EVT #1: How to make money like a hedge fund

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Welcome to "Events Trader". My name is Riccardo Marzi. For the past 15 years, I've worked as a City trader in European equities for various institutions, ranging from small start-up brokers to large investment banks.

During my career, I've learned all about the best strategies to make money. I know how to separate useful information from useless spam. And I've learned when it's time to invest, and when you should sit on the sidelines and wait.

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Right now I see a lot of good opportunities in the market. I aim to use my experience and my knowledge to help us all make money from these opportunities using the same strategies employed by hedge funds and investment banks. Individual private investors are perfectly capable of using these strategies it's just that they don't tend to hear about them.

My view on the economy

I'll tell you more about my investment style shortly. But first let me explain what I think the future holds for the economy and why that means plenty of money-making opportunities for us.

The good news is that I think we've seen the worst of the economic contraction. The economy should start rebounding, probably from the fourth quarter of 2009. Why do I think this? Well, the economic slump started in Q3 2008 as consumer demand plunged after the credit markets seized up. It got worse this year as firms cut back production and reduced inventories. But soon the inventories correction should be over and firms will restart production very soon.

The car market is a classic example. After the credit markets seized up, no one could get credit to buy a new car, so inventories of unsold cars piled up, new registrations fell 30-40% year-on-year and car production plants were shuttered, from Luton to Dagenham to Sunderland. But as soon as credit becomes more widely available, people who put off buying a new vehicle for a few months will start to visit dealerships looking for new cars. And with inventories having been run down, car makers will have to ramp up production, boosting activity.

But here lies the biggest danger! People will assume that this recession was a blip and that the world will go back to the credit-fuelled, supercharged economy we saw from 2003 to 2007. But I believe the economy will instead go back to the rather slower growth that we saw in the period from 1995 to 1999, with the added negative that we're in a lot more debt now. Growth will be sluggish for years to come while people repair their balance sheets and pay down all the debt they took on when credit was cheap. The savings ratio will go back to 10% as it did in the late 1990s (it was 0% in 2004-2007 and rose to 5% in Q4 2008).

This is a sucker's rally

The equity market is already rallying in anticipation of the rebound. But this is a sucker's rally here's why. The level of equity markets depends broadly on corporate profits and interest rates. Corporate profits were supercharged by the credit-fuelled economy and in the US reached 14 % of GDP, the highest level ever achieved. But now corporate profit should return to its long-term mean of 8-10% of GDP, implying that equity markets should be lower than in the recent past.

Another negative factor will be the shrinking of the financial sector. In 2007, financials accounted for 40% of all the profit in the S&P 500. But gone are the days of self-regulating markets - now we face much more state intervention. The banking system will be overly regulated, credit will be restricted no more 100% mortgages - and only given to people who can repay it (which is no bad thing anyway). So it's very hard to imagine that the beleaguered and soon-to-be-heavily regulated financial sector will be able to repeat the same profitability pattern.

The worst-case scenario

And we could yet see some more nasty surprises derail any recovery. For example, the worst-case scenario for the near future is an economic crisis in an Eastern European country or - even worse - in a big European economy (Ireland, Spain and Italy all spring to mind). This could have a very negative impact on the euro and the equity markets. But it could also provide an incredible buying opportunity.

Eastern European economies suffered the same fate as the US and the UK, with large current account deficits and big investment and property bubbles. But while the US and the UK are submerged by debt in their local currencies (dollars and pounds), the Eastern European economies took on large amounts of foreign currency debt in lower-yielding currencies, such as the euro or the Swiss franc. So this adds the possibility that a currency crisis will wreak havoc in these economies. Meanwhile, large European economies like Ireland or Spain had a property bubble much worse than the ones in the UK or the US, while Italy might find it difficult to refinance its public debt.

With such concerns hanging over investors, not to mention further woes in the banking sector, I believe the market will take 5-10 years to regain the ground lost in the past year. It could even go lower in the next couple of years while the economy readjusts to the new world order. In the meantime, we'll see the market shrink in size and volume, with many hedge funds and investment banks leaving the market all together, and those remaining taking on a lot less risk.

