An arbitrage method to eliminate systematic risks and industry-related risks

1. Philosophy

1. There are some factors determining the price of stock that are statistically difficult or even unlikely to be accurately estimated. The accuracy of an absolute valuation should not be highly expected statistically.

2. CAPM is misleading. While I admit I have not been able to prove that CAPM is wrong theoretically, the CAPM theory is not clear mathematically. However, the common way to calculate Beta, the factor that plays a key role in the use of CAPM, is actually wrong. The calculation goes through the same wrong way as described in another paper of mine on the misuse of statistics in practice. Therefore, if CAPM is wrong, an absolute valuation method based on CAPM won’t give us the right answer.

3. However, a smart arbitrage method can help eliminate risks by bypassing the factors that we don’t know well and focusing only on those ones that we can control.

2. Stock picks and L/S operation

Search a pair of relatively mispriced stocks in the same sector and with similar product, service, and business structure.

Long the good one and short sell the bad one simultaneously.

3. Logics and theoretical base

a. Compared with forecasting macro economy or market or analyzing an industry such as consumers and new product, it is always easier to compare a pair of companies’ relative asset quality (current product and service), business operation (expense), and its finance structure.

b. In a bullish or bearish market, the differences of comparable companies in the firm-specific factors mentioned above may not be reflected completely on the price of their stocks, because the whole market, which is exerting the same influence on them, is performing too good or too bad.

c. A radical change in macro economy or market will significantly differentiate this pair of comparable companies in terms of their ability to generate cash flow based on their asset quality, expense management, or strength of financing, and thus correct the mismatch. For example, in a down turning market, the price of good one that we long will go down more slowly than the bad one that we short. It is just the opposite in a going up market.

d. In this way, we can gain returns according to the degree to which this pair of stocks are mispriced. Although returns are cut more than half in this operation, it helps rule out completely systematic risk and industry risk, and leave only a small part of firm-specific risk, which is well under control based on my experience.

4. Timing and holding period

Short bearish/ bullish cycle on Asia and EM provides tremendous opportunities for such operation.

One formula that I developed based on my own understanding of China and its macro economy data can help trace a clue: more than 9% change in the total of personal consumer’s expenditure + adjustment in residential housing investment + net exports