TradeStream Your Way to Profits : Building a Killer Portfolio in the Age of Social Media [1 ed.] 9780470637098, 9780470575116

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TradeStream Your Way to Profits

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TradeStream Your Way to Profits Building a Killer Portfolio in the Age of Social Media

ZACHARY MILLER

John Wiley & Sons, Inc.

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Copyright


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2010 by Zachary Miller. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Miller, Zachary, 1974– Tradestream your way to profits : building a killer portfolio in the age of social media / Zachary Miller. p. cm. Includes bibliographical references and index. ISBN 978-0-470-57511-6 (cloth) 1. Portfolio management. 2. Investments–Computer network resources. I. Title. HG4529.5.M544 2010 332.6–dc22 2009054226 Printed in the United States of America 10

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To Grandpa Jack, who taught me that investing, like life, is an enduring learning process

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Contents

Foreword—Investing in the Internet Age: In Search of Jack

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Acknowledgments

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INTRODUCTION Why You Need This Book Investor Performance? Ha! Few Exceptions to the Rule What’s a Brother to Do? Copying: Investment Flattery Done Profitably Strategy Stubbornness Investing in the Age of Social Media Social Media for Investment Research Facebook versus Twitter Why Me as Your Guide? What This Book Won’t Do What This Book Will Do Getting Started It’s Time to Tradestream Your Portfolio

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CHAPTER 1

Ride the Long Tail—Financial Blogging: The World’s Largest (Free) Investment Research Organization The Long Tail of the Financial Internet Where We’ve Come From The Demise of Traditional Research Online Finance’s 800-Pound Gorilla The Blogger’s Rise and the End of the Megabuck Website Why These Highly Paid Analysts Write Blogs What’s Different Now? Why This Trend Is So Important Broad Coverage Deep Analysis

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CHAPTER 2

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Contents

Global Trading Creates New Demands Finance 2.0: Real-Time Research Platform Research via Microblogging: Twitter and Social Media Investment Discovery Deep Stock Research Bloggers as New Form of Investment Analyst The Move Beyond the Website

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Piggyback the Pros—Following Top Money Managers’ Every Move Pays Off The Pilgrimage to Omaha Do Hedge Funds Really Outperform? How Hedge Funds Win Hedge Funds as State-of-the-Art Research Machines High-Frequency Trading Big Gains from Small Companies Net Worth Hurdle SEC Requirements Piggybacking the Pros Works Two Objections to Piggybacking Broad and Deep Implications Tracking Gurus Is a Breakthrough Step-by-Step Piggyback Portfolio Building Individual Portfolio Clone AlphaClone What Top Investors Are Doing Using AlphaClone Clone Strategy AlphaClone–Powered Portfolios

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Commune with the Experts—Follow Your Neighbor: He May Turn Out to be the Next Warren Buffett Not Your Father’s Stock-Picking Communities Types of Expert Communities Why Investors Are Turning to Experts Where to Find Experts Expert Communities for Investors Gerson Lehrman: Connecting Hedge Funds with Industry Experts How GLG Is Growing What Clients Are Asking Experts

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Expertise for the Rest of Us Aggregation Technologies Social Networking and Blogging Moving toward Managing Real Investor Money kaChing Rocks On Covestor Plays above the Rim Inner Workings of Expert Platforms Open Membership Ranking Expertise Transparency: The Human Algorithm Covestor Expert Profile EPIC’s Business Three Ways to Grow a Registered Investment Advisory Tradestreaming His Way to Expert Status Future of the Financial Advice Industry Differences between Crowdsourcing and Expert Communities Next Stop: Investment Management Other Sources of Expert Investment Advice to Mimic Join the (Expensive) Club SumZero: Definitely Not Zero Sum Hedge Fund Collaboration of Ideas Growth in the Industry CHAPTER 4

Crowdsource Your Portfolio—Tapping the Wisdom of Crowds for Investment Ideas Guru Dinner Experiment: Crowdsourcing Investment Ideas The Results Free but Not So Useful Research with an Ear to the Ground Crowdsourcing: An Overview Netflix Prize Crowdsourcing and the Wisdom of Crowds By the People, for the People Large-Enough Population Anonymous Voting Equal Weighting of Votes Aggregation System Avoiding Redundancy Crowdsourcing Investments

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Does It Work? Wikinvest: Enabling Crowdsourced Investments Wikinvest’s Wiki Everyone Is a Chartist Piqqem: A Better Way for Investors to Pick ’Em Two Levels of Functionality Piqqem’s Five Flavors of Sentiment Schroy’s Capital Market Wiki

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Screening 2.0—Bringing the Best Investors’ Strategies Back to Life via Computer Simulation Screening 2.0: Re-Creating Guru Strategies Online Most Investors Stink Going to the Source First Steps Extending Reese’s Guru Strategies Screening 2.0 Piggybacking versus Screening 2.0 Why Use Screens? A Brief History of Stock Screening Screening 1.0 Couple of Honorable Mentions Simulating History’s Best Investors via Computer Single-Strategy Screens Joel Greenblatt’s Magic Formula Ken Fisher and Super Stocks Peter Lynch Outdoes Wall Street Under the Validea Hood Strategy Gurus Technique Results Stock Picking and Portfolio Development Why Screening 2.0 Is So Important

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Tracking Inside Moves—Pursue Corporate Executives in Their Search for Wealth The Not-So-Legal Kind The Problem with (Illegal) Insider Trading Differentiating Inside Information Insiders Do Invest A Different Type of Expert Why Be in Business in the First Place?

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The Profit Motive Insiders Trade Profitably Investor Reaction to Inside Moves Whom Should We Follow? Muzea Behavioral Model Seyhun Information Model Follow the Smart Money How Are Insiders Basing Their Decisions? Tracking Insiders: The Strategy Tracking Inside Moves: A Checklist Pros and Cons of the SEC Database Yahoo! Finance Determining What Insiders Are Doing from Their Filings Where to Turn for Insider Trading Information CNBC’s Ownership Tab Insider Food for Thought CHAPTER 7

CHAPTER 8

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Grind the Rumor Mill—Sorting Truths from Falsehoods and Profiting from News Flow Buy the Rumor and Sell the News Whisper Numbers Rumors and Hearsay Are Important . . . Sort Of Rumors: A Model Rumor Model Rumors and How They Affect Trading Rumors and Preannouncement Trading Trade the Preannouncement Rumors Antitakeover Rumor Strategy Trading Whisper-Number Volatility Crowdsourcing Rumors in Real Time The Fly on the Wall Briefing.com: Adding in Analysis to Rumor Flow Message Boards Bulls and Bears—at the Same Time

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Co-Lateral Research—Find the Investment Value in Nonfinancial Information on the Internet There’s Value Outside of Traditional Research The Internet and Transparency Trade Data Trade Associations Search Volume and Stocks

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Google Domestic Search Trends Prediction Markets Predict the Future Intrade: Real Money and Real Investment Potential Crowdsourcing Your Portfolio versus Co-Lateral Research Seeking Alpha’s Secret Weapon Summary

The Future of Finance—Online Brokerage App Stores and New Global Markets DIY Investing Online Brokerage App Stores Investment Field Riddled with Platforms Online Brokerages as Investment Platform Ameritrade’s Premier Partners Platform The Future of the Online Broker New Markets Trafficking in Humanity Forex Content Providers as Asset Managers Return of Active Asset Management RIAs Video and More Video Personal Finance

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Notes

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About the Author

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Index

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Foreword Investing in the Internet Age: In Search of Jack

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y father was a young attorney with a few bucks to invest the first time he stepped in a local brokerage house off of Market Street in Wilmington, Delaware. It was the summer of 1970 and the stock market had been largely flat for the past few years, but you wouldn’t think opportunities were lacking from the chatter in the room. “You’d open the door to smoke wafting through the air and the aroma of strong-brewed coffee, and find 20 or so retired altacockers sitting around a sort of minitheater, peering up at the electronic quotes rolling by on the wall, plotting their next moves,” he recalls. In the corner, some of the men crowded around a ticker tape machine that tap-tap-tapped out the latest market news wired down from New York. On a nearby table, a few loose-leaf binders issued by Standard & Poor’s held one-pagers on the most commonly traded stocks: management bios, basic financials, price history. “Oftentimes you’d go to research a stock from the S&P binder and its page would be missing,” my dad recalls. “Some of these guys didn’t read so fast, so they’d sneak a few sheets home in their jacket pocket to peruse after watching Cronkite.” Behind the altacockers were the brokers, including my father’s brokerto-be, Jack. For this generation of stock market investors, the brokers had all the real information—and clout. Upon receiving fresh research from his firm’s Wall Street analysts (who enjoyed privileged access to company executives and industry data and trends), Jack would dial up his clients selectively to suggest buys and sells that drove his own, entirely commissionbased income. But that misaligned incentive didn’t seem to bother his clients so much. On the golf course and at dinner parties, the young professionals bragged to one another about the stocks that their broker “put them into,” and Jack was held in high esteem by my father and his community peers: “Jack was a tall, thin, good-looking Ivy League–educated type with a lot of integrity. Everyone liked him, everyone respected his opinions on stocks, and everyone wanted to be one of Jack’s favored clients and hear his best ideas. You were flattered to be called by Jack and you were proud of your access.” xiii

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For my father’s generation, stock market investing was defined by information scarcity and personal trust in your broker. Fast forward to 2010. Today’s Internet has almost completely wiped out this scene from just 30 years ago. Today’s individual investors confront a market characterized by information overload and a need for personal decision making. The good news: No missing pages on that loose-leaf binder—you can get massive amounts of information and opinion on any given stock with the click of a mouse. The bad news: There’s no Jack. You’re on your own to make sense of it all and, unless you have the means to hire an asset manager, to build your portfolio yourself. So where to begin? Most individual investors today are familiar with the large portals like Yahoo Finance and MSN Money that allow you to enter your portfolio or watchlist and receive mounds of data, breaking news and traditional journalism on stocks you own or follow. The portals also offer some powerful stock screens that can help an investor with specific strategic goals to access stocks, ETFs or other products that meet those objectives. My website Seeking Alpha augments this content with informed, well-researched opinion and analysis from market professionals and sector experts, plus free conference call transcripts to read what industry leaders are saying about their business and sectors. Instant access to regulatory filings (coupled with Regulation FD) grants everyone immediate access to company reports, important developments, top investors’ moves, and corporate insider stock sales/buys. And new players in the market like Covestor and other “crowdsourcing” sites aim to bubble up the best individual investors and stock pickers, so individual investors can lock onto their ideas or even copy their trades. So where’s today’s Jack in all this? Or, given the fact that investment goals differ so greatly, perhaps the question is better phrased: Where’s your Jack in all this? I’m aware of no one who’s better equipped to provide a truly helpful overview of all of these tools than my friend Zack Miller, who has deep experience in all three of the areas that Internet-based investment tools have impacted: fund management, online financial media, and financial planning/wealth management. This book will both save you a ton of time in assessing the new tools of investing and provide some truly helpful direction in deciding how to use those tools in your own investing. The bottom line is that you need to build your own Jack today. That means you need to do more homework, but once you’ve found the tools that work well for you, the process of portfolio building is much more rewarding and, likely, lucrative than it was a generation ago. This book is a terrific starting point to that end. Mick Weinstein Editor in Chief, Seeking Alpha

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Acknowledgments

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his book has benefited from the support and encouragement of my colleagues, friends, and family. First and foremost, I’d like to thank my business partner, Aaron Katsman, who has been both an encouraging influence and a good listener. This book has benefited from the time we’ve spent working together, and I eagerly look forward to what the future has in store. I’d like to acknowledge the great research done by many of the researchers I cite in the book. Their investigative work has provided the meat behind many of the strategies I develop to best use social media to make better investment decisions. It’s early in social media’s development, so their works provided grounding to what’s happening around us. I’d also like to thank the many executives who were so willing to participate in the interview process. Their willingness to share their work histories, company secrets, and visions for the future was extremely enlightening and crucial to the writing of the book. I’d like to recognize the contributions made by handful of individuals who acted as my own personal board of advisors throughout the writing of the book. Thanks so much to J. J. Sussman, Mick Weinstein, and Richard Demb. Insane kudos to Sara Sherbill, whose editing and advice enabled me to become a better writer throughout this process. She was always willing to take the time and expend the effort to make this book possible. I’d like to thank Debra Englander, editorial director at John Wiley & Sons, for her unwavering support and excitement throughout this process, and Kelly O’Conner, development editor, who’s achieved V.I.P. status for her hawkish insight, kind professionalism, and international patience. The collaboration with everyone on the Wiley team has certainly made this book a better product. Anna Olswanger of Liza Dawson Associates, my agent, deserves special props for all the time, energy, and understanding she’s put into this process. Her shepherding of me, the book, and the entire writing process has been incredible.

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I’d like to thank my children, Adina, Aryeh, Rachel, Nava, and Akiva. As the writing of this book was the equivalent of taking on another job, they shared the burden along with me and provided loving support along the way. It’s great to hear your six-year-old ask how the book is coming along— you are a great family. Last, I’d like to thank my wife, Minda, who’s been a true partner and friend for everything in my life. I look forward to being around for the ride, seeing her life’s book unfold. The introductory chapters are already masterpieces.

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TradeStream Your Way to Profits

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Introduction

There is one important caveat to the notion that we live in a new economy, and that is human psychology . . . which appears essentially immutable. —Alan Greenspan They always say time changes things, but you actually have to change them yourself. —Andy Warhol

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hen I graduated Harvard in 1996, I began to flirt with the idea of creating a serious portfolio. After surveying the options that were available to me and shadowing my father’s investment activities for a week, I realized I had no chance. The cards were totally stacked against me. As a recent grad, I didn’t have enough capital to become a client of Bear Stearns or Lehman Brothers. These investment houses were exclusive clubs, open only to those with enough money to afford admission. Had I had enough assets to warrant their attention, I would have received regularly scheduled morning research reports on my desk by 9:00 AM. I would have received in-depth information that my own classmates at Harvard, now stock analysts, were faxing to institutional clients all around the world. I would have received morning calls from my broker telling me which stocks my brokerage firm was touting that morning. In short, I would have had the access of a professional investor. Fast forward 15 years, and I now have a leg up on my father. His fax machine is a turtle compared to my broadband connection. Bear Stearns and Lehman Brothers are gone. It’s 9:00 AM, but where? Tokyo? Mumbai? London? New York? The death of distance has enabled individual investors to trade the world markets from their home computers. Those same Harvard graduates who used to write research for investment banks are now working for multibillion-dollar hedge funds making money hand over fist. Wall Street firms are a shadow of their former selves, and social media communities like Facebook and Twitter are proving to be treasure troves of investment research. 1

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In the pages that follow, I’ll analyze these important changes to learn how the Internet and social media have changed investing forever. Through this book, I’d like to offer you (and my dad) help to acclimate to this new world of investing. More than just a survey of the landscape, I will offer actionable strategies to help you take advantage of this new investing environment. For the first time in our history, you, me, our friends, and my dad have the opportunities to be as successful as the greatest investors of all time. I’ll show you how.

Why You Need This Book Regardless of how we visualize our investing performance, most investors never come close to achieving the average market return of about 11% annually over the past 60 years. We’ll look briefly into why that’s the case, but the fact is that by underperforming the markets, we’re leaving lots of money on the table. We owe it to ourselves to become better, more accurate, and more profitable investors. By besting our previous returns, we can regain historical losses and begin to build serious wealth. New advances on the Internet have made much of this possible, and we’ll figure out how best to utilize the world’s most powerful and valuable investment research tool. Most investment books teach investors how to analyze investments. These how-to books take a bottom-up approach—there’s little discussion about designing a portfolio, and, instead, the focus is on stock picking. Readers are instructed how to identify stocks most likely to appreciate in value. By following a simple formula, people who read these books are taught how to size up individual investments. The focal point is on selecting winning stocks. If it were so easy, we’d all be hedge fund managers. These investment books make us feel that we can’t lose. Instead of boosting investor performance, this actually just compounds the problem of underperfomance. It turns out that there is a direct relationship between how good we envision ourselves as investors and how poorly we actually perform.1 This overconfidence frequently leads to overtrading—the bard of bad performance for most investors. This book will prove, I hope, that while it may be fun and entertaining to populate your portfolio with what you expect to be the next Google and Apple Computer, we’re actually better off—a lot better off—by aping other strategies. There are quite a few different forms of piggybacking others’ ideas, and we’ll explore them all in the pursuit of better investment returns.

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Introduction

Investor Performance? Ha! While most of us fancy ourselves as exceptional investors, unfortunately for us (and our IRAs), we’re not. The data bear out the fact that individual investors almost always underperform the market. While there are ways to boost this performance, for the most part, individual investors would be better off buying large mutual funds that track the markets rather than putting our best picks on the line and betting our financial futures. Starting from Burton Malkiel’s A Random Walk Down Wall Street, first published in 1973, modern-day investors have been pummeled with data decrying that even most professionally managed mutual funds don’t beat market indices. Trying to time the markets—moving in to capture upside and selling out before stocks tank—doesn’t work. Malkiel found that over 15 years, between 1994 and 2008, those who remained fully invested in the stock market returned an average annual return of 6.5 percent. If investors missed the best 30 days, they were down 3.7 percent annually. Staying out of the market for any longer period and missing the best 90 days, these investors would be down 14.6 percent per annum on average. (See Table I.1.) Market timing is just a bad idea. Hence, for three decades, investors have been fed a diet consisting of index investing and buy-and-hold philosophy. The hundreds of billions of dollars in index mutual funds and exchange-traded funds illustrate that many investors realize that trying to beat the markets is a sucker’s game. The solution to underperformance offered by academia was to buy the market via an index fund and hold on to it for a long time. If novice investors perform badly, professionals fare no better. The underperformance of most professionally managed mutual funds attests to this fact. In a 2004 address to the United States Senate Committee on Banking, Housing, and Urban Affairs, John Bogle, the founder of the Vanguard Group and godfather of index investing, testified that most mutual funds don’t perform as well as the stock market does.2 The data Bogle quoted showed that most mutual funds underperformed the Standard & Poor’s 500 somewhere between 2 and 3 percent per year for over 50 years. Compounded annually, TABLE I.1 Value of Being Fully Invested Market Timing for 1994–2008 Fully invested Missed best 30 days Missed best 90 days Source: Reuters.

Average Yearly Investment Returns 6.5% –3.7% –14.6%

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this is major money squandered. Investment newsletters and investment services fare no better.

Few Exceptions to the Rule We could debate why people invest so pitifully: Studies point to overconfidence and avoidance of regret as two leading suspects of lagging market returns.3 It appears investors get overly bullish on their stock-picking abilities and don’t take profits when it’s prudent to do so. Conversely, investors don’t like to sell losers and lock in losses. So they end up riding their dogs all the way down. The issue is pretty black and white: Investors left to their own devices perform worse than the markets. It’s a fact, and we can try to deceive ourselves that we are the outlier points in a very large data set, that we’re the few with above-average returns. We need to face the truth: Very few of us can be exceptional. That’s what exceptional means—most of us, though, fall squarely into the fat part of a bell curve, and that means we underperform the markets. It would be a good time to ask why we keep committing welldocumented mistakes in light of research that shows we are poor investors. Investors tend to get in at the top and out at the bottom. We do this because we are human. We are emotional beings. We like to feel that we’re smarter or more talented than the masses of investors buying and selling stocks throughout the world. We believe that we understand things differently and have some higher level of clarity. Much of this is gut feeling, but it persuades us to keep banging our heads into a wall while losing money. We’re all complicit here—even the biggest proponents of indexing. When interviewed about their own investing activities, many supporters of index investing admit to trying to time markets and buying individual stocks. Typically, investors choose to ignore the data because stock picking is fun or they feel a rush like gamblers do when they throw money down on the poker tables. They do it knowing full well there must be a better way.

What’s a Brother to Do? Without any free lunches in the stock market, many of our trading activities result in losing our lunch money. Does that mean we should just hang up our financial calculators and let our subscriptions to the Wall Street Journal lapse? Should we all go out and buy Vanguard funds, checking on them every 10 years? No way. We may not be able to skillfully make money over time by outsmarting the markets, but there are those who do. They are the truly exceptional with well-documented, long-term investment returns. These select few have

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found and tasted the secret sauce. They’re just not us. Using a well-structured and a disciplined approach, combined with established and documented tactics, these investors consistently outperform the market indices over time. Instead of going at it alone, we need to learn from these masters. But how? I’ll get to that in just a minute, but first, you need to know who you are going to need to mimic.

Copying: Investment Flattery Done Profitably Why recreate the investing wheel when you can copy others who are so successful? They may be guru investors like Warren Buffett, unknown up-andcoming portfolio managers, or even chief executives of companies trading in their own firms’ stocks. Regardless, evidence shows that these investors are much better at investing than we are. Many of them have exhibited market-beating numbers that have embarrassed market returns for decades. To make investors’ lives easier, many of these people and their activities are quite public. A small subset of them are happy to share what they know with other investors. For instance, Warren Buffett learned from his mentor, Benjamin Graham. Now Buffett has taken it upon himself to teach the next generation of investors. You just need to know where to look. Then just start aping. Despite differing ways of achieving great investment returns, winning investors like Warren Buffett all share a common methodology: They’ve created systematic techniques to identify undervalued stocks. Some invest in growth; others choose to bet on value. It doesn’t matter: Their strategies have all worked over the long haul. Sometimes these successful methods go through tough times and underperform. These professional investors have the discipline to stick to their strategies despite their emotions telling them otherwise. In short, this book analyzes how social media enables investors to profit via eight different types of investment mimicry, from cloning top hedge fund managers’ stock picks to identifying and piggybacking the next Warren Buffett. 1. Blog bigwigs. The financial blogosphere has created a virtual stock research bonanza and enabled researchers to strut their stuff. These investment bloggers provide institutional-grade advice at a fraction of the cost. How is $0 for your own, personalized research team? 2. Present-day gurus. While most investors underperform, there are those few who are exceptional. While you and I may not be gurus, Warren Buffett is. Eddie Lampert is. David Swensen is. These superinvestors

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exhibit great long-term performance. We can win, as well, by following these gurus’ every move. Undiscovered experts. Thousands of people manage virtual and real portfolios, competing against one another for top performance. As time elapses, expert investors emerge from the rabble. Previously unknown and unsung top performers bubble up to the top. Following their moves can lead investors to the promised land of profits. Rumor mills. Strategies can be developed to harness the information—or disinformation—inherent in most rumors, especially ones that concern mergers and acquisitions. Monitor these in real time or view them in the aggregate. The information here is important for investors even if they don’t trade on it. Insiders. Corporate insiders are notoriously good investors in their company’s stock, even when they trade legally. And they should be: Given access to sales forecasts and operational metrics, these investors have a knack for buying low and selling high. They, too, can be followed and followed profitably. Historical gurus. Stock screening allows investors to sort quickly through thousands of stocks for those few that exhibit specific criteria. Mimic screens allow us to search for the same parameters historical investors like Peter Lynch and Benjamin Graham used in their hunt for great stocks. Crowds. Crowdsourcing is a very popular subject. There is a lot of predictive power in the wisdom of crowds, as borne out in political forecasting and sports betting. Crowdsourcing can be used to locate good investments, as well. Investors can win by tracking the changes in sentiment of the investing masses. Co-Lateral information. Not all tradable information is purely investment related. Much of it exists in other forms. Learn to recognize valuable resources, such as trade and commerce sites that publish information that can be gleaned to aid our search for investing profits.

Some of these forms of flattery have been studied closely while others are so new that they’re just beginning to inspire research. Regardless, all have been inspired by the sheer transparency that today’s Internet provides. Most of these strategies can be implemented via free Internet sites. This book discusses each one of these forms and provides a framework through which to view investing in them.

Strategy Stubbornness As we begin to develop our mimicry strategies, it’s important to realize how important it is to stick to a strategy—any strategy—even one that’s

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had a tough year or two. Abandoning a strategy is like breaking up with a partner when times get tough. Those who do so don’t get to experience how much better the good times are when things get patched up. So, too, the investor: Abandoning a good strategy when it’s down probably signals that the sale is occurring somewhere near the strategy’s bottom. Doing so will ultimately cause an investor to miss out on the gains when the strategy bounces back. When discussing the importance of strategy stubbornness with Aaron Katsman, my business partner, he wasn’t at all surprised to learn that piggybacking others actually works. He believes that most of what we do as investors is shadowing others smarter, more knowledgeable, and better at investing than we are. In some sense, we’ve come full circle as investors in acknowledging that we have a lot to gain by learning from our teachers.

Investing in the Age of Social Media So, now to answer my previous question: How are you going to mimic these successful investment strategies? Simple: By using the Internet and the phenomenon of social media. In blending the resourceful use of the Internet with the advent of social media, this book shows you how to implement strategies that mimic numerous successful approaches to achieve outsized returns. It’s time to get back to basics. That’s the most interesting thing that’s accompanied the Internet, broadband access, and Facebook. Online trading has made research and buying and selling stock extremely easy. Despite the speed of online brokerages and the sheer amount of information out there, for most people investing hasn’t gotten easier. The double-edged sword of speed and information has not actually simplified things. It’s time to stop falling for every get-rich scheme that enters into our attention span. While technology has gotten infinitely more complicated, one of its most valuable uses is in something so basic: copying others. I’m not talking about plagiarism. With social media, all of our activities, thoughts, and feelings are being logged and published via sites like Twitter and Facebook. Smart investors are copying others’ trading activities—they’re plugging into the tradestream. I’m describing an ongoing learning process of tapping into those more experienced and talented than ourselves. Technology has brought us all the way back to something we knew was true throughout history. Instead of Back to the Future, it’s about fast-forwarding to the past. This past is full of experiential learning, gleaning of investment wisdom, and absorbing what our teaching masters have to share. Investing in the age of social media is about tapping the right people willing to share the most valuable information.

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Social Media for Investment Research Facebook and Twitter have captured a lot of user and media attention. What makes social media so compelling is its real-time view into the lives and activities of people who interest us. Unlike the early Internet bulletin boards where posting was a free-for-all, social media allows us to plug into the lifestreams of only those contacts we care about. Instead of everyone competing for our attention, we can turn down the noise level on Twitter and Facebook to focus on what our friends and business contacts have to say. It’s a game of supply and demand: Our contacts are logging their daily activities, creating a vast supply of information. As users of social media, we lap this stuff up. Driven partly by a desire for sociability and partly by sheer voyeurism, social media has begun to change our lives in subtle and not-so-subtle ways. Both Facebook and Twitter—there are numerous other platforms but, for sake of argument, these are the biggest and most influential—have grown their user bases to generate more than 100 million page views per month. LinkedIn, one of the foremost business networking sites, has over 50 million users. Social networking has moved beyond the early-adoption stage by technologists and found a home in the sweet spot of the general population. What’s more interesting about today’s social media trends is that both Facebook and Twitter are much more than websites where people go to chat with their friends. Both are actually very vibrant platforms that encourage third-party software development—or apps—to create a much broader ecosystem around their sites. Facebook makes it easy for developers to launch software products that integrate seamlessly into users’ Facebook pages. From fantasy sports leagues to sharing of music to thousands of casual games, Facebook has turned itself into a mega-community with tons of different functionality for everyone. One such program, the kaChing stock investing app, has made a big splash with young investors on Facebook. kaChing allows users to simulate investing portfolios and compete with others on performance. Nothing groundbreaking there. But because kaChing is a social network application, the game becomes much more exciting. Users can see every move their friends are making, turning the game into a higher-stakes bragging match. Users spend a lot of time researching their competition’s every move. The social media aspect that kaChing and Facebook add to investing opens channels of communication for sharing information among investors. With social media, also called participation media, investment research has evolved from a solitary analytical process and morphed into something entirely different. Investing in the age of Twitter and Facebook is about collaborative learning and sharing. With communities of investors tuned in

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to each other, the enterprising individual can vet ideas with other investors to get immediate feedback. Investing is now a completely transparent, participative process. It’s still early in the evolution of social media and investing. We’re going to see a lot of changes along the way. For investors today, social media is in the process of moving from facilitating the sharing of information to one that incorporates actual trading. This is happening as the second generation of online brokers is tying together social networks with trading platforms. This tie-up of research and trading is also occurring in the reverse direction: Successful social media sites for investors are rolling out trading capabilities to their users. The purpose of this book is to help investors make sense of how things have changed and provide a system to take advantage of these new resources.

Facebook versus Twitter Facebook and Twitter are more than just the new, new thing. Of course sites will emerge in the future that will compete for users with new functionality and coolness factor. But for the time being, Facebook and Twitter have emerged as truly powerful platforms. While both have chosen different ways to build sustainable businesses, it’s clear that this maturation process is occurring, just as it did with the first generation of Internet companies. For investors looking to tap into social media’s power, it’s worth analyzing both platforms’ strengths and weaknesses. Facebook is very much an extension of a traditional web experience. While users are certainly using Facebook on their mobile phones, the Facebook experience is essentially what we’ve grown to expect from a website. Users hook up with one another by friending each other. Once connected through an online friendship, users can see all their friends’ Facebook activities through what’s called the Facebook News Feed. This feed is a running commentary—the collective lifestream—of all contacts and group activities. Users can also embed third-party applications in their Facebook pages to enhance functionality. Facebook started as a social network for college students. Incoming freshmen would sign up at Facebook, build their profiles, upload pictures, and begin connecting with potential friends before the first day of classes commenced in September. As Facebook usage spread like wildfire among the collegiate community, the network was eventually opened up to the broader public. Its history is important because it established a dynamic that makes Facebook relationships more personal. Facebook users are having fun just hanging out with their friends on the site. I find my 14-year-old daughter sneaking onto Facebook in the middle of the night to chat with

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her friends—all of whom are logged onto Facebook at the same time. The giant social network feels just like a cool place to chill with friends. If you haven’t used Twitter, it’s somewhat harder to explain and get your arms around than Facebook. Where Facebook exists as a traditional website, Twitter doesn’t really exist anywhere. More than a website, it’s a communications platform. It’s estimated more than half of all Twitter traffic happens away from Twitter.com. Twitter is the convergence of a short message communications platform and social network. Instead of heading to a website, Twitter users use one of the many Twitter software clients available for the computer desktop and mobile phone to tweet messages 140 characters or less. Like Microsoft’s Outlook for email, these programs allow users to have control over all their inbound and outbound messaging. Twitter users subscribe to one another, just as they do on Facebook. Like Facebook’s News Feed, Twitter users receive an ongoing stream of information from their subscriptions. What differentiates Twitter from Facebook is its purpose. Twitter is a communications platform. For investors, this razor-sharp focus means that Twitter provides a fertile milieu for identifying who’s smart and worth listening to. Investors on Twitter are already sharing their tradestreams—a running commentary of their thoughts on the market and a log of their trading activities. With simple search tools, hedge funds and other professional investors are mining Twitter to find specific information to develop trading ideas. Social media aids investors in implementing the strategies outlined in this book; it’s a tool enabling easy piggybacking of investment activities. Many of the tactics outlined in this book were feasible before social media came along; Facebook and Twitter just make them a whole lot easier.

Why Me as Your Guide? Now that you have a general understanding of how you are going to learn to build a killer portfolio in the age of social media, you may be wondering why you should choose me as your tour guide. Well, I began my career in investing as a junior analyst for a multinational hedge fund. Besides learning how to make really strong coffee for my superiors, I got firsthand experience identifying and using profitable research resources. We had subscriptions to all kinds of cutting-edge sources of information paid for by seemingly unlimited resources earmarked for uncovering the next winning investment. As a researcher, I grew to understand the value of these resources as well as their limitations. These research platforms were really powerful in the hands of a well-versed user. While a lot of research conducted at hedge funds is novel and groundbreaking, some research work centered around merely aping

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others’ activities—from other analysts at competing funds to strategies used at investment banks and mutual funds. It was around this same time that I also began to experiment with developing my own investment strategies. Our portfolio manager—a genius trader in his own right—hammered home the importance of finding an edge in trading. He believed that edges could be identified by doing more work on a particular investment than our peers did. In the United States, it’s quite hard to find an edge in IBM or Microsoft when so many smart people are looking at the same things we are. You’d have to expand your purview to underfollowed small caps and mid caps to identify such an edge. That said, this same portfolio manager also believed that edge could be created by finding something no one else was looking at. Creating edge was about developing a unique idea, one that others hadn’t (yet) thought of. After developing the thesis, it was important to vet the idea, by running it by every smart person we knew. This process helped to validate our ideas and, frankly, to get others interested in the idea as well. Creating edge, to this newbie, was not merely talking up your investment picks to your friends, peers, competitors, and brokers. It was about creating a compelling investment story and then giving others with influence the tools to discover how great an investment it truly was. This type of edge is about providing others the wherewithal to mimic your moves. This experience was crucial in my development as an investor and strategist. From here, much of the work I’ve done has centered around researching mimicry strategies proven to work in an academic environment as well as with real investment money. After I left the hedge fund, a friend who is a venture capitalist suggested that I speak with one of the founders of a start-up in which he was invested. This meeting turned out to be with David Jackson, founder of Seeking Alpha, the fastest-growing next-generation financial website. That meeting changed my life. At the time of my first meeting, Seeking Alpha was merely one smart man’s investment blog. I knew of Jackson as a stock analyst who used to work for Morgan Stanley. After leaving the investment bank, Jackson turned to blogging his research thoughts down on his website, Seeking Alpha. While at the hedge fund, my interests overlapped with Jackson’s as we were both investing in Internet media companies. I was a Seeking Alpha reader because I liked what Jackson had to say. I had no inkling of his vision for the future. Jackson had big plans for his blog. He wanted to turn Seeking Alpha into an aggregator of financial content—a website that assembled opinionated content from various sources. He was already on his way. Scrubbed by a ragtag team of editors, Seeking Alpha was already publishing short posts written by the blogosphere’s best talent. Jackson understood that his

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readers, both professional and individual investors, were looking for advice on investments, not just run-of-the-mill, blah-blah journalism. For Jackson, it didn’t matter whether readers agreed with an opinion on his website. What mattered was that the website had a view. He also understood that Seeking Alpha would provide a lot of editorial value to his readers by ensuring only high-quality investment counsel made its way onto the website. Jackson’s vision was simple yet bold: With opinionated, editorial-driven content, Seeking Alpha would become a quick competitor to the likes of the Wall Street Journal Online. The audacity of it all seemed almost ludicrous. To think that a mere blog with a few employees working from home could challenge the likes of Dow Jones’ crown jewel was almost preposterous. But Jackson is a big thinker. So, too, were the investors who believed in his vision. He sold me on the idea and offered me a position to run business development activities for the fledgling firm. Being an investor myself with a background in Internet technologies made me a good candidate to help contribute to getting the firm off the ground. And that’s exactly what we did. As the company matured its editorial offering, we were successful in convincing most of our competitors in mainstream financial media that we were going places. What soon followed were partnership discussions with many of the leading players: Dow Jones’ Barron’s, MarketWatch, WSJ.com, E* Trade, Yahoo Finance, Reuters, AOL Money, and Google Finance. These discussions all turned into actual partnerships delivering real value to the parties involved. All of a sudden, Seeking Alpha was catapulted out of obscurity into the spotlight. Seeking Alpha was no longer just a blog. Its success was a harbinger to the major changes happening to financial media. With blogs, investment research was fragmenting into small pockets of really smart analysis. Large periodicals were fighting to maintain users; the business model of the periodical was being threatened. Seeking Alpha made huge strides, and I was helping to drive these successes. This background information is just a long-winded way of explaining why I’m the right person to be writing this book. My experience has provided me with a court-side seat to some of the most exciting changes on the financial Internet. But I wasn’t just a spectator; I had skin in the game, helping to secure some of industry’s game-changing deals. In addition, I’m putting my money where my mouth is. I’m not just blathering on about some arcane strategies. I’m an investment advisor, currently working with investors to help them implement the strategies I describe in this volume. I hope that my experience can help me to help you make sense of all these changes. Through this process, it’s my goal to assist you in becoming a better, more knowledgeable, and profitable investor.

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What This Book Won’t Do When discussing this book with various publishers, one well-known publisher mentioned that it would be interested in working with me on one condition: that I reduced my framework to the “one thing you need to know to always make money in the market.” I don’t believe there is a single formula that works for all investors. Nor do I think that what I’ve designed for investors can be reduced to a single formula. This is not a book that claims to have one magic formula to making money in the market. If you bought the book based on that assumption, I apologize. I don’t believe that there is such a formula and caution investors to be wary of anyone who stakes such a claim. I tell my clients, friends, family—basically, anyone who will listen to me—to be wary of people touting a magic formula, a black-box software program, or anything else that stakes bold claims of consistent market beating returns. We’ll see shortly that there are the blessed few who achieve alpha and not just beta in their investing. In other words, they’re beating the market based on skill, not luck. But for the rest of us, it’s not purely skill when we beat the market. Most of the time, it’s just noise. And that’s okay. We just need to recognize this as a truism and invest accordingly. This book will help you do that. Next, this book is not an introduction to investing. While I’ve tried to write the book in a manner that makes no assumption of any preexisting knowledge about investing, I don’t explain basic concepts in enough detail for complete novices. I recommend reading a book on the basics of investing, stock analysis, and overall investment strategy. For instance, Andrew Tobias’s The Only Investment Guide You’ll Guide You’ll Ever Need is a great place to start. There are plenty of free websites as well that provide beginners with the fundamentals of investing. To this end, be sure to check out Forbes.com’s Investopedia. I also recommend that clients keep an investment diary. It sounds corny, but taking down what you’ve done correctly and incorrectly should make you a better investor in the future. Investing is not merely an activity—it’s a learning process. In a similar vein, I’ve written pretty extensively about the Internet. I’ve also drilled down into social media and what platforms like Twitter have to offer us in terms of an investment strategy. Again, I’ve made no presupposition as to whether readers have a lot or little experience online. I’ve attempted to write for the broad public. I don’t assume a reader is totally familiar with the Internet, but this book is not intended to be a formal overview of Internet media. Another issue I grappled with in writing this book was how to use Internet references. Many of the strategies I describe can be best implemented

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using a single web service. Given the world we find ourselves in today, I didn’t want to turn the book into a long list of Internet sites. My feeling is that while some of these resources are fantastic services, they might not exist in their current form (or any form) in a matter of months or years. My children play a version of Monopoly, entitled Monopoly—The Internet Version. Introduced in 2000, half of the game’s properties are no longer in business. I didn’t want to risk that with this book. Go to my website, www.tradestreaming.com, and I will do my best to keep updated lists and descriptions of the tools and sites I discuss in the book. While I’ve refrained from making audacious claims, this book provides the framework for tapping into the tremendous potential in social media to boost investment returns. Many of the strategies and tools I describe can be used immediately by investors. Things are moving fast, though. New models and applications rise and fall in popularity. With the tradestreaming framework I’ve developed, you should be well prepared to continue to hone your ability to tap the Internet for new investment ideas. The book begins a process full of tremendous opportunity to utilize Internet and social media tools to identify, locate, and implement strategies based on some of the theories described herein.

