MICC Journal April 2011

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The MICC Journal

Volume 3, Issue 2

Mutual Investment Club of Cornell Monthly Newsletter Apirl 3, 2011

1

A Random Walk Down The Human MindBy Ali Yazdi

When Eugene Fama galvanized the Ef-

cient Market movement in the 1960s

his work went largely unchallenged

until the 1990s, and the Efcient Mar -

ket, a notion that suggests monkeys

throwing darts at the Wall Street Jour -

nal have just a good a shot as anyone

else in outperforming the market,reigned supreme. During this time

though, if you had been with Warren

Buffett in 1964 when he bought Berk -

shire Hathaway for $11.5 a share, you

would, on December 13, 2007, have

made $13,043 for each dollar invest-

ed. Thus, unless we are to attribute

Buffett’s amazing returns to pure luck,

we have to ask ourselves if the Ef-

cient Market Hypothesis truly holds.

So as is my duty as a member of

the investment community, I will

set out in the course of these next

400 words to try and suggest that

MICC and Wall Street is not just a

bunch of people wasting their time

with the work of monkeys. In fact

for you, the individual investor, I will

try to illuminate some of the more

interesting aspects of the market.

The contrarian investor is a man who

lives life on the edges. The Clint East-

wood of investors, he buys when ev-

eryone is screaming sell, and although

I love Clint Eastwood, the numbers

since January 3rd, 2000 suggest if

the good old contrarian had bought

whenever the S&P had been down

over the past twenty days or sold if

the S&P had been up, he would have

been 1332 times correct to 1480

wrong. Of course, such numbers sug-

gest the market is pretty random right?

Well, here’s where it gets interest-

ing. Let’s control for every time the

market has been up 4% over the

past twenty days. With these param-

eters, the market goes down over the

next twenty days at a count of 177

in comparison to a count of 294 for the market to continue upwards. In

this case, our poor Clint Eastwood

contrarian investor would have been

absolutely slaughtered as the mar -

ket continuously churns upwards.

So I could stop here, throw a few

citations in, do some studies, adjust

my vernacular to the “you will be

asleep in two minutes” mode, and

bam…Nobel Prize. I’m suggesting

when the market has been up signi-

cantly (in this case ~4%) the market

wants to continue up. Follow the

trend, right? Yes, but denitely no.You see, when we take out those

days when the market has been up

4% in the past twenty days, we see

that 1186 times the market goes in

the same direction and 1155 times

it reverses directions. Almost a dead

heat. Now, let’s go deeper and see

what happens when we only look

at the returns over the next twenty

days, when over the past twenty days

the market has dropped between 7

and 18%. Magically all of a sudd

the contrarian investor is a sheer g

nius as the market reverses directi

and goes up 121 times in comparis

to 93 times it continues downwar

The returns come out to 0.39%

prot per trade, which is really ne

to nothing, but if you could guar

tee yourself 0.39% in returns for t214 trades where those criteria we

met, you would be sitting with ov

a 100% gain compared with an 1

loss over that time period in the S

Now calm yourself over there, b

cause the next argument is where t

true money lays. When we look

the 214 times when the market

been down between 7-18%, we s

that the average move of the marover the next twenty days comes o

to an outstanding 6.73% move. If

did a buttery option with wings b

ginning ±6 from the current price w

would have made roughly 8000 d

lars at roughly 40 dollars per tra

Thus, to sum it all up, the market lov

following the trend and optimi

when it’s climbing upwards, but wh

it goes down, it goes down fast, ait gets chaotic, but ultimately the co

trarian wins in the end. So when you

investing in the market, go ahead a

take a Clint Eastwood stand w

the market is down 10%, but stay

the bandwagon when it is going

Why is this the case? Just take a r

dom walk down to a MICC meet

Total Up

(>4%)

Total w/

Col II

Down

(7-18%)

