Searching for the Bottom

In this economic climate, in a similar thread to my post about the Hawk Dove model, everyone is waiting for the bottom so they can start to get in. I would, however, like to attempt to make the alternate case for those interested in getting in early by taking my most recent post about Daydreaming and Buyer's Remorse and extending it to explain why searching for 'absolute bottoms' is a bad strategy.

As have repeatedly mentioned, prices in the 52 week high or low category are at the extremes of stock prices. Consider this graph below:Today is represented by the leftmost point. In other words, this graph hasn't 'happened' yet. Assume that this is an optimistic view that this is the potential future of the stock you are analyzing. This assumption requires the belief that the stock will not stay down forever (a key point here, however, is that the time quantiles are not defined, that is to say we don't know how long it will take for this pattern to emerge). You can see some clear trends and spreads which emerge in the diagram below:The question I would like to propose is what is the best price to buy the stock? Instinctively, most of use would probably say at the very bottom of the through (at the very beginning of the second trend segment - the price stabilization point). However, I submit to you, that even if you could model the stock with extreme precision and pin point the bottom of the stock price valley, and even if you submitted an order to your broker who was exceptionally skilled, unless you yourself were sitting at a Bloomberg terminal with special trading hotkeys for one touch execution (such as those on the trading floors at major institutions) you would not stand a chance of getting in on the "ground floor"). Let's look again at the stock price, but using a more statistical analysis approach:Here we can see a more clear picture. The 52 week low occurs only once. Whereas purchasing a stock at any price below or near the lower trading band is common (almost two thirds of the total time window shown here). Also, the stock is entirely below the intrinsic value we modeled.

The challenge here is if you can have the foresight to correctly model the price of the stock using the appropriate valuation tools, you can maintain a relatively safe position while you wait to the stock to go up. The only problem with buying too early is that there is a bit of stomach turning as the price drops as well as the time elapsed between when you buy and when you start to see positive returns.

Sustainability and a Green Focus

The top issue with MBAs and other business leaders today is the idea of sustainability (Wikipedia article authored Jan 8, 2009) coupled with corporate responsibility. Although, MBAs are currently highlighting this area as important, it lacks a definition which is meaningful as actionable advice.

I would propose that the most base definition of sustainability should relate directly to energy capture and consumption. However, since products cannot simply be arbitraged nor modeled directly as energy consumption, there are many other aspects which must be considered: carbon emissions, land use, natural resource extraction rates etc.

It is quite obvious that anything which is consumed and not replaced is in an inherently unstable relationship. Currently, companies such as Monsanto are working "diligently" in order to increase the yields of products we consume (in Monsanto's case, GMO food products) as a solution to assuage the strain and diminishing return of our resources. However, even the most cynical and fastidious capitalists must recognize that there exists some natural limit of efficiency (even with technological augmentation).

Biotechnology growth has recently spiked up as a result and its now up to companies to find out what that means for them. How should companies incorporate business practices so that they can benefit from this inevitable trend. While some companies are contributing at the forefront with new innovations in resource management, other companies will have to find which services they can provide or will demand in the future. Whether these companies are innovating to create substitutes or trying to increase the efficiency of how we use our resources, sustainability management will likely become an increasingly popular (and necessary) field.

Daydreaming and Buyers Remorse - Using the right metrics

If there is a pet peeve I have when it comes to investing, it's the use of 52 week highs and lows to calculate potential gains or losses. I think it's absolutely absurd that some investment "professionals" will quote 52 week records as potential gains (or losses). Or quote the 52 week high as "proof" of the potential in the stock. If there is one obvious lesson that should be apparent, it's that sky high (as well as rock bottom) prices in the extreme ranges are a function of exuberance and certainly not any rational decision making.

Also understand this. Do you know how many trades were made at the 52 week high (or low)? One. That was the last trade before the price started moving back towards it's equilibrium price.

