, but then buy more recently when the stock fell back.  I failed to follow this rule with Electro Energy (EEEI) this January, and optimistically put in an order to sell 40% of my holdings at 2.5 times my purchase price ($1.30), but the stock peaked in intraday trading at almost exactly twice my purchase ($1.05.)

Both these tocks have since fallen back, but I was able to buy more of CPTC with part of the gains from my sale, while I have my original position in EEEI.

Rule #3: Capture Short Term Losses

Come tax time, I want all my capital gains to be long term ones, taxed at only 15%.  To that end, if I'm sitting on a good sized loss in a stock I bought 9-11 months earlier, I seriously consider selling so that I can use the loss to offset short term capital gains in the coming year.  If I'm very bullish about the stock, I will usually buy more, wait a month to avoid a wash sale, and sell the original position.  If I'm just neutral on the stock, I sell without buying more first.

Rule #4: Get Paid for Your Decisions

If I plan to sell some of my holdings because of one of the above rules, I often do so using covered calls.  For instance, if 4% of my portfolio is currently General Electric (GE) at $37, it would be over 5% if the stock goes to $50, and I would want to sell some because of Rule #1.  I can currently sell GE Jan 2010 $50 Calls for around $1.  If I sell calls covering half of my position, I make an immediate 1.3% (=1/37 x 1/2) gain on my holdings, and only if the stock goes up to $50 before January 2010 do I have to sell half my holdings... something would do anyway because of Rule #1.

This strategy is very similar to how I often buy stocks, using cash covered puts.

Rule #5: If You Need the Money

If you need the money for something else, it's quite likely that you will be forced to sell something at precisely the wrong time.   Because of that, I always try to keep enough cash around to cover several months of normal or anticipated expenses, and I never buy stocks on margin (because of margin calls).  If I need small amounts of cash anyway, I often sell covered calls or cash covered puts, as described in rule #4.  Try to plan ahead as far as possible in advance, and keep enough cash that you never have to sell on short notice..  


I often think that knowing when to buy and sell is often more important than knowing what to buy and sell.  All these rules are simple, but it's easy to lose track of them chasing the next hot stock tip.  These rules are especially valuable in the volatile world of alternative energy stocks, as the examples in Rule #2 show.  If you normally come to this blog for stock tips, remember that knowing when as what to sell is at least as important as knowing when and what to buy.

DISCLOSURE: Tom Konrad and/or his clients have long positions in CPTC, EEEI, and GE.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

March 23, 2008

Neutralizing Your Peak Oil Risk

by Tom Konrad

Lifestyle Risks from Peak Oil

In the US, we all have a large exposure to the risk of rising energy prices.  In addition to the cost of gasoline, the whole US economy runs on oil, so a rise in the oil price is likely to affect our jobs, and the prices of all our assets, including our homes.  If other people have less money to spend and invest because of high oil prices, there will be a fall in demand for anything they were buying or investing in.

House prices in exurbs and suburbs where the car is the only available transport option are likely to be most affected because living there entails relatively high car use.  If you live far from where you work, your expenses will not only go up with the price of oil, but the value of your home is likely to fall, leaving you doubly exposed.  In contrast, real estate which is centrally located or which is well-served by mass transit may show positive correlation with the price of gas, and hence serve as a against the gas price.  

This oil price exposure can be (imperfectly) hedged with investments in clean energy or oil price futures, but a more effective way to reduce your risk is to live close to your work.  If you already live far away from most jobs and own your home, you can reduce your personal expenses by finding ways to telecommute or use mass transit, but the value of your home is still linked to the oil price.  Since this is a long term trend, you may be able to protect the value of your home by advocating for better public transit in your area, but given the time and effort this entails, a large allocation of your portfolio to clean energy stocks or oil futures is probably the best you can do.  In addition to my own blog, Jim Kingsdale's Energy Investment Strategies is an excellent place to learn about investments available to the retail investor.

However, you should not underestimate the magnitude of oil's direct impact on your expenses.  If you drive 30 miles round trip, five days a week, that's about 300 gallons a year, even in a 30 MPG vehicle.  Each $1 increase in the price of gas requires $300 of extra income a year to hedge your exposure.  

Driving an alternative fuel vehicle is not a hedge for oil price risk, since the prices of alternative fuels are highly correlated with the prices of petroleum based fuels, although a more efficient vehicle is a partial hedge.

Investments as a Peak Oil Hedge

For investments to hedge that expense, you will need investments that increase $6,000 to $8,000 for each $1 increase in the price of gasoline to produce $300 of extra income annually.  Assuming you have found a portfolio which increases 10% for every $1 increase in the price of gas, you will need approximately $70,000 invested to hedge your commuting costs, and possibly as much again to hedge the price of your home.

Even with $70,000 to invest, most stocks or portfolios of stocks are an imperfect hedge against the price of gas.  The best hedge in terms of correlation with gas prices are oil or gasoline futures, but trading futures is considerably less accessible than trading stocks, and does not produce income.  Trading oil futures is a zero-sum game: for everyone who makes money, a counterparty loses money.  In stockmarket investing, the internal profits of companies can provide a basis for a positive net return for all investors.  That extra benefit and the opportunity to invest with my beliefs, make me willing to accept the much weaker correlation clean energy stocks have with energy prices.

Better Than a Hedge, Reduce Your Risk

If you don't have $70,000 in your portfolio to neutralize your gas-price risk, or are uncertain of your portfolio's correlation to the gas price (most stocks will actually fall as the price of gas goes up,) it makes sense to find less gas-intensive options to your normal commute.  Then, if fuel rises to a painful level, it will be easier for you to switch quickly to less fuel-intensive options. 

Even though I live near my work, I've been doing just that, ever since I became convinced that better cars are not an effective solution (or investment response) to peak oil.