What This Book Will Do So, now, let me tell you what this book will do. This book puts forth eight different ways to become a better investor using simple Internet tools and basic social media strategies. All involve some level of mimicry, and most have been proven to beat the market. Social media has enabled these strategies to be easily researched and implemented. Readers of this book will walk away with an overview of how changes in the investment research industry, the Internet, social media, and financial content have provided investors with an unprecedented level of access to some of the worlds’ most talented investors and valuable investment resources. This new world resides online, and you need to embrace it in order to further build your killer portfolio. Don’t take just my word on it; throughout the book, I’ve included numerous insights culled from personal interviews with various professionals—individuals with deep industry experience and knowledge. With this backdrop and knowledge in hand, readers are supplied with eight distinct strategies designed to utilize all that’s available to investors online. I’ll explain the strategy in detail: why it works, its historical performance, and how to implement it. Each approach uses different tactics to exploit the power of social media, which I’ll describe as well. Last, I’ll do my best to turn the strategy into something more practical and useable—readers

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will be capable of turning to basic Internet resources like Facebook and Twitter for an advantage in building winning portfolios with great stocks. If there are easy-to-use-and-understand resources online that assist investors in implementation of these strategies, I’ll point them out and describe them and their use. Otherwise, I’ll direct readers to more generic sources of information and leave it to readers’ own devices to determine how best to work the strategy. Here’s how the book is organized:














Chapter 1: Ride the Long Tail. This chapter analyzes how expert blogging has stood traditional research on its head as the Internet created the world’s largest investment research organization. Crops of stock analyst-bloggers are writing on a wide and deep variety of topics, the likes of which the investing public has never seen. No matter what an investor seeks, someone has written about it. In this chapter, you’ll learn how to tap into the vast sea of stock information to find new potential investments and better research your own investment ideas. Chapter 2: Piggyback the Pros. Professional investors must report their portfolio holdings at given intervals. This information is freely available to those investors who know how to locate it. Why spend your time researching the same stocks on which professionals have already done their own due diligence? In Chapter 2 I show how to build an all-star portfolio comprising the best picks from top professionals or to clone the investment portfolio of your favorite guru investor. Chapter 3: Commune with the Experts. Here it’s time to tap into the minds and portfolios of the next great investors. Social media has provided the underlying infrastructure for communities of all kinds of experts to communicate with one another. Expert investor communities use performance rating tools to audit and identify investing experts. Some of these experts may be professionals; others are merely armchair stock jockeys. Chapter 4: Ask the Crowds. Sports betting markets have proven that there is collective insight in market sentiment. The crowds have a hunch where things are headed if queried en masse. Universities have successfully used so-called prediction markets to test the likelihood of various events. The Internet has created ample opportunities for investors to benchmark how the crowds are sizing up potential investments. Just ask ’em. Chapter 5: Screening 2.0. Here you’ll see how to create screens for stocks based on the same presets that the world’s best investors use. Picking profitable stocks is notoriously tough. For every stock bought, there is someone selling it on the other side of the transaction. How does an investor size up various potential investments? Why recreate

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the investment wheel when you can use the same criteria that top professionals use to their trading advantage? Chapter 6: Tracking Inside Moves. Research throughout the years has shown insider buying of stock—that is, infrequent purchases of stock by corporate insiders—to be a profitable indicator of future stock movement. Just as large investors need to report their buying and selling, these insiders must file a report of their trading activities. Find out who is doing what and plan your investments accordingly. Chapter 7: Grind the Rumor Mill. New platforms have emerged that bubble up rumors and break information many times more quickly than mainstream media is able to report. This information is generated by people in the trenches, so it’s frequently insightful. In this chapter you’ll learn to distinguish rumor from fact and build a portfolio that capitalizes on how influential information sways the stock market. Chapter 8: Co-Lateral Research. Investors really have an arsenal of investment tools at their disposal online. In addition to the Yahoo Finances of the world, there are other sources that investors can utilize to their profitable advantage. Here you’ll learn how this strategy works and how to locate and utilize resources that will help you find the next ten-bagger stock. Summary. Having outlined these eight different strategies, I conclude the book by tying all these concepts together and focusing on where the next opportunities lay for the farsighted investor. I also analyze where investing is headed in the future and how investors can position themselves now to take advantage of the changes.

Getting Started Before we jump into our first investment strategy, “Ride the Long Tail,” I want to make a disclosure. This book has been the product of an ongoing process that started many years ago. My grandfather grew up during the Great Depression and began investing in the stock market soon after. He saw bubbles made and bubbles burst. He saw his local barber in Detroit take intermittent breaks to trade on hot tips. I grew up with my grandfather’s early guidance. He was an independent thinker and liked to buck trends, buying things out of favor and selling things when the bulls jumped in. While he never bought anything after reading a pundit’s recommendation, he had the utmost respect—reverence—for Warren Buffett. In fact, in a weird way, they remind me of each other. While my grandfather never met the Oracle of Omaha, he did learn from Buffett and tried to emulate him. I learned the value of creating an investment philosophy that was at

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once independent-minded yet also made room for learning from the greats. Warren Buffett was a great and my grandfather was no less. From my hedge fund experience to my financial advisory business today, my style has evolved. As a 20-something investor, I used to believe that I could always pick winners. Now, as I’m older, my grandfather’s counsel resounds in my ears and my investing style, both personal and what I recommend to clients, combines both original thinking with the mimicry of today’s gurus, including Buffett. I’ve learned to care less about coming up with original stock picks. I’m happy now, for me and my clients, to incorporate the strategies that I’ve written about in this book into my portfolio management. I believe, as my investment philosophy evolves, that I will continue to evangelize the value in mimicry strategies. After a decade of subpar investment results, buy-and-hold has failed a lot of people, especially those investors nearing retirement. That’s not to say that buy-and-hold is a failed strategy. In fact, I don’t see it as a strategy at all. It’s a philosophy that recognizes the dangers in overtrading and presents one solution to the problem. Trading too frequently is one of the most common investment mistakes. But there are other ways to mitigate overtrading. Tradestreaming should be part of your investment arsenal.

It’s Time to Tradestream Your Portfolio Tradestreaming is a new way to invest, made possible by Facebook and Twitter. Today’s Internet provides a level of transparency that’s never been experienced by investors. Fully taking advantage of social media from an investment perspective requires an understanding of what’s behind this change. TradeStream Your Way to Profits provides a methodology, a new way to look at investing, by using the Internet and social media to better research and mimic successful investing strategies. In this sense, the book occupies the meaty space somewhere in between a classic how-to investment book and a typical business book. I write a lot about the financial content and investment research industries and how the Internet is changing the rules of the game. But this analysis is done with an eye on providing actual investment strategies that best leverage this transformation. Investors themselves can decide how to proceed given the theories I develop. While investors will learn proven techniques that have been shown to make money, there are no specific formulas associated with tradestreaming. Rather, investors should finish this book smarter and more knowledgeable about what really works for profitable investors and how to use the Internet to tap into it. Tradestreaming is about identifying successful investors,

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strategies, and powerful computer programs and following their every move. For investors, imitation really is the most profitable form of flattery. Trying to beat the market may be enjoyable, but it’s a sucker’s game and not one that I want to play anymore. Social media has made it possible to easily recreate battlefield-proven investment strategies of all sorts. This book describes the strategies, how they work, and how investors can begin using them to become better investors. Investing is an ongoing learning process. Reading this book should be the start of that process, not the end. In the coming chapters, I teach you about social media strategies that leverage the incredible latent value in online investment information. Where necessary, I point you to specific websites that can assist in learning about and implementing these strategies. Readers also get another benefit: access to www.tradestreaming.com, a website I’ve created specifically for the readers of this book, free of charge, to expound on some of the concepts in this book and to keep the conversation going. These strategies are evolving as the Internet, social media, and the financial industry continue to mature. I’m flattered by your participation in the process. Let’s get moving.

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Ride the Long Tail Financial Blogging: The World’s Largest (Free) Investment Research Organization Now, with online distribution and retail, we are entering a world of abundance. And the differences are profound. —Chris Andersen, The Long Tail Our research shows that millions of people claim that reading Seeking Alpha impacts their investment decisions —David Jackson, CEO, Seeking Alpha

O

nce upon a time, investment bank analysts and financial journalists provided investors with everything they needed to know about identifying winning stocks. If a savvy investor read the reports issued by his brokerage house and took the Wall Street Journal with his morning coffee, he had done his due diligence. That was before the demise of traditional investment research and before the rise of the Internet, blogosphere, and social media like Facebook and Twitter. Today, bloggers are quickly rivaling investment bank analysts and top journalists in their capacity to both research and analyze a broad swath of stocks. A rising wave of small, individual voices (many of them professional money managers or experts in their particular fields) has begun to compete with the large, monolithic financial media firms for the time and attention of the average investor. Whatever the reality on Wall Street, we are in the midst of a bull market for stock market content. Blogs—and the aggregator sites that have sprung up to give them a more prominent platform—are part of what’s known as the long tail, the abundance of useful, actionable knowledge that is available to consumers (in this case, investors) in an increasingly democratic, technology-driven marketplace. Of the thousands of publicly traded stocks out there, only

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a couple hundred are covered by traditional research houses. Financial bloggers fill the gap by writing about thousands of midsize and small-cap companies, often focusing on those distinctly under the radar: the long tail. Bloggers, many of whom have personal, firsthand knowledge of the stocks they’re writing about, are posting their findings online—for free—where anyone can read them. This is very good news for investors: With an abundance of analysis being published 24/7, investors get a view of stocks that is simultaneously more in depth and wider in scope than anything we’ve seen before.

The Long Tail of the Financial Internet It’s 2006, a year before the bastion of upper-crust financial content, Dow Jones, a 100+-year-old company, is sold to Rupert Murdoch’s News Group. The deal, which was eventually sealed in December 2007, was seen by many as a harbinger of things to come for the industry, including the mass marketing of investment content that was previously accessible and marketed solely to the rich and powerful. I’m sitting in the Dow Jones war room on 200 Liberty Street, overlooking New York City’s Ground Zero, with the Statue of Liberty in the background. I’ve just flown in from Israel on the red-eye and haven’t slept a whole lot in the past couple of days. I’m sitting there with David Jackson, the chief executive and founder of financial media upstart Seeking Alpha, for a morning meeting with several top Dow Jones executives. My electric shaver has broken, and I’m looking the part of the tousled-haired Internet executive. We’re joined by the WSJ.com editor, Bill Grueskin, along with MarketWatch’s general manager, Maria Molland; MarketWatch’s editor, Dave Calloway; and a smattering of Dow Jones business development, legal, and marketing people. We’re also expecting the president of Dow Jones Consumer Division, Gordon McLeod, to make an appearance. It’s an important day for us at Seeking Alpha and, in retrospect, an enormous day for the future of financial content. Let me take a step back. Around the time of the Dow Jones meeting, Seeking Alpha had recently emerged from being just a technology and stock blog written primarily by Jackson, an ex–Morgan Stanley analyst, to an aggregator of third-party blog content by other leading stock bloggers around the world. I had been an analyst at a hedge fund investing in public Internet firms and was brought on to Seeking Alpha to head up business development: the result of an introduction from Seeking Alpha’s financial backer, Benchmark Capital’s Michael Eisenberg. My job description meant that it was my responsibility to find a way to partner with firms like Dow

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Jones. We weren’t quite sure what those partnerships would look like or how they were to be structured, but we thought we had a very interesting, novel way to address stock market opinion that made a lot of sense to our potential partners. At the time, we had hundreds of investment content bloggers contributing tens of articles to us daily. We had hired a small team of part-time editors working from home to run an editorial comb through all these articles by removing extraneous content, tagging them for stock tickers to make the content easier to find by search engines, and tightening up headlines to make them more readable on our platform. We had fewer than 1 million unique monthly visitors and a couple million monthly page views at the time. While the content was ramping in terms of volume and quality, we didn’t have a lot of resources. We all worked from home. We had outsourced some of our technology development. We were based 10 hours ahead of Silicon Valley in Israel. We didn’t even have business cards. All of a sudden, within a few months, we’re sitting in a conference room at the most prestigious financial media firm in the world, meeting with some of its most esteemed executives. We knew we were on to something with our model, but we hadn’t yet realized that we were to be the game changer of the industry. Our model of providing aggregation of content from the far reaches of the Internet written by professional money managers was a huge departure from the traditional model of financial journalism employed by firms like Dow Jones. We liked the fact that our contributors had skin in the game and owned and traded the same stocks they were analyzing. We liked the short, personal, and opinionated format utilized by these analyst-bloggers. We stood in full contrast to our big-box, button-down eventual partners at this table except for one thing. It was this one thing that enabled us to cut a deal with Dow Jones (and numerous other financial content leaders), and it was all about editorial direction. As the Wall Street Journal’s editorial director of online content (now dean of Academic Affairs at the Columbia University School of Journalism) Bill Grueskin said to us then, “The reason we’re sitting here together is that we see Seeking Alpha playing the same role in your market as we do in ours. You’re the editorial filter. You’re the Wall Street Journal of the blogosphere.” Whoa. We saw ourselves that way, but what an approbation for our start-up and what a message from up above. Suddenly, instead of seeing this army of blogger-analysts as a ragtag group of financial mudslingers, mainstream media was saying that there was an important role for them. Media generated by financial professionals outside of the confines of traditional journalism and posted freely onto the Internet was to be the next big thing.

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If the Wall Street Journal editorial staff understood its responsibility as sourcing, editing, and publishing the financial information required by every investor and business person, Seeking Alpha’s aggregation of financial blog content was the next generation. We never saw Seeking Alpha’s model replacing mainstream journalism. In fact, we always envisioned a peaceful marriage of our opinionated content with hard-hitting journalism, helping investors make sense of the events as they unfolded. If Dow Jones wrote the news, Seeking Alpha explained it. As Dow Jones’s model required an objective journalistic voice, we wanted Seeking Alpha contributors to have an opinion and state it clearly. Together, this was the future of financial content. The future is now.

Where We’ve Come From The notorious stock analyst Henry Blodget correctly predicted in 1998 that Amazon.com’s stock price would soon hit $400. It did so a month later, gaining 128%. More picks followed with the same type of outcome. Perhaps he was superaccurate with his picks. Perhaps his picks actually influenced huge stock price appreciation. Regardless, Blodget was on fire and making his clients millions. In 1998, if I’d have walked into Merrill Lynch’s offices and requested a copy of Blodget’s research, they would have asked me to open an account with them, qualify my net worth, and agree to pay high-commissioned trading fees in exchange for the access. In short, I would have had to pay to play. Investors without huge portfolios were left out in the cold. Today, a decade later, anyone can read Blodget’s running market commentary on his website, Silicon Alley Insider. He is one of the top contributors to Seeking Alpha, now the largest online aggregator of stock market opinion in the world. Not only can I access his reports at the click of a mouse, but so can my grandmother. It’s there for the taking. In just a few short years, blogging has radically altered the entire investment playing field, empowering a new generation of investors.

The Demise of Traditional Research As fundamental, structural changes have occurred in the stock research industry over the past few years, investors no longer have to rely on their brokers to get access to information about investments. A scarcity of information with limited distribution has given way to almost unlimited abundance of information widely available.1 Technology investor and venture capitalist Fred Wilson calls this entire process a dislocation “because of this

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move from scarcity and exclusivity to abundance and scale.” The velocity of information is continuing to accelerate, led by technological advances in Internet connectivity, social media, push email, blogs, and an easy-to-use method of publishing Internet content, Really Simple Syndication (RSS). We spent a generation believing certain parts of our business needed to be scarce and that advertising and other interruption should be abundant. Part of the pitch of free is that when advertising goes away, you need to make something else abundant in order to gain attention. Then, and only then, will you be able to sell something that’s naturally scarce. —Seth Godin, “Flipping Abundance and Scarcity,” 12 September 2009, http://sethgodin.typepad.com/seths blog/2009/09/flippingabundance-and-scarity.html

All these advances are occurring against a backdrop of massive change on Wall Street. The powerhouses of investment information have been decimated. Investment banks have either gone under, like Lehman Brothers, or have been forced to merge, like Morgan Stanley and Smith Barney. Today’s walking wounded of the investment industry were once the largest and most persuasive sources of investment research. As the total number of research analysts is waning, investors have been forced to look elsewhere for their information. There’s more to the story here. Part of the changing landscape includes what Robert Fagin, former managing director of research for Bank of America, describes as a convergence of trends in a chat we had in the Fall of 2009.2 Fagin sees such an incredible leap in the sophistication of large investors over the past few years that he wonders why any individual investor would go it alone. Fagin says, “So much money is being spent on information and investing tools that it’s hard to beat the resources of the large players.” He points to increasing value being placed on depth of information and data. With the Internet empowering globalization of resources and intelligence, Fagin says the days of just picking stocks and putting them away are over. “The new players have broad and deep knowledge of markets and securities. There is so much out there for sale. Expert networks can instantly put investors in touch with experts for specific industries. Investors can really get to the source of deep product knowledge in a way that they never could before.” In the past, given their size and influence, investment bank research departments created demand for stocks. If a research team liked a stock, it published favorable reports and marketed these reports to brokerage divisions, which pushed them out to investors. Favored stocks mostly went

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up. Stocks without research accompanying them typically languished. With nobody there to grab investors’ attention, these stocks had to find other ways to get the word out. This research always came at a price, though. For investment banks, stock research was never a profit center—few clients would ever directly pay for research. Instead, banks offered research services as a kicker to companies with which they were engaged in banking relationships. By providing their corporate clients with research coverage on their own stocks, investment banks could create awareness, increase liquidity, and ultimately inflate stock prices by marketing flattering research to thousands of eager brokerage clients. In turn, the research produced within a bank was distributed to a captive audience of brokers and clients, chomping at the bit for the next big investment idea. This model obviously led to abuse. Companies were offered prepackaged buy ratings in return for their continued investment banking business. Stocks were falsely promoted, and bubbles were created. As the excess of the Internet stock run imploded in 2001, investors were left holding the bag. Analysts were shown to be wearing no clothes. The feeling of mistrust of the Wall Street research department is still felt today. The conflict-ridden marriage of research and investment banking has left investors reeling for almost a whole decade. As banks have pared back their research, they’ve begun to concentrate their resources on only the most widely held stocks. As Michael Eisenberg, a partner with top venture capital firm Benchmark Partners and investor in Seeking Alpha, told me recently, “In general, the cost structures in traditional media are obviously broken. We needed to create a lower cost for financial media. And almost more importantly, real information was getting lost under the veil of objectivity of research and needed to be liberated away from investment banks.” Fagin sees an evolving role for investment banks away from stock research to a more holistic approach (although no self-respecting stock analyst would ever use that word). He sees investment banks working harder and smarter to help their clients via their broad array of services. When brokers at the banks speak to their clients, they can offer research on a company that encompasses not only the company’s stock but also includes information about its debt and options. In this manner, investment banks assist their clients along the same lines as investment analysts at hedge funds work to dissect a particular opportunity. To achieve this, he points to the huge advantages Bank of America and all other bulge-bracket investment banks have in servicing their clients with information flow from across all their groups trading options, bonds, and stocks. Fagin explains that investment banks are comprised of huge networks of smart people looking at investment opportunities in different ways. While brokers and

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analysts can no longer selectively disclose valuable trading information to clients, they certainly can and do provide value for clients by putting them in touch with different experts in their fields within the bank. By connecting all these moving pieces, investment banks provide a sophisticated offering with which it’s hard to compete. On today’s Wall Street, only a mere fraction of the thousands of stocks listed are covered by research. Prior to 2007, this would have left investors completely in the dark, floundering in the absence of stock market research. But from the void left by shrinking investment banks, an entirely new type of research provider has emerged, one that can help both professional and individual investors make money: the analyst-blogger.

Online Finance’s 800-Pound Gorilla From its launch, Yahoo! Finance was a revolutionary web property. For the first time, investors had free access to an integrated stock research platform available online 24/7. Yahoo! Finance took information that was once the exclusive domain of stock junkies and professionals and democratized it. Financial data, such as balance sheet and income statement information, was suddenly freely available online. Press releases and other commentary were displayed alongside useful stock charts. Given the breadth and quality of its offering (and the billions of page views it generated every year), Yahoo! Finance was the clear leader of Finance 1.0. By prescreening trusted sources to be included on its website, Yahoo makes it easy for investors to research companies. What Yahoo is really good at is providing data—reams and reams of it. Yahoo aggregates content from tens of sources into one console. In a very real way, Yahoo! Finance empowered every investor to run his or her own personal poor man’s Bloomberg terminal from the comfort of his or her home. Prior to Yahoo, it was extremely hard for investors to get real-time information on their portfolios and the news affecting them.

The Blogger’s Rise and the End of the Megabuck Website Yahoo! Finance undoubtedly cost tens of millions of dollars to create and manage. It was created in an era of megabuck websites. Landmark deals were signed with top content providers like the Wall Street Journal and Reuters to syndicate their content. Yahoo! Finance was built in an era when it cost a huge amount of money to conceive, create, launch, and manage a major website. These websites were essentially web portals, one-stop shops with all the resources you needed to conduct your financial activities.

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As the biggest and the best, Yahoo! Finance tapped the highest quality content and data providers to create a self-contained research environment. From looking up stock quotes on a portfolio to researching mutual funds to staying current on today’s business news, Yahoo! Finance was unbeatable. Everything worked according to plan. Yahoo! Finance combined a great research product with the fire hose of traffic that was Yahoo!. Everything was self-reinforcing. Yahoo! Finance attracted the majority of the finance traffic online with hundreds of millions of page views a month. The firm monetized this traffic by selling ads on the page. Yahoo! Finance used this money to pay for content and data from the best sources online, ensuring that the limited real estate on the page was reserved for only the largest content providers. The big information players got bigger and the smaller, new entrants in the game couldn’t compete. But in the past few years, an extremely important trend has arisen that is chiseling away at Yahoo! Finance’s domination: It no longer takes a team of programmers and millions of dollars to create a decent financial website. Free, easy-to-use web software is enabling millions of people to publish content onto their own blogs every day. The cost of publishing web content is currently being pushed to zero. Where investors once had only a handful of resources to research their investments, they now have thousands. It’s hard to track the growth of web publishing. While past surveys used to count the number of servers hosting websites and then use that as a proxy for the size of the web, it’s becoming harder to estimate using this methodology. One survey found that by June 2009, there were about 240 million websites, about double the number in May 2007.3 Much of this growth comes on the heels of web publishing software like Google’s Blogger and Wordpress.com, two leading services that host their clients’ websites free of charge. (See Figure 1.1.) This new reality has given rise to a new kind of analyst: the bloggeranalyst. Armed with investment insight and a personal website, both armchair stock operators and professional money managers are using the Internet to distribute their opinions on companies, industries, and markets. And in contrast to paid journalists, many of these blogger-analysts are shareholders in the companies they are writing about. They have skin in the game. They’ve done the research and have put their money where their mouths are. It’s an entirely new perspective—citizen journalism written by the investment enthusiast. The financial blogosphere is a pretty diverse place. Blogger-analysts have widely varying styles and rigor behind their research and opinion. Many analysts who have lost their jobs at major investment banks have also turned to the Internet to begin publishing their ideas on stocks and industries. Many of them turn this hobby into a full-time business or use

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Yahoo! Finance

Complexity

Market Watch

Reuters.com blog blog

blog

blog blog blog

Cost FIGURE 1.1 End of the Megabuck Website their know-how to land a job with a hedge fund or independent research house. Others are merely smart people with insight into investing that they enjoy sharing with their readership.

Why These Highly Paid Analysts Write Blogs Beyond the self-serving aspect of writing a blog (“I’ve got something very important to say!”), there is a clear purpose behind this trend toward financial blogging. And it’s not money. As Seeking Alpha’s David Jackson explains, “People started writing blogs where they were writing for free and not making any money. You can ask ‘Why?’ but that’s a fact. They want to write. That’s what they do.”4 The thing about blogging is that it’s fun, it gets you into conversations with people, it can help provide business leads and further your career. But bloggers are not looking to become journalists. “Most bloggers would make more money flipping burgers,” says Jackson. “If you can be real and expose people to how you think about things, people will seek you out.” Asset managers who blog are focused on bringing in new business. As brokerage firms are being slowly replaced with more boutique-type investment houses that charge their clients fees as a percentage of overall assets under management (AUM), bringing in new accounts and new money is key to building a successful money management practice. Asset managers

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are turning to blogging in order to create a community of active readers of their investment research and style. It’s free public relations, and some readers actually convert into paying clients. In short, a blog provides a public face for an investment professional so prospective clients can essentially try on a particular manager before deciding to turn their monies over to be managed. Blogs are becoming an important marketing channel for investment managers looking to build their brands in the investment marketplace. They’re free, easy to manage, and provide a blogger-analyst with a global soapbox from which to preach. Again, Michael Eisenberg, venture capitalist, explains that throughout history, the publication had always been the overarching brand. That’s all changing now. The Internet and social media have created a new era of individual brands, whose sheer numbers undermine the authority of large publications. “Blogging gives individuals a platform for influence,” says Eisenberg. “Everyone who sits somewhere has important information about something that can help investors make investment decisions.” Auto workers in Detroit knew how dire the situation was for the Big Three in 2008 way before most investors did. Doctors conducting cutting-edge neurological research are aware of the potential of the work they’re doing way before their findings disseminate into the investment world. The blogosphere is about giving voice to all these perspectives Instead of huge publications dominating financial discourse, we now have bloggers asserting their opinions and frequently moving stocks. Financial bloggers are quite different from the Yahoo! Finance model. Whereas Yahoo! Finance is a top-down model comprised of professionally crafted press releases, news articles from the foremost financial media firms, and data from the stock exchanges, financial bloggers are frequently brash, wooly, and extremely opinionated. The quality of the publishing varies wildly: Some of it is trashy but some of it is very, very good. And investors who know how to plug in are finding tremendous research power at their fingertips.

What’s Different Now? Chris Anderson, editor in chief of Wired, introduced the term “long tail” to describe the value of certain online retailers compared to their offline competitors. In his seminal piece, entitled “The Long Tail,” Anderson writes about the future of the online entertainment business being about misses, not hits.5 With a global clientele and infinite inventory, next-generation media businesses like Apple’s iTunes, Amazon, and Netflix no longer have to rely on blockbuster hits on the shelves one week and replaced the next to see huge profits.

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We’ve moved from a world of scarcity to a world of abundance in which obscure titles and back catalogs are as profitable as megahits. In a stark example of the long tail, Anderson explains that what’s really amazing is its sheer size. The average Barnes & Noble store carries 130,000 titles. But when you look at Amazon, more than half of its sales come from outside its top 130,000 titles. “Consider the implication: If the Amazon statistics are any guide, the market for books that are not even sold in the average bookstore is larger than the market for those that are,” explains Anderson. “In other words, the potential book market may be twice as big as it appears to be, if only we can get over the economics of scarcity.” What’s happening in businesses like Netflix and Amazon.com is also occurring in the finance world. It used to be all about what the Wall Street Journal and Barron’s (both published by Dow Jones) had to say on a stock. In the blogosphere, new financial blogger-analysts are writing prolifically and finding that their opinions are influencing investment decisions and, occasionally, stock prices. Sure, some of it is worthless and shameful promotion. But some of it is quite good. It’s this rising wave of small, individual voices that’s starting to compete for attention against the large, monolithic financial media firms. Filtering and curation become essential as the sheer volume of investment content ramps. This is the difference between push and pull, between broadcast and personalized taste. Long Tail business can treat consumers as individuals, offering mass customization as an alternative to mass-market fare. —Chris Anderson, “The Long Tail,” Wired (October 2004)

Analyst-blogging is the financial industry’s response to what’s going on around it. As more investors embrace do-it-yourself investing and research, many become consumers of this type of content. A smaller subset decides to become writers of financial research in this ecosystem. The boundaries between consumer and producer of research fall away in today’s democratized investing. There are numerous winning trades waiting to be discovered in the deep recesses of the financial blogosphere—the long tail. The key point here is that for every individual looking for specific nuggets of important information on the Internet, there is a knowledgeable someone out there talking about it. That’s extremely valuable. That’s the long tail of investment content. The blogger-analyst has filled the gap where research coverage tapers off for large caps and found a way to provide opinion on the thousands of midsize and small-cap companies. Investors now have a liquid market in research that spans a much larger percentage of stocks out there. Seeking Alpha, for example, has published

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research on over 6,000 companies just within the last six months as of December 2009.6 Regardless of what the economy is doing around us, we’re smack dab in a bull market for stock market content.

Why This Trend Is So Important Investors are getting more sophisticated—and it’s that growing sophistication that’s driving innovation in research. In order to keep up with the demands of today’s investors, research teams have had to become more creative. This evolution is taking time. Bloggers—many of whom are professionals in their fields—have been able to fill the gap between demand and supply for cutting-edge research, unencumbered by the corporate overhead of large banks or news organizations. Their writings are imbued with the same level of sophistication that today’s investors require and investment banks are struggling to keep up with. Consider the case of the website AOL Money. In case you’re not aware, AOL Money went through an extremely challenging time as it transitioned to a stand-alone website, Daily Finance, having been birthed into existence by the old AOL service. All of a sudden, AOL Money didn’t have millions of people stopping by automatically when they logged into their AOL accounts to check their portfolios. For the new AOL Money, run-of-the-mill press releases and the typical professional financial articles didn’t suffice. Editor of AOL Money Jamie Hammond explains that the large Internet portal also felt the call to help readers with actionable investment advice to supplement AOL’s mainstream financial news product. For AOL, though, blogs served an unmet need between the rise and subsequent fall of AOL Message Boards, which did a good job with providing snarky buzz about stocks. Unfortunately, they had a bad signal-to-noise ratio for investors.7 “We redesigned our site and found that blogs fit in between, by providing more information and showing credibility, transparency, and the ability to quickly publish breaking stories,” says Hammond. “We saw incorporating blogs on our site as a very strategic move for fulfilling an unmet need, a good way to build experience in producing our own content (and not just syndicating others), and just trying to do better overall for the AOL Money site and its users.” Even the mighty news organization Reuters, after its megamerger with Thomson, is getting into blogging in a big way. It’s not aggregating thirdparty blog content as much as it’s freeing paid journalists from some of their structural boundaries and giving them a long leash to develop their own brands and their own public opinions in blog format. Mark Goodrich heads up Reuters U.S. product development on the flagship Reuters.com website. Goodrich forecasts that Reuters will be moving more heavily into branded

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blogging in the future by bringing in influential voices to offer opinions under the Reuters label. For a large global news organization like Reuters, it’s imperative that it distinguishes clearly for its readers what’s fact and what’s commentary. But by recognizing that readers need access to both and by adding bloggers to its staff, Reuters incorporates the kind of intelligent dialogue that’s so important to today’s investor. Goodrich explains, “Whether you agree or not with what the blogger is saying doesn’t matter. You go on your way more informed to make decisions.”8

Commentary is becoming a really important part of the Reuters offering. By adding Felix Salmon and other A-level bloggers to our staff, we mix in that kind of intelligent dialogue that’s so important for today’s investors. —Mark Goodrich, Reuters, personal interview, Fall 2009

Reuters recognizes the value that blogger-analysts bring to the table in terms of helping make sense of the news. The analytic layer on top of objective reporting helps investors make decisions. It’s a relationship that is, at its essence, symbiotic. Bill Grueskin, dean of Columbia University’s School of Journalism, insists that the rise of blogging in no way indicates the end of the need for mainstream media outlets. “Bloggers don’t typically break news stories—they analyze them,” says Grueskin. “Bloggers still need a core news product to work off of. Bloggers and aggregators depend a lot on the reporting function that is more often than not fulfilled by traditional media.” With all this in mind, we have a clear formula for how investors looking to ride the long tail of financial content can best manage their investments. (See Figure 1.2.) News + Blog Analysis = Actionable, tradable information for investors

Objectivity

Opinion

News

Blogs

Broad Coverage

Deep Analysis

Invest

FIGURE 1.2 Research Investment Process

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Broad Coverage Long-tail content reverses the trend away from broad stock coverage. Many financial bloggers are focused on just a handful of stocks that fit into their investment strategy. We’ve seen a lot of value investors posting their findings online. It’s almost cultish how much activity and emotion goes into blogging about value stocks. Other analyst-bloggers have focused their interests on specific industries, most commonly technology companies, such as Apple and Google. Still others are focused on stocks in certain geographies. The aggregate total of all these subpockets of research has exploded the amount of content and analysis written about the stock market. The financial blogosphere has vastly increased the breadth of coverage on the stock market, effectively providing research on thousands of stocks, including midcaps and small caps. This has opened up a vast swath of the stock market that wasn’t previously accessible to most investors. Remember Chris Anderson’s long tail. While a handful of stocks may see above-average interest, much of the value of the market is in the aggregate thousands of stocks populating the tail. That is what’s so powerful about the explosion of the financial blogosphere: By untethering the cord connecting financial content and journalism, it’s freed up real investors to start writing not just about mega-cap, Dow Jones Industrial Average–type firms but also about innovative small caps that fly under the radar of most investors. But as more and more analyst-bloggers write about a growing number of stocks, investors may face overload from the long tail. Eisenberg cites the need for better and more advanced filtering and selection techniques backed by technology to help good ideas bubble up and keep the noise level down. This is already beginning to happen.

Deep Analysis Within this long tail coverage of a broad and diverse number of stocks, blogger-analysts have honed a level of specialization by providing surgical expertise on companies, industries, and markets. One well-known blogger focuses only on eBay. He examines ongoing auction trends, pricing, demand, and message boards; attends local eBay-sponsored events; and covers anything and everything to understand more about the firm. This is unprecedented analysis for investors. Even the best of professional analysts are required to cover a variety of different companies at any moment in time and only publish research periodically. The long tail has created u¨ ber–blogger-analysts who can apply their own time and resources to research the hell out of whatever interests them and write every day about their findings.

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Other bloggers have turned their attention and focus on a narrow industry, such as consumer electronics. Given the way professional research teams are organized around traditional industry codes, companies or industries that combine disciplines have always created problems for research analysts. Most of the time this manifests itself in the struggle to cover conglomerates like General Electric or United Technologies, two large companies with business units in a variety of industries. Not so with bloggers. Technological advances are creating industries that previously did not exist. New fields have emerged at the intersections of multiple sectors, such as consumer electronics, which evolved from the software, hardware, telecommunications, and retail industries. Within a traditional investment bank, there is no such thing as the consumer electronics industry. An investor looking to capitalize on new trends in the mobile Internet would have to speak to different analysts spanning multiple industries. It’s a bloody mess. On the Internet, blogger-analysts who have the ability to write about multiple disciplines are adding their voices to commentary on companies like Apple and Google, which are beginning to defy definition.

Global Trading Creates New Demands Investors perceive current events in different ways. Some people see in the rise of China a permanent change in the investment landscape—one where the United States plays a relatively smaller role in global capital markets. Others see Chinese ascendance as something cyclical. Regardless of your bent, it’s hard to deny the fact that the U.S. market no longer holds the majority of global market capitalization. Investors and their advisors are seeing better growth and opportunities overseas. This hasn’t been lost on the brokers, either. In 2007, E* Trade launched a major project that enabled account holders to invest directly in stocks in six foreign markets and five local currencies Until then, many of these markets were out of reach for most investors. I remember working on a deal in early 2007 with E* Trade to provide its account holders with direct access to Seeking Alpha content through the E* Trade trading platform. One trend E* Trade cited driving its interest in forging a deal with us was the relative lack of content on global stocks. E* Trade realized that its role was to lubricate global trading for clients by helping them make better trading decisions. Providing plain vanilla news is not sufficient because it doesn’t help guide investors into action. As it was developing a global trading platform, it was important for E* Trade to provide investors with tools to make more informed investment decisions. Seeking Alpha content was one of the ways E* Trade could do so.

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As the global investment community is growing closer, the demand for information on investments outside the United States is increasing. Bloggeranalysts have turned their attention to writing about specific geographic markets. Given China’s size and scope, certain writers are spending their time thinking and publishing about Chinese stocks. With bloggers providing this level of analysis, investors are treated to a view of stocks that is simultaneously much deeper and much broader than we’ve seen in the past. With all this analysis being published 24/7, investors can easily create an institutional-grade real-time research platform using free tools.

Finance 2.0: Real-Time Research Platform Things are really heating up in online investing. New tools and services, many of which we discuss in this book, are enabling investors to make quantumly better informed investment decisions. With clients and at lectures, I like to call this loose group of related technologies Finance 2.0. As a leader in Finance 1.0, Yahoo! Finance tried to be all things to all people. That meant the site needed to incorporate all the data and content a reasonable investor would require to manage her finances. As the explosion of content has changed the investment landscape, Yahoo! Finance cannot keep up. Other tools are required for investors to stay informed. Bloomberg terminals, the cornerstone of the professional investor’s research arsenal, are being attacked from all sides, as well. Like Yahoo! Finance, Bloomberg works to license content and data to be included in its platform. Because these are black boxes by definition, powerful new tools are going to be left out. Bloomberg, like Yahoo! cannot possibly keep defending its closed-environment products against the constant onslaught being waged by newer, more open technologies. The next generation of financial tools will be comprised of so-called mashups of other services. Combining new syndication technologies and open-source architectures, mashups enable developers to create applications and services combining multiple suppliers of data and technology. Think of a mashup as the online version of a food court, in which various merchants have each adapted their offerings and delivery methodologies to work in a specific environment. The end user, the eater, has the opportunity to enjoy an experience greater than the sum of its parts. The same thing is occurring online. New research platforms, such as Skygrid, monitor a deluge of information being published online by mainstream media, blogs, and social networks. Investors using these platforms get a real-time view of all the breaking news stories affecting the stocks in their portfolios. While the

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volume of news stories may be enough to choke on, these platforms are smart enough to help investors make sense of whether the news is affecting their stocks positively or negatively. They do so by using sentiment indicators to visually label news, allowing investors to quickly scan and assimilate loads of real-time information. Imagine a running news ticker on steroids streaming information on all the stocks you’ve ever been interested in.

