Contrarian Investing

by: Felix Salmon November 12, 2008    
Felix Salmon

Felix Salmon

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Baruch has a corker of a post over at Ultimi Barbarorum on hedge funds, and why it is that they've unravelled so spectacularly this year despite largely escaping the bursting of the dot-com bubble unscathed. Go read the whole thing, but here's a tiny taster:

The hedgies are hanging onto the winners of the Great Moderation, and instead of selling them when they go wrong, their first impulse is to defend, manipulate, and hang on.

Baruch also talks about how difficult it is to go short a stock or asset class which everybody else is long:

This is harder than you think. It means going against everything everyone in Wall Street tells you to do... It is lonely being short QCOM with no friendly sell-siders to hold your hand and tell you it will be OK in the end.

I was reminded of Michael Lewis's article in the last issue of Portfolio magazine, which spends a lot of time on a fund manager named Steve Eisman who was similarly bearish among a crowd of bulls:

There's a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It's not easy to stand apart from mass hysteria -- to believe that most of what's in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded -- without actually being insane...

Zelman alienated clients with her pessimism, but she couldn't pretend everything was good. "It wasn't that hard in hindsight to see it," she says. "It was very hard to know when it would stop." Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. "You needed the occasional assurance that you weren't nuts," she says...

There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. "The thing we couldn't figure out is: It's so obvious. Why hasn't everyone else figured out that the machine is done?" Eisman had long subscribed to Grant's Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006, he decided to investigate these things called C.D.O.'s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.'s to potential investors and for several days sweated and groaned and heaved and suffered. "Then he came back," says Grant, "and said, 'I can't figure this thing out.' And I said, 'I think we have our story.' "

Eisman read Grant's piece as independent confirmation of what he knew in his bones about the C.D.O.'s he had shorted. "When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm."

The thing to note is that for all Eisman's self-confidence and ability to make his own decisions, he's still human: He surrounded himself with like-minded professionals at his hedge fund, and would hugely value confirmations and affirmations of his investment thesis from the likes of Zelman and Grant.

Eisman would also badger the bulls, asking them question after obnoxious question. He obviously wasn't trying to persuade them that he was right and they were wrong -- but he was trying to persuade himself. So long as other smart people couldn't give him simple answers to simple questions, he reckoned, he was much more likely to be on to something.

This is the human element of investing. It's always easier to be long than to be short; it's always easier to do what everybody else is doing than to do the opposite. Certainly all responsible investment advice says pretty much the same thing to pretty much all people: Buy index funds, rebalance occasionally, don't trade, don't try to time the market (beyond rebalancing), over the long term stocks will outperform. Is that, now, a crowded trade? The only reason that so many people are doing it is that it has generally worked in the past. But as we're reminded daily, everything works until it doesn't.

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This article has 12 comments:

  •  
    Nov 12 11:11 AM
    "Easier" to be long? so you're saying you agree with Mr. Eisman? Was he long in the 80's and 90's? Or was he Mr. smartypants back then, too? Bulls and Bears make money, pigs get slaughtered. That seems to be one age old adage that seems proven again and again to me and is certainly proven true now. It's not just smart people who make money in markets such as these--reasonable people make money in markets such as these, too. Maybe it's an internet phenom, but who let the lunatics out of the funny farm? Markets are in a constant search for a variety of things, some knowable, some not--having one's personal vanity justified is not one them. The bottom line is that there are people who work for a living out there--providers I think they're called--and life sucks for them right now. How does running around screaming "I told you so" by claiming there is (was?) too much a of good thing solve anything? Now if you want to make a case for a little anarchy, that's a whole other story...
    Reply | Link to Comment
  •  
    Nov 12 12:35 PM
    "There's a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It's not easy to stand apart from mass hysteria -- to believe that most of what's in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded"


    True. It is difficult to overcome the herd mentality, but it is possible.

    August of 2007 Countrywide fired the first shot:

    "Countrywide Financial Corp., the largest U.S. mortgage lender, said on [Aug 16, 2007] it drew down an entire $11.5 billion bank credit line as a global credit crisis limits its access to short-term cash." - Reuters

    For those who were paying attention, this was the beginning of the end of the bull market. The market tumbled over the following months and struggled back up near the peak again by Oct/Nov 2007.

    finance.yahoo.com/q/bc...=

    When the market broke to lower even prices in early Jan 2008 it should have been a sign to exit most positions and raise cash, possibly to go short.

    There are methodologies which can help with this. See CANGX fund based on Investor's Business Daily method of CANSLIM. Near year end of 2007 they were nearly 60% cash. The fund dropped during the first quarter and nearly recovered by June/July 2008 only to slide in the 3rd Quarter. They are currently 45% cash and only down 20% in 2008. Not too shabby considering they aren't allowed to short.

    Blind adherence to 'buy and hold' won't cut it any more unless you are buying a fund that does your allocation for you in a manner that preserves your capital. CANGX appears to have done a reasonable job given the limitations under which they operate. There may be other funds that have done as well or better, but it takes some thought and work to find them.

