The Follies of Finance

I was recently looking for an inspiring topic to write my next article about when I turned to a collegiate textbook from the first finance class that I ever took. I turned to the chapter about bear markets and recessions and tried to find a topic that I thought would be applicable to current market conditions.

As I read, I was shocked about how many times I found myself in absolute disagreement with the author of the textbook. There were two topics in particular that I, with now actual market experience behind me, take issue with. These topics are the textbook’s notions of consumer behavior and diversification.

After further study of these topics, I am prepared to assert that academia as a whole, not just my first finance textbook, believe generally the same thing about both consumer behavior and diversification. This not only makes me question “real world” value of collegiate finance teachings (I have always questioned that), but it also makes me wonder if the finance world is full of professionals who, due to college teachings, wholeheartedly believe what I believe are some of the “follies of finance (teachings)”.

My first issue is with the thought that actual consumer behavior can be as broadly generalized as it is in finance textbooks. In several collegiate level finance textbooks, I reviewed the idea of consumer behavior in times of recession and economic weakness and all of them stated approximately the same thing. These textbooks all made the generalization that in times of economic weakness, consumers drastically change their spending patterns and cut off virtually all discretionary spending, which allows for investing opportunities in the consumer staples sectors.

I then looked to the one of the consumer staples industries, the food retail industry, and found that, contrary to what the textbooks may say, this industry as a whole is in the red year to date. This measure even includes several foreign food retailers; it would undoubtedly be much further in the red if only the American grocers were factored in.

Take for example Safeway Foods (SWY), a company that, according to conventional “textbook” thinking, would be considered a safe haven in such periods of economic weakness. Safeway, for the year 2008, is down nearly 20% as of August 8, 2008. This is certainly not what I would call a safe haven.

Furthermore I think that this generalization ignores the various classes of wealth that exist as those with more wealth likely will not cut discretionary spending in times of economic weakness. I also believe this generalization ignores the possibilities that people may resist change in their spending patterns by using savings accounts or by use of other means.

I think that this represents an instance where academia actually may not have known what to write about. The inherent problem with textbooks is that they rely on generalizations and I believe that writing about where to invest in times of economic weakness requires precise specification. This is a type of specification which simply cannot be captured in textbooks. As a result, this type of “inside the box” thinking is prevalent in the finance world even though it is not necessarily true.

The topic of diversification is another topic that I take issue with. Diversification is something that goes much further than the scope of academia and has founds its way into the thought process of virtually everyone involved in the financial markets.

I will go out on a limb here and say something that few others would ever dare to say; diversification is a folly.

I am fully aware that in a diversified portfolio the risk of the portfolio can be reduced to approach the market rate of risk. Reducing risk is a great thing; however, in reducing this risk down to the market rate of risk, the return is also reduced to the market rate of return.

I question the hassle of even investing in the financial markets if diversification only allows a market rate of return. You might as well invest in mutual funds or money market funds if all you can achieve is a dismal market rate of return.

While I am sure that many people out there will point to such prominent investors as Warren Buffett, who is actually fairly well diversified, as an example of why diversification works. My response to that is that Mr. Buffett’s portfolio and many other multi-million dollar portfolios are diversified because of the excess of capital that they contain. With a large amount of capital it is natural that an investor, such as Mr. Buffett, would pursue many different opportunities. This leads to a portfolio which may look as if it is intentionally diversified; however, I believe that it is simply a result of an excess of capital, of which only a limited amount can be put into a particular investment.

Large portfolios like Mr. Buffett’s also have such large investments in any given stock that they can see gigantic profits at minimal stock price movement. I think that the success of such portfolios is proof of the old mantra that “it takes money to make money”. I do not believe that “diversified” success like this can be replicated by individuals with smaller portfolios.

It is the inarguable truth that smaller portfolios can only see monumental success by taking on higher levels of risk. This risk does not have to risk the entire value of the portfolio; in fact, I find that option trading is by far the best method to recognize levels of returns greatly in excess of the market rate of return while only risking the minimal cost of the option itself.

I will say that the only positive that diversification brings is a minimized risk and I question any type of participation in the financial markets if someone is so risk averse that they feel as though diversification is necessary. In the financial markets both risk and reward abound. Reward will rarely ever be realized in smaller value portfolios if risk is not first taken. It takes multimillion dollar portfolios to achieve success in such a manner as someone like Warren Buffett. And if one does not have a multimillion dollar portfolio risk is the only method to gain reward.

I will give a quick example of the type of rewards that can be achieved when risk is taken. When US Airways (LCC) was trading at below $2 per share near mid July, the August $2.50 option calls were trading for about $1.50 per contract. If one were to invest just $3,000 dollars into these options to buy 20 contracts, those 20 contracts would be worth $10,800 as of August 8 (a return of 260%). One could also have recognized a great return by trading the low share prices of US Airways, but I provided this example as an example of how options can give great reward with fairly minimal risk (in this case the maximum risk was only $3,000).

As someone who tries to make profits by understanding the market psychology, I am very interested in understanding any type of prevailing market thinking (be it regarding diversification or consumer behavior). Even though I disagree with both of these principles as they are generally taught, I understand that because they are taught as the unquestionable truths of finance they are the prevailing thoughts for most finance professionals. In knowing this, I think that those of us who use market psychology to gain an edge can better understand the prevailing market forces.

