Monday, January 4, 2016

Betting on Stupid: A Foreign Policy Investment Strategy

If you've ever considered managing your own money in the stock market, you've probably heard the mantra to "Invest in what you know". The basic idea is that by investing in industries that you personally know things about, you'll actually have a pretty good chance of picking out the best companies. If you were knowledgeable about computers and programming, maybe that meant you could see that Google was the real thing before everyone else. If you're a movie buff, maybe you knew Blockbuster was going to perish before it did. The point is that even if you're just a layperson who isn’t an expert on the stock market, there's a chance you'll still know more about what companies will succeed in your niche area of interest than the professional analyst who was arbitrarily assigned to work on that industry.

I find this idea compelling for a couple reasons. Psychologically, there's something appealing about thinking that the little guy will still be able to best the experts. And empirically, it is quite easy to point to various historical episodes, like 2008, where the conventional wisdom among most experts was disastrously mistaken.

But, when it comes to actually adopting and implementing this idea, there seems to be a problem. You see, the thing I know the most about is US foreign policy, and the only meaningful way to bet on that is to invest in the Defense contractors. And being a noninterventionist myself, making money off the companies that a) lobby for more aggressive US foreign policy and b) manufacture the weapons and munitions that inevitably kill civilians, seems to be a decidedly gross prospect on the surface. However, this moral repugnance we have to investing in objectionable public companies does not stand up to closer scrutiny.

All of which brings us to the focus of today's piece. I would like to tentatively propose an investment strategy based on our understanding of US foreign policy. For obvious reasons, I call it Betting on Stupid. We'll begin by discussing the ethical considerations of this strategy and then proceed to discuss the details of the strategy and why it should work.

(And before I get to the details, in case discussing such matters violates laws I don't know or opens up the possibility of legal liability for myself, please note that the strategy I'm proposing is highly speculative and risky. I am not a professional investor, I have no directly relevant licenses, and should you choose to follow the strategy presented below, you do so entirely at your own peril.)

Ethical Considerations of Investing

Many people do not understand the complicated nature of the relationship between a company's shareholders and share price on the one hand, and its actual operations on the other. The relationship turns out to be very indirect, which has important implications when considering ethics. Here, we'll just go over some of the basics, and we'll use Joe Gun Co. as our hypothetical protagonist.

Private companies go public through an IPO process (or initial public offering), where shares are first offered to the public for sale. The price of these shares (the offering price) is determined by the underwriter that is coordinating the sale (think Goldman Sachs and their competitors) based on its valuation of Joe Gun. On the official day of the IPO, the shares get sold to public at this price, and Joe Gun gets the proceeds of the sale (offering price times number of shares) less a small commission taken by the underwriter. Joe Gun will then use these proceeds to expand its operations, hire new workers, etc. The key thing to note here is that after this first day sale, Joe Gun has relatively little involvement with the stock itself.

Let's say for instance, that Joe Gun initially sold 1,000 shares at an offering price of $20 per share. Joe Gun would get around $20,000 (less commission) to invest in its operations. But if next week, the stock price shoots up to $30 per share, nothing really happens to the company. It might gain some notoriety, but the company itself doesn't get any extra money as a result of its stock price rising after the IPO. The existing shares are simply trading hands in the open market among random investors, and the price fluctuates according to how promising Joe Gun appears to be.

Now, there are certain limited ways in which the stock price does impact the Company. Here are the main ones:

  • Joe Gun’s executives are hired and fired by the major investors (via the Board of Directors). If the stock price plummets for too long, irritated investors might blame the existing executives and try to fire them. 
  • The executives typically own stock themselves, which gives them a direct interest, and they also know there’s a chance that they will be fired if the stock performs very poorly.
  • If the share price falls very low, the company might decide to buy back some of its shares. This will help existing investors because fewer shares in the marketplace means each share represents a larger percentage of the company. But this also reduces the resources the company has available to expand its operations. (This, in turn, means that if you don’t like what a particular company does, a share buyback is probably a good thing—because in the future, the company will have less resources be able to do as much of anything.)
  • Conversely, if the share price is very high, the company may be considering offering additional shares. This would give the company extra resources (just like the initial offering did), but it dilutes the value of each share. Thus, it tends to make the existing investors angry and doesn’t happen all that often.
Once we look at the limited ways the stock price can actually impact a company, we realize that the linkage is very weak. An individual investor’s decision to buy a stock on the market increases the demand and will tend to increase the price of that stock. As one individual among thousands in marketplace, it is of course unlikely that you could cause a visible impact on the stock. But even if you did have a visible effect, the loose link between shares and the actual company means it has little effect on the company’s actual operations in any case. Thus, it appears that the decision to buy a share of stock in an ethically questionable company is not itself unethical because it has a negligible impact on the company itself.

What about after the purchase is made? Can we ethically justify holding shares of companies we find objectionable? After all, owning a share typically entitles a person to a share of the company’s profits as well as gains if the company’s success increases the stock price. However, just because you stand to benefit financially if the company performs well, that does not necessarily mean that you hope they will succeed. For example, stands to continue generating page views and revenue as long as the US government keeps participating in and agitating for wars. Obviously, it does not follow that the administrators of the website hope that is what happens. On the contrary, they are actively working for their own obsolescence.