An EV You Can Carry in One Hand

A couple weeks ago I mentioned that I was cutting my driving with a Motorboard.  The motorboard is an electric scooter which is so compact that you can fold it up in a few seconds and carry it in one hand (it weighs about 16 lbs.)  I think of it as a much cheaper and cooler Segway which I can carry.  Since it has a low range, it is best seen as a supplement to mass transit, not a stand-alone transit option.  The combination of motorboard plus transit allows distance travel without the limitation of start and end points within walking distance of transit stops.

I wrote a review of the Motorboard for, which you can read here.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

March 06, 2008

Calling for a Marshall Plan, not a Manhattan Project

Electricity too cheap to meter.  For many renewable energy advocates, that is the holy grail… new technology which will not only solve the problem of carbon emissions, but be so transformative that we no longer have to worry about turning off the lights when we leave the room.

We could argue for days about the viability of any such technology, be it cold fusion, hydrogen, or photovoltaic nanodots.  I personally have strong opinions about the likelihood of any technology to produce energy so cheaply that it would not make sense to use some mechanism like price to ensure that it is used productively.

We could argue about that, but it would be the wrong argument.  The time we have to act to confront Climate Change is much shorter than the time it takes to develop and implement new technologies.  Even if photovoltaic nanodots achieve their early promise, they will take decades to reach large scale availability.

New technology will be too late to save us from Climate Change.  The longer we wait to make real reductions in carbon emissions, the more drastic those cuts will have to be.

Marshalling our Energy

Much more (and sooner) than we need new technology, we need to implement the technology we have today.  The good news for all of us is it is much easier to pick well-run companies in established industries than it is to decide which new technology will produce the promised manna from heaven.  Rather than politicians and investors trying to pick which hot new technology we should back, we should look at existing technology 

If we're truly serious about tackling Climate Change today, we will let next year's technology take care of itself, and spend our efforts implementing the very effective technologies we have today.

Many Renewable Energy advocates and scientists are calling for a new energy Manhattan Project.  That's the wrong metaphor.  Instead, we need a Marshall Plan for Energy.  Much more than new scientific resources, we need to leverage our financial and organizational resources to get the needed projects on the ground today.

Here is what we can do with current technology in North America today to fight climate change: 

  1. Build a continent-wide High Voltage DC grid along the interstate corridors to bring Concentrating Solar Power from the Southwest and Wind Power from the Great Plains to the rest of the country, and balance demand across the continent, lowering the need for new peak capacity.

  2. Never build another building that does not include all economic energy efficiency upgrades.

  3. Change the incentive structure to reward everyone for driving less, not more.

  4. Invest in our public transit systems.

  5. Implement continent-wide smart grid and metering to better manage the fluctuations of renewable energy sources, give people information about the energy they are using, and time-based pricing to better align supply and demand.

  6. Never build another exurb.  Encourage infill and denser growth that allow people more travel options.

That's my Marshall Plan.  Every one of those items will save more money for society than it will cost.  Some are complete win-wins, others will produce more winners than losers.

When we've done those six things, we'll have technology which can take us the rest of the way.  Those technologies (Wind Power, CSP, PV, Biomass electricity, Plug-in hybrids or Electric vehicles) already exist, and require only incremental improvement and deployment.  We'll have a lot less far to go, and the improved infrastructure will make any new technology easier to implement.

January 18, 2008

Short Demand for Cree High and Rising

I got a call from my broker this morning asking me if I'd be willing to loan out my shares of Cree, Inc. (NASD:CREE) to a short seller.  Since the only cost to me is that I will not be able to vote my shares, and I will earn 2.5% per annum on the value, I said "yes." 

Normally, brokerages get the shares they lend out to shorts from margin accounts with a margin balance.  Since I never carry a balance (although I do have a margin account in order to trade options) they must ask my permission and pay me interest in order to borrow my shares.  I'm planning on holding these shares for the long term, so I'm happy to earn an extra 2.5% on my money.  (I could still sell them, in which case the short seller would have to find shares to borrow from someone else, or cover his position.)

I also had the idea of creating some synthetic cash-covered short puts (a combination of the long position in the stock with short calls) to give me more shares to loan out, but the relative prices of calls and puts on Cree make this unattractive.  Most likely, other arbitrageurs who are able to earn higher interest on their loaned shares have already pursued this route to the point where it is no longer attractive to me (my return on capital would only be about 8%; I can do better with a plain-vanilla cash-covered puts.)

What to Make of the High Short Ratio?

Cree's short ratio (the ratio between the number of shares short to the company's float, or shares available for trade) is an extremely high 26.9%, and has risen over the last month.  This is why my broker was calling me to borrow shares.  But, other than my opportunity to make an incremental profit on my shares, what does this mean for the future of the stock?

On its face, a high short ratio means that a lot of investors are bearish about Cree's prospects.  This can be good or bad news, depending on how likely the shorts are to be right.  The contrarian position (and I usually lean towards the contrarian) is that most investors are usually wrong, meaning that a high short ratio is a bullish indicator.  We also know, since I'm getting calls from my broker, that few new investors will be able to short.  Finally, there is the potential of a short squeeze, which could be triggered by positive news such as another buyout rumor.  Short squeezes can lead to radical price increases over short periods.

I'm taking the call from my broker as another moderately bullish sign.

DISCLOSURE: Tom Konrad and/or his clients have long positions in CREE.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

January 08, 2008

How to Buy Losers: Tricking Yourself with Cash-Covered Puts

It's that time of year again.  I've started studying for the third (and final) CFA® exam, and my readers are "treated" to my theories of the market and trading.  No stock picks today; put your thinking caps on! 

CAPM: Nice Theory, Too Bad About the Market

In Level II of the exam, we studied efficient-market theories, such as CAPM and APT.  I actually like an elegant theory (I spent nearly decade of my life studying mathematics), but as a market practitioner, I know the market doesn't work that way.  I learned this lesson the hard way.  

Early in my investing career, I would short overpriced stocks.  For instance, I twice shorted Amazon (NASD:AMZN) in 1999.  At the time, Amazon was bouncing up and down between $50 and $100 (split adjusted), and, looking back 8 years later, it was clearly overpriced even at $50.  After all, it's only at $88 today, meaning the annualized return from buying the stock in 1999 at $50 has been about 7%, while the expected return under CAPM for a stock with a Beta of 3.02 would be around 18% per annum.  (Assuming a 6% risk-free rate equal to the ten year Treasury note yield at the time, and a very low equity risk premium of 4%.)