Let's take a look at the stock chart below. Look familiar? It should. Almost all stocks on the market have exhibited similar behaviour:That heavy drop would have made it's appearance at different parts of last year depending on what industry sector your company was in, but this shape is fairly common (unfortunately). The next graph we add a moving average trend line for technical analysis purposes.Finally we highlight our 52 week highs and lows.I think the next portion is the most important (and the overall lesson), is that aiming to hit the 52 high and low is ridiculous. Even the most advanced traders would probably be happy making a reasonable spread between the upper and lower trading bands shown here. For mathematical purposes, assume that they are only one standard deviation from the mean. And for assumption purposes, assume that the mean is the intrinsic value of the stock (what it *should* be worth)Assuming that you trade within the band, your volume will cover 68.2% of all the trades (one standard deviation) and you'll make a hefty profit (especially if the stock's volatility is high).

You can also do a trade off between profit and risk if you narrow your band (to say, half a standard deviation). In the extreme (of small margins and high volumes) the sales and trading technique is known as 'scalping'. Granted that these statements assume that your valuation model can identify these parameters, but even if you can't get exact parameters, the concept still holds (stronger precision and accuracy will provide stronger profits).

A critical observer would also note the following: "But what if the 52 week low we see here isn't the bottom?"

That is the topic of my next post: "Searching for the Bottom"

The Hiring Process

With the economic downturn, it has become more important than ever for companies to employ the best HR practices possible, whether they are looking to shed excess capacity (lay off workers) or use this opportunity to pick up top talent.

I don't think anything drives this point home more than a recent job fair I went to in Toronto where the line up went out the door and across the floor of a crowded convention hall to meet up with a hand full of employers, only a fraction of which were actually hiring. Although these employers can have their pick of the litter, it becomes very difficult to sort the wheat from the chaff.

The recruitment process, a process like any other, has many metrics which can be used to determine it's success rate. Recruitment and hiring can also be evaluated at different stages to understand the relative performance and contribution of each stage to the overall success of recruitment efforts. First let's take a high level look at the recruitment process:
Recruitment Events:

Although it would be perfect for recruiters to be able to attend all recruitment events with potential candidates, the reality of the situation is usually that there is a limited staff and budget. This in turn means that recruitment teams have to prioritize their attendance based on their recruitment goals and needs. Similar to a targeted marketing campaign, HR recruiters need to advertise to their perspective new hires to get them interested in applying. A valuable metric to evaluate for this stage is how many applicants applied and how did they find out about the posting. While job boards like Monster.com might have a swarm of applicants, the quality and relevance of each applicant might not be of the caliber or fit you are looking for.

Application Process:

The problem with recruitment today (especially in this climate of high unemployment) is that there is usually an insurmountable number of applicants. The application process needs to be able to navigate through the clutter, however, it also must be concerned with disguarding good candidates. Even the best tools in this area will appear as double edged swords. The application process is usually as follows:

1. Application materials are screened by an automated process (Resume / CV, cover letter, references, transcripts)
2. Recruiters pick out top candidates for a first round interview. In this interview, the recruiter does a pre-screen for fit within the company, behavioural interviews, and leadership / soft skills assessment etc.
3. If the candidate passes, they are then passed along for a second interview, usually with the hiring manager or colleagues for competencies and technical skill.
4. A subsequent interview may follow by a senior executive for long term potential within the company and final approval.

Many companies have referral programs which aim to quickly identify good quality candidates. These pre-existing relationships act as a pre-screen for candidates as current employees vouch for their ability to perform the roles. It has often been said that 80% of all jobs are found through networking. Some companies even provide an incentive for employees by offering a referral fee for candidates who are extended an offer.

At this stage, it is also important for companies to evaluate the process and individuals participating in what Jack Welch calls the Hiring Batting Average. It's essentially a review of the success of your company's recruitment team to ability to identify and hire star employees at each stage. Those who are proficient should continue to be involved (or escalate their involvement) while those who are less successful need to improve their "batting averages" or be taken out of the process.