Research via Microblogging: Twitter and Social Media Other blogging tools are helping to make sense of the vast amount of information being published on social networks. StockTwits, founded by serial entrepreneur Howard Lindzon, is developing an entire investment research and communications platform built on top of Twitter. Twitter is revolutionizing the way people are communicating. A form of microblogging, Twitter allows 140-character messages to be shared among friends and contacts. Twitter users publish and read content. Through a nice subscription mechanism, I only read content that my friends recommend. It’s incredibly efficient and useful from a research point of view. As my friend and colleague Mick Weinstein, Seeking Alpha’s editor in chief, once said to me, “Joining Twitter is like entering a party and seeing that all your friends are already there having a good time.” Eisenberg says this is a great example of the tools to filter and select what’s important out of the jumble of information we’re hit with every moment we’re online. “Seeking Alpha uses human editorial but so does Twitter. People edit what others should read. Each individual is doing editorial for himself.” In addition to writing investment content, investors using these platforms quote and link liberally to other valuable resources so that readers can easily ferret out who the real experts are. The result: Twitter has turned into an incredible platform for smart, like-minded people to flesh out the next winning trade. Twitter and Lindzon’s StockTwits allow investors to both publish and read a real-time information stream about stocks. This tradestream, provides an outlet for pundits’ ever-changing views on the markets and specific investments. Outside of watching talking heads on a cable channel, investors have never before had the sheer volume of information available to them. What’s more, given the flexibility and customization capabilities of these platforms, you can turn up the volume on exactly what interests you written by who interests you while tuning out the rest. We discuss how investors can best utilize Twitter later in this chapter and in Chapter 3 when we’ll learn how to identify and mimic soon-to-be star investment advisors. Finance 2.0 incorporates these new tools, mashups, and syndication technologies to provide investment-grade research to aid investors in three

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ways: by discovering new investments, deeply researching them, and personalizing the right portfolio.

Investment Discovery Investors used to scour anything they could get their hands on for investment ideas. Famed Fidelity mutual fund manager Peter Lynch, who ran the Magellan Fund for a decade of market-beating returns, writes in One Up on Wall Street that witnessing his wife buying a certain type of pantyhose piqued his interest, compelling him to launch into research mode to learn more about the manufacturer of the undergarments. The legendary investor’s stock-sleuthing ended with a fabulously profitable investment in the parent of L’eggs Pantyhose, a novel product that was slightly less quality than what was available in department stores but was sold through the drugstore/supermarket channel, where women spend more time during the week. Discovering new investments, whether they are mutual finds, exchange-traded funds (ETFs), or individual stocks, is an important part of the investment process. Historically, investment discovery was limited to just a few channels. In previous generations, investors relied primarily on their brokers for new investment ideas. In turn, these brokers relied on the research departments within their own firms for their ideas. As we know, many investment suggestions offered by these brokerages were littered with conflicts of interest. Banking clients of the firms were promoted as investment ideas, and investment decisions were made to boost certain stocks that benefited the bank itself, such as promoting initial public offerings or stocks owned heavily by the bank’s asset managers. Investors also relied on trade journals and business dailies, such as the Wall Street Journal, for investment ideas. While these periodicals didn’t have the same conflicts that brokers had when publishing investment information, they are, at their hearts, journalistic products. Free of opinion and vetted by editors, newspapers and their online brothers attempt to provide unbiased coverage of information affecting investments. Most journalists are prohibited, or at least discouraged, from owning real investments that they write about. While the reporting can be stellar, certain practical knowledge can’t be gained just by researching a topic. You have to get your hands dirty. Blogger-analysts, unlike financial journalists, bring real-life investing familiarity and hands-on experience to their writing.

ENTER SEEKING ALPHA AND THE FINANCIAL BLOGOSPHERE With minions of analyst-bloggers combing the Internet for good, actionable investment ideas to research and blog about, investors can employ an army of virtual research assistants by reading a variety of blogs every day. To make our lives easier,

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blog aggregators, like Seeking Alpha, use either an editorial staff to pick out the most thought-provoking and well-researched blogs for inclusion in their platform or a computerized algorithm to decide what to publish. By reading many of the hundreds of blogs included in these aggregators, investors are exposed to numerous trading ideas they would have never even heard of by reading traditional research sources. And because numerous links are embedded in each article, investors can follow the bread crumbs from one blog to another to discover which stocks the most talented researchers are writing about. Comprised of thousands of blogger-analysts, the financial blogosphere has morphed into a distributed informal research organization. I originally encountered Seeking Alpha as a user when I was an analyst at a hedge fund. David Jackson, who spent years as an analyst at Morgan Stanley, began Seeking Alpha as his personal blog, where he wrote about both technology and media stocks. I was invested in many of the companies he was writing about, so I began following what he had to say. But Jackson’s vision for Seeking Alpha was already changing. He had higher aspirations that included covering a variety of sectors. “It was clear to me that it wouldn’t work by hiring a professional analyst to cover each domain,” says Jackson. “You can’t fight the long tail and, plus, I didn’t want to create a business that employed highly paid, prima donna, superstar analysts.” Aggregating thirdparty blog content was not only a more realistic proposition; it’s ultimately better for readers. Using the financial blogosphere for investment discovery is not limited to researching stocks. Investors who use ETFs or mutual funds as part of their investment strategy will find many useful resources online. The past few years have seen hundreds of new ETF products come to market. In fact, there have been so many that journalists and investors have struggled to keep up with the new developments. The blogosphere hasn’t. Before many of these new products have seen the light of the trading day, bloggers have already pored over Securities and Exchange Commission filings to make heads or tails of these new products. ETFs are stealing market share from the mutual fund community. Consequently, there is a lot less commentary written about mutual funds these days. ETFs, because they are low cost, easy to trade, and provide exposure to markets and sectors via passive indexes, are proving to be the tools of choice for many of today’s leading investors. All this research is published daily, comprising the long tail of financial content, and makes its way onto thousands of blogs and aggregators.

Deep Stock Research After discovering new investment ideas, investors then need to drill down, do the work and flesh out whether a particular investment makes sense. Often this involves comparing a particular security to its competitors or a

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particular ETF or mutual find offering that captures the same strategy. For example, an investor discovers that China should play a role in his portfolio. But deciding how to capture the China theme requires hard work. Buying an ETF will skew the Chinese investment toward overweight exposure to the largest banks in China. Buying the largest industrial company captures just part of the reasoning an investor may want to be in the country. Traditionally, investors were exposed to only one opinion when reading a research report published by an investment house. Beyond some of the conflicts of interest embedded in such a report, it was hard to decipher the other side of the argument. What if the analyst is wrong? How wrong can she be? What’s the risk? Financial blogging is about voicing an opinion, not breaking news or forecasting the next quarter’s earnings per share to the penny. Blogger voices are diverse and frequently, a research piece will elicit strong views. Ideally, blogs provide a framework to make a knowledgeable investment decision; they don’t always tell you what to do. Other sites, such as Wikinvest, include user-generated content to help investors go deeper. Like the granddaddy of all wikis, Wikipedia, Wikinvest allows users to edit and contribute their own research about companies. Each company has a description page that is built, maintained, and edited by Wikinvest users. We look at the wiki structure in Chapter 4, but suffice it to say that there is something extraordinary afoot when investing content is being written by actual investors in real time. In an effort to help investors make sense of potential investments and provide actionable commentary, Wikinvest launched its Bulls and Bears section on each company it covers. Provided in real time, investors can see all the potential issues—pro and con—surrounding an investment, written by their fellow investors. Journalists typically interview people on both sides of the investment fence. Now you and I can write our own content, perspectives, and opinions to be included on a major investment site. Mike Sha, cofounder of Wikinvest and a classmate of mine at Harvard, put it succinctly: “What Wikinvest does is help you understand the risks and bets you are taking when sizing up a potential investment. We say, ‘Here’s how Apple Computer [AAPL] makes it money and what could cause it to go up and what the risks are for value destruction.’” Investors are already using the long tail of investment content to make profitable trades. A huge chunk of users have gone on record to say that Seeking Alpha frequently impacts their investment decisions.9 That marks a significant change from just a couple of years ago, when most investors would turn to Forbes or the Wall Street Journal for their investment needs. Investors are getting more and more comfortable turning to nontraditional sources of information to help find new ideas for their portfolios. Relationships online are really one to one, and blogs usher in a new level of

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connectivity between analyst and investor. These sites are not only great sources of fresh stock ideas, but they’re social in nature, places where readers connect with analyst-bloggers. Ultimately, it means the best ideas find their way to those most interested in hearing them.

Bloggers as New Form of Investment Analyst In addition to providing the tools, data, and analysis to probe deeper into an investment opportunity, bloggers are enjoying a newfound preeminence in the market. As the new investigative journalists, they are gaining access to the executives populating the corner offices and often act as go-betweens for investors and corporate management. With entr´ee into the boardroom and access to CEOs, bloggers can provide an opinionated analysis layer on the commentary emanating from companies and help investors make sense of everything. Early on, the mainstream media often ridiculed analyst-bloggers. The criticism leveled at these writers usually came in a few forms:








They are not credentialed. Who are these people? Where did they come from? Are they just day traders sitting around writing and trading in their pajamas? No oversight. Bloggers are not professional journalists employed by a paper, newswire, or service. They don’t have an editorial duty of objectivity. Lack of disclosure. Journalists are not normally allowed to own stocks. Bloggers, however, write about things that they own personally or through an investment vehicle that they are managing. Is it clear to the reader what’s at stake for the blogger?

In order to address these issues, some aggregators of financial content put a human editorial filter on the blogosphere. No blogger or article goes up on Seeking Alpha, for example, without complying with certain editorial conditions. Periodicals provide this level of trust—when a subscriber to the WSJ reads an article about a stock, she can be pretty sure that facts have been checked, details accounted for, and an objective voice addresses the issues responsibly. In an era that’s experiencing the weakening of the influence of large periodicals, aggregators have stepped in to provide this editorial direction for their content sources. It’s not a matter of just having great analysis on blogs; it’s extremely important to set the trust bar high so that when readers read analysis on a certain company, they know exactly what type of source is producing the content and whether this person has

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any conflicts of interest. It’s okay if the blogger-analyst has some skin in the game and owns the stock that she’s writing about); investors just need to take that into consideration when sizing up the research. To succeed at putting a layer of trust on top of an inherently free medium, aggregators must address credentialing. Readers need to know that they are not being gamed by schemers or shameless stock promoters. This can be a difficult balance to strike for aggregators, who want to keep the quality level high but the submission bar low. Readers stand to gain when more voices are heard and pretty much anyone can submit content. To get their content published on these new websites, bloggers typically have to submit to a variety of rules similar to some of those found in traditional newsrooms. These standards, adapted from Seeking Alpha’s contributors page,10 include such things as:

1. Author Qualifications. Authors must attest that they have never been prosecuted for or sued about any securities-related issue, been barred from the securities industry, or convicted of a felony. 2. Disclosure of Positions. Authors typically agree to disclose the existence of a financial position (long or short, and including stocks, options or other instruments) in any stock mentioned in an article. Authors cannot pump stocks, meaning that they may not write about stocks with the intention to manipulate prices in order to trade the stock. 3. Disclosure of Conflicts of Interest. Authors generally agree to disclose any material relationships with companies whose stocks they write about or parties that stand to gain in any way from the viewpoint they are outlining. This means that anyone paid to produce research on a stock must identify that relationship. 4. Noninfringement of Copyright. Bloggers typically don’t break investment news; they analyze it. Large news organizations are very wary of bloggers lifting their stories without proper attribution. Bloggers must respect copyright rules. 5. Commitment to Accuracy. While many bloggers don’t have the resources of a typical newsroom, they must make an effort to provide accurate information in their analysis. 6. Anonymity and Accountability. Many aggregators of stock information don’t permit a financial blogger to hide behind a veil of anonymity. The stakes are just too great when dealing with securities. Seeking Alpha and other sites require analyst-bloggers to at least provide the editorial staff with contact details, even if the analysis is published under a pseudonym.

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While it’s hard to ensure water-tight enforcement, many blogger communities are incredibly well self-policed. Reputable sites have found that authors willing to submit to the compliance standards do, for the most part, keep them. Users who have any question about an author’s integrity can voice their complaints to the editorial board, which takes these things very seriously. As a result of the work done by firms like Seeking Alpha, an inherently roughshod type of journalism with an extremely low bar to entry has been turned into a serious source of financial information for professional and individual investors today. With hundreds of millions of page views per month and some of the best investor demographics online, the popularity of the financial blogosphere speaks to the success of blogging as the new form of financial research.

The Move Beyond the Website The success of aggregator sites marks a pivotal stage in investment research. Third-party aggregators provide a soapbox to every professional or amateur stock analyst to market his own ideas and, consequently, his own brand. As a leading aggregator, Seeking Alpha is growing by leaps and bounds and sports a readership that any financial firm would drool over. The site brings fresh, professionally written opinions about thousands of stocks freely to investors globally. Certainly, huge stuff. Seeking Alpha was early to the game in the financial blogosphere. In fact, in some real way, the firm helped spur the growth of investment blogging. But some would say that in spite of this success, Seeking Alpha has been slow to react to the next wave of financial research: the demise of the website and the dismembering of a centralized location for financial information. Earlier in this chapter, Michael Eisenberg, venture capitalist and investor in the field, foretold the end of the publication. (He even thinks banks may go the way of the dinosaur, but that’s another discussion.) Howard Lindzon, investor, entrepreneur, and founder of StockTwits, agrees. Instead of going to an aggregator to get advice on what to buy or sell, Lindzon sees investors turning directly to trusted experts who in turn refer them to other experts if they can’t answer their questions. In short, Lindzon believes that the era of the large website trying to keep investors within its walls to maximize advertising revenues is over. His platform, StockTwits, is designed to demolish these walls. Built on Twitter, StockTwits has almost 100,000 traders at the end of 2009 sharing information with one another in real time. By subscribing to the collective tradestream, they are privy to great traders’ minds and investment activities.

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Many of these users never even visit a website to participate in this type of discussion. Instead, they use Twitter software clients that sit on their computer desktops to sort through all this information, not unlike how many of us use Outlook to manage our email flow. This is the fulfillment of one-to-one, person-to-person investing. Lindzon knows his stuff. He’s founded and sold numerous technology companies and is a small investor in Twitter and Covestor, a firm we analyze in Chapter 3. Here’s how he describes the difference between a megasite aggregator and StockTwits: When people come to Howard Lindzon looking for his investment advice, they’re sorely disappointed. I don’t tell them what to do. What I do is point them to experts in particular fields and recommend they tap them for advice. We’re interested in making stars out of other people, not StockTwits. We don’t think that works big. It still feels like bubble investing mentality, dependent on eyeballs. The big site, the old model, is broken. What Howard is saying is that the aggregators, in an effort to provide a huge mouthpiece for thousands of analyst-bloggers around the world, needed to get big. They needed to become large websites with lots of resources, dependent on advertising revenues for growth. They needed to become prominent and build a brand. But there is an inherent tension to this approach: While an aggregator depends on its contributors for content, it can’t afford to share the entire limelight. It has to be bigger than the sum of its parts. StockTwits, however, isn’t reliant on a website. Users and contributors can publish and read their tweets by using Twitter client software on their desktops, BlackBerrys, and iPhones, without ever venturing to the StockTwits site. Because Twitter was developed as a completely open communications platform, it’s entirely diffuse. Every tweet has the potential of being a one-to-one message. Investors interested solely in energy stocks can subscribe to the top analysts on StockTwits devoted to this sector and turn off the noise about everything else. It’s a stream of real time information driven directly by the user’s predilections. (See Figure 1.3). The move toward Twitter and microblogging has not been lost on Seeking Alpha’s Jackson. He sees his firm’s audacious goal as “building an integrated suite of products to allow smart people to express themselves in the financial vertical any way they want to: whether it’s a fully baked article, short posts, or microblogging.” Jackson sees each of these media as part of a holistic set of communications tools. “Our strategy is to integrate all this

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Bloggeranalysts

Bloggeranalyst

StockTwits.com

SeekingAlpha.com

User

User

User

User

Bloggeranalyst

User

User

User

User

User

FIGURE 1.3 Seeking Alpha versus StockTwits

so people who care about what you say can find your opinion anywhere,” he explains. To that end, Seeking Alpha recently launched its StockTalks and Instablogger products. Like its blogging platform competitors Blogger, TypePad, and WordPress, Instablogger allows bloggers to quickly and easily build and manage a website and publish frequently to it. And because it was developed primarily with the financial blogger in mind, certain technologies are embedded in it, such as stock ticker translations and automatic industry groupings. Jackson thinks there are a few areas in microblogging that are particularly interesting. He suspects news will find certain experts who will build large audiences, much like Michael Arrington’s TechCrunch has done in the blogging and technology sphere. As with blogging, news and opinion will continue to build weighty opinion generators in the microblogging space. “You can say this stuff in 140 characters or less,” says Jackson. “What you can’t do is provide significant analysis. It’s better to see microblogging fitting within the larger context of a communications toolbox, which has to include longer stuff as well. With pure microblogging, you run the risk of extreme dumbing down.”

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Summary Bloggers are quickly rivaling investment bank analysts and top journalists in their capacity to research a broad swath of stocks as well as drill deep down in their analysis. As financial information has become more democratized, investors should harness the long tail to help make sense of it all. In turn, this new model provides investors with a real-time research platform to bubble up previously undiscovered investment opportunities and then surgically analyze them. Blogger opinion resides in the long tail, a tremendously valuable repository of information just waiting to be tapped.

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2

Piggyback the Pros Following Top Money Managers’ Every Move Pays Off Imitation is the sincerest form of flattery. —Charles Caleb Colton By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third, by experience, which is the bitterest. —Confucius

T

he Internet is an amazingly powerful tool. Just a few years ago, top professional investors could make strategic investments in relative obscurity. Now investors can stay apprised of the every move of these guru investors. Famed hedge fund managers Steven Cohen, John Paulson, and even Warren Buffett can be tracked online using simple tools. Research shows that following these masters pays off handsomely for investors. As regulation has tightened around the hedge fund industry, top portfolio managers are increasingly required to disclose big moves in their portfolios. All this information is made public to investors through public databases. By following the iterations of guru portfolios, investors can mimic the huge returns these professionals are producing. In this chapter, we analyze how best to employ a piggybacking strategy via online resources.

The Pilgrimage to Omaha Every year thousands of investors, large and small, flock to Omaha, Nebraska, to commune with one of the most successful investors of our era, 45

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Warren Buffett. These people are actually insane. They have the same commitment to Buffett as members of a cult do to their shaman. They eat, live, and breathe his every word and action. Not to miss anything, hundreds of media people are there to cover every second of the event. World leaders attend Buffett’s Berkshire Hathaway powwow, too. In fact, these same world leaders actually get second billing when it comes to the curiosity, attention to detail, and sheer time accorded to the famed Buffett. We’ve witnessed the world’s wealthiest man, Microsoft’s Bill Gates, not only attend these events but challenge the Oracle of Omaha to a game of Ping Pong. What compels these otherwise normal people to leave their homes and businesses for a week and fly, drive, ride, and swim to Omaha? To hear every word that an 80-year-old investor with a penchant for miserliness has to say? Buffett’s historical performance has been unassailable for at least two generations of investors. While statistics and academic studies show us that even if some asset managers exhibit a hot hand and beat the market averages, over the long term, most investment advisors tend to revert to the mean and end up with returns that look like the market averages. Not so with Buffett. Take Bill Miller, fund manager of Legg Mason’s Value Trust and chairman and chief investment officer of Legg Mason Capital Management. Miller was hitting it for years. During the late 1990s, he was revered like Buffett. He partied like a rock star. With a strategy of investing in stocks trading at low prices but high in value, Miller was always on top of the leaderboard when it came to performance as the stock market rallied during the 1990s. Investors in his fund would have seen returns that beat the market by over 100% during that decade. Based on his performance record, he was the manager to beat during the 1990s and after. Miller was untouchable. So, what happened? I think most people know how the story played out. Somehow, like most advisors with market-beating performance, Bill Miller lost the touch. He reverted to the mean. Miller has underperformed the market significantly since 2008. So much so that he’s pretty much given back decades of investment gains. Mutual fund investors can attest to this fact. Many of us have bought into a fund that had a stellar performance record only to see our investment dwindle with bad performance. I always thought that it was just my own bad luck, but it’s a fact of investing.

[I]t’s rare that a leader from one decade repeats in the next decade. —Bill Miller

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As in any statistical distribution, there will be a few performers who completely wallop the averages over the long term. Few in number, these standouts have the ability to consistently and persistently return large sums of money to their investors. Warren Buffett is one of these. When Warren Buffett talks about investing, the whole world listens. It wasn’t always like this. While Buffett has performed well for decades, his level of superstar status is a relatively new development. He was not always the media darling he is today; nor did he always have the entire investing world hinged on his every word and action. Now it’s enough to learn that Buffett has invested in a particular company to send that company’s stock soaring. Buffett’s rock star status is the result of a process that’s been unfolding for years. As the velocity of information traveling around the investment world has increased, so, too, have requirements to make certain information part of the public domain. Professional investors, particularly those managing large sums of money, are required to submit forms to the Securities and Exchange Commission (SEC) monthly, quarterly or even when they make a change to their existing holdings. These filings comprise a public database called EDGAR or, in its new form, the Interactive Data Electronic Applications (IDEA). As soon as these filings hit the wire, individual investors and institutions can monitor what guru investors are doing and even choose to cherry-pick the best ideas of investors like Buffett and Miller or of new entrants on the scene: hedge fund managers like George Soros, SAC Capital’s Steven Cohen, ESL Investment’s Eddie Lampert, Baupost Group’s Seth Klarman, and Greenlight Capital’s David Einhorn. While these names may not be dinner-table favorites, industry insiders see some of these rising stars as successors to Buffett in his quest for longterm, consistent market-beating performance. As hedge fund managers, they don’t have some of the restrictions traditional mutual fund managers have. With some street smarts and a lot of technology at their disposal, they are crushing the market averages. And they’re doing so by taking on less risk than typical buy-and-hold strategies.

Do Hedge Funds Really Outperform? The success of these hedge fund superstars has inspired every Harvard MBA to start his own hedge fund. None of this has been lost on investors. As an industry, there were an estimated 9,000 hedge funds at the end of 2008. Many are just small shops, but the largest 100 hedge funds control about 75% of all hedge funds assets.1 With $1.9 trillion dollars in assets by 2007, money has been flowing consistently to the top managers. The horrid stock

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market of 2008 saw a lot of redemptions by hedge fund investors. Some of this money will make it back into these vehicles when the all-clear signal is sounded, and some of it won’t. Regardless, it’s likely that many small hedge funds will fade and money earmarked to this asset class will consolidate around a handful of these funds. It seems that in spite of subpar performance in 2008 and 2009, everyone wants a piece of these guys. Many institutions, such as the Harvard and Yale endowments, have turned to these alternative investment vehicles as part of their overall asset allocation strategy. Hedge fund strategies are even being implemented in new mutual fund and exchange-traded fund (ETF) offerings. Investing in these funds will become even more accessible for average investors interested in aping the methodologies hedge funds use to lower volatility while achieving above-average returns. While hedge funds have reaped huge profits for investors, old-school mutual funds haven’t performed as well. Much of the historical research around mutual funds showed that winning funds didn’t continue to outperform from year to year. This means that most of the time when mutual funds achieved some level of outperformance, it could be attributed to luck. A whole generation of MBA graduates and investors were educated on the Efficient Market Hypothesis (EMH), which basically holds that most investors would be better off just putting their money in broad market index funds. Hell, that’s what I learned at Harvard and at the Kellogg School of Management, and that’s what was behind the billions of dollars that flowed into index fund company Vanguard Investments over the past two decades. But that view is starting to change as the academic community continues to look at hedge fund returns under a microscope. Academic researchers Kosowski, Naik, and Teo took a new approach to hedge fund returns and have spawned a lot of new research into outperformance.2 These researchers found that the great performance of certain hedge funds was based on highly skillful investing and can be repeated from year to year. In one fell swoop, the EMH appears to be on its last legs. In other words, the hedge fund gurus we read about in the news are actually highly skilled investors regularly beating the markets. You can’t say the same for mutual funds. These guys are for real. It’s been an incredible turnaround in thinking about investment performance. The abnormal performance of top hedge funds cannot be attributed to luck and hedge fund abnormal performance persists at annual horizons. —Robert Kosowski, Narayan Naik, and Melvyn Teo, “Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis,” Journal of Financial Economics (2007): Volume 84

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For three decades, conventional wisdom within the academic research community maintained that it was impossible for an investor to consistently outperform stock market indices over the long term. Sure, certain investors had good years or even a string of good luck. But most investors, including professionals who get paid a lot of money to manage assets, some time or another revert to the mean performance of an index. Hot hands don’t persist, and for the most part, markets are efficient, making it impossible to really beat the performance of the overall stock market. These academics, followed soon after by the founder of Vanguard Funds and mouthpiece for index investing, John Bogle, recommend putting investment money in passively managed mutual funds or ETFs whose sole purpose is to track the performance of certain stock market indices, such as the Standard & Poor’s (S&P) 500 or the Russell 2000. While this is where previous research pointed, I’m sure most individual investors and a large swath of the investment community knows that this is hogwash. There have been numerous examples of investors investing large sums of money for decades who have consistently outperformed their benchmarks. They’ve become billionaires themselves and have made whole generations of wealthy investors even wealthier. Conventional wisdom says that even though these types of investors exist, it’s very hard to become one of them, and most investors are better off not even trying. But it you happen to be one of these really talented gunslingers, it’s hard to argue with performance. Investors like Joel Greenblatt, whom we learn more about in Chapter 5, posted returns close to 40% per year for 20 years. That’s real money. But newer research coming out of the academic community has a different message for investors. Hedge funds, because they are for the most part unregulated, provide a hard sample to study because there isn’t institutionalized uniformity among competitors. Funds have entirely different investment styles, making it hard to do apples-to-apples comparisons. Recent studies have been able to make sense of these investment vehicles, and what they’ve found corroborates what many of us sensed: Top hedge fund managers do seem to bring home the bacon. Another set of academic researchers—Jagannathan, Malakhov, and Novikov—focused on studying whether hedge funds managers were subject to the same “hot hand” biases that mutual fund managers were.3 We’ve all seen basketball stars hit shot after shot. It appears that with every shot they make, these players get better and seem more likely to make the next shot. Turns out, they’re not; nor are mutual fund managers. The majority of mutual fund managers exhibiting great performance in one year are not likely to show the same outperformance the next. In Do Hedge Funds Deliver Alpha? Kosowski, Naik, and Teo found that studying hedge fund returns yields “striking” empirical results. Backing our own intuition, these

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researchers found that funds performing highly in a given two-year period were more likely to outperform over the following two years.4 Hot hands smoking, these researchers proved that top hedge funds do in fact beat markets repeatedly—through skill, not luck—and can continue to beat the markets over time.

How Hedge Funds Win By passing Regulation Fair Disclosure (Reg FD) in 2000, the SEC did away with selective disclosure of important information by companies to analysts and investors. Reg FD required all impactful information to be given over to the public at once. Immediately, the investment field had been leveled. We now exist in an investment environment where small investors have more or less the same access to information from companies as larger professional investors do. Reg FD put individual investors and institutional investors on equal footing by preventing companies and analysts from leaking important information to a select group of investors. The old boys’ network’s builtin advantages are a thing of the past. We don’t have to look farther than hedge funds to see what new advantage professionals have employed to their benefit: technology. Huge hedge funds managing tens of billions of dollars have essentially become incredibly well-run, well-funded, state-ofthe-art trading machines. Hedge funds continue to maintain their edge over most investors by employing two distinct techniques: 1. Doing better research on companies than other investors. When I was an analyst at one of these top hedge funds, our portfolio manager, Seth Fischer, a master trader in his own right, used to focus us on “edge.” We needed to have an edge over others, or it wasn’t worth making the trade. If you know only what others already know, you have no edge. We were trained to either find an edge or create one. If not, just don’t bother playing. Hedge funds can do extensive primary and secondary research by talking to management, collecting their own data, analyzing suppliers and customers, and using third-party research. Your average investor is not looking this hard and wide for an edge. 2. Looking at companies other investors aren’t looking at. Most investors look mainly at the top stocks in terms of market capitalization. That means the likes of ExxonMobil, Microsoft, Johnson & Johnson, and Procter & Gamble. Investors aren’t to blame. These are the same stocks discussed by mainstream media and research analysts. Small-capitalization firms lack coverage. No one’s interested. They’re the strange kid in high school hanging by the punch bowl during the

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end-of-year dance. Hedge funds want to party with this guy because no one else is looking at him. If they get him to dance, the potential for gains far outweighs the average return on a mega-cap stock. This search for unnoticed gems isn’t limited to stocks; it includes other types of securities that haven’t found mainstream acceptance. Hedge funds made lots of money since 2007 investing in SPACs, special purpose acquisition companies. They trade like stocks and investors who did their homework had almost no downside. Hedge funds bought these with two hands and did quite well on them. By more thoroughly researching well-known stocks and by finding under-the-radar treasures, hedge funds continue to capitalize on opportunities and make money.

Hedge Funds as State-of-the-Art Research Machines Institutional investors employ a tremendous amount of resources trying to outperform the market in all types of environments. These resources, both research and human, are a strategic advantage for these funds as they look to deploy their capital. For example, Gerson Lehrman Group Partners (GLG), founded in 1995, is one of the largest hedge funds in the world with over $19 billion in assets under management. It employs almost 400 people globally searching high and low for the next winning trade. GLG uses extremely sophisticated computer models, scours balance sheets, meets closely with corporate management, and crunches huge amounts of data in the pursuit of outperformance. With computer models spinning away at gigabit speed analyzing any inconsistencies in global pricing of stocks, hedge funds are able to take advantage of global arbitrage in equities, indices, convertible bonds and the equities they are tied to, and currencies. Picture a top-secret war room at the Pentagon and you’re probably pretty close to what a trading floor looks like at one of the top technology-driven hedge funds. Some academics have attributed hedge fund outperformance directly to this huge investment in research. Grossman and Stiglitz, two well-regarded researchers, found just that after looking at returns from numerous investment funds.5 Their hypothesis was that skilled investors get compensated for their large investments in research with outsized investment returns. They achieve market-beating returns because they act as “efficiency insurers,” identifying mispriced stocks. When investing in these stocks, hedge funds provide some level of market efficiency. Hedge funds, with their massive investments in research, are able to profit from opportunities the broader market is not generally able to identify. In return for this investment, hedge funds deliver man-size returns.

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Skilled investors are rewarded for the cost of information production (acquiring better information and/or better processing of available information) that keeps markets efficient. Such ability would enable the skilled investors (efficiency insurers) to identify mispriced stocks and earn positive risk-adjusted returns as compensation for information production. —S. Grossman and J. Stiglitz, “On the Impossibility of Informationally Efficient Markets,” American Economic Review 70 (1980): 393–408

High-Frequency Trading If you really want to see the inequality in trading technology and techniques between professionals and retail investors, visit your neighborhood hedge fund. Gracing the front pages of most major periodicals these days is an arcane technique that’s enabled some of the large investment banks, such as Goldman Sachs, to practically print money. A handful of hedge funds and investment banks are making billions of dollars a year doing what’s called high-frequency trading. High-frequency trading uses extremely fast computers and complex software algorithms to trade huge volumes of stocks. In the summer of 2009, you might have read about the hullabaloo that transpired after a Goldman Sachs software engineer posted the firm’s software code to one of these systems onto the Internet. We’re talking super-high-tech and maximum security surrounding these programs and computers because they are so powerfully profitable. Given the choice between making lots of money and having a good public reputation, Goldman Sachs will always choose the former. —Felix Salmon, Reuters, 5 October 2009, http://blogs.reuters.com/ felix-salmon/2009/10/05/goldmans-image-problem/

In fact, according to Goldman Sachs’s earnings report for the three months ending June 26, 2009, the firm experienced 45 days (out of a possible 90) with daily net trading revenues over $100 million. (See Figure 2.1.) Part of how Goldman accomplished this incredible feat was by flash trading, a technique that has everyone up in arms, including the U.S. Senate, because it underscores just how advanced hedge funds are compared to the rest of the investment world. The Wall Street Journal describes flash trading as allowing some traders to “have a sneak peek at market activity.”6

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Number of Days

10 5 >100

75–100

50–75

25–50

0–25

(25)– 0

(50)–(25)

(75)–(50)

(100)–(75)

5%

FIGURE 5.4 Ken Fisher’s Super Stocks Source: John Reese, The Guru Investor (Hoboken, NJ: John Wiley & Sons, 2009), 168–171.

0.4%. Not too shabby. Again, Screening 2.0 utilizes the same methodologies that guru investors use in their investment calculus and then identifies a group of stocks that comply with such criteria to achieve gains that beat the market.

Peter Lynch Outdoes Wall Street Peter Lynch is perhaps one of the best-known and most respected mutual fund managers of all time. The respect the Street accords Lynch comes from an investing track record that’s hard to shake a stick at. While at the helm of Fidelity Investments’ Magellan Fund, Lynch scored an annualized return of 29.2% from 1977 until 1990, almost doubling the S&P 500’s annualized returns of nearly 16% during the same time span. Such a huge outperformance meant that investors in Lynch’s Magellan fared extremely well with their investment dollars. To put things in perspective: $10,000 invested in Magellan the day Lynch took the helm meant $280,000 by the time he retired 13 years later. A fund that started with just under $20 million in assets ballooned to $14 billion by the time Lynch finished his dirty work. Looking at Lynch’s performance is still bewildering. It’s just smoking. Although Lynch attended the University of Pennsylvania’s esteemed Wharton School of Business, his investment theories didn’t emanate from the Ivy tower. Like Greenblatt’s Magic Formula, Lynch’s philosophies are so simple that anyone can follow them. Lynch wrote One Up on Wall Street in 1989, and it functions as much as an investing primer as a philosophy book. In a move toward empowering all investors, Lynch’s concept of investing in what you know means that investing isn’t relegated to those who do it

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for a living. Lynch believed that investing doesn’t have to be complicated to be done well. Much of this chapter and the rest of this book shows that investors really can beat the markets when they turn to an elite group of investors for help. Lynch began with talking about utilizing the local knowledge each investor has. [Invest in] a business that any idiot can run—because sooner or later, any idiot is probably going to run it. —Peter Lynch

When discussing Screening 2.0 strategies with clients, I like to relate a famous story about Peter Lynch that’s become almost investing folklore by now. Indulge me if you’ve heard it before. At Magellan, Lynch was always on the prowl for what he called a “ten-bagger stock.” Borrowing a term from baseball, Lynch wanted to buy stocks that would increase so much after he bought them that he chalked up “ten bags,” the financial equivalent of two home runs (four baggers) plus a double. That’s 10 times a stock’s original worth, and Lynch did it with legendary gains in Fannie Mae, Ford, Philip Morris, MCI, Volvo, General Electric, General Public Utilities, Student Loan Marketing, Kemper, and Lowes (in order of profit from Lynch’s other book, Beating the Street 5 ). Lynch was able to do this by citing the value of local knowledge, of investing in things an investor knows and understands well. Lynch mentions one of his top investments in Hanes, the maker of L’eggs Pantyhose. At that time, pantyhose were typically sold in department stores. Women visited these places of commerce relatively infrequently (I’m not taking advantage of the obvious, clich´ed joke here), and the quality of pantyhose was high. To achieve this level of quality, the pantyhose were also quite pricey. Lesserquality pantyhose were sold in grocery stores and drugstores for cheap. Hanes, the consummate underwear maker, spotted an opportunity to blend models and sales channels. It developed L’eggs, a higher-quality pantyhose than what was typically found in drugstores and chose to sell them in drugstores and grocery stores, which women typically frequented at least once a week. They were a big success and Lynch knew it would be a killer investment because his wife liked the product. After testing them out on her, Lynch conducted more research, decided to pull the trigger and invest in Hanes, and made six times what he paid for the stock.

THE LYNCH METHODOLOGY While Lynch pioneered the idea of investing in what you know, he didn’t do this willy-nilly. He didn’t walk into a store, see something that caught his eye, and then return to his office to purchase the

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stock. He was thorough in his analysis and used the idea of local knowledge as a driver of idea discovery. But before he bought the stock, he’d run his own analysis. This analysis, which is what Lynch is best known for, was perfect for identifying fast growers. To do so effectively, Lynch crafted his own metric to judge valuation for high growth stocks: the P/E/G ratio. Basically, Lynch took the standard, plain-vanilla price/earnings ratio (P/E) and compared it to the growth rate of the stock (G). Lynch’s rationale was simple: Higher P/E ratios typically identify higher-growth types of stocks. Growth is great but it comes at a price, and he didn’t want to pay up for growth. Lynch evaluated a stock’s P/E, its value by comparing it to its growth rate. According to Reese, P/E/G was Lynch’s application of GARP investing, growth at a reasonable price. As a growth investor, Lynch outlines three different categories of stocks according to their sales numbers and growth prospects. 1. Fast growers. These are stocks with over $1 billion in sales, earnings per share (EPS) growing 20% to 25%, and a P/E less than 40. 2. Stalwarts. These are companies growing a bit slower than fast growers. Lynch describes Stalwarts as growing earnings at a 10% to 20% clip with over $2 billion in sales. 3. Slow growers. These are larger companies with very little growth. Lynch grouped stocks in this category with sales of over $1 billion and a dividend yield higher than what is typical for S&P 500 stocks. Figure 5.5 shows Lynch’s methodology.

P/E/G < 1

Inventories Growing Slower than Sales

Debt to Equity < 30%

Nonsexy Product Lines

Boring Company Names

Under-theRadar Firms

FIGURE 5.5 Peter Lynch’s GARP Methodology Source: John Reese, The Guru Investor (Hoboken, NJ: John Wiley & Sons, 2009), 142–149.

