How hard (or easy) is it to outperform?

It’s not supposed to be easy. Anyone who finds it easy is stupid.
Charlie Munger

I started writing a post about how the recent market volatility provides a good moment to reflect on your skills as an investor, but I realized that the more interesting topic – that is somewhat related – is how easy or hard it is to outperform the market. I think this is really the most important question that every investor faces since the answer has huge implications on what kind of strategy you should follow. While this is a very fundamental question I don’t think there has ever been a good definitive answer. Are markets almost perfectly efficient and is your best bet an index fund? Do you need 150+ IQ points and read 500 pages/day to have a shot at out performance? Can you have an edge with an average or below average intelligence, but with a contrarian mindset and enough time? Can you be successful if you are really smart, but when you lack the “magic” psychological profile?

What kind of people should consider what kind of strategy?

Usually, this is a question that isn’t even asked when people ask for investment advice. Ask for investment advice on and everybody is going to advise a portfolio of low-cost index funds. Ask the question somewhere else and they probably recommend their own strategy; which could be buying owner operators, compounders, cheap value stocks, magic formula stocks, swing trading, forex trading, and whatever else exists.

Some of these strategies are probably not a good idea even if you are a genius and have a massive amount of free time (hint: forex trading) while other strategies could be executed by anybody with little effort. But being able to differentiate between a good and a bad strategy is also a skill. Some people might stumble on when they start out as an investor and go for some value strategy while other might stumble on a forex trading site and go that route. If your process for choosing a certain strategy is flawed the possible alpha of that strategy is not really your alpha. And if you are really smart and could generate alpha, but go for a passive indexing approach because that strategy sounded more convincing it’s also proof that investing is hard (unless of course it’s a conscious decision but you, for example, go for indexing because you have a lack of time or interest in investing) .

When I started investing I wasn’t at all convinced about my ability to beat the market, but I knew that there was a large amount of evidence that retail investors underperformed their benchmarks by large amounts by structurally buying high and selling low. I figured if they are able to underperform by such a wide margin I should be able to do well by just trying to do the opposite. That’s easier said than done, but on a day like “black Monday” I thought that the correct course of action was pretty obvious: buy stuff when you see ridiculous trading activity. I bought, for example, some Retail Holdings – because that is a stock that I know – at ~$16 because someone was selling at any price and no-one was buying. In some ETF’s there were even bigger opportunities, but I was too late to that party.

There is actually some research that suggests that intelligent investors are better at buying low and selling high. It doesn’t really sound like a surprising result, but it’s not easy to research since your broker usually doesn’t know your IQ. But in Finland nearly every male of draft age is IQ tested, making an interesting paper possible. Especially this graph that shows when people in the 1995-2002 period were buying tech stocks is pretty neat:

Buying/selling in tech stocks during bubble by IQ group

So I think if you are reasonable smart (maybe 120+ IQ?) and have enough time to research strategies and stocks active investment is perhaps worth a shot. I don’t really think that having the right mindset is extremely important because I think that is largely created by having the right knowledge (for example knowing that selling in a panic is almost the worst thing you can do). But I wouldn’t be surprised if many people think differently, and I also wouldn’t be surprised if I’m wrong about this. Anyway, enough rambling. To sum it up; I think that what people should do really depends on their intelligence, education, available time, their personality and probably other factors that I’m missing. There is no strategy that is a good fit for everybody. Indexing isn’t the right strategy for everybody, nor is value investing.

You have to be brutally honest with yourself about what is the right strategy is for you.

PennantPark closes merger with MCG Capital

PennantPark Floating Rate Capital closed the merger with MCG Capital today. This was one of my higher conviction merger arbitrage idea’s, but it didn’t exactly work out. The higher HC2 bid fell through while PFLT started trading at a discount to NAV. As a result, MCGC shareholders will receive approximately $4.37 value in share according to my calculations, based on PFLT trading at $12.90/share. I managed to exit a little bit higher than that, but the result is a very small loss despite the merger actually going through (can’t complain though since it is less than 4bps).

With PFLT now trading at a 10% discount it might actually be a decent long. Historically it has been trading right around NAV, and now that it is bigger it should, in theory, have some economies of scale and be a bit better as well. I’m not really interested in buying something at a 10% discount, but it is probably not a terrible idea.


