What's Your Edge? How To Find Great Trades - Bezek's Daily Briefing

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Includes: CALM, DIS, GOGO, PSMT, TAHO, WING
by: Ian Bezek

Summary

Today's Briefing discusses the "Buy what you know" principle.

This adage has merit, but is often misapplied.

We discuss one piece of information I learned this weekend, and how it can be applied to generate profitable trade ideas.

And we discuss how you can start to systematically find these opportunities in your areas of knowledge.

We're taking a different approach with today's Briefing. My horizon looked like this for most of Monday:

Click to enlarge

Volcanoes near Guatemala City, Guatemala. Author's photo.

And this airline didn't have Gogo (NASDAQ:GOGO) in-flight wifi. So I was away from the internet and am unable to offer intelligent commentary on the day's events. Instead, today, we're going to zoom out a bit. We'll discuss how to find your best trades and investments using the buy-what-you-know idea.

At the risk of badly generalizing, most investors and traders tend to have a few approaches for deciding what they're going to trade or invest in. Some rely primarily on momentum and technical analysis. That's outside my area of expertise.

Some folks mostly copy other investors. If you're copying top hedge fund managers, or wise investors such as Buffett, this can be an alpha-rich approach. Though, be aware that by the time you know what they own, there's a good chance the stock will already have moved or they may even have sold.

On the other hand, if you're copying what CNBC is talking about, or trading things because they're in the news and catch your attention, you are unlikely to achieve long-term results above average, particularly after including trading costs.

One of the more popular approaches for many investors is the so-called "buy-what-you-know" approach popularized by star mutual fund investor Peter Lynch. There are various schools of thought that have developed out of this.

To the best I can tell, Lynch originally meant to invest in areas where you had specialized knowledge. For example, if you are an engineer in a semiconductor business, you probably have above-average insight into how your direct competitors are faring. If you get a sense that one of them is leading the pack, there's likely alpha to be found buying the stock if the market hasn't priced that in yet.

Or, for example, if you were researching the effect of dairy on health and knew that new data were pointing to eggs not having a link to heart disease, you might consider buying a pureplay egg producer such as Cal-Maine Foods (NASDAQ:CALM). Once the 60 Minutes special on heart-healthy eggs hits the mainstream attention, the stock would start moving, and you'll be positioned to profit.

The possibilities are endless. If you have a job that requires specialized education, you probably learn very specific bits of information and have the inside scoop on news flow in your niche. To the extent that this knowledge would impact publicly traded companies, you can try to beat the market and your odds are pretty good compared with other strategies.

However, many people take buy-what-you-know to mean that you should buy popular companies because you like their products. Or you use the N=1 experience you have shopping at a local store. Without fail, every holiday season, I'll see people going long or short retail stocks because the store in their neighborhood was unusually full or empty.

Without going deep into the statistical weeds, let me just say that visiting any one store from a chain of hundreds of stores produces a totally meaningless data point. Or let's say you go to Disney World and have a blast, so you buy Disney (NYSE:DIS) stock. What do you know that the other hundreds of thousands of satisfied Disney customers don't?

It's easy to get emotional from good (or bad) customer service. After Wingstop (NASDAQ:WING) went public, I was interested in the stock. By some random chance, here in my home of Queretaro, Mexico, there happens to be a Wingstop. What luck! So I dragged my girlfriend there and we sampled the new IPO's culinary offering.

And in a word, it was awful. The wings tasted like chemicals. The chicken was still almost raw inside. We asked for them to be cooked more and they came back burnt. Burnt chemical taste. It was nasty.

If I were a vindictive person, I could short Wingstop stock, since they served me one of the worst meals of my life.

But that's not rational investing. My experience isn't indicative of the whole Wingstop chain. Maybe this was a franchised store that wasn't following book. Maybe the Mexican part of the supply chain sources horrible sauces and the American locations have good ones. Maybe the cook was new and wasn't trained well yet. Though I will never be back to Wingstop as a client, I can't conclude the restaurant - as an investment - is a dud based off just one bad experience.

How I Apply Lynch's Principle

I'll give a live example here of using what you know to the current market. This is a daily Briefing, not a philosophy article after all. I live in Mexico, but I needed to spend this past weekend in Guatemala. As an investor, traveling is one of the best ways to generate good new trading ideas.

As it would turn out, I've lived in Guatemala on and off several times and know the economy fairly well. Up until this trip, I would have described it as probably the second fastest growing Latin American economy. However, now I must downgrade my assessment.

This trip, the mall I usually frequent had almost twice as many empty stores as usual. The number of construction cranes around downtown was down noticeably. There was a drop in pedestrian traffic on the main retail street.

It was clear that something had changed with the Guatemalan economy over the past six months. I went back to my hotel and read the news and economic indicators for Guatemala nothing looked particularly unusual. Fitch in fact reaffirmed its Guatemalan BB rating and stable outlook earlier this month.

I went to a few local watering holes and after talking, it became clear what the problem was. The Guatemalan currency, the Quetzal, is de facto pegged to the US dollar. I knew this but hadn't considered it until it was actively pointed out to me. Neighboring countries have seen their currencies plunge as the US dollar has ascended since 2014. Most importantly, the Mexican Peso is down almost 30%.