Candidate Offers:

Hopefully, by this point there are few hiccups in hiring process. However, for highly skilled or demanded candidates, there may still be the need to negotiate terms, benefits and salaries. If you offer competitive salaries, you will not lose as many good candidates to other companies (and retain them for longer also). Looking at your compensation system and ensuring that it is aligned with your needs and value proposition as an employer of choice.

Hired!

By looking at all of these items independently and as a whole, companies can make the most of the resources they have in order to provide the most benefit for their operational teams. In an environment where more is being demanded with less, it is crutial for all members in a company to operate at their most efficient levels. Especially the component which is responsible for adding more memebers.

Elasticity - Inferior Goods - Opportunity for Observation

I have recently been discussing Elasticity because it is an important economic concept which aims to describe a component of human behaviour when in comes to economic choices. As I had previously mentioned, the current environment is a spectacular opportunity to observe and learn. It is a chance to see if the lessons we learned in class hold up in the real world and probably as "ceteris paribus" as we will ever get as this is probably the worst economic conditions we've had in a good long while.

Having said that, theoretically, what should our studies in this area have told us to predict?

Elasticity is a function of our anticipation of price movements. If we expect prices to fall, our consumption will drop as much as our elasticity will allow. For instance, if you plan on making a purchase of a good, if you expect it to be cheaper (in real terms) tomorrow rather than today (and you can wait), chances are you will buy it tomorrow. If you expect that the price will see a dramatic rising tomorrow, you will buy as much today as you can reasonably stockpile (assuming your product's life expectancy and expiry is aligned with your consumption habits - you'll "front load" your consumption). A good example of that is TTC token sales and hoarding rules before an expected price increase.

Also, your consumption of various goods will also depend on the "weight" of consumption as expressed as a percentage of your total income. For instance, your consumption of rent (or mortgage) is probably your largest outlay. Most of us will probably compromise on the size of the apartment we rent (or the house we buy) in order to stay on budget and are more sensitive to price changes here because a small percentage change in the price reflects a large percentage change in our total consumption.

There is also the idea of "inferior" goods. The typical examples are small motorcycles, rice and potatoes, public transit etc. The idea is that these uniquely positioned products have a negative relationship with income elasticity. What does that mean? Unlike normal goods where an increase in income generally increases demand, inferior goods actually become less popular (contra their substitutes) when income goes up. If you make more money, you'd probably stop taking the metro and start driving.

In an environment where people are losing benefits, taking pay cuts or flat out losing their jobs across the board, it would be interesting to see the economic effect on the purchases on some of these goods in some form of "inferior goods" index as a measure of general economic hardship. This might be one area which would actually benefit from economic recession.

I hope I don't appear like I am profiteering, but I think that the best way to get out of an economic crisis is to find the bright spots and leverage them (I don't mean "financially leverage" - not taking out loans to buy the stock, I mean strictly in the strategic sense) to being our slow climb out of the recession. Essentially, I'm trying to identify places which might do well in a recession, places with these qualities that would probably increase their hiring and slowly bring spending back up (along with consumer confidence).

Local Coffee House Profit Conundrum

Introduction:

A local coffee house was looking at its books and noticed that it's profit margin for the last quarter were down. This was a seemingly large contradiction and interestingly confusing to the management, who decided to investigate further as growth had been fairly steady. In fact, their intuition told them that they had more customers these last few months than usual. Let's use the Rotman School's Integrative Thinking model to break down the problem.

Salience:

In breaking down the their profit model, they were certain that their cost model was the same: Despite the fact that there was more traffic coming to the store, they had not changed their hours or personnel per shift. Standard supply side items such as rent and food and beverage suppliers had not changed and there were not any large capital outlays for new equipment nor maintenance.

In investigating the revenue side of the profit function, very little had changed as well. The product prices had remained the same and volume had even gone up recently.