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According to Validea, Lynch outlined these procedures to best capture growth prospects in an investment portfolio:






P/E/Growth rate. He looked for this to be positive and less than 1. Inventory to sales. Lynch knew it was a red flag when companies’ inventories increased faster than actual sales. For Lynch to like a stock, inventories should be growing slower than sales. Debt to equity. Lynch liked stocks with total debt-equity ratios less than 30%.

Besides including fundamental research in his book, Lynch discussed other attractive traits he looked for in a stock:














Nonsexy product lines. Lynch didn’t like technology stocks. He would rather buy a stock in a dull business. Boring company names. Dull, nondescript corporate names belie the real value and growth potential in companies. Under the radar. Lynch liked doing the extra work to uncover companies the masses weren’t flocking to. Industries not growing. Choosing performing companies in underperforming industries was classic Lynch. Corporate buybacks. Lynch liked the signal buybacks gave to the market and appreciated how the reduced share count added to EPS down the road.

Peter Lynch remains a remarkable character in the history of the investment world, combining as he did world-class performance with a practical investing strategy that anyone can understand and implement. Screening 2.0 can make all investors capable of achieving Lynchian returns by finding growth stocks at reasonable prices. You can bank on that.

Under the Validea Hood Reese’s Validea has led the push toward Screening 2.0 with the first multistrategy platform to screen for a variety of market-beating investing strategies. Validea has deconstructed each guru’s methodology to create a Screening 2.0 platform that provides investors with access to history’s best investment minds. With tight focus, Reese has provided a generation of investors with unprecedented access to massive computing power that recreates a variety of winning investment strategies. His scrupulous attention to detail and process has ensured that his offering is ready for prime time. Here’s how Reese does it.

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Strategy Validea’s value proposition consists of algorithmic screens to search for explicit investment criteria used by the gurus whose investment methodologies Reese chooses to follow. He then applies these guru rules to almost all stocks on the American exchanges. Each stock receives a guru ranking. The top 10 or 20 are then placed in a portfolio that is rebalanced monthly, quarterly, and annually.

Gurus Like many in the investment community, Reese doesn’t believe wholly in the Efficient Market Hypothesis and cites studies into research house Value Line that seemingly disprove this theory. The Value Line Enigma, posited by Fischer Black, showed that Value Line’s top-ranked stocks produced a riskadjusted return of 10% versus a negative return for stocks ranking lowest by Value Line.6 Fear, greed, and lack of correct underlying information make a market not entirely efficient when it comes to pricing. Gurus have figured out their own investment strategies that have beaten the market over the long term. Investors screening for stocks that play by the same strategy can also see outsized returns. Reese is very deliberate when it comes to choosing which gurus to track and is very slow to add new gurus to the mix. Validea typically tests new gurus internally for a number of years. By doing the testing in house, Reese feels that he’s able to determine whether there is any predictability in a guru’s technique. I asked Reese how he thinks Screening 2.0 techniques stack up against the concept of communing with experts, or following leading but unknown investors in expert investment communities like Covestor. He feels that Screening 2.0 trumps following hot managers within these types of platforms. The data shows that there is no predictability for what happens in the next period for a set of the top 20% of investors. Even though an investor looks hot in one period, there’s no way of ensuring she’ll continue to do well. Reese explains, “You need long investing track records of over 10 plus years. Without this, there is going to be very little success factor when people just follow any investor.” What about hot hedge fund managers who employ a market-neutral strategy, using simultaneous short and long positions to achieve marketbeating returns with lower risk? “I haven’t found one guru who’s written about shorting with an established track record,” says Reese. As for famed investors like David Swensen, the chief investment officer of Yale University’s endowment, Reese finds it hard to track these types of endowment

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investors because they invest in opaque securities like private equity, which he doesn’t cover. Validea currently screens for 11 individual guru portfolios, including: Model Portfolio Value Investor Small-Cap Growth Investor Price/Sales Investor P/E/Growth Investor Earnings Yield Investor Growth Investor Contrarian Investor Growth/Value Investor Low PE Investor Patient Investor Book/Market Investor

Based on Book By/About Benjamin Graham Motley Fool Kenneth Fisher Peter Lynch Joel Greenblatt Martin Zweig David Dreman James P. O’Shaughnessy John Neff Warren Buffett Joseph Piotroski

Technique Reese explains that Validea’s Screening 2.0 technologies have a lot of human intelligence built into them. “Occasionally, important things surface that gurus weren’t completely clear about,” he says. Different analysts and investment advisers define earnings per share and growth rates differently. In fact, growth rates turn out to be one of the most complicated variables to calculate reliably. Many screeners, both 1.0 and 2.0, fail here because one-, three-, and five-year growth rates are so hard to predict. Far more often, earnings growth rates turn out to be quite variable and not well predictable. How do you get around that? Well, Reese gets around this issue by using an average of three-, four-, and five-year EPS historical growth rates. But even this requires extra clarification because one of these data points may be unusable, such as 0 or a negative number. Unlike Screening 1.0 products, Validea implements a lot of artificial intelligence into its platform. Reese cites a poignant example: One of [guru investor and founder of Investor’s Business Daily] William O’Neil’s rules is that a stock must exhibit year-over-year earnings increases unless there is a dip one year. If there is a dip, the earnings must recover to new highs. That kind of intelligence we’ve built into O’Neil’s

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strategy. Another example of the intelligence we’ve built into Validea is the way we deal with earnings growth rates. What if you begin looking at three years of earnings and the first year was 0 or negative? The system adjusts to be able to assess the stock and make it usable in a screen the same way human analysts would cope with such an issue. That doesn’t happen in Screening 1.0 products, and it’s their shortcoming. Nor are their databases clean. They lack all data points, can’t adjust for certain criteria, and are off on their scale. Reese holds a patent on his work for a computational engine to simultaneously analyze multiple guru strategies. Validea differs from some of its competitors who take a 1.0 approach and analyze just a single strategy. Reese decided to promulgate many—a decision that appears to be working for him, his firm, and its clients.

Results As a scientist himself, Reese recognizes the value in running a multistrategy guru screening platform. After tracking the results of his computer-simulated screens for multiple years, Reese has a lot of insight to share with the broader investment public about Screening 2.0. All Validea guru portfolios have beaten the market. Validea monitors and ranks its portfolios along a variety of factors. Most portfolios were conceived in 2003 and 2004, and all have handily beaten the S&P 500 during the same time period. We’re not talking small gains, either. Validea’s Value Investor portfolio, screening for stocks that the father of value investing, Benjamin Graham, would approve of, has returned almost 17% while the S&P has barely eked out positive gains in the same time period. The same holds true for the Motley Fool Small-Cap Growth Investor and the Price/Sales Investor by Ken Fisher. Both have achieved over 12% over this period. Given that Reese has essentially been running Screening 2.0 strategies since 1995 and monitoring them since 2003, he’s got a bird’s-eye view into how these strategies play out. He’s got two interesting takeaways we all can learn from: 1. Multiple, simultaneous successes. To his surprise, Reese has found that several approaches to Screening 2.0 have been successful over the same term. That might strike many of us as counterintuitive, given that we’ve been trained to believe that as some strategies win, others have to lose, and vice versa. While this may be true in the real short term, Reese has witnessed that both growth and value disciplines can succeed, and do succeed, at the same time. It’s all in the value of the screening.

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2. Stick to your guns. While certain strategies can and do excel at the same time, there are times when some strategies just can’t seem to win. These periods are dejecting for investors and can last for years. Hope need not be lost, though. “Given what we’ve seen, you have to be disciplined to stayed fixed to a single strategy in the long run, even when you’ve been severely hurt by the market in the short run,” says Reese. “Many investors don’t stay the course. You have to stick with it. David Dreman and Ken Fisher both say that you have to continue with a strategy no matter what, and resist changing it.” That’s hard to do but it pays off in Screening 2.0. While each and every guru has had a down year or two compared to his benchmarks, over the long term, they’re all beating the indices and the vast majority of professionals. Reese even tested this concept when he wanted to see if investing in a guru strategy the year after they had had a terrible go at it would work. He found that in most cases, strategies made up their losses and returned to green the next year or within one year after. That’s an amazing statement: Guru screening strategies typically make up for losses and then some within one or two years after a really bad year. You just have to wait it out. It’s essential to stick to your strategy for the long term. Even the best strategies have down periods, and it can sometimes take over a year to reap the benefits of a good method. If you try to time your use of a strategy, you’ll likely miss out on some big gains. —John Reese, The Guru Investor (Hoboken, NJ: John Wiley & Sons, 2009), 262

Stock Picking and Portfolio Development Reese credits the success guru strategies enjoy to the methodologies these gurus have developed in picking stocks and running portfolios. Given all he’s seen, it doesn’t seem to work for most mortal investors just to pick individual stocks. There’s more rigor required for competent stock selection. Portfolios should have at least 10 stocks because it’s all about statistics. We can see that 60% of the picks in guru strategies are winners, but we have no idea which ones they will be. Purely screening for stocks and then investing in the results removes the human component from the investment process. For most investors, the extra human analytical component actually provides no help in determining which stocks outperform the S&P 500. That’s why Joel Greenblatt is confident that the Magic Formula’s success will persist in spite of making it widely available and even providing free screens for

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investors to use. It’s also why Screening 2.0 technologies are just beginning to take hold. Investors now have the data to back up using such strategies. The next step is convincing them to trust the numbers, to trust the gurus who developed the methodologies, and stop trusting themselves. Screening 2.0 is all about the screen.

Why Screening 2.0 Is So Important With their ability to help investors narrow down investment choices as well as serve as a stand-alone market-beating investment strategy, Screening 2.0 technologies and tools usher in a new era for investors who don’t have the large allocation of research dollars that many top investing professionals have. Investors without mathematical and computer programming skills can also benefit from the ease of these new point-and-click tools in these ways:





Price point. Very few investing professionals don’t have access to a computer terminal developed by the market leader in investment technology and research, Bloomberg. Those who don’t subscribe to a Bloomberg service work with one of its smaller competitors. Bloomberg terminals retail for over $1,500 per month and provide investors with a nuclear arsenal of investment power. From basic graphing and news, Bloomberg quickly enables investors to build sophisticated mathematical modeling of companies, their financials, and their historical performance. They are the lifeblood of today’s professional investor at mutual and hedge funds. Unfortunately, like Gerson Lehrman’s pricing of its expert network, a Bloomberg terminal’s price point makes it prohibitive for the majority of investors out there. Screening 2.0 technologies are either free or, like Validea, priced at a standard rate that makes them a reality for most investors. Sophisticated modeling. Even if we could rationalize that spending $1,500 per month on a research terminal made sense from a return on investment point of view, most of us would find it quite hard even to begin leveraging the vast screening capabilities inherent in these systems. As we saw, even simple ratios done right, such as Greenblatt’s return on assets and Reese’s earnings estimates, require massaging existing data. Investors must make sure that the data sets they are working with are clean and that the way certain financial metrics are calculated jibes with the analysis at hand. Much of this work is beyond the scope of what investors are willing to do to research investments. Screening 2.0 allows individual investors to play with the big boys. In fact, it lets them be the big boys.

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Summary Piggyback investing lets investors mimic the actual moves of the world’s best investors. By peering into monthly financial filings, investors can build portfolios to duplicate the successes of these gurus. Screening 2.0 allows investors to build portfolios based on the investment criteria that current and past investment heroes have described in great detail in their writings. Screening 2.0 gives investors access to the same powerful screening tools that previously were used only by the pros. Piggybacking works—it’s been proven academically. Screening 2.0 technologies are just taking root. We’ve begun to see similar outperformance of guru screens as we witnessed in guru portfolios themselves. The power of decades of market-beating research has filtered its way down to the majority of investors. Use it.

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CHAPTER

6

Tracking Inside Moves Pursue Corporate Executives in Their Search for Wealth Anybody who plays the stock market not as an insider is like a man buying cows in the moonlight. —Daniel Drew All the good ideas I ever had came to me while I was milking a cow. —Grant Wood

W

hile insider trading is illegal, it doesn’t mean that investors can’t learn from corporate insiders. These senior executives have easily beaten the performance of the stock market over time by buying and selling—legally—their own firms’ stocks. By tracking insider moves, investors can follow them to the promised land of profits. It’s getting easier and easier to do that online. How? Like hedge fund managers, insiders must log their trading activities. They do so publicly, and, as investors, we should be paying attention to their moves. With market-beating returns over history, insiders have proven to be some of the most successful investors in terms of building long-term wealth. In this chapter, we discuss the best sources to find out what insiders are doing and devise strategies to take advantage of our ability to track their trades.

The Not-So-Legal Kind Martha Stewart was a billionaire in 2001. She floated her own media firm, Martha Stewart Living Omnimedia, on the New York Stock Exchange in 1999 and witnessed her stock price double on the very first day it began trading. 161

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Her TV shows, combined with magazines and home furnishing lines, were expanding her audience globally. Her smart, simple, and fresh ideas for living, cooking, decorating, and organizing had made her queen. Unfortunately, Stewart went from champ to chump overnight. According to the U.S. Securities and Exchange Commission (SEC), in late 2001, Stewart, upon receiving a tip from her broker at Merrill Lynch, Peter Bacanovic, decided to sell her holdings in the biotech firm ImClone.1 An assistant to Bacanovic, forever known as Martha Stewart’s broker,2 told Stewart that ImClone’s chief executive, Sam Waksal, was selling all his shares in advance of a report from the Food and Drug Administration that would severely impact ImClone’s stock. Stewart sold, too, avoiding a loss of $45,673.3 In 2003, Stewart was indicted on a variety of charges, including securities fraud and obstruction of justice. She was ultimately found guilty of conspiracy, obstruction of an agency proceeding, and making false statements to federal investigators.4 She was sentenced in July 2004 to a fivemonth term in a federal correctional facility after which she was released to home confinement for another five months and required to wear an ankle bracelet. Arguably, Stewart will never regain the same magic and charm she held for millions of people. But it’s not only her image that’s been tainted; her stock has also suffered. Martha Stewart Living Omnimedia’s market cap now sits at a little more than $330 million, down from a high of $1.5 billion. What brought Martha Stewart tumbling down to earth was a decision to trade on information—inside information—that’s illegal to act upon. Compared to her net worth at the time, the money she saved by bailing out of ImClone stock was pocket change, but the consequences of her actions will likely stay with Stewart for the rest of her life. In more recent news, we’ve just uncovered the largest case of insider trading in the post-Madoff world. The Galleon Group, run by famed hedge fund trader Raj Rajaratnam, churned out 25% yearly returns like butter. From its inception in 1992 until the fall of 2009, the fund returned almost 3,000% cumulatively.5 Rajaratnam, a billionaire himself, built his empire on what appeared to be an intimate knowledge of the technology industry. His deep knowledge of the sector allowed Galleon to gain an edge on the market; his fund seemed to know exactly where tech stocks were headed at all times. Investors put almost $3 billion into the fund as it grew in assets and fame. Rajaratnam’s industry expertise made him the envy of his peers. His contacts were unrivaled, and the research that Galleon’s analysts produced shamed investment bank analysts. On a quarterly basis, Galleon clients were provided with a veritable treatise that mapped out exactly how Rajaratnam and his team saw their stocks performing. While Rajaratnam dabbled in

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other industries, Galleon’s success was predicated on the firm’s expertise in high tech, including semiconductor, computer hardware, and Internet stocks. It turns out that Galleon’s ability to achieve outsized returns wasn’t exactly kosher. According to one regulator at the SEC, it appears that Galleon was extremely adept at making money off insider information: “Deliberate and systematic use of inside information to inform his trading decisions was for all practical purposes [Galleon founder Raj Rajaratnam’s] business model.”6 Apparently, the SEC had uncovered an intricate web of accomplices and industry contacts that fed Galleon valuable, secret—inside—information over the years. For Galleon, it meant easy money. By soliciting high-level executives in technology firms to become investors in Galleon, Rajaratnam created an insider army with access to secret data at some of the world’s biggest and best organizations. You just gotta trust me on this. Here’s how scared I am about what I’m gonna tell you on AMD . . . September . . . I swear to you in front of God . . . You put me in jail if you talk . . . I’m dead if this leaks. I really am . . . and my career is over. I’ll be like Martha F**king Stewart. —from an FBI transcript on the Galleon insider trading case

What neither Rajaratnam nor Stewart appeared to know is that there are plenty of strategies built on a completely legal version of insider trading that have been proven to beat the market by a wide margin. No whispered secrets, no dark sunglasses, no winking required. When I speak to groups of investors about trading on inside information, their lawbreaking antennae instantly go up. The idea of trading on information culled from insiders sparks panic in most law-abiding citizens. And it should—look how the SEC dealt with Martha Stewart over a seemingly minor infraction. But there is a form of insider trading that’s completely legal and easy to implement—and has been shown to perform.

The Problem with (Illegal) Insider Trading Investing is a game of averages. As we saw in Chapter 5, investors don’t need to win on every trade to be successful. For every transaction, there must be a seller and a buyer. For every reason one investor has to buy a stock, there’s another investor who has a reason to sell it. That’s what creates liquid markets—and the opportunity for profit.

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Trading illegally on inside information changes the rules of the game, giving insiders an unfair advantage. In a fair market, when a buyer and seller come together to trade a stock, everyone has access to the same information. In a lopsided market influenced by insider trading, the insider profits at the expense of everyone else. It’s almost as if they can’t lose. That’s bad for investors on the other side of the trade and for markets in general. It’s also why regulators and law enforcement go after these types of crimes so vigorously. When Wall Street professionals or others exploit inside information for an illegal tip-and-trade binge, they undermine the level playing field that is fundamental to our capital markets. —The SEC’s Director of the Division of Enforcement, Robert Khuzami

The incentives to trade on inside information are huge. Corporate executives have millions of dollars of their own wealth tied up in their companies’ stocks. Hedge funds are like battering rams, smashing everything in their way to uncover the next winning trade. They call on senior management incessantly to get up-to-the-minute snapshots of how businesses are performing. They’ll do almost anything to get their hands on a morsel of information that can tell them just how well a company is faring. It’s a game. Investment analysts have to turn profits, so they’ve got to have high levels of conviction in their investments. Management is complicit, too. They woo large institutional investors to buy their stock. Any upward movement in their stock benefits the insiders, who gain in two ways: They’re rewarded by shareholders who appreciate the rise in their holdings, and they gain in terms of their own net worth. Bonuses may even be set to certain milestones in their firm’s stock price. Insiders frequently toe the line in terms of providing the type of information professional investors covet. And in the case of Martha Stewart or Raj Rajaratnam, insiders occasionally step over that line.

Differentiating Inside Information Differentiating between Martha Stewart’s infraction and an entirely legal, profitable trading strategy requires a bit of explaining. But first we must define: 1. Who is an insider? 2. What is considered inside information?

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H. Nejat Seyhun, a professor of finance at the University of Michigan, has devoted an incredible amount of time to studying insider trading. His research has set the groundwork for a profitable—and legal—insider trading strategy. In his book Investment Intelligence from Insider Trading, he cites security laws that define insiders as officers, directors, and owners of more than 10% of any equity class of securities.7 These are an organization’s senior executives and large shareholders. We’re not concerned with an employee’s title when defining him or her as an insider; we’re looking to test if the officer’s decision-making authority affects the entire organization.8 If an employee makes decisions at a senior-enough level, she’s considered an insider and is subject to restrictions on her trading activities. After defining who is an insider, we need to consider what constitutes inside information, the kind that’s illegal to act on. Impermissible inside information has two defining characteristics: It must be material and nonpublic.9 In practical terms, that means that a firm’s employees cannot trade their own firm’s stock based on private information that, if made public, would impact the price of the stock. Nor can they divulge this information for others to trade on. In addition to these restrictions, corporate insiders must report their trading activity to the exchange that the stock trades on and to the SEC within a reasonable time, generally by the end of the next month after they’ve made the trade. This is all part of the regulatory scheme that protects investors from rogue trades based on nonpublic information. Preventing insider trading helps all investors by leveling the playing field.

Insiders Do Invest Even with all these restrictions, insiders can still trade in their own firm’s stock. They just can’t do so when it’s based on knowledge others don’t have access to that would move the stock. If an executive likes the prospects of his company, he can buy it. If he feels it’s a good use of his hard-earned cash, so be it. He’ll have to report this trade with the stock exchange and the SEC. Additionally, most publicly traded corporations place restrictions on their executives, further limiting their trading activities—all in an effort to prevent anything that smacks of insider trading. In most firms, this means creating trading windows for executives—specific dates when insiders are allowed to place their transactions. Insiders must obtain permission from their compliance officers to trade, as well. In some firms, any trade made by an upper-level executive, whether in the company’s stock or another’s, must be filed. Most firms prohibit buying or selling the company’s stock within a one- to two-week window surrounding quarterly earnings announcements.10 While insiders cannot trade on inside information, they certainly can buy their company’s stock for other reasons. These insiders obviously know

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a ton about their businesses. Their positions give them front-row seats to the macro- and microeconomic factors affecting their companies. Of course it’s sometimes a gray area: It’s hard to determine just where illegal inside information stops and legal inside information begins. Executives are privy to everything inside a company: sales forecasts, discussions with large customers, competitor analysis, and so on. It’s all the information executives have that’s not inside information that makes them such great investors in their company’s stock. It’s this type of insider investment that we’ll examine in the coming pages.

A Different Type of Expert All the strategies we’ve discussed until now are predicated on the idea that investors can achieve better investment returns by learning and mimicking the trading activities of those rarefied investors who have found the secret sauce to achieving big profits over the long term. There is another type of expert, though, who can lead investors to the promised land of fat returns. But this investor doesn’t get paid to invest for a living. Nor does he spend a lot of time designing his portfolio. In fact, most curious bystanders overlook this person’s acumen, insight, and ability to build multigenerational wealth. Yet research indicates that this type of investor consistently beats the market. This expert investor is the corporate insider. Investors looking to use new Internet tools to boost their profitability need to get to know this insider better on their way to outperformance. By methodically following their activities over time, investors can align their moves with these insiders and make money alongside them.

Why Be in Business in the First Place? One of the first questions I was asked when I enrolled in business school was simply “What is the goal of a company?” Surprisingly enough, most people didn’t have the answer. Some students felt that the goal of a company was to provide legal cover to limit the liability of a firm’s owners. (These students typically held law degrees.) Others said that a company’s role was to do good in the world and increase employee satisfaction. (These students went on to work for nonprofits.) The right answer—the answer the finance professor was looking for—was that a company exists to maximize shareholder value. For corporate decision makers, maximizing shareholder value means boosting profits. Management has two ways to accomplish this: by selling more and by using fewer resources. But an interesting thing happens when

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we look at corporate incentives. Top managers typically get paid a fixed salary with a varying component of stock and cash based on hitting certain milestones—a bonus. Making a nice corporate salary is a good way to make a living, but the way management views itself getting wealthy—truly rich—is via their variable compensation paid out in stock. So, by paying managers with equity, their incentives are aligned with those of other shareholders: An increase in stock price benefits everyone. In this current structure, management is a significant stakeholder in the company’s success. We find strong evidence that insider trades are associated with the firm’s future earnings performance . . . consistent with insiders trading on the basis of both security misevaluation and private information about future cash flows. —Joseph Piotroski and Darren Roulstone, “Do Insider Trades Reflect Superior Knowledge about Future Cash Flow Realizations?” (January 2003)

Because their wealth depends on stock price appreciation, management frequently takes their own cash and plows it back into company stock, essentially doubling down on their bets on their firm. With both their salary and their nest eggs dependent on a future rise in stock prices, senior executives are every bit as much investors in their company as they are employees. With the eye of an investor, a senior manager buys and sells his own firm’s stock in an attempt to maximize his return on his investment. George Muzea, a former broker and author of The Vital Few vs. the Trivial Many: Invest with the Insiders, Not the Masses, describes why insiders buy and sell stocks. “All insiders understand the intrinsic value of their own companies’ stock,” says Muzea, who has also founded a firm that tracks insider trading for institutional clients. “Intrinsic value is the price at which a company could be liquidated or sold to an interested buyer. When their company’s stock approaches or drops below intrinsic value, insiders buy.” The inverse is also true: When stock prices rise above their perception of intrinsic value, insiders sell. For Muzea, the psychology behind insider activity in a firm’s stock is a simple calculus of buying low and selling high. Once managers own stock, they are essentially the same as any other owner of stock. The difference is that managers, unlike passive shareholders, work for the company. They can witness and influence higher sales, lower inputs, boost output, effect mergers and acquisitions, and design and launch new products. Their insider view gives them a better vision of where the business—and where the stock price—is headed than a passive shareholder

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could ever dream of. To accurately track where a company is going, we’re going to want to look at insider buys and sells on the open market and not the exercising of options, which is essentially a noneconomic activity.11 As we’ll see, open market transactions—that is, the process of simply buying or selling stock via a broker—tell us a lot more about why an insider may be buying or selling than exercising options does.

The Profit Motive Like any other investors, insiders are motivated by profit when they buy and sell their firms’ stocks. One might describe this as the new Golden Rule, as told to me by high-tech investor J. J. Sussman: “He who has the gold rules.” If a manager/stockholder believes that her stock is going to go up, assuming she is a rational being, she will buy more. If she believes that the stock price of the company she works for is going to go down, she’ll sell off her holdings. The interesting dynamic here is that management has the ability to effect a change in stock price by being better managers. At the same time, it’s management’s bird’s-eye view that makes these corporate insiders better investors. As we see when we drill down to the results of the research, professional investors could never match that level of insight because they are, for the most part, passive, outside owners of a company. It’s precisely this hierarchy of insider stock ownership, from top managers active in steering the firm down to the passive institutional investor, that accounts for their different investment returns. As we would expect, the results of an insider tracking strategy differ depending on what class of insider we follow. The more involved a senior manager is in the company’s day-to-day operations, the better signal his purchases and sales are for the company’s stocks.

Insiders Trade Profitably Before we begin designing the tracking inside moves strategy, it’s important to test just how well insiders invest. Given the fact that they’ve got a great view into the business, we’d expect them to trade profitably. Research shows that for those firms reporting insider buying activity, stock prices rose 24% in the 12 months following insiders’ purchases. Stock prices went up only 15.1% during the 12 months following insiders’ sales. The average stock price movement during the 12 months following the overall sample is 19.2%. (See Table 6.1.) The lesson for us is that insider buying activity signals greater-than-average stock price increase, while insider selling signals lessthan-average stock price increase.12 The takeaway is that insiders perform

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TABLE 6.1

Insiders Beat the Markets Buying . . . and Selling Number of Trading Months

Buy Sell

Subsequent 12-Month Return

144,884 164,309

4.5% –2.7

Source: H. Nejat Seyhun, Investment Intelligence from Insider Trading (Cambridge, MA: MIT Press, 1998), 38.

better than the market in general, and that means we’ve got the makings of a strategy.

Investor Reaction to Inside Moves From the data, we know that stock prices drift higher when insiders buy stocks and drift less high when insiders sell. The biggest moves following insider activity are within the first six months, but stocks can react for periods of up to one year. Those looking for a clear pop to the stock price following insider buys will be disappointed. The same research shows that there is not typically a spike or sharp drop following news that an insider bought or sold a company’s stock. Rather, the stock exhibits a gradual rise or sloping fall over time. So investors wishing to build a portfolio based on tracking insider moves don’t need to immediately jump on a stock when they get word of insider activity.13 (See Table 6.2.)

Whom Should We Follow? Clearly, not every insider is created equal, and not every insider trade signals the same thing. Given where a chief executive officer (CEO) or chief financial officer (CFO) sits in most companies, he or she is exposed to much broader and deeper information than is the vice president of marketing or the director of operations. So, we’re going to put greater value on the most TABLE 6.2

Prices Following Insider Trades

Purchase/Sale

Less than 6 Months

After 6 Months

Purchase Sale

Relatively significant price rise Relatively significant price drop

Stock drifts gradually higher Stock drifts gradually lower

Source: H. Nejat Seyhun, Investment Intelligence from Insider Trading (Cambridge, MA: MIT Press, 1998), 46–48.

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senior executives’ trading than we would on that of other members of the firm. Following this line of reasoning, insiders who sit on the board of directors or are passive owners of more than 10% of a firm’s stock will rank lower than senior management in the strength of signal their trading sends out. Because not all insiders are the same, we’ll focus on two models of insider activity as we begin to define our insider trading strategy: the Muzea Behavioral Model and the Seyhun Information Model.

Muzea Behavioral Model Typical insider behavior is to buy stock when it’s weak and sell when it’s strong. It makes sense: That’s what rational investors acting on a profit motive do. Muzea looks at regulatory filings by insiders and tries to piece together the backstory of why an investor may be buying or selling. Interestingly, the data he uncovers frequently reveals a change in the trading patterns of individual insiders or a group of insiders. It’s this kind of behavioral shift—buying stock after repeatedly selling it or the reverse—that Muzea considers valuable in terms of forecasting future stock movements. To classify different types of insiders, Muzea concentrates on the reasoning behind an insider trade rather than on who is doing the trading. In this respect, his model for insider trading takes a behavioral approach. He sees two types of trades by insiders. In the first, buying and selling activity is part of a larger investment thesis—an insider establishes or disposes of a long-term position in her firm’s stock. In the second, trades are part of tactical rebalancing of a portfolio—she’s taking advantage of short-term pricing. Like our piggybacking strategy, which is built on creating a portfolio from regulatory filings of guru investors, tracking inside moves requires some guesswork. It’s not always clear what an insider is up to just from looking at her trading activity. An insider who takes advantage of a big drop in price to boost ownership in the company’s stock is not the same as someone who is merely rebalancing her portfolio.

Your eyes should become wide open when you see an insider, especially the CFO who normally sells stocks only when the price rises, suddenly break this pattern by selling into price weakness. —George Muzea, The Vital Few vs. The Trivial Many: Invest with the Insiders, Not the Masses (Hoboken, NJ: John Wiley & Sons, 2005), 50–52

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Based on typical insider behavior, Muzea defines two classes of these types of investors:14 1. Value insiders. Approximately 70% of all insiders fall into this category. These people do not care about quarterly changes in earnings or increasing visibility into next year’s sales when they buy or sell stock. Simply put, these insiders are focused on intrinsic value. If the price of their stock drops beneath this value, they’ll be buyers, and vice versa if the price eclipses value. Outsiders looking to identify temporary mispricing in stocks should track these insiders to see what they think of current prices. Check to see if they’re putting their money where their jobs are. 2. Catalytic insiders. These insiders are not concerned with book value. They are the corporation’s equivalent to momentum traders. While short-term trading isn’t permitted for insiders, catalytic insiders base investment decisions on the quality of news coming through the company over the next couple of quarters. These investors provide good signals for outsiders to track and validate current trends in the stock. The Muzea Behavioral Model looks at insider behavior—really, motivation—to get inside the heads of insiders to determine why they are trading. The model makes the distinction between long-term and short-term trading among insiders. Investors tracking insiders will need to make similar distinctions as they look at insider filings to determine whether an insider is value oriented or what Muzea calls catalytic.

Seyhun Information Model Seyhun provides more detail in his description of the hierarchy of insiders. Instead of trying to gauge insider motivation, he focuses on the quality of information specific insiders possess. He equates access to higher-quality information inside the company with better investment returns. He presents four classes of insiders: 1. Senior management. These are C-level executives who have their management finger on the pulse of the company and are in a great position to judge the intrinsic value of their firms. Seyhun expands this group to include an officer of the company who also has a seat on the board of directors, chairman of the board, and president of the company. 2. Officers. This is Seyhun’s catch-all category. Basically, anyone who doesn’t fit into the other three categories of insiders falls here. These

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insiders are typically employees of the firm but not senior enough to make decisions that affect the whole company. 3. Directors. These insiders hold seats on the board of directors. Most typically, they are outside directors, so they don’t have any particular insight into how the company is being run at any given moment other than what is reported to them. 4. Large shareholders. These are usually institutional investors, though not always, who have purchased more than 10% of a company’s stock. For legal purposes, they are required to file their transactions in company stock as any other insider must do. The informational model makes intuitive sense: Insiders who possess better information should be better investors. As we’ll soon see, they are. Seyhun’s Informational Model makes it easier for us to size up the insiders we track. There is a clear difference in how well insiders possessing critical information invest compared to those without such access.

Follow the Smart Money It turns out that senior management seriously beats stock market averages by opportunely investing in their own firms’ stocks. What’s more interesting is that the data conforms nicely to Seyhun’s Informational Model. Top executives are better investors than more junior employees. (See Table 6.3.) So, as we develop our strategy to track insiders, we should remember that different insiders have access to different types of information. Seyhun says that these findings in Table 6.3 offer “proof that there exists an important hierarchy of knowledge with large shareholders at the bottom and top executives at the top.”

TABLE 6.3

Hierarchy of Insider Trading Profits Number of Trading Months

All insiders Large shareholders Directors Officers Top executives

309,193 32,976 140,824 277,951 78,403

Subsequent 12-Month Net Profit 3.5% 0.7 3.6 3.9 5.0

Source: H. Nejat Seyhun, Investment Intelligence from Insider Trading (Cambridge, MA: MIT Press, 1998), 71.

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Note that large shareholders, typically investment firms, perform most poorly. We can’t credit these funds with any informational advantage. They are passive holders who are not necessarily involved in the companies they invest in. Even with the best research teams, they could never understand these businesses as well as the people who run them. Their investments get smoked by senior management. They would be better off giving CEOs their money to manage.

