Tag Archives: Contrarian

Only the Contrarian Survive.

“Wall Street people learn nothing and forget everything.”

-Benjamin Graham

. . .


“To be in opposition is not to be a nihilist. And there is no decent or charted way of making a living at it. It is something you are, and not something you do.”

-Christopher Hitchens, “Letters to a Young Contrarian”

. . .

In between Christmas parties and naps, I read a wonderful piece by Morgan Housel over the weekend. Entitled, “You Win By Thinking Everyone Else is Wrong,” it underscored a long-held theme of ours. That is, Wall Street and Main Street sentiment serve as the most effective contrarian indicators available.

Because both, more often than not, move in a direction opposite of success. Let me explain.

Bloomberg reported earlier this year that the 50 stocks with the worst Wall Street analyst ratings at the end of 2011 outperformed the S&P 500 by seven percentage points in 2012. So, whereas most investors fall woefully short of the index, Wall Street’s most detestable stocks trounced the benchmark.

This inspired Housel to analyze 2013’s top buy- and sell-rated companies, as reported by FactSet, among Wall Street’s top analysts. The results? Hardly surprising.

Including dividends, the S&P 500 is up roughly 27 percent year to date. Stocks with the most Wall Street Sell ratings in January are up a median return of 52 percent. So, Wall Street’s lowest-rated companies beat the index by 25 percentage points.

Conversely, the stocks with the most Wall Street Buy Ratings in January have returned a median rate of 20 percent, so under performing the index by 7 percentage points. And under performing their worst-rated peers by 32 percentage points.

How about those apples?

From experience, I can tell you that Wall Street, its analysts and its minions of salesmen cum advisors do two things very well. First, they talk investors into buying mutual funds and money managers that do not outperform their benchmarks with anymore regularity than the Cincinnati Bengals. Second, they talk clients into buying positions that the firm’s sell-side analysts love. You know how that can work out. Remember Jack Grubman? Henry Blodget?

Housel makes a very telling point when he writes, “One of the most important lessons in all of finance is to understand the incentives of the guy sitting across the table from you.”

So long as Wall Street can make billions of dollars each year by gathering assets from investors and then hitting grounders back to the pitcher, there will be no incentive to change.

Remember, among the most bullish calls from Wall Street’s institutional equity strategists came in Q1 2000 and Q3 2007. Both were immediately followed by catastrophic bear markets.

Truth is, Wall Street’s biggest concern has never been the accuracy of its forecasts, the prescience of its picks, or the financial health of its clients. Otherwise, it would not have sold derivatives that forecast a continuance of the housing boom, even as the firms had begun to bet against it. Nor would the firm’s advisors continue to allocate client capital to funds and managers that have no history of outperformance. But, they do permit advisors to spend most of their time on everything but managing client capital.

Look, I get it. Even Darth Vader had to make a living. Funny thing is, you can see the entire mechanism slowly taking shape.

As the market continues to rise, Wall Street has realized that it cannot remain bearish forever. Not five years into a bull market! So, the nation’s financial behemoths are suddenly getting on board. Which means that their salesmen cum advisors are getting on board. Which means that Main Street is, five years in, getting on board. Right as the smart money moves toward the exits.

Need anecdotal evidence?

At least five times over the last year I’ve received calls from friends relating that their acquaintance, who works for a large brokerage firm, was counseling them to get out of the market.

My response? “If your friend at that brokerage is counseling you to get out, then that only bolsters my conviction that this market has legs. Let me know when your friend is bullish.”

Suddenly, he is.

In fact, now these guys are pouring in. Right as the economy heats up. As credit and capital flows are approaching all-time highs. As flows into mutual funds have never been stronger. As sentiment soars.

These hyper-bullish indicators tell me to beware. Recall what Buffett said : To invest successfully, you must be fearful when others are greedy, and greedy when others are fearful.

Well, I’m looking around, and people are beginning to look piggish. The fear is dissipating. Replaced by a desire for easy profits. Which flashes a warning indicator. Be prepared to exit.

U.S. equities have reached expensive heights. More so than investors realize.

The median prices-to-earnings ratio for the S&P 500 is nearing record levels. Well above its peak in 2000. Back then, only a handful of large-cap stocks traded at large P/E ratios. They pushed the average P/E to nearly 50. But, the median P/E never approached those levels. Today they do.

Now above 25, even the Shiller P/E sits at a record high.

So, Wall Street and investor enthusiasm have skyrocketed. Valuations have followed. The Fed continues to pump capital into the system. That cash continues to find its way to Wall Street. Value line reports that only 14 percent of investment advisors are bearish. At 2.5 percent of GDP, margin debt at the New York Stock Exchange has reached the highest level in history. American Funds, Fidelity, Dodge & Cox and others are seeing massive inflows. The herd is in motion.