Moves

Same

Direction

1480 294 1186 93

Reverses

Direction

1332 177 1155 121

Contrarian

Success

Ratio

0.901 0.602 0.974 1.301



By Abhishek Shah

A Year-To-Date Look at the MICC Portfolio (as of 4/5/11)

Overview YTD 3 Mo 6Mo

Por tfolio ▲1.7% ▲1.4% ▲5.0%Por tfolio (excluding cash) ▲2.4% ▲2.0% ▲7.1%

S&P 500 ▲6.0% ▲4.6% ▲14.8%

Dow Jones ▲7.1% ▲6.0% ▲13.3%

NASDAQ ▲5.1% ▲2.9% ▲16.2%

A Look at Some Portfol io Updates

Buy, Buy Buy!

In the last week of March (3/28 – 4/1), several

acquisitions approved by the members of the club

were executed. This consisted of positions in Archer

Daniels Midland (ADM), Safe Bulkers (SB), Walt Disney (DIS), Vestas Wind (VWDRY), Scana (SCG), Otter Tail

(OTTR), and Gilead Sciences (GILD). In total, our

presence in these positions is roughly $18,800. This

corresponds to roughly 32% of the portfolio and 45%

of invested assets. Due to this, the overall composition

of our portfolio has been significantly changed. (P/E has

decreased from 14.5 to 11.1 while ROE has doubled

from ~13).

Where Will iGo (IGOI) Go Now?

Looking at the second chart on the right, the blue line

represents the extreme volatility of iGo’s stock price in

the last 3 months (went from a 30% gain YTD, to a

30% loss YTD). Our position in iGo is relatively small,

so there wasn’t a great loss to the portfolio. However,

this combined with the recent (significant) additions

may signal that it is time to reevaluate our current

positions. If it looks like iGo will pop back up from its

recent decline, should we increase our positions to

capture this upside? On the other hand, it may make

sense to cut our losses / realize our gains in other positions. Whatever the case, our sector analysts are

monitoring our positions to maintain and grow our

capital.

A Look at Future Earnings

April 20: UNP

April 21: PMApril 26: TSYS

Por tfolio Per formance Year-To-Date

The portfolio has experienced much less volatility than the

markets in the first three months (which can be seen by thesteep drop in mid-March). Recent acquisitions have been made

to capture market upside.

Major Winners and Losers

Overall Weighting in PortfolioIncluding Cash Excluding Cash

BCO ▲24.55% 4.03% 5.60%

EM ▲20.75% 2.53% 3.52%PM ▲11.58% 3.37% 4.68%

CSCO ▼14.52% 2.47% 3.43%

HXM ▼16.50% 2.91% 4.04%

IGOI ▼27.33% 1.42% 1.98%(BCO: The Brink’s Company, EM: Emdeon Inc., PM: Philip Morris Intl. Inc.,CSCO: Cisco Systems, Inc., HXM: Homex Development Corp., IGOI: iGo, Inc.)

Key Portfolio Statistics (Excluding cash reserves)

P/E forward: 11.11

P/B: 2.17

ROA (Return on Assets): 7.30

ROE (Return on Equity): 26.19

Yiel d %: 2.36%

Beta 1: 1.11

Avg. Market Cap: $9,874.82 MM

Note1: Calculations for beta excluded HHC and EM.



Inefcient Markets and the Closed-End Fund PuzzleBy Peter Cui

There comes a crucial moment in ev-

ery Cornellian’s life when one must

take a side on the efcient markets

debate. The closed-end fund phe-

nomenon may offer the ammunitionyou need to defend your position.

A closed-end fund is a mutual fund

that typically holds other publically

traded securities. However, it is-

sues a xed number of shares and

trades like a regular stock. It has no

xed liquidation date, so normally

an investor must sell their shares to

other investors rather than redeem

them with the fund itself for the netasset value (NAV) per share. The

truly perplexing feature of these

closed-end funds is that, when they

are rst formed, they typically trade

at a 10 percent premium to NAV,

but within half a year, drop to a

discount of 10 percent. Preposter -

ous–where are the arbitrageurs?

