Saturday, September 8, 2018

Forget about efficient market theory, it is super emotional

My stock performance has been market performance, that is a bit in between the Canadian and U.S. market performance. I should have done better and maybe during a future commodity price crash I will. The pattern is always the same, when commodity prices are depressed, the U.S. outperforms Canada and for Canadians, U.S. stock performance is then also often helped by a stronger U.S. dollar – a double whammy. When commodity prices are up, Canada and the Canadian dollar out perform. So, over the last 5 years my annual performance was just over 7%.  Not that bad because that is in a period without meaningful inflation; exactly what typical stock market performance should be.  I lucked out, because my oil and gas holdings were during the oil price collapse virtually zero. Yet to me that is disappointing. Without trying to brag, during the commodity boom between 2001 and 2008, I easily outperformed Warren Buffett. 

Not because I am a genius, it is because of investment style. I tend to invest more in commodities; that is my Canadian bias. I have not been very smart, as said, over the last 5 years or so, I should have more invested in the U.S.  Mr. Buffett tends to invest more in stocks with predictable net income and stocks that have a strong competitive edge (“wide moat”). Commodity based companies are price takers and do not have such a competitive edge.  Oh, and Warren also knows that markets are often not efficient contrary to what many traditional investment advisors tell you. Look no farther than aforementioned oil and gas!

Many oil companies and related service industries trade currently at prices less than when oil was under $30 per barrel. Too many people lost money investing in oil and gas stocks during that down turn. They don’t blame this on their own risky market speculation, i.e. hoping for higher and higher oil prices. Instead, with some justification, they are blaming low oil prices and bad management for their failure. Today, they are afraid for oil and gas (our good luck) and have moved their bad speculative habits to where the new action is – high tech, FAANG.  They no longer are interested in the incredible bargains that oil and gas companies are right now.

The same happened in the late 1990s, when oil prices gradually recovered from 1982 and 1986 and along with them the oil and gas industry recovered. But, it took several years before markets realized the profits oil and gas once again were making. That is until someone woke up. Next, many invested in these energy stocks as if they couldn’t lose and threw all caution in the wind. That was our profit moment.

Is that rational?  Absolutely not! In the spring of 2009, when markets recovered from the financial crisis, most investors did not realize that they were at the start of the longest bull market in history. How many ‘experts’ said that economic growth in the West would from now on be no more than 1 to 2% per annum. Well, did you see Canadian or the U.S. growth numbers lately? Yet, apart from FAANG, many U.S. companies are trading at very modest evaluations. For example, Hersey or even Disney. The latter hasn’t seen a lot of appreciation for over 2 years now.  But just buying a S&P500 ETF in 2009 would have returned close to 300% as of today and there is still opportunity (apart from FAANG).

You see, there are nearly always stocks whose value is not correctly reflected. Yes, some other stocks are priced for ‘perfection’ and everyone is hanging on the lips of the managements of said companies (like today FAANG) to distill every miniscule tidbit of news that is immediately reflected in their price. But many other, very valuable, companies are completely ignored, as currently oil and gas are. It is pure emotion, pain from the recent past and distraction by other ‘hot stocks’. Only after the oil and gas stocks have improved performance out of sight of todays fashionable trends, will they explode upward and then everyone jumps on the bandwagon. That time of unbound optimism is when you should have your finger on the sell trigger. 

Often there is lots of time, sometimes years, to buy valuable but out-of-favor stocks for a song. Then, the market suddenly wakes up and valuations shoot through the roof. Even If you don’t recognize that prices have ‘bottomed’ there is often plenty of time to buy those ‘diamonds in the rough’. It is not that they will shoot up right-away and there are likely ‘false starts’ Look no further than early 2016 at the start of the bull market in gold. Now goldminers and gold have settled back. But that doesn’t mean there is no bull market in gold right now. You can buy many miners and gold itself today very cheaply and it may not be until inflation returns that this bull market really takes off. In the meantime, many ‘experts’ are trying to explain that gold is dead for years to come. They are probably wrong.

That is why, when near market bottoms, you don’t have to jump in with a ‘full investment position’. Instead, you buy a bit, and when things work out you buy a bit more. You may even fall back to losses but over the next 5 or 10 years, you will make your profits, especially when everyone else jumps on board much later. During those months or years of waiting, you will see so much value, you’ll have a tough time not to buy. That is how you gradually and carefully build up a full position and you cash in during market euphoria. You must realize by now, that fundamentals are important to ensure a company’s survival and its earnings growth - creating truly great and valuable companies. But it is market emotion, fear and greed, that ultimately sets the share price of those valuable companies to near unsustainable levels. Prices at which you should be happy to sell, followed by waiting for the next market crash.  Never forget, the higher a market goes, the higher the risk! It is not that the markets or the masses are always wrong, it is just that they are driven by emotions rather then rational. That is why you have to think differently than most investors, thus you can take advantage. That is what makes you a contrarian value investor.

That is also what rebalancing of a diversified portfolio does for you. You basically reduce your most successful positions when they become too large, too expensive AND too risky. Next, you use the proceeds to increase your holdings that are more depressed in price and out-off-favor. You know, buy low and sell high!

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