The good news is that this should increase the price of risk, leaving decent returns for the people who are prepared to shoulder it, returns that should comfortably beat those offered by your average bank account. This is exactly the opposite of the market we witnessed from 2005 to 2008 when risk was underpriced and everyone was taking on too much of it, which meant there were barely any decent opportunities to make money. Now there are going to be plenty.

What this means for your existing portfolio

While the economy readjusts, I think you should favour nominal assets (bonds) over real ones (equities and property). For one thing, you'll avoid the risk of dilution, as companies issue more shares to raise capital. For example, if you had £1,000 in bank shares, you would have lost almost all of it through the various recapitalizations over the past six months, whereas if you had £1,000 in bonds issued by the same bank you would have lost less, and your asset would still have a nominal value of £1,000, which should still be paid in full at the expiry of the bond. Even in the event of a bankruptcy you are better off with bonds. While equity holders are generally wiped out, bondholders can expect to recover a fraction of their nominal value, which according to the seniority of their claim could range from 10% to 60%.

The main risk further down the line in two to three years time is inflation. So any bonds you do hold should be of short-term maturities, at most three years. I would favour corporate bonds over government ones as they yield more, and if you buy a corporate bond issued by a big blue chip company you can probably expect some sort of state bailout if it runs into serious trouble.

As for wider investing, you should only play specific situations and not the general market. And this is where I come in.

My investment strategy

As I said above, I learned a lot during my 15 years in the City. But the two most important lessons I learned are 1) buy when everyone else is panicking; and 2) capital preservation is the most important thing money-making opportunities will always be around but they're no use to you if you don't have the money available to play them!

These two lessons have shaped my investment strategy. For one thing, I don't believe in classical fundamental analysis, where you buy a stock and hold it for five years because it has a bright future or because an analyst says Buy'. I have seen this strategy fail miserably too many times.

Instead, I prefer to play specific opportunities actively, using various strategies used by the likes of hedge funds and investment banks. These strategies range from classic event-driven plays (based on a piece of news or sector trend); to risk arbitrage; yield enhancement using options; pairs trading; risk selection using exchange traded funds; and my favourite of the lot, distressed assets. Don't worry if you're not familiar with some or all of these I'll talk you through exactly how each trade works.

In terms of what I look for in a trade, I am a contrarian. My philosophy is to look for a favourable risk/reward profile. I look for risks that the market has exaggerated, or returns that no one has yet spotted, or are too scared to play. The timeframe of my trading ideas will range from two weeks to 10 years, and I don't limit myself to a specific strategy or a single asset class. Money is money regardless of where you make it - £1,000 made in equities is exactly the same as £1,000 made in commodities.

Most importantly, each position has to make money. I don't see the point in worrying about outperforming a market, especially one that falls. Who cares if you only' lose 10% when the market has lost 15%? You're still out of pocket. Because of this, I believe risk should be minimized. I would rather produce a 15% return without market risk in a market that rises 20%, than a 22% return with extra risks in the same market.

I will be launching the Events Trader service officially next month. But over the next few weeks you will be part of the small exclusive group who will receive my weekly newsletter and recommendations completely FREE.

One last important thing, I welcome feedback, so do feel free to ask me questions or send in your views. My e-mail is eventstrader@f-s-p.co.uk.

And now we'll get straight into our first tip

Rights issue-driven strategy: Snam Rete Gas (Milan: SRG)

Snam Rete Gas is the Italian equivalent of British Gas owner Centrica. Snam's main business is the transportation of gas through a pipeline network in Italy. It's a regulated, stable utility-like business that has as a business model a return on its Regulatory Asset Base (RAB) more or less like the way the water sector works here in Britain. Below is a chart of the share price over the past five years.

The fundamentals of the stock are average, not too dear and not too cheap, with the stock trading on around 15x earnings and with a historical dividend yield of around 4.7%. It's also a low volatility stock, with a beta of 0.5 versus the main index (in other words, the stock is about half as volatile as the main index).

Snam just reported first quarter results for 2009 which showed net profit falling 13% to €116m with earnings before interest, tax, depreciation and amortisation (EBITDA) falling 8% and revenues dropping 5% to €453m. Results were impacted by lower demand due to the recession and also due to lower transport fees as a result of the Russia-Ukraine gas dispute at the beginning of the year.

