Black Swans & The Lame Ducks

We all know what “Black Swans” are, at least in hindsight, but what about the “Lame Ducks” that we see every day? For example, Alcoa, the aluminium company, is down (-14%) this year whereas the Bank of America is up (+44%) this year. One is too big to eat (or not tasty at the present time) and the other, too big to fail, apparently. But they both have the same volatility risk and more or less the same investment risk. What, then, is the difference between these two companies? Why is one being bought and bid up and the other not?

The question becomes important because both companies are in the thirty companies of the Dow Jones Industrial Companies and Index (DJI) which is routinely bought and held in large quantities by the very largest investment interests such as the banks, insurance companies, mutual and hedge funds of all sorts, and the public and private pension funds. For example, just 5% of the current market retails for $200 billion which is a lot of money to throw around if one doesn’t really know how to do it. (Please see our Post, What’s a girl to do?, June 2012.) And if the volatility risk is the same, then one is as good as the other as far as they’re concerned. But even though the investment risk is also the same, we know the difference and have held neither all year and had double digit returns in the Perpetual Bond™ by simply knowing and respecting the difference. (Please see the Postscript.) Moreover, should any of the “Lame Ducks” suddenly become a “flight risk”, we’ll know that too and be in a good position to do what needs to be done, unlike our friends who are lurking in the “blinds” (also called, hopefully “alternative investments”) and the “bushes” (hedge funds), expensive cannons at the ready. (Please see our Posts, The Active Investor (DOA), November 2012, Volatility for the Delta Challenged, June 2012, and Hedge Funds Bushwhacked by Volatility, November 2012, for more background on this.)

The “smallest” company in the Dow is AA Alcoa Incorporated with a current market value of $8.6 billion (which is less than 1/10th of the average) and total assets of $40 billion and net worth of $13 billion (exceeding the market value) which doesn’t suggest a lot of investor confidence or “likeability” (please see our Post, The Price of Risk, August 2012, to understand “likeability”) for the stock or the “security” of its debt ($27 billion) which might make it hard to swallow, even at record low prices.

But still, the company goes on – it “paddles” and “floats” – and pays $128 million per year in dividends ($0.12 per share for a current yield of 1.4%) and, despite all of that, the market a.k.a. investors bid down the price of Alcoa by minus (-14%) this year from about $10 at the beginning of the year to the current $9 or less and a loss of “market value” from $11 billion to the current $9 billion – $2 billion, easy come, easy go. they say? Not really. We think that the reasonable explanation is that investors, on balance, do not think that Alcoa and its management will be able to deal with its various market and financial pressures but it is more usual for the press and the “volatility players” to put the cart before the horse and say that commodity prices are low and there is an oversupply of aluminium products at the present time. Indeed, the competition is tough and untimely but regardless of how short sighted such an assessment might be, or how capable the management, we still can’t buy Alcoa because – and only because – the ambient Stock Price (SP) (Red Line where shown and a step-function) has been below the Risk Price (SF) (Black Line and also a step-function) all year and it still is now and shows no sign of getting any better absent an “aluminium famine” or offer to “shoot it” (takeover).

Exhibit 1: (B)(N) AA Alcoa Incorporated – Risk Chart

Alcoa Incorporated is engaged in the production and management of primary and fabricated aluminium and alumina combined through its active and growing participation in all aspects of the industry: technology, mining, refining, marketing and sales.

(Please Click on the Chart to make it larger if required.)

In contrast to Alcoa, BAC Bank of America Corporation (please see Exhibit 2 below) has a current market value of about $107 billion, up from $65 billion at the end of last year (less than twelve months ago) for a +44% gain in the stock price – the biggest gainer in all the Dow – plus a dividend payout of $428 million to the shareholders ($0.04 per share for a current yield of 0.4% (less than 1% and less than inflation)). The Bank also manages (so to speak) $1.9 trillion of other people’s money (OPM) and has itself a net worth of $239 billion which is nearly twice the market value. But, alas, we could not own it this year because the Stock Price (SP) tended always to be below the Risk Price (SF) – the same reason that we did not own Alcoa – although (please see Exhibit 3 below) there are other factors that we might account for in hindsight and even earlier this year.

Exhibit 2: (B)(N) BAC Bank of America Corporation – Risk Chart

Bank of America Corporation is a bank holding and a financial holding company which, through its subsidiaries, provides banking and non-banking financial services and products throughout the United States and in selected international markets.

(Please Click on the Chart to make it larger if required.)

The other factors that might reduce the perception or understanding of “investment risk” are that the bank is “too big to fail” and that its management and business strategy is changing for the better. It is reasonable (and mandated by the theory) that we should “calibrate” the Risk Price (SF) to the lowest stock price if, in fact, the new Risk Price is “validated” by the subsequent market prices post $6 in 2011 which it appears to be (please see Exhibit 3 below).

Exhibit 3: (B)(N) BAC Bank of America Corporation – Too Big To Fail

Investors might have a different and well-founded perception of the investment risk and, as usual, vote with their money which is not a bad thing to know.

(Please Click on the Chart to make it larger if required.)

Even though the “volatility risk” has not changed, the “investment risk” has and the price of risk, the Risk Price (SF), is currently $8 and rising rather than $11 and falling, and we could use that new information going forward using our usual “price protection” in stop/loss or long puts offset with short calls on our long position in the stock. Please see our Post, The Wall Street Put, August 2012, and Popoviciu’s Volatility, September 2012.

Postscript

Does any of this make a difference? Is there really a distinction between “investment risk” and “volatility risk” that we should know? Well, let us explain.

This year’s Dow is likely to return +4% or so on the Index and its been stuck there (up or down) since January. It will be a fallow year for the heavy hitters on Wall Street (absent fees and commissions) and best that they shoot some ducks before Christmas. Next year looks to be just as uncertain and two years of “hunger” is already a famine for many pension, trust and endowment funds.

The Perpetual Bond™ on the other hand is at +10% now plus an additional 2%-3% of dividends this year – and we can’t do any worse than that until the end of the year because of the stop/loss and option positions. The Perpetual Bond™ selected sixteen of the thirty companies of the Dow in early January and trimmed that back in the course of the year to the current nine as companies dropped out (and appeared to be affected by something more than just volatility) and we took profits by selling our positions. Four more companies (Bank of America, United Technologies, The Travelers Companies and Proctor & Gamble) could be included in the 2013 Bond.

Exhibit 1: The Dow Jones Industrial Companies Perpetual Bond™ 2012

(Please Click on the Chart to make it larger and Click again to make it still larger if that is required.)

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of  investment lore. We have just one product

The Perpetual Bond™
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
Guaranteed
With No Fees and No Loads on Capital

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Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.