Archive for August, 2006

Paul Notari on confronting the Oil crisis

If you’re wondering about how the US should deal with the looming oil crisis, Paul Notari wrote an excellent overview on RE Insider this week.   His prescription for the US is exactly what we need.

High oil prices are starting to move us in the right direction, but not nearly fast enough.  We need to take action before Adam Smith’s invisible hand forces action on us, through demand destruction.  Demand destruction is a nice way of saying that when gas hits $20 a gallon, people will start taking their bikes to work because they can’t afford to do otherwise. 

Economists who pooh-pooh peak oil becase “demand destruction will take care of the problem” are forgetting the human element: demand destruction is incredibly painful.  We need to take proactive steps to solve the problem, such as those outlined in Paul’s article, or the problem will be solved for us… and it will hurt.  A lot.

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Green Energy Stock Challenge

It’s official; I’m not the “Ultimate green tech investor.”  That’s according to www.GreenTechInvestor.com, who ran a fantasy stock trading game from mid June to mid August this year.  I participated, and did end up being one of the winners (I turned my fictional $200,000 into an equally fictional $775,000 in the two months the contest ran.)  I think I won a book.

For readers expecting a sour-grapes rant, yes, I would have liked to have won the electric car.  What green-blooded techie wouldn’t?  But that’s not what I want to talk about.  I want to use this stock trading game as a cautionary tale:

Stock trading games are not the real world.  They are games.  Please, do not let success in trading games make you think that you know how to deal with the real, live, stock market.  If you do, you are just begging to lose money.

Returns like mine, and the ultimate winner, Russ Michaud, are not achieved through investing skill.  I achieved my returns by manipulating flaws in the trading game, and I believe he did as well.  In the real world, the best investors may have returns of 20% to 100% in a single year, depending on how much risk they take on, but over the long term, this can never be sustained.  The only person in Forbes top ten list of the wealthiest people in the world to have made his money by investing is Warren Buffett (number two), and his average returns over time have been around 20%.  At 20% annual returns, it would have taken over seven years to turn $200K into $775K, which I did in 2 months in the trading game, and I wasn’t even in the top five players.  Buffett, on the other hand, is the top player in the real investing world.

Stock trading games are not like the real stock market.

Here’s how they differ:

  1. In stock trading games, no matter how much of a stock you trade, it goes through at the most recent price.  In the real world, you buy at the ask (which is higher) and sell at the bid (which is lower), and if you are making a big trade, the price will probably get worse for you (higher when you’re buying, lower when you’re selling) in the middle of your trade
    1. In the game, I was frequently trading over 1,000,000 shares of stocks with average daily volume of just a few thousand shares.  I probably traded more shares of several stocks than had traded over the entire life of the company.
    2. Russ, who won the electric car, said in an interview “My winning strategy keyed on playing the smaller ‘penny stocks’”—penny stocks are very low volume, so it would have been impossible for him (as it was for me) to replicate his trades in the real world.
    3. The reason we were both trading penny stocks is that the lack of trading means that penny stocks are often mispriced by a large margin.  Mispricings are what allow investors and traders to make excessive returns.  The difficulty in trading these stocks means that it is not very profitable to try to trade on these mispricings in the real world.
  2. It’s not real money.  The hardest part of investing successfully is the psychological element.  Human nature is to get out when things look very bad, and pile in when they seem good.  An investor who wants superior returns needs to get in when most people are (wrongly) too scared to invest, and get out when everyone else is euphoric.  This is emotionally very hard to do, and it becomes much, much harder when getting it wrong means your child isn’t going to go to college, or you’re never going to be able to retire.

Take-home message: Stock trading games may be fun, and you may win an electric car (or a book) if you know how to manipulate the system, but it’s lousy training for the real world of investing.

