Looking Back At Two Years

Back in the summer of 2005, I was really excited about the potential of a new wireless technology called WiMax and the prospects of graphics card maker ATI Technologies, which was about to launch its next generation of products to compete against rival Nvidia (NVDA). While sharing my thoughts about both these opportunities with my cousin by email, I figured it may be a good idea to also send this snippet of information to all my friends and family members in the form of a newsletter. InsideArbitrage was born as a small and simple email sent just before midnight on August 2nd to less than 100 people.

If I had any idea what I was getting into that night or the time and effort it was going to take in the coming months, I would have probably gone to bed early. But I am glad I did not and looking back at the last two years, I have to say the experience has been very fruitful and financially profitable thanks to the performance of my personal portfolios. Twenty three out of the twenty seven positions I hold in my personal portfolios are currently in the InsideArbitrage model portfolio or have been featured in the newsletters in the past. The returns of the InsideArbitrage model portfolio are given below and they are also independently tracked by Mark Hulbert of MarketWatch.com who has been receiving the newsletters since inception. Mark’s newsletter, the Hulbert Financial Digest (HFD) has been tracking the records of investment newsletters for almost three decades.

Learning:

Some of the most successful investors retain a dairy in which they jot down the lessons they learnt in their long investing career and they often refer to these notes. I used to do something similar using a lengthy word document to store strategies. After I started InsideArbitrage, the newsletter and blog became that diary and along the way I learnt a lot from fellow investors, bloggers and subscribers who wrote to me or left comments on the blog.

I learnt about merger arbitrage, using LEAP puts to hedge a long portfolio, applying long/short strategies to closed-end funds, investing in spin-offs and investing in companies that have declared stock splits.

I also learnt a very big lesson about acting swiftly with options as you not only have to be correct about the direction of the stock or market but also the time frame within which such a move is likely to occur. Just getting the direction right is difficult enough but with the added pressure of time decay (the theta of options), it becomes a herculean task. To illustrate, if I had purchased options in Countrywide Financial (CFC) that expired just a month later, my profits would have been a few hundred percent instead of a 66% gain I registered in the model portfolio on July 10, 2007.

I also learnt a lot about the blogosphere, creating XML feeds and search engine optimization (SEO) as discussed in the “The Website and blog” and “Search Engine Optimization” sections below.

The Big Wins:

My biggest wins over the last two years were,

• Shares of VA Software (LNUX), which rocketed up shortly after we picked them up,  helping us register an average gain of 161.57% over three different sales transactions. As a geek I was aware of how much of a dedicated following Slashdot had amongst geeks and noticed that the company had announced that they were going to be profitable in the second quarter of fiscal 2006. It looks like most of Wall Street missed that little announcement and had probably written off Slashdot in the Web 2.0 frenzy. The company is now called SourceForge Inc after getting rid of its enterprise software division.
• Picking a list of home builders in September 2005 to buy put options on just as the real estate bubble was about to pop. As discussed in the blog entry Housing Sector in Pain, I unfortunately did not add these puts to the model portfolio and only added puts on St Joe (JOE) in November 2006 as mentioned in the section Hedging The Economy Through LEAP Puts. Those puts are now up almost 50% and still have more than 5 months before they expire.
• While I was a little late picking up puts on the home builders, I did not repeat that mistake with the mortgage lenders and initiated put options on New Century Financial and Countrywide Financial (CFC) as mentioned in the blog post The Effect of Housing Weakness on Mortgage Lenders. New Century eventually went bankrupt and in the process helped us register a gain of 541.67% through two different transactions. As discussed earlier, Countrywide Financial also helped us post a gain of 66%.
• Suggesting subscribers pick up Chipotle Mexican Grill (CMG) at its IPO in January 2006. Chipotle priced its IPO at $22 per share and closed its first day of trading with a 100% gain at $44. The stock is now trading over $100.
• Graphics card producer ATI Technologies who happened to be one of the two stocks in the first edition of InsideArbitrage was acquired by Intel’s archrival Advanced Micro Devices (AMD) for $5.4 billion dollars in cash and stock, helping us sell ATI for a gain of 54.18% a little less than a year after we picked it up.
• Picking up relatively unknown weight management company Medifast (MED) shortly before the highly volatile stock started a big upswing. I was prudent enough to take profits off the table with two sales that netted gains of 233.95% and 231.54% but just like a dieter who is drawn back to a calorie rich cake, I was drawn back to Medifast and added to our position in March 2007 after the stock had dropped significantly. Unfortunately the stock has dropped since then and only time will tell if the decision to get back in was a good one or not.

