Friday, 28 December 2012

"Buy fear & panic, sell greed & hysteria"

An under-priced asset

Trading at only $5.00, Stockcat has identified an under priced asset. OK, it's not a stock. Nonetheless, Stockcat reckons it's an asset that should be held by every investor.

'The Book of Investing Wisdom' glues together writings from 10 of the world's best investors. You know, the usual suspects such as Warren Buffet, Peter Lynch... (full list at end of blog).

The beauty of the book (aside from being an audio book, making it aptly suited to lazy readers like Stockcat) is how it summarises the investment philosophy of the world's investment legends in one convenient place. It really is much easier than trawling through the whole library of publications by these authors / investors.

Well, that's enough promotion (which certainly is not the purpose of this blog).

What The Book of Investing Wisdom does not do is tie together all the common threads running through the book, and thus help readers form a coherent and robust investment strategy. So, here's Stockcat's crack at doing just that.

Stockcat has boiled the wisdom from these great investors down to five themes, aimed at guiding readers toward making robust future investments. These themes will be split across five blogs - one for each theme - starting with #1:

     "Buy fear and panic, sell greed & hysteria"

What does this mean?

The quote is from Jim Rogers' 'Get Smart & Make a Fortune'. Its meaning is simple: be a contrarian.

The contrarian rule aims to profit from having a contrary opinion (or opposite opinion, if you like) to the market. It exploits the market's tendancy overreact. It also helps investors identify extreme market tops and bottoms.

In short:

  • when the market is nervous and selling: BUY
  • when the market confident and buying: SELL

  • The 1987 stockmarket crash is a (somewhat extreme) example

    Think of the lead-up to the October 1987 sharemarket crash. The NZX rose 99.2% in the prior year (1986), the market's performance often featured on the front page of The New Zealand Herald, share clubs were in vogue, and Kiwis were becoming rich. The mood was positively euphoric. "Greed and hysteria" were abound.

    Sadly, what goes up must come down.

    On 20 Oct 1987, following a bad day on the US markets, the NZX dropped 22.3%. To put this in perspective, the drop represents ~$10bn of wealth destruction. I.e. the total value of stocks listed on the NZX fell from $44.4 bn to $34.5 bn. By the end of the year, this figure was $23.4 bn.

    For more on the crash, see this excellent article.

    Arguably an investor following Jim Roger's "buy fear and panic, sell greed and hysteria" rule would have sold during the greed and hysteria phase, and avoided this drastic market decline. The investor may have then re-entered during the fear and panic phase, picking up quality stocks that had survived the crash for around half the price.

    Follow three guidlines when being a contrarian

    Right now, I can imagine a reader of this blog saying "well, that's OK with the benefit of hindsight. In reality it's not that simple". Fair enough. And I would like to add it's particularly hard to be a contrarian when all your friends are making money from an over-hyped market boom.

    However, Jim Rogers does provide some insights to help with your market timing:
    1. There is always certainty of market participants at extreme market tops and extreme bottoms. Think of the headlines during the depths of the Global Financial Crisis. The media knew that the 'end was nigh', and even speculated about the end of 'capitalism'. Capitalism did not end, and the NZX has since recovered to nearly reach its peak
    2. Amateur investors enter at extreme market tops. Think of the number of share clubs leading up to the 1987 crash, vrs the number of share clubs today. Market tops tend to attract retail investors who otherwise would not enter the stockmarket
    3. There's a general feeling that 'this time is different' at extreme market tops. Think the tech bubble. Investors were pricing dot com stocks at a 'squillion' times revenue, thinking there was something different about the dot com model that justified these insane valuations

    Contrarian rule endorsed by other investing legends 

    Many investors buy stocks during heated markets, even when they know the stocks are overvalued. They see the general public making money and don't want to be left behind, so they jump on the bandwagon.

    Edward Johnson calls this the "bigger fool theory". You buy at a foolish price because you expect a bigger fool will buy off you at an even higher price. Stockcat agrees that this is a risky strategy, at best. If a stock's earnings or tangible asset backing don't justify the valuation, there is no price floor when the market's sentiment turns.

    Even Warren Buffet went so far as to dissolve an investment fund when the market was overpriced. A bold thing to do, but an excellent endorsement for the contrarian strategy.

    In another book, Peter Lynch did some high-level back testing which supported a contrarian strategy. He showed how investors who ploughed more cash into their portfolio every time the market fell would generate superior returns.

    In summary, when timing your entry or exit, be a contrarian. "Buy fear and panic, sell greed and hysteria". Or, to put it another way:

         "Against the crowd, act boldly. With the crowd, act cautiously"
              - Edward Johnson

    Appendix: The Book of Investing Wisdom contains excerpts from:

  • Warren E. Buffet: "Track Record is Everything"
  • Jim Rogers: "Get Smart and Make a Fortune"
  • Peter Lynch: "Stalking the Tenbagger"
  • Edward C. Johnson II: "Contrary Opinion in Stock Market Techniques"
  • Peter L. Bernstein: "Is Investing for the Long Term a Theory or Just Mumbo-Jumbo?"
  • Mario Gabelli: "Grand Slam Hitting"
  • Robert R. Prechter: "Elvis, Frankenstein, and Andy Warhol"
  • George Soros: "After Black Monday"
  • Leo Melamed: "The Art of Futures Trading"
  • Martin E. Zweig: "Selling Short - It's Not Un-American"

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