How Are Insiders Basing Their Decisions? Based on the data, insiders appear to be pretty good investors. And they should be. But what exactly motivates these insiders to take action and buy and sell stock? We’ve mentioned both their ability to assess mispricing of their company’s stock versus intrinsic value as well as their access to useful information regarding their investments. It turns out both of these reasons compel insiders to put their money where they work. The legendary stock market researcher Joseph Piotroski explains it in a study about insider behavior: “Together, our evidence suggests that insiders are rational, economic agents. They appear to trade on the basis of their superior information about contemporaneous and next period’s earnings innovations.”15 In short, insiders are using the information legally available to them to make smart investment decisions. Another team of researchers, Jim Hsieh, Lilian Ng, and Qinghai Wang, studied the timing of insider trading against a backdrop of analyst recommendations. These academics were interested in seeing if there was any correlation between the behavior of analysts, who get paid to dissect stocks, and the behavior of insiders. They determined that analysts and insiders have negative correlation. That is, analysts and insider behave in contradictory ways. It seems that insiders actually trade against the recommendations of investment analysts.16

Such evidence is consistent with the interpretation that insider trading regulations and analyst bias contribute, at least partially, to the observed differences in the informational value of analyst recommendations and insider trades. —Jim Hsieh, Lilian Ng, and Qinghai Wang, “How Informative Are Analyst Recommendations and Insider Trades?” presented at the American Finance Association Annual Meeting, 2006, 3

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Unlike individual investors who frequently get swayed by buy lists compiled by professional analysts, insiders appear to filter all that noise out. They make trading decisions based on other considerations. In fact, insiders are more likely to buy shares when their stock is out of favor with Wall Street analysts. Insiders are contrarian investors, going against the grain in their trading activities in pursuit of profits. This finding is extremely important: It shows us that insider trading has predictive power for future stock returns only when analyst recommendations have changed.17 One thing that strikes readers when they see this data is how large shareholders fare. In spite of their extensive research departments and prodigious investing acumen, it appears that hedge funds and mutual funds just barely strike a profit on average. According to Seyhun’s Informational Model, we could predict as much. Yet Seyhun cautions us not to think that tracking large shareholders is useless: “We should nevertheless point out that the finding in [Table 6.3] does not mean that all transactions by large shareholders are noninformative,” he says. “It simply says that the typical transaction by a large shareholder is noninformative. It is still quite possible that large transactions (e.g., 10,000 shares or more) by large shareholders may still be informative.”18 Research has shown that large shareholders perform better when they are trading large amounts of stock in a given transaction. In fact, other studies have shown that the mere presence of a large shareholder, specifically an institutional owner, actually serves to limit the profits of other insiders. According to this research, long-term institutional owners provide a kind of “back-door” governance mechanism, even when they do not engage in explicit monitoring.19 Large shareholders act as a de facto night watchman, ensuring that management perform its fiduciary duties to all shareholders. With their analyst corps and access to senior management, hedge funds and mutual funds seem to provide a level of corporate oversight for all shareholders. The results provide preliminary evidence suggesting an incremental negative relationship between proxies for institutional monitoring and insider trading profitability. —Garen Markarian and Robert Bricker, “Institutional Investors and Insider Trading Profitability,” 2008

One study conducted at the Massachusetts Institute of Technology actually found that the interplay between management and the analyst community was an influential factor in insider trading. This study, aptly named “The Walkdown to Beatable Analyst Forecasts,” examined how stocks

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behave going into their quarterly earnings season.20 Every quarter, corporations around the world participate in this strange ritual. Company management hosts a meeting, both in person and transmitted over the phone, to discuss their performance over the last quarter. They also issue guidance to investors, describing how well they believe their firm will perform in the future. Every firm handles forecasting differently. Some notoriously set the performance bar quite high, exciting current shareholders at future prospects and then disappointing them down the road. Other firms, most notably Apple Computer, like to set earnings forecasts low only to crush them later on, much to the delight of current shareholders. This bizarre dance—where management forecasts and investors react—has gone on for decades. Because stocks typically react violently to missed or exceeded expectations, it’s been ripe for study by academics. In the MIT study, researchers found that a high level of pessimism in management forecasts is strongest in firms whose managers have the highest personal stake to avoid earnings disappointments. Sandbagging—setting expectations low in order to beat them in the future—is apparently practiced by insiders with the largest stock holdings. Firms with managers who sell stock after an earnings announcement are more likely to have pessimistic analyst forecasts prior to the announcement. What this means is that managers with a significant stake in their firm’s stock will opportunistically guide analysts’ expectations around earnings announcements to facilitate favorable insider trades after earnings announcements. In short, all of us are just being played. The most striking finding is that, during the 1990s, analysts issue systematically optimistic forecasts early in the fiscal year followed by systematically pessimistic forecasts as the earnings announcement approaches. This short-horizon pessimism in forecasts is consistent with our hypotheses based on managerial and firm incentives to sell shares in the postannouncement period. —Scott Richardson, Siew Hong Teoh, Peter Wysocki, “The Walkdown to Beatable Analyst Forecasts: The Roles of Equity Issuance and Insider Trading Incentives,” MIT Sloan School of Management, Sloan Working Paper 4221-01, August 2001, 26-27

Tracking Insiders: The Strategy Research on insider trading demonstrates that it’s profitable for insiders. In the aggregate, it appears that an informational pecking order enables those

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insiders with the best information to profit the most. But what if there were other ways an outsider could track insider activity to increase the odds of beating the market and, in doing so, boost his overall returns? Insider tracking strategies appear to work, but by developing the strategy beyond just naively tracking managers, investors can juice their returns. Here are some ways investors can benefit from tracking corporate insiders:











Focus on active versus passive insider transactions. Research shows that there is a distinction between those insiders initiating positions in stocks based on forward-looking information and those merely making subsequent purchases to rebalance their portfolios. For example, two investors may be selling company stock: One is selling because she envisions a rough patch up ahead while the other is merely taking profits. Research shows this distinction is very influential in affecting performance on an insider trading strategy. To capture this effect, investors should focus on insiders actively trading, not merely capping off a previous trade. It turns out that outside investors can add an extra 12% to their portfolio returns (before transaction costs) by following active insiders. That’s a huge return for investors using tracking strategies merely by filtering out active trades from passive ones.21 Buys, not sells. To improve returns, investors tracking management should focus on their purchases and not on their sales. Insider buys typically do better than the market over the long term. While both insider purchases and sales drift higher over time, buys outperform the market at levels greater than insider sales underperform it. In the language of researchers, this means that buys are more informative. By tracking the buys as opposed to the sells, investors can boost performance: Data shows that stocks purchased by top executives outperform the market by 8.9% while sales underperform by 5.4%.22 Clustering and consensus. Muzea’s experience has shown that, most of the time, outside investors profit more by identifying clusters of insider buyers who have all made decisions to buy stock in their companies. There is more predictability in a stock going up when multiple insiders buy a stock around the same time. In addition, Seyhun finds that consensus—no conflicting buys and sells among a group of insiders—plays an important role in determining the quality of insider trading signals. As more insiders trade in a given direction, the value of insider trading information increases. Investors tracking insiders should look for stocks where there’s clustering and consensus. Go small cap. Insider trades are more profitable if they are transacted in small firms versus big ones. In fact, in small firms, all classes of insiders appear to trade profitably, which is not the case in large-cap

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companies. Here the size of the firm really impacts overall performance. Insiders in small firms average 6.2% more than market returns while insiders working for Fortune 500 firms see only 1.7% more. So, give more weight to insider transactions at small and mid-cap companies than you would mega caps. Trading in small caps is tricky and risky—investing in companies with market caps under $100 million typically has higher costs. Because there is less liquidity in these small firms, the difference between what one investor wants to sell the stock for and what another wants to buy it for—the bid-ask spread—can be significant. Earnings surprises. In general, if a company experiences a positive earnings surprise—it beat analyst estimates in a given quarter—stock prices go up for a year following the earnings announcement date. While insiders don’t appear to exploit these surprises (it probably smacks too much of illegal insider trading), results are better when a strategy of insider buying is combined with buying companies after an earnings surprise. It appears that best results occur when both these signals reinforce one another. Insider buying at bidder firms. When two companies engage in a merger or an acquisition, a typical script plays out: The bidder firm experiences a drop in price while the company being acquired sees a nice jump in its stock. So, what about tracking insider activity in companies in the throes of mergers or acquisitions (M&A)? My hunch was that insider buying at firms being acquired would be a good signal for future outperformance. It seems logical: Executives at firms being purchased know the true value of their franchises and whether the acquisition bid meets it. If not, executives expect to see a higher bid, either from the bidding firm or from another competitor stepping in. Senior management would look to buy more of their firm’s stock in anticipation of a bidding war for their firm. But my initial hunch was wrong. It turns out that the good buying signal in an M&A is insider buying at the bidder firm, not at the company being purchased. In fact, it’s a really good signal. Research shows that large insider buying (10,000 shares or more) prior to a takeover attempt is an especially good signal regarding the eventual performance of bidder firms. Bidder firms where top executives bought 10,000 shares or more during 12 months prior to the announcement outperform the market index by 13%. Individual investors would do well to track insider transactions in firms with a preannouncement stock price run-up and in firms that pay cash for their acquisitions instead of issuing stock or debt. Larger purchases typically signal more conviction and higher profits. Even the smallest trades made by top executives exhibit profitability.23 As trade size increases for senior managers, though, so

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Active vs. Passive Buys, Not Sells

Large Purchases

Follow the Insiders

Bidder Firms

Earnings Surprises

Clusters of Insiders

Insider Consensus Small Caps

FIGURE 6.1 Track the Inside Moves does the amount of money they make on the transaction. It matters to returns how large the inside trades are—the larger, the more profitable. The same cannot be said of large shareholders. As insiders buy larger and larger amounts of company stock, returns go up and investors tracking them can boost their own performance. (See Figure 6.1.) While all of these methods improve returns, the three most important determinants of quality insider trading are top executives, small firms, and large trading volumes. The presence of these three criteria seems to be a good bet that a stock will go up in the next 12 months (mostly in the next 6 months). Many of these methods that boost returns for investors tracking insiders work better when combined with other methods—they are additive in their effects. For instance, senior managers buying large stakes in their small-cap firm typically perform better than senior managers buying lesser amounts in the same company. This is good news for our tracking strategy because there aren’t complex interactions between all these variables.24 The more criteria you incorporate, the greater the aggregate returns. That means

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we can hone our insider trading strategy, enhancing returns by including all the various parameters in our tracking trades.

Tracking Inside Moves: A Checklist As we’ve described, tracking insider moves is another form of piggybacking. Like piggybacking guru investors, individual investors can consistently beat the market by using regulatory filings (and some legwork) to populate winning portfolios. The first place to monitor this information is at the source: the SEC’s repository of regulatory filings. Because tracking insider moves is also built on interpreting these missives, the SEC’s EDGAR database is a great, free resource to tap into to find out who is buying what. But as we saw in Chapter 2, while the SEC’s database may be a great repository for this type of valuable, actionable information, the tools provided to get at the information are still quite rudimentary. We know that there are various parameters we want to include in our insider trading to enhance our returns. Table 6.4 shows a checklist of the most profitable types of insider transactions to mimic. TABLE 6.4

Insider Moves Checklist

Identity of the insider

Senior management

Type of insider transaction

Purchase

Insider motivation behind trade

Active acquisition of long-term position in stock

Does this trade diverge from previous insider behavior?

Yes

Market capitalization of insider Small, < $1 billion firm Size of trade

Large, > 10,000 shares

Accompanied by earnings surprises

Yes

Insider firm involved in M&A activity

Yes, bidding company

Multiple insider transactions

Yes, cluster of 3 or more insiders

Insider consensus

Yes, no conflicting trades

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Pros and Cons of the SEC Database The SEC’s EDGAR doesn’t allow investors to screen for all these parameters. The database works when you know the name of the firm you’re interested in or the name of the insider you want to track. But if an investor is looking to screen for small-cap firms with three executives or more buying 10,000 shares or more, he’s out of luck. Unfortunately, there aren’t a whole lot of publicly available, free websites that can assist us in this strategy. But other online resources can help take some of the pain out of tracking insider moves. Enterprising investors will either have to shell out some money for a subscription service, such as TrimTabs, InsiderScore, or GuruFocus, or piece together a variety of sites to track insiders. For readers of this book, I’ll keep an updated resource list of sites that aid in tracking inside trading at my website, Tradestreaming.com.

Yahoo! Finance The Grand Poobah of online finance sites has a simple interface that helps investors drill down on individual stocks to monitor insider activity. Yahoo! Finance users can get at insider activity information via a stock page. Once an investor has found a stock she’s interested in, she can click on a link called Insider Transactions on the left sidebar. She’ll then be guided to a page with the aggregate number of insider transactions over the past six months and how they break down into purchases and sales. Lower down on this page, she can browse a historical ledger, in reverse chronological order, to analyze which insiders are doing the trading, what their status is (officer, director, large shareholder), whether their trading was done directly or indirectly (meaning on the open market or via options exercise), whether the transactions were buys or sells, and what the net proceeds of the transaction were. If a user is interested, he can click through on a name of the insider to get a list of all his transactions. A search like this one can help users determine whether the insider is passively or actively buying and whether current activity diverges from previous behavior. Users can even try to gauge how good an investor really is by filling in some of the blanks. Try plotting the trades along a chart of the stock price to see how well timed the investments were. It’s labor intensive, but much of the raw data is there for the taking. Yahoo! Finance’s insider trading functionality is still fairly basic. The site comes up short for those investors looking to screen through lots of stocks to generate investment ideas based on tracking insider moves. Without the ability to search for the criteria we described earlier, investors would be better off using other financial sites to implement this strategy. On Yahoo! Finance, investors are limited to researching one stock or one insider at a

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time. The functionality here is similar to the limited capabilities of the SEC’s EDGAR.

Determining What Insiders Are Doing from Their Filings As users begin using Yahoo! Finance and other sites to implement this strategy, they will quickly bump up against an issue I warned about previously: Because filings merely explain what an investor did—he bought or sold—it’s up to us to determine what he was really up to and why. Executives trade their own company’s stock for various reasons. Some are merely rebalancing their portfolios while others are making well-calculated moves with their investment dollars. Others may be selling off stock for tax planning. Still others may be periodically selling to pay for their new winter home in Colorado. Regardless, in light of stronger laws and processes to ferret out illegal insider trading, executives have changed their behaviors to ensure that they are not accused of anything that even whiffs of disreputable activity. In the vast majority of cases, when planning open market transactions to buy or sell stock, insiders space out their activities so that they don’t bump into any quarterly surprises in earnings or announced big deals. Trading windows typically have been tightly defined so that executives don’t run into any of these problems. (See Figure 6.2.)

Trading Window

Blackout Period

Trading Window

Stock Price Date Eligible to Trade FIGURE 6.2 Insider Trading Windows

Blackout Period

Trading Window

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The SEC understands that while the incentives to game the system are huge, most executives do trade in their stock occasionally and do so honestly. Issues arise all the time, though: What if a CEO calls a broker to sell a stock one month from today and, in the interim, finds out terrible news that would severely impact the price of the stock? If she doesn’t cancel the order, is she insider trading? If she cancels the order based on inside information, is that a problem? Insiders almost always have access to material information and, nevertheless, are permitted to trade in their stock. It’s complicated and requires a comprehensive solution. To help alleviate some of these problems, the SEC enacted the 10b5-1 rule in October 2000. This rule allows officers, directors, and other insiders of publicly traded companies to transact in their company shares at all times, not just during the permitted open trading windows. Insiders can do so by structuring well-defined trading programs that stay clear of insider trading prohibitions. The 10b5-1 plans are automated, standing instructions with set dates and minimum selling prices to buy or sell stock on an executive’s behalf. Corporate shareholders use a similar type of trading to accumulate and diversify out of large holdings. Say a mutual fund wants to buy 2 million shares of a small-cap stock that trades under 100,000 shares per day. With such light volume, the mutual fund doesn’t want to buy all 2 million shares at once in the market—doing so would cause the stock to rocket. The mutual fund would be bidding against itself as it pushed the stock price higher. Instead, the fund can load trading instructions into a computer trading program and set the parameters to buy no more than 10,000 share per day at a maximum price. The decision to buy and how much to buy was made at the outset. The actual trading, though, is completely automated. The 10b5-1 plans function similarly. With a plan in place, the decision to buy is effectively taken out of the insider’s hands and no longer subjected to the quality of information at her disposal. (See Figure 6.3.) Investors who want to determine if insiders are accumulating or divesting stock positions will have to differentiate between profit-seeking trades and trades made as part of a 10b5-1 plan. For the investing public, these plans try to clarify signals: An executive selling out of stock via a 10b5-1 plan isn’t necessarily selling because he sees worsening prospects over the short term for his firm. Nevertheless, he is selling, and outsiders tracking these moves will want to understand his motivations for doing so. Even if an executive has a plan in place, he can still trade other stock outside the plan. Again, what’s important in tracking executive moves is divergence—any change in behavior that’s out of the ordinary. Most premium online resources that track insider behavior will make a distinction between trades made as part of a plan and those that are not. In the cases of many free websites, which don’t offer this service, users can generally identify

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Trading Window

Blackout Period

Trading Window

Blackout Period

Trading Window

Stock Price Date 10b5-1 Plan

Eligible to Trade

FIGURE 6.3 10b5-1 Insider Trading

trades made as part of 10b5-1 plans by the regularity of transactions and the similarity in share count. From this output on Yahoo! Finance, take a look at what Jonathan Rosenberg is doing in Figure 6.4. Rosenberg is Google’s senior vice president of project management. Having joined the Internet powerhouse in 2002, he’s most likely a holder of a boatload of stock options. From this slate of insider transactions, we see Rosenberg periodically exercising his options and then selling the resulting shares on the open market. It’s worth noting that it’s extremely regular. For a few days at the beginning of each month, 215 shares are acquired via an options exercise and then sold. Again, we’re interested in the activity and the signal to the market. Rosenberg doesn’t appear to be selling out his entire Google wealth based on an assumption that business is getting worse for the search giant. Instead, with this level of regularity, it’s hard to imagine anything really strategic is going on other than Rosenberg selling about $300,000 worth of stock every month. Cha-ching. Investors tracking insider moves in Google would want to monitor Rosenberg’s activities over a longer period of time for any change to this pattern. If Rosenberg suddenly stopped dribbling stock out into the market or switched from seller to buyer, investors should take note. We’d assume that either he exhausted his options grants (unlikely) or that he may be holding off selling in expectation of a higher price. Remember, we assume

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Date

Shares

Stock

Transaction

3-Nov-09

*216

GOOG

Sale at $530.01–$536.26 per share (proceeds of about $115,000)

3-Nov-09

*216

GOOG

Acquisition (non–open market) at $0 per share

3-Nov-09

216

GOOG

Disposition (non–open market) at $0 per share

3-Nov-09

216

GOOG

Acquisition (non–open market) at $0 per share

2-Nov-09

*105

GOOG

Sale at $529.50–$536.95 per share (proceeds of about $115,000)

2-Nov-09

*216

GOOG

Sale at $529.51–$537.6 per share (proceeds of about $115,000)

2-Nov-09

*216

GOOG

Acquisition (non–open market) at $0 per share

2-Nov-09

216

GOOG

Disposition (non–open market) at $0 per share

*Indicates that some (or all) shares are held indirectly (e.g., in a trust, by a spouse, etc.).

FIGURE 6.4 Google’s Jonathan Rosenberg’s Insider Trading Source: Yahoo! Finance

insiders sell at perceived high prices and buy at low ones. If Rosenberg’s selling activity began ramping up, we’d have to take a view that his perceived value of Google shares is relatively expensive. By following insider moves and looking for changes in behavior, investors have another extremely powerful tool in their investing toolkit.

Where to Turn for Insider Trading Information In light of the success insiders have trading their own stock, numerous subscription-based services follow their activities. Like hedge funds managers, insiders are required to file trades in their firms’ stocks with regulatory bodies. So insider trading activity is publicly accessible. Most free sites just display some rudimentary information. A couple free services, though, go further for investors.

CNBC’s Ownership Tab This book would be remiss without mentioning CNBC. The 24/7 financial news network is the granddaddy of financial content delivered over cable.

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There are few, if any, trading floors in banks and hedge funds that don’t have CNBC’s commentary droning on in the background throughout the trading day. CNBC caters to those investors obsessed with an all-encompassing trading lifestyle. In most cases, traders don’t base investment decisions on what they hear on CNBC. The network’s running chatter and interviews with some of the best and brightest money managers provide idea generation and, frankly, just some good financial entertainment (if you like that kind of stuff ). In fact, CNBC has found an audience beyond the cubicles of Stamford, Connecticut, and Wall Street. Jim Cramer, the raging hedge fund bull, has provided a glimpse into professional investing and engendered a love of stocks for millions of CNBC viewers around the globe. In some sense, CNBC has helped expand the investor universe by catering to a broader audience. CNBC’s success has been in video. It gets financial TV and understands how to optimize the format and content of its programs for consumption by the ADHD investment community. Short sound bites and flashy images abound (let alone nice-looking female commentators) to catch whatever morsels of attention the cable channel can garner from its subscribers. It’s with this background that CNBC gingerly approached the Internet a few years ago. CNBC believed, rightfully so, that the future of online media would incorporate globs of video. So, when the media firm built and launched its site in 2007, it heavily featured streaming video. Much of this content was taken straight from the studio and posted to the web. Unfortunately, while current bandwidth and compression technologies mean that viewing video online may be less frustrating than in years past, investors are just not turning to the Internet to watch investment video—at least, not yet. There is just too much competing for investor attention at any given moment for investors to engage with video. For those who need to consume a lot of data and information every day, text still remains the medium of choice. Investors can scan a lot of text really quickly and abandon ship at any point if they deem an article unworthy of their time. It doesn’t work that way with video—you can’t skip around. Having to watch a video to its end to know whether it was worth watching just doesn’t work online. So, while professionally built and marketed, CNBC’s website sits in relative obscurity. It’s a shame because CNBC really understands investors’ needs. The firm has built in a lot of useful tools for the website, most which can be accessed freely by users. On the stock pages, there are great resources for those investors looking to monitor stock ownership. There is a nice holdings summary, which not only lists most recent transactions but plots sales and purchases of stock, as well as options exercised, versus time. CNBC also

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provides insider data at an industry level to give investors an overview of which industries are experiencing the most insider buying. That’s pretty unique and quite useful. CNBC.com also has an Insider Trends tab that aims to monitor sentiment of a given stock by comparing the aggregate value of insider buys versus sells. Users accessing this page can examine insider sentiment and how it changes over time. Sentiment is determined by a quantitative company scoring method that considers an insider’s role within the company, trade volume, number of insiders participating in the activity, insider’s prior trading success, and market capitalization of the company. If Professor Seyhun had created this tab himself, it wouldn’t be more useful. A few sites online provide insider trading activity for investors. Unfortunately, there is no one overarching site that provides everything an investor using the Track Insider Moves strategy would need. What exists online are various stock screens on megasites, like Yahoo! Finance. A couple of standalone sites are good sources of useful insider information. StreetInsider.com, InsiderCow.com, Stockguru.com, and Finviz.com are a few of the best free sites. Although they do little analysis on the data and leave it up to the user to assimilate the information, they all provide daily and historical lists of insider activity ranked by a range of factors and searchable for users.

Insider Food for Thought Tracking insider moves provides investors with an easy-to-implement strategy that typically beats the markets. Insiders provide outsiders with an invaluable signal: how they themselves view the future value of their companies. By mimicking their actions, we align our views with theirs and cast our investment lot with them. As rational beings investing to maximize profits, they’ve got a better view of their business than any hedge fund analyst could ever hope to have (unless he worked for Galleon). Things get really interesting as we think about how management shareholders maximize their net worth. We’ve discussed stock ownership in this chapter as the way management truly builds its own long-term wealth. Executives buy and sell with a keen eye toward present and future profits. But that’s not the only way management legally profits from its status. Corporate shareholders frequently affect transactions on behalf of the organization that further boost share prices. They do this via share buybacks. We’ve been conditioned to believe in share buybacks. We think, “Hey, the company believes the stock is cheap enough to commit its own funds to buy it. Why shouldn’t we?” In fact, what a stock buyback means, beyond what it signals to the investment community, is that the share count of the company decreases. With no change in company performance, stock prices typically

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go up after a stock buyback just because of the arithmetic. A company is worth its total share count multiplied by the number of shares outstanding. If the company is worth the same after a stock buyback, which decreases the overall share count, stock prices should rise. This is a very simplified model, of course, but this is typically what occurs. Yet all is not so simple. Sometimes previously aligned incentives diverge and what’s good for management may be less good for the rest of the shareholders. Let’s drill down a bit and study how stock buybacks work. There are generally two types of buybacks: one voluntary and one mandatory. In a voluntary buyback, management offers current shareholders a certain price for their stock holdings, and stock owners decide whether to tender their shares. Mandatory buybacks mean just that—certain shareholders will have their holdings called in at whatever price management sets. Insiders [use tender offers] to exploit their access to insider information and make profits at the expense of public shareholders. —Jesse M. Fried, “Insider Signaling and Insider Trading with Repurchase Tender Offers.” University of Chicago Law Review, Vol. 67: 421-477 (2000)

In a very real way, a mandatory buyback is management’s way of saying that it believes shares to be undervalued—so much so that it would like to increase its stake in the company while decreasing other shareholder ownership. It’s a transfer of value from shareholders to corporate management. To put it bluntly, executives use stock buybacks for insider trading. It works like this: If the repurchase price is set above the actual value of the stock, the share buybacks—called a repurchase tender offer in finance circles—transfer value from the remaining shareholders to the tendering shareholders. If the repurchase price is below the actual value of the stock, the stock buybacks transfer value from the tendering shareholders to the remaining shareholders. Thus, management can sell its stock at a high price to the remaining shareholders. Conversely, if management sets the repurchase price below the actual value of the stock and doesn’t tender its shares, insiders can buy a stock at bargain-basement prices from tendering shareholders.25 By structuring stock buybacks, management has created a mechanism to accumulate or dispose of stock. This is an important signal to those monitoring insider trading. Insider trades are both explicit—Mr. Insider X buys shares—and implicit—via share buybacks. Investors should pay close attention to what insiders are doing via all the instruments at their disposal in order to plan their own investment activities.

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Summary Like piggyback investing, which uses the regulatory filings of professional investors to mimic their performance, tracking inside moves follows the regulatory filings of corporate insiders in search of outperformance. Corporate insiders, especially senior management, have an informational advantage over outside investors due to their vantage point within their firms. Investors who create a strategy that tracks their moves should experience similar outperformance. If corporate insiders profit from their activities, why wouldn’t we always follow these transactions?

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7

Grind the Rumor Mill Sorting Truths from Falsehoods and Profiting from News Flow To a philosopher, all news, as it is called, is gossip, and they who edit and read it are old women over their tea. —Henry David Thoreau Gossip is called gossip because it’s not always the truth. —Justin Timberlake

W

ith the explosion of the blogosphere and social media, an overabundance of information about the stock market is available. After all, social media provides a mouthpiece to anyone with something to say about stocks. Given how easy it is to share information online, rumormongering has been taken to new levels. A deluge of data and commentary relentlessly pounds stocks during the trading day and long after. Much of this noise is just that; it doesn’t really amount to anything. But social media also provides us with the tools to better understand and harness this dynamic. In the coming pages, we learn how to distinguish valuable information from useless buzz and devise investment strategies that profitably extract the value of constant news flows and take advantage of rumors.

Buy the Rumor and Sell the News Rumors make the investment world tick. Without rumors there would be no need for 24-hour financial networks. No CNBC. No Bloomberg Television. Without unsubstantiated gossip, there wouldn’t be huge gyrations in small-cap stocks. No pump-and-dump, get-rich-quick schemes that make 189

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only the originator of the schemes rich. Hot initial public offerings would become lukewarm stock offerings. In short, the investment world would probably become a much quieter, safer place for investors. But that’s not the reality we live in. The truth is that rumormongering is pervasive. Some investors craft their entire livings around rumors: from brokers who call clients with something they’ve heard to friends who share hot stock tips on the tennis court. Daily gyrations in the stock market are the result of the recalibration of perceived value of stocks based on chitchat. Rumors focus on new products. In the history of investing, there probably hasn’t been a gossip-generating company like Apple Computer. Every other month there is chatter about a revolutionary new iPod, laptop, media book, or chief executive. Entire livelihoods could be staked on trading Apple stock before and after these rumors hit. Apple understands this dynamic and takes advantage of it. Before the end of every quarterly earnings period, Apple begins to play into the investor chatter surrounding the firm’s product line and earnings power. News of new products frequently leaks into the market babble. Whispers abound that Apple’s earnings are likely to be even higher than analyst and investor expectations. The stock responds in kind with occasional swoons and even more frequent leaps. Rumors are the grease that lubricates the Apple machine.

Whisper Numbers In the late 1990s and early 2000s, deep in the throes of the Internet bubble, a different type of stock analysis took center stage. It’s unclear exactly how this type of research gained such prominence and why investors ascribed such value to it, but publication of this information seemed to propel stocks to astronomical levels every few months. I’m talking about whisper numbers, a hazy metric that adds a bucket of salt to Wall Street analysis. As such, whisper numbers were one of the first valuable tools of crowdsourced financial information. Here we explain more about crowdsourcing investment ideas and how to use crowdsourcing to make more informed investment decisions. Founded in 1998, Whispernumber.com, an independent research firm, collects these whisper numbers—earnings expectations from the investment public. These are projections that somehow embody what investors are really thinking about a company. I say somehow because it’s not entirely clear how these numbers are actually compiled and tabulated. Researchers believe that most likely they come from a variety of sources, such as stockbrokers and/or financial analysts as well as firms’ investor relations departments.1 Hearken back to 1999. When companies were preparing to announce their quarterly earnings and forecasts, these whisper numbers made their

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way on to prime time news. If a firm was expected by Wall Street analysts to earn $X for the quarter, the whisper numbers—what investors really thought would happen—were typically significantly higher. Earnings (for non-Internet companies) were ramping and Wall Street analysts’ projections weren’t rising fast enough. Whisper numbers plugged this hole. They seemed to inject a dose of reality into analyst projections. If companies hit these whisper numbers or surpassed them, the firms would be rewarded by seeing their stocks rocket upward. These were heady times, and the significance of whisper numbers was a good example of rumors going mainstream. We find that whisper forecasts are, on average, more accurate than First Call forecasts and that their superior accuracy does not depend on whether they are greater or less than their First Call counterparts. —Mark Bagnoli, Messod Daniel Beneish, and Susan Watts. “Whisper Forecasts of Quarterly Earnings per Share,” Journal of Accounting and Economics 28 (1):45(March 1999)

A lot of research has been devoted to the accuracy of these whisper numbers. One such older study by Mark Bagnoli, Messod Daniel Beneish, and Susan Watts tried to demonstrate that these numbers were more accurate than those of analysts.2 The findings—that whispers are more accurate than other sources and have a lot of informational value—facilitated a mind-blowing conclusion. It meant that rumors were more useful for investors than were analyst and company estimates. The findings didn’t sit well with the academic community. What bothered researchers was that it was entirely unclear how private information would make its way to the anonymous sources producing the whisper numbers without any apparent monetary reward. And, in fact, more recent studies show that whisper-number forecasts are typically more optimistic, not more accurate.3 It turns out that whisper numbers are more likely to fill the void when management hasn’t provided enough ongoing guidance to their performance and the market is overly optimistic about a firm’s expected performance.4 Management likes to reset expectations lower in an effort to make their job of outperforming easier. In short, whisper numbers say more about how inaccurate analyst forecasts are than about the accuracy of predictions based off of rumors. Of course, most rumors are just distracting. While occasionally, very substantial morsels of tradable information make their rounds through the investor community, the majority of this chatter is worthless. Real important information that would severely impact a stock price can’t filter its way through the public. This insider knowledge is prohibited from being

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disseminated; those who conduct insider trading risk going to jail. So, most rumor activity is based on mere speculation. That’s not to say that some of the rumors don’t have legs. As investors, we frequently hear an interesting tidbit floated months before it’s corroborated by the company. Regardless, since we’re all privy to the same information (Regulation FD ensures this) and insider trading is illegal, it’s a good assumption that most of the gossip we hear of amounts to nothing. Excluding malicious rumors aimed at moving stock prices, much investment gossip comes from a good place, though. CNBC, financial journalists, and other types of pundits base their livelihoods and stake their reputations on attempting to explain events. When the market closes up 1%, make sure to check out the headline of every major financial website that claims to know exactly what caused the rise. Of course, they can’t possibly know. Rarely is there ever one reason that compels stocks to behave in any particular way. Rumors and gossip abound because they are the manifestation of humans’ desire to understand things and explain them. Now take everything I just said and toss it out the window.

Rumors and Hearsay Are Important . . . Sort Of With millions of rumor-laden messages populating stock message boards on sites like Yahoo! Finance and Raging Bull, these message boards are online rumpus rooms for investors of all sorts to share information—and rumors—about stocks they’re following. Investors would like to believe that these messages could somehow predict winning trades. Sometimes, though, locating compelling information in this sea of gossip seems futile. For every posting that seems to have all the answers, there are nine others that are just noise. It turns out, though, that there is informational content—meaning, value—in stock message boards. In “Is All That Talk Just Noise?: The Information Content of Internet Stock Message Boards,” researchers Werner Antweiler and Murray Frank do a deep dive into the freewheeling world of Internet stock posting.5 What they found is pretty compelling. Internet message boards have come of age . . . even investment pros are watching the message boards closely and profiting from it. With posts running in the millions, Internet message boards have become an essential part of the savvy investor’s arsenal. Internet message boards really do move markets, for better or worse. —“Where Everyone Is an Expert,” BusinessWeek (May 22, 2000). http://www.businessweek.com/archives/2000/b3682002.arc.htm The two academics were interested in determining whether message board postings really do move stocks. If bulletin board messages have

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predictive power, investors could monitor these communications to get a jump on the next stock to move. By studying these sites for any extraordinary activity, investors could get a sneak peek into the inner workings of the stock market. For this to work, though, it would mean that a few investors contributing to the online debate are better informed than the marginal trader. Somehow, this knowledgeable minority knows more than the rest of us, including professional investors getting paid to be the smartest in the room. Using advanced computer tools to analyze text on the message boards, the researchers determined, as they expected, that the messages do not have any special forecasting ability for extraordinary stock returns. Investors have to look elsewhere for an easy way to make money on rumors. Still curious, the researchers drilled down farther and found that message board activity is informative—but in a different way. There are periods of time when more messages are posted than others. Some days there is high volume of people writing on message boards on Yahoo! Finance and Raging Bull, while other days see a significant drop in action. There appears to be a connection between the number of postings and stock market activity. In other words, when above-average numbers of messages are posted, subsequent trading volume tends to be high. Accordingly, unusually high volumes of communications are accompanied by higher volatility in stocks, signifying abnormally big movements in stock prices. What’s interesting here is that message boards provide value above and beyond rehashing traditional news stories. This study included analysis of all contemporaneous stories published in the Wall Street Journal (WSJ ) during the period under research. Accounting for mere rehashing of daily news, Antweiler and Frank still found that the message boards have predictive content. Stock volume and volatility were elevated, and it wasn’t caused by merely acting on the day’s news. In fact, message postings are particularly elevated one day before a story appears in the WSJ . This data, on the whole, means that a simple strategy of monitoring stock message boards and trading excessively bullish or bearish boards wouldn’t work. That doesn’t mean that message boards can’t be useful tools in our quest for more informative trading. They certainly are. They may not be able simply to point us in the direction of the next winning stock, but their influence is substantial. Containing millions of messages on thousands of stocks, Internet stock boards clearly sway stock market volume and volatility. Rumors, it appears, do have legs.

Rumors: A Model There’s been quite a fair amount of research done on rumors, how they spread, and their influence on decision making. Cass Sunstein, coauthor of the best-selling Nudge: Improving Decisions about Health, Wealth and

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Happiness, wrote a fascinating paper on rumors as a law professor at Harvard Law School. This paper made its way to press in book form titled On Rumors: How Falsehoods Spread, Why We Believe Them, What Can Be Done. Rumors seems an interesting follow up to Nudge. In Nudge, Sunstein and coauthor Richard Thaler explore how both public and private organizations can help people make better, more optimal decisions in their daily lives. Organizations can spur improved decision making by thinking long and hard about their presentation of choices to their constituents (think retirement and health care plan options) without limiting the number of choices. Rumors, like Malcolm Gladwell’s The Tipping Point, creates a model of how information—in Sunstein’s case, rumors—is propagated between individuals and groups and how its influence grows through its dissemination.

Rumor transmission often involves the rational processing of information, in a way that leads people, quite sensibly in light of their existing knowledge, to believe and to spread falsehoods. This problem is especially acute on the Internet. —Cass Sunstein, “‘She Said What?’ ‘He Did That?’ Believing False Rumors,” Harvard Law School Public Law Working Paper No. 08-56 (November 2008), 2

Rumor Model In his paper, Sunstein describes a very useful framework with which to understand how rumors get started and propagated—influencing decision making.6 His views can help us make sense of whispers and rumors in our trading activities. Understanding the mechanics of how rumors and gossip get disseminated will help us craft a strategy to profit from the changes in stock prices that result.

Propagators

Self-interested Altruistic

Priors

Motivations Beliefs

Cascades

Informational Reputational

FIGURE 7.1 Sunstein’s Rumor Model Source: Cass Sunstein, “‘She Said What?’ ‘He Did That?’ Believing False Rumors.” Harvard Law School Public Law Working Paper No. 08-56 (November 2008), 3–10.

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Sunstein begins by describing the various actors in the social transmission of false information.





Propagators. Sunstein asserts that rumors are often begun by propagators, who may or may not believe that the relevant rumors are true.7 Just as in real life, the motivations behind investment rumormongering are infinite. From trying to make a quick buck to intending to harm another person or company, most propagators tend to exhibit some level of self-interest. Sunstein cites three different types of people who spread rumors:
Narrowly self-interested. These propagators seek to promote their own interests by harming a particular person or group.
Generally self-interested. These spreaders of lies tend to do so because they want to sell something or just attract attention. Sunstein believes that on the Internet, people often spread false rumors as a way of attracting eyeballs. When rumoring is applied to stocks, though, the financial incentives are tremendous.
Altruistic. These propagators are sincerely interested in promoting some kind of cause and willing to do anything to realize their mission, including lying. Sunstein sees many radio and online political commentators falling in this category. For Sunstein, they are especially dangerous because, as he writes, there are unusually cavalier with the truth “in the sense that they are sometimes willing to say what they know to be false, and sometimes willing to say what they do not know to be true.” Priors. According to the research, the success or failure of rumors depends significantly on how closely they approximate the prior beliefs of those who hear them. This makes sense. If we hear something that clashes with what we believe to be true, we require substantial proof to change our minds. If, however, we hear something that reinforces our perceptions, we’re likely to buy into it without further research. Our acceptance of new ideas depends on the following:
Motivations and dissonance. People don’t enjoy hearing bad things about people close to them, especially friends and family. People aren’t likely then to accept a negative rumor about loved ones because of the cognitive dissonance that arises. But the flipside is true, as well. If we are predisposed to distrust or dislike an organization or person, we are open to believing false, damaging claims against them.
Beliefs and updating. Sunstein explains that people who have strong prior beliefs usually do so because of what they know. Their beliefs are generally supported by the information they have at their disposal. It will take significant new information to upseat those beliefs. If someone believes that a company is destined to fail, any

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information that arises to support that belief, even if false, will work to fuel the rumor.
Heterogeneous priors. Most of the time, our strongly held beliefs are actually a hodgepodge of various and conflicting opinions. This is true on the societal level, as well, where researchers have noticed a lot of heterogeneous beliefs even within a single population. Different types of people will accept or reject false rumors based on their various beliefs. However, at a certain tipping point, most people eventually will be led to accept a given rumor. Cascades. Sunstein further develops the mechanisms of rumor transmission by first assuming that people rationally process all the information available to them. If someone believes a false rumor, it’s because he lacks the information that should lead him to skepticism. Rumor transmission is also highly dependent on people’s motivations: Why, how, and when people accept or reject a rumor is intimately connected to how the information affects their personal desires.8 This leads to the following:
Informational cascades. Sunstein describes a deliberating group, like a jury, whose task it is to determine if some person or group has misbehaved and if the behavior warrants punishment. If each person on the jury were to state her opinion, she would be drawing on her own private information and belief systems. But in a group system, each person is affected by all the other opinions in the room. Propagators may spread rumors, influencing those who believe differently, in spite of everything they know to be true. What’s happening here, similar to what happens on the Internet each and every day, is that the group is led to accept a verdict in spite of individuals’ private information. Imagine an investor posting false financial information about a firm on the Yahoo! Message Boards. If the information sounds plausible and it seems the investor did his due diligence, others are definitely susceptible to believing it.
Reputational cascades. Similar to an informational cascade, people might be led to believe things that are in conflict with what they know is right but do so to curry good favor with others. It’s in our nature that we don’t want to be a singular dissenting opinion. We like to fit in; we believe that people like us better when we go with the flow of group sentiment instead of opposing it. This is equivalent to a fund manager or researcher going on CNBC as an expert. His status and reputation will influence others’ beliefs and actions, whether he is correct in his analysis or not. Group polarization. Deliberation among like-minded people often entrenches false rumors.9 When false statements and facts are floated, Sunstein finds that like-minded people typically end up in a more

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extreme position in line with their predeliberation tendencies. If people believe a particular stock is a great candidate to be sold short, they will believe it’s an even stronger short after speaking to others who believe the same thing. This tendency goes beyond just beliefs. When risk takers talk to others, they encourage group-wide risk taking. In the investment space, others may be influenced to short a small-cap biotech company after reading some negative rumors on a Yahoo! Message Board, even if this type of short is riskier than the typical trade they make. Sunstein concludes that group polarization spreads rumors for three reasons: 1. Exchange of information intensifies preexisting beliefs. 2. Corroboration breeds confidence and confidence breeds extremism. 3. People’s concern for their reputations can increase extremism. Investors are (mostly) normal people. They have preexisting biases and beliefs. This value system gets tested all the time when encountering information that challenges these ideas or reinforces them. With social media turning everyone into a micropublisher, there is a growing cacophony of voices online constantly critiquing investments. As investors, we understand the incentives of these rumormongerers. In addition to just trying to garner attention, there is a lot of money at stake in the market. Nowhere is this dynamic more apparent than in announcements of impending mergers or acquisitions. Mention of a simple M&A is enough to send stock prices soaring. Investors bank a lot on the potential for corporate tie-ups and synergies. In many cases, the sum of the acquired company is greater than the parts. Sunstein’s rumor propagators are frequently pumping their versions of potential corporate weddings. Stock prices ebb and flow based on these types of rumors. It turns out that there is a strategy to harness these rumors and make money out of trading them.