Put another way, if Amazon had been fairly valued according to CAPM at $50 in 1999, it should have been around $190 in 2007, when in fact it mostly traded below $100.  It should never have fallen below $6 in 2001.

Looking back at my records, I actually made money on those two shorts (I made $4,661 on the first and lost $3,045 on the second), but it's the loss that stuck in my mind and prompted me to use this example.  After I closed out the first short near $50, the stock rebounded to $59 and I shorted again.  It kept on rising, and I got cold feet and took my loss at $65 (I also needed a tax loss, but that didn't make it hurt any less.)  

Although I didn't know it when I sold, if I'd tried to wait for the stock to start falling again, as it did in 2000, I would have had to ride through a paper loss of $24,000 before the stock fell to where I was in the black again.  Even people who have the margin balance to ride through a reversal like that find it very hard to do emotionally.

Lessons Learned

The lesson I took away from that (and a couple of other painful shorting episodes), is that CAPM alone is a lousy theoretical basis for investing or trading.  I still do occasionally short, as I am currently doing with First Solar (Nasdaq:FSLR), but I generally take smaller positions and do not rely solely on valuation.

My primary investment framework is Behavioral Finance, actually a grab-bag of theories which focus on investor psychology to explain market behavior that cannot be explained by traditional theories such as CAPM which assume market efficiency.  To my pleasure, Level III of the CFA® exam contains considerable material on Behavioral Finance, which I am reading now.

The Winner-Loser Effect

One of the most widely documented market behaviors which cannot be explained in an efficient market is the Winner-Loser effect.  Put simply, stocks which have performed badly over a period of a few years tend to outperform stocks which have performed well over the same period in subsequent periods.  I take this to mean that, all else being equal, I should prefer to buy stocks which have performed badly over the last couple years to stocks which have recently done well.

This is harder than it sounds.  I think the easiest way to demonstrate this is through introspection.  Compare this chart, eeei.png

from my original article about Electro Energy (NASD: EEEI) to this more recent chart of the same company:


Looking at the charts, which of these stocks would be easier to buy?  If you can honestly tell yourself that the first would be easier to buy, you're very unusual.  I personally would have a much easier time getting myself to buy the second chart, and was only buying the first chart and the dip that followed because I know that I have face my fear to make good trades.

People who bought EEEI at $0.50 when I first recommended it (and managed to hold not sell when the stock dropped as low as $0.30) are now sitting on a 70% gain in just a few months, and can look forward to participating in the same gains that someone who bought it in response to my Top Ten Picks for 2008 article.  (I'm almost certain that the reason the stock jumped 40% on December 31st was because of that article... there was no other news relating to the stock that day, and most of the move was due to a single large purchase a few minutes before the close.  If you were that buyer, I strongly suggest using limit orders when trading a thinly traded stock like EEEI.)

Cash-Covered Puts

With small cap stocks like Electro-Energy, the only way I have to make sure I buy them when they're down is keeping a tight rein on my emotions, but with larger capitalization stocks which have exchange-traded options available, I have a trick that makes it much easier.  Consider another pick from the same article, FuelCell Energy (NASD:FCEL.)  Part of the reason I chose to include it in the list is that its five year performance has been lackluster, especially when compared with other alternative energy stocks.  Unlike EEEI, I had not been following it closely and only had a small position before I wrote the article.  However, I convinced myself that the company has excellent prospects while doing my research, and so I wanted to buy more.  

Rather than putting in an order for the stock, I looked at the longest dated options available, in this case options expiring in July 2008

I sold (or "wrote") a number of July 2008 $5 FCEL Puts for $0.25 each when the stock's price fell on January 2nd.  For each contract, I was paid $25 by the purchaser, and I am obligated to buy 100 shares of FCEL at any time between now and July 19th for $500, or $5 each.  Keeping the necessary cash available until then, I not only earn interest on the $475 of my money, but also the $25 I've already been paid.  If FCEL does not fall below $5, that put will never be exercised, and my $475 has earned me about $36 in six months, or a 15% annualized return (actually a little less because I had to pay a commission, but it's still over 12%.)

If the stock price has fallen to $4 (a situation I find emotionally hard to believe now, but one which I intellectually know is a real possibility) then the put will be exercised, and I will have bought FCEL for about $4.75 a share, even though it's trading around $10 now.  The irony is that, although I'd be jumping for joy at the prospect of buying FCEL for $4.75 a share today, experience tells me that if the option is exercised next July, I won't feel happy about it at the time.

Here's what might happen: some bad news will come out about the stock in the next four months, and the stock will fall to $4.  I'll then be sitting on a 16% loss on my $4.75 per share investment in a "loser" stock.  If all that happens, and someone asks me if I want to buy more at $4 (16% less than I feel would be the deal of the century if I could have it today), I'd almost certainly say no.  In other words, when I wrote those Puts on January second, I tricked my future self into buying a loser.

Losers, in the long term, tend to out-perform winners, and this is a loser I like for all the reasons I outlined, even if I may not be feeling so happy about it in July.  In order to get in that position, all I have to do is to not sell the stock for a loss.  Not selling a loser you already own is actually easier emotionally than selling and taking the loss.

That's what I mean by "tricking myself."

Getting Started Writing Cash-Covered Puts

If you'd like to try the above strategy yourself, I have some bad news.  While selling cash-covered puts and covered calls are actually lower risk strategies than buying and selling equivalent amounts of the underlying stocks, there are a lot of other things you can do with options that are much, much riskier.  For instance, you could sell the puts above, but decide you have better uses for the $500 cash than leaving it in a money-market fund... until the stock falls precipitously and you have to come up with the cash.