No position in MCGC or PFLT

Make more than 65% with the ROIQ warrants

ROI Acquisition Corp. II is a blank check company that consummated an IPO on September 20, 2013 that raised $125 million. At the end of July the company announced that it had found a suitable target and that it would buy Ascend Telecom Infrastructure, a provider of telecom infrastructure in India (investor presentation). Concurrent with the merger the company intends to exchange its outstanding warrants. Initially the company wanted to exchange all warrants for $0.50/share in cash, but that offer was revised today to the following:

Under the revised Warrant Amendment Proposal, warrantholders would have the option to either:

  • have their warrants survive and become exercisable for Ascend Holdings ordinary shares following the closing of the Business Combination in accordance with the terms of the Warrant Agreement, as amended; or
  • have their warrants exchanged at the closing for $1.00, comprised of $0.50 in cash and 0.05 of an ordinary share of Ascend Holdings.

While I already had a position in the warrants (subtle brag) before this announcement I think that the warrants are today even more attractive than before for a merger arbitrage play. The value of the warrants has increased with 100% while the price has lagged and is up just ~70% (as of this moment). With the warrants at $0.60 you can make a whopping 66.7% return when the merger is completed. That’s a pretty insane return for a merger arbitrage.

At the same time, the fact that the exchange proposal has been revised higher and to include an option for warrant holders to keep their warrants is probably a positive signal. The only reason for keeping your warrants is when you think that the surviving company will be worth a lot more than $10/share in the future. The warrants have a strike at $11.50 while they are callable when shares start trading at $24.

While the possible return is very high this is also a deal that has more risk than your average merger arbitrage. When the merger isn’t completed the warrants are going to be worthless because in that case ROIQ will be wound-up and cash will be returned to shareholders. When you own a normal stock instead of warrants during a merger arbitrage your downside is usually a couple of dozen percent to something in the direction of the pre-deal price. Because of this I think that ROIQ warrants should offer a return that is roughly three or four times higher than a normal merger arbitrage, and the position should also be sized accordingly.

But even when we adjust for the higher risk the deal appears to be very attractive. A 65% return divided by four is still more than 16%, and usually something like 4 or 5% is already a pretty big spread. The current spread is basically implying that the probability of this deal going through is just 60%, which I think is way too low. But perhaps I’m missing something?

ROIQ transaction terms


Author is long ROIQW

Exited Conrad and AIG

I exited my position in Conrad a week ago and I sold my position in AIG today. I bought both stocks in 2012, and they were both big winners (although I could have done a lot better if I sold Conrad earlier). Including dividends Conrad returned 114.7% while I made 92.6% on AIG. At this point in time, they were both low conviction ideas, and I needed to make some room. My portfolio is currently 102.7% long and 5.0% short for a net long exposure of 97.8%, so I’m still almost fully invested. Luckily a couple special situations will also be concluded this month.

Northern Offshore reported that the merger with Shandong Offshore was completed earlier this week and that the cash payment will be made on August 12. MCGC has scheduled their shareholder meeting for August 14, and if enough shareholders vote in favor for the merger it should and could be completed shortly thereafter. There is a risk that the company will not be able to gather enough votes because a lot of shareholders are retail investors who might not take the trouble to cast a vote. I don’t think people will vote against the merger because they are unhappy that the deal with HC2 didn’t go through since that deal is now totally dead after HC2’s stock price dropped ~40%.


Author is long NOF.OL, MCGC, no position in AIG and CNRD anymore

Northern Offshore merger arbitrage

Northern Offshore (NOF, NFSHF) is a marine drilling company that managed to attract the attention of several value investors in 2014 (a good write-up can be found here). Even when oil prices were high it was a somewhat speculative investment, and when oil prices crashed at the end of 2014 the stock followed. In the past year, the stock moved from a high of NOK12.55/share to a low of NOK1.75/share. In hindsight, the selling panic in the stock proved to be an excellent buying point since Shandong Offshore International announced that they reached a deal to acquire the company at NOK7.59/share two weeks ago. While the big money has now been made I think that playing the merger arbitrage is also attractive. The stock is currently trading at NOK7.20/share which implies a possible 5.4% absolute return.

I think that is a big spread for a deal that should be pretty low risk. There is no regulatory risk, the deal will be financed from the purchaser’s existing cash resources and 65% of NOF shareholders have already indicated that they will vote in favor for the acquisition. In addition to this there is a US$12.5 million break-up fee payable by the purchaser if they fail to complete the acquisition. That’s a large fee since the total deal value is just US$160 million. I’m guessing that the spread is relatively large because it’s a transaction in a small cap stock on a foreign exchange (for most investors), and the fact that the acquirer is a Chinese company is probably also not helping. If this is indeed a real risk I think you are getting paid enough to take it.

Northern Producer


Long Northern Offshore