Causality:

However, upon inspecting the volumes of each types of products purchased, it became apparent to the management that there was less people dropping in for snacks. There was a steady strong demand for lunch products such as sandwiches, but a decline in the demand for coffee, a high margin product.

As a result there was also a shift in the peak periods from the 10 am to the noon hour, when a local university's students were let out of their morning classes for lunch.

Architecture:

To identify how to build a framework around the issue, the management team looked at the causes of the drop in profit margin and looked for opportunities and strategies to capitalize on this new dynamic.

By identifying this shift in consumer behaviour, there is an opportunity to better align their services with their new client base to serve them better.

Resolution:

Based on this demographic shift, there was a higher demand for their lunch products and potential to develop a more robust menu beyond the limited offering they were currently providing.

There also exists the possibility to shuffle the shifts to meet the change in demand from the shift in the clientele and to adjust their inventory sizes accordingly to minimize inventory carrying costs and spoilage.

Sunday Reflection: Supply and Demand Curves to Describe Equity Prices

Basic economics can be used to describe the investment landscape and are easy to explain if you consider investment vehicles as different products and different asset classes as substitutes for each other. Again, just like any fungible item which can be bought and sold, stocks are bound by the laws of supply and demand.
Savers (with net positive capital) represent the demand curve for investment vehicles, while companies issuing various investment vehicles (net negative capital) represent the supply curve of investment opportunity.

The float or the number of outstanding stocks actively traded at any given time, would be described as quantity supplied / demanded where the supply and demand curves meet. Note that unless there are additional shares issued (or a company stock buy back) the supply curve is relatively inelastic.

Trading volume and price would be represented by incremental movement of the qs / qd equilibrium (notice that for every transaction, there is a buyer and seller of the same product so the qs /qd immediately returns to its equilibrium point) and it's associated price movement.

Substitute products for equity class assets include fixed income instruments such as bonds, mezzanine instruments such as preferred shares or others investment vehicles.

IPO's or secondary offerings would be represented by a right shift in the aggregate supply curve (more supply and options for investment vehicles)

Companies going bankrupt would be a left shift in the aggregate supply curve (less supply).

The aggregate demand curve (and movement in it) would most likely be caused by growth in the wealth of the general population (more wealth means, more saving and more demand for investment vehicles) manifesting as more people putting money into the market.

Finally, "financial innovation" usually describes a method of artificially boosting the one of the market's economic curves. Previous examples include: RRSP or 401k qualified purchases of stocks (demand right shift - releasing more cash into the market), and the more recent (and disastrous) recursive packaging of various CDO trenches (supply right shift - providing additional places to put your money to maintain growth).

Now that we have all the pieces, how can we use this to describe the current economic crisis?

While the market was super hot, bankers had to look increasingly harder for new investment vehicles which could potentially give the same return. This has lead to the poor lending practices we so often hear about where banks were loose with their money in the housing market. These housing loans were collateralized to redistribute the risk and parceled out to investors.

When these bad loans started to default, people started to panic as they realized that what they had bought wasn't investment grade (as they had be lead to believe) but really just junk.

Then people start to liquidate their positions and the demand curve for that asset class takes a huge shift to the left dropping prices in equities across the board. It is very hard for the companies to match this movement (as a left shift in supply means they are rapidly becoming smaller) and supply is relatively inelastic in this scenario. Unless the company is delisted or otherwise has its stock forced off the market, there remains an oversaturation with the number of stock issues.

However, all this capital flowing out has to go somewhere. This is the "flight to quality" that everyone hears about, where people take their money out of risky asset classes (such as equity) and start dumping them into more stable US government T-bills or bonds (or stocks in defensive companies). This causes a huge right shift in the demand curve of that asset class and the prices skyrocket.

As an Engineering student, I've always believed that "You can cheat on your exams, but you can't cheat physics" as a good lesson and warning for those who would try less scrupulous methods to succeed. However, even in investing where the science is greyer and mixed with equal parts art, it's both reassuring and telling that the laws of gravity and science of economics still hold.