That puts Guatemala in a deeply unenviable position, since they trade extensively with Mexico. Guatemalan goods now cost 30% more in Mexico, and Mexican goods are ludicrously cheap when imported to Guatemala.

Tourism is also a key driver of the Guatemalan economy, but when Mexico, Costa Rica, Colombia, and other leading tourist sites see their currencies diving, Guatemala becomes less and less competitive.

I always stay at the same hotel in Guatemala City. In the past, there'd be tons of Canadian tourists that stayed there. This time there was only one. With the Quetzal appreciating 30% against the Canadian dollar over the past two years, Canadians are being priced out.

Talking to Guatemalan locals, it became clear that many folks are expecting the peg to break and the Quetzal to plunge. The government is resolutely trying to maintain the peg in an effort to ditch the country's long-running "banana republic" reputation.

But failure will be almost inevitable if the Fed keeps driving the dollar and quetzal, via peg, to further and further heights. If even China had to devalue, how is Guatemala going to stand strong?

Knowing that a devaluation may be coming, capital has likely started moving into dollars and/or leaving the country. Businesses delay investments, due to the economic uncertainty. With time, the economic motor slows down.

In fact, just this past week, Guatemalan newspapers reported that some ex-government officials are now pushing for a Quetzal devaluation. But if you search "Quetzal devaluation" in Google News English, you'll find this Seeking Alpha article (I assume). And nothing else.

No one is covering this in the English speaking world. My edge? I know of a probable future event that few other English speakers are paying attention to. Then the question becomes, how to profit?

There's no Guatemalan ETF and no easy way to bet against the Quetzal, so you have to think past that. The easiest way might be to bet against PriceSmart (NASDAQ:PSMT), the so-called Latin American Costco. This chain of Central American, Caribbean, and Colombian hypermarkets has a meaningful concentration of revenue from Guatemala.

I already played this trade, shorting PriceSmart at $93 in December. The Colombian Peso was in freefall, so it seemed likely the quarter would miss. Sure enough, earnings were soft, and Colombia was at fault. Anyone who knew people in Colombia would have had a hunch this would be the outcome. I won a Seeking Alpha contest with that pick, and any subscribers that shorted with me made $20/share shorting the stock in a month.

I covered that short, but if Guatemala devalues, we'll get to run the exact same trade again. If you read my research, I'll alert you if and when it's time to go back to the PriceSmart well.

There's other potential trades. For example, Tahoe Resources (NYSE:TAHO) runs one of the world's largest silver mining operations based out of Guatemala. A substantial devaluation would lower their operating costs greatly. You'd get a nice tailwind to earnings. However, the current chatter suggests the company has some rather stark corporate governance issues and underappreciated political risk. I'll be watching for a trade in either direction.

Given my specialized knowledge in certain parts of Latin America, I have a shortlist of dozens of such opportunities that are contingent on various events occurring. I follow the news closely, and when something happens that would trigger such a trade, I strike.

It doesn't have to stop there. Seeing how Guatemala is faring with their pegged currency at the moment, you can ask: Is anyone else facing the same problem?

In Latin America, El Salvador, Panama, Ecuador, and Bolivia use the dollar or are effectively pegged to it. These economies are likely facing similar strain from having an overvalued currency. Ecuador and Panama are both large enough that numerous US-listed companies have significant exposure. Panama in particular, due to the importance of its banking system internationally, would lead to some interesting side effects if it devalued.

Outside of Latin America, you can start asking other interesting questions. Perhaps most importantly, what happens if Saudi Arabia's peg to the dollar breaks? Needless to say, there would be substantial geopolitical consequences to Saudi Arabia's long-running currency peg busting. I know little about Saudi Arabia, but it's not hard to network with people who do.

Hong Kong is another systemically important country that sees its local money becoming greatly overvalued as the dollar continues to rise. Hong Kong has bravely held the dollar peg for many years now, but will this be the crisis that causes them to break?

Bringing This Back To You

I raise my personal example from this weekend to show my thought process. Subscribers to my premium service see this in action. (Also my poor girlfriend constantly endures hearing me test out novel investing hypotheses) Anytime I find some piece of information that most investors would be unaware of, I start trying to find a trade. And I further extrapolate to see if I can find other investable situations that track the same pattern.

In your life, you almost assuredly have information that most people don't. If you have a typical professional job, you know many things specific to your niche that other investors such as myself wouldn't know. Ask yourself constantly how you can apply what you know to your investments. Be curious!

And pick your friends' brains as well. People love to talk about their work and their hobbies. Give them the green light to share and they'll tell you tons of fascinating things you can't find on Google. Some of my best investment ideas have come from hearing about triumphs or disasters happening to my friends' companies and/or their competition.

To be clear, you should never act on inside information. If you are privy to something that the public has no way of knowing - say contract negotiations or an upcoming M&A deal - you can't trade on that.

But most good investments come from putting together pieces of publicly available information that no one else has connected yet. Many of the greatest investors are known for being voracious readers and being extremely curious.

Machines can compete with human investors in many ways. It's hard to execute faster than a high frequency computer. It's difficult to come up with a backtested strategy that will top what a supercomputer can spit out. But computers are still a ways from being able to truly learn naturally. Your specialized knowledge and ability to find investing angles with it can be a great skill that will be difficult for others to duplicate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.