Rumors and How They Affect Trading Throughout this book we’ve discussed the fact that when investors trade in and out of individual stocks, they tend to lose to Mr. Market. To counter this, we’ve developed tradestreaming strategies that mimic better performers. We can follow Buffett or unsung trading heroes competing in expert communities. We can use Screening 2.0 technologies to screen for winning stocks just like Peter Lynch and Benjamin Graham did. With this backdrop of piggybacking others, trading rumors at first blush doesn’t sound like a formidable strategy—and typically, it isn’t. What is important is to understand how

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rumors get started, how they impact stocks, and how to determine if there are any information inefficiencies created in their wake that can be traded.

Rumors and Preannouncement Trading Announcements of M&As typically set off chains of volatile trading that can send stocks screaming upward or plummeting. Because these types of events are so unpredictable, investors able to anticipate them can make huge profits. We get a glimpse of these rich incentives through the takeover rumors that often precede such announcements. Unfortunately, in the vast majority of cases, the takeovers never materialize. But that doesn’t mean the game is over.

While sellers lose money when a rumor precedes an actual announcement, in most cases rumors fail to materialize into public announcements. —Yuan Gao and Derek Oler, “Rumors and Pre-Announcement Trading: Why Sell Target Stocks before Acquisition Announcements?” (June 2008), 1

In spite of all this activity around an acquisition event, there are clear winners and clear losers: Companies being acquired typically see significant stock price appreciation while acquiring firms see their stock drop. Much research has been spent trying to gauge the effects and motivation behind buying activity in rumors leading up to an M&A announcement. It turns out that buyers of these rumors are a motley bunch; they include potential acquirers building a toehold in target companies, investors with inside information on the takeover, and those trying to anticipate a takeover announcement through other means.10 These parties have an interest in purchasing this stock. We’ve seen this dance before. A couple of days before an acquisition is announced, chatter starts that Company A may purchase Company B. Company B’s stock starts inching up, even before any corroboration from the companies involved. In spite of the lack of a press release, rumors push the stock higher. Volatility goes up. If an actual M&A occurs, acquisition companies typically experience a nice pop in their stock. If there isn’t an actual takeover, stocks settle back down to about the levels they were trading before the rumors started. In spite of the fact that acquisition targets tend to go up in the wake of takeover rumors, there seem to be quite a few investors who sell their stocks. In the chaos of buying and selling, it turns out that selling the stocks of acquisition targets into rumors has not turned out to be a particularly

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profitable activity. So, if the stocks of targets of acquisitions typically go up, why would investors sell into this information? Or put differently: How are investors who sell target stocks compensated for this risk?

Trade the Preannouncement Rumors After analyzing a new sample of rumors drawn from the WSJ , it turns out that short selling rumored acquisition targets—betting the stocks will go down—is a profitable strategy. Research duo Gao and Oler published an academic paper titled “Rumors and Pre-Announcement Trading: Why Sell Target Stocks before Acquisition Announcements” that examined such a strategy. According to the researchers: On average, stock prices of rumored firms drift down to their pre-rumor level over a 70-day period after the initial price jump when a rumor is published, and that only 12% of rumored takeovers materialize into actual announcements within 70 days. The average abnormal returns to a shorting-rumor strategy over this period are 4.2%; when we restrict our strategy to “hot” M&A years and exclude extremely large firms, profits increase to 12.7%.11 Put in plainspeak, rumored takeovers that do materialize result in a rise in stock prices for the company being acquired. That said, 78% of mergers rumored to be happening never come to fruition. When they don’t, stock prices typically drift lower for over two months. If an investor were to put together a basket of stocks all rumored to be the targets of acquisition, he would have seen historical returns of 4.2% greater than just purchasing the market index during the same time period. So the statistics are on your side to create a portfolio of rumored takeover targets. The researchers attribute the profitability of this trading strategy to the fact that the market overreacts to takeover rumors. Don’t we all know the trading aphorism, “Buy on the rumor, sell on the news”? It turns out that it’s kind of true. In Sunstein’s world, propagators tend to be successful in convincing others that a merger is in the works. A reputational and informational cascade challenges investors’ prior beliefs. Even those who were initially skeptical of such news begin to believe it. They know that if it is true, if a real M&A event is announced, they’re likely to see big gains in the acquisition company’s stock. Investor sentiment becomes even more polarized—with some investors making bigger, riskier bets on the probability that the merger will come through. Gao and Oler demonstrate, though, that smart investors want to be on the other side of that trade. According to their paper, traders who are uninformed about a specific takeover but who are informed of the overall

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Buy-and-hold abnormal return

0.1 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 –10

0

20

10

30

40

50

60

70

Day relative to the rumor day

FIGURE 7.2 Postrumor Drift Source: Yuan Gao and Derek Oler, “Rumors and Pre-Announcement Trading: Why Sell Target Stocks before Acquisition Announcements?” (June 2008), 40.

low probability of rumors resulting in takeover announcements may take advantage of this overreaction by short selling after observing a rumordriven price increase (see Figure 7.2).12 While sellers lose money when a rumor is followed by an actual acquisitions announcement, they tend to make money overall because only 12% of all rumored acquisitions actually happen.

Antitakeover Rumor Strategy Rumormongering increases volumes and volatilities of affected stocks before and after the actual announcements. When rumors are followed by an actual announcement, get out of the way: Acquired companies typically see significant price appreciation. The problem is that for most of us, it’s extremely hard to determine which of the 12% of all rumored acquisitions are actually going to occur. Research shows that it’s a better idea to short a basket of all stocks rumored to be acquisition targets in the WSJ . This simple, antirumor strategy would look like this: 1. Research. Scan the WSJ daily for reported but unsubstantiated mergers and acquisitions. It’s important to use the WSJ or a similar source because the sample of rumors must be independent of whether an acquisition was subsequently announced to avoid a peek-ahead bias.13

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The research substantiating this strategy was based on a sample of all rumors, regardless of whether a subsequent acquisition was announced—so investors have to employ a similar information source. 2. Adjust portfolio. Research has shown that by excluding shorting any extremely large firms—mega caps—an investor could increase profitability of this strategy. By leaving large companies out of the shorting strategy, abnormal returns jump to almost 7.5%. Analysts believe this to be the case because extremely large companies are far more likely to be acquirers than targets; therefore, the market won’t overreact when a rumor is floated. 3. Trading. Short sell a basket of these rumored acquisition targets and hold each one for 70 days after the rumor first appeared. Cover the short after 70 days have passed. You can buy a market index, like the Standard & Poor’s MidCap 400, as a hedge against the short. 4. Timing best for hot M&A years. The study looked at the historically hot years for takeover activity, 1995 to 2001. If this trading strategy is restricted to these types of environments, when corporate America is undergoing serious consolidation, abnormal returns go up to 12% if large-cap firms are still excluded. By gauging the increase in M&A activity from year to year or accounting for the number of published and unpublished rumors in circulation at a given time, an investor can do quite well with this strategy. The antirumor strategy works because most takeover rumors never materialize. (See Table 7.1.) While the few that do come to fruition see a nice jump in their stock price, the vast majority of firms settle back down after the rumor frenzy dies down. Building a basket of rumor-tainted stocks and shorting the whole portfolio makes sense in light of the research.

TABLE 7.1

Antitakeover Portfolio Checklist Activity

Research Adjust portfolio Trading

Timing

Using a data source like the WSJ , compile a list of rumored takeover candidates. Remove all firms that are over $20 billion in market cap. Short sell a basket of rumored targets and hold for 70 days after the rumor first appeared. Cover. Hedge if you’d like. Strategy performs even better during periods of increased M&A activity.

Completed X X

X X

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Trading Whisper-Number Volatility While research has shown that whisper numbers may be, in some instances, more accurate than actual analyst forecasts, there doesn’t seem to exist an obvious, profitable trading strategy based on exploiting this behavior. Taking hypothetical long positions in firms that appear more likely to hit whispered targets (higher) than analysts’ targets (lower) doesn’t provide consistent returns that beat the market as a whole.14 We find that the surprisingly strong performance of whisper forecasts says more about relative weakness in analysts’ forecasts in certain contexts than relative strength of whispers. —Susan Machuga, Karen Teitel, and Ray Pfeiffer Jr., “Explaining the Surprising Performance of Whisper Forecasts of Earnings” (July 2008), 3

Part of the reason that a broad trading strategy based on whisper numbers doesn’t work is that there are a lot of things going on in the background that affect how a stock will react to making or missing a forecast. Not all stocks are created equal, and stocks behave differently around earnings periods. Some react violently to success and failure in meeting forecasts; others don’t react at all. Still others seem to always go up or down, regardless of how well their performance matches prior expectations. So a broad-base strategy that tries to game the differences in whisper forecasts with analyst forecasts theoretically shouldn’t work. Investors shouldn’t be disappointed, though. Whispernumber.com, the independent research firm that crowdsources this information, has found a way to profit from its research (surprise). It’s a premium service, which means investors will have to pony up some money to subscribe (currently around $700/year). Investors should also be aware that the data proving the viability of the strategy comes directly from the company backing whispernumber.com, Market Sentiment LLC, and, therefore, should be looked at critically. Instead of picking a wide swath of stocks with whisper numbers higher than analyst forecasts, this service, Whisper Reactors, focuses on those stocks that are regularly big movers on earnings information. Instead of a pure whisper strategy, Whisper Reactors is more like a post-earnings price volatility strategy, capitalizing on expected movement in certain stocks over a finite period (up to 30 days). Whisper Reactors uses stock performance data of certain stocks after earnings periods and recommends buying particular companies over a specific window of time (from 1 to 30 days).

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Here’s how Whisper Reactors works: Whisper Reactors are a set of companies that experience above-average volatility in their stock prices when they don’t hit their whisper numbers. These companies have a high probability of positive price movement following an earnings report if they beat the whisper number and negative price movement if they miss the whisper number. This is a high probability, more volatile set of companies very sensitive to whisper numbers. Those companies immune to whisper numbers are removed from the research pool. The Market Reactors product has researched how these whispersensitive stocks typically react to forecasts. All firms react differently and in different time frames. While some firms may see a quick pop on earnings day, others may see a more gradual rise over a week or a month. Market Reactors claims to take this into account. According to an example on the Whispernumber.com website, H&R Block (HRB) was a typical 10-day reactor—it takes 10 days historically for surpassing whisper numbers to be fully reflected in the stock’s price. The stock also rose on average of 4.4% when it beat whisper forecasts. For the June reporting season of 2007, HRB missed analyst expectations but exceeded whisper forecasts. HRB realized gains of 3.6% within the 10-day window. Not too shabby. Table 7.2 shows the historical results as provided by the firm. From the small data set available, it appears that all Whisper Reactors—from 1-day to 30-day—significantly beat the comparable returns of the market over that period of time. Specifically, 30-day reactors—those firms that take 30 days for the reaction to earnings to be fully reflected in their stock price—do the best over the longer term. We’ve seen that M&A announcements and earnings beat can frequently contribute to stock price appreciation for up to one year, so this is not necessarily surprising.

TABLE 7.2 Whisper Reactors 1-day 5-day 10-day 15-day 20-day 25-day 30-day

Historical Results of Whisper Reactor Strategy YTD 2009

2009 no stop loss

Jan–Dec 2008

2008 no stop loss in Q4

Jan–Dec 2007

Aug–Dec 2006

+83.8% +93.4% +67.4% +51.8% +220.8% +40.1% +140.7%

+78.1% +19.7% +35.4% −32.6% +162.5% −83.3% +326.7%

+87.2% +13.7% +72.8% n/a −7.3% n/a +183.1%

+127.6% +103.2% +180.8% n/a +54.6% n/a +220.2%

+6.5% +18.7% +38.8% n/a +18.8% n/a +118.2%

+27.6% +24.7% +18.3% n/a +12.8% n/a +30.5%

Source: http://whispernumbers.com/works wr.jsp.

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If this service performs as well as it appears, it could be well worth its subscription price. Do-it-yourself investors could re-create this strategy by running their own mini-experiments. They would use the Whispernumber.com website to get the actual whisper numbers—this part is free—and then study which stocks are typically the biggest reactors. To optimize the strategy, DIY investors would also want to analyze the time frames it takes for these reactors to fully appreciate or drop in price. With this data in hand, they would invest in 10 or so stocks every quarter, buying those reactors with the biggest difference between analyst expectations and whispered forecasts. Then the investors would sell them according to their historical reaction period (1 to 30 days later), and rinse and repeat by doing the same strategy three months later ahead of earnings. Whisper numbers are an intriguing phenomenon: These crowdsourced forecasts from anonymous contributors fill the expectations void left by corporate management and Wall Street analysts. Whispers have a way of resetting expectations in a way that appears to trump the professionals. We’ve explored possible reasons why this is the case, and, unfortunately, we’re left with forecasts that, on the whole, aren’t profitable as part of a simple trading strategy. Instead, according to the publishers of whisper numbers, a better strategy is to bet on those companies most likely to see price volatility whether they beat or miss the whisper. While whisper numbers have been the subject of a lot of independent research, it’s important to stress the fact that the data and results feeding this strategy all originate from an independent research firm that sells the strategy as a research product.

Crowdsourcing Rumors in Real Time Social media’s enabling of true conversations in real time has transformed how investors conduct research and monitor the news. As a group, investors have always had the most voracious of appetites when it comes to consuming content. From earnings announcements, M&A activity, and new product introductions, stock holders must stay abreast of formative situations. Investors used to check Yahoo! Finance three times a day: once premarket, once at midday, and another after the stock market close. Obviously, this doesn’t include the thousands of times they refreshed their browsers every day to update prices on their portfolios. The point is that the Internet used to reflect a basic journalistic model that we’ve grown accustomed to since our youth: Early-morning and late-afternoon editorial deadlines meant that we got our news served fresh twice a day. Today, this all seems so quaint and outmoded. Social media’s contribution—for better and for worse—has been to make media part and

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parcel to our lives. The most striking change has been the fragmentation of broadcast journalism. The large website, updated two to three times a day, has been replaced with blogs, Twitter, lifestreaming, and, for investors, tradestreaming. Media is now an ongoing conversation, sometimes done so granularly that we’re chatting person to person (P2P) and in small, intimate groups. Knowledge is no longer just taught; it’s learned as interactivity has become personal. Investors can engage with the financial Internet in ways that were inconceivable just a couple of years ago. Rumors, news, and opinion are available in all-you-can-eat buffet. The issue is not only being able to keep up with all the breaking news but what to do with it as well. We’ve outlined a couple of strategies, notably the antitakeover rumor and the post-earnings price volatility models, that capitalize on research-backed trends behind rumors. This next section focuses on some of the tools investors can utilize to stay on top of market news and rumor-driven media.

The Fly on the Wall When I was at the hedge fund, in addition to our daily dose of expert community Gerson Lehrman Group, we subscribed to a couple of services that provided us with an information stream of much of the chatter that was happening on Wall Street. Two of the leaders in that business were The Fly on the Wall (TFOTW) and Briefing.com. Combining in-house analysts and industry sources, both these sites could provide up-to-the-minute information impacting stock in our portfolios and watch lists. At a single glance, we had access to:











Daily event calendars to see which stocks were reporting and when Political news bytes summarizing any news coming out of Washington that would impact the market and stocks Merger and acquisition news Summaries of investor conference speeches News of closed business deals between suppliers and distributors Snippets from analyst reports including upgrades and downgrades Rumors of any type Industry data

TFOTW provides daily buzz from Wall Street. Its analysis doesn’t have the feel of traditional financial journalism—there are no lifestyle articles or people pieces. Most of the 600 stories per day going through its Live News Feed are short, no-frill pieces of information including earnings summaries, executive changes, and new product announcements.

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Understanding that investors get great ideas by speaking to trading desks, money managers, and brokers, TFOTW provides a stream of these snippets throughout the trading day. Frequently these ideas, along with analyst recommendations and trading calls, show up on TFOTW before they appear on most mainstream news sites and channels. To help investors prepare for the daily deluge of news and rumors, the site supplies a schedule of important events, presentations, and conferences that can affect stock prices of numerous companies. Essentially, TFOTW is an investor’s wiretap into the buzz on Wall Street. TFOTW still has the feel of a start-up. Its content is fast and valuable, but the website is not as polished as we’ve become accustomed to for premium content. But it doesn’t really matter—the site’s value proposition is to bubble up ideas, news, and rumors throughout the trading day as quickly as possible. Investors have to pay up for this service with a monthly or yearly subscription. Ultimately, you would have to calculate how much access to this type of information is worth to you and then decide if paying for it makes sense. There are no blog readers involved, no RSS, and no visiting numerous websites in an effort to achieve informational Zen. Sites like TFOTW are plug and play—you get everything you need to know about Wall Street activity delivered through an Internet browser.

Briefing.com: Adding in Analysis to Rumor Flow Briefing.com takes the news flow of TFOTW and advances it one step further by adding in a layer of analysis to the mix. Briefing’s In Play product is similar to what’s offered on TFOTW but with an overlay of actionable suggestions. Here, too, there’s ongoing market commentary that includes coverage of breaking events, earnings, and Wall Street research. News and rumors are published around which investors can craft actionable trading and investment ideas—it’s instant market analysis. Briefing also provides a whole slew of customization tools, including filters that allow users to fully personalize the service to best suit them. Some of the content is free, while others reside behind a pay wall. Briefing.com also has a free website companion named Briefing.com Investor that provides just a smattering of the premium service, along with market snapshots and stock research. It’s Ahead of the Curve column provides useful analysis to help investors stay on top of trends affecting the market. These are typically big issues, such as “The Impact of Health Care Reform” and “On Inflation.” There’s also a nifty little calendar that has earnings information and upgrade and downgrade data. It’s a basic site and acts as a small showcase of the type of content Briefing.com provides with its premium services.

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Message Boards Yahoo! Message Boards are a treasure trove for patient investors willing to wade through reams of spam in order to uncover the occasional jewel. Positioned firmly in the realm of Finance 1.0, stock message boards have been around as long as the Internet as we know it has. These rowdy, unfettered environments allow investors to post their ideas about stocks and respond to others who have done the same. Frequently, message board posting devolves into idiotic adolescent flaming (trolling), but within this messy environment, many a smart, knowledgeable investor lurks. Yahoo! Finance dwarfs its competitors in terms of usage. (Y! Finance sees almost 25% of all investment web traffic in the United States.)15 Yahoo! Message Boards are some of most popular boards for investors to get access to what other investors are thinking (or at least posting). Twenty million people visit Yahoo! Finance each month, and many visit at least one of the 1 million Finance message boards.16 Rumors, analysis, and outright chicanery are all included. Investors discuss everything—from recent news stories to upcoming earnings expectations—and frequently discussions become so impassioned that bulls and bears take sides to argue for their ideas. For such high usage and heartfelt discourse, these boards work rather simply. Most U.S. stocks that trade on a stock exchange (excluding American Depositary Receipts and stocks trading over the counter) have an associated message board on Yahoo! Finance. After finding a stock’s page, investors can click on Message Board in the left sidebar to leave the world of news and data to enter a world of ardent opinion. Investors should be aware that there are so-called Message Board trolls hanging out on these boards. These faceless people seemingly exist to harass other board users. Either they have a political message that overrides all other stock discussions, or they just believe their thesis on a stock should drown out any dissenting opinions. Occasionally they’re plain nasty. These voices can sometimes ruin an experience. While there is information worth its weight in gold on these boards, much of it is lost in the noise. Yahoo! Finance has a tough job managing this asset. While keeping entry requirements low and encouraging broad discussion is a priority, the technology firm recognizes that privacy and user experience are also extremely important. The Message Boards recently enjoyed some much-needed changes to help users manage their identities on the site to prevent spamming and flaming. With a recent light refresh of the boards, Yahoo! introduced some functionality that makes them more social. Users’ messages are ranked by others on a five-star scale. Therefore, users gain a reputation regarding how valuable their posts are. This is important in the hierarchy on the boards as it’s sometimes hard to know whom to trust. User-based rankings help create a

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clear pecking order among users. You can even filter out low-ranking posts to read just the good stuff. If investors can zero in on a particular participant on the Message Boards whom they think is in the know, they can cut across all of his posts and see what other stocks he’s discussing. Last, Yahoo! has made the boards more searchable with a search box on top of the page. This functionality allows you to search within a specific board or across all stock message boards. Previously we mentioned that there is extremely valuable information lurking in stock message boards. There is a structural problem, though, with how the boards are displayed. While it’s easy to post, it’s extremely hard to find pertinent information on the boards because all posts are displayed in reverse chronological order. That means that the most recent posts rise to the top while older posts get pushed down and ultimately off the page into the financial content ether. This makes it easy for investors to identify the most recent information or rumors floating about a simple stock but quite difficult to locate the most important commentary.

Bulls and Bears—at the Same Time As an investor, I believe in diversity of opinion. I respect ideas that I don’t personally hold and enjoy the discussion. Debating a thesis forces me to reconcile my views in light of dissenting attitudes, and I leave the discussion either changing my beliefs or strengthening the feelings I held previously. I frequently recommend that investors engage in the same process. Remember, on a secondary market like our stock market—where third parties sell to other third parties—for every buyer of a stock, there is a seller. We should put ourselves in our adversary’s position to understand why she’s selling. To aid this process, investors should head to the message boards to see what the bull and bear cases are for any of their holdings or perspective buys. Occasionally, there will be other users there with similar questions. It’s interesting to see the behavioral patterns of users on these boards. They typically fall into four broad categories. (See Figure 7.3 for a visual depiction.) 1. Lurkers spend most of their time just spectating on the message boards, and it takes a lot to get them to come out of their shells. They’re either shy or don’t necessarily want to contribute to the ongoing conversation. The majority of message board users fall into this category—watching the action without participating. Many professional investors hang out on the boards without getting involved. 2. Helpers are just too happy to assist other investors in their research. Their opinions aren’t necessarily the strongest weighted, but they go out of their way to help fellow board users. Often they know the right

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Lurkers

Smarty Pants

Helpers

Bullies

FIGURE 7.3 Four Types of Participants on Internet Stock Boards answers to questions posed, but what’s so great about Helpers is that they’ll find the answer or point an investor to a better resource. While professional investors and insiders typically only read in these environments, investors occasionally encounter someone who has extraordinarily good information about a firm. These Helpers may be anonymous employees of the firm or work professionally as investors. 3. Smarty Pants are the class nerds of the message board world. While regularly knowledgeable about topics at hand, Smarty Pants have a hard time admitting that they don’t know certain things. They’ll claim to be experts at everything. Users should beware of these types; they sometimes cloak their ignorance in professed knowledge. 4. Bullies can (unfortunately) be found on most boards. Sometimes they are just outright nasty; other times, it takes getting backed into a corner to show Bullies’ true fighting colors. Because message boards typically are anonymous, some users feel uninhibited to be cruelly obnoxious because there aren’t really any consequences to this behavior. Those Bullies really stepping over the line can be reported to administrators and booted from the boards, though. In order to size up their informational value, it’s important to understand that message board users generally have distinct behavioral patterns. While Smarty Pants typically know a lot about investments, they don’t know everything, in spite of their claims otherwise. They will debate strongly for a view that’s half baked, and novice users may take their estimations as truth. As with anything on the Internet, caveat emptor. Read everything and believe just a fraction of it. If users believe there is actionable information in social media post (or even a journalistic piece from reputable publications),

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they should attempt to validate or confirm such information. With the deluge of data and content floating around in the financial Internet, it’s up to investors to distinguish right from wrong. Investment site Raging Bull is another gray-haired website providing investors with fertile message boards to analyze news and rumors. No fancy functionality, no bells and whistles—Raging Bull is all about stock message boards. There are thousands of boards here, searchable by ticker and filterable by sector, stock price, and most activity. Pretty much all Raging Bull does is manage message boards, and the site has a loyal, active following. Check boards on multiple sites to corroborate or refute new rumors and chitchat. Google Finance, while sorely trailing its much larger competitor, Yahoo! Finance, also has message boards. Activity on them was dismal when Google launched its first financial product, but in recent years, the site has seen increased usage. Google calls its boards “discussions,” and they can be found on every stock page on the site. One nice piece of functionality that Google has introduced to its boards is an email function. Users can sign up to receive breaking alerts on the message boards for stocks in their portfolios. This may be informational overkill, but it’s nifty for monitoring rumor flow.

Summary Rumors have always played a part in investing. Talented day traders make their livings off of trading the ins and outs of news as it hits their computer screens. Most conventional investors would be better off not trying to game the system. That said, we’ve described two strategies that leverage the power of rumors. One such strategy, the antitakeover rumor play, involves short selling a basket of stocks rumored to be in play as acquisition targets. The other strategy, trading whisper-number volatility, uses crowdsourced data to position trades in companies sensitive to earnings that are expected to perform better than analysts have forecast. Stock message boards are a veritable rumor stew that investors can both extract and add value to via participation. At the least, rumor monitoring is important for portfolio management as investors need to stay informed of what’s moving stocks in their investment accounts. Social media makes this all possible.

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8

Co-Lateral Research Find the Investment Value in Nonfinancial Information on the Internet Don’t bother people for help without first trying to solve the problem yourself. —Colin Powell You can get help from teachers, but you are going to have to learn a lot by yourself, sitting alone in a room. —Theodore Geisel

T

here’s no doubt that today’s investor has access to history’s most powerful investment research device. The Internet turns every aspiring investor into a professional through access to professional resources. But social media has had an impact on all types of information. A small subset of this content can be used as inputs into successful investment decisions. For instance, the Google Search Box is invaluable for our daily activities. But Google can also help us size up investments. It turns out that there is a correlation between search data and stock prices. There are other seemingly unknown tools online that investors can utilize to pick great stocks. In this chapter we discuss what resources are available online and how investors should be using them in their portfolios.

There’s Value Outside of Traditional Research It’s 2005 and I’m still researching an investment in Gateway Computer, the great trade I referenced earlier. I hope you remember the company. The home computer boom was gaining momentum and Gateway was vying for its share. The company was known for its creative packaging that resembled 211

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a cow with black spots on a white background (or was it white spots on a black background?). The firm was based in the Dakotas and utilized this corporate history in its marketing. Regardless of the quality of the computers and the company’s business model, Gateway excelled in service and tried to attract more business through its focus on customers who would value this service proposition. Typically, Gateway customers were not as tech savvy as those who bought from Dell and required more handholding throughout the setup process. I’ve done my research and I’m liking what I see. Although many of the tools discussed in this book were just in their infancy, I utilized a real 360-degree approach to sizing up this investment and put these rudimentary platforms to the test. We were willing to commit a lot of capital to this position. But to do so, we needed to provide evidence that Gateway Computer was indeed turning into a retail player after its purchase of low-cost computer manufacturer e-machines, which was already hitting its stride at big-box retailers like Best Buy and Circuit City. To do that, we needed to pull out all the stops. I began piggyback investing and launched a major search into regulatory filings to see if any other institutions had the same intuition that I did. In fact, a few of our competitors were beginning to amass positions in the same company. You could argue whether this was a good thing or not, but at least it bolstered our thesis. We had received corroboration that Gateway was worth exploring. Next I turned my sites to Screening 2.0 technologies and saw that this type of investment would fit the investment protocol of quite a few esteemed value investors, including the true professor of value investing, Benjamin Graham himself. Good start. Although Seeking Alpha existed, it didn’t resemble its current self and wasn’t yet aggregating third-party blog content. But there were other bloggers out there, and a couple of them were beginning to look under the Gateway covers to see if there really was an opportunity there. I connected with them and picked their brains about the prospective investment. What I heard was generally positive, but what was just as important was that these bloggers helped me evolve my own thesis by revealing the pros and cons of my investment. It was clear there was a lot of hair on this stock and the potential for loss was great. But as we delved deeper, so was the potential return. We pulled the trigger and made a lot of money in just a short time. But, interestingly, our thesis never really played out. With the popularity of the notebook computer and the beginning of Apple’s iPod craze, investments in computer hardware companies had become less appealing. But as I’ve experienced throughout my career, a thesis doesn’t have to play out in its entirety in order to work. What needs to happen if you want to profit from

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an investment theme is that enough investors have to believe that it’s going to come true. The more we discussed our ideas with other investors and used the tools put forth in this book, the more we began to see that public opinion was changing. Many of the same investors who initially rolled their eyes when we mentioned Gateway were beginning to warm up to the idea. They were beginning to believe it could happen. Money started flowing into Gateway, propelling it higher in just a short amount of time. Our research proved right and our test case of these new tools was successful. We made some good money along the way. Previous chapters focused on using new Internet platforms to implement research-backed strategies that beat the market. Each chapter contained a turnkey system to access online tools to develop an entire portfolio. This chapter, however, is not about any particular strategy. There are numerous places to turn online for help in both finding investment ideas and developing them. They may or may not exist as part of a cohesive strategy but nevertheless, the sites and tools I describe in this chapter are extremely potent and deserve a place in every investor’s arsenal. You can decide how to implement them in your own investment process.

The Internet and Transparency We live in an age of ever-increasing transparency and content creation. In addition to the bull market in financial content touched off by the popularity of financial blogging, the Internet has enabled migration of all types of information into the public domain. Our new environment is characterized by two things: Data analysis, visualization, and other techniques for seeing patterns in data are going to be an increasingly valuable skillset. —Tim O’Reilly and John Battelle, “Web Squared: Web 2.0 Five Years On,” Web 2.0 Summit, 2009

1. Information made public. Much of the information that has made its way online in our era once existed elsewhere: in private repositories, in libraries, and in government databases. What has changed is that the Internet has made this data publicly available 24/7. Think of guru value investor Benjamin Graham sitting in his office or library poring over public data sets and crunching the numbers tirelessly. We can only guess how frequently this information was updated. It wasn’t so long ago that most newspapers published stock market sections complete

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with yesterday’s stock prices. How outmoded is that? The age of the Internet has brought all this online, updated in real time. 2. New types of information. In addition to bringing information online and lifting the veil of obscurity, the Internet and social media have created entirely new forms of information that haven’t existed before anywhere. Investors have unbelievably powerful access to entire realms of new, actionable trading information. From Twitter-powered tradestreams to online trade data, investors can plug into this data and quickly apply it to the investment process. Consider yourself lucky to be an investor in these days of free investment content, transparency, and powerful tools. We’ve discussed various models that investors can use to take advantage of this unprecedented opportunity. Up until now, we’ve discussed the methods smart investors use to plug into expert opinion. Research has shown that most investors on their own significantly underperform markets. Following the activities of top professional investors has proven to be a winning strategy over the long term. The long tail aggregates the running commentary of blogger-analysts to provide investors with incredible insight into the investment universe. Communing with experts gives investors an invaluable tradestream from which to learn and trade, complete with trading logs and commentary, from a community of investors the world hasn’t yet recognized. Screening 2.0 is an algorithmic solution to develop portfolios that the world’s top investors, both present and past, would approve of. Beyond this incredibly powerful and profitable set of investment tools, the Internet has provided another area of content from which investors can draw important data to aid them in their quest for profits. These sources of information are not recommendations to buy or sell certain stocks; rather, they are primary and secondary data points that investors can use as inputs into their investment decisions. These tools are all lateral to the actual investment process. Co-lateral research is about using these various sources, not at all related to actual investment advice, to uncover valuable clues about making smart, profitable investments. But, why should investors turn to various sources online to aid in the investment process?


Sales numbers. Sites like Amazon produce best sellers lists for their customers. Generally, ecommerce sites won’t tell you exactly how many products were sold during a given time period, but they will provide a relative ranking of what the hottest sellers were and what products are moving up and down the lists.

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Product reviews. Most ecommerce sites provide an active string of product commentary written by customers themselves. Customers can rank how much they liked a given product as well as provide free text reviews to describe their experience with the product. Stock researchers can learn how customer adoption is occurring with new technology products from companies like Apple Computer. Relative performance. Again, Amazon sales statistics don’t say exactly how many iPods were sold during a specific time period. What you can find from the Amazon top sellers page is how well iPods are selling compared to other devices from Creative or SanDisk. You can compare how quickly new iPod products are cannibalizing older models. Very often it’s useful to see not only how well a product is selling versus that of its competitor; you also can use this information to estimate growth rates. With this second-order information, investors can get a picture of what future sales and profits may be for a firm and its competitors. Expert opinion. Many customers write reviews that focus on minutiae. Most of these reviews will not be helpful to investors, but a small percentage will hold gems of valuable information. These reviews will most likely be written by experts in their fields, offering an insider’s view of a product or service and insights into the company itself.

Trade Data While some investors might not view much of the activity occurring online as valuable to the investment process, others are beginning to incorporate these new sources into their investment strategies. With the advent of ecommerce, trade data is migrating online, offering a window into the volume of commercial activity happening on some of the world’s top ecommerce sites.

One example of the power of online feedback popped up on Amazon.com in November 2008 when Brian Govern posted a satirical review of a T-shirt emblazoned with three wolves. “This item has wolves on it, which makes it intrinsically sweet and worth five stars by itself, but once I tried it on, that’s when the magic happened,” he wrote. “After checking to ensure that the shirt would properly cover my girth, I walked from my trailer to Wal-Mart with the shirt on and was immediately approached by women.” No one paid much attention to the review until it appeared on collegehumor.com on May 4, 2009. Then it went viral. To date, there are nearly 1,500 reviews on the Mountain Men’s Three Wolf Moon Short (continued )

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(Continued ) Sleeve Tee, and more than 15,000 people have voted Govern’s original review as “helpful.” Although there were instances in the past where products received thousands of comical reviews, Amazon.com says this was the first time in which the jokes catapulted the item to best-seller status. For several weeks in June and July, the T-shirt was the No. 1 apparel item in the store. —Spencer Ante, “Amazon: Turning Consumer Opinions into Gold,” BusinessWeek, 15 October 2009

Take Amazon, for example. Amazon’s website is visited by millions of customers every year. Everything they do on the site—what they buy, research, and comment on—is logged by the site. Much of this information then makes its way back online in the form of customer ratings, sales rankings, and top sellers lists. There is a treasure trove of information here waiting for investors. Here are a couple of particularly useful online resources.





Customer comments. When researching our Gateway Computer trade, it was important for us to know just how well received some of the new models were that were hitting the sales floor. Our thesis centered on Gateway’s ability to remake itself into a retail giant by focusing on a more direct, mail-order model. For this to be successful, products needed to sell well in stores like Best Buy. We used Gerson Lehrman Group to see how well products were selling and used Amazon to get a feel for how much customers liked the new low-priced, easy-to-use machines. Amazon also uses a rating system where customers can rank a product with 1 to 5 stars. Those rankings are then aggregated to provide each new product with an averaged star count. While this doesn’t provide a truly quantitative feel for sales numbers, investors can turn to commenting systems to get a qualitative picture for what customers think about new products. These rankings can serve as a proxy for actual data. Sales rank. While Amazon doesn’t reveal exactly how many units have been sold of a certain product, it does rank its sales figures relative to one another. Investors can glean both first-order—how sales are moving—and second-order information—how quickly sales are changing—from sales ranking information. Investors can then use this sales ranking to see how well something is selling among Amazon’s millions of products. Use changes in this ranking to see if sales are trending up or down. Again, this is clearly not an exact science, but it

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is one of a number of data points investors can (and should) use when investigating an investment thesis.

Trade Associations Ecommerce sites like Amazon and eBay provide just one window into economic activity. Most vertical industries have trade associations that combine individual data from their constituents to produce research for their industry as well as for the public. At the hedge fund, I focused a lot on small- and mid-cap technology stocks. More than anything, I liked to uncover smaller stocks that were trading below intrinsic value with a lot of cash on their books. Typically, these stocks weren’t suffering from company-specific problems. Instead, they were victims of a downtrend in their industry. In the case of the semiconductor field, low stock prices are frequently attributed to a technology cycle that finds less demand for these products. One of the most interesting aspects about investing in semiconductors is that in spite of its high-tech pedigree, the semiconductor industry exhibits a lot of the same dynamics of other commodity industries, with big ramps and swoons in supply and demand that can make a ride on these stocks feel like a world-class roller coaster. We had our eyes on some of the smaller suppliers of semis that didn’t compete with monster firms like Intel but supplied more niche types of hardware in very specific industries. Some of the stocks we had our investment sights on were trading at very depressed values. Some were trading below liquidation value. Others were trading below cash. We felt our downside was pretty well protected but we needed some indication—some signpost—of where we were sitting in the technology cycle. Were things rapidly getting worse, or were we sitting in the trough of a large downturn with a lot of upside ahead of us? We turned to the Internet and to the trade association for the semiconductor industry. Beyond premium research products, we tapped the best of what existed for free online. A couple of industry sources proved to be very valuable in our quest to understand this particular investment. iSuppli and EETimes combine industry reporting, fact finding, and proprietary research to analyze the semiconductor industry for the rest of us. This is just one example—numerous industries publish valuable analysis online aiding and abetting investors all along the way. Many make this information available for members. Consider joining an association if the price of membership isn’t too steep. At the least, see if the company would provide you with a scaled-down version of the research reports it makes available for members of the media. Make Google your friend and identify these resources. It’ll make you a better—smarter—investor.

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Search Volume and Stocks Technical analysts and traders spend a lot of time looking at charts before they make a move on a stock. Whether it’s moving averages or relative strength indicators, chartists have a lot of tools at their disposal with which to guess what a stock’s next move may be. These traders believe that by looking at historical movements in stock prices and other complementary data, they can get a pretty good idea of what the stock is going to do next. Many of these purists could care less what industry and what products lay behind the stock they are charting. What matters to them is the chart, plain and simple. Fundamental analysts don’t ascribe much value to these charts. While every fundamentalist I know uses a chart to plan his entry into a prospective investment, none of them solely believes that charts act as a crystal ball for future moves. They would rather stake their reputations and money on analyzing the company behind the stock. Balance sheets, discounted cash flows, and income statements are all game for the fundamental investor. The Internet has created entirely new types of information that could turn out to be of great import to both types of investors. To understand its import, let’s take a quick Internet history lesson. In the late 1990s, when Internet use was first becoming widespread, most users accessed the World Wide Web via a portal. Through a series of partnerships, these portals became a one-stop shop for users, with functionality including finance, shopping, and news. Some of these portals were so all-inclusive that their users almost didn’t realize there was more to the Internet than just the portal. Instead of navigating the deep bowels of the Internet, these users had everything they needed within the confines of the portal. America Online was the portal taken to the extreme. Once users logged onto their AOL dial-up connection, they were bombarded with all manner of pressing activities. “You’ve got mail” was symptomatic of this walledgarden approach to Internet use. The Internet is big and confusing; portals acted as a safe and manageable microcosm of the entire web. But then along came a small company named Google that changed everything. Now Internet users no longer rely on a portal to find their way online. Big, flashy websites with tons of links and ads have given way to a clean, bare-bones site with a search box and not much more. Google has absolutely changed our user behavior. We now pull onto the Internet freeway searching for something, for everything. Our new portal is the Google search box, which places us one search term away from whatever we’re looking for. This is more than just talk. Google has run away with the vast share of online searches, routinely seeing billions of searches run through its web servers each month. And the total number of searches continues to rise as individuals keep increasing their search activity. Because Google and its

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competitors have gotten so good at what they do, our movement online is becoming almost entirely powered by where the search engine tells us to go. Think about it: Billions of searches are executed every month in Google alone. There’s got to be tremendous value in the data underlying all these searches. What if this data of how often and how frequently users search for specific things had investing value, helping us make better, more informed investment decisions?