The Big Losses:

My biggest disappointments over the last two years were,

• Eaton (ETN). Most traders put some checks and downside risk management in place where they sell a position when it falls more than a certain amount or percentage from their buying price. I normally do not subscribe to this behavior and prefer to take Warren Buffett’s approach who once said that if you can’t handle your investment dropping by 50%, you should not be investing. However back in September 2006  when second quarter 2006 GDP growth slowed down to 2.5% and our position in Eaton had dropped over 10%, I made the mistake of selling and taking a 11.51% hit even though I believed in the long-term prospects of the company and felt that the fluid power division of Eaton was going to benefit from the booming aircraft industry. It turns out that my initial bet on Eaton was spot on as the stock is currently trading at $94.53, up more than 23.32% from our point of entry in May 2006 and up almost 40% from our point of sale in September 2006.
• I repeated the mistake I made with Eaton when I sold our position in technology and engineering consulting company RCM Technologies (RCMT) for a loss of 21.76%. However since I do not always have to sell positions in my personal portfolio to purchase new positions like I have to do in the InsideArbitrage model portfolio, I decided to hang on to RCM Technologies in my personal portfolio and recently sold it for an average gain of 40% on the stock’s recent upward ride to $10 per share. This highly volatile low volume stock has since given back some of those gains and is current trading at $7.75.
• The timing of the puts on the iShares Dow Jones Transportation Average Index Fund (IYT). I was expecting the ripple effects of the real estate bubble deflation to spill over into the economy and hence hit the entire transportation section. Towards this end I started hedging the portfolio through LEAP puts as discussed above. While most of those puts turned in spectacular gains, the transportation sector never looked back and I eventually sold the IYT puts for a steep loss of 76.92%. Allocating just 1.14% of our portfolio to this position certainly helped limit the damage to the overall portfolio.
• Another set of put options that turned sour were the puts on the online customer relationship management company Salesforce.com based on disappointing earnings. You would think that I would learn from these losses and stay away from put options. Not taking into account the Apple strangle (which was profitable), four out of the 6 put options we purchased posted gains and the magnitude of some of these gains was very big. Moreover these put options were in place as an insurance policy in case the market took a hard hit and hence I used small position sizes.
• Investing in new and unproven technologies or ideas can be very risky and a common mistake is to get in too early. Understanding the potential of WiMax made me forget this fundamental rule of investing and I now have a 34.34% loss in Airspan Networks (AIRN) to show for it. As described in the blog entry Hedging Your WiMax Bet,  I had learnt from an earlier mistake of investing in just a single company in an emerging area and started a position in competitor Alvarion (ALVR) as well to spread my WiMax bets. A 78% gain in Alvarion since the start of this year has more than offset the Airspan loss. Alvarion was expected to reach profitability in 2007 and it did just that when it announced second quarter results on August 1, 2007. Airspan is expected to reach profitability in 2008 and the prospects for WiMax have never looked brighter. So there is hope yet for our Airspan position.

Note: You can find every single historical trade from a link titled Historical Trades at the top right corner of the model portfolio page.

The Website and Blog:

About a month after I launched my newsletter, I launched InsideArbitrage.com to support the newsletter and manage the subscription process. Based on subscriber feedback, I decided to launch a blog in December 2005 to provide updates in between newsletters. Because I was a geek, I embarked upon building my own blogging platform from scratch instead of using a service like Blogger or WordPress and to date this platform powers the InsideArbitrage investment blog. While this proved to be a time consuming endeavor and something I would not repeat again, I learnt a lot about everything from RSS feeds to search engine optimization (SEO).
With the help of my trusted friend/cousin/engineer (who also doubles as my editor when I am done writing the newsletters in the wee hours of the morning), we expanded the subscription management process, optimized the automated model portfolio that I had built over one frustrating weekend and added several new features such as a subscriber exclusive area, forums, watchlists and a cool flash chart that automatically updates itself just like our model portfolio.

