Profit By Betting Against The Crowd

There's a traders saying that warns against trying to "catch a falling knife". That is, you shouldn't buy assets which have sharply declined as they're likely to go down further before there's any recovery. I'm not sure when this saying gained popularity but I suspect it speaks a lot to the short-term mentality of most investors today. Because history suggests that you should do the opposite - buying assets down 60% or more has delivered fantastic results on 1, 3 and 5 year timeframes. And intuitively this makes sense. If almost everyone has sold out of an asset and there are only buyers left, there's usually only one way for prices to go. Given this, I thought it'd be worth taking a look at the assets which have been pummelled and may be due for a comeback. Globally, the most obvious standouts are Greece and junior gold miners. There are others though, particularly in agriculture, where sugar and coffee are still down 75% and 65% respectively from their all-time highs in the 1970s. In my backyard of Asia, stocks in China and Japan qualify, down two-thirds from their all-time highs. Vietnam is also a contender, having fallen 60% from its 2007 high. And among currencies, the Indian rupee is worth considering, given that it hit all-time lows versus the U.S. dollar in recent weeks. Of the above, gold miners, coffee, Vietnam and the rupee look the most interesting. What happens when you buy assets down 80%? Over the past week, global fund manager Mebane Faber wrote a brief article with the aforementioned title. Specifically, he looked at the performance of sectors, industries and the total stock market in the U.S. after they've been hammered. And here's what he found: Average 3 year nominal returns when buying a sector down since the 1920s: 60% = 57% 70% = 87% 80% = 172% 90% = 240% Average 3 year nominal returns when buying an industry down since 1920s: 60% = 71% 70% = 96% 80% = 136% 90% = 115% Average 3 year nominal returns when buying a country down since the 1970s: 60% = 107% 70% = 116% 80% = 118% 90% = 156% Faber went on to conclude: "It's hard to buy something down 80%, especially when you owned it when it was down 30%, 50%, then 80%. But usually that is a great time to be wading in ... Some recent examples of assets that have got clobbered include tech in 2002, homebuilders in 2009, and Greece and (Junior) Gold Miners now." Other supportive evidence Faber isn't the first to notice this phenomenon. Some years ago, two U.S. professors, Werner DeBondt and Richard Thaler examined the investment performance of U.S. stocks with the worst and best prior investment results. In each year from 1932-1977, the professors selected the 35 best and worst performing stocks over the preceding five year period. And the results were compared to a market index, namely all of the stocks on the New York Stock Exchange. They found that the worst performing stocks over the preceding five-year period produced cumulative returns 18% better than the market index some 17 months after formation. Meanwhile, the best performing stocks in the five years prior produced returns 6% below the market index over the subsequent 17 month period. Similar results have been found in other studies. Two U.K professors, D.K. Power and A.A. Loonie, examined the worst and best performing stocks in their home country between 1973-1982. They then looked at the subsequent performance of those stocks from 1983-1987. The professors found the 30 worst performing stocks in the prior decade outperformed the market index by more than 10% annually in the five years after. Source: Tweedy Browne Finally, U.S. professors James Poterba and Laurence Summers studied the investment results of the best and worst performing stocks in the U.S. from 1926-1985 and in 17 other markets from 1957-1986. They concluded that investment returns tend to revert to the mean over a period of more than one year. That is, current high investment returns tend to be associated with lower future investment returns and vice versa. The cons to this approach Before blindly going out and buying assets that have been crushed though, you should at least consider the following: - The above studies have limitations. Most are focused on U.S. stocks, which have performed well over the past century. The obvious counterpoint to the findings in these studies is Japan, whose stock market has languished +65% below 1989 highs for much of the past decade. Perhaps the recent uptick in Japan may start to confirm the findings, albeit with a significant lag. - Buying beaten down assets without regard to value doesn't make sense. Yes, things that are down 90% are normally cheap but not in every case. Historical research indicates that buying stocks with cheap price-to-earnings, price-to-book and price-to-cash flow ratios produces far superior returns to market indices (and beats 95% of fund managers too). - Beware of buying assets where structural changes may make their products redundant. We've all heard about the tales of Kodak and Xerox, where technology crushed their key products. Today, I'd suggest that parts of the retail industry (and related industries such as retail real estate) may be in the same boat with the internet taking a greater share of consumer pockets. This is a tricky one though as this trend should at least be partially reflected in the prices of retail stocks already. - It's nice to have a potential catalyst for a beaten down industry or country to turn around. Again, this is tricky as you must be able to detect the catalyst before other investors, otherwise it'll already be reflected in prices. Assets that qualify That said, buying unloved assets does have merit. In my view, there are four such assets which provide potential opportunities today: 1) Junior gold miners. Smaller gold companies have been annihilated after the gold price peaked in September 2011. The GDXJ junior gold miners ETF in the U.S. is down around 80% since that time. I am long-term bullish on gold (though did foresee the latest correction, which probably has a little more to go) as few of the fundamental reasons for owning the metal have changed. Principally, that it acts as a hedge against central bank profligacy and currency debasement. But you don't have to be bullish on gold to see upside for the junior gold miners, many of whom are now priced for oblivion. 2) Coffee. I must admit being a sucker for almost any asset that's down 65% from all-time highs reached 36 years ago. And the good part is that supply/demand fundamentals for coffee look reasonable. Inventories remain relatively low, while demand growth looks very solid given the increasing attraction of coffee to the developing world, particularly in Asia. The ICE coffee price is below, courtesy of tradingeconomics.com

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