Regulators know about these risks, and they make investors jump though a lot of hoops to get option trading permission.  The procedure varies from broker to broker, but there is usually a net worth requirement (as if money made people smarter) and you also have to claim that you understand the risks involved.  Don't take short-cuts on this; just reading this article is not enough!  Get yourself a good book on options trading , or spend a few days learning about them online (you may have to do some searching... I had trouble finding a free option information resource that I would recommend.  But I can tell you what to avoid: anything that talks about getting rich quick.  I don't actually know that the linked book is bad, but why waste your time?)

Check with your broker to see if your net worth qualifies you to trade options.  Study up on them if you need to, and then fill out your broker's options trading permission.  

My own broker was a day trader in the late 90's.  Like most day traders, he lost his money and had to go back to a real job.  He says that the only traders he knew who made money were the ones who wrote puts on stocks they liked.

DISCLOSURE: Tom Konrad and/or his clients have long positions in EEEI, FCEL, and a short position in FSLR.

DISCLAIMER: The information and trades provided here and in the commetns are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

July 05, 2007

Will Climate Advocacy Pay for Shareholders?

On Monday, we learned about big coal companies pushing back against the major US corporations of the US Climate Action Partnership (USCAP,) which advocates for mandatory regulation of greenhouse gas with their own lobbyists.  

Since I have advocated buying companies that take a proactive stance on climate change, I thought it might be instructive to compare the returns of the original ten members of US-CAP with the returns of the big coal coal companies (more companies have since joined,) over the six months since the Climate Action Partnership issued their Call for Action on Climate Change.  

The Payoff

Coal Price, July 3  YTD Dividends  Price, January 1 YTD  Return
ACI  $              35.62  $                0.13  $              29.90 19.6%
BTU  $              48.85  $                0.12  $              40.02 22.4%
CNX  $              47.17  $                0.14  $              31.80 48.8%
MEE  $              24.95  $                0.08  $              23.15 8.1%
Average     24.7%
US-CAP Price, July 3  YTD Dividends  Price, January 1 YTD Return
AA  $              41.50  $                0.34  $              30.05 39.2%
DUK  $              18.52  $                0.42  $              20.00 -5.3%
FPL  $              56.80  $                0.82  $              54.42 5.9%
BP  $              73.50  $                1.44  $              67.27 11.4%
CAT  $              77.99  $                0.60  $              61.71 27.4%
GE  $              38.70  $                0.56  $              37.41 4.9%
PNM  $              28.12  $                0.45  $              31.30 -8.7%
LEH  $              74.60  $                0.30  $              78.13 -4.1%
PCG  $              45.75  $                0.72  $              47.30 -1.8%
DD  $              52.13  $                0.74  $              48.70 8.6%
Average     7.7%
  Price, July 3  Appx YTD div  Price, January 1 YTD Return
S&P500  $          1,525  $              21.70  $          1,418 9.1%
XLE  $              70.75  $                0.39  $              58.31 22.0%

So far, shareholders of the big coal companies have done much better than shareholders of the US Climate Action Partnership companies.  The former have received a year to date total return (including dividends) of 24.7%, which easily exceeds not only the return on the market as a whole, but also is slightly higher than my proxy for the energy sector, XLE, the iShares energy sector SPDR, which returned 22%.  In marked contrast, the original partnership companies returned only 7.7%, which was below the total return on the S&P500 for the same period.  

On a more optimistic note, the four companies that I have actually been buying for my own and client accounts (shown in gray) have returned a much more respectable 11.7% over the period, although naturally our returns varied from this because we did not purchase an equal-weighted portfolio of these 4 companies on January first.   These selections are based on my subjective analysis of how much these companies actually stand to benefit from climate change, as well as traditional valuation and governance factors.


Despite the record of the last six months, we should not conclude that climate advocacy is bad for a company's share price.  Political action on climate change is a process that has only begun.  If there is a payoff for climate advocacy, it will be seen over a period of years or decades, not months.  

In addition, the coal companies must think that carbon regulation will hurt their bottom lines, or they would be unlikely to fight it.  An investor who thinks mandatory carbon regulation is coming will therefore want to avoid owning those companies when such regulation comes to pass.  Likewise, companies which self-select by joining the partnership probably expect to gain from carbon regulation.

Finally, most of us want not only to achieve our financial goals, but also to live in a world where we can enjoy them.  Several recent studies have shown that the costs of dealing with climate change are far smaller than the costs of doing nothing.  While we may have to give up a fraction of a percent of GDP growth in the near term , we have to balance that sacrifice against losing a large fraction of our GDP if we are confronted with the droughts, flooding and erratic weather predicted as a consequences of climate change.  These effects will also be felt by your whole portfolio, including by companies that have stayed out of the debate entirely.

In the end, we want not only a nice income in retirement, we want a nice planet to retire on.

DISCLOSURE: Tom Konrad and/or his clients have positions in these companies mentioned here: FPL, CAT, GE, and DD.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

May 13, 2007

How to Beat the Market: Less Money and More Judgement

Last week, I looked at how a small investor could gain an advantage in the market by understanding the other players.  The most important other players are institutional investors such as hedge funds, pension funds, mutual funds, and investment banks who have considerably more resources and valuation skills than the individual investor, and so trying to take them on directly to beat them at their own is likely to be an expensive exercise in futility.

Two Exploitable Weaknesses

On the other hand, I argued that institutional investors have certain handicaps and biases which do allow small investors to enter the market on our own terms, and not compete directly with the institutions.  These include:

  1. Too much money.
  2. A focus on quantitative as opposed to qualitative analysis, which leads to a focus on the past.

I listed several other weaknesses last week, but these are the two I focus on when doing my own investing.  While the overall returns of some money managers are hurt by the agency problem (looking out for their jobs rather than their client's returns) and the like, I have not come up with methods of taking advantage of these weaknesses.  In fact, I think that there are a bunch of other traders and hedge fund managers out there doing just that, and the last thing I want to do is go up against hedge funds.