Sounds ominous.

Time to tighten your trailing stops. Check the landing gear on your downside protection mechanisms. Perhaps its may be nothing more than a random stench. But, something smells. May be nothing to worry about. Could be months, perhaps years away. But something has raised our hackles.

If you read our five-part series, Investment Perspectives: The Road Ahead, you’ll recall that there were four areas of the market in which we believe that targeted allocations offer solid short- and long-term opportunities. Regardless of what lay ahead. The shale and natural gas renaissance. China. U.S. small-caps. And 3D printing and other next-generation technologies. Come hiccup or earthquake, these opportunities will continue to serve prescient investors well.

Further, those areas that were especially out of favor this year — gold miners, teen retailers and coal miners, to name a few, may be next year’s high flyers. The darlings of their indexes. The analysts hate them. Main Street investors treat them like lepers. So, they’ll likely outperform the benchmarks by two and three times.

That said, most will never allocate a dime in their direction. Because the mutual funds and blue chip client companies recommended by the brokerages will be charging like a herd of buffalo. Running in lockstep with the markets. Taking investors up to and over the cliff.

Until investors are willing to make decisions that fly in the face of conventional Wall Street investment wisdom, they will never have a shot at outperforming the market benchmarks.

When Billy Bean introduced Saber metrics to the Oakland As, the old scouts mocked him. The As went on to post the best record in baseball for the next decade.

When Winston Churchill questioned Neville Chamberlain’s placation of Hitler’s German in 1939, he was branded a blowhard. He went on to repel the German blitzkrieg and save England.

When Jerry Seinfeld proposed doing a prime time network television show about four people who spend their lives doing nothing, networks executives said it would never work. “Seinfeld” went on to become one of the longest running, successful shows in television history.

Point is, taking the contrarian’s path can be discomfiting. Difficult. So, if you’re uncomfortable moving against the herd, then being a contrarian is not for you. If you value the comfort of the crowd over the lonely rewards of prescience, then by all means, go with the flow.

However. If you’re comfortable with stepping back. Taking a wholly objective, dispassionate survey of the situation. Then, acting upon your individual analytical instincts. Then, perhaps you are a contrarian.

If you study the scene and recognize the errors and omissions so prevalent in the group think that drives societal trends, then perhaps you are a contrarian.

If you recognize that every table has a patsy. And when you cannot spot him, you realize that perhaps you are he. Then you just may be a contrarian.

Yet, most investors find the process too difficult. They simply don’t care to do the heavy lifting. Would prefer that others, regardless of the agenda, do it for them. Regardless of how consistently incorrect those others have been.

There is a singular lesson that forever eludes most. Yet, is grasped by contrarians. And so guides most contrarian decisions.

There is no free lunch. And by the time the masses gather around the banquet table, whatever leftovers remain will have grown soggy and cold.

Investing Like Billy Beane.

Baseball season, gateway to the summer, has arrived. While my beloved Reds have dropped five in a row, including a sweep at the hands of the lowly Pirates, I remain optimistic.

Baseball and investing have much in common. Consider this:

1) While there are many fans, there are few aficionados. Rare are those experts with an insider’s perspective of the game.

2) As in baseball, investing places a premium on total disclosure. An investor must rely upon a team’s price-to-earnings ratio, much like a GM must rely upon a player’s on-base percentage. Statistics and the ability to measure performance and value are vital.

3) Baseball teams, like investments, experience hot and cold streaks. A solid investment can decline in the short-term. An absolute dog can inexplicably appreciate for a while. Good squads will lose to bad ones. Yet, over the course of time, players, teams and investment options inevitably revert to the mean.

4) Baseball rarely crowns the same World Series champion in consecutive seasons. In other words, past performance is no indicator of future returns.

5) Trends and manias may temporarily prevail, but eventually fade into obscurity. Methodology trumps chance. Artificial turf. Polyester uniforms. Tulip mania. Tech stocks. Fads come and go. But the rules of the game never change.

Perhaps no story better captures the correlation between baseball and investing than Michael Lewis’s classic book turned movie, Moneyball (click here).

Moneyball is the true story of the Oakland A’s maverick general manager, Billy Beane. In the early 2000s, the small-market Athletics had a $40 million budget, one of the smallest in baseball. Compared to teams like the Yankees, and their $126 million budget, one understands what teams like the As (and Reds) were up against.

The As had a capacity for drafting talented players and turning them into successful major leaguers. Yet, as soon as they became free agents, they’d sign with big-budget teams like the Yankees.