Google Domestic Search Trends Google is a smart company with a lot of smart people working there. The company is aware of the inherent value of all its search data in predicting economic activity, and now its making it available for investors around the world to play with. This is a tough foray into forecasting and one that must be carefully trod. Yogi Berra once said “It’s tough to make predictions, especially about the future.” This data, called Google Domestic Search Trends (GDST), appears in industry-specific form on Google’s financial portal, Google Finance. From air travel to unemployment, GDST tracks search traffic across specific sectors of the economy by monitoring changes in the search volume of these sectors on google.com. Because there is just so much data, investors can find unique economic insight by analyzing the trends.1 Google’s made an investor’s job easier by creating approximately 25 indices that measure sector search volume as compared to the total number of searches on google.com. It’s important to note that these indices measure relative volume. That means that while the index may decrease over time, real search volume may actually be going up. To gauge interest in a specific sector, the indices track search terms specific to that industry as a percentage of all search terms. Fortunately, Google is more than prepared to serve up all the data we want. It’s up to us to make sense of it. —Chris Nerney, “Google Searches as Investment Guide?” MediaBistro, 3 September 2009

GDST doesn’t tell you what to invest in, but the trends it illuminates can be important input into the investment research process. To see the power in this set of data, an investor merely needs to overlay search trends on top of a relevant stock or index. Frequently, as this is just raw data, users will have to fill in the holes by hypothesizing what’s occurring in the background. If restaurant search trends as a whole are going down but

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1.1

30

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25

0.9

20

0.8

15

0.7

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Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09

Actual Sales in Billions of USD Google Retail Index

FIGURE 8.1 Google Retail Index and Clothing Store Sales Source: Google.

fast-food joints are seeing resurgence, what does that mean? In tough economic times, it might suggest that consumers are willing to go out to dine as long as costs are kept low for food and travel. Google takes us part of the way toward converting search data into investable information—its industry data is displayed by benchmarking search trends for a specific sector with its comparable stock index. Take the Google Retail Index, for example. (See Figure 8.1.) The Google Retail Index tracks terms like “clothes” and “The Gap” and compares them to trends in all search terms in the United States. What investors will see is that over time, since 2005, the index has been on a pronounced downward trend. And when plotted against clothing store sales, we can see that actual sales exhibit a similar trajectory. With this information, investors can form a variety of hypotheses:








Consumers have been hit extremely hard by the current recession and are shopping less. Christmas shopping, which accounts of upward of 40% of yearly sales for some retailers, has been getting steadily worse. Big brands like The Gap or Amazon have stronger brand recognition and instead of searching Google for them, consumers go straight to the website itself. By typing the brand name into the browser’s address bar, some users may be bypassing Google entirely on their way to make a purchase. By plotting the Standard & Poor’s (S&P) 500 against Google’s Retail Index, it’s clear that the stock market traded down in 2004 while retail

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searches remained relatively stable. This was a harbinger of an eventual stock market rebound that began in earnest later in the same year. This rally continued for almost four years in spite of worsening consumer search traffic. Ultimately, when the wheels came off the economy in 2008, that spread closed entirely. Google’s Retail Index still has not rebounded, yet the stock market has made a significant bounce off the lows in 2008–2009. We’re now seeing a big divergence between the S&P 500 and retail searches. Can this continue? Will we see another eventual collapse of the stock market, or does this presage a pickup in the Google Retail Index? There appears to be somewhat of a correlation between retail search traffic and retailers’ stock prices. This makes sense: Like stepping into a physical store, search traffic is the initiation of the buying process. Less search means less buying. Investors would want to monitor this data for any changes. A reverse of this trend may prove to be an early sign that the consumer is strengthening and spending more at retail—a boon for retail stocks.

We see important descriptive value when we drill down into the Google Auto Buyers Index. (See Figure 8.2.) The index, which tracks terms like “buy car” and “Ford,” compares auto-related search terms to overall search traffic. Just by looking at the search trends, we can see the effects of the recently completed Cash for Clunkers program. Car-buying activity almost doubled at the end of July 2009 when compared to November 2008. Most investors—and the data maintain this claim—believe that Cash for Clunkers will not provide a meaningful, lasting stimulus for the auto industry. Instead, it appears that the program provided just a momentary glimpse of hope for a much-maligned auto industry. Investors can use past, current, and future search traffic trends to support this assumption.

FIGURE 8.2 Google Auto Buyers Index Source: Google.

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Currently, what you see is what you get for Google Domestic Search Trends. The information is prepackaged; investors will have to wait to map their own queries and corresponding trends. As users continue to interface with the Internet via a search box, many simply type three- or four-letter stock tickers into Google to retrieve stock prices and charts. By doing so, these investors bypass the financial portals like Yahoo! Finance and use search to monitor the markets. It would be extremely valuable to see trends in searches for specific stocks and then analyze whether this has any significance on stock prices. Hal Varian, as an economics professor at the University of California, Berkeley, stated his belief that computational linguistics—the methods employed by Google Domestic Search Trends—can be a useful tool in financial economics. In an Op Ed piece published in the New York Times in 2004, Varian quipped, “In the 1970s we saw the rise of Wall Street quantitative analysts. Then came program trading. Perhaps computational linguistics and textual data mining will become the new hot technologies in financial economics.”2 Perhaps that’s why just three years later Google hired the famed professor as its chief economist. Google has scrutinized its own figures and, to its credit, hasn’t yet boasted that Google Trends data help predict the future. Rather, the company claims that its search data is useful in forecasting the present—telling us what’s currently going on behind the scenes and helping us to connect the dots.3 As explained earlier, search trends are inherently valuable in describing current behavior. Auto search trends skyrocketed when the Cash for Clunkers Program of 2009 was nearing its end—automobile owners turned to Google to locate local dealers to whom they could sell their cars. That’s fine for investors: Knowing these search trends and their corresponding sales trends can help us explain what’s happening now. In turn, this may tell us how a specific automobile company may perform in next quarter’s earnings release. The next step for Google, and for investors, is to study how trends may be useful in predicting turning points in the data. These upticks and downturns—the breaking of a trend—may prove to be helpful in identifying a bottom or top in prices of an investment. Not to be outdone by Google, Facebook, the massive social network that’s been growing like a weed the past couple of years, also recognizes the value of its users’ activities. With little fanfare, the firm launched its Lexicon product to monitor trending activity in certain themes. Unlike Google, which is primarily concerned with search traffic, Facebook’s purview is much broader. The social media giant is essentially a content platform where people from all walks of life post their news, ideas, and pictures—their lifestreams. As Facebook users spend more time contributing to the site, they’re putting more and more of their lives online. Users running applications from within Facebook participate in all kinds of activities, including

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stock picking and portfolio management. This is all extremely valuable information for investors. Facebook is in the early stages of producing a service to compete with Google Domestic Search Trends. Lexicon includes this functionality:

















Dashboard. Graphs the number of posters, the percentage of all posters, and the number of posts for specific terms over time. Like GDST, Dashboard helps investors see how certain topics are trending. Demographics. Breaks down who is discussing a given topic by age, gender, and country. Investors could find this data useful: For example, investors know that 18- to 25-year-olds can’t stop talking about iPods. If women over the age of 55 are equally as obsessed, that could prove to be a positive for Apple’s stock as the company aims to expand its customer base beyond early-adopting, tech-hungry young adults. Associations. Certain associations of terms that are frequently mentioned together. Investors can get a feel for just how Facebook users are communicating ideas relating to certain terms. Sentiment. Uses linguistic analysis to plot whether mentions of certain topics are positive or negative and maps it over time. Investors can use this data to see how sentiment changes over time. Really useful are abrupt or severe changes in historical sentiment. Pulse. Shows keywords that frequently occur in the profiles of users who mentioned the topic. Utilize Pulse information to assess how serious the Facebook users are who mention these expressions. For example, a user who describes himself as a Britney Spears junkie (no offense) is probably not a great source of analysis on the economic state of the U.S. health care system. Maps. Plots all this information on a U.S. map. This gives readers a good idea where all this activity is occurring and can be used to further analyze all of Lexicon’s output. It’s interesting to know if the majority of the chatter about Microsoft is occurring in and around Redmond, Washington—the site of Microsoft’s world headquarters. Most likely this prattle is coming from Microsoft employees.

Google Domestic Search Trends and Facebook’s Lexicon are integral parts of a growing development of companies turning their data inside out to provide ancillary value to their core businesses. Google is the biggest and baddest search engine. By mining its statistics, Google has found another way to provide value—this time to investors. Investors can be creative in locating these new types of resources to aid them in their quest for profits.

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During the 1960s and 70s the scientific study of financial markets flourished due to the availability of massive amounts of data and the application of quantitative methods. I think that marketing is at the same position finance was in the early 1960s. Large amounts of computer readable data on marketing performance are just now becoming available via search engines, supermarket scanners, and other sorts of information technology. Such data provides the raw material for scientific studies of consumer behavior and I expect that there will be much progress in this area in the coming decade. —Hal Varian, “The Economics of Internet Search,” University of California at Berkeley, February 2007

For years, MasterCard produced data that it sold to the investment community comprised of retail credit card trends. Investment funds devour this type of information as it sheds light on how consumers are behaving before their actual purchasing behavior is reflected in corporate sales and profits. Firms measuring traffic across the Internet have sold their data to investors and other businesses seeking insight into where surfers are spending their time online. Usually people spend money (or, at least, advertisers do) where they hang out. Look to tap these current resources—and newer ones that come online—as businesses continue this tendency of turning their proprietary statistics inside out to allow public access. There’s definitely an advantage here for investors willing to put in the time.

Prediction Markets Predict the Future In Chapter 4 we discussed methods to tap into the wisdom of crowds when building a portfolio. Numerous sites aim to harness the incredible predictive power of the crowd for investing—and beyond. If you believe that when given a democratic platform to vote, the crowd’s wisdom surpasses even that of experts, plugging into the crowd’s decision-making capabilities is extremely valuable. In 2003, the United States’ Defense Advanced Research Projects Agency proposed an exchange for future contracts trading based on political developments in the Middle East. The theory was pretty simple: Investors could trade securities based on the probability of future events occurring in the region. Like betting on your favorite sports team, speculators could wager on current events. Because futures contracts represent the price set by two rational beings, this price ascribes a probability to whether an event will actually occur. When the price of pork belly futures rise, that’s the market saying that it believes the spot price—the price you would pay on a day in

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Probability of Overt Action (%)

Market Method Analyst Reports Expert Polls General Polls

Probability of Terrorist Activity (%)

FIGURE 8.3 Predicting Hostilities Source: Department of Defense.

the future—is also set to go up. This Policy Analysis Market (PAM) would therefore be able to handicap the chances of terrorist events, assassinations, and coups by enabling anonymous speculators to bet on such outcomes. It was believed that by having this information in hand, our intelligence community and armed forces could better protect its citizens and interests around the world. (See Figure 8.3.) While the Pentagon ultimately scrapped the program amid public criticism of the proposal, the science behind it is sound. The Department of Defense maintains that futures trading has proven effective in predicting such events as changes in oil prices, elections, and ticket sales. The DOD was quoted at the time as saying “Research indicates that markets are extremely efficient, effective and timely aggregators of dispersed and even hidden information. Futures markets have proven themselves to be good at predicting such things as elections results; they are often better than expert opinions.”4 The idea of a federal betting parlor on atrocities and terrorism is ridiculous and it’s grotesque. [It’s] useless, offensive and unbelievably stupid. . . . How would you feel if you were the King of Jordan and you learned that the US Defense Department was taking bets on your being overthrown within a year? —U.S. Senators Ron Wyden and Byron Dorgan. “Pentagon Axes Online Terror Bets,” BBC News, 29 July 2003, http://news.bbc.co.uk/2/hi/americas/3106559.stm

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The PAM program was a form of futures market, or predictive market, an exchange that uses different types of incentives to encourage participants to play. The activities of rational participants using all the information available to them sets a probability of future events occurring that appears to be extremely accurate. The Iowa Electronic Markets are run by the University of Iowa’s College of Business. Like the proposed PAM, these markets are small-scale, real-money futures markets where contract payoffs depend on economic and political events.5 While these markets are the product of an academic exercise, they’ve become a veritable treasure for study into their predictive abilities. From work done in Iowa, prediction markets have been demonstrated to vastly outperform polls in their ability to correctly forecast things like elections. (See Figure 8.4.) One study showed that these types of prediction markets were closer than polls to determining the outcomes of two-majorparty-split votes 74% of the time in the five presidential elections since 1988.6 Most interestingly for investors, some research around prediction markets shows that these markets can be designed and used for decision support—helping decision makers to select between choices by providing 5.0%

Final Polls Market—Election eve Market—Last week

4.5%

Mean Absolute Error

4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

FIGURE 8.4 Iowa Electronic Markets’ Accuracy Source: University of Iowa.

Average

91 Turkey

98 Germany

94 Germany

90 Germany (L)

90 Germany (F)

90 Germany (B)

95 France

90 Denmark

96 Austria (EP)

95 Austria

96 US Pres.

92 US Pres.(3 way)

92 US Pres.(2 way)

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forecasted results. This works really well for voting, nomination, and election choices. Some research has even suggested that Colin Powell would have been a “particularly strong candidate against Clinton” in the 1996 presidential election. If the Republican Party had sent General Powell to battle Clinton, they could well have nominated a stronger candidate.7 These findings point to the potential of using prediction markets to aid decision making across a variety of industries—including box office receipts. For a movie producer, knowing that audiences were expected to fawn over an upcoming flick could help determine whether to boost or minimize a marketing campaign. Studios could test various movie endings and have markets vote on them to see which would yield the highest returns when it hits theaters internationally.8 The film industry routinely puts over $100 million behind marketing the next blockbuster; prediction markets can help studio managers optimize their investments. In fact, that’s just what the Hollywood Stock Exchange (HSX) is doing. Investors sign up and receive $2 million in virtual dollars to bet on new movies and celebrities as they would on stocks. Bid and ask prices are created, and movies trade up and down based on the virtual money flowing in or out of these stocks. HSX.com, launched in 1996, was one of the first open predictive markets. The site is so popular that it has launched new types of virtual securities that mimic behaviors of debt instruments, mutual funds, and other types of derivatives and options. Investors can make lots of virtual loot by betting on the next megahit and on rising-star actors. How well does it work? Well, HSX’s owner, Wall Street trading firm Cantor Fitzgerald, is launching a platform to allow investors to use realmoney trading in Movie Box Office Contracts. Investors who think they know which movies will be a hit and which will fail will be able to speculate on ticket sales. Conversely, studios and producers who have a lot of money tied up in a given production (and are banking on its success) can use the Cantor Exchange to hedge their exposure ahead of release.

Creating a real money market is important. Think about it this way. HSX was originally conceptualized with the intent of going into real-money trading of movies. We know from our many years of experience and the trader feedback we receive that there is a market out there for real-money trading. Many people have knowledge of films, and they would like the opportunity to profit from box office earnings. —HSX’s Alex Costakis, “Interview with Alex Costakis of HSX,” UsableMarkets, 14 July 2009, www.usablemarkets.com/ 2009/07/14/interview-with-alex-costakis-of-hsx/

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While still awaiting regulatory approval, entertainment professionals, traders, and film buffs will be able to speculate on Hollywood’s success 24 hours a day with real-time quotes. This transaction platform is built on top of the HSX.com service. Because HSX.com has proven to be relatively accurate when it comes to predicting future revenues of a motion picture, we’re seeing an entirely new type of market emerge, where speculators set prices and producers have a next-generation film-financing tool that allows for unprecedented hedging opportunities and the ability to multiply revenues by taking on further leverage. Cantor’s new market is just one of many that investors can look to when seeking to learn about the probabilities of future events occurring. The Iowa Electronic Markets is a great case study in how well these futures markets predict actual events. The ability to handicap future events successfully features prominently in every investor’s investment process. We need to know if new products will be successful. We’re interested in what the market thinks of a new political party taking control of the White House. What if Afghanistan actually ends up better than expected? What then? This is the converse of the Gerson Lehrman model—the expert network, which uses a web of leading experts to help investors assess and understand the probabilities of future events. Here the markets are our guide.

Intrade: Real Money and Real Investment Potential The Iowa Capital Markets was one of the first examples of the predictive power of futures markets. However, it’s mainly an academic exercise: Small bets are placed and no fortunes are gained or lost. That said, many offshore markets use real money to bet on real-life events. Most of the bets are wagered on sports, but these exchanges will trade anything, as long as there is interest on the buy and the sell side. The largest of these markets, Intrade, is just a huge, global futures market. Founded in 1999 and launched in 2001, Intrade is run out of Ireland for the global market.9 After a series of mergers, acquisitions, and divestitures to solve regulatory and ownership issues, Intrade is now entirely focused on non–sports-related trading markets; a couple of sister sites manage activity in sporting events. Contracts are traded on Intrade for everything from climate change to politics. For example, it’s incredibly important for investors in food and commodities to know how likely it is that the current calendar year will turn out to be one of the five warmest on record. Turning to Intrade, investors will find a contract named “2010 Global Average Temperature—Average Global Temperature for 2010 to THE warmest year on record.” Looking at

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the trading chart, it’s traded steadily upward from the start of 2010 reaching a high of 36 at the end of February. Investors are becoming more convinced (36%) that 2010 is going to be sweltering. So, anyone who owns a stock that may be unduly affected by high temperatures should sit up and take notice. For purely stock-related information, turn to Intrade’s Financial section. At a very basic level, Intrade’s platform trades contracts determining where the Dow Jones Industrial Average will close on specific dates. That’s pretty important. Today’s trading activity shows that investors are betting that there is about a 15% chance that the Dow will end 2010 trading below 7000. Similar contracts exist for the S&P 500 and commodities. It’s interesting that people are betting on Intrade’s platform and not just putting their money where their mouths are by buying regular, plain-vanilla options on the same indices.

[A]s prediction markets become more popular, it’s important to also keep our expectations of their abilities in check: They’re not going to get it right every single time, but they’re the best available tool out there for divining the future. —Zubin Jelveh, “Prediction Markets: Be Careful What You Wish For,” Portfolio.com, 13 February 2008, www.portfolio.com/views/ blogs/odd-numbers/2008/02/13/prediction-marketsbe-careful-what-you-wish-for/

I think there are a couple of reasons for this. Many of the people betting on Intrade see their activities as bets, not necessarily as investments. For many, Intrade is less intimidating than opening up an online brokerage account and figuring out how everything works. Intrade does not use technical, financial jargon, and there are very few bells and whistles. It’s simple to use and has a very low learning curve. Intrade contracts are essentially unleveraged bets. Contracts trade like bonds on a scale from 0 to 100, where 100 equals $10. Investors buy and sell contracts based on which direction they think a contract is headed. Stock options, as we know them, are essentially leveraged bets, some with unlimited loss and gain potential. That’s not the case with Intrade contracts. With Intrade, the most you could lose is your entire bet and the most you could win is essentially 100 times your original investment (if you buy a contract at 1 and sell it at 100). Many investors and traders shy away from the big leverage associated with traditional options contracts and turn to Intrade to place their wagers.

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Corporate America knows the value in predictive markets and the data spit out from these forms of wagering. In addition to over 100 global media firms, governments, central banks, investment houses, universities, the military, private traders, consultancies, and individuals have all licensed Intrade market data.10 They do so to aid in decision making. As Intrade’s popularity grows, the firm is expanding its operations by running prediction marketplaces for firms like Yahoo! and the Financial Times. Intrade currently has over 100,000 members and has transacted over 500 million orders. Intrade’s chief executive John Delaney told CNBC in a 2008 interview that his firm is “very good, but not perfect in predicting future events.”11 “When you aggregate information from a very diverse, large community or crowd of people, then typically the type of information that you aggregate has the opportunity to be smarter than any one individual,” he explained.12

Crowdsourcing Your Portfolio versus Co-Lateral Research Our section on crowdsourcing described using various tools to determine what the crowds are saying about specific stocks. It answers the question: What do the masses think of GE? What about Caterpillar? Unlike crowdsourcing, Intrade and other predictive markets don’t focus on actual stock picks. In this chapter we’re describing techniques that rely on third-party information, external to an actual investment, to help in our stock research. It’s one of many inputs, and it’s lateral to the actual trade an investor would make. The information gleaned from prediction markets can be used in sizing up potential investments and support decision making concerning trades. (See Table 8.1 for a comparison.) TABLE 8.1

Crowdsourcing Your Portfolio versus Co-Lateral Research

Purpose for investors

Focus of research How to interpret

Crowdsourcing

Co-Lateral

Use wisdom of crowds to make better investment decisions Stocks What crowd thinks of stock can be a good indicator of future stock movement

Use data to make better investment decisions Things other than stocks Requires specific analysis to determine how information impacts future stock movement

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Seeking Alpha’s Secret Weapon Of course, usability isn’t the only motive for institutional investors and analysts to want transcripts. Fiduciary responsibility, coupled with the reality that it’s next to impossible to listen to every conference call and still manage a portfolio, is another reason. —Dominic Jones, IR Web Report, www.irwebreport.com/features/morsel0201.htm

In Chapter 1 we analyzed the value in the long tail of financial content. In the aggregate, the trend toward blogging about investments is virtual pay dirt for investors. Seeking Alpha is not only leading this trend but it’s helped promote the growth of the entire industry. Reading Seeking Alpha is the equivalent of an individual investor hiring an investment bank’s entire research department for free. But beyond aggregating financial blogs, Seeking Alpha also has a free database of the transcripts of quarterly conference calls most publicly traded companies hold to announce their earnings for the period, discuss performance, and submit estimates as to what management believes the future has in store for them. These transcripts are a veritable gold mine for investors. For decades, professional investors paid a lot of money to access these transcripts to learn how companies in their portfolio were performing. Most earnings calls follow a specific formula:














Earnings statement. The chief financial officer or an investor relations professional essentially reads a formal press release written by the firm that speaks to the company’s revenue and income statements. Discussion of earnings. Senior management then describes why earnings were what they were, detailing what went right and what went wrong for the firm in that quarter. Discussion of business. The chief executive may take the lead here or bring in a senior marketing or sales executive to discuss the underlying dynamics of the business and speak to its health. Forward estimates. Investors wait with bated breath for this, as senior management talks about what it expects for the company in the upcoming quarter and fiscal year. Investors need to know what management sees in its pipeline to gauge future prospects for the stock. General question-and-answer (Q&A) session. When I use words like “pay dirt” and “gold mine” to describe earnings call transcripts, it’s really this section that gets me pumped. The previous sections are all prepared beforehand under the close guidance of lawyers and

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bankers. After management finishes its prepared remarks, most firms allow investors and analysts to ask unscripted questions. When this happens, all hell breaks loose, and it’s valuable to see how management responds off-the-cuff to hard questions. These questions are not softballed, either. Frequently, shareholders are angry or confused, and they rattle management. Smart investors take great pain to monitor how management explains its decision making and describes its own performance. Seeking Alpha has democratized these transcripts, putting them online for everyone—professional investors, individual traders, and journalists—to access for free. Now anyone can turn to the Q&A section of a transcript for their research. What makes the transcript a killer app for investment research is its searchability. Assume an investor wants to know how many times the phrase “lowering guidance” is used in the conference calls among the 3,000 companies Seeking Alpha covers. That would be very useful in determining where an investor thinks the market may go next quarter. Boeing, for example, is launching a much-anticipated new plane chassis that aims to change air transportation as we know it. The 787 Dreamliner is a much-heralded, much-delayed new entry. By searching for this term—Dreamliner—in the transcript database, an investor can hear not only what Boeing is saying about the new jet, but what every partner and every other firm in the industry is saying, as well. Here’s how to use Seeking Alpha’s Power Search: 1. Surf over to Seeking Alpha’s Transcripts center and make your way to the search box. 2. In the search box, input a word or expression that interests you. (See Figure 8.5.) 3. In the results that are displayed after the search, click on “Transcripts” to filter the search results. (See Figure 8.6.) 4. Browse results. (See Figure 8.7.) 5. Make killer investments. Now that you know how to search, the next points will teach you what to search for.


Product mentions. A game-changing product like Apple’s iPhone or Boeing’s Dreamliner affects not only its own company but everyone in the industry. Certainly these products will be mentioned by competitors, but they’ll also be discussed by suppliers and distributors. As money flows into the industry, it winds its way around the entire value

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Get Quote or Search

Apple iPod Quick Links: Breaking News

Transcripts

Alt.Energy

Watchlist/Portfolio

FIGURE 8.5 Seeking Alpha Power Search Source: SeekingAlpha.com.







chain. Seeking Alpha’s Transcript Power Search can help identify the developer of top applications for the iPod, iPhone, and iPad before the rest of the market identifies them. Competitor analysis. Similar to product mentions, companies discuss their own products and services as well as those of their competitors on conference calls. If I have investments in the semiconductor industry, I want to know what AMD is saying about Intel and what Intel is saying about AMD. I want to know how smaller upstart Nvidia decides what markets and technologies to compete in. Power Search enables investors to drill down to answer these types of questions. Macroeconomic tone. As in our example before, users can search through all the transcripts from a given quarter to see how many

Home » Search Results

Search Results Results 1 - 10

Refine results for Apple iPod: Articles Jobs

FIGURE 8.6 Search Results Source: SeekingAlpha.com.

Transcripts Q&A

Authors

Tickers Forums

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Apple F4Q07 (Qtr End 9/29/07) Earnings Call Transcript - Seeking Alpha Apple F4Q07 (Qtr End 9/29/07) Earnings Call Transcript ... Apple executed a very smooth transition to an all-new iPod lineup without a hitch. ... seekingalpha.com/article/50846-apple-f4q07-qtr-end-9-29-07-earnings-call-transcript Labeled Transcripts Articles

Vital Signs, Inc. F1Q08 (Qtr End 12/30/07) Earnings Call ... Vital Signs, Inc. F1Q08 (Qtr End 12/30/07) Earnings Call Transcript ..... across all our transition by typing a phrase like “Apple iPod” or “solar power” ... seekingalpha.com/article/71492-vital-signs-inc-f1q08-qtr-end-12-30-07-earnings-call-transcript? source=feed Labeled Transcripts Articles

Apple F3Q07 (Qtr End 6/30/07) Earnings Call Transcript - Seeking Alpha 25 Jul 2007 ... Apple F3Q07 (Qtr End 6/30/07) Earnings Call Transcript ... We sold 9.8 million iPods, representing 21% growth over the year ago quarter. ... seekingalpha.com/article/42374-apple-f3q07-qtr-end-6-30-07-earnings-call-transcript Labeled Transcripts Articles

FIGURE 8.7 Transcript Results Source: SeekingAlpha.com.




executives are still cautious on the economy, how many are still lowering their guidance, and how many are still witnessing slowing sales (currently #7 on the top 10 most popular transcript Power Searches). If investors are searching for information about a product or company that crosses industries and is the talk of its competitors, Seeking Alpha’s transcript database has it all. Investor voyeurism. Seeking Alpha provides lists of some of the most popular searches on Power Search. Investors can piggyback ideas emanating from the crowd to see what others are looking for and what they’re interested in. Additionally, investors can see which transcripts are most popular to help them size up demand for a particular stock.

Seeking Alpha’s Transcript Power Search is just another way investors can peer into the activities of the crowd to generate investment ideas. This whole chapter has been on bubbling up nonfinancial sources of content that can assist investors in making more informed, higher-probability trades. By no means have we exhausted listing these resources. There are innumerable examples online of new types of data and information that can help us build killer portfolios. Whether it’s trade data or something seemingly unrelated to stocks, such as search traffic, investors should conduct research lateral to traditional methods to fully capitalize on the trend of more and better information.

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Summary The various resources referenced in this chapter are by no means all that exist online that can be turned into successful inputs for profitable investing. Bits and pieces of websites, web services, and communities are there for the taking for any investor creative and perceptive enough to locate and use them. As websites continue to become more transparent and web communities continue to grow, they’re spitting out tremendously valuable data and content 24 hours a day, 7 days a week. Use these sources. Test them to see if they’re useful in your trading and investing. And in the true spirit of the open web, don’t forget to share your findings with everyone else.

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The Future of Finance Online Brokerage App Stores and New Global Markets Content is still king and will find the right eyeballs over time. —Nikesh Desai We want to liberate information that exists elsewhere only in the heads of investors. —David Jackson

H

aving spent the last few years on the front lines of the financial content wars, I’ve seen a few watershed events. When Seeking Alpha started, I’d cold call potential collaborators and partners. Inevitably, after my quick elevator pitch, they’d respond, “Seeking Who?” Fast forward a few years; today there is not a serious investor around who hasn’t heard of, let alone read, Seeking Alpha. Similarly, investors are using social media to research new ideas and share their own. Where investing used to be a very quantitative, lonely slog, it’s morphed into a truly collaborative process. Today’s top investors are both teachers and students, feeding others their best ideas while simultaneously learning from others with different strengths and focuses. The proof that things have changed for good is in the readership of the next generation of financial websites. Seeking Alpha recently benchmarked itself against many of the leading financial firms online including Bloomberg.com, Barron’s, WSJ.com, MarketWatch, and the FT.com. The results were astounding. The research firm Nielsen found that the startup has the highest percentage of financial professionals reading the site of any major finance site, as well as the highest percentage of readers with portfolios over $500,000 and $1 million. Today’s leading online financial communities are made up of extremely influential readers and analysts.

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To better understand the sweeping changes in online finance, it’s important to take a broader view and understand what’s occurring in the industry as a whole. On these pages, we’ve discussed the investment value in the long tail of financial content. We’ve seen how expert communities are letting undiscovered stock pickers float to the top of the asset management world. Piggybacking guru investors has never been easier. Tradestreaming, powered by social media, allows each and every investor a gateway into the daily trading activities of some of the world’s most talented traders. Consequently, traditional financial sites are losing traffic and attention to smaller upstarts. This demographic coup speaks to what’s occurring in the financial content industry as a whole. There are a few trends contributing to these changes. DIY investing. As online investing gets easier and people take more control of their finances, do-it-yourself investing continues to recruit more adherents. This trend has been fostered by the chaos unleashed on the financial industry after Lehman Brothers and Bear Stearns both imploded in 2008. We’ve witnessed large outflows of assets and client accounts from traditional brokerage houses and large inflows for online brokerages, such as E* Trade and TD Ameritrade. New start-ups, including Zecco, have come onto the investing scene offering cutthroat pricing and enhanced social investing platforms. Successes of recent start-ups such as Mint, acquired by Quicken parent Intuit, point to investor demand for better tools to self-manage finances. Fragmentation. The explosion in free blogging tools has turned anyone following the market into an analyst. This trend continues as traditional website destinations lose traffic to the thousands of small, opinionated personalities populating the blogosphere. To differentiate themselves, larger sites are going to have to get snarkier and provide more than just standard news and reporting. As spectators have become publishers themselves, we’ve seen bloggers become really niche in their analysis. This fragmentation provides scrutiny to new markets and industries that historically haven’t seen such light of day. User-generated content. The line between reading and writing has been permanently blurred. Research aggregators offer bloggeranalysts big platforms and broad distribution of their content. From microblogging to participating within the comments sections of financial sites, certain subsets of users have become extremely active in publishing content as well as consuming it. The periodical, as arbiter of financial truth, has seen its influence diminished as investors look to alternative sources for investment counsel.

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Multichannel media communications. When web content was essentially unidirectional, users read and publishers published. Websites were primarily text driven with a little multimedia thrown in. Now social media enables publishers of financial content to choose the form of their communications—from microblogging to longform article—and then combines all communications into a single platform. The popularity of social media and video will continue to transform the creation and consumption of investment research. Collaborative research. Investment research is no longer a tometapping, library-sitting, solitary process. Real-time communications platforms such as Twitter make research more of a conversation than a data-mining process. In the spirit of the Internet, these discussions are frequently held in public, encouraging participation and learning. As investors become more organized and structured in their work, this data, content, and commentary will become more valuable. Most leading stock bloggers cite the valuable contribution of commenters to their articles. Smart writers have smart readers. Both parties reinforce one another to create living, organic investment analysis.

DIY Investing With the backdrop of one of the worst financial environments of their lifetimes, many investors are at a crossroads trying to figure out what to do next. Financial institutions have failed and, in their wake, investors are less likely to trust these powerful firms and the people working for them. Huge financial scandals perpetrated by the likes of Bernie Madoff and Alan Stanford only accentuate this inherent distrust in the gatekeepers of the investment castle. Yet an aging population coming into money through imminent retirement and inheritance requires professional help to manage its finances—especially after the losses some investors sustained in 2008–2009. It turns out that some wealthy investors decided that their well-heeled, active money managers and fancy financial advisers didn’t know much more than they did about making money in bear markets, and they switched from full-service brokerages to self-directed discount brokers—where they are also less likely to run into the likes of Bernie Madoff. —“Blue Chips,” Barron’s, 16 March 2009, http://online.barrons.com/article/SB123698734062425763.html#

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Some investors, such as the retiring baby boomers, are getting to a point where they need guidance from professionals to help them structure retirement and intergenerational planning. Beyond success in their own businesses, they’re poised to be the recipients of the largest transfer of wealth in history. Seventy-eight million Americans born between 1946 and 1964 are expected to inherit more than $41 trillion in wealth from their parents.1 While many have debated exactly how much money will be inherited by this generation, nevertheless, an aging population coming into money puts specific demands on professional-grade financial advice. Instead of turning to old-school stockbrokers, baby boomers are hiring investment advisors to quarterback their financial planning. However, many investors have had enough with overpriced and underperforming financial advisors. In the past, younger investors tended to fit this mold. Now we’re seeing investors of all shapes and colors manage their investments on their own. They’re closing their accounts at Smith Barney and Merrill Lynch and opening online at TD Ameritrade and E* Trade. They’re doing so because they prize the ability to manage their finances easily without the subjective help of advisors. By conducting their own investment research and using no-brainer products like index funds, these types of investors feel they’ve taken control of the investment process. Encouraged by the low fees introduced by discount broker Charles Schwab in the 1980s and empowered by the online trading platforms developed by E* Trade in the 1990s, investors have flocked to these new firms. Traditional brokerages continue to lose clients and assets to the online brokers. The years 2007 and 2008 were impactful in the brokerage business as trillions of dollars of assets were lost in the market drop. To make matters worse for brokers, clients continue to seek out low-cost, easy-to-use solutions to manage their assets independent of professional oversight. Brokerage firms have been bleeding assets. The largest Wall Street firms saw about $67 billion drain from brokerage accounts in 2008, reflecting moves by dissatisfied clients. Online brokerages are becoming the de facto investment platforms for millions of investors worldwide. Research, trading, and financial products are just a click away. By removing—disintermediating—the full-service broker and investment advisor, online brokerages provide best-in-class trading at just a fraction of the historical price for such services. Without any human interaction, online account holders feel that they’ve escaped the conflicts of interest that have plagued the industry. Online brokerages put control in the hands of the owner of the assets. After a decade of negligible returns (1999–2009), many investors feel that they can do better by doing it themselves.

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Objectively, online trading has been a boon for many investors: The brokerage profession has had its fair share of ruthless salespeople out to make a buck off their clients. Misanthropic brokers sold products to their clients that weren’t appropriate. When choosing between making a sales commission and doing what’s right by a client, many brokers chose the easier path. I don’t mean to debase an entire industry—there are plenty of brokers and financial professionals who work ethically and always choose what’s best for their clients. Online brokerage frees the industry from many of these conflicted trade-offs but leaves investors with new carrots and sticks to deal with. As with most things in life, DIY investing is also fraught with issues. Just because there is no one pitching specific investments at an investor doesn’t mean that all conflicts are resolved. Online brokerages sell financial products, and many have their own asset management divisions. These firms seek to maximize profits and may recommend products and services that aren’t cost effective for the expected returns for their clients. Keeping trading costs low—sometimes unnaturally now—encourages clients to overtrade, a serious no-no for long-term performance. It’s important to understand: Investors are not free of conflicts of interest when they move online. The conflicts are just different. What’s happened, though, given the size and complexity of these systems, is that they have become walled gardens. E* Trade and Ameritrade have worked diligently to keep their investment platforms safe, regulatory compliant, and outstandingly functional. With this focus, they’ve lost a step toward innovation. To run something as complex as an online broker requires ensuring accounts, customers, and money are always kept safe. Complicating matters, online brokers are subject to a sometimes crippling regulatory regime that monitors everything: from wording on an advertisement, to the color of hyperlinks on a website to the lawyer mumbo-jumbo on disclaimers. Because online brokerages service so many aspects of their clients’ financial lives, these firms have to stay wildly focused when introducing new products or services to ensure function and compliance. One slipup could cost the broker dearly in negative PR, regulatory scrutiny, and client defections. In an industry that’s fighting against commoditization, brokers must be insanely vigilant. Because of this dynamic, these firms have been painstakingly slow in launching new, cutting-edge products and services. Account holders have had to look outside their brokerage accounts for investment advice. Rudimentary portfolio analysis tools provided by brokers have hampered investors as they continue to struggle with understanding their current portfolios in light of their personal and family financial plans. By being hawkishly aware of their guarantee to provide safety for all

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participants, online brokers have been slow to advance new tools and services to help their clients. This is all changing. Given all the innovation going on around them in the finance space, online brokers know that they need to find a way to harness new developments. If not, their competitors will, as everyone fights fiercely for new accounts and assets. This competition occurs over new assets flowing to the online investment platforms, away from traditional brokers. New clients are not overwhelmingly young and Internet savvy. They’re not accustomed to turn to the web for all of their business needs. These newer clients are looking to the online brokers to deliver professionalquality services that match service levels they received from their offline brokers. The needs of older and wealthier clients have not been lost on the leading players. For example, E* Trade recently launched a service called Online Advisor. The new service, developed as part of E* Trade’s newly minted Investor Resource Center, is a nifty little financial planner in a box. In a quick and easy four-step process, Online Advisor: 1. 2. 3. 4.

