Third Derivative Investing
The capital markets may appear to be extremely complicated featuring many players backed with huge sums of capital each with their army of research analysts. These numberless people scour the world in search of the latest tidbit of information, devouring 10K’s and 10Q’s looking for an edge on the thousands of stocks and bonds that make up the investing universe. So how can you as an investor compete with that? Simple answer, you can't. At least not at that game. So what is the game that will help you create excess, giant returns? It is something we at Pecunia Capital call Third Derivative Investing.
A typical stock investment usually occurs when a broker or financial consultant phones up their customer to recommend some company that the investing professional believes has a bright future. Again, virtually every stock in the market is followed by a slew of analysts, some of the bigger names are followed by dozens of analysts. Each analyst devours a company’s financial condition, investigates the company’s competitive environment, and comes out with a projection of future earnings and with it a future price. This is a game that cannot be won by the individual investor as the people with the money and the inside connections have a distinct advantage over you the individual investor. Your best bet it to put your money in a low-cost index fund and just ride the market up over time as the economy grows.
The key reason that individual investors are at a disadvantage in the purchase of a single security is what we call the first derivate conundrum. No matter how many analysts are following a stock, they never all agree and secondly, they are almost always wrong. That is because in this context, the future is rarely knowable. The first derivative is a change in the consensus estimates of the future cash flows of the stock in which you invested. For some reason that will never become apparent to you until it is too late, the company will miss their earnings, their sales will fall short of what they predicted, and the stock will move down. It can just as easily be the reverse, the company does better than expected and the stock price increases. But as you can see this is as close to random as random comes and an individual investor’s chances of keeping up and making profits are limited.
Next, we come to the second derivative. This is a change in the change of the consensus. In other words, something unknown in the business world acts to change the future outlook of the company. Something very few, if any, were expecting. The business suddenly develops a new product, or a new marketing strategy or consumer preferences change either for the benefit or detriment of the company. This is where a normally staid investment turns into a rather good investment. If you have a particular insight into a company or an industry, you can profit from these moves. But if you are like most, you will rarely be able to predict this.
It is the third derivative where the true fortunes are made and the reason that they are spectacularly great investments is because they are rare and the trends that they represent are seldom noticed (by the vast swaths of the investing world) as the great investment opportunities they will soon become. The first thing you might wonder is why not? Why doesn’t Wall Street see these Third Derivative opportunities and let you the investor know about them. And the answer exists in the following dilemma. The financial services industry needs to always be selling you something. Always. Waiting around for these once-a-year opportunities (or once every other year) does not serve their business interests, or their pocketbooks. They must be constantly selling you something, the latest investment fad.
So, what is Third Derivative Investing? Third Derivative Investing is where the fundamental nature of a business or consumer preferences change, and that change is not recognized by the market. But more importantly, it always takes far longer (than one would imagine) for the truth to become apparent to the investment universe. You may have to wait a long time, sometimes years, scouring the business environment, looking for these rare opportunities and they are rare because as stated above there are numerous players with huge budgets that make sure the markets are mostly, almost always efficient. But notice, mostly and almost always. In the midst of this market efficiency comes opportunities that present themselves and for a brief moment in time may be acted upon by savvy investors. Investors who are religiously paying attention to those one or two opportunities per year can reap huge rewards.
Such distinct changes in the business environment usually occur in the commodities markets such as oil and natural gas, precious metals such as gold and palladium, the forex market and especially in the technology area.
A perfect example of this was the introduction of the iPhone by Apple. From its original launch it was becoming increasingly clear that everyone was eventually going to buy an iPhone, both for its superior applicability and its groovy style. The leader in the industry at the time was Blackberry who swore up and down that they had an answer to the Apple juggernaut. Anyone who was paying attention knew that was baloney. But the market took its sweet time punishing the stock of Blackberry for this change in technology and consumer behavior. Savvy investors made a fortune shorting the stock as it slowly drifted from its high of $140 to around $10 where it sits now. Another examples of a current, major business disruption is the ongoing cord cutting whereby consumers (especially the young) are refusing to sign up for expensive cable tv packages, instead going “over the top” with a range of internet delivered options. If you have children, you may have notices that they rarely if ever watch television. That will create both chaos in the market and great investment opportunities for those who are paying attention.
