Trade Archive
What follows below is an inventory of
the "rational speculations"
that were introduced at the conceptual level in the Philosophy
page of this website. As the contents indicate, these were actual
trade opportunities (note that I am using "rational speculations"
interchangeably with "trades," though my definition of the latter is much
more narrow than the colloquial version). The explanation presented
for each trade is a summary of the reasoning behind it rather than the
entirety of the analysis. Presenting more than that simply wouldn't be
practical. The reader should note that all trades are post-hoc and
offered for illustrative purposes only. All of these trades fall squarely within my definition of rational speculations, but view these and all other
examples with the appropriate skepticism.
Most "worked" in the literal sense of being profitable, but each one is inevitably flawed, and
in a number of cases I spotlight what I perceive to be the shortcomings of
my own analysis. These are only a handful
among hundreds, but I attempt to provide a broad spectrum of fundamentally different
examples in order to highlight how diverse these opportunities can be.
iShares MSCI Japan Index ETF (EWJ) Trade on Overreaction to Livedoor Scandal and TSE System Breakdown (January 2006) This trade was based on a combination of events: (1) An overreaction to the scandal surrounding alleged violations of disclosure rules (among other regulatory concerns)
by a company called Livedoor and (2) A technology-related breakdown of order flow on the Tokyo Stock Exchange (TSE). On January 18th the TSE, the second largest
stock exchange in the world, was so overwhelmed with order flow that
for the first time ever it shut down trading early. The Nikkei 225 average, which rose by 40% in 2005 , lost 5.7% in two days, as did the broader TOPIX Index. This would on its face seem odd, given that Livedoor isn't even listed on the TOPIX, but
one theory making the rounds was that so many online traders used Livedoor shares as collateral that
a multiplier effect took hold. Historically speaking, this type of
cross-security contagion isn't without precedent. Theoretically, the advent of online brokerage accounts and overwhelming influence of program-driven trading probably increases the odds of self-reinforcing
declines in the market. Exchange officials certainly didn't have to exacerbate the problem on the 18th by announcing at mid-day that they might close the TSE early that day.
It's hard to think of a better way to trigger a stampede. What does any of the preceding have to do with the apparent recovery of the Japanese economy or the companies that comprise the EWJ? Absolutely nothing. It was a dislocation forced by technical factors that had no relationship with the fundamentals underlying the EWJ ETF and assets it comprises. Hence, this was a rational speculation both entered and exited very aggressively,
but for divergent reasons. Once I put the position on I almost immediately realized that in order to have a substantial return the trade would have to be held for an extended period. Even if the EWJ bounced back
hard, over-correcting to an overreaction, there wasn't much of a margin to capture
in the short-term. Having not done enough homework on the big-picture fundamentals, I resisted the lethal temptation to convert a short-term trade into a long-term investment. From a
speculative viewpoint, the round trip wasn't a bad maneuver, but there were no victory laps when I closed out the position.
I had merely succeeded in picking an easy nickel off the
pavement before the steamroller got too close to my fingers. Ackerley (AK) / Clear Channel (CCU) Spread Trade Enhanced by CCU Call Sale $0.14 Out-of-the-Money 1 Day before Expiration The AK/CCU merger spread was trading at $0.07 - an insubstantial return. However, one day before expiration one could put the spread on - that is, buy AK and short the buyer CCU - by selling the CCU 50 strike call expiring the following day for $0.40. This meant that you would be putting on the short leg of the trade (CCU) at $50.40 ($50 strike + $0.40 in call premium), effectively locking in the spread at $0.26, or 1.5% gross / 33% annualized. The only risk was that CCU would not close above $50, with the result that rather than locking in the spread you would simply be long AK. However, the $0.40 that you would collect