As every new website founder finds out, unless you are creating an absolutely ground breaking website that meets an unmet need, it is very hard to be discovered amongst the vast millions (billions?) of websites and blogs that dot the virtual landscape. In a recent conversation with my friend Dev who operates the free mutual fund newsletter Kinetic Financial, he asked me what happened to those millions of users who were supposed to show up if we had a good service that was also free. After all wasn’t there a study that claimed that the three words most likely to get a reader’s attention were “free”, “now” and “sex”. InsideArbitrage satisfied the requirement of the first word and in fact has a name that hinted at the possibility of the third word but traffic and subscribers were still elusive in the early days.

I told Dev that the media tends to focus on the success stories like MySpace, Facebook and YouTube that were literally overnight sensations without mentioning the millions of other websites and outstanding bloggers who toil away in relative obscurity. If this was anything other than labor of love, many would have stopped a long time ago and indeed the average blog lasts only a few months.

The word about InsideArbitrage was slowing spreading through family, friends and early subscribers and was certainly helped by a partnership with SeekingAlpha who in the words of founder David Jackson, “really liked my work” and started syndicating my content. Thanks to a partnership between SeekingAlpha and Yahoo Finance in September 2006, my work was now appearing on Yahoo Finance. Posting 2006 returns that not only beat the market but more than 99.9% of mutual funds and at one point every single paid newsletter (as tracked by the HFD) should have helped but only had a marginal impact. This is not very surprising given the length of time it takes to build trust with your readers. A subscriber recently mentioned that he had been reading my work for a year before he decided to subscribe.

Search Engine Optimization:

About a third of my traffic has come directly from search engines and all the months spent optimizing InsideArbitrage for search engines eventually paid off. After spending months in the Google sandbox, I started ranking well for the keywords I was targeting. I have been showing up within the first three links on Yahoo for the search term investment newsletter and a recent change in Google’s algorithm helped me get to page 1 of Google for the same keywords. To understand how competitive the keywords “investment newsletter” are, consider the fact that Yahoo suggests bidding $9.67 per click in case you want your website to show up in the “sponsored links” section. That is $9.67 for someone just clicking on your sponsored link once and landing on your website with just a small possibility (conversion rates are usually just 1% to 5%) of a sale. Since about 80% of people searching for something tend to click on “organic results” and not the sponsored links above the search results, the value of ranking well high in the organic search results for competitive keywords is priceless.

Oddly enough, most of the people using search engines tend to find InsideArbitrage through keywords or phrases that I could not have even imagined optimizing for. For example when I mentioned Chipotle Mexican Grill (CMG) as an excellent IPO in early 2006, a lot of people searching for “Chipotle Investment” landed on InsideArbitrage. Recently it has been people searching for the words “model portfolio”. Looking at conversion rates, I am inclined to believe they had a different kind of model in mind.

Regrets:

Investing is riddled with regrets. At the end of each year you are probably going to be left with more regrets (missed opportunities, sold too soon, sold too late, etc..) than gains and losses. However my biggest regret has nothing to do with investing and with having to lock myself into a room to write the newsletters for hours on end (I am a slow writer, often reviewing and revising what I have written before publication) and not spending that time with my family. Minor regrets include not being able to blog often and not being able to devote the amount of time it takes to get MustFeed.com and the InsideArbitrage forums off the ground.

Testimonials:

Throughout the last two years, I heard frequently from subscribers and visitors who either had a question, wanted to congratulate me on an investment or just wanted to let me know that they look forward to reading the newsletters each month. Those words of encouragement have gone a long way in helping me continue burning the midnight oil to keep this website alive (if not extremely active) while holding down a job and trying to spend time with my family, without whose understanding and support this would not have been possible. Given below are a few of these testimonials,

“I am still waiting to receive your Sep ’06 newsletter. This is the only thing I look forward to read on first of every month other than my salary advice (paycheck).” – Ram N., when the September 2006 newsletter was delayed on account of my trip to Oregon

“I have learned a lot through making bad decisions or rash decisions. Patience is to be practiced and I try to be more and more as I get older. Many things I’ve read on your site, or links provided, have made a very positive impact in the way I think about investments.” – Kevin K.

“I was impressed with the style that (you) wrote with.  There is so much hype when it comes to investing, and your presentation of the investing information is not the norm.  Your presentation came across as personal, and to the point.  Your presentation of the facts was very professional, and was without a bunch of comical fluff.” – Bill M.

“First I would like to thank you for the time you take to frequently share your investing ideas, experiences, and stocks of choice. I, like many others, really enjoy reading your blogs and monthly Newsletter which has surely thought me a lot. Your exceptional track record is clearly a manifest of your ability to pick value stocks.” – Shoaib M.