Furthermore, after a closed-end

fund announces a liquidation date,or their intention to become open-

end, the price on their shares ap-

preciates to eliminate the discount

to NAV. In light of this, one could

seemingly create a perfectly hedged

arbitrage by simply buying the fund,

and shorting the underlying as-

sets. Then one just sits tight until

the fund opens, and pockets the

spread. At least, that’s what the ef -

cient markets hypothesis wouldpredict. What could be amiss?

The price behavior of closed-end

funds have traditionally been attrib-

uted to three factors: agency costs,

restricted stocks and capital gains

tax liabilities. Intuitively, sufciently

high agency costs, or management

fees, could cause discounts. How

ever, management fees are typically

a xed percentage of NAV and thus

cannot account for the wide uc-

tuations in the discount rate or why

funds start off at a premium. The oth-

er two explanations face similar dif -

culties when evaluated against theevidence, and even all three, taken

collectively, fail to explain our puzzle.

This puzzle was again tackled from

a behavioral nance approach in

1990 by Delong, Shleifer, Summers,

and Waldmann (DSSW), who devel-

oped a model involving both rational

investors that trade only on funda-

mental information, and noise trad-

ers that trade for any other reason.

First, to explain the lack of arbitrageurs,

DSSW make the assumption that ra-

tional investors have nite time hori-

zons, which implies they care about

resale value as well as the present

value of dividends. This assumption is

realistic. After all, portfolio managers

face periodic evaluations, individuals

have liquidity needs for selling, and

there exist borrowing costs on as-sets, notably those associated with

short selling. DSSW then assumes

noise traders’ sentiment cannot by

perfectly forecasted. Under these

two assumptions, the unpredictability

of sentiment adds additional risk on

the assets commonly traded by noise

traders. For example, at a time when

an investor might want to sell an as-

set, noise traders might be par ticular -

ly bearish about it. As long as rationalinvestors have nite time horizons,

this risk is every bit as real as the fun-

damental risk of low dividends. As a

result, arbitrageurs with nite time

horizons face costs and risks that pre-

vent them from taking on sufciently

large positions to eliminate the dis-

count. As John Maynard Keynes once

joked, “Markets can remain irrational

longer than you can remain solvent.”

Furthermore, empirically, there ex

ists signicant correlation on the dis

counts across closed-end funds, as

well as between closed-end funds

and small cap stocks, both of which

have a larger composition of individual stockholders as opposed to insti

tutional. Since noise trader sentiment

is systemic, being correlated across

noise traders and assets, therefore

noise trader risk, like fundamenta

risk, will be priced in at equilibrium

One nal element is needed to ap

ply the DSSW model to closed-end

funds: differential clientele. There is

much empirical evidence to suggest that closed-end funds are owned and

traded primarily by individual inves

tors. Lee, Shleifer and Thaler (1991

found that in a sample of closed-

end funds, the average institutiona

ownership was only 6.6 percent. In

comparison the average institutiona

ownership for a random sample from

the smallest decile of NYSE stocks is

26.5 percent, and 52.1 percent for a

sample from the largest decile. Thisevidence reinforces the conjecture

that the sentiment affecting closed

end fund discounts also affects other

asset classes such as small cap stocks

The critical insight to be drawn from

differential clientele is that individua

investors, more prone to trading

closed-end funds than the underly

ing assets held, are responsible for

greater noise trader risk in theseclosed-end funds than in the un

derlying assets. As this noise trade

risk is priced in equilibrium, closed

end funds will actually be more

risky than the underlying assets, so

investors on average will demand

a higher risk premium! The DSSW

model also explains why closed

-end fund prices appreciate when a

(continued on page 4)

3



(continued from page 3)

a liquidation or opening date is an-

nounced to reduce the discount

to NAV, as arbitrageurs can hedge

and earn the spread within a guar -

anteed time horizon. Finally, the ir -

rational exuberance attributed

to noise trader sentiment ex-

plains periods where these funds trade at a premium to the NAV.

