2011 Q4 | Do the Opposite
In one episode of the hilariously funny 1990’s sitcom Seinfeld, George Costanza, a slightly overweight, balding, unemployed and self absorbed 30 something, decides to make a change in his life. He concludes that he should try to do the opposite of his every idea and instinct. Immediately, things begin to go his way; a girlfriend, a job with the Yankees and moving out of his parent’s house (a real achievement if you know the character). Although George Costanza hardly represents a beacon of financial acumen, the history of the markets suggests that “doing the opposite”, zigging when others are zagging, can actually work. Conversely, if you are content to take the tried and true paths of others, in your best case scenario you may wind up equal to the pack and have achieved nothing more than the overall market average.
The dictionary defines a contrarian as a person who takes an unpopular position opposite to that of the majority. A contrarian investor believes crowd behavior among investors can lead to exploitable mispricing of securities. For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks and understates its positive prospects. Widespread optimism, conversely, can lead to speculative bubbles with unjustifiably high valuations. The Dutch tulip mania is a well known example of wild speculation. Contrarian investing is related to value investing in that overwhelmingly negative sentiment can give rise to what Benjamin Graham famously called a “margin of safety” when purchasing stocks, essentially the ability to purchase earnings and income at a discount to their intrinsic value. Arguably, that “margin of safety” is more likely to exist when a stock has fallen a great deal and is usually accompanied by negative news and general pessimism.
Today’s market environment is full of sobering reminders that all is not perfect. The European debt crisis offers no clear solution other than painful austerity to assuage the international investment community. The “Arab Spring” of 2011 initially appeared to be a move toward freedom, but is now drifting towards other forms of tyranny with a large portion of the world’s oil supply potentially hanging in the balance. The bond market, which is sizably larger than the stock market and viewed by many as a better proxy for economic sentiment, is essentially saying this; excess capacity in our economy (factory utilization and unemployment) is leaving investors with no fear of inflation despite near zero interest rates and the nosebleed heights of the Federal Reserve’s balance sheet (the printing of money).
With all of the negative news, it is not surprising that a large amount of investment dollars are on the sidelines waiting for the storm to pass or in search of a safe haven in other asset classes. As investors we should resist the temptation to flock with the crowd and instead use the market’s disarray as an opportunity to own the best companies at the best prices. Many of the stocks we own generate dividend yields which are higher than the bonds of those same companies and certainly higher than U.S. Treasuries. At HCM, we are cognizant of the risk, but also recognize that risk is everywhere and that there is also risk in doing nothing. If we can maintain the discipline of buying and selling securities at prices based on intrinsic value and not be scared away by market emotion, then the path to financial success is clear even if it means to just “do the opposite”.