The Microcap Speculator

Double or Nothing by Tom Breitling with Cal Fussman is a fascinating book about two best friends who parlayed their $105 million sale of Travelscape into a shot at their dreams — owning a Las Vegas casino and restoring the Golden Nugget to its prior glory. For entertainment value alone, its a great read, and its free at the above link. I started this on the train ride home the other night, and didn’t stop until I was done.

I am quite sure the authors never intended the book to have anything to do with trading. However, like most books touching on gambling, and in particular the mathematics behind gambling, there are important lessons for traders.

My favorite lesson involved a craps player nicknamed Mr. Royalty who took the Golden Nugget for over $8 million. The odds in craps are better than most games, and far better than some like keno, but the house still has an edge. For traders, think of this as a negative expectancy. Yet, despite the house’s edge, Mr. Royalty won an amazing twenty-two times in a row. The odds against that kind of streak, according to the authors, are a whopping 7,869,881 to 1!

As Mr. Royalty proves, streaks happen, even wildly improbable ones. The casino’s edge, or the trader’s setup, can only define probability. Edge does not and cannot define outcome over one or even a small number of trades. Edge only imposes its will over a large sample. The only way to stay alive long enough to let your edge prevail is to keep your risk per trade low.

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Several weeks of extensive business travel and the dismal on-time performance of American and United Airlines gave me time to read two recent investing books.

The first, Active Value Investing: Making Money in Range-Bound Markets by Vitaliy Katsenelson, is a deep exploration into the metrics that lead to superior stock performance in flat or even bear markets. Katsenelson stresses three factors: quality, valuation, and growth. The book provides very detailed methods for examining each factor. If you have had the pleasure of reading Marc Faber’s excellent book Tomorrow’s Gold, Active Value Investing will seem familiar. Katsenelson brings to a micro, company-specific level the same type of data-intensive analysis that Faber does on a macro level.

Though some of the specific methods outlined in the book, like Katsenelson’s valuation models, are better suited for larger, more mature stocks, many of the concepts he discusses are applicable to microcap stocks. For example, he urges investors not to think of P/E multiples as linear functions. Katsenelson emphasizes that multiples fluctuate as well as earnings. As a result, investors need to be cognizant about the potential for multiple expansion or contraction, as well as changes in absolute earnings. Highlighting this factor is just the beginning — Katsenelson backs up his analysis with decades of data demonstrating that multiples, across markets, tend to be mean reverting. In other words, high multiple stocks are likely to face compression over time, which can provide a stiff headwind unless the absolute earnings skyrocket. Low multiple stocks, in contrast, tend to benefit from multiple expansion, and therefore can increase in price without substantial gains in absolute earnings.

I learned quite a bit from my first read of Active Value Investing, and will undoubtedly learn even more the second time around.

I also enjoyed Tim Sykes’ An American Hedge Fund: How I Made $2 Million as a Stock Operator & Created a Hedge Fund, but for very different reasons. An American Hedge Fund is not a trading book; it is pure entertainment. Sykes gives a blow-by-blow recap of how he parlayed his Bar Mitzvah windfall into The Cilantro Fund. If you traded through the crazy internet blowoff, this book will be a fond trip through memory lane.

Sykes is very guarded about the insights he learned, perhaps saving those for his $297 DVD set. That is too bad. While he certainly has his critics, it is hard to contest that Sykes did a few things exceptionally well. First, at a very young age, he detected a viable strategy by focusing on the intraday price and volume patterns of thinly-traded stocks, especially their performance in the closing hour. More impressively, he realized exactly when that pattern stopped working, and correctly determined that its failure foreshadowed a failure in the overall market, leading Sykes to switch to the short side. There are also great lessons to be learned from Sykes’ mistakes. Perhaps his greatest error was throwing all discipline to the wayside and dumping a perverse proportion of assets into Cygnus, a pink sheets reverse merger that Sykes was overconfident about because he knew the company and its owners, and was permitted to participate in private funding deals.

I would have enjoyed An American Hedge Fund more if Sykes directly addressed the trading lessons he learned, and how he thought they could be applied going forward. Nevertheless, if you love the markets and enjoy reading about them, An American Hedge Fund will be a few hours well spent.

Book contest: Have a great stock idea? E-mail me with a description of the stock and your analysis of its benefits and risks. I will send a copy of Vitaliy Katsenelson’s Active Value Investing to the reader providing the best submission.

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What does Nassim Nicholas Taleb’s excellent book The Black Swan have to do with trading microcaps? The book, subtitled “the impact of the highly improbable,” focuses on the fact that events which should be highly improbable under the standard Gaussian (bell-curve) model actually occur with far more frequency than the model suggests.

Take the performance of microcap stocks. If I told you that a watchlist of microcaps was breakeven year-to-date, Gaussian distribution would suggest that the bulk of stocks would be clustered in the 0 to +/- 5% range, with far less in the +/- 6-15% ranges, maybe only a few in the +/- 16-25% ranges, and perhaps one or maybe none in the more than +/- 26% ranges (note: the numbers here have been simplified and, in an actual analysis, the ranges would be determined by standard deviation levels).

But our experience as microcap traders is far different. Many stocks we watch will double, or lose 50%. Those outcomes are not highly unusual, or even infrequent. Such extreme results are commonplace with microcap stocks, a phenomenon statisticians call the “fat tail.” As a result, mean-reversion strategies such as doubling-down are exceedingly dangerous on these stocks. Upside movement can also be extreme, rewarding traders who are patient about taking gains.

If we could tell in advance which stocks would be the doublers and which would be halved, trading would be easy. It’s not. We can all locate promising setups, but I believe it is impossible to predict which stocks will actually deliver on that promise. My money management strategy, which I will discuss in greater detail in an upcoming post, does not assume or require that predictive ability.

DISCLOSURE: Long one dog-eared copy of The Black Swan. Short one bell-curve.

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Note: what follows is an unsolicited shameless plug for a book I think is fantastic. I don’t get any money from the book sales but you should know that I’m not unbiased — I have great respect for the author and consider him a personal friend.

If you are a technical trader or want to learn more about chart patterns, this is the next book you should buy. Most books on technical analysis tell you what patterns are or why they tend to recur. “Trade Chart Patterns Like the Pros” is far more practical, telling you step-by-step exactly how one of the best traders I know trades each pattern (entries, exits, stops, etc.). Not all the patterns work with microcaps, but many will.

You can buy the book at his website: www.surinotes.com, or click on the book cover.

Authors: if you want me to review your book, let me know. I read voraciously, and will try to feature my favorite trading reads here from time to time. I never take any compensation, but if I like your book I’ll post a review and link like I did here.

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