Saturday, December 9, 2017

Book review: "Long-Term Front-Running" by Michael Fritzell

Many stock traders try to make money by predicting the immediate future: Will tax reform spark a stock-market rally? Will Apple beat earnings estimates next quarter? Et cetera.

Long-Term Front-Running suggests a different tack: instead of guessing at the near future, investors should try to predict which companies will take off in the next few years and buy their stocks before other people catch on. By getting in before the crowd, they'll benefit both as the company's earnings rise and as investors catch on to the story and award the company a higher price/earnings multiple. In my experience, the best-performing stocks are usually a product of those two things paired together, so investors who look for “compounders” should find the book interesting.

Short-term traders should also find it interesting. Trading off immediate events can induce tunnel vision and make one's trading strategy essentially reactive. Looking past the near term should give traders both more perspective and less competition.

A big strength of Long-Term Front-Running is its versatility: it discusses both corporate fundamentals and investor sentiment, both macroeconomic and company-specific events and processes, etc. It also touches on the importance of “reflexivity,” i.e. how perception can affect reality in the financial world and create positive feedback loops.

Unfortunately, in a way the book's versatility is also a drawback. Since it covers a lot of ground in just 100 pages, its specific ideas are mostly rules of thumb, i.e. guidelines on what to do in typical situations. And as I get more investing experience, I've come to believe that many of the best investment opportunities involve atypical situations.

For instance, Fritzell writes that “The best time to bet on a commodity is when inventory is tight; future supply is likely to be low while demand is racing ahead.” This is generally true, but the shale-drilling revolution provides a counterexample. There have been times in the recent past when natural gas inventories were low, yet prices didn't rise. The shale revolution seems to have overwhelmed the traditional relationship between inventories and future prices.

Lest I seem too critical, I'll say that I enjoyed many of the book's rules of thumb. For instance, it includes a checklist for identifying corporate fraud that I found very useful. I also liked its case studies, particularly the one about Delclima, an Italian HVAC manufacturer that began life as a neglected spin-off but soon became a stock market darling.

Notable and quotable

To give you a flavor of the book, here are some of my favorite passages:

The potential to tap future customer demand can be summarized in the term “consumer surplus.” It can be defined as the difference between the price customers are willing to pay and the what the product costs. If there is a huge gap, then the company is potentially sitting on a goldmine.

Return on invested capital itself is not a useful metric: it often reflects a cyclical peak in the industry or the mature phase of the ramp-up of a particular technology.

Products that aren't particularly functional – Tamagochi, baseball cards, Beanie Babies, etc. - are fun for a while but we usually get tired of them. If the product is fashionable and also serves a real functional purpose – for example UGG shoes or Canada Goose jackets – they may survive for a longer period of time.

(In my opinion, this mix of fashion and function explains much of Apple's popularity. Apple's smartphones cost much more than competing phones—they clearly have a fashion premium. Yet they're also cheaper and more functional than what preceded smartphones—the iPhone is like a mobile phone, laptop, digital camera, watch, and GPS rolled into one. The combination of so many things in a convenient device lets people justify paying the fashion premium.)

Not every company is able to take advantage of industry growth... in a commodity industry, ruthless competition may take away most of the opportunity for gain, despite a solid underlying growth trend.

Sometimes people criticize new technology due to certain weaknesses but fail to realize that those weaknesses will disappear over time. Online streaming in the early 2000s was unbearably slow, but with the spread of fixed broadband, online streaming was almost certain to take off.

High credit growth not only pushes money into the stock market, it also improves the value of assets used as collateral in loans, improving creditworthiness and fueling further credit growth.

Whenever a particular method of investing becomes popular, flows into that strategy start to accumulate. Those flows can by themselves help that strategy perform and attract further inflows.

1 comment:

  1. As I write this, the book appears to be sold only as an e-book:

    Hardcover copies aren't available yet AFAIK.