I suppose that sometimes the answers for those of us who believe that profits come from understanding the market psychology can sometimes come from such an unlikely source as an old college textbook. So, whether you agree or disagree with me about the topics from the textbooks, you cannot disagree that these topics are the prevailing market methods and in understanding them one can gain a greater understanding of the overall market movements.
(Disclosure: author is long LCC)

Happy Investing

InglefoX
(www.inglefox.com)

Too Many Reillys, Too Many Issues: Why It May be Good to Short Lamar

Those of you who follow the company Lamar Advertising (LAMR) know that, with only two exceptions (one rather brief and one lasting roughly two years), the company's stock price has been extremely range bound. That range has been, more or less, between $30 and $40. After a recent bull run, which saw Lamar's share price touch $70, the stock has recently entered this range again.

With the shares trading at $37.53 as of Aug. 4, 2008, it is actually at the high end of this range and I think that Lamar's upcoming earnings report on August 6 may disappoint and send the share price back down to the low end of this range. This could give traders a chance to pick up some puts or short some of Lamar's shares and make what could potentially be a quick profit.

I do think that Lamar may miss their earnings target on August 6, but even if I am wrong about them missing their upcoming earnings, I still view Lamar as a good medium term short play, or at least until the share price touches the low end of what has been a consistent range. Traders can potentially play Lamar's shares over and over again, shorting the shares once they touch the top of the range (near $40) and covering once they touch the low end of the range (near $30).

First of all, the main reason that I see Lamar missing on their upcoming earnings is because of the high put activity that I am seeing in the options market. I have found that time and again, the options market is a reliable (but not infallible) indicator about upcoming earnings.

I compare the ratios of calls to puts by looking at the open interest levels for the single option with the highest open interest and also the total call/put ratio. For the August options, the August 35 puts are showing the highest open interest at 5,739. The straddle option for this put would be the August 40 calls which are only showing an open interest level of 1,496. This means that the straddle call/put ratio is a high 3.8 to 1.

I generally also look at the same strike ratio for the option with the high open interest as well as the opposite ratio which compares the option with the highest open interest against the option on the other side (call or put) with the highest open interest. In the case of the Lamar options, the same strike (35 calls) also happen to be the calls with the highest open interest, meaning that the same strike ratio and opposite ratio are the same in this case, the ratio being 1.8 to 1 in favor of the puts.

Lastly, the total put to call ratio adds all of the open interest up on the put side and divides it by the total open interest on the call side. In the case of Lamar Advertising the total put open interest is 14,197 versus a total call open interest of 5,647. This gives a ratio of just over 2.5 to 1 in favor of the puts.

These ratios are all on the high side and are an indicator that the options buyers, for whatever reason, are under the impression that Lamar may miss their earnings and that Lamar's share price will be below $35 by the third Friday of August.

The options open interest levels are why I think that Lamar may miss on their upcoming earnings report, but they are not the reason that I think Lamar will be range bound for a long while to come.

The first issue that makes me wary of Lamar Advertising is the prevalence of members of the Reilly family in corporate governance and operation. Though the company is publicly traded, the Reilly family controls 67% of the corporate voting power by virtue of their ownership of Lamar's class B shares. The class B shares, created by CEO Kevin Reilly Jr. and COO Sean Reilly, carry an incredible 10 votes per share. This means that the Reillys have free reign over the fates of Lamar Advertising and there is nothing that any discontented shareholders could do about it.

Reilly family members hold the aforementioned positions of CEO and COO. Furthermore, Kevin Reilly Jr. also holds the title of Chairman of the Board, Wendell Reilly holds a seat on the board of directors and Anna Reilly also serves as a director.

While the fact that the Reilly family holds stern control over Lamar is not an issue that should sit well with outside investors, it does not automatically disqualify Lamar from being a profitable company. The biggest issue with Lamar is the nature of their business in outdoor billboard advertising.

Outdoor billboard advertising can be a profitable business, requiring a large upfront cost followed by only minimal maintenance costs and a steady stream of revenues. The problem with the business is the lack of growth that the industry has historically shown.

Since the days of LadyBird Johnson, billboard advertisers have met resistance with virtually every new billboard that they attempt to erect. Many people view billboards as eyesores that detract from the natural beauty along the nation's highways and also as accident causing hazards that attract people's attention away from driving. The billboard opponents have been very successful in the courts at severely limiting the construction of new billboards. In fact, if you are to look at Lamar's recent headlines, there are always several news articles dedicated to legal battles that are currently ensuing regarding the construction of new billboards.

As a result, new billboard construction is not a reliable source of growth, but Lamar has adapted to this over the past years and has produced growth by constant acquisition of smaller outdoor advertising companies. The issue with this type of growth is that it will eventually be terminal, and also one has to assume that Lamar and its competitors have already purchased the best of these available companies.

A new type of billboard, the digital billboard, is offering Lamar a new opportunity that will offer many times more revenue and much higher margins than the traditional billboard. Many on Wall Street are expecting that digital billboards will give Lamar and other outdoor advertisers a significant boost, but the problem is that digital billboards are meeting even stricter resistance from the public and local governments.

Lamar has faced a legal battle for many of the digital billboards that they have constructed in such cities as Omaha, NE, Mufreesboro, TN, Fayetteville, NC, Kansas City, KS and many more. Opponents claim that the flashing billboard signs cause an even greater distraction to drivers and still present just as much of an eyesore as their predecessors.

The end result is that Lamar's growth is stunted by an inability to construct new billboards. There certainly is an ample supply of customers for Lamar and other outdoor advertisers even under these weakened economic conditions, but without the ability to produce new billboards Lamar cannot recognize maximum revenue potential.

The bottom line is that many factors point to Lamar being a good short play in both the short term and the longer term. The August 6 report could shed further light on the current situation for the company, but I think that this is an excellent short play going into that report. The options market is pointing to the short side for Lamar's report and several other indicators are pointing to the short side for the longer term. In my view, Lamar simply has too many Reillys and too many issues.
(disclosure: author intends to take a short position in LAMR)

Happy Trading

InglefoX