Where Human Brains Still Beat Computer Algorithms

Where Human Brains Still Beat Computer Algorithms

Zacks Investment Research just upgraded electric generating company NV Energy to its top rating: "Zacks Rank #1: (Strong Buy)." A few months ago, that would have been an awesome call. But in this case, Zacks is way late to the party on this particular upgrade, and it showcases a danger inherent in relying too much on what appears to be a computerized decision-making algorithm.

The reason is simple: NV Energy is on track to be bought out by Warren Buffett's Berkshire Hathaway , with a target closing date in the first quarter of 2014. That buyout has been public knowledge since May, and NV Energy's stock has already leaped to take out most of the expected value from the acquisition.

Strong buy = 3% returns?
Berkshire's acquisition price for NV Energy is $23.75 per share, paid in cash. NV Energy closed on Monday at $23.59 per share, and it currently pays a $0.19-per-share per quarter dividend. Assuming it keeps its dividend steady until the Berkshire Hathaway takeover, shareholders can expect somewhere between $0.28 and $0.57 in total dividends.

Adding those dividends to the target purchase price gives a total value of $24.32 to be realized over the next eight or so months. With a starting price of $23.59, that works out to a total return of around 3.1%. That's before taxes, and the capital gains (if any are to be had after commissions) will be short-term for anyone buying now, if the acquisition closes on time.

From the looks of Zacks' upgrade, it's probably using an entirely automated rating system that doesn't know how to factor in acquisitions. It's true that investors following Zacks "Strong Buy" recommendation could get a return that pays better than an eight-month CD at the moment. Still, that 3.1% is about the maximum likely upside potential on the investment, and it depends both on the acquisition closing as expected and the company keeping its dividend until the acquisition closes.

Perhaps even worse, if the acquisition doesn't close for some reason, there's plenty of downside potential in NV Energy's stock. The stock closed at $19.28 just prior to the acquisition announcement. If, for some reason, the acquisition falls through, there's a very real chance that the stock could fall back to around that level. Starting from Monday's close of $23.59, that's a worse than 18% drop! While chances are good that the acquisition will close as expected, that's a substantial downside risk for what at this point is a pretty small gain.

Note that the downside risk is there because Berkshire Hathaway offered to pay a 20%-plus premium over the market price for NV Energy prior to the announcement. That much of a premium may seem out of character for the value-focused Buffett, but in reality, it makes sense to Berkshire Hathaway.

For one thing, healthy companies rarely agree to be bought out without some sort of shareholder premium. For another, NV Energy will be integrated with Berkshire's existing electricity generator, MidAmerican Energy. While a 20%-plus premium to the company's prior market price may be steep for NV Energy as a stand-alone business, with the economies of scale and overhead cost savings from the integration, it seems to make sense as a bolt-on.

Make thinking part of your investing
The Zacks pronouncement that NV Energy is a "strong buy" wouldn't have been a bad call prior to the Berkshire Hathaway acquisition announcement. Indeed, NV Energy was a selection for the real-money Inflation-Protected Income Growth portfolio back in December -- months before Berkshire Hathaway announced its deal -- as I saw the potential for growth in the Nevada electricity market.

As a result, the iPIG portfolio got the benefit of the substantial acquisition premium that Berkshire Hathaway is paying for NV Energy -- a premium that Zacks' "strong buy" devotees won't get. Of course, not every iPIG selection will likely turn out as well as NV Energy is expected to. Still, the portfolio's selection criteria of growing and covered dividends, healthy balance sheets, and reasonable valuations should help assure that the portfolio gets a decent share of upside surprises.

It didn't take rocket science to find NV Energy prior to Berkshire Hathaway's bid for the company. But it did take a willingness to think about what key characteristics would make the company a decent investment, and then the commitment to invest real money when the company passed those tests. That's what we did at the iPIG portfolio, and that's why we got the returns that those following Zacks' "strong buy" on the stock won't.

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The article Where Human Brains Still Beat Computer Algorithms originally appeared on Fool.com.

Motley Fool contributor Chuck Saletta owns shares of NV Energy. The Motley Fool recommends and owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published