9/19/06: Collision or Convergence  (Wiley Finance)  My book showed up.  This is it:

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Water and energy

Last month, several nuclear power stations in Europe had to shut down during a heat wave (and consequent period of extreme electricity demand) to avoid releasing overheated water back into the environment.  As many other astute observers have pointed out, this pokes another big hole in the arguments that nuclear is our best choice of carbon-neutral generating technology.  A power plant that goes down precisely when you need the most power is almost useless for the current grid.

It also brings up the broader point of the role of water in electricity generation.  Nuclear is not the only technology that uses water for cooling.  Coal plants, including “next generation” IGCC plants mostly use water for cooling (air cooling can be used, but it makes them less efficient, and hence more expensive to run, and is seldom used in practice.)

This is a problem because water, in most countries is under-priced.  Resources that are under-priced tend to be overused, since the user does not have to bear the full cost of supply.  This is the cause of a large number of ills, such as the drying up of the Aral sea due to irrigation for cotton farming.  It is not only poor countries who don’t have enough water.  In the US, mispricing means that almost every aquifer is being pumped at much faster than sustainable levels.  In this context, it seems certain that power plants are also paying too little for the water they use for cooling.

 With a looming need to increase farming to supply biofuels, it is more important than ever that water be priced appropriately, especially in planning scenarios for power plants.  When water is under-priced, generation technologies which use more water are likely to be inappropriately favored in comparison to technologies which use little or no water for generation.

 Like nuclear, thermal electric systems are usually water cooled.  Fossil-fueled power plants account for approximately 39 percent of the water used in the United States, second only to agriculture. For coal plants, this typically amounts to 3 gallons of water (Texas study) or 0.5 gallons (NREL study) for every kWh produced (25 gallons are used for cooling, but only 3 evaporate in the process).  Nuclear, Biomass, and Oil fired plants also require large amounts of water lost as steam in the cooling process.   Some Solar thermal technologies also require significant water for cooling.

Water use by large hydropower projects is more complex, since water in reservoirs is more useful for some purposes (recreation) but often less useful for wildlife.  However, there is no question that reservoirs increase evaporative losses.  An NREL study quantifies these losses in the US.  Overall, in the US evaporative losses average over 18.2 gallons per kWh of hydroelectric power generated.  These numbers vary widely depending on the reservoir, from 2-3 gallons per kWh in cool northern states, up to over 100 gallons per kWh in KY, OK, SD, and WY.  Keep in mind that a lot of these reservoirs have other uses besides power generation, such as storing water for dry seasons, but the numbers can be mind-boggling.

Technologies which use little water include gas turbines (both natural gas and gas from renewable sources such as landfill gas), and geothermal (the water is typically re-injected into the ground).

Wind, photovoltaic, and wave power require no water to generate electricity. 

Energy efficiency, by its nature, uses no water.  Readers will recognize that as an ongoing theme: Given the choice, it is better to avoid using a kWh than it is to generate a kWh (regardless of source… even renewables have environmental impact.)

Renewable energy advocates should also be advocating for more rational water pricing, especially in planning scenarios.  Water use in generation will eventually come to be recognized as a significant cost (and source of uncertainty, as France found out last month).  The sooner this happens, the better for everyone.  Pricing water properly will not only save water, it will help move us to renewable energy technologies.

Investors may do well by concentrating their investments on low water use technologies, especially in parts of the world where water is (or will soon be) scarce.

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Contrarian Investing is Hard

I just came across an apparently defunct blog (no posts since June.)  It’s called Big Mike’s contrarian investing blog, and it seems that he advocated a lot of the same things I was recommending to clients.  The difference is that my clients are still in them… I have my doubts about Big Mike and the readers of his blog.

 [9/4/06 Note: It seems like my guesses about Big Mike were off the mark…  see his comment below.  Regardless, I stick by what I say about investor psychology… the best time to buy is often when things are most discouraging.  And that is precisely when it’s hardest to buy… or  recommend someone else buy.  ]

 For those of us who were commodity bulls in this spring, times seemed tough.  To be a successful contrarian, you need to keep the long perspective.  As Jonathan Graham said, “In the short run, the market is a voting machine, in the long run, it is a weighing machine.”  If you invest based on fundamentals, you have to be ready for the market to turn against you for months or years.  I’m get the feeling that Big Mike, despite his MBA, BS in economics, and 6 week stint as a broker, did not have the financial or emotional resources to stick it out when the votes started going against him.