I'll deal with just these two, and point to some tactics a small investor can adopt in the pursuit of an edge in beating the market.  The underlying theme is always the same: in order to beat the market, we have to identify mispricings: instances in which the value most market participants place on a security differ from its true value. Small investors, with far fewer resources than institutional investors, should focus on securities that institutional investors are ignoring, or analyze securities in ways institutional investors do not.  If you can think of other ways to exploit weaknesses of institutional money managers, all the better: you won't be in competition with me, either.

Too Much Money

To a small investor whose biggest financial decision in life so far has probably been the purchase of a house, the idea of having too much money may seem laughable.  Nevertheless, too much money is a very serious handicap for institutional money mangers, and the only handicap they all share.  If you have $50 million dollars to invest (the size of a small mutual or hedge fund), and you're looking for a stock that will add 0.1% to your returns if its price doubles, you are going to have to invest $50,000 in that stock.  That won't be a problem if you want to buy Archers Daniels Midland (NYSE: ADM) for exposure to ethanol and biodiesel, because your trade will barely be a drop in the daily volume of stock traded.  On the other hand, if you want to buy $50,000 of Earth Biofuels [OTCBB: EBOF],  which has a market capitalization of less than $100,000, you could easily wind up doubling the price of the stock in the process, greatly reducing or even eliminating any potential gains.

In other words, in order to make any profit on a stock, that stock must have some degree of market capitalization, and trade enough volume to make a substantial investment at a reasonable price.  In other words, institutional investors are compelled by their size to invest only in companies that are (at least to some degree) reasonably large and liquid.  There are no particular cut-offs on what makes a stock large or liquid enough for institutions, since institutions come in all sizes.  

Because large investors can buy them, shares in highly liquid securities often trade at a higher price than they would otherwise (called a liquidity premium), and hence illiquid securities have, on average,  higher long term returns.  More importantly for our discussion, there are few or no analysts trying to asses the value of illiquid securities, and so a diligent individual investor is more likely to be able to identify an under priced security. If you want to find a rare coin, you have a much better chance if you look through a jar of pennies found in the attic than if you look in your loose change jar.

With a liquidity premium comes liquidity risk: the risk that, should you want to sell an illiquid security, you will not be able to sell at a reasonable price, or, on occasion, at any price.  I have a personal rule not to put more than 1% of a portfolio into an illiquid stock, especially ones that trade off the regulated exchanges, and even then, I'll also limit the fraction of the portfolio devoted to these sorts of stocks.  Nevertheless, given the low professional interest in illiquid stocks, most of them are mispriced: the trick lies in finding the ones which are substantially undervalued rather than overvalued.  It's not uncommon to see a stock go up many times in a single year.  On the other hand, it's not uncommon to see them plummet to nothing in the same period.

Given the prevalence of over the counter stocks that are little more than an excuse to part investors with their money, I only look at companies that I read about in the non-financial press.  I think of it this way: if a company's purpose is to sound good to investors, they will target investors with their public relations.  On the other hand, if they are out in the world solving real problems or providing necessary services for paying customers, then I'm much more interested.  A company that's talking about its great business plan to solve a problem I had not thought of on my own is much less appealing.  Worse yet are companies setting out to solve a problem that everybody is talking about, which I take as a sign that a company is trying to hop onto a bubble bandwagon. Companies which are actually out making news (as opposed to generating PR news releases) are much more likely in my mind to have something customers want, and these are the companies which deserve further research.

If you're considering investing in small, illiquid companies, no matter what sort of analysis you intend to do, I suggest you limit yourself to investing in no more than one third to a half of the companies you analyze.  This will discipline you into making hard choices, and prevent you from putting money into a company simply because you feel that all the hard work you did researching it deserves to be rewarded.  The market does not reward hard work: it rewards good judgment (a much rarer commodity).

Quantitative Analysis, and a Historic Bias

Much of my article last week was devoted to making the case that institutional money managers focus too much on quantitative analysis rather than qualitative analysis, and I won't repeat that argument here.  When considering the same companies that large investors analyze, we should not spend much time doing traditional valuation: it's already been done by many other people who spend days analyzing one company, and poring though the footnotes.  

When looking at big companies, the small investor's potential advantage is lateral thinking, leaps of intuition that become less and less likely the more analysts delve down into the footnotes of a financial statement.  

The stock market, and history as a whole, is prone to breaks and sudden reversals.  When everything is going well, it becomes harder to see dangers lurking in the corner.  When the roof seems to be caving in, it becomes hard to see the light at the end of the tunnel. Aggravating this is the fact that financial statements are historical documents.  Typically, when an analyst wants to project the future of the firm, he will start with this historical data, and see how all the factors he can identify have interacted in the past, try to guess what these factors will be in the future (often by extrapolating existing trends), and see what comes out.

But what if the key to the future is not contained in the past?  The millennium bug was a disaster that everyone saw coming, and because of that, they took the necessary steps to deal with it, and when 2000 rolled around, the whole thing was a fizzle.  On the other hand, Long Term Capital Management failed because their sophisticated mathematical models of the complex relations between a wide variety of different financial assets failed when those relationships broke down during the Russian default in 1998.

Such Black Swan events are, by their nature hard to predict.  But, to beat the market, we don't have to predict the unpredictable, but only to make a prediction that most other people have not yet made.  Some events defy prediction by their very nature, but more defy prediction because of our psychological biases.  Put simply, few people predict things that should be obvious because they don't want to see them coming.  For instance, you probably know someone who was in a doomed relationship, but absolutely refused to acknowledge the relationship was ending until long after it was over.  That happens all the time in the stock market.  People did not believe that the stock market was overvalued in 2000 (despite repeated warnings) because they were too attached to making 15-20% a year on their investments.  They were flipping condos up until a year ago despite the fact that both the ratios of home prices to rents and home prices to median income were at historic highs.  These were predictable changes in the market, which people did not see because they didn't want to see them.

I spend a lot of time trying to think about the unthinkable.  What could happen that would totally change the rules of the game?  What is the disaster that no analyst is building into their projections because it's too difficult to contemplate or quantify?  What are the chances that these things might happen anyway?

