The trouble with the markets and the investment industry is that jargon is everywhere. Ever tried to discuss crypto or coding with a tech geek? That’s how non-financial people feel when looking at an investment fact sheet or reading a fund manager letter.

In this article, I  explain a few of the concepts that are important for you to understand when digesting the financial news or publications by asset management firms.

Alpha

Let’s start with alpha (rather than Alfa – a motoring passion that helps me spend any money that I do manage to make on the markets).

The pursuit of alpha is an obsession for investment professionals and traders worldwide. Alpha is the excess return over the market in a given period. This is typically measured vs. a broad market index and must be assessed in the context of the investment mandate or strategy.

For example, in an SA-only equity fund, alpha would be the return in excess of the JSE All Share Index return. If you’re managing your own money, you don’t need to worry about adjusting for fees. If you are paying advisors and asset managers, I would only ever look at this return net of fees.

Remember, you can easily achieve the index return through a passive strategy by buying ETFs (e.g. Satrix 40) which comes at a low cost of 0.1% per year. If your asset manager and advisor are stripping 2% out of your money in fees, they need to achieve alpha of 1.9% just for you to break-even vs. a passive fund.

Market capitalisation

Usually shortened to just “market cap”, the simplistic definition for this concept is the number of shares in issue multiplied by the share price. It gets slightly more complicated where the company has implemented share buybacks and holds treasury shares, which most market data providers would deduct from the market cap. In many cases, it’s an immaterial difference, although share buybacks seem to have grown in popularity among South African corporates.

The important thing for you to understand is that the market cap is the traded value of the company and this may not be the same as the fair value. Markets are not efficient. Prices do not always reflect fair value. Otherwise, why would any of us bother in this game?

The process of generating alpha requires market participants to actively try and find mispriced companies.

For a terrific discussion on how to identify attractive stocks that may be undervalued, listen to Episode 11 of Magic Markets: Tech Truffles and Unicorns where Mohammed Nalla and I discussed investment strategies with expert stock picker Craig Antonie of AnBro Capital Investments.

Long vs. short

A long strategy is a belief that prices are going up. If you buy shares on Easy Equities or any other share trading platform, you are backing the prices to increase so that your shares become worth more.

A short strategy is the opposite. Despite the absolute nonsense you may read on Twitter about how shorting shares is “immoral” and how hedge funds are evil, the reality is that short sellers and their research is critical in the market. Just think about how Viceroy finally blew Steinhoff up, revealing what local fund managers should’ve seen all along.

Going short on a particular share is much riskier than going long. The reason is simple: a share price cannot go lower than zero but has theoretically infinite upside. This means the potential profit on a short is limited but potential losses are uncapped.

When going short, the trader must borrow the shares from a stock lender and sell them in the market, promising to buy the same number of shares in the market at a later stage and return them to the lender. The idea is that the shares will be cheaper at a later stage, so the trader makes a profit by selling at a high price and buying later at a lower price.

During that period, the stock lender charges a fee to the borrower. This is called “scrip lending” and is commonly practiced by long-only funds to help boost returns in the fund by earning a lending fee from short-sellers.

When the trader gets it right, a successful short is guaranteed alpha. Profit was made on a share dropping in value, while the index registered a loss in value due to the share price of the constituent company going down.

Importantly, simply avoiding that share in a portfolio would also generate alpha, as the portfolio avoided the losses that the index suffered. Getting the short right is a double-whammy of alpha awesomeness.

The appeal of simply avoiding overpriced shares rather than shorting them is best explained by one of my favourite quotes about the markets, courtesy of John Maynard Keynes:

“The markets can remain irrational longer than you can remain solvent”

I firmly stand by my view on Tesla, but the crazy price behaviour and the army of Musk fanatics powered by US stimulus payments makes Tesla the riskiest short I’ve ever seen. Instead of shorting it (and potentially losing my house in the process), I simply avoid Tesla instead. Locally, Capitec is just as irritating. I am convinced that the bank is heavily overvalued, yet it continues to trade at what I believe is an unsustainably high price-to-book ratio.

In Episode 10 of Magic Markets: Losing their Shorts, we talked about the GameStop phenomenon and the attacks on hedge funds, along with more detail on the mechanics and risks of shorting.

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