How to Profit from Trend Changes

Wednesday, September 29, 2010

Yesterday I discussed a likely trend change coming (see “WSJ Accidentally Identifies Macro Investing’s Probable End of the Line“). Investing for such a change can be highly profitable.

Trend changes are actually numerous, relating to virtually all investment types, groupings or management approaches. The goal isn’t to spot all of them. Here’s what’s needed…

To take advantage of a trend change, there is one absolutely critical need: An understanding of and a willingness to practice contrarian investing. I have addressed the importance of this skill in a number of articles you can access here.

And that takes me to my experiences. I previously covered four examples in “Contrarian Investing (Part 3) – My Own Personal Experiences” (December 14, 2009). The fourth example in that article is most relevant to today’s market environment. Another, discussed below, is what happened in 1988 when individual and institutional investors, along with their consultants, believed that growth stock investing was dead.

1988: A new approach easily beats a proven one

In 1988, leveraged buyouts (LBOs) were all the rage. LBO (think private equity) firms would acquire a weak firm using a large amount of debt. Different management approaches would then be put in place – from cutting expenses to the bone to breaking up the company to trying for a turnaround. Investors were trying to guess the next company to be acquired because the low-priced stock would be bid up. Value stock managers naturally performed well because they held the types of stocks acquired. Arbitrage managers (buy cheap stocks, short the market and leverage everything) did even better.

Meanwhile, growth stock managers were out in the cold. LBOs of the higher-priced growth companies didn’t make sense. Pursuing performance, investors shifted money in earnest – out of growth, into value and arbitrage.

Naturally, as the money movement ballooned, the performance differences became more pronounced, encouraging more to jump aboard, with the consultants and press cheering them on.

The diversification question: Rebalance to growth?

At the time, I was at the Liberty Asset Management Company mentioned in the third example in the article above. The closed-end Liberty All-Star Equity Fund had five managers, ranging from deep value (David Dreman at Dreman Value Management) to fast growth (Jeff Miller at Provident Investment Counsel). The performance differences illustrate what we were contending with.

Midway through the third quarter, the S&P 500 Stock Index was up year-to-date about 12% (including dividends), Dreman was up well over 20% and Provident was dragging along at about 3%. Because our approach was to equally allocate assets among the five managers, we needed to rebalance, taking money from Dreman and the other managers, giving it to Provident. The amount was large, so were evaluating whether Provident should be kept or replaced.

Consultants’ advice was unanimous and emphatic: Dump Provident and hire an arbitrage manager. They said Provident’s problem was that it continued to focus on growth stocks, an investing style they believed to be obsolete. Bolstering their confidence was Provident’s weak performance. The firm ranked at the bottom of major institutional investment managers for 1-year, 3-years, 5-years and 10-years.

The decision is made: Rebalance to Provident

However, we kept Provident and rebalanced, giving them a sizeable amount of the fund’s assets. Why? The notion that growth investing was dead ignored why it existed in the first place. Some companies grow faster than others, and investing requires special skills to identify and analyze them. We believed Provident remained a leader at doing so. The fact that such stocks had underperformed while money flowed to other, hot areas, did not diminish the value of their process. In fact (and here is where contrarian thinking really pays off), the more the companies grew while their stocks languished, the better the valuations and the higher the potential future returns.

The payoff

The results? Much better than we anticipated. Growth stocks began rising in earnest shortly after the rebalancing, producing excellent returns in each of the following three years. At the same time, value managers and LBOs ran into a serious down market for their stocks as well as the LBO approach, itself. By the end of 1991, Provident’s performance for 1-year, 3-years, 5-years and 10-years ranked them at the top of that manager database.

The takeaways from this example

The important lessons from this example that we can apply to today’s market are:

  1. Human nature is capable of extrapolating an extended period of good or bad performance into “forever” projections
  2. Even the professionals can be fooled into thinking this time things are truly different
  3. We all need to have a grounding in what works in investing and why (what the philosophers call the “basic truths”). This fundamental understanding provides a foundation for making wise decisions in the midst of powerful and enticing (or frightening) trends
  4. Most important: Profiting from trend changes doesn’t mean having to be prescient. Contrarian investing based on what everyone knows but few are acting upon is at the heart of any correct trend-change decision.

Personal note: I realize it can be hard to get excited about an investment action that took place over 20 years ago. After all, that was then, and this is now. However, this experience retains its importance because one thing doesn’t change in investing: Human nature.

So… This example and the others I previously described show that profiting from a trend shift is possible. Next, we will discuss what I believe we can do to profit from the trend shift that appears to be upon us.

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September 2010