To beat the market, we need to "think outside the box."  It's a cliché, but it's still a lot easier to talk about than do.  And there's no instruction manual.


Neither of these tactics is simple or easy to implement.  If beating the market were an easy task, everyone would do it.  Before you even try, you should first ask yourself if there is some reason you may be better than anyone else, because if you're not better than most people who try, your results won't be any better either, and you'll end up losing money.   Last year, I put together a quiz, with a very serious purpose: to help people self-assess if they might actually have an investing edge (or at least if they don't have many of the traits that cause people to fail.)  It's not very scientific, but I like to think that it will help someone who shouldn't be trying to beat the market to decide to index their portfolio, or at least persuade someone who is bound to try any way to dip their toe in rather than diving in head first.

I believe it's possible for a small investor to beat the market over the long run, but I don't think that most, or even many, small investors have much of a chance.  It's human nature to believe that we're the exception to the rule, and in some ways it's rather ridiculous for me to be telling you to take a hard look at yourself before you try: I wouldn't have taken that advice.  

What we need to decide for ourselves is how much of our confidence is actually overconfidence.  Most of us who try to beat the market will fail, but I like to think that I've helped a few small investors along the way to success.

DISCLOSURE: Tom Konrad and/or his clients have positions in the following stocks mentioned here: ADM.
DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

May 06, 2007

Beating the Market, Part I

Because I'm currently studying for the second (of three) CFA® exam, I'm going to take a break from my usual article analyzing some aspect of alternative energy.  This week and next, I'll take a step back and try to answer an existential question: How can I possibly hope to beat the market, when "the market" consists of professional money managers with resources far exceeding my own?  Every active investor should ask themselves this question: the answer will either make you a better investor, or save you a lot of time and money if you are humble enough to realize that you're like the majority of mutual fund managers who would be better off not trying, and should be indexing their portfolios instead.

Beating the Market

Is it possible to beat the market?  The unequivocal answer is "Yes:" no matter how many economists say "the market is efficient" it's only the existence of smart money managers out there who find mispricings and exploit them that keep the market as nearly efficient as it is.  Market efficiency requires that there be money managers who can detect mispricings and take advantage of them.  The abnormal returns (or Alpha) they make by so doing are their wages for making the market more efficient for everyone else.  

Because of the thousands of highly trained analysts out there, constantly looking for and exploiting mispricings ("capturing Alpha") in the stock market, I know that if I buy an index fund and keep my costs low, I'll probably outperform a majority of actively managed mutual funds, after fees.  

Unfortunately, the fact that some managers do consistently outperform over the long term is of little comfort to the small investor who is hoping to beat the market himself.  After all, institutional money managers (mutual funds, investment banks, hedge funds, etc.) possess resources that the individual investor can only dream of: teams of analysts to read through the footnotes of GE's 10-K's and annual reports line-by-line, who understand the difference between a capitalized lease and the Capital Asset Pricing Model (CAPM).  Quant hedge funds have supercomputers which can do technical analysis of 5,000 stocks in the blink of an eye, and recognize a head-and-shoulders top formation faster than you can say "dead-cat bounce."

Can a small investor or money manager who can't pay a team of analysts or computer programmers to do market analysis have a chance of finding some mispricings?  It's generally accepted that, at any given time, there is only a finite amount of profit to be made by identifying and exploiting mispricings in the market.  Put another way, there is only a finite amount of Alpha to go around in any one market.  On the other hand, there must be some Alpha available in any financial market: according to the Arbitrage Pricing Theory (a much more general and realistic version of CAPM), it is the successful active managers who make markets efficient, and they make profits by doing it.  

It's my belief that small investors and money managers can beat the market, and institutional managers.  We can do this by understanding the competition, and exploiting their weaknesses, or just avoiding the competition altogether.  Active portfolio management is a game that can be played as many ways as there are active portfolio managers, but large portfolio managers are shaped by who they are and the nature of the money they manage.  

Number Crunchers and Alchemists

We are primarily concerned with big, actively managed pools of money.  They could be actively managed mutual funds, pension funds, endowments, or hedge funds.  By definition, index investors do not trying to capture Alpha, and so they do not reduce the amount available for other investors.

How do active managers go about finding mispricings to exploit?.   They are either highly trained analysts, such as CFA® Charterholders, or brilliant individuals or teams like Warren Buffett or George Soros who have the right combination of skills, insight, and emotional outlook to be one step ahead of the market most of the time.  Most CFA® Charterholders will try to beat the market by superior analysis: they patiently gather all the available information about a company, make adjustments to financial statements to make the information more meaningful, and use that information to project future earnings, cash flows, or dividends into the future to come up with a valuation of a company: that is what the curriculum teaches.  If the market price of the security is significantly under-(over-)priced, their fund will buy (or sell) the security in question.  Warren Buffett follows a similar procedure (I highly recommend Robert Hagstrom's book The Warren Buffett Way.)I consider this approach "number crunching": gather data, analyze carefully, and take action.  

Investors like George Soros, on the other hand, practices what he terms Alchemy of Finance (see link to his book of the same name).  He looks for the trends under the market that the numbers hide from us: the forest, rather than the trees.  More recently, this sort of financial alchemy is being explored by academics and market participants alike in the form of Behavioral Finance: the art of understanding how our emotions and ingrained biases lead us to make bad decisions in the market.  Investors and traders who, like Soros, can see those biases in themselves and others can capture entirely different forms of Alpha that simply are not visible to pure number crunchers.

I am only implicitly addressing the discipline of technical analysis (as opposed to fundamental analysis) but I feel that it also breaks down into number crunching and alchemy.  Number crunching technical analysis uses computers to analyze stock charts to detect and exploit formations as the evolve with sophisticated statistical analysis.  This approach has actually been statistically validated by Lo and MacKinlay in their cleverly-titled A Non-Random Walk Down Wall Street (I don't recommend this one unless you like reading statistics for fun; it's quite a tome... If you want to read more, start with this article on TraderFeed.)  The alchemists of technical analysis are people like Richard Russell, who look at a chart and have an instinct for how it will evolve.  I think this is the way most successful day traders operate; I expect that number-crunching technical analysis is dominated by hedge funds, who can afford the computing power and programmers it requires.