John Maynard Keynes once said “The market can stay irrational longer than you can stay solvent.”  Big Mike seems to be a case in point.

The moral of the story is that you should never invest money that you need to fund your current expenses.  If you place money into an investment because you know that the long term prospects of that investment are good, you have to be willing and able to leave that money there for the decade it might take for the market to stop voting and start weighing again.

Gold’s nowhere near the $730 an ounce it hit in May, and Oil is not much better (ditto for alternative energy stocks), but for those of us who feel certain that the US$ is headed for the trashcan, and uncertainty and fear are only going to increase (which will be good for gold), and that Peak Oil is already showing its effects in the energy markets, the volatility this spring and summer were easy to bear.

Rules to keep in mind:

  1. Don’t invest on a hunch.  You have to have conviction.
  2. Don’t lose your conviction just because prices move against you.
  3. If the reasons you became convinced in the first place change, get out!

One last quote from Keynes: “When the facts change, I change.  What do you do, sir?”  (but don’t change unless the facts change.)

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High stakes decisions: Where to put your money, and mistakes to avoid

I’ve recently read two articles about the state of healthcare in the world today, one by speculator and libertarian Doug Casey, with a somewhat paranoid (but perhaps justified) view of the state of cancer treatment, and another in Business Week, about the lack of evidence based decision making in medicine today.  The underlying theme in both these articles is that medicine, as it is practiced today, shows a remarkable hostility in the medical establishment towards rigorous evaluation of therapeutic alternatives.

 

I see a parallel here between medical treatment and investment advice.  In both cases, the choice of expert is an extremely high-stakes decision: if your landscaper does a lousy job, you may have to replace a few dead shrubs.  If your doctor prescribes the wrong course of treatment, you may not wake up the next day.  An incompetent investment advisor may leave you unable to ever retire.

 

The extreme high stakes of these decisions can lead to us making worse decisions in the first place.  Combine that with the fact that, when it comes to expert services, it is very difficult for the customer to determine the value of what they are getting.  When we visit a doctor, we have no way to know if they are prescribing unnecessary tests or prescriptions, we only know our ongoing state of health, and as we often do not even know what the other alternatives are, we can’t compare the outcome from the particular course of treatment.

 

Similarly, we don’t know how good our advisor’s recommendation for portfolio allocation is until it’s too late.  He can show us fancy charts about how the portfolio has performed in different historical market conditions, but in the same breath, he’s obligated to tell us that “past performance is no guarantee of future results.”  Investing is more an art than a science, because it is impossible to perform a repeatable experiment; financial markets constantly change and adapt to new information, including to the results of past experiments.

 

That is not to say that superior investors do not exist, but the sad fact is that most investors and advisors truly believe themselves to be better than average.  The sad fact is, that even if everyone were honest with each other, we still wouldn’t know if we were competent investors ourselves, or if the people offering their advice were, either.  Worse, the only measuring stick we have is past results, which, I’ll repeat, are no guarantee of future returns.

 

It’s enough to make you throw up your hands in frustration and go home.  Which is exactly what people who advocate index investing suggest.   Indexers basically ascribe to the theory that if you don’t know if you’re buying rotten fruit, buy the fruit that you know is only lightly bruised, and pay discount prices.

 

I’m a great fan of discount prices, but most people do not have enough saves that they can afford to accept the slightly-below-market (because of fees) returns promised by index funds, especially since we have very little idea what those market returns might be.  Historically, stocks have returned around 10% depending on how you count, over the long haul.  However, current valuations look more like those typically seen at market peaks, and investors who buy at market peaks typically have to wait a decade or more to get their money back.  With this perspective, slightly-below market returns look much less appealing.

