Everyone Is Shy Of Calling A Top

Everyone is gun shy about calling a top in equities or bonds.

Too often in the recent past anyone who has called a top has been steam-rolled. As a result it is only ideologues and dogmatists who have been calling a top for years who are left to carry the flag.

I don't think we are in a bubble, but I do think the market is way overextended. The contrarian in me wants to take the under.

I'm Going To Mark This Spot For Active Management

With the release yesterday of Vanguard's funds performance relative to peers showing the pure dominance of passive over active management over whatever time frame you want to look at, I am going to put a marker in the ground, and as a good contrarian, say that marks the pinnacle of passive over active for this cycle.

I have no idea how long active vs passive relative performance cycles last, but if something can't go on forever, then it probably won't.

The irony of course is that I am launching a passive index based advisory practice just as active is likely to see a turnaround in its fortunes.

The other giveaway to the "peak passive" theory is the increasing crescendo of headlines touting the fact.

Oh well, back to basics. The principles of investing are simple. The act of investing is hard.

Keep It Simple - The Crux of Value Investing

I don't think you have to do fancy algorithms or deep quant or anything else to uncover deep value. You only have to be patient and be willing to pick-up a good company when the market has discarded it to the side of the road.

I call this value investing. In order to do it you have to have some gumption as to what you think the company is worth. The reason and the cause of the 'fall from grace' are important because you have to discern that it is a temporary setback.

The aforementioned is a company specific self-inflicted own goal or some sort.

The other major time when 'value' investing can work healthily is when the market itself has got itself in a panic and is casting everything out with the bathwater.

Contrarianism is ingrained deep within the process. 

Both instances call for a gauge of intrinsic value, conviction, courage and patience. Those are the most important elements to being and becoming a better investor.

Exploitable Anomalies

Small cap.
Value.
Information diffusion time lag. 
Momentum.
Mean reversion.
New fund.
Small AUM.
Quality companies.
Seasonals of all kinds. 

Got To Know What You're Good At

One way to know what you are good at is to identify those things you are bad at.

I'm bad at recognizing the dislocative disruption of new players and new trends. I see the trends but I don't extrapolate their likely diffusing effects very well. At the same time, I tend to give to much credit/strength to the incumbent(s), eg. Nokia.

Another area I am not particularly good at is identifying who the next big thing is going to be, ie. emerging leader. Part of the reason is that the market has already given the name a huge multiple and I can't bring myself to join in the party (late). Of course, if something is the next big thing, then its addressable market is a multiple larger than it is at the front end and it warrants the high multiple (that in hindsight now looks like a great price).

I'm a sucker for discounted relative value plays. Currently, CALL, ESI, ACI and OUTR are on my radar. But there is usually some good reason why they traded at an apparently steeped discount to their peers. If it is too good to be true, then it is probably too good to be true. I can't tell you the number of times I've been attracted to a name (sometimes bought it) only to find out there were shenanigans going on that I didn't know about (but the smart money did).

I am good at buying companies when the market has thrown the baby out with the bath water. This is an incredibly dangerous strategy, but it is in keeping with my own investing personality (DNA).

I don't have great vision for choosing the next great growth stock, but I have the courage to buy when/after the market has thrown something on the trash heap.

Contrary investing - the trapdoor and the panic

Two good strategies. Both require tremendous patience and discipline. One is a micro approach, the other a macro angle.

The first is the trapdoor spider strategy. You keep your powder dry waiting patiently for the market to throw you a prize. The prize is a great company that is overowned and has stumbled. Problems and concerns have arisen, but there is no fundamental rearranging of the deck chairs. Just a misstep. These things happen. Could be a 1 to 2 year workout. Don't buy too soon. The stock will bottom before the worst of the information comes out. When you see it holding fast or rallying on bad news. That is a good sign. But it can take some time for the stock to find its legs again.

The second is a general market panic. Could be a country. Could be an industry. Could be the whole market. Everything is marked down. Fear is rife. Buy the country or industry champion. These are too big to fail, too deeply entwined in the fabric. Again, another 1 to 2 year workout.

