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By Tai, September 2, 2010 9:57 am

It is well argued that idiosyncratic risks are not desired and can be diversified away (Bodie et al 2007). While this knowledge dominates introduction to finance courses (subjects/modules), idiosyncratic risk is in other most circumstances the key to wealth.

Firm-specific and industry-specific characteristics are key to capture excess returns from CAPM expected return. For example, retail industry, food industry, metal industry etc. fluctuate to business cycles, and business cycles are not captured in CAPM.

Next, idiosyncratic volatility is useful for speculation purpose, especially when you do not have a concrete target on where to exit the investment. Volatile means holding through (or even shorting during) dip and exit during peaks. You earn steady income through dividends and small gains on stable stocks, but you make fortune on volatile-but-fundamentally good investments.

Treynor Black model for alpha specifies that on the Single Index Model

Active portfolio A should receive investment weight

where the rest of the portfolio should be invested in market index. This is one example in the academic world where idiosyncratic is, indeed, good.

Practical relevance: for smaller stocks and international investments, particularly emerging markets, ‘beta’ approach almost does not work. These are the cases where idiosyncrasy comes to play.

Bodie Z, Kane A, Marcus A, 2007, ‘Investments’, McGraw-Hill, 2007

Treynor, J. L. and F. Black, 1973, ‘How to Use Security Analysis to Improve Portfolio Selection’, Journal of Business, January, pages 66–88

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By Tai, June 10, 2010 12:34 am

Amazon positions itself as a technology company, not a retailer

1. Target the long-tail with million titles, while the largest physical book store may only store 400,000
2. Intensive investment in technology
3. Location: Seattle, near computer talents
4. Product search, data mining, personalized shopping
5. In-house software systems
6. Leader in cloud computing
7. Supplementary product: Kindle
8. Scalability
9. B2C to C2C

Jeff Bezos’s vision and financial expertise

1. Prior to Amazon: Princeton Computer Science & Electrical Engineering graduate, 2 years in Commercial Banking and 4 years in NY Investment Banking
2. Focus on customer service, avoid price war
3. Started with books then diversified
4. Act like a Venture Capitalist to other younger e-commerce firms then get advertising fees from these partners
5. Lock out competition with this partnership network
6. Use sophisticated financial structure including:
   • Private equity (only $1m in 1994)
   • Convertible preferred shares ($8m in 1996)
   • $326m 10% senior discount notes mature in 10 years
   • Debt repurchase
   • $1.25b 4.75% convertible subordinated notes mature in 10 years
   • $680m 6.875% euro-denominated subordinated notes mature in 10 years
   • Live many years on credit rating CCC but the company has had enough cash to spend. Good governance!
7. Good accounting compliance

Operations

1. Revenue sources: commission, advertising, affiliate marketing, cloud computing leasing
2. Order from suppliers after customer has made an order
3. Weathered the dot-com bubble and GFC well

Reference

Cott J., Palepu K., ‘Amazon.com’