Investment: Fun for physicists?

By James R. Claycomb

I began investing in 1993, when I was a beginning graduate student in physics. As an undergraduate, I had accumulated a modest sum of money by participating in an employee stock-ownership program (ESOP) offered by my employer, Randall’s Food Markets. I contributed 14% of my weekly income and Randall’s matched half of that, or 7%. Luckily, before I left Randall’s, their stock price doubled, and I split the funds between an E*TRADE margin account and an Accutrade (now Ameritrade) Roth IRA. I opened a Wells Trade account in 2003 with rollover 403-b funds I had accumulated as a research assistant and post doctoral associate at the University of Houston, Texas Center for Superconductivity.

My stock picks throughout the remainder of the 1990s and early 2000s were determined by price graphs and volume data. Having a background in physics, I found such technical indicators appealing. I had some mixed results picking companies that I had no feel for, such as Telefonos de Mexico (TMX) and PotashCorp (POT). Often I would put in a stop loss after purchasing a stock that would result in an immediate loss. Sometimes I made a profit. The strategy I tried to follow is outlined in the classic book, How I Made $2 million in the Stock Market, by Nicholas Darvas.¹ I would find stocks in Investors Business Daily (IBD), online, and on cable TV. Each year I was left with a pile of trade confirmations and routinely declared a net loss on my income tax. I might have had greater success if I wasn’t more interested in plotting chaotic trajectories in MathCAD than concentrating on stocks.

A turning point came in 2003 after I invested all my remaining funds in Krispy Kreme Donuts (KKD). The stock promptly dropped several points, at which time I liquidated all of my holding for a healthy loss. About that time, I actually visited a Krispy Kreme in Houston. The donuts were not hot and steamy as I had imagined them. I think part of the disappointment is that a conveyer belt transporting the donuts through the deep fat fryer is showcased behind a glass wall, whereas donuts purchased from the rack are at room temperature. The not-at-all-strong coffee was served in a polystyrene foam cup with microbubbles adhering to the sides.

At about that time it occurred to me to buy stocks in companies whose product or service I use or admire. This is the strategy of stock guru Peter Lynch, author of Beating the Street ² and One Up on Wall Street.³ It was a pivotal moment for me. I decided that not only would I buy stock in companies with products or services that I use or admire, but that I would purchase many such stocks to hold long term with the idea that, on average, the group of stocks had to do well. My initial picks included Starbucks (SBUX), Whole Foods (WFMI), eBay (EBAY) and Google (GOOG). At that time internet stocks were not particularly popular, having led the market collapse of 2000. I also decided to go long in my positions and not frantically buy and sell. Although my portfolio began to grow, I had some lessons yet to learn.

Lessons learned

A few of my holdings, including Bombay Company (BBA), Bally Total Fitness (BFT), and some fuel cell stocks went to zero or epsilon. I noticed that a lack of earnings, with a price-to-earnings (PE) ratio listed as N/A, was common among these stocks. I was not devastated by the losses because other stocks in my portfolio were making significant gains.

I considered the fuel cell stocks as speculative plays and purchased a few shares after their monumental collapse in 2000. Unfortunately, I got to ride them down even further. Stocks without earnings that rise precipitously are the financial equivalent of a false vacuum.

I have been a member of Bally’s since 1989 and was excited about having a health and fitness stock in my portfolio. Although the company was in financial trouble, I reasoned that if they could fill up the parking lot every day, then they wouldn’t go broke. The stock plunged 99% and was removed from the NYSE.

Bombay Company made the mistake of opening too many stores and subsequently closed all their US stores. I have yet to relinquish my worthless shares. I never would have guessed that something other than a lack of earnings would cause this one to go belly up. I now own stock in Kirkland’s (KIRK), which is also in the inexpensive home décor business.

New Alternatives Fund (NALFX) features solar, wind, and other alternative energy sources and advertises that it holds no nuclear or petroleum-based stocks. I became weary of seeing NALFX underperform the rest of my portfolio. Upon further investigation, I found that many of its primary holdings had no earnings! I dumped it. My alternative energy stocks are now Sunpower Corp (SPWRA) and American Superconductor (AMSC), currently at a very discounted price. I would be interested to see a geothermal energy company become earnings positive. I am against using the precious resource of nuclear energy to generate light pollution and fuel toaster ovens. Nuclear materials should be conserved for applications in which it is uniquely suited, such as for space exploration.

Partly as a result of these lessons, I waited for Amazon.com (AMZN) to become earnings positive before purchasing it. I am currently eyeing Tesla Electric (TSLA) vehicles in hopes they will become profitable. Evidently Tesla’s Roadster has a top speed of 125 mph with 288 hp and a range of 245 miles. Some recent picks of mine include CarMax (KMX) and Sirius Satellite Radio (SIRI). CarMax has introduced some standardization to the used car industry.

