Pondering the 3 Faces of Alpha

Cullen Roche had an interesting post about the three sources of alpha. They are better information, better analysis of the same information, and recognizing when prices are manifesting an extreme in greed or fear.

Occasionally anyone can stumble across better information (even though they may not realize it) and clearly many will try to regularly access better information ... but for most of us, a method that relies on better information on a consistent basis is probably not realistic.

Better analysis of the same information is multifaceted. For example, not many people were able to look at the volume information from Sino-Forest (SNOFF.PK) and draw skeptical conclusions. The information was there for anyone who sought it, but very few people truly understood it. With individual stocks, there are changes in little data points that can warn of a slowdown (talking something far less dramatic than a fraud) or a turn up in business.

Better analysis of the same top-down information is much easier. To recycle a joke from past posts, how many times do you have to read that housing and banks in Europe are in a lot of trouble -- and this is why before you start to think, Hey, housing and banks in Europe might be in a lot of trouble?" In the build up to and the rolling over of the housing/financial crisis in Europe and the US, we heard all sorts of arguments as to why everything was just fine -- ranging from faulty analysis to "political lies" rhetoric.

Some who may have missed the financial crisis -- but see in hindsight what the warning signs were in terms of actual data and various indications of sentiment -- can hopefully apply some of that to whatever the next crisis will be. For example, in both 2000 and 2007 we heard why the yield curve inversion didn't matter "this time," or why various metrics of analysis were no longer relevant (tech stocks and then housing) and so on.

Extreme greed or fear can mean recognizing when the price of something is too low or too high. This is easiest in the face of an extreme move in price. If an energy stock you own goes up 100% in six months while the Energy Sector SPDR (XLE) goes up 6%, then you probably should take some off the table. Understanding when good news or a scare is overdone comes from really understanding the business and the nature of how the stock trades. "Really understanding" is of course vague and subjective, as however well you know a stock you own, there are other shareholders who know it much better than you ... and others who know far less then you.

While no one can be universally correct with these sources of alpha, I believe that the last two are reasonably accessible to do-it-yourselfers.

Source: Pondering the 3 Faces of Alpha