# Second Factor Derivatives : Going Where the Mind Cannot

#### Sanjeev

Have you ever wondered why childhood mathematics was limited to addition, subtraction, multiplication, and division? In almost every country, you can be called ‘educated’ if you have mastered these skills. But why isn’t Square Root, or r2 (a.k.a. Correlation), square variance, relative movement (a.k.a. beta), regression or logarithmic relationships not used so much in everyday parlance? Are these mathematical relationships less relevant to the real-world market?

Declaimer: This article was originally in May 2010, and some data points may be outdated.

Pythagoras, Fibonacci, and a few other geometricians showed us the existence of a few variables that appear regularly in our ‘random’ world. If at all there is proof that there is (a) God, this is it….how can something so perfect, so symmetrical and so regular suddenly happen in such a chaotic, ‘big bang’ universe? So, e=mc2, a Nobel Prize is given (or not), and everyone goes home….

The Efficient Markets Theory says that all knowledge about a stock is instantaneously factored into its price, assuming perfectly competitive markets. This has since been mostly proved to be bunkum; almost every word of the sentence above has been proven wrong. The Random Walk Theory went a step further and claimed that stock prices followed a ‘random walk’. In its details, however, the book made 2 important points: one, that any ‘trading rule’ that outperformed the markets would be copied by everybody till it no longer works. This, of course, assumes perfect and uniformly transferred knowledge, which I know as a Professor is impossible…but never mind.

However, even Burton Malkiel acknowledges one ‘trading rule’ that has been known to outperform the market over a hundred years, although he does still maintain that individuals cannot outperform the market. And that is, that Beta migrates and a portfolio of low Beta stocks will outperform the market over any long period, i.e. what the market forgets, the market later remembers, and this is a consistent cycle. Hence, what the market forgets is that it cannot be invested in (by definition), so a good strategy to beat the market would be to invest in a portfolio of Beta stocks.

I have lots of disagreements with this rather simplistic theory. First, the role of human intervention and ‘special intelligence’. There are many ways to beat the market, which is no benchmark. Over the long run, I would think that market returns should track GDP, liquidity, inflation, and the profitability of businesses. But they don’t, giving us the feeling that Mr. Market would not make a very good portfolio manager. Just staying out of the market from Jan- Oct 2008 would have made you 4 times richer than someone who did; what does it say about Mr. Market?

The most devastating attack on these theories comes from the likes of Warren Buffet, Peter Lynch, George Soros, etc…..by their very existence!!! Mr. Malkiel had no comment, saying something like, “….but they too must die”.

So here is my theory, around which I seek to do a Ph.D. someday.

The human mind is incapable of second-factor (derivative) thinking. It takes an exceptional mind to look at a ticker, full of moving random numbers, and be able to calculate the ‘dispersion’ around the average, even as you calculate the moving average. Jesse Livermore could do it, in his famous ‘bucket shop trading’. It is somewhat similar to being able to calculate the moving odds in a game of Black Jack, which an American professor learned to do, to beat the casino (and make \$3.5 mn in a night). I have practiced this skill, and have got particularly good at it.

If you can do the above, you will get a sense of ‘beta migration’, i.e. in a bullish market, which are the stocks being ignored by the market? If you then see a perverse steadiness during the subsequent correction, you can tell that this stock is being ‘supported’ with an investment hypothesis, which has still to work out. But ‘smart money’ is in the stock, and the first indication of the ‘investment hypothesis’ showing results will result in a huge uptick, which will be confusingly understood as ‘beta migration’ by Mr. Malkiel. For example, Bharti Airtel is going through that phase just now.

Why so? Because Mr. Malkiel deals only with market-level phenomena, not with individual stories. That is why he cannot understand the people who beat markets. Rather like sitting on the moon and observing that Mumbai is ‘going nowhere’. Oh, but Mukesh Dhirubhai Ambani is…….if you just look deeper!!!

Since Mr. Malkiel does not understand Bharti, he will just take a ‘portfolio’ of low Beta stocks, which will comprise HPCL, Balrampur Chini, and Unitech/ DLF now. They are different stocks with different investment hypotheses, displaying the same behavior for different reasons. In the case of HPCL, at some price point not very far from here (say, 270), ‘smart money’ will pile in and quietly sit there, waiting for oil prices to fall, or the Govt to tire with its OMC- raping. Or the Govt to wake up to the need to pay for new infrastructure in oil refining, or to pay attention to its Balance Sheet Fiscal Deficit….whatever! They just buy HPCL at a discount of 50% to Book Value and go to sleep. In India, bad things happen for a long, and then India surprises you…..just when you give up, something good will happen, when and where you least expect it. The upside is 150%, and the downside is 20%…..an equation acceptable to ‘smart money’.

But what is Unitech doing here, the crane among the storks? Its Beta has already migrated, and the stock has been an outperformer recently, giving 15% returns in a flat to reducing market.  Its Beta was running at a whopping 6.39 in the run-up from 2004-2008; what is much more relevant is that during the downturn of 2008, its Beta ran consistently above market, i.e. it fell at TWICE the rate of the market.

Remember, when something rises, the sky is the limit, but when something falls, the floor is the limit. To outperform the market during the upswing is no big deal, but to outperform the market during the downswing says something special. Three snapshots: market fell 22.09% from 8th Jan, ’08 to 22nd Jan, ’08, Unitech fell 33.22% over the same period for a Beta of 1.5; market fell a further 48.68% from 22nd Jan’08 to 27th Oct, ’08 in a once-in-a-century dive and Unitech outperformed it by falling 87.84% with a Beta of 1.8. Now hold your breath: market ROSE 2.34% over the period 27th Oct, ’08 to 9th Mar’09, but Unitech showed a NEGATIVE Beta by falling a further 41.85% for a negative Beta of 17.85.

So a Beta Tracking strategy would have come to serious grief if it had chosen Unitech to practice its skills. This brings me to the point about there being much more to it than a simple ‘single factor’ relationship to this complex question. What goes up must come down…. maybe…. but what goes down must come up is not necessarily true.

The human element is obvious: a computer program that apes Mr. Malkiel’s view-from-the-moon strategy may ‘outperform’ the market over a hundred years, but Mr. Warren Buffet is sure to leave out Unitech from his portfolio intuitively. That would surely improve his track record over the long term.

For example, I have developed 14 such filters to make sure that I don’t ever get caught in an over-priced stock. Yet, I don’t call myself a mathematician; the critical skill I have built is that of a Behavioural Economist, who builds an ‘anticipator’ of ‘smart behavior’ (like I have done for HPCL above) and then tracks it to check for reality.

On Key

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