While the DSSW model does not

point to any risk-free arbitrage op

portunities, it does suggest several

interesting results. Lee, Shleifer and

Thaler (1991) believe these discounts

are a sentiment index for individual

investors, the same sentiment affect-

ing returns on other assets held and

traded primarily by noise traders. Fur -

thermore, as the same investor senti-

ment causes additional noise trader risk for small cap stocks, they must

also be underpriced relative to their

fundamentals! This would explain the

famous historical result that small-

cap stocks provide excess risk-ad

justed returns over larger cap stocks

To conclude, dear reader, the next

time you are accosted by the efcient

markets hypothesis, simply whip out

the closed-end fund puzzle. To add

extra weight to your argument, drop

a few names like Andrei Shleifer andRichard Thaler, economists extraordi

naire. In my experience, though, some

times it’s more fun just to play along

Visit us online:

www.cornell-micc.com

4

MICC’s Interview Questions

Q. A windowless room has 3 lightbulbs. You are outside the room

with 3 switches, each controlling one of the lightbulbs. If you can

only enter the room one time, how can you determine which

switch controls which lightbulb?

T u r n o n t w o s w i t c h e s ( c a l l t h e m A a n d B ) o n a n d l e a v e t h e m o n f o r a f e w m i n u t e s . T h e n

t u r n o n e o f t h e m o f f ( s w i t c h B ) a n d e n t e r t h e r o o m . T h e b u l b t h a t i s l i t i s c o n t r o l l e d b y

s w i t c h A . T o u c h t h e o t h e r t w o b u l b s ( t h e y s h o u l d b e o f f ) . T h e o n e t h a t i s s t i l l w a r m i s

c o n t r o l l e d b y s w i t c h B . T h e t h i r d b u l b ( o f f a n d c o l d ) i s c o n t r o l l e d b y s w i t c h C .

The Economic Implications of the Crisis in JapanBy Ihsan Kabir

On Friday March 11th, Japan suffered

one of the worst natural disastersever witnessed in history. Not only

did a 9.0 earthquake, with its epi-

center less than 50 miles from Japan

rock the country, but a tsunami with

waves over 15 feet high struck the

coastline as well. Soon after, multiple

nuclear reactors around Japan broke

down, causing nuclear radiation aler ts

and power shortages. Around a

month later, the economic implica-

tions are becoming increasingly clear.The most pressing concern is the

supply of electronic parts, followed

by the shortage in supply of cars.

In today’s society, Japan provides

much of electronic parts required in

the electronics sector. For instance,

according to The Economist, Kureha

provides a polymer integral to the

construction of the Apple iPod bat- tery. Kureha owns 70% of the market

for this polymer, and they have ex-

perienced severe shortages in their

product due to considerable dam-

age in one of their plants. According

to the Wall Street Journal, American

based companies, such as Fusion

Trade Inc. are struggling to keep up

with the increased demand that re-

sulted from many of Japan’s compa-

nies having to scale back on production. Texas Instruments has had to cut

back on production, as has Toyota.

Companies around the U.S. have had

to pay their workers overtime to

keep up with the demand, but this

is clearly not sustainable. Eventually,

the supply of these materials will fall

Consequently, we will experience

what is known as cost-push ina

tion. Due to the shortage in supplyof electronic and certain consume

goods, companies will have to reval

ue their products in order to satisfy

the demand. The overtime hours that

the workers have to work in orde

to produce this newfound demand

simply is not sustainable, and eventu

ally the extra hours will catch up to

them. As a result, we will have to start

looking at higher prices on items

ranging from TI-89 calculators to theToyota Corolla. American companies

simply do not have the required re

sources to keep up with this new

level of demand, and, until Japan re

covers, we will face increased prices

Documents

MICC Journal April 2011