My classification of active managers into number crunchers and alchemists is not strict.  Successful investors most likely do some of both, and one skill set is invaluable in informing the other (which is why I'm studying for the CFA® exam.)  As the curriculum frequently emphasizes, good analysis requires judgment, and knowledge of the weaknesses of the method you are applying.  However, I believe that the number crunchers vastly outnumber the alchemists, and that the judgment that the CFA® curriculum attempts to instill is likely the hardest part of the curriculum to learn.  Judgment is also extremely hard to test, and while the CFA® exams are very comprehensive and require considerable study, most of what they test (in my experience so far) is numerical methods, not judgment.  Additionally, the Chartered Financial Analyst® designation is an elite designation (how many people have time for 200+ hours of study each year for a minimum of three years?), and I'm constantly impressed by the emphasis placed on individual judgment and the weaknesses inherent in the models taught.  The majority of people who describe themselves as "stock analysts" or "portfolio managers" do not have the CFA® designation, and probably have not had so much emphasis placed on the inherent weaknesses of analytical models. (I did a quick, unscientific check on the prevalence of the designation by searching LinkedIn: only about 10% of the people who have the words "stock analyst," "investment analyst," or "portfolio manager" in their profiles also mention the CFA® designation, and a good number of those, like myself, are CFA® candidates.)

I think the availability of enormous computing power compounds the number-crunching trend: when you have a hammer, every problem looks like a nail.  Add the fact that the skills of a number cruncher are much easier to evaluate and put on a resume, and large institutions with money to manage are more likely to hire people with these skills.  

If we wind up with far more money being managed by market number crunchers than by alchemists, it follows that there will be a lot more unexploited alchemy-exploitable Alpha than number-crunching exploitable Alpha. The small investor, with limited time and resources to hunt for Alpha, should hunt where there are fewer hunters, and exploit the weaknesses inherent in large pools of money managed by number crunchers.

Weaknesses of Large (number crunching) Money Managers

What are the weaknesses small investors should try to exploit?  Here are some I see:

  • Too Much Money: Because they have so much money, the can only trade very liquid securities.
  • Agency problem: A manager's strongest incentive is often to keep his job, not to make as much money as possible.
  • Analysis paralysis: Too much modeling, not enough judgment.
  • Historic bias: all data is historic data, but we are trying to predict the future.
  • Benchmarking: the goal is often to beat a benchmark, not make money.
  • Inflexible mandates: many managers don't have much choice about the type of securities they invest in.

Next week, I'll go into some detail about how I try to take advantage of them.

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

April 29, 2007

Preparing for Catastrophe: Is your global warming portfolio ready for rising sea levels?

A Worse[sic]-Case Scenario

I believe that a large part of global warming denial is fear: fear that if we acknowledge that global warming is happening, we will be morally obligated to do something about it, and that the problem is too large for us to do anything effective.  I also believe that denying the problem is certain to render us all ineffective in dealing with it.

But getting over our global warming denial is not the only obstacle in our way to dealing with it.  Global warming is already happening, and  future temperature rises are already inevitable given the continuing effects of global warming gasses already released in the atmosphere.  Depending upon our actions today and over the next decade, we will effectively choose between a planet that is uncomfortably warmer than it is today, and one which is much too toasty for even the Russians (who some economists predict will be net beneficiaries of global warming) to be happy about it.

That's my belief.  If it makes me sound like a raving lunatic, so be it.  As an investor and investment advisor, I see my job as having an opinion that differs from the consensus, being correct in that opinion, and investing in such a way that I will make money for myself and my clients if I am correct.  As long as I am correct more often than not (or realize my mistake before I've lost too much money), I'll actually make more money the fewer other market participants agree with me.

I gave an example of this when I discussed how to prepare your portfolio for Peak Coal, on the assumption that while the production of coal may not peak in the next decade or two, rising demand may nevertheless drive price spikes that create investment opportunities.  I'm personally not certain when peak coal will happen, but I'm fairly confident that most investors are too complacent about it, and that is reason enough change the allocations of a diversified portfolio.

Investors Believe What they Want to Believe

Since people tend to deny ideas that are just too scary, a consequence of global climate change that I expect most investors are under-prepared for is a massive (15+ foot rise) in sea level rise due to the melting of either the Greenland or West Antarctic ice sheet.  From casual conversations, I note that Al Gore got a lot of flack for even bringing up this possibility in "An Inconvenient Truth"... despite the fact that he was careful not to do more than raise the possibility, as opposed to predicting it.

We don't know if those ice caps will melt suddenly, or, if they do, when it will happen.  We do know that their melting has accelerated in recent years, and I believe that society has massively underestimated the danger, because a 15 foot sea level rise (let alone a 20 or 40 foot rise) is just too horrific for most people to think about.  Given our propensity towards psychological denial, I feel confident that the markets are underestimating the chances sea level rises large enough to seriously disrupt large coastal cities.  Note that I'm not saying we will see such a sea level rise in my lifetime; rather that the probability of such a rise is currently underestimated by most market participants, and that this complacency is likely to be reflected by a relative overvaluation of investments which stand to lose from such a rise, and an undervaluation of investments that might gain.

If we can identify the exposure of individual securities to the risk/opportunities of sea level rise, we should then underweight our portfolio to investments which stand to lose, and overweight towards investments which stand to gain. This begs the question: Other than coastal real estate, which investments are which?

One environmental activist friend of mine asked me about using the Chicago Mercantile Exchange's new housing futures or options to effectively short real estate prices in coastal cities.   While this may be a good strategy to hedge against further implosion of the current housing bubble, these derivatives all expire within one year, which even I feel is much too short a horizon to hedge the risk of rising sea levels.  In addition, given mass flooding from a rise of sea levels, there is no guarantee that the very indices that the futures are based on would not be changed to only reflect the values of real estate in higher lying areas, which would probably increase in value as people moved to higher ground.