Analyzes an investor’s current portfolio and financial goals Suggests a recommended asset allocation Displays the solution Allows investors to quickly implement the solution

Online Advisor is a great example of a new service launched by the online brokerages that combines professional-level service (in this case, basic financial planning) with automation. In just four steps and about four minutes, an investor can analyze, tweak, trade, and optimize her portfolio. Online Advisor is not a breakthrough service; it’s a basic tool to help account holders optimize their investments according to their risk profiles. But the new service showcases some of the most exciting things happening in the online brokerage industry. Here’s what the future has in store:





Tools like Online Advisor further blur the line between fullservice brokers and online investing. While the Online Advisor tool was launched only recently, it has been in development for some time. Its launch is fortuitous in that it coincides with this growing trend of DIY investors moving online and requiring more than just a trading account to help them make informed, responsible trading decisions.
Expect more internally developed tools from online brokers to deliver automated professional-grade investment guidance Watch for online brokers to move into more open architecture and develop trading platforms. Like Apple’s App Store for

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the iPhone, brokerages are beginning to open up their platforms to third-party software development. In this model, brokerages provide the software community with hooks into their technology platforms with which to build new services. With a click of a button, investors can integrate these services into their brokerage accounts. While privacy and security remain high-level concerns, this works for everyone involved.
Investors get access to a software marketplace developed independent of the notoriously slow and conservative brokerages.
Online brokerages get to service customers with new applications without having to use their own resources to develop them. This opens up new revenue streams as online brokerages manage the customer relationships and provide a matchmaking service to software applications and services— the makings of a true investing platform.
Third-party services and apps historically have struggled to grow because it’s been hard to get investors to adopt solutions outside of a traditional online brokerage login. As online brokerages open up, app developers will be granted the keys to the castle. We should see a tremendous amount of innovation in this space. Smaller investors also get access. By using exchange-traded funds (ETFs), E* Trade can create a well-diversified portfolio for investors with as little as $10,000. Even actively managed ETF portfolio managers have been lowering their minimum account size to compete for assets. Setting lower minimums further levels the investing playing field. Online brokers continue to build out financial advisor platforms. If online brokerages can develop applications and services like Online Advisor that drive significant usage, it’s another channel to connect DIY investors, who like managing just part of the investment process, with professionals offering appropriate investment advice. The brokerage acts as a middleman, connecting its clients requiring personalized advice with a financial advisor using the broker’s trading platform.

Online Brokerage App Stores It’s been a truism that the secret to runaway success in technology has always been in platform building—building the infrastructure accepted and used by entire industries to design technology. I learned about the intricacies of building platform leadership from a book by the same name, Platform Leadership, which I read during my MBA. The book by Annabelle Gawer and Michael Cusumano details how Cisco, Intel, and Microsoft drove

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industry innovation by building a robust, standardized technology platform into which other leading-edge products could plug.2 The premise of the book was powerful: Companies that successfully create products and services that serve as the center of a powerful technology ecosystem become extremely valuable. Think Intel Inside and Microsoft’s dominance of the home computer’s operating system. Both platforms provide software and hardware developers with the tools to develop their products to work within the Wintel environment. Think of what Salesforce.com is doing with its Force.com and what Amazon is doing with Web Services offering. Most strikingly, Apple’s iPhone App Store has stimulated incredible sales growth for the master electronics designer. Apple has experienced over 1 billion downloads by its customers of applications for the iPhone. By creating a system where developers are incentivized to design and build products to work with the firm’s own technology, these companies have created something much more valuable and harder to displace than a mere product. They’ve created a platform.

Investment Field Riddled with Platforms The investment field is riddled with platforms, too. Bloomberg runs a content empire through a global install base of Bloomberg terminals in most of the leading investment institutions around the world. You want to reach institutional investors with financial content? You’ve got to work through Bloomberg. Yahoo! Finance is the granddaddy of financial sites, far and away seeing more page views than any of its competitors. To reach the retail investor, you’ve got to get on Yahoo! Finance. Platforms provide necessary structure to certain markets. In the investment field, Bloomberg and Yahoo! Finance serve to:








Aggregate content. Investors don’t have to hunt down information by doing hundreds of Boolean searches on the Internet. By serving as content aggregators, the platforms serve as a clearinghouse and central node to investment information. Establish an orderly market. Platforms create order by formalizing certain standards for their products and partners. Bloomberg and Yahoo! Finance established syndication guidelines with which partners must comply to be on the platform. Create viable business models. It’s not clear to me that many investment research products could survive on a stand-alone basis. Investors don’t like to pay for content. By aggregating page views on a single site, Yahoo! Finance actually creates a viable business model for their partners and shares its success with them.

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Consolidate usage to mark a single jump-off point to reach users. By consolidating the market, making it orderly, and putting viable financial metrics behind it, finance platforms are the gateways to users. For content publishers on today’s Internet, it’s too hard, too complicated, and too expensive to try and reach investors directly.

These platforms act as market makers for the investment content, bringing suppliers and customers together to produce and consume financial information.

Online Brokerages as Investment Platform From the perspective of the platform, it turns out that the online brokerages are doing the exact same thing that Apple is doing around the iPhone. In fact, it’s a huge misnomer to call firms like TD Ameritrade and E* Trade “online brokers” at all. Although they began as online trading systems, these firms are now in the platform business. They provide services and products that include advisory services, trading execution, and financial and mortgage products, as well as core banking. As this evolution develops away from just trading toward the development of a true investment platform, these firms are creating something so much larger than just online trading or banking services.

Ameritrade’s Premier Partners Platform Just as Salesforce.com has turned its technology infrastructure inside-out and encouraged third-party software application development on top, Ameritrade currently has a handful of applications that are accessible through it for clients to receive trading alerts, Jim Cramer’s wisdom, ongoing advice about when to sell, and some nifty charting. Called Premier Partners, the online broker has opened up its platform and clients to outside software and service providers. Ameritrade is establishing itself as the nucleus of the investment ecosystem. By allowing developers to build tools and hook them up to Ameritrade’s Advanced Programming Interface (API), the firm is concretizing its position as the investment platform of choice. If you’re a service provider and want to reach investors, get on the platform. Offering a platform enables software/services developers to effectively reach the investor smack dab in the middle of the investment process—something heretofore impossible to do. Look to see a lot of services develop around this ecosystem.

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The Future of the Online Broker With a broad investing platform, the sky is really the limit for what an account holders could accomplish. After logging on to an investment account, users could download or activate programs that enhance their ability to invest. At a very basic level, I could imagine subscription newsletters pinging their subscribers directly in their investment accounts when a trade signal occurs. Taking this further, users could enable these same information services actually to execute trades in their own accounts when certain signals flash. Providing investment services this way provides a greater level of transparency as it’s very clear what occurs within an account holder’s own portfolio. In addition to merely linking data with trading, other apps could begin to change the way we invest. Imagine apps that allow greater levels of socialization between account holders. Promoting information sharing among informal social networks can’t be a bad idea, and, with a social hierarchy, experts could bubble up to the top and others could learn from them. Maybe these apps could facilitate paired investing, where an expert and a beginner work together, learning from mistakes and ensuring more successful investments. In fact, it could open up entirely new markets for account holders. Imagine an app that allowed account holders to trade things other than stocks. Perhaps these pieces of software could enable account holders to sell their own homes to other account holders without using an agent. Almost like an online broker version of eBay, the platform is so powerful it could help locate suitable buyers using geographical and demographic information. Buyers and sellers are so much more qualified in this model, given their participation histories and customer profiles on the platform. Buying direct in the housing industry could become a reality. Beyond homes, account holders could lend money to one another outside of the traditional banking system, much like a couple of microlending sites do today. These sites allow interested individuals to bid on lending money to other people by adjusting how much they’re willing to lend at certain interest rates. Because these platforms are so robust, risk assessments of default would be very accurate as the brokerage has a lot of financial information about all the various parties. Even illiquid securities, such as those lonely mortgages and derivatives sitting on banks’ balance sheets all over the world, could find a buyer and seller in a bulletin board–like exchange where both parties would work to discover a mutually suitable price to transact. Ultimately, it’s the direct access to millions of account holders within the platform itself that will make these apps so powerful. It’s a boon for the brokers—the firm can provide more services for its client base without having to develop them in house. It’s a score for consumers, because they

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no longer have to wait for their broker to provide new services. It’s a win for software developers, because a move toward establishing open investment platforms puts them in business. Firms providing investing services had a much harder time reaching investors when they had to go around the brokers. Now in the platform model, new services are intertwined in the platform itself. I think this is a huge breakthrough in the understanding of what the future holds for these particular firms, their clients, and technology development. The financial industry’s version of a mashup portends great things for all players.

New Markets Technology has allowed us to accomplish tasks faster. We can shop surgically online, buying only what we want to be delivered when we need it. The Internet has also opened up entirely new ways of doing things. The investing industry is experiencing technology-driven market development where technology serves as the enabler to transacting in fresh ways. Banking services are being provided by individuals through a web platform. Investors can now make online transactions in foreign currency. The near future will see new markets opening up for investors to participate.

Trafficking in Humanity The Internet has changed the way we interact with one another. While I bark at my children daily to get off their Facebook accounts, I understand that this is how people interact nowadays. Social media doesn’t just help us meet new contacts; it also helps us to communicate with people we know well. My kids are online with the rest of their classmates chatting about everything. Participation media has created an easy way to converse with our web of connections. With all these nodes of contact, entirely new markets are opening up online for everything from foreign exchange trading to personal loans. It’s not about who you know. It’s about who knows you. —Mitch Joel

One such market that should interest investors is in expertise. Investors have always requested others’ opinions to assist in picking winning stocks. Although it began as a system that favored the old boys’ network, today’s investing is a pretty level playing field—all members share the same

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information, more or less. Connecting with experts gives investors a slight informational advantage, however small, that can lead to winning trades. Gerson Lehrman Group (GLG) understood this dynamic better than anyone. In creating a pay-to-play expert network for investors, GLG traffics access to people. The fees associated with joining GLG are out of reach for most individual investors, but that doesn’t mean we can’t implement our own expert networks. I frequently recommend that people start using business networking sites such as LinkedIn to expand their own Personal Investment Network of Experts (PINEs).

We live or die on our database. —Chris Brogan

LinkedIn has over 50 million members in over 200 countries around the world. Users build very specific profiles of themselves, including educational and work experience. The user profile is the centerpiece of the LinkedIn experience. Investors looking to tap the value of the site will soon see that the more they put into building a presence on LinkedIn, the more they’ll get out of it. Investors expanding their PINEs must show potential contacts that they have something to offer. LinkedIn provides the platform to do just this: In addition to general curriculum vitae information, users can showcase their smarts by participating in groups on the site and by answering questions floated by other users. Participation builds users’ reputational capital. It’s this capital that is used to further expand PINEs. Today’s online investment environment rewards social networking. Investors don’t need to know the answers to every question; they just need to know where to look. Investors are actually doing this already on platforms like Facebook and Twitter. By connecting with other investors, social media users are tapping into the expertise of their networks. In the future, this collaborative process will emerge to be a main generator of investment ideas.

Forex Globalization has created a keen awareness of how economies are intertwined. There is no better place to see this than in the foreign currency exchange market, or forex. It’s huge: With average daily turnover of $3.2 trillion, forex is the most traded market in the world.3 According to a report from the research firm Aite Group, close to 75% of all forex trading will be done electronically by the end of 2010, up from a bit over 50% in 2006.4

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Markets will be made in real things that we haven’t seen before. Core markets will develop for liquidity purposes but also direct point to point trading between entities. Banks hold money and loan it out at a higher rate. In 2008, all their risk models failed. Google has $20 billion on its balance sheet. They could give it to Bank of America to store for the company or plug their own risk models into an SAP system and loan it out at a better rate. Banking is an inefficient system. I wouldn’t be surprised if banks just went away. Banks have not existed since the beginning of time and nothing says that they need to in the future. It’s possible that they get disintermediated entirely. How do you educate consumers to make new markets work? Content. Content is the leading indicator powering these new types of markets. In the future, we’ll see P2P [person-to-person] and forex-type sites provide the most bang for the buck. Even capital markets will be affected. Why go through an IPO via an investment bank? Everything will be like an online bulletin board, bidding for musical talent, buying crops, etc. —Michael Eisenberg, personal interview, Fall 2009

Banks have foreign currency desks that work 24/7 moving monies from one currency to another at breakneck speed. They use these markets to hedge risk, so they’ve typically been a place where the big boys play. That hasn’t stopped speculators from trying their hands, attracted to the huge leverage employed in forex trading and the potential for outsize profits. While corporations use foreign exchange markets to convert currency as part of doing business globally, over 95% of forex volume is pure speculation.5 In recent years, investors have seen the rise of numerous online forex sites, allowing investors (and, of course, speculators) to transact among the world’s currencies quickly and cheaply. For most account holders, this speed and ease means they lose their money quicker and more easily. But for the rest of us who live in a global marketplace, currency exchange outside of the traditional banking cartel can provide a lot of value. Investors interested in tracking macroeconomic developments may find forex trading a great way to put this knowledge to work. Forex traders place bets on currency pairs, essentially betting on the relative strength of one currency against another. Most traders focus on the biggest, most liquid currency pairs. These “Majors” include the U.S. dollar, Japanese yen, British pound, euro, Swiss franc, Canadian dollar, and Australian dollar.

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In spite of being a huge market, very little forex trading occurred online historically. That’s all changing now: Online forex trading is growing in popularity as groups of users adopt these platforms:











Foreign businesses with activities outside their home base. Businesses use online forex trading to convert currencies for global customers and suppliers. Both small and large businesses with exposure to a foreign currency may want to limit their liability to any one currency, hedging profits and ensuring low costs. Online forex trading allows this to be done cheaply and quickly. Expatriates. I’m a prospective candidate. I’m an American, earn American dollars, and pay American taxes. I spend most of the year abroad, though, with my family. I live in one place while my business is in another. My net worth is very much connected to the U.S. dollar while my expenses are based in a foreign currency (in my case, shekels). While the U.S. dollar continues to slide against most of the world’s currencies, expatriates around the world are feeling the pinch. Forex trading would allow me to hedge my exposure to the dollar and replace it with something (currently) more stable. Investors. Investor portfolios typically suffer from home bias—that is, portfolios reflect holdings in firms closest to home. In spite of the data that global investing may boost returns and lower volatility, investors continue to suffer from this malady. Many, though, have acknowledged this problem and are working to correct it. Hundreds of new ETF products launched in the past couple of years are global in nature, giving investors exposure to the rest of the world in one security. Forex can enable the globalization of investors’ portfolios. Speculators. Where there’s money to be made, you can be sure you’ll find investors looking to book quick profits. Forex is enticing for these types because investors aren’t required to put up the full value of their positions. This means that investors can initiate significantly larger positions than if they needed to pay cash up front to trade. Some sites offer leverage of 200:1—for every $1 in the account, speculators can trade $200 worth of a position. This means very quick—and large—potential for profits and losses.

Content Providers as Asset Managers While traditional journalism soul-searches to find a way to make money in the world of free content, kaChing and Covestor recently introduced the business model for the investment content industry. Asset managers have always been in the content business. It’s very common for a mutual

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fund manager to sell a subscription newsletter showcasing recent picks. Al Frank’s “The Prudent Speculator” may be the oldest and best-known marriage of a popular content product with asset management. That’s why there’s a constant carnival of fund managers on CNBC: Analysts and money managers appear on TV in an effort to boost PR and bring in more assets. For asset managers, content has always been about extending their marketing muscle and providing a sales channel to their core product: asset management. Covestor is the eBay of money management. Just as eBay allowed anyone to become a store owner, these peer-to-peer investing sites allow anyone to make money from being a great stock picker. You no longer need to set up a hedge fund; just trade as you always would, and watch as the number of paying subscribers to your successful ideas grows. —Seeking Alpha’s David Jackson, personal interview, Fall 2009

With the advent of expert communities like kaChing and Covestor, the reverse is occurring: Expert content providers are moving upstream into managing real investment dollars. The expert community, coupled with a money management arm, can turn every blogger and armchair commentator into full-fledged asset manager. Expert communities put all financial content start-ups into business. Simply, these sites allow anyone to build and manage a portfolio. That’s pretty standard—Internet users have been able to do this for years through online stock market games. What’s different here is that these sites now allow investors to program their online brokerage accounts to mirror portfolios on the site. When a stock is bought or sold in the model portfolio, the same automatically occurs in the investor’s account. All of a sudden, anyone managing a virtual portfolio can get paid to be a money manager. This is an incredible development—every blogger, closet analyst, and speculator can turn his commentary into a viable business. If the analysis is good and makes readers money, financial tradestreamers can make a nice living. It’s hard to make money by selling research—investors don’t typically pay for it. Now the research becomes a loss leader for a much more scalable business: portfolio management. It won’t be long that smaller hedge funds and mutual funds—funds with less than $500 million in assets—use these platforms to recruit more investors. Investors really stand to gain the most through this evolution. Never before have investors had such visibility into the activities of the people managing their investment money. In the expert community model, an

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investor can peek into her portfolio activity at any moment in time. Buys, sells, rebalances—all are updated in real time for investors to observe. The market for asset management becomes hypercompetitive, battling on performance and risk management. Performers get paid, slackers can’t contend, and fees go down.

Return of Active Asset Management If you can time the market successfully, fine. Go do it. In my opinion, I’ve never seen anyone who can do it consistently, successfully and in a practical way. The other part of buy-and-hold obviously depends on what you buy and what you hold. Since I don’t believe in efficient markets, I don’t see buy-and-hold as synonymous with index investing. Many do. I think it’s certainly possible for investors to make reasonable decisions that will lead them to beat the market over the long haul. —Eddy Elfenbein, “The Death of Buy and Hold,” http://seekingalpha.com/article/105504-the-death-of-buy-and-hold

The rise of index investing brought with it a bull market in exchangetraded funds. These securities, as the second generation of mutual funds, are an upgrade on the old-school way of managing money. Like mutual funds, they pool assets so that owners of ETF shares get diversification and exposure to hundreds of securities. Unlike mutual funds, they can be traded throughout the trading day (not just once, after the market closes) and even sold short. Part of the attraction for investors is the extremely low fees these indexed products charge. With more transparency and esteemed investors like Vanguard’s John Bogle leading the cavalry, investors piled billions of dollars into ETFs over the past couple of years. Some of the oldest and best known ETFs, such as SPY, which tracks the Standard & Poor’s (S&P) 500, have multibillion-dollar market caps. There is now over $700 billion of ETF assets, with over $50 billion of that money coming just in 2009.6 Much of this new money (over half) has made its way into fixed income products as hurt investors look for more stable yield in bonds rather than test risky returns from stock funds. There are now almost 800 of these funds, compared to thousands of mutual funds. More ETFs are on the way. New ETFs launch every month, offering investors useful exposure to underinvested markets (such as Asia ex-Japan or global real estate). In this rush, arcane products have been launched as well (European Union Carbon Allowances) that may have a

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harder time finding a place in retirement portfolios. From their launch, ETFs have had a clear value proposition for investors: low-fee offerings that allow for diversification and easy targeting of investment themes. Indexing brought a change of mind-set to mutual fund investors accustomed to chasing hot returns. The theory, in its simplest form, was that most investors could only hope to do as well as the market averages due to management fees, poor performance, and overtrading eating away returns. Instead, insisted the indexers, it’s wiser to put your money into a passive fund—one that aims merely to mimic a broad index, like the S&P 500—and hold forever, rebalancing allocations every year. This way, investors stayed out of trouble and avoided common investing mistakes. Individuals would ride an ever-rising wave of stock market returns, neither beating or doing worse than the market. Unfortunately, things didn’t work out so well for the indexers. Investors who owned some of the broadest and widely held ETFs, including SPY, have seen no growth over the past decade (1999–2009). Those with fortuitous timing (they bought earlier in 1999) experienced close to a 0% average yearly gain over this period. Those who bought later that year and held until today lost almost half their portfolio’s value. This “Lost Decade” has been disastrous for investors on the cusp of retirement and those already living the good life. Investor psychology frequently takes past returns and extrapolates them forward. While we’re reminded not to employ this line of thinking on every financial advertisement we see or hear (how many times have we heard that “past performance is not necessarily indicative of future results”?), investors look backward and then project experiences out into the future. When researching mutual funds, we can look at 1-year, 5-year, and 10-year returns. Past performance is all most people have at their disposal to size up potential investments. So, when individual investors look back on the dismal performance of their ETFs during the Lost Decade, they’re going to want to make sure that they don’t fall for this again. This isn’t to say that they would have fared better by putting their monies into an actively managed mutual fund. Earlier in the book we saw that professional managers typically don’t fare any better. The point isn’t that indexing is inherently a bad strategy—it just failed on its promise. The market has gone up and down over the past decade, leaving investors in almost the same spot as when 1999 started. Without any returns to show for their ETF holdings, some investors now feel that they would have been better off at least trying to beat the market. While mutual funds may have performed just as poorly, I predict that investors won’t want to let this happen again. We’ll begin to see the reemergence of the actively managed fund. Enter active asset management.

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Investors looking to avoid making the same mistakes over again will look to asset management as a godsend. In fact, many of the strategies described on these pages incorporate a more active approach to managing money. It doesn’t mean that ETFs don’t play an important role in the future—they very well might. Investors won’t look to buy and hold these securities, hoping for a bright future. Instead, they will look to include ETFs in more active, tactical portfolio management. Piggyback investing has shown to be an interesting strategy for investors to ape the performance of top professionals. These titans of industry aren’t buying and holding. Instead, they’re researching the hell out of underappreciated stocks and trading them for profits. So, too, are experts in the new, fledgling investing communities of Covestor and kaChing. Screening 2.0 technologies have proven to re-create profitable strategies of guru investors throughout history. They work because they’re about stock selection—the ability to filter through thousands of stocks to find those few that are most likely to succeed. I expect to see an eventual reversal in capital flows. Instead of new monies making their way out of mutual funds and finding a home in ETFs, we’ll see the opposite occur. Investors, smarting from a decade of no growth, will return investment dollars back to professionals who actively manage accounts. Even if these funds don’t outperform in the future, they at least represent the possibility of outperformance. Reading that hedge funds continue to make money hand over fist doesn’t sit well with retirement investors who have seen their portfolios go nowhere over the past 10 years. The strategies we outline in this book, along with actively managed financial products, will make a comeback in the years to come. Keep your eyes and wallets open to the possibility.

RIAs Another winner of the move back to active portfolio management is the investment advisor industry. Concurrent with substantial client defection at traditional brokerage house is another emerging trend: Traditional brokerage firms’ own brokers are jumping ship after a year of terrible investment returns. They aren’t leaving empty-handed, though—they are bringing their biggest and best clients with them as they start or join new independent investment advisory firms.7 These firms, with investments in technology and service that rival their older competitors, generally take a different approach to managing their clients’ assets. Instead of selling products, which positions brokers and their clients with competing interests, these investment advisors (known as RIAs, or Registered Investment Advisors) generally take a fee for managing their clients’ portfolios. This serves to better align incentives and provide more objective advice.

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Alternatives used to exist in the traditional broker-dealer world, but it’s much more limited right now. The marketplace is wide open. We’re trying to bring back the boutiques that existed on the Street in the ’50s, ’60s and ’70s. There were older boutiques and a lot of great regional broker-dealers—Tucker Anthony, Advest, those kinds of firms—where the chairman knew all the advisors at the firm. Today, wirehouses are . . . global empires. I think a lot of people are looking for alternatives and we’ll fill that niche for some. —Ed Sullivan, “The Wirehouse Boutique,” 1 July 2009, www.researchmag.com/Issues/2009/July-1-2009/Pages/TheWirehouse-Boutique.aspx

There are over 11,257 Securities and Exchange Commission–registered investment advisors, up 2% year over year in 2009. While the number of investment advisors continues to grow, total assets under management dropped precipitously in 2008 to $34 trillion, down 20% from $42 trillion in 2007. It’s currently a very top-heavy industry: Only 4% of SEC-registered RIAs manage over 80% of the assets. So, growth in the industry is coming from small businesses (fewer than 50 employees) getting into the asset management game with over 90% of the overall market makeup.8 These numbers include over 1,500 hedge funds with $14 trillion in assets under management (AUM). Since advisors typically get paid as a percentage of AUM, smaller asset managers feel the hurt after a 20% drop in assets across the industry. Many have shuttered their businesses, but the ones who have made it through are growing stronger and consolidating assets, looking for a home. One such new upstart, HighTower Advisors, has made headlines recently by snatching a few high-profile brokers, some with billion-dollar books of business. Backed by some of the smartest people in the business, HighTower’s success shows how the business is changing. Many large brokerage houses own their own clearing and custodial firms. If they don’t, they typically have one strong relationship in place. What this means is that the brokerage controls every touch point of their clients: from providing financial advice, to housing their assets, to clearing and reconciling all their trades. HighTower has multiple relationships with custodians and clearing firms, allowing their brokers and clients some flexibility. Most interestingly, brokers aren’t mere distribution channels to market HighTower; the advisors own HighTower and are incentivized to build their practices and the firm as a whole. Clients win with better service and (it is hoped) performance. Advisors win with more flexibility to service their clients and the right monetary incentives to do so.

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Video and More Video In all my discussions with senior executives in the finance industry, one thought seems to be shared by almost everyone: Video is a game changer for investors. Everyone agrees that its potential going forward is huge. We’ve migrated from watching television at scheduled times to viewing video online whenever and wherever we get the craving. It’s just happening faster than anyone anticipated. The jury is still out as to how users will use video in the future. But for investors accustomed to 24/7 financial news networks, video will continue to pay a central role in the industry. Apple’s iPod and iTunes have completely revolutionized how people consume video content. Think about it: Apple sells millions of TV shows through iTunes. People are paying to watch otherwise free television shows, but do so on their computer or mobile device. It’s just a matter of time until Apple’s more robust video device—the iPad media player— continues to change how content is distributed and devoured. Why would users pay for free content? For Apple, the answer may be in how easy it is to purchase content and load it up on a device. Users may also pay for free content in this manner because it gives them the ability to timeshift—to watch the program when they want to, not when the network schedules it. It’s an important issue: As firms continue to tweak business models around content, it’s imperative to understand why users pay for things in order to create a thriving industry. If we can answer this question, we will continue to see world-class content produced by a huge variety of sources. Financial news network CNBC has put much of its video content online. Reuters, in the wake of its multibillion-dollar merger with Thomson Financial, is spending a lot of time and money making video a central part of its financial news. Every financial website seems to have a video module. It’s going to take time to get video right. Digital ownership and usage rights need to be addressed for video distribution to work. Questions about portability of video content must be answered: Can users take the video with them? Can they share it? Is it tethered to their devices? Of course, it’s still unclear how to monetize video content. Google’s YouTube struggles to generate meaningful money. Financial video must find a way to compensate content creators for the time and effort it takes to produce the content.

Personal Finance Quicken parent Intuit purchased Mint, a hot personal finance start-up, in the fall of 2009. Mint links users’ accounts together to give a coordinated, panoramic view of their financial health. Using credit card statements and

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access to bank and investment accounts, Mint is an incredibly easy and useful platform to take control of your finances. By following money flows in and out of accounts, Mint makes practical recommendations, suggestions on lower costs and boosting savings. Mint and its competitors will thrive in today’s tough economic environment. User demand for automated, professional-grade advice is driving growth in the personal finance arena. If Mint’s success lies in giving people a bird’s-eye view of their finances, Cake Financial gives them a similar perspective for their investment accounts. For years, investors have struggled to fully understand the risk inherent in their portfolios. Investors need to know if their investments match their risk profile. Often investors can optimize their allocations to certain assets to better their long-term returns without accepting more risk. The problem is not that there aren’t sufficiently good financial planning tools; it’s that most of the tools are too arcane for gain widespread use. Cake Financial is changing all that. Cake Financial plugs into its users’ brokerage accounts and furiously analyzes transactions. The result is that Cake does a good job of understanding its users’ risks. Once the system finishes mining the data, Cake compares it to over 1 million users’ transactions that it’s analyzed. From there, Cake can help all kinds of investors, including those planning retirement, with suggestions to better their portfolios. Cake users are supplied with graphical analytical tools to get a clear picture about their performance, risk levels, and how they stack up to the markets. Those wanting more can even receive a list of personalized investment recommendations. Cake’s value is evolutionary—it provides analytical tools to users’ existing brokerage accounts. Better-informed investors perform better over the long term. That’s probably why giant online broker E* Trade purchased the firm early in 2010. Now part of larger organizations, Cake Financial and Mint are helping investors get there. The future will present investors with more tools like these to make sense of their portfolios. Nikesh Desai, the founder of Investing Channel, a financial industry advertising network, agrees with this assessment. He calls for the creation of a service that combines Yahoo! Finance’s breadth of information with Mint’s personalized utility. The same trends that have led to the success of social stock-picking sites should influence sites to provide more directional advice. Investors still need help in designing an effective portfolio, not just in picking individual stocks. For this to work, sites need to do a better job profiling their users. The better sites truly understand their users, the better they’ll be at offering useful instruction. Right now, sites know very little about us. Perhaps we’ve given them an email address. Maybe they know a little demographic data about us. Financial websites can learn what we’re interested in by following our activities on their sites. They’re likely to know a little about us from the

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data we’ve passed them in our web browsers. (They know other sites we’ve recently visited.) None of this is enough, though, to offer us personalized advice. Desai calls for development of an “eHarmony for finance”—a site that understands users so well that it can offer personalized, actionable advice. E* Trade is already doing some of this with its Online Advisor product. Expert investing networks match investors with appropriate portfolio managers. Cake and Mint are two of the best examples of second-generation financial websites educating users with better analytical tools and directing next steps with sound guidance. The future will augur more of these types of tools: easy-to-use services that help investors better understand their financial status and provide personalized suggestions for the future.

Summary Tradestreaming has changed the way people interact with the investment process. With the rise of the blogger-analyst, we’re witnessing the disintegration of the large, influential publication. It’s being replaced by the fragmentation of investment advice, provided by numerous voices, each with a different field of expertise. While it’s become harder to stay abreast of everything amid the deluge of information, atomization of content has been a boon for investors. It means that content is being produced on such a precise scale that there is counsel for everyone. It’s no longer one size fits all. This enables the automation of personalized, professional investment advice by a second generation of financial websites. The medium doesn’t matter; this advice is being delivered through a variety of means, including video. Timing has been perfect—in the wake of a decade of nonexistent investment returns, investors are demanding more active tools to manage their portfolios. It’s getting really interesting out there. Tradestreaming is the future, and it’s here today.

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Introduction 1. Brad Barber and Terrance Odean, “The Courage of Misguided Convictions: The Trading Behavior of Individual Investors,” Financial Analysts Journal, November/December 1999. The researchers turned to behavioral economics to try to explain deviations from rationality and what causes investors to make mistakes. They found that the human desire to avoid regret influences investors to sell their winners too early and that investor overconfidence causes investors to trade excessively. 2. John Bogle, Testimony before the United States Senate Governmental Affairs Subcommittee on Financial Management, the Budget, and International Security January 27, 2004 Bogle is not an unbiased source of information. His firm, Vanguard Investments, manages approximately $1 trillion, primarily through its family of index funds. Bogle helped pioneer index investing, founding Vanguard in 1975. He believes that trading costs and excessive management fees, combined with trying to time the market, are ruinous for investor returns. Indexing was Bogle’s solution to historical underperformance. 3. Barber and Odean, “Courage of Misguided Convictions,” 8–15.

Chapter 1 1. “Scale Economics,” 9 January 2009, www.avc.com/a vc/2009/01/ scale-economics.html. Fred Wilson discusses scarcity in the context of online advertising. He posits that with the bull market in content online, advertisers have moved from an environment of scarcity—marked by limited ad inventory and high prices—to abundance—characterized by too much ad inventory pushing prices consistently lower. While all this hurts traditional advertising-driven websites, it benefits social media

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properties with plenty of page views to sell and improving technology to pinpoint ad targeting. Robert Fagin, personal interview, Summer 2009: “Investment banks have a huge network of people that investors can speak to. Banks and firms can no longer selectively disclose impactful information to select clients. What is allowed, as we’ve moved to fair disclosure, is the sharing of opinions within a firm. As an equity analyst, I can provide huge value by asking a sales trader how a particular stock is trading, what the bonds are doing, and how investors are using options to play out a thesis. All this has become a very sophisticated offering and this is a trend that’s continuing on Wall Street. We’ve moved away from a heavy focus on stocks and even famous stock pickers are paying attention to so many moving parts now.” “July 2009 Web Server Survey,” 28 July 2009, http://news.netcraft.com/ archives/2009/07/28/july 2009 web server survey.html. David Jackson, personal interview, 9 August 2009. “People started writing blogs where they were writing for free and not making any money. You can ask ‘why?’ but that’s a fact. They want to write. That’s what they do. You want to do it because it’s fun, it gets you into conversations with people, it provides business leads, furthers your career, but really, it’s just fun. Bloggers are not into it to become journalists. Most bloggers would make more money flipping burgers. If you can be real and expose to people how you think about things, people will seek you out.” Chris Anderson, “The Long Tail,” Wired (October 2004), www. wired.com/wired/archive/12.10/tail.html?pg=1&topic=tail&topic set=. Anderson made a big splash with his long tail article and subsequent book. Wired’s editor describes the long tail in the context of ecommerce: where businesses have inventory—real or virtual—and customers actually pay for things. I’ve extrapolated his framework to the financial content space. The explosion of the financial blogosphere is similar to Anderson’s description of customers’ unlimited selection when it comes to buying books or music online. As opposed to the periodical model—a one-size-fits-all compilation of investing news—the long tail of financial content assures that there is analysis written for everyone seeking it, no matter how niche. These low-trafficked and high-value blogs are filling the holes traditional media and research left behind. Mick Weinstein, personal interview, December 2009. Jamie Hammond, personal interview, December 2009. Reuters is making a big move into commentary. In 2009 it hired Felix Salmon from Portfolio.com to spearhead Reuters’ branded commentary. Salmon is one of the most notable financial bloggers and writes about

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everything from hedge fund compensation to industry regulation to exotic derivatives. Just recently Reuters announced a much-rumored purchase of financial blogging group Breaking Views. 9. Nielsen NetRatings provided to me by Seeking Alpha’s David Jackson. 10. SeekingAlpha.com, “Our Contributors,” http://seekingalpha.com/page/ our contributors.

Chapter 2 1. “GLG—Strategically Focused on Opportunities,” Barclays Capital (February 2009). 2. Robert Kosowski, Narayan Naik, and Melvyn Teo, “Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis,” Journal of Financial Economics Vol. 84 (2007): 3. 3. Ravi Jagannathan, Alexey Malakhov, and Dmitry Novikov, “Do Hot Hands Exist Among Hedge Fund Managers? An Empirical Evaluation,” National Bureau of Economic Research (2006): 37. “Relative performance persistence over a three-year horizon, that is, that managers with higher estimated alphas in one three-year period tend to have higher estimated relative alphas in the following three-year period.” This study flies in the face of supporters of the Efficient Market Hypothesis. Other research has shown that hedge funds return 1% of alpha on average. While previous research on hot hands disparaged the mutual fund industry, the outtakes of this study could theoretically be applied to that industry. If that’s the case, mutual fund underperformance could be driven by fee structures or conflicted incentives—outperformance brings in new assets which forces money managers to buy stocks they have less conviction in, resulting in eventual underperformance. 4. Robert Kosowski, Narayan Naik, and Melvyn Teo, “Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis,” Journal of Financial Economics Vol. 84 (2007): 3. 5. Sanford Grossman and Joseph Stiglitz, “On the Impossibility of Informationally Efficient Markets,” American Economic Review 70 (1980): 393–408. Gerson Lehrman Group’s expert model monetizes gaps in information diffusion. In specialized fields, information is less liquid and the velocity of its transmission slows way down. GLG makes a lot of money because it matches demand for discrete information with the few sources of it. 6. Scott Patterson, Kara Scannell, and Geoffrey Rogow, “Ban on Flash Orders Is Considered by SEC,” Wall Street Journal, 5 August, 2009, http://online.wsj.com/article/SB124940289965505053.html. 7. Ibid.

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8. Nina Mehta, “Flash Point: Equities Industry Clashes Over Flash and Stepup Orders,” Traders Magazine (July 2009), www.tradersmagazine.com/ issues/20 296/-103978-1.html?zkPrintable=true. “The primary argument against flash orders is that they create private markets and are therefore a step back for market structure. These programs are creating a private locked market for a small group of participants, and they are holding up the execution process for that marketable order. . . . Our issue is that this creates a tiered market.” 9. “Form 13F—Reports Filed by Institutional Investment Managers,” SEC.gov, www.sec.gov/answers/form13f.htm. 10. “Schedule 13D,” SEC.gov, www.sec.gov/answers/sched13.htm. 11. Gerald Martin and John Puthenpurackal, “Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway,” 2005. 12. Ibid., 34. 13. Ibid., 2. “This indicates the market under-reacts to the initial information that Berkshire Hathaway has bought a stock and is slow in incorporating the information produced by a skilled investor. . . . The market reacts positively and significantly to the public disclosure of an initial Buffett stock investment so the information produced by such a skilled investor does appear to be incorporated rapidly into stock prices: however, the market under-reacts to this information since investors who mimic the portfolio after it becomes publicly known are still able to obtain significant positive risk-adjusted returns.” 14. Mebane Faber, “What Stocks to Clone?” AlphaClone.com, http://blog. alphaclone.com/alphaclone/2009/07/what-stocks-to-clone.html. 15. Randolph Cohen, Christopher Polk, and Bernhard Silli, “Best Ideas,” 2009. 16. David Blitzer, “The S&P Equal Weight Index,” 8 January 2003, www2. standardandpoors.com/spf/pdf/index/SPEWIWhitePaper010703.pdf. 17. Kosowski, Naik and Teo, 15.

Chapter 3 1. “Rivel Research Study Reveals Evolving Role of Sell-Side Analysts”, Reuters, February 26, 2008,