And so the same can be said for the stock market. Another way to see this is by comparing it to betting on football. I support the Miami Dolphins and thus deeply dislike the New England Patriots. Unfortunately, the Miami Dolphins are rarely good and New England Patriots have performed well for quite some time. If the two played each other and I wanted to place a bet on who would win, the smart move would be to bet on the Patriots. I can still cheer for the Dolphins, but I should bet based on what I think will happen, not what I want to happen. In this case, betting on the Patriots wouldn’t mean betraying my loyalty to the Dolphins, because my betting decision has no chance of impacting the course of the game. If I were to place a bet and then try to bribe the officials in the Patriots’ favor, that would be an issue. But betting alone is not. Placing a bet or holding a share is not a moral endorsement of the outcome or the company. In both cases, I’m just a spectator making a prediction about what the future holds. The subject matter is different, but the underlying logic is the same.

Thus, we arrive at a counterintuitive conclusion. It’s not unethical to invest in an unethical public company. As long as you avoid the IPO, buying and holding the stock of even the worst company is still a fundamentally neutral activity.

The Strategy

With our paradoxical moral justification in place, we can proceed to discuss the specifics.

In the aftermath of the recent terrorist attacks in Paris, The Intercept had a piece reporting on the soaring stock prices of all the major weapons manufacturers. The logic here is intuitive. In spite of the fact that all of the terrorists involved in those attacks were European citizens, it was virtually inevitable that Western countries would respond to the attacks by increased bombing and potentially sending more ground troops to Syria or Iraq. That, in turn, means more munitions sales for the weapons manufacturers. It also means more instability in the general region, and likely, more terrorism blowback in the near future. And as the past 14+ years have shown, it’s unlikely this is going to end any time soon.

Perhaps the market is focused on the short-term consequences, or perhaps the investors understand what our politicians pretend not to—that the War on Terror is self-perpetuating and does not solve anything. Either way, The Intercept’s piece was intriguing and I decided to look at the historical performance of some of the companies listed. It turns out, their stock performance has been consistently strong throughout the War on Terror era. Here are a few examples:

As you can see, the general pattern for these is similar. Except for a small drop in 2008, they have all been basically increasing steadily since 2001 and the inauguration of the War on Terror. And again, this should be predictable. US foreign policy has been remarkably hawkish throughout this period, under Republican and Democratic leadership alike. The Afghan War continues and the US still has troops in Iraq, but now Obama has given us bonus chaos in Yemen and Libya, in addition to what the weak Republicans were able to achieve through 2008. And with the Presidential campaign shaping up as it is, it’s difficult to see any of this changing any time soon. Our best hope for 2016 would seem to be a President that isn’t giddy about the prospect of directly antagonizing Russia.

Tangents aside, all of this represents a somewhat perverse investing opportunity. Unfortunately, we have every reason to believe the US foreign policy toward the Middle East will remain horrible and belligerent into the foreseeable future. When Republicans get in power, they will continue bombing, etc. because it was their platform and most of them believe that the best way to support the military is to use it as often as possible. When Democrats get in power, they will continue bombing, etc. because they are afraid to look “soft” on national security. As this tragedy unfolds, the stocks of the arms manufacturers are poised to continue their climb.

So, the way I’m attempting to bet on this understanding is by buying long-term out-of-the money call options on a dedicated arms manufacturer. For instance, I ended up purchasing the June 17, 2016, $230 call for Lockheed (LMT). This means that I am entitled to buy 100 shares of LMT at $230 a share any time until June 17. Now, LMT’s stock is currently at only around $217, so this is useless right now, but that also made it more affordable. My contract was purchased for $490 total or $4.90 per share a few weeks ago.

A key benefit (and risk) of options is that they tend to fluctuate much more wildly (especially in percentage terms) relative to the underlying security. This is because options are much cheaper to buy, but they move about as much as the stock itself. So if Lockheed goes up $4 or about 2%, it’s entirely possible for an associated call option to rise $4 which represents 30% or 50% as a result. But the same is true on the downside as well. A relatively small decline in a stock means a much more significant decline in the option. And if the stock price remains below $230 on June 17, 2016, the option will expire and I will have lost all the money invested.

Obviously, this is a very high risk, high reward strategy. It would be foolish to dedicate any large portion of your investments to such a strategy, but a small bet could have a payoff. The proper way to look at this is as an expensive lottery ticket with a reasonably good chance of success. I find this speculative approach preferable to actually buying shares in these companies because the shares themselves will still take a major hit if the market crashes again; even the War on Terror can’t save them from that. So small bets have a chance of making a decent return, but because we're not investing any real savings in it, we can’t get wiped out.

And at the risk of being too detailed, I also think it’s important for this strategy to pick the companies that are strictly defense contractors. For example, Boeing (BA) would be a bad choice because it also makes civilian airplanes. US foreign policy doesn’t tell us anything about how well that industry is going to do, so it’s better to focus on companies that provide few, if any, products are designed to benefit non-military customers. In other words, if they’re making significant amounts of money off of things that don’t center on surveilling or maiming, they’re ineligible for this strategy. Thus, Lockheed, with its F-35 boondoggle, is a perfect candidate for testing out this theory. It’s too soon to tell if this strategy will work, but I will keep you updated on the progress in future posts.


Reading foreign policy news often seems like watching a horror movie. The outcome seems unavoidable, but there’s still a big part of you that hopes the main character won’t decide to investigate the noises in the basement, alone, in the dark, and… then start bombing yet another Muslim country in the fighting terrorism. But as long as we’re going to follow and understand the news, there’s no reason that we shouldn’t use our insights to devise a profitable investment strategy. Buying stocks or options in the arms dealers does not benefit the company or further its mission, so there’s nothing morally wrong with doing so. And unfortunately, the future path of US foreign policy looks certain to involve more bombing and more chaos. As we mourn and oppose the stupidity of US foreign policy, I think we should bet on it as well.

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