Arguably, the most successful trader of all time died Friday. Although his trading secrets remain closely held by the firm he founded, what’s the most important lesson he left the rest of us? How I think about Jim Simons’ legacy, and a trade on one of the most successful retailers, Costco, follows. First, a contrarian view in Costco: Costco (COST) is one of the best performing retailers over the past year. Up nearly 20% year to date and more than 56% over the past 52 weeks, the company continues to execute. As consumers demonstrate at companies like Starbucks a sensitivity to inflation, Costco seems well positioned to capitalize, selling consumer staples at competitive prices. With price volatility, margins for many retailers can be too. Costco is not immune to this, but because the company also has subscriber fees/revenue, it is far better insulated than many competing retailers and grocers. Last week, Costco released their four-week retail sales results for the period between Monday, April 8th and Sunday, May 5th. The company reported net sales of $19.8 billion for the month, an increase of 7.1% over the $18.4 billion reported for the same period the year earlier. U.S sales, which represent about 73% of overall sales, increased 5.8%. There is only one thing I don’t like about Costco, the price. Not any of the goods they sell or the hot dogs in the food court, but the stock. To illustrate this I created the following chart which shows what I like and what I don’t. The chart is likely not one you typically see, so I’ll explain it. In blue is earnings per share, but reflected in a log scale. I illustrate it this way so that we can observe the rate of earnings growth over 30 years. A chart of the actual EPS would look like a hockey stick and I am interested in whether the rate of earnings growth is consistent over time. This chart shows remarkable consistency in this regard. The orange line is the historical price/estimated (forward) earnings multiple of Costco. What investors believed was a fair price to pay for Costco, measured this way at least, has fluctuated considerably over decades, and where it closed on Friday represents an all-time high. If you own Costco shares I think it is prudent to take some profits at these levels, but unfortunately for many, reducing their exposure by selling the stock may come with some unwelcome tax implications (Important Note: this isn’t tax advice and investors tax considerations will vary, so consult with your tax advisor). Costco trade One way to generate a bit of yield from an existing position, particularly those where one suspects the upside potential in terms of capital appreciation may be more limited in the near-term, is to sell covered calls. Usually I do not advocate selling covered calls through earnings, because earnings is when new information is released, but in Costco’s case, because they release interim sales results, it’s less likely earnings will provide an enormous upside revelation. Recent good news is already out there. A holder of the shares could sell the June $820 strike calls for $12/contract, or 1.5% of the current stock price while still preserving another 4% of potential capital appreciation over the next 39 days through June 21st expiration. Annualized the premium collected works out to about 14%. Not quite the 40% or so that Jim Simons achieved, but when combined with the potential for some price appreciation with the underlying shares, a respectable return nevertheless. Most successful trader of all time Jim Simons, quite possibly the most successful trader of all time, died Friday in New York, at age 86. For 30 years, his firm’s Medallion Fund produced nearly 40% annual returns, net of fees, more than $100 billion in gains, a feat unmatched by any of the most famous investors in the world. While mirroring the success of the pioneer of artificial intelligence in investing, with a team of 100 PhDs working collaboratively to accumulate data and develop models, is not realistic, he did leave an important lesson for the rest of us. There is trading “edge” to be found in the markets, even if we may only aspire to capture it. In an interview in 2015, he said “there’s something called the efficient market theory which says that there’s nothing in the data, let’s say price data, which will indicate anything about the future because the price is sort of always right. The price is always right in some sense, but that’s just not true. So there are anomalies in the data even in the price history data.” What Jim referred to as “the efficient market theory” is more commonly known as the “efficient market hypothesis,” a theory that no amount of work analyzing historic price data or fundamental data, can produce excess returns in financial markets. That research and analysis cannot produce any benefits for investors feels wrong, but is it? What is the foundation for the idea? The “wisdom of crowds” is a concept popularized by James Surowiecki in his book of the same name. The idea is that a diverse group can collectively make more accurate judgments and decisions than individuals, including experts because a group’s aggregate knowledge and insights compensate for the biases and errors of its individual members. The book opens with an example from 1907 where Francis Galton asked the attendees of a fair to guess the butchered weight of an ox. While none guessed correctly, the average of those guesses was almost perfect. Better than the best guesses of “experts” in attendance. A closely related idea in financial economics, but one that predates Surowiecki, is the “efficient market hypothesis” which is most widely attributed to Eugene Fama in the mid-20th century and posits that asset prices reflect all available information. The foundations of the hypothesis were articulated, by at least two French mathematicians in the late 19th and early 20th century and possibly by others well before that. Three forms of EMH have been described. The weak form suggests past market prices, which are generally observable, are fully reflected in stock prices. Because technical analysis depends on an analysis of past pricing data, if this form of EMH is true, then technical analysis would be ineffective because all insight it provides has already been incorporated into the current market price. The semi-strong form suggests asset prices adjust to new information immediately and without bias. If this is true, then fundamental analysis according to EMH would be ineffective too. The strong form of the hypothesis, which many readers will likely dismiss immediately, suggests all information, public and private, is fully reflected in stock prices, and not even those trading on inside information could have an edge. Because the efficient market hypothesis is related to the same concepts that Surowiecki discussed, we could presume that it depends on some of the same conditions that the “wisdom of crowds” does. For example, when group members are too like-minded, which can occur when there is too much communication between members. Rather than aggregating diverse opinions, the group may coalesce around a popular idea or simply be convinced by view espoused most forcefully, particularly by those perceived to be more knowledgeable. Certainly we frequently see consensus around some stocks. 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