Using Emotional Arbitrage To Gain An Investing Advantage

Includes: AMZN, BAC, BP, XOM
by: The Keating Letter

In poker, if you can't figure out who the sucker is at the table, chances are it's you. You should take the same view with investing. It's not enough to simply figure out if a company has strong management, a durable competitive advantage, and pricing power. If the rest of the market already knows that -- and chances are that they do -- you have to pay dearly for the opportunity to own that company. Amazon (NASDAQ:AMZN) is a great company. That's why it trades at 135 times earnings. You may be the sucker for buying it at that price.

I look at every potential investment as an arbitrage opportunity. I am arbitraging my perception of the value of the company with the price that the market is offering it to me. By looking at it this way, it helps to identify where I think I have the advantage. If I can't identify it, then I probably don't have an advantage. There are three potential arbitrage advantages: Emotion, information, and time.

I'll go into information and time arbitrage in future articles. Here, I want to discuss making an investment when you have an emotion arbitrage advantage. When I say emotion, I mean that psychologically it's difficult to own a particular company for some reason. If you can control your emotional feelings toward that company at that particular time, and you can identify that the rest of the market is not approaching the investment analytically, you may have an advantage.

It may help to think of it this way: In the housing market, real estate agents know that buyers have an advantage if one of the 3 d's are present. These are debt, death or divorce. If a seller is going through one of the 3 d's, they are put in a position of being forced, emotional sellers and they won't get a good price. It's similar in stocks.

Fallen angel stocks are good examples of a potential emotion arbitrage advantage. When BP (NYSE:BP) had the oil spill disaster in the Gulf of Mexico in March 2010, the stock took a major plunge. In the two weeks after the spill, BP was down more than 18% while the overall market was up 7%. Almost a month later, BP was down 30%. When you're talking about a $150 billion market cap company, a drop like this is big, and it makes sense… to a degree.

If you had BP gas stations in your area, you may remember them being like a ghost town. When given the choice, people had so much anger towards BP that they refused to fill up their gas tanks with BP gas. It made no difference that the owner of that gas station was probably a member of your community who was just trying to make a living. Mutual fund companies, pension funds, and other large institutions acted the same way that you did as a driver. They did not want to show a large ownership stake in BP in their next quarterly statement, or sometimes any at all. It often didn't matter what the price was, they just wanted to sell out.

Certainly there was a cost to BP and a great deal of uncertainty surrounding the situation. Economically, the company was going to be affected. The challenge for investors was to distinguish how much of the price drop could be attributed to the costs of the spill and how much to irrational emotional selling. That's not an easy thing to determine and there are no precise answers. Looking at the situation through the eyes of a contrarian helps, but you still have to figure out if the market has over-reacted. Hindsight is easy, of course, but BP shares recovered by 50% by the end of 2010.

Tragedies like the BP oil spill, a quarterly earnings miss, a scandal, or short term public hatred of a company or industry may provide an excellent buying opportunity. The challenge is to determine if these short term problems will be a long term negative for the company.

More recently, Bank of America (NYSE:BAC) was the victim of an emotional response from the public. It seemed as if every day there was a headline about the company. Other banks attempted to raise fees last year on things like checking accounts, but Bank of America was the company singled out. If you held the stock and were steadfast in your belief in the company, like Bruce Berkowitz was and is, you were seen as a bit of an idiot. You may have even lost investors because of it.

The tobacco industry has historically been looked at in a similar way. All those companies did was generate a huge amount of cash through the years and use it to buy back shares and issue fat dividends.

News moves extremely fast today. Much faster than in the past. That may provide an advantage to investors who use an analytical approach and can identify emotional arbitrage situations. The BP spill was a bit like the Exxon (NYSE:XOM) Valdez disaster in 1989. In that case, Exxon's stock was only down 3.9% two weeks after the crash. It was flat a month later.

Use the emotions of our news cycle to your advantage. Determine if the negativity surrounding a company or industry will change the long term fundamentals or not. In the examples above, it would have paid off to make the unpopular decision to buy and hold until the negativity passed. And it usually does pass.

Disclosure: I am long BAC, XOM.