Holding back the Flood

On Earth Day, Marc Gunther reported on an idea to come out of  a Goldman Sachs conference on the business of climate change: dikes.  If sea levels were to rise even a foot over the next couple years, that would require massive new barriers to protect existing structures from the ravages of the sea.  The companies who build those dikes are likely to profit handsomely as soon as the need is recognized.  I'm not an expert on the construction industry, but my impression is that it is fragmented and most of the companies are privately held.  However, makers of the equipment and materials necessary for shoreline reinforcement may be easier to find, such as companies in the cement industry such as Cemex (NYSE:CX.)  Another likely beneficiary a dike building boom would be Caterpillar (NYSE:CAT), given their leadership in earth-moving equipment.  CAT has the added benefit of being a company which is actively lobbying for meaningful greenhouse gas regulation, which I pointed out in my article on blue chip companies involved in alternative energy.

On the downside, one loser would be any owner or operator of seaside resorts, such as Club Med (CLBXF.PK.)  When considering an investment in any REIT, I would make sure to check their portfolio of properties, and avoid ones that have excess exposure to oceanfront or low-lying properties.  On the other hand, REITs and other real estate firms focused on areas where people are likely to flee (my own Denver, for instance) might stand to gain.


Given the massive uncertainties in predicting the probability and timing of large sea level rises due to melting ice caps, I don't advocate buying or selling any company solely because of the risks or rewards which would be a consequence of rapid sea level rise.  I do, however, advocate considering the possible effects of sea level rise on any investments you currently own or are considering buying.  Managing risk is essential to long term superior results, and ignoring a risks in the hope that that they will go away is an excellent way to lose your shirt.

DISCLOSURE: Tom Konrad and/or his clients have positions in the following stocks mentioned here: CAT.
DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

January 23, 2007

State of the Union Address: Alt Energy Sectors and Stocks to Watch

So it came and went, the much anticipated State of the Union Address. While the pundits will inevitably focus the bulk of their attention and commentary on the Iraq question, there were undoubtedly some very interesting nuggets of alt energy info in that speech.

Above all things, one crucial variable has changed from a year ago: Congress is now controlled by the Democrats and already the slew of alt energy and climate change proposals brought forth by various senators leads one to believe that, as far as the federal government is concerned, 07' should see more than just hot air on the alt energy and clean tech fronts.

Sectors Of Focus

OK, so let's dive right into it (see a complete list of 2007 State of the Union Policy Initiatives here):

Automotive and Fuels

By far the category that got the most attention and the clearest targets. Key points are:

- Cut down gasoline consumption by 20% by 2017

- A mandatory Fuels Standard requiring 35 billion gallons of renewable and alternative fuels by 2017 (read: mostly corn-based ethanol for now with coal-to-liquids starting in the latter half of 2010 and cellulosic ethanol in about 2012)

- Tougher fuel economy standards via a "modernization" of CAFE standards

- Research into battery technology for hybrid cars and plug-in hybrids (this is worth noting)

- Focus on cellulosic ethanol (not entirely unexpected but noteworthy nonetheless)

- Doubling the current capacity of the Strategic Petroleum Reserve (SPR) to 1.5 billion barrels by 2027 (hhmmmm...indirectly constraining oil supply in light of the forecasted supply-demand environment of the next 2 decades...that can only mean good things for alt energy!)

Electricity Generation

- More solar and wind (yyaaaawwwnnnnn...)

- Clean coal technology (at least another few years away, but worth trying to spot early movers on the technology development side (rather than on the utility side))

- A renewed focus on nuclear power (this is interesting and something several people have been pushing for - one the best ways to play this from a growth angle is via exposure to uranium miners and exploration companies, but that is for another blog to discuss)

Climate Change

- 1st time, as far as I can tell, that this administration was so emphatic about the need to combat climate change

- The President's strategy "will help confront climate change by stopping the projected growth of carbon dioxide emissions from cars, light trucks, and SUVs within 10 years (read: Bush agreed to saying "climate" and "change" together in the same sentence as a gesture of good will but he is nowhere near ready for federally-mandated greenhouse gas caps and carbon trading, so probably forget '07...but I wouldn't exclude '08)

Stocks To Watch

Here are a few stocks to watch over the near and medium terms. Admittedly, this is not an exhaustive list and I would welcome suggestions from our readers, especially with regards to battery makers.

Fuel Economy

Toyota Motors [NYSE:TM]
Honda Motor Co. [NYSE:HMC]
Borg Warner Inc [NYSE:BWA]
Magna Int'l [NYSE:MGA]
Raser Tech [NYSE:RZ]


Himanshu Pandya beat me to it with a nice and comprehensive post. If you want to make a quick momentum buck, you should be in for a fun ride over the next few days. Beware the hangover!!


Rentech [AMEX:RTK]
Syntroleum Corp [NASDAQ:SYNM]
Headwaters Inc. [NYSE:HW]
Sasol [NYSE:SSL]

Batteries for Hybrid and Plug-in Hybrids

Altair Nanotech [NASDAQ:ALTI]
Maxwell Tech [NASDAQ:MXWL]
Energy Conversion Devices (via its Cobasys unit) [NASDAQ:ENER]

Cellulosic Ethanol

No public company with exposure to cellulosic ethanol to speak of...yet

To Conclude This Evening's Broadcast...

No, I did not include every single alt energy company listed on US stock markets, and that is because this speech was very light on details for most alt energy areas except transportation. Transportation is the only category on which we heard some a) new and b) substantive things tonight. Nevertheless, I'm curious to see how the solar sector will do tomorrow. Something tells me we might be in for some interesting action.

Independently of this Address, there is some movement on a number of fronts that will be beneficial to various alt energy sectors, but those initiatives have to be examined independently. Keep checking in for an upcoming review of all of the federal proposals currently on the table.

DISCLOSURE: I do not have a position in any of the stocks discussed above but I do have exposure to the solar and uranium mining sectors.

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