    The "everyone else was doing it" excuse is simply the lazy man's way to pass the buck for not paying attention or not putting the effort into a prudent allocation of savings.

    Disclosure: I do not own, nor have I ever owned CANGX. It is simply one example of professionals who compete with hedge funds for customer money and were able to buck "conventional wisdom" and outperform those who have followed the herd. There are some out there who do manage to think independently. Do your own research as you are responsible for your money.
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  •  
    Nov 12 04:13 PM
    Fantastic article. A must read for those who adhere to "Buy index funds, rebalance occasionally, don't trade, don't try to time the market (beyond rebalancing), over the long term stocks will outperform."
    Reply | Link to Comment
  •  
    Nov 12 04:37 PM
    Actually,

    It's easy being a contrarian, when you're exactly the lone contrarian. Because in that case, Either everyone else is right, and you're insane; or everyone else is wrong and you're right (but you're probably still insane).

    It's orders of magnitude more difficult being a contrarian in a roomful of contrarians. You'll have to answer the insane question of whether you're a contrarian at all!

    It should be obvious to all by now that contrarian or not, we're all bagholders now. The Govt will make sure that everything is bailed out; the square peg will fit the round hole; regardless of costs.

    GE Capital just got bailed out, AIG got it's 3rd round of spending -- YET ASIA IS PEGGED TO USD STILL, foreign banks are still buying US Debts and not letting the natural bond interest rate correction happen.

    When the connections of a structure become extremely rigid; the structure doesn't become stronger; instead it becomes more vulnerable to catastrophic changes in formation. i.e. it becomes breakable.

    When enough pressure builds, perhaps when the FED issues 1000 trillion in debt to bail out everything in sight, then it will end.

    By then, Being a contrarian is like being the lone survivor after a nuclear holocaust. It is worth surviving it? Can you survive what's *after* the blast?
    Reply | Link to Comment
  •  
    Nov 12 05:06 PM
    It's hard to be a contrarian because it's impossible to know what everyone is thinking in order to be on the other side. Maybe you can just try to see what people are doing instead of what they are saying or thinking. Not easy. One day most people are buying; the next day they're selling. One day the news is great; the next horrible. My point is that you can only be a contrarian in hindsight. Trying to be one is like grabbing smoke. The answer is to have a core set of beliefs as to how markets and economies operate and act on those beliefs. That might mean losing, but losing based on your beliefs is better than losing based on trying to be the opposite of someone you can't see, hear or touch.

    Have a great day.
    Jolly Rancher
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  •  
    Nov 12 05:19 PM
    I saw it coming. I froze with the audacity of my negativity. I ate it.
    Reply | Link to Comment
  •  
    Nov 12 06:45 PM
    Jim Rogers said today that "We may be hitting `a' bottom, I don't know if it's "the" bottom"

    Jim is quite of a contrarian but usually he is right but early in his calls.


    www.jimrogers-investme...
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  •  
    Nov 12 06:59 PM
    Contrarian Investing is a great long-term way to invest. If you think about it, value investing is a (long) contrarian strategy because you believe the stock is undervalued.

    A great turnaround company is Tupperware (TUP). It's priced at a discount.

    I cover more on both Tupperware and Value Investing on my site.

    But in response to a point in the article, shorting stocks is very expensive. You have very high interest rates, and you have to put up money to short the stock. If the stock goes up past where you bought it, the broker can make a margin call. If you don't have the cash for it you'll have to sell the stock you have. Be careful when shorting, make sure you know what you're getting in to.
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  •  
    Nov 12 08:29 PM
    I cant help. I have to say it. The last thing that people need in this mad market is more Tupperware.
    Reply | Link to Comment
  •  
    Nov 12 09:06 PM
    I prefer to think of the fundamentals. Value is relative to its fundamentals. If a business is bad, it will be expensive no matter what because of the diminishing E. As to what view, be it contrarian or others, it is purely a name to how someone prefers to call it.
    Reply | Link to Comment
  •  
    Nov 12 10:50 PM
    This is what I have said in an interview with Mark Gilbert Bloomberg ,London,on June 3 2005.
    Higher rates,renewed wariness among indebted consumers ,and continued recycling of dollars into Treasuries by investors will help drive down yields.
    Then I have said "All of the economic forces point to a dramatic slowdown ahead which will turn into a serious recession with almost no tools left to abort that possibility".
    On September 18 ,2007 ,in an interview with Brian Sullivan (Bloomberg TV),I have issued a warning about the subprime Armageddon that is about to hit the markets-Other than my costumers ,I dont recall any other vocal support for that view.
    Now,I am bullish as hell on the markets as the FED ,the Treasury and the Foreign Central Banks are implementing correct and mega stimulative measures which will be responsible for the unprecedented rally ahead-period.The volatility and the consolidation of the market will continue while longer.
    Reply | Link to Comment
  •  
    Nov 13 01:33 AM
    The closer sums it up...

    [quote]But as we're reminded daily, everything works until it doesn't.[/quote]


    Amazing profundity there. What exaclty was the point of this article, other than what appears top be tired posturing and trite remarks like the one i've quoted above? Give it a rest.

    Reply | Link to Comment
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