Friday 4 September 2015

Contrarian rules part II

Rock Solid, 2015

What feels today like a long, long time ago I published an article that I called Contrarian rules. This article contained the set of rules that David Dreman claim to be one of the best approaches to reach a high yearly growth on your investment.

Back in 2012 I read plenty of investment books and once I had started this blog I went back to them to dig out the advice or rules as they were given which lead me to the publication back in March 2013.

David Dreman and his contrarian rules seemed to fit very well to my personality. I know that I do not panic and I know that I do not care if the share price drops -50% after I have bought them. Based on this knowledge I thought that the unloved, out of favour companies would be my thing. I even named the blog after this investment strategy.

Now I have been working, with a large part of my portfolio, according to this principle since early 2012. I have mixed in some Lynch and some Buffett (both have worked very well) but the largest part is still Dreman. I am sure that David Dreman as well as many of you will say that 3.5 years is not long enough for a strategy to start working correctly and I can accept and agree with that but there is one thing that have crept up on me and this is the reason for this article.

This is copy/pasted from the previous article that I linked to above:


11. Positive and negative surprises affects favoured and unfavoured stocks very differently.

12. (A) Surprises as a group improves out of favour stocks and impairs favoured stocks. (B) Positive surprise has a major effect on out of favour stocks and limited on favoured stocks. (C) Negative surprise have little impact on out of favoured stocks and a major stock value impact on favoured stocks. (D) The effect of an earnings surprise continues for a longer period.

13. Favoured stocks under perform the market while an out of favour stocks out perform the market but the reappraisal happens slowly.

14. Buy solid companies, currently out of favour of the market. measured by the price/earnings, price/cash flow, price/book value or by their high yields.

Part of the research made by Mr. Dreman and hence these four rules, claims that the low P/E, P/B companies are treated differently by the market when something happens. My experience until today's date says that this is not true.

Each time when there has been additional bad news in my companies they have dropped with an additional %-age, sometimes even very large. 
Each time when the entire market has dropped a %-age my dirt cheap companies have done exactly the same. Sure one can say that if that favoured company arrived with bad news they would fall even more... maybe... but I have not seen that happen. Bad news in high P/E companies (when P/E is due to high quality) have caused them to drop but from what I have seen often even less than what the low P/E companies have done. A -50% drop is always -50% and a company will then go from P/E 8 to P/E 4 while another one goes from P/E 28 to P/E 14. 

Here I stretch my neck out a little but I am fairly certain that more investors would love to buy the high quality company at P/E 14 than what they would like to buy the unfavoured one, that not only has gone from the already crazy low, P/E 8 but it even dropped further to P/E 4 on top of things. High quality P/E 14 versus low quality at P/E 4 which one would you be the most excited to buy?

When I look back at the very low P/E valued companies then that period have often been followed by either a year / some quarters of negative earnings or extremely low earnings giving crazy high P/Es. Often there are some write-off of the book value and assets. This does not happen in the same fashion with the high quality companies. Their earnings grow quarter after quarter and fluctuations are rare.

My problem here is pretty obvious. If I have discovered that four of his rules are bunk then what about the other ones? What about the entire book, the data collection and graph representations that were made? To make things worse... I have more or less based my entire investment principle on that what is bad and unfavoured today will rise again in the future and my downside will be protected since these unfavoured companies will hardly fall any deeper. Bunk is what it is! The downside is by no means protected and -50% is always -50% and will always remain as such.

So what do I do now? Do I call it quits? Do I slowly but surely move away from the strategy and expand the Lynch & Buffett strategy?


Falk said...

Hi Fredrik,

thank your for your honesty to us and to yourself. This alone together with the possibility to learn from your mistakes should lead to better investment results in the long term.

When I started investing I made the exact same mistakes. I invested in quantitive cheap companies, crossed my fingers and waited for returns that never came. After loosing only small money (lucky me) I realized that I also had to analyze the quality of the company. To quote Buffet: "Price is what you pay, value is what you get"

I also had to realize that my circle of competence was not as wide as I thought it was and that most of the companies were cheap for a good reason. I didn't have any edge at all. You already linked valueandopportunity and his latest article, so you know what I mean.

Last but not least I realized that temporary problems that lead to depressed prices will normally only be solved by an trustworthy management with a good track record and with fair incentives. There are a lot of bad managers out there that only think about theirselves first and destroy the companies they are working for.

So if you ask for my advice: reanalyze your current portfolio and focus a little bit more on your circle of competence, the quality of the company business models and their current management. Then rank them, based on the quality and the current over-/undervaluation. And then sell the low quality + overvalued companies first. Or only the low quality stocks. Or only the ones outside your circle of competence. Just my five cents...


Fredrik von Oberhausen said...

Thank you for your feedback Falk!

Well... yes, it is hard to have a quick edge on something but I still consider myself to have two edges:
1. I am not scared of -50% (which I probably should be) and
2. I do not have any real time/performance pressure (compared to active managers) that
on the other hand can lead me into beautiful value traps such as... Utility?

Hear, Hear on the managers! I find them to be more and more crucial and I am looking into that even more specifically via my Tessenderlo and Avtovaz investments. Less good though is that I am fairly annoyed by several of the managers in my current holdings... which leads us to your advice.

I would have to kick out so many companies. So many. It makes me sad. Really sad. I do not think I am able to do that today. I do not think I am strong enough for that. Not yet. I need to think.

Thanks Falk.

Garry said...

Hi Frederik

I think Falk is right: be more selective in your picks, the financial and energy sector is too difficult to predict and to invest in, too many parameters. I would add more Buffett-type investments to your portfolio. (pricing power, deep-moat,easy to understand, wonderfull companies at good price...) And cut the rest while your loses are controllable.

Every month you buy a new stock, but to me it seems impossible to have every month a great new idea. Be patient until a real opportunity comes around, don't just buy stock to buy something.

Studying Buffett may help (books, quotes,...)

"An investor should act as though he had a lifetime decision card with just twenty punches on it."

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

"The stock market is a no-called-strike game. You don't have to swing at everything — you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"

I think the current volatility results in opportunities to pick up some wonderfull companies at good prices.


Fredrik von Oberhausen said...

Hi Garry,

Thanks for your feedback!

I have spent the weekend digging into the blog of Lundaluppen (you can find him in the blog roll but it is all in Swedish). He was one of the most successful value invest bloggers in Sweden until he stopped to write a couple of months ago. I needed that to clear my thoughts a little.

I fully agree that financials and energy are difficult because as an amateur investor one will probably never be able to fully understand the companies and often I even doubt if the managers fully do... The thing is, if we take banks as an example, I can not get it into my head that German banks should trade at P/B of 0.5 (which they are at today) while many other banks are trading above a P/B of 1.5 in Europe. I simply cannot understand that. So even though I know that I do not understand the business to me that P/B difference makes no sense and for that reason I also cannot sell my banks.

I fully agree that I swing the bat far too often in terms of buying new companies. I do however not like to have cash lying around. My thoughts were always that a cash pile will be built up when sales are made and once the dividend payments reach such a level that it is well above my monthly "savings" but until that point is reached I want to keep pushing in every € that I can when I get it.

Oh, I should probably also say that I think that writing the blog is negative for accepting mistakes and selling stocks. It simply makes it one step harder to do so because I need to report it and write about it. So one have to rub salt into the wounds additionally due to the blog.

I will most likely start to phase things out and the "new strikes" will be more wonderful companies and then I will still increase positions in the companies I have where the valuation makes no sense but I must stop to buy companies such as Fugro, Eniro