Implications of Momentum Investing

Trend following, aka momentum investing is probably the weakest part of my investing DNA. I am a natural contrarian with a strong value tilt. I have learned the value of growth and the importance of sentiment and momentum, but they are still both hard for me to fully commit  to.

Over the past 10-15 years research has vindicated and validated trend following strategies as a way to add alpha. Consequently, and in conjunction with the increasingly quantitative/algo driven basis of the market, I believe trends, predicated upon more momentum investors and trend followers, will be longer and of greater magnitude that previously. The nature of momentum is that it feeds upon itself. It is self perpetuating, self replicating. There are three major implications. First, you need to incorporate momentum into your investment strategy. Second, a momentum based market leaves opportunity for fundamental based value investors. Because the trend goes longer and for a greater duration than fundamental value would indicate, it creates an opportunity for a fundamental based value perspective. Third, turns in the market or changes in trend will trip up a lot more investors. Trend followers, quant or qual, always get burnt by the turns in the market. The length and magnitude of trends will be greater on boths sides of a trend. Significant alpha will come from picking a change in trend. Incorporating a market reversal component into an investment process (albeit incredibly difficult) will be very rewarding.

The old adage, go with the flow will be the dominant characteristic of future markets.

Why jumping on the band wagon is so tough for me

I am a natural contrarian.

I think mean reversion is etched into my DNA.

I also have a bad case of regret embedded within my psyche.

Consequently, jumping on the band wagon aka as trend following or momentum investing really cuts against the grain for me.

I am happy buying when others are selling and then riding it down, and I am happy selling when others are buying and then seeing it continue higher. But I have a hard time bringing myself to buy after the horse has bolted (even if I can see clear air ahead) and selling after a holding has been pinged. The reason is because the regret of jumping on board and being wrong, ie. having the stock go back down, or selling a loser only to see it rise, weighs heavily upon me.

I've got to cure my momentum reluctance. It is not constructive.

Speculations on the Consensus

At a purely intuitive level (and I hope I am not projecting here) I get the very distinct impression that the unremitting rise in the market this year has managed to shape and mould the consensus toward a very positive perspective on 2014.

Focus will shortly shift from 3rd and 4th quarter (which are accepted as strong and solid) to a more critical look at 2014. I just don't get the impression that anyone is expecting a pullback of any size. Having been wrong on that count since the bottom was put in back in 2009, the market is crushing any resistance. If anyone has been anti, then they have paid a very steep price.

For my part, although it is incredibly hard to go against the flow and there are no specific things to get overly worked up about, my contrarian radar is saying now is the time to make the hard trade. Put some money in the bank and see what the market throws up.

Burned Out For Profit Education Sector Set To Run

Been looking at a few names in the burnt out for profit education space.

I think it will recover - maybe not to its former glory (read that profit margins and growth rates) - but it will survive and live to fight another day. Which means at current valuations most of the stocks in the space are really cheap.

The sector recently staged an impressive rally off the bottom. The interesting thing is that enrollment data has continued to decline. When a market rallies this strong from such a low valuation on no tangible information, it indicates to me that the bottom trollers have put their hooks in and are getting in ahead of the crowd. I expect the sector to see a turnaround in enrollment fortunes in 2014 which should propel it higher (depending upon how much it has already rallied in the interim).

Make no doubt about it, this sector is scary risky. From massive regulatory overhang to no sign of recovery, it is not for the faint of heart. Despite offering up tremendous value from a contrarian perspective, it may not be appropriate for a long term investor looking for good quality companies. Fundamentals are still declining and things look bleak on the surface. It is only under the surface when you look at the potential and the value being attached to assets that have enormous operating leverage, that you see something positive.

As a long term investor you always need to remind yourself that you really want to own good quality companies, in good industries, with good tailwinds. The for profit education sector does not offer those characteristics. But for contrarian value investors, it offers up an attractive profile.

On a final note. I have a lot of disdain for the sales and marketing practices of these firms. I don't like the way they do business. I don't like how they operate. They do however have a great business model (at least it use to be great). It is an ethical dilemma to invest in an industry/sector where they operate in a manner that you don't like but where there is tremendous value in the businesses who operate in the space.