Similarly, in the oil markets a crazy thing happened when the pandemic hit. The economies of most major industrial countries ground to halt and with it their seemingly insatiable desire for oil. Oil demand went from around 100 million barrels per day to less than 70 million. There is a major problem with oil production and that is, it is extremely difficult to shut down a producing oil field and shutting down a field can lead to permanent damage to the oil reservoir itself. However, the market was unable to absorb this massive amount of overproduction. Every available oil storage tank was filled. The industry even resorted to “floating storage” where the oil would sit on oil tankers with no place to go. Eventually the industry ran out of oil tankers and with nowhere for oil to go, instead of charging $100 per barrel (the price in 2019) they had to resort to paying you to take their oil. Instead of charging $100 per barrel they were paying $40 to anyone who could take their oil off their hands. The key to making money off this debacle was this. It took months before the market came to grips with this catastrophe, as firm after firm went bankrupt. But for those savvy investors that followed the oil markets it was easy money. One of the true “investments of a lifetime”.
Other examples of Third Derivate situations range from the mortgage debt mania that led to the mortgage crisis in 2009, the internet bubble in the late 1990’s, and more recently to the explosion of social media, the introduction of electric vehicles, and renewable energy, all of which will have massive future business opportunities. Again, all of these investment opportunities take time for the market to digest (because they are so new) and savvy investors can generate enormous returns in the process.
Just to complete the investing circle there is the fourth derivative, but these tend to be binary and usually come about because of a change in the regulatory environment or simply the government outlawing or encouraging one industry or another. These come along even more infrequently than third derivative situations and can be extremely profitable as well. An example would be the virtual ban on smoking that decimated tobacco stocks, which were some of the best performing investments for something like 50 years. Better yet was the decision by the Obama administration, in 2015, to end the ban on the export of oil and natural gas that led to the melt up of E&P players and the bubble in that industry. A bubble that eventually broke in 2020. Let’s look more deeply at that decision. In the past, with very few exceptions, oil and natural gas could not be exported outside the US which makes sense as it is a limited natural resource and should be available to the people of the United States and their descendants, not sold off to foreign countries. What was once, a valuable commodity, saved for the common good of the people, would now be sent overseas for the profit of a few rich people. Again, such major changes in government policy can have far and wide-ranging effects on investments. In this case, oil production in the US exploded, rising to a high of thirteen million barrels per day from an average of about four million barrels per day, where it had been for decades. At $100 per barrel that was a lot of money that a few savvy investors were able to profit from.
The best way to achieve life changing returns is to follow the principles of Third Derivative Investing. That is, watch and study the markets religiously, be patient and wait for the emergence of those third derivative (and fourth derivative) opportunities and take advantage as the unfolding scenario plays out. Only problem is that you may have to spend many days, weeks and months staring at your screen waiting for these opportunities to arise. That is what we do for you.
If you would like more information, please feel free to contact us.
A typical stock investment usually occurs when a broker or financial consultant phones up their customer to recommend some company that the investing professional believes has a bright future. Again, virtually every stock in the market is followed by a slew of analysts, some of the bigger names are followed by dozens of analysts. Each analyst devours a company’s financial condition, investigates the company’s competitive environment, and comes out with a projection of future earnings and with it a future price. This is a game that cannot be won by the individual investor as the people with the money and the inside connections have a distinct advantage over you the individual investor. Your best bet it to put your money in a low-cost index fund and just ride the market up over time as the economy grows.
The key reason that individual investors are at a disadvantage in the purchase of a single security is what we call the first derivate conundrum. No matter how many analysts are following a stock, they never all agree and secondly, they are almost always wrong. That is because in this context, the future is rarely knowable. The first derivative is a change in the consensus estimates of the future cash flows of the stock in which you invested. For some reason that will never become apparent to you until it is too late, the company will miss their earnings, their sales will fall short of what they predicted, and the stock will move down. It can just as easily be the reverse, the company does better than expected and the stock price increases. But as you can see this is as close to random as random comes and an individual investor’s chances of keeping up and making profits are limited.
Next, we come to the second derivative. This is a change in the change of the consensus. In other words, something unknown in the business world acts to change the future outlook of the company. Something very few, if any, were expecting. The business suddenly develops a new product, or a new marketing strategy or consumer preferences change either for the benefit or detriment of the company. This is where a normally staid investment turns into a rather good investment. If you have a particular insight into a company or an industry, you can profit from these moves. But if you are like most, you will rarely be able to predict this.
It is the third derivative where the true fortunes are made and the reason that they are spectacularly great investments is because they are rare and the trends that they represent are seldom noticed (by the vast swaths of the investing world) as the great investment opportunities they will soon become. The first thing you might wonder is why not? Why doesn’t Wall Street see these Third Derivative opportunities and let you the investor know about them. And the answer exists in the following dilemma. The financial services industry needs to always be selling you something. Always. Waiting around for these once-a-year opportunities (or once every other year) does not serve their business interests, or their pocketbooks. They must be constantly selling you something, the latest investment fad.