seemed a more than adequate cushion to exit the trade on Monday at no significant loss in the event that you were naked long the AK at Monday's open. For the spread trade to work, CCU had to rise only $0.14 (at which price the call you sold would be executed and you would effectively be short CCU against your long AK position). This position was taken on the assumption that the deal would close, but the only remaining hurdle was FCC regulatory approval. Tyco (TYC) Trade on Overreaction to Radionics Unit Inquiry This trade was based on an overreaction to the announcement of an FDA warning to Tyco re. the quality control at their Radionics unit in Mass., which manufactures shunts and catheters. Investors were so gun-shy re. this stock that it plummeted $1.50 intraday without any consideration of the negligible impact such a development would have on the company's bottom line. This is a primary example of a fundamentally irrational response and a great, low-risk intraday trade. This wasn't a large position due to the highly volatility and continuing
transformation of TYC's shareholder base, and wasn't a home run on a gross return basis, but it nonetheless presented a very attractive, low-risk incremental profit. Compaq (CPQ) / Hewlett Packard (HWP) Trade on News of Walter Hewlett Lawsuit Upon the announcement of Walter Hewlett's legal challenge to the results of the CPQ/HWP proxy, the spread on the merger widened to $1.05. My immediate reaction was that it was extremely unlikely that HWP and CEO Carly Fiorina would engage in overt proxy fraud and/or violate SEC regulations - as was alleged in the suit - in order to succeed in the takeover. Later perusal of the court filing unveiled that the suit was based on
(among other things) an "unidisclosed understanding" between HP management and Deustche Bank, whose asset management division was a major shareholder but whom also had an investment banking relationship with HP,
ostensibly prompting DB to change its vote to "for" the takeover just prior to the closing of proxy solicitations. For this trade, the ultimate outcome was effectively irrelevant because of the extremely brief holding period. The spread was put on at $1.05 (it traded wider
- one could argue I timed it poorly) and unwound less than 2 hours later at $0.80, capturing at least $0.25 at very little risk and over a very short time period. Compaq (CPQ) / Hewlett-Packard (HWP) Trade on ISS Announcement (3/4/02) Proxy adviser Institutional Shareholder Services' (ISS) evaluation of the Hewlett-Packard/Compaq merger, which was announced March 5, was
interpreted as having influenced the votes of institutions holding approximately 20% of the shares of HWP. I felt that the merger would succeed regardless, but prior to the ISS announcement there was
an opportunity to put the spread on (long CPQ, short HWP) at the $1.80 level, only to unwind the
position the immediately following day for $0.75 or less, effectively collecting $1 in profit in less than 24 hours. It's worth noting that this profit was achievable without shouldering the risk
pertaining to the ultimate outcome of the deal, which was a much more complicated analysis than simply speculating that the ISS vote would have a more positive than negative impact on the spread. Additionally, because the spread was already so wide to begin with, the prospect for significant losses as a result of an "against" vote for ISS was more than acceptable. Kimco (KIM) Trade on K-Mart (KM) Exposure (10/19/01) Kimco was a once-removed trade on K-Mart's stumble into bankruptcy. I was too late to exploit the KM price decline, but the market had yet to grasp the impact I anticipated that KM, KIM's biggest client, would have on the latter's bottom line. Two additional factors making this an attractive trade were: -
KIM was already trading near an all-time high in terms of valuation; and -
Based on a one-off transaction KIM executed related to the properties of the defunct Montgomery Ward, there was reason to believe that the company would have difficulty replacing said transaction with recurring revenue from other sources. Militating against the trade was the fact that KIM was one of the most respected REITs in the business. Also, it seemed unlikely that the price would decline too greatly because the dividend (if assumed reliable) would put a floor under the price (in other words, as the price descended it would eventually reach a level where the dividend yield would drive buyers back into the stock). Thus, it was attractive as a short-term trade only - I held the position for 5 days - but very profitable within that scope. In hindsight, KM's bankruptcy appeared to have little impact on well-managed KIM. However, enough factors were
leaning in my favor for the trade to be profitable over the short term.