Considering the severity of the recession I do not think these results were as bad as some other US or European companies. But the main reason I am suggesting this stock, is that Snam recently announced the purchase of another company, Stogit (or Stoccaggi Italia), from its main shareholder ENI .

ENI is the integrated oil company that dominates the Italian energy market (Italy's equivalent of BP or Shell). It has a controlling stake in Snam. Stogit is the company that controls gas storage in Italy. Much like Snam Rete Gas, it has a stable business whose returns are also based on its RAB.

The opportunity

The opportunity lies in the fact that to finance the purchase of Stogit, Snam will conduct a large rights issue, offering new shares to existing shareholders. So the stock is expected to come under pressure for a few days while the rights issue is taking place and then hopefully to rebound once the whole thing is over.

Snam is looking to raise €3.5bn, which in the current market is not a small sum. The main shareholder ENI will take up its part of the issue, but the market is still expected to come up with the other €1.9bn.

The details of the rights issue are as follows: Snam is issuing 11 new shares for every 12 old shares, at €2.15 each. This represents a discount of around 35% to the current share price. The issue runs from April 27th of April until May 15th. The new shares will not be entitled to the 2008 dividend and will be delivered to the subscriber around May 17th or 18th.

During the rights issue, the stock is likely to come under pressure. That's because people who are not prepared to invest more money in the company will likely sell their rights in the market. This will result in a steady stream of sellers that will push the price of the rights and the price of the stock lower, perhaps by as much as 10% or slightly more.

This effect is generally most evident in the last couple of days of the rights issue, when most of the rights are sold off by the banks and the brokers on behalf of their clients. Once the issue is over, the stream of sellers ends and the stock generally outperforms the market in the following few weeks. The profit for this kind of trade could be around 5-10%, but this depends on the movement of the stock before and during the actual rights issue.

The strategy

The strategy is very simple. Just wait for the end of the rights issue and then buy the stock in expectation of a bounce, which is generally in proportion to the stock movement during the rights issue.

The best strategy is to wait for the last two days and buy the stock on Thursday May 14th or Friday 15th in other words, near the end of this week. Clearly the stock has to fall in price there's no point in buying if it hasn't fallen, as there may be no bounce.

The stock to buy is Milan-listed Snam Rete Gas (IM: SRG) don't buy the rights! You should buy the stock at between €3 and €3.10 (it is currently trading at around €3.31). So you could place a limit order at €3.10 (a limit order is an order that only gets executed if the stock reaches the price of your limit).

As the price can be quite volatile during the right issue period be prepared to buy more stock if it falls below €2.90 per share. The best idea in my view, is to buy 50% of the position between €3 and €3.10, and the remaining 50% between €2.80 and €2.90, if it falls that far. If the stock does not fall enough, don't worry, just run the smaller position I just think it's always worth having spare ammunition on hand.

Once you have bought the stock, all you have to do is sit and wait for it to bounce back. This might take up to two weeks (three at worst). The target selling price is between €3.35 and €3.40 - but of course this will also depend on the mood and movement of the market. In any case, I'll send you an email to let you know when to sell.

The risks

The main risk with this strategy is market risk the danger that once you have bought your stock the market as a whole might move lower (especially in volatile times like these). As we will be invested in the stock for at most three weeks there is little scope for market hedging (unless the market becomes choppy as in February). The other risk you carry is currency risk. As Snam's stock is listed in euros, you bear the risk of a rise in the value of the pound, which might decrease your profit or increase your losses. Again this could be hedged, but it's not worth it for a position that should run only for a few weeks.

Conclusion

If the stock does not hit €3.1 or lower, don't buy it, as the risk / reward profile will not work at a higher price. Something else will come along soon remember there will always be opportunities!

The stock will go in the control portfolio at the opening price on May 15th. And one final point I do plan to use this strategy for my own personal portfolio. Due to my publisher's rules on personal trading, I'll have to wait to buy until May 15th, but if the stock goes lower than our target buy price before then, you should buy.

Summary

Buy: Snam Rete Gas (IM: SRG)

Expected timing: 14/05/09 and/or 15/05/09

Buy price: 50% between €3 and €3.10; 50% between €2.80 and €2.90. (If the stock does not fall to €3.10 or lower, do not buy)

Sell price: Between €3.35 and €3.40

Estimated duration of trade: up to two weeks (three at most)

Good luck!