So, what is Third Derivative Investing? Third Derivative Investing is where the fundamental nature of a business or consumer preferences change, and that change is not recognized by the market. But more importantly, it always takes far longer (than one would imagine) for the truth to become apparent to the investment universe. You may have to wait a long time, sometimes years, scouring the business environment, looking for these rare opportunities and they are rare because as stated above there are numerous players with huge budgets that make sure the markets are mostly, almost always efficient. But notice, mostly and almost always. In the midst of this market efficiency comes opportunities that present themselves and for a brief moment in time may be acted upon by savvy investors. Investors who are religiously paying attention to those one or two opportunities per year can reap huge rewards.
Such distinct changes in the business environment usually occur in the commodities markets such as oil and natural gas, precious metals such as gold and palladium, the forex market and especially in the technology area.
A perfect example of this was the introduction of the iPhone by Apple. From its original launch it was becoming increasingly clear that everyone was eventually going to buy an iPhone, both for its superior applicability and its groovy style. The leader in the industry at the time was Blackberry who swore up and down that they had an answer to the Apple juggernaut. Anyone who was paying attention knew that was baloney. But the market took its sweet time punishing the stock of Blackberry for this change in technology and consumer behavior. Savvy investors made a fortune shorting the stock as it slowly drifted from its high of $140 to around $10 where it sits now. Another examples of a current, major business disruption is the ongoing cord cutting whereby consumers (especially the young) are refusing to sign up for expensive cable tv packages, instead going “over the top” with a range of internet delivered options. If you have children, you may have notices that they rarely if ever watch television. That will create both chaos in the market and great investment opportunities for those who are paying attention.
Similarly, in the oil markets a crazy thing happened when the pandemic hit. The economies of most major industrial countries ground to halt and with it their seemingly insatiable desire for oil. Oil demand went from around 100 million barrels per day to less than 70 million. There is a major problem with oil production and that is, it is extremely difficult to shut down a producing oil field and shutting down a field can lead to permanent damage to the oil reservoir itself. However, the market was unable to absorb this massive amount of overproduction. Every available oil storage tank was filled. The industry even resorted to “floating storage” where the oil would sit on oil tankers with no place to go. Eventually the industry ran out of oil tankers and with nowhere for oil to go, instead of charging $100 per barrel (the price in 2019) they had to resort to paying you to take their oil. Instead of charging $100 per barrel they were paying $40 to anyone who could take their oil off their hands. The key to making money off this debacle was this. It took months before the market came to grips with this catastrophe, as firm after firm went bankrupt. But for those savvy investors that followed the oil markets it was easy money. One of the true “investments of a lifetime”.
Other examples of Third Derivate situations range from the mortgage debt mania that led to the mortgage crisis in 2009, the internet bubble in the late 1990’s, and more recently to the explosion of social media, the introduction of electric vehicles, and renewable energy, all of which will have massive future business opportunities. Again, all of these investment opportunities take time for the market to digest (because they are so new) and savvy investors can generate enormous returns in the process.
Just to complete the investing circle there is the fourth derivative, but these tend to be binary and usually come about because of a change in the regulatory environment or simply the government outlawing or encouraging one industry or another. These come along even more infrequently than third derivative situations and can be extremely profitable as well. An example would be the virtual ban on smoking that decimated tobacco stocks, which were some of the best performing investments for something like 50 years. Better yet was the decision by the Obama administration, in 2015, to end the ban on the export of oil and natural gas that led to the melt up of E&P players and the bubble in that industry. A bubble that eventually broke in 2020. Let’s look more deeply at that decision. In the past, with very few exceptions, oil and natural gas could not be exported outside the US which makes sense as it is a limited natural resource and should be available to the people of the United States and their descendants, not sold off to foreign countries. What was once, a valuable commodity, saved for the common good of the people, would now be sent overseas for the profit of a few rich people. Again, such major changes in government policy can have far and wide-ranging effects on investments. In this case, oil production in the US exploded, rising to a high of thirteen million barrels per day from an average of about four million barrels per day, where it had been for decades. At $100 per barrel that was a lot of money that a few savvy investors were able to profit from.
The best way to achieve life changing returns is to follow the principles of Third Derivative Investing. That is, watch and study the markets religiously, be patient and wait for the emergence of those third derivative (and fourth derivative) opportunities and take advantage as the unfolding scenario plays out. Only problem is that you may have to spend many days, weeks and months staring at your screen waiting for these opportunities to arise. That is what we do for you.
If you would like more information, please feel free to contact us.