Investment Strategy

Ernesto Hontoria
(versión en castellano)


It had been a couple of weeks in which the dynamics of work had prevented me from having lunch with my new colleagues. Today, however, we did it again. We have lunch together and a nice conversation around Henry's investment strategy. I will explain his strategy but, although it may seem infallible, do not get too excited that my friend has found it is not lucrative so far.

Henry's strategy is to buy shares that he thinks are below their real value. For doing this, Henry follows the capital market daily and every time the price of a stock falls dramatically, he reviews the news to find out why the price has fallen so much. He looks stocks that lose more than 20% of its price in few days. From his news analysis, he determines whether the market, that is, the people who negotiate with that stock, is overreacting or acting rationally, and based on this judgment he buys or not the stock. If -in his opinion- the price of the stock has fallen more than it should, meaning that the people has overreacted to the news, he buys the stock, waits for the price to recover and then sells it again, obtaining a profit.


He had already explained us his strategy in a previous lunch’s conversation. Indeed, I asked him on that occasion, to share with me every time he finds one of those 'bargains' to look as well. He did so, and couple of weeks ago, he gave me the name of a company in the uranium business whose price had plummeted for a news that change nothing the conditions in which the company or the industry operates.


It was a company that extracts and trades with uranium in the United States, whose price on the New York stock market had fallen by more than 40%. The collapse of the price seemed related to the refusal of the government of that country to impose import tariffs on that element. Apparently, the industry’s lobby groups, which had been pushing for protections and barriers to secure the internal market, had collided with a resounding denial of the Trump administration.


Although the news did not change at all the current conditions in which the company operates (the company has to compete against the same competitors, in exactly the same conditions as always), it did affect the projections that some investors might have of its future. Certainly, the refusal of the authorities to impose new tariffs did not make the situation worse for the company, but it probably eliminated the hopes that many shareholders had for a more favorable future for their business. Henry was convinced that once investors swallow the bitter pill of their disappointment, the company's action would regain its value.


Since his argument seemed reasonable, I decided to look at the company numbers. In a matter of minutes, I completely ruled out investing in it. My reason: the company had more than four years losing money. Surely investors were betting that the US government would impose tariffs and the company would soon see the light at the end of the tunnel. Put it simple, the stock price reflects the expectations of the investors in the future of the company, not just its present conditions. The price before the crash was reflecting the investors' expectations about coming regulations favorable to the company's future, and the new price was the adjustment of those expectations.


In any case, what we discussed during lunch today was some new ideas Henry has in mind to perfect his technique. He wants now to use artificial intelligence to correlate the news in the media with the fluctuations of the stock market and allow virtual intelligence to recommend him which stocks to buy. He had made hypothetical estimates of what percentage of failures against successes could he tolerate, and how the gains of the successes would cover the losses of the failures. In his model loses are more frequent than successes. I suggested him to incorporate in his analysis the financial results of the target companies. I think that without the financial information his exercise is very similar to put artificial intelligence to guess the numbers that will come out in the lotus.


Basically, what Henry wants is to guess a future result based on past observations. So far, it has not worked either in the lottery or in the stock market, perhaps because we have not had enough computing power to analyze all the variables that could affect the results. Of course, the computing capacity is increasing rapidly, and maybe at some point it will be possible to predict human behavior quite accurately and, through it, how the capital market will react to different news. But I fear that for now Henry has no chance of incorporating all the variables in his artificial intelligence model. I did not want to discourage him, because I enjoy his lucubration about how he will become millionaire. After all it is a simple lunch conversation.