Accenture (ACN) Trade on Exposure to Anderson Liability (3/8/02) Arthur Andersen
as a result of its relationship with the Potemkin corporation Enron. Accenture, the consulting arm once referred to as Andersen Consulting, separated from the accounting business, Arthur Andersen, the accounting firm, in 1989. However, the two entities
were still associated by a coordinating body based in Geneva which theoretically could have served as sufficient legal relationship for liability to travel through to the Accenture business. Whether the aforementioned ACN lawsuit would ultimately succeed is irrelevant because, given the vastness of the Enron liabilities
and comparative absence of assets, it seemed
inevitable that the plaintiff's bar would pursue the Accenture assets. Thus, the trade was based not on the ultimate success of such litigation but on the inevitable drop in the share price when the litigation was announced. Additionally, as an event trade this was an attractive opportunity because ACN was already trading at a very rich multiple and
close to its all-time highs. Being short the stock presented little potential downside because, in light of the Enron scandal, an upward valuation of ACN was very unlikely. This observation was ratified when during the pendency of the trade several firms upgraded the stock to "strong buy," but to very little effect. All of this activity was against the backdrop of a huge overhang of stock in the hands of management that would soon be "unlocked"
and thus free for sale, potentially exerting
significant pressure on the stock price. An unexpected but very beneficial catalyst that allowed me to exit the trade relatively quickly was an announcement by ACN that the company was going to double the number of shares available for trading. That ACN chose to issue additional equity at the same price that I shorted the stock in the very least confirmed that they shared my viewpoint that the stock was fully valued. Petroleum Geo-Services (PGO) / Veritas DGC (VTS) Spread Trade on Completion of Bank Financing (3/13/02) I had been involved with this deal almost from inception, and considered the possibility that the spread might react significantly to PGO receiving bank financing that would serve as a bridge facility to carry the company through to the deal's completion. The logic of this thesis was very straightforward: Given the leverage and operational difficulties of PGO, the bankers would
under no circumstances extend bridge financing unless they were sure that the other components necessary to the deal's completion were in place. The
bankers, of all parties, would be in a position to know, and because extending the bridge under any other scenario would be foolhardy, the market would probably react favorably to their extending financing. The bridge was extended and the spread contracted by approximately 26%. Again, this was an attractive opportunity because it was both an event within an event and it was a very short-term commitment. Veritas (VTS) Long Position on Revaluation Post Amended Agreement (3/28/02) On March 28 the merger agreement between PGO and VTS was amended, adjusting the stock exchange ratio from .47 VTS per PGO to .40
- a 17.5% change. The rationale for buying VTS was straightforward: Not only did the ratings agencies see the deal as a positive with respect to more favorable pricing after the two dominant firms combined, but the deal post-amendment entailed 20%
less leverage than originally contemplated. Many analysts were favorably disposed toward the deal, but if there was one concern it was that the combined entity would be heavily leveraged. With the firm fundamentally 20% less leveraged with the adjusted ratio, it was an intelligent speculation that the stock would trade up. Honeywell (HON) Position Post General Electric (GE) Deal Break (10/2/01) As is typical with a broken deal, the target sold off massively, losing approximately 1/3 of its value. This created a merger-related trading opportunity because the price of HON was much more a function of the post-deal break selling pressure than it was the underlying value of the company. If one bought shares at the time the deal was officially terminated, there was both enormous opportunity for profit and
ready means of exit based on the daily trading volume. Providian (PVN) Position on Restructuring of Balance Sheet (10/19/01) Providian Corp. shares and bonds plunged after the fifth-largest U.S. Visa and MasterCard issuer announced credit-card losses were mounting and its chief executive officer quit. 30% of its US loans ($9.4 bil.) were to high-risk borrowers, and there was a crisis of confidence; the company had earlier announced that it was going to set aside at least $100 million for loan losses in the fourth quarter, and there were concerns that the rising losses threatened the company's ability to raise money in the asset-backed bond market, which would result in their not being able to raise the funds necessary to make further fee-generating loans to their customers. In order for PVN to be a candidate for bankruptcy one had to assume that the highest default rates in the industry were only going to climb higher - an assumption that would seem to entail a severe recession in the US. Balancing that picture was a company with
arguably valuable assets on its balance sheet that was aggressively searching for a new CEO and prepared to sell off whatever assets they needed to in order to survive. This was a longer-term arbitrage on the value of the assets on the balance sheet, and hence was not a candidate for a large portfolio allocation. The stock traded down significantly, creating further buying opportunities but introducing substantial volatility. Meristar (MHX) Position Post-Merger Break with FelCor (FCH) (11/21/01) FelCor Lodging Trust (FCH), the nation's second largest hotel real estate investment trust (REIT) announced on May 10th that it would acquire MeriStar Hospitality Corporation (MHX), the nation's third largest hotel REIT. This merger was terminated September 21 when FCH invoked the MAC (material adverse event) clause in the merger agreement based upon the events of September 11. With the termination of the merger there was enormous selling pressure on the target, MHX. The general perception was that both companies were vulnerable to an extended downturn based on what was expected to be an extreme
decline in leisure travel and tourism. However, given the book value of the underlying assets of MHX in particular, one had to accept irrationally negative assumptions regarding hotel occupancy rates. Ultimately there was logical reason to believe that these companies could actually benefit from Americans limiting their travel to the domestic US rather than venturing overseas.
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