The Art of Streetplay

Friday, August 19, 2005

Keeping an Eye on the Environment

If I have the ability to learn on an intimate level how one and only one industry operates, what sort of characteristics would I be looking for in that industry? For starters I've got a few ideas.

1. The total number of stocks trading in that industry; the more the better. This is because I would have the ability to make bets on a wider array of stocks; in other words, better breadth (thanks Alex). From a completely pragmatic point of view, a larger number of stocks increases my chance of finding one or two that are really really cheap witout having to move outside of my sphere of confidence.
2. The absolute correlation of the industry with the overall market; the less the better. If I have little ability to predict what the market will do going forward, do I want my investments to be driven by the market? I may know that the market generally has positive expected returns over long time horizons, but from a risk management point of view, that's a tricky argument to play. It's an unhedged risk.
3. The level of flux inherent within the industry; the more the better. Even if there were a ton of stocks in my industry, if they were all perfectly correlated with one another that wouldn't leave me with too much to work with-- arguably, the wider set of stocks would offer me little advantage in that scenario. Flux implies whatever steady state that industry will evolve into has yet to surface. This is the sort of environment in which fundamental analysis and critical thinking can be truly value added.
4. The market value of the industry; all else equal, the more the better to avoid possible capacity constraints.
5. The level of competition within the industry; the less the better. Small caps may have one fortieth the market value of large caps, the competition is also markedly lower, and reasonably so. For investors who don't have to worry as much about capacity constraints, one could make a few compelling arguments for why small caps may be a lucrative place to be.
6. The amount of insider buying within the industry; the more the better. This is a very nuanced subject which I won't go into here. I have issue with most academic studies on this topic because their academic techniques strip a lot of them of creativity and flexibility. There are a few great books written on this... but needless to say, the data is there to be inspected.

The cool thing is that literally all of the above factors can be quantified! I will attempt to lay out some actual numbers soon. God knows how helpful such an analysis would be, but it's definitely very doable, and for a stupid kid like me, it might actually prod me on to focus a little more on one particular industry in addition to the generalist individual stock stuff I've been doing up to this point.

Quantified or not, from a risk management point of view it may be of value to take a second look through your portfolio and ask yourself just what sort of environment your investments are living in... or whether you have a coherent investment paradigm in the first place.


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