After reviewing market cycles and swings of the pendulum, it becomes obvious we should invest when the cycle and pendulum reach their troughs and sell when they reach their peaks. In other words, be contrarian investors.
Being a contrarian is the subject of chapter 11 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.” Author Howard Marks (Trades, Portfolio) began by describing most investors, the crowd, as “trend followers.” Superior investors, on the other hand, go in the opposite direction, buying when the crowd wants to sell and vice versa.
However, it is not easy being a contrarian. Challenges include:
- Finding stocks or securities with prices that are mis-priced, according to intrinsic value.
- Being able to defy conventional wisdom.
- Resisting the myth that the market is always efficient and always right.
- Having enough time to ride out the extremes.
There is also the challenge of accepting that contrarianism is not always reliable, because:
- At times, there are no market excesses to bet against.
- “Overpriced” is not the same as “going down tomorrow.”
- Mis-priced stocks or securities can stay that way for years.
- It can be very hard to go one direction while the crowd goes the other.
- Even contrarianism can become too popular and become a new crowd.
Simply betting against the crowd is not a real strategy — going in a different direction makes sense only when we take a position based on reason and analysis. Only when you know the fundamentals well will you have the strength to maintain and perhaps even grow a contrarian position.
Marks added that one of the most interesting aspects of investing is its paradoxical nature, “how often the things that seem the most obvious — on which everyone agrees — turns out not to be true.”
For example, when popular opinion gets behind a particular investment, the intense interest can eliminate its profit potential. He added,
“If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.”
So, if everyone likes a particular security, then the price may not have much more growth potential. That also means it is unlikely to be available at bargain prices. However, there is also the opposite risk that if the crowd changes its collective mind, the stock price will be clobbered too much.
With that, he summarized these ideas into two “primary elements in superior investing:”
- Find some element that the crowd does not see or appreciate, and that does not factor into the price.
- Have the market later accept that the element you found is valid, and the price moves.
The recent financial crisis shocked Marks. He wrote, “The global credit crisis of 2007–2008 represents the greatest crash I have ever seen.” He learned several lessons from it, the most important being a new understanding of skepticism. “I’m not usually given to epiphanies, but I had one on the subject of skepticism,” he wrote.
Normally, skepticism is expressed in terms of avoiding investment fads, being caught up in bubbles, and the like. He said that his new understanding occurred in the middle of October 2008, when several events occurred, events that had been beyond his previous imagining:
- The failures or near-failures of Lehman Brothers, Bear Stearns, Freddie Mac (FMCC, Financial), Fannie Mae (FNMA, Financial) and AIG (AIG, Financial).
- The potential failure of Goldman Sachs (GS, Financial) and Morgan Stanley (MS, Financial).
- Prices for credit-default swap protection on U.S. Treasuries rose.
- Short-term T-bill rates fell close to zero.
- Knowing that, for the first time, there was a limit to the U.S. government’s financial capacity, as well as limits to simply printing new dollars.
Marks saw it, at the time, as a vicious circle that had no obvious end. “No scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish,” he wrote. As he put it, a lot of “bad things” occurred more or less simultaneously, things that were not supposed to happen, and they happened to many leveraged investors.
Obviously, then, the investors who had lost money had not been suitably skeptical or pessimistic. But then Marks had his epiphany, that skepticism and pessimism are not exactly the same:
- “Skepticism calls for pessimism when optimism is excessive.”
- “But it also calls for optimism when pessimism is excessive.”
In other words, he and other investors had failed to apply the second maxim, that they should be optimistic when the level of pessimism gets too high. They were not aggressively buying, so the price fell, and even “gapped down.” He added, “The negative story may have looked compelling, but it’s the positive story — which few believed — that held, and still holds, the greater potential for profit.”
Marks pointed out that skeptical investors often say, “It’s too good to be true,” but he began to realize in 2008 that the opposite can also be true: “It’s too bad to be true.” It was difficult to buy in the final quarter of 2008, yet it was rewarding for contrarians: Distressed debt produced returns of 50-100% or more in the following 18 months.
So, the job of a properly contrarian investor is to catch falling knives before they hit the ground, before “the dust has settled and the uncertainty has been resolved.” That’s because those who wait for the knife to hit will miss the exceptional bargains. According to Marks, the concept of intrinsic value is critically important because it allows investors to buy when everyone else is selling.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