Realizing he could not beat the big-market teams at their own game, Beane becomes determined to find a way to compete on a fraction of the budget. He turns to sabermetrics, a little-known methodology applying rigorous statistical analysis to the valuation of talent. Instead of building a team of expensive, high-profile stars (who are often not as valuable as they appeared), he builds his roster with cheap, unknown players laden with under-appreciated skills. The result? The As went on to win 103 games, including a record 20 consecutive victories.

Beane, utilizing the talents of his assistant, Paul DePodesta, a Harvard economics graduate and statistical whiz kid, used sabermetrics in much the same way that a talented investor will utilize fundamental analysis. He realized that the sum of the parts supersedes star power and current contract values.

Beane placed a premium on specific areas of maximum importance, which often contrasted with the means by which traditional baseball scouts viewed talent. In so doing, he debunked much of the traditional baseball wisdom. His system revealed that many statistics — batting average, runs batted in, fielding percentage and a pitcher’s win-loss record, say little about a player’s real value.

Further, Beane showed that time-honored principles like the sacrifice bunt, the “clutch hitter” and the stolen base, despite their inherent appeal, had very low probabilities of success.

By taking a contrarian’s view, Beane’s As were able to find hidden value where other teams saw mediocrity. And so the As were able to assemble a very productive team for a fraction of the cost.

They won their division for the next two years, even as the Texas Rangers had a payroll of nearly three times their own. Over the next decade, the As assembled one of baseball’s best overall records.

Sabermetrics enabled Beane to emphasize in-game statistics, as opposed to the industry norm of using career averages — statistics so widely utilized so as to provide little real incremental value. Everyone ends up bidding for the same players and skill sets, thus pricing small market teams out of contention.

Some of the more colorful metrics Beane used included “late-inning pressure situations” (LIPS), and “narration, exposition, reflection, description” (NERD). The Yankees, Red Sox and Rangers had no idea what these terms meant, let alone how to use them in evaluating talent. This provided Beane’s As with a much needed competitive edge from an analytical perspective.

Investing is no different. It is competitive. It involves winners and losers. And like Billy Beane, the average investor is playing against institutional investors with significantly more money and resources at their disposal.

If you invest in a company based solely on its price-to-earnings ratio, you’ve already lost. Because that data has been digested by every investor, so providing no competitive benefit. As the As developed different, more nuanced means of analyzing talent, so too must the investor who aspires to be better than average.

For instance, let’s consider two little known yet theoretically effective measurements for valuing prospective investments that few investors have the willingness (or capacity) to determine. But, for those with time and patience, the result could be a better portrayal of an investments current value.

Realizing that many value stocks are often companies in distress, the Piotroski Score seeks to separate those distressed with good future potential from those more likely to be value traps. Based upon a series of nine criteria for evaluating a firm’s financial strength, the stocks scoring highest outperformed a portfolio of all value stocks by 7.5 percent over a 20-year test period.

Conversely, those scoring lowest were up to five times more likely to file bankruptcy, or to de-list their shares.

The Altman Z-Score works similarly to the Piotroski Score in that it is a predictor of financial distress used by value investors. Altman Z-Score uses five ratios to predict the likelihood of bankruptcy within two years. It was found to successfully predict 72 percent of corporate bankruptcies two years beforehand. Only 6 percent of the time did it falsely predict a company’s demise. Studies have shown the method to accurately predict financial distress 80 to 90 percent of the time.

Two unique, contrarian means of determining valuable probabilities capable of statistically stacking the odds in your favor. Why are they so valuable? First, they reveal a company’s value with reasonable accuracy. Second, neither you nor most other investors have even heard of them.

Scarcity value dictates that a product or service has more value when demand is high but utilization is low. As in the case of these types of calculations. Everyone uses price-to-earnings and PEG ratios. Nobody uses Piotroski and Altman Z-Scores.

Beane would love them for their accuracy and anonymity.

Still, with no statistical edge, the average investor still prefers to imitate the Yankees. Buying big names on big news. Purchasing slick tech stocks with unknowable business models. Buying at the top. Selling at the lows. Running with the herd.

Moneyball showed that anyone willing to spend the time and effort can find an edge to exploit. If only briefly. Yet, it also showed that soon thereafter, everyone will adopt your successful metrics, rendering them much less successful. In which case, you’ll endeavor to find new means of getting an edge.

In other words, those looking to succeed must continuously evolve. A truism in all of the games we play. Be it baseball, investing, or life.

Extraordinary Popular Delusions.

Last week was risk on. Stocks shot up 3.7%. If you owned them, you made money. If you owned Treasuries, you did not.

Structurally, not much has changed since we stared into the abyss three weeks ago. Global investors have spent so much time staring into the abyss these last few years that I’ve changed my address labels to “The Abyss.”

Europe is still a chaotic mess of fiscal uncertainty. The U.S. economy appears to be trending down. And all of the geopolitical events that have roiled markets with all the regularity of a Lebron James 30-point performance remain on the table. Iran. Syria. The Arab Spring.

