The Price of Conformism
(Guest Commentary by Rick Konrad – November 15, 2007)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.
In this commentary, Rick will be sharing his thoughts on a certain (mechanical) investment strategy that is driven by adopting a contrarian view of institutional investors. According to this strategy, now may be a good time to buy certain stocks/industries if you have a long-term investment timeframe (Henry's note: Even though we are currently short via our DJIA Timing System, I still don't believe this bull market is over, although I do believe that the current correction has further to go before bottoming). Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Are Pharma Stocks Making You Ill?” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
One of the things I really appreciate about being an occasional contributor to Marketthoughts is that Henry provides complete flexibility as to my topics. This has allowed me to write about individual stocks or investment strategy with equal flexibility.
One of the strengths of Henry's work is that it is quite non-conformist. Equity allocation decisions to increase or reduce exposure have been very successfully implemented. Today, I'd like to talk about the philosophy of contrarianism and the rewards of non-conformity.
Many of us may mistakenly believe that we are contrarian, yet few of us are actually very successful at it. Contrarianism, popularized by David Dreman (if indeed one can popularize contrarianism) has been regarded as a positive contributor to returns for a very long time.
Indeed, even Keynes declared contrarianism as a central principle, “The central principle of investment is to go contrary to the popular opinion, on the grounds that if everyone agreed about its merit, the investment is ultimately too dear and therefore unattractive.” If the consensus is correct, presumably all investors would achieve a fair or “efficient” return. The price reflects the sum of market participants' “votes.” It has nothing to do with the value per se.
Thank goodness, markets are not efficient, and behavior driven by fear and greed works wonders to ensure that very positive returns accrue to some and unfortunately, the corollary of very poor returns are available to the rest. Hence, the great divide of investment returns, the dichotomy of investment gurus versus the rest of us.
In an investment world where first class managers are scrambling desperately to outperform everyone else, doing what everyone else is doing is unlikely to generate an iota of out-performance. As Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority.”
Despite the prevailing wisdom, there is very extensive anecdotal evidence that managers imitate the investment strategies of their peers. When we see a marked tendency to overreact to news, our choice is to “go with the flow,” a momentum strategy, or to bet on a return to normalcy, a contrarian strategy. One piece of evidence that condemns the notion of independent contrarian thinking by investment managers is an increase in correlation during turbulent market conditions. At the very time that international diversification should be relied on to provide diversification benefits, these benefits disappear.
In a 2006 paper by Amil Dasgupta of the London School of Economics, co-authored by Andrea Prate and Michela Verardo, conformist investment management by institutions is examined. Lemming like behavior of institutional investors can generate systematic mispricing followed by subsequent corrections. The degree of mispricing and consequential outperformance or underperformance can be exploited by us as individual investors. Let's have a look at some of this data.
First, a bottom-line: The stocks that institutional fund managers are busy buying are outperformed by the very stocks they are selling!
Dasgupta, et al examined U.S. fund managers' filings between 1981 and 2004. Each quarter, stocks are assigned to different portfolios depending on the persistence of institutional net trade defined as the number of quarters for which a net buy or a net sell is recorded. Stocks that have been persistently sold by institutions over several quarters outperform stocks that have been persistently bought by them over a period of at least two years in the future. On average, a strategy that buys stocks that have been sold by institutions for five quarters and shorts stocks that have been bought by them for the same period yields a cumulative market-adjusted return of 8% over one year and 17% after two years. Here is a view of this strategy:
from Dasgupta et al, The Price of Conformism
The left axis of this chart describes the amount of outperformance or underperformance of a strategy relative to the market ranging from +12% excess return over the index to -8% return below the index. A persistence of -5 includes all stocks that have been sold for at least five quarters, and a persistence measure of 0 shows stocks that have been bought or sold in the current period.
Hence, over a two year period, there is a 17% difference in returns with stocks that the institutions sold the most outperforming the market by 11% and stocks they purchased the most underperforming by 6%!
Why does this occur? Frequently, it is important for fund managers to keep a fairly short-term perspective, and it is important to stay “in the hunt.” It is optimal for them to invest in overvalued stocks even though they are aware of the excessive valuation. This argument is even more potent if fund managers are evaluated on the basis of relative performance because with relative evaluation, underperformance would mean losing future inflows.
Unlike most investment managers, we as individuals can afford to diverge from the pack. Unlike the average fund manager, we do not concern ourselves with tracking error and benchmark risk, the urge to not diverge. Think of the Stealer's Wheel lyrics, “Clowns to the left of me, Jokers to the right, here I am, stuck in the middle with you."
Be different. Don't get caught up in the noise. Stick with cash when you don't have a great idea. As Seth Klarman wrote in 2003, his large cash position was “the result of a bottom-up and failed search for bargains.”
“Diversification is an admission of not knowing what to do, and an effort to strike an average,” according to Loeb's Battle for Investment Survival. Don't get carried away with your diversification. Don't let it become a collection rather than a portfolio.
Humans are natural conformers. There is a tendency to ostracize those of us who are different, those of us who don't herd. Why do smart people do irrational or stupid things? We fear disapproval and become self-conscious. We may have reputation concerns.
Where are these opportunities to do something different? Where is there uniformity of opinion with little respect for the downside? Or where is there complete terror and fear?
In my view, we should be questioning many emerging markets investments. Few analysts are negative, few ask critical questions at the height of the boom, and there seems to be an overwhelming belief that the Chinese are in some ways masters of the 21st Century universe. It seems to me that valuations reflect a very cheery consensus.
The other side of the behavioral coin is fear. I suspect that somewhere in the rubble of the banking and mortgage crisis are some decent values. It may be early. Great stocks are always too early! Quoting a hedge fund manager with a decent eye toward value:
"Clearly, we've got fear now, and at the epicenter of that fear is the U.S. real estate market. This fear is reflected in extraordinary volatility and stock price declines for those companies seen most vulnerable to the real estate bust – most notably homebuilders, mortgage lenders, and mortgage guarantors – coupled with all-time high prices for disaster protection on these names."
He is buying title insurers. In my view, a terrific idea at the periphery of the crisis yet whose valuation has been impacted by the crisis. I will admit that I have also recently stepped up to the plate on Citigroup (C) itself. A bank I have bought only in times of crisis, and given their size, they manage to find enough of them. The Brazilian debt crisis, the near bankruptcy of the company in the early 90's… I have lived and thrived through them all, albeit with a lot of anxiety and hair loss. Defeat has always seemed so near, yet prosperity was there for the taking.
Once again, I am long and hearing that most of my confreres have sold their position.
Clients are unanimous in thinking that either I am crazy or at best, early. I suspect that institutions are falling over themselves to get their financial services weightings down to near nothing as year end approaches. I may be on to something.
Disclaimer: I, my family, or clients have a current position in Citigroup.