 

I feel that the biggest mistake we can make with our investments is to believe that we deserve a particular return, because that is what we need to reach our retirement goals.  This belief leads to chasing returns; moving money to a new manager/stock/fund/asset class because it has had the returns that we thought we were going to get in the manager/stock/fund/asset class we thought we were in.  This usually makes our problem worse.  Recent performance is just about the worst reason to choose an investment or manager.

 

What is a good reason to choose an investment or investment manager?

  • Because you are getting a good value: you should have an idea of what you are buying is worth, and be paying less than that.  This should be an absolute valuation (“apples are worth $1 a pound”), not a relative valuation (“apples cost less per pound than oranges”,) because relative valuations lead to us buying the least rotten apple on offer, when we should just keep our money in our pocket and look at the oranges.  When it comes to investment managers, most, in my opinion, are rotten apples.  If you do not have the time and patience necessary to decide if a manager is as good as he thinks he is, you’re better off indexing your investments in a low fee, no-load life cycle fund.  This is essentially what you’d be getting from most planners, and the bells and whistles some add on almost never justify the fees they charge.  As far as I’m concerned, with most financial planners, you’re essentially paying for hand-holding.  Following this logic, I first got into investing because I thought I could so better saving the 1-2% fees I would have been paying with an advisor and doing it myself.  

When should you switch investments or managers?

  • When the reasons you got in in the first place have changed.  If you chose an investment manager because you thought he had a methodology that would beat the market over the long term, if you later found out that he was picking stocks that he heard recommended on Mad Money (I actually think Jim Cramer’s a very smart guy- if a bit hyper for my taste- but even the best guru’s picks cease to be useful when too many people follow them… and Cramer’s worse than most in this regard because he makes stock picking fun… The best investments tend to be ones it’s hard to get excited about… because that means no one else is excited, either.)  On the other hand, if you chose a mutual fund because it has low fees, the time to switch is as soon as you find one with lower fees.

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Green REITs

I just read an article in Jetson Green where he talks about Wells Fargo’s recent investments in LEED certified buildings, and advocates more bank lending for green buildings.  This would be wonderful, but I don’t think banks are the best vehicle for pushing green building… their business tends to be too diffuse, and not concentrated enough in the real estate sector.

The companies who can really make a difference, and quickly, are Real Estate Investment Trusts(REITs), which allow individual investors to pool their money and invest in property under professional management. 

I don’t currently advocate investing in the real estate sector; I feel the real estate market is peaking or has peaked.  Better to wait a few years, and buy when property is cheap.  That said, here are some REITs I’ll be looking at when I feel it’s time to get back in to real estate:

Arden Realty, and Equity Office Properties, both of which have been singled out by Innovestas green REITs.  Trizec Properties, Inc., which is also becoming more vocalabout its green record.   According to Innovest, REITs which were active partners in DOE’s Energy Star program outperformed non-active partners and non-partners by 18% over the period from June 2000 to June 2002, so another good place to look would be an attempt to determine which REITs are corrently or are becoming active partners in Energy Star.

Related article about Trizec.

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What does all this environmental stuff have to do with investing?

Question: What do all these long postings about Ethanol, Biodiesel, Global warming, and CFLs have to do with investing?

TK: Superior investing arises out of having a deeper understanding of the companies and industries you’re investing in than other market participants. 

Global warming is not just an impending ecological disaster, it is an economic disaster as well. Understanding global warming, energy efficiency, and renewable energy are the first steps to protecting our financial assets from the effects of global warming and peak oil.   

Many consider it immoral to profit from disasters.  That is a recipe for going broke when the disaster hits.  When there’s a drought, I want to be able to pay my water bill.  If the water system shuts down, I want to be able to come up with whatever it takes to buy a few gallons wherever I can find them.

It’s sensible to use our investments to mitigate the problems we see on the horizon, and make a profit which we can use to help shield ourselves and those we care about from those problems when they arrive.  To do that, we have to understand the nature of those problems, and the possible solutions.

Causing disasters is immoral.  Preparing is the right thing to do.

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