When is a good time to sell?

A key feature of my current strategy is maintaining long positions without frequent trading. However, I have tried to lock in some profit when stocks make precipitous price increases. For example, I sold half of my initial Google purchase at various times after its IPO in 2003. I used that capital to buy new stocks such as Netflix (NFLX). I have recently taken some profit in Netflix by selling more than 50% percent. I am also monitoring the Facebook IPO projected for 2012.

Financial markets generally exhibit unstable behavior, with crashes of varying sizes and durations. The dynamics may be an example of self-organized criticality (SOC)⁴ in which correction sizes and durations are described by power laws. Unlike SOC models that exhibit slowly driven, interaction-dominated threshold behavior,⁵ market dynamics are not slowly driven. Middle East turmoil may drive the market one day and unemployment figures the next. When the stock market begins to make a top, large day-to-day fluctuations can occur in the Dow Jones industrial Average and in the NASDAQ stock exchange.

That was the case in 2000, 2008, and 2011. It is best not to be on margin during a correction. Before 2003 I was usually on margin and suffered double losses when stocks plummeted. I have since resolved to stay off margin completely and have not taken much of a beating, even with the collapse of my zero-earnings picks and the market correction of 2008. Amidst the market turbulence of 2008, I liquidated roughly 20% of my holdings and was later able to pick up such favorite stocks as eBay and Whole Foods at a reduced price. In August 2011, I liquidated about 30% of my current stock assets. Figure 1 shows a double-sided histogram of the portfolio with increases (decreases) since purchase.

A $1000 taco

A recent visit to Chipotle Mexican Restaurant (CMG) succinctly highlights my stock picking strategy. On this occasion I ordered the soft tacos. They were so good that I decided to buy some of the company’s stock. I was amazed to see that the stock price was over $100, so I purchased only a few shares. The stock soon doubled, and I decided to sell 25% of my CMG stock and thus lock in some profit. It is now trading at over $300 per share.

In summary

My advice for physicists who are beginning to invest is to start searching for companies that you actually find interesting. Visit their homepage or physical establishment. Look up their stock graph and earnings data on charting services such as Big Charts . Many companies you find will not be publicly traded. Some investors build a portfolio of franchises. You don’t have to purchase the stock immediately or establish your ultimate position in one transaction. If the stock is run up, you might wait for a correction to stick your toe in. On several occasions when I thought it was too late to buy, the security would continue to make spectacular price increases. Sometimes I would sell a stock and it would keep climbing. I finally decided to sell small fractions after major run ups and turbulent times.

Your success probability is greater if you diversify and go with companies that are earnings positive. Before 2003 I would never have dreamed of purchasing a stock priced over $100. I had to overcome my psychological resistance to purchasing small, odd lots of pricey stocks. If you find a company with attractive features but have some reservations, then wait. Sometimes companies treat their employees poorly or have some other major downside. Investigating companies online and on the ground is important and can be revealing. Picking companies that you find interesting makes the investigation a less tedious process. Here are some key points:

• Buy stock in companies whose products or services you like. This makes investing fun.
• Diversify your holdings. Don’t bet the farm on a donut shop you have never visited.
• Avoid erratic buying and selling unless you are actually good at trading.
• Don’t go on margin.
• Raise a little cash when markets get shaky. Look for bargains when volatility subsides.
• Sell a few shares when the stock price rises precipitously.
• Sell if the company’s attractive features diminish or if the company is no longer profitable.
• Buy stock in companies with earnings. Put attractive stocks on your watch list until they are profitable.
• Take advantage of employer matching in your 403-b or other retirement account.
• Keep an eye out for ‘churning’ in your retirement account. Sometimes fund managers engage in erratic buying and selling to generate commissions at your expense.

References

• 1. N. Darvas, How I Made $2,000,000 in the Stock Market, American Research Council, Larchmont, NY (1960).
• 2. P. Lynch, Beating the Street, Simon & Schuster, New York (1993).
• 3. P. Lynch, One Up on Wall Street: How to Use What You Already Know to Make Money in the Market, Simon and Schuster, New York (1989).
• 4. P. Bak, How Nature Works: The Science of Self-organized Criticality, Springer, New York (1996).
• 5. H. J. Jensen, Self-Organized Criticality: Emergent Complex Behavior in Physical and Biological Systems, Cambridge U. Press, New York (1998).

James Claycomb belongs to the department of mathematics and physics at Houston Baptist University. His research involves magnetic measurements using Superconducting Quantum Interference Device (SQUID) magnetometers.