There’s Always Money in the Banana Stand – Part 2!

Date Added: August 21, 2017 | Comments (0) | Filed under: Blog

In a previous blog I talked about the areas of market inefficiency that we were able to exploit to help us to earn an approximate 20% compound annual rate of return for approximately 20 years at Aquilon Capital and a predecessor employer.

Furthermore, I promised to talk about possible areas of opportunity in today’s market in a future blog. This is that blog.

  1. Long Positions in Small Capitalization Stocks:

It is a well-documented phenomenon that small capitalization stocks have historically provided the greatest rates of return. A partial explanation for this phenomenon is A. that “growth” has a bigger impact on a smaller economic base, and B. that due to restrictions on certain types of investors, more small capitalization stocks fly under the radar of market analysts – and thus market efficiency.

Today the opportunity for mispricing and opportunity in small capitalizations stocks may be greater than ever. Why? One factor is the demise of the small brokerage firm that would traditionally provide financing and research coverage to smaller businesses. A second factor is the increasing popularity of passive investment strategies in the form of ETFs which generally hold the same securities as those held by an index, and seek to mimic the behaviour of that index. Most small capitalization stocks are not part of any index and are left behind when ETFs buy securities. Finally, the popularity and well-funded status of private equity pools mean that some companies that would have grown in the public domain now operate as private businesses. This third factor can also be seen as an opportunity to correct pricing inefficiencies as private equity pools compete for opportunities, and this competition spills into the public markets.

So, small capitalization stocks are an opportunity to find mispriced securities today perhaps more than ever – but the means to correcting these pricing inefficiencies is more likely to be a strategic buyer or private equity pool, rather than enthused traditional public market participants. Because these buyers are business buyers, one should expect the time frame for transactions and pricing correction to take longer than it has in the past.

2. Short Positions in Corporate Debt:

Corporate debt has always offered a favourable risk/reward opportunity for the short seller. Debt sold short near or above par is unlikely to appreciate to any great extent but can fall in price dramatically under certain circumstances. One only has to look at the price of the debt of certain resource based companies over the past few years to see the extent to which this debt can fall in price. The asymmetric nature of the risk/reward in shorting debt makes it an appealing opportunity for the astute short seller, particularly in today’s market with investors clamouring over one another to find yield in a yield starved world.

3. Short Positions in Bull Levered ETFs:

There are certain ETFs which are designed to provide 2, 3, or even 4X the return to their owners for a given price change in the underlying asset that they hold. These levered ETFs are designed for short term holding only, as their structure can result in the erosion of price for a long term holder depending upon the path of price change of the underlying asset. Essentially, if the path is volatile, the price of the levered ETF is likely to erode. One could borrow and sell short the bull levered ETF after a long and positive run with the expectation that a reversal of this momentum OR EVEN a period of subsequent volatility will erode the price to the benefit of the short seller. I chose the “bull” levered ETF because while markets sometimes crash “down” they don’t crash “up” and therefore if the position were to move against the short seller he can reduce his exposure rationally.

These are some of the areas that we are exploring for pricing inefficiencies and sources of return.  If anyone has other ideas, we would love to hear them.

Scott

*** This blog is a general study of where opportunities may exist in the market to exploit pricing inefficiencies.  It is not a recommendation to invest in any particular strategy or security.  Furthermore, short selling is a sophisticated investment strategy.


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