What happened to those summer days when all I needed to worry about was the Reds and my tan?

So, why did markets have such a bumper week?

Possible European bailout? Possible Fed stimulus? What intrigues us are the storylines you won’t read about.

This market spent the first four months of the year heading skyward. Then, sovereign debt and European banking issues cut those gains down to the nub. Last year, same thing occurred. A great start was derailed by bad news (U.S. debt downgrade, European debt issues), only to see the markets recover and shoot upward into this year’s second quarter.

Are we in for an encore performance? Possibly. Though November’s election will add a lot of uncertainty. Or maybe not. Shouldn’t we expect the unexpected?

What could transpire is that the economy derails President Obama’s reelection effort to the point that markets discount a Romney victory. Most private sector participants believe, rightly or wrongly, that a Romney election would be good for the economy. This could have a buoyant effect on markets.

Still, another factor rouses the optimist within.

So many investors are convinced that the stock market is on the cusp of tanking that it cannot help but disappoint them all.

The strategists at the largest Wall Street brokerage firms are as bearish as they’ve been in 16 years. Only 51 percent are recommending stocks. From a contrarian’s point of view, this is great news. The most optimistic these brokerage strategists have ever been was Q1 2001. They loved equities. And equities responded with a two-and-a-half year bear market.

Household investors are also bearish. Very bearish. Having bought more Treasuries in Q1 than the Fed and overseas investors combined. In fact, the Investment Company Institute reports that investors withdrew $7.2 billion from American equity mutual funds the last full week of May. These same investors withdrew $178 billion over the trailing 12 months.

Household investors are, without fail, always wrong when it comes to market calls. So much so that from 1988 to 2007, while the S&P 500 returned 11.81% per year, the average mutual fund investor earned a paltry 4.48% per annum.

Brokerage firm equity strategists and Your Coworker Bob may arrive at their conclusions in different fashion, but they generally end up in the same place. Dead wrong.

Traditionally, when risk aversion has pushed investors en masse to risk-free investments, the S&P 500 has taken the opportunity to shoot upward.

You don’t put money to work when household investors are bullish. If you did, you’d have purchased stocks in March of 2001. And September of 2007. You’d have bought equities right as the market prepared to drop like Bobby Brown’s Q Rating.

All of the contrarian indicators are flashing green.

Yet, one cannot base investment decisions on contrarian maxims and inverse decision mechanisms. Let’s look deeper.

Investors must essentially pose two questions prior to determining whether to stash cash into the market or into the mattress.

First, will public officials, who have gotten policy right more than they’ve gotten it wrong these last few years, watch the euro fall apart or will they unite in an initiative that avoids the worst-case scenario? Will European officials allow their 24-year grand experiment to implode in the face of today’s sovereign debt issues? To throw the European baby out with the Greek bathwater?

Second, will Q2 earnings massively disappoint or, as with every quarter these last three-and-a-half years, will earnings come in positive, leading to a mean reversion in P/E multiples which currently sit at 13.5 to a historical average of about 15?

For all of their austerity tough talk, the Germans realize they have more to gain by saving the EU than letting it fail. And so, after much castigation of their southern brethren, the Northern European industrial overlords will, most likely, steer the EU’s ship into safe harbor. If that occurs, the market will stage a relief rally that raises all ships.

As for the second question, I see the economy slowing.

Last fall, we discussed Lakshman Achuthan of the Economic Cycle Research Institute, and his forecast of a U.S. recession. Looking at the employment and manufacturing data, it looks like that may come to fruition. However, we must also remember that interest rates are low. Inflation remains in check. The Fed wants markets to rise. And U.S. corporations have tightened their belts to the point that stocks may have room to rise anyways. Those are very important tidal currents that could conspire to disappoint all of those bearish investors by pushing the market upwards.

And for all of the media’s contention that this election will be tight, I’m seeing a slow yet deliberate tide turning against the current administration. I’m not saying that a Romney presidency would be any better for the economy. But, the private sector has acclimated to the idea that the current administration cannot turn the ship around. So, any allusion to a Romney victory will likely provide fodder for yet another relief rally.

The S&P 500 is up 5.4% on the year. In April, it was up 13%. I’ll call that a correction. Where does the index head from here? No idea. It seems madness that, given all of the headwinds, markets could elevate from here. Yet, I’m optimistic.

In Charles Mackay’s seminal effort, Extraordinary Popular Delusions and the Madness of Crowds, he wrote the following: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Mackay’s book was written in 1841. Yet, even today, no words have ever been truer. So, when looking at current circumstances and likely outcomes, we will gauge the direction and sentiment of the crowd. And walk away.