Market Due A Pullback

The market is due a pullback. The odds are in my favor. I know that. x number of up days in a row. x number of days without a 5% pullback. But just because I know the odds are in my favor, doesn't make it any easier to sit on losing positions and watch them drain away.

The market is up 16% YTD. 21% in the last six months. The move has been relentless. 7% in just the last month. There has been little to no respite. A couple of minor pullbacks here and there. Other than that, it has been a tidal surge.

The move is flushing the bears and the laggards out. I feel it. I can feel the sentiment changing. I feel better about the future. I see things differently from what I saw them before. I can see the justifications for valuation levels, expanding multiples and all sundry of related thoughts that go hand in hand with this kind of move. Don't fight the Fed (or is it ABE and don't fight the trends/momentum). I have some short positions on that are getting pretty painful. I shorted for the wrong reason (valuation) and they are names leading the charge. I have gone against this thing for the last couple of months - selling into it, putting on shorts and directionally speccing on market puts. I know that you need to manage your risks. I know there are times to cut and run, take the loss, live to fight another day.

But I have been here before. I felt those same feelings, and I have not held to my conviction or had the patience to hang tough. I have spat the dummy and watched as I missed out on the rewards that were there waiting for me. Not this time. I am going to go with my conviction. I am going to have the fortitude to go against the flow. But I am also going to put in some stops that will minimize the damage should it continue to go against me.

When Contrarianism Can Hurt You

Contrarianism when things are falling is a slightly safer bet than contrarianism when things are rising.

In both cases, you are following the go against the herd dictate - "buy when they are selling and sell when they are buying."

However if you stick your toe in the water at -10% and it goes to -20%, then to -30%, then that is very painful. But at least there is a floor somewhere, and if history is any guide, the market will eventually recover and sometimes will do so in spectacular fashion. So you are better off sucking it up, waiting for the turn and then letting it flow.

Conversely, when the market is moving up and you dip your toe in to sell, it can be incredibly painful watching it go up another 10%, 20%, 30%, because you have no way to recoup that lost opportunity cost and you have no idea how much further it might rise. Even if you know there is a short term limit, you don't know where it is and you can't be assured you'll be able to get your timing right when the dip comes.

Systematic Mistakes aka Bad Wiring

I am prone to the same mistake on different sides of the cycle.

When markets are trending up, I am reluctant to chase and look for a pullback to make an entry (but it either never is enough or I move the goalposts when it comes my direction).

When markets are trending down, I am reluctant to cut and run and look for a bounce to sell into (but it is either not enough or I move the goalposts...does that sound familiar).

If I could get those two elements out of my software, it would improve my decision making and results enormously.

The problem is that I am wired as a natural contrarian, and both mistakes imply a lack of conviction.

Going Against The Grain

It is hard to put the kabosh on something when it is working well for you.

As the market rises, you begin rationalizing that all those winners are worth a lot more than where they are and the market is only now waking up to that fact.

By nature I am a contrarian, but I have learned greater patience in letting my winners run (need to work on cutting my losers loose). This has not necessarily been to my benefit as, although the markets have been positively trending since the low, I would have been better off at times looking to trade in and out of positions more actively.

Still, even though the trend is positive and I think we are moving away from the edge, I reduced my exposure to those names that have significantly outperformed and raised a little cash to provide cognitive support should the market trade back down and a little extra powder should any conviction opportunities present themselves.

I didn't feel like selling, but overruled my emotive state. I've seen a colleague do that before and thought he did a good job of it. It is kind of, "the markets have had a great run, I don't see anything that should lead me to sell per se, but I know things don't move in a straight line and it seems prudent to book a little profit ahead of the game."

Contrarian Asset Play - Coal-Based Utilities

I don't even know the space, but it doesn't take a scholar to work out that coal-based utilities are persona non grata right now (they are the nuclear power plants of the new century). In classic Wall St fashion, the market has fled (and will continue to flee) the space, thereby abandoning what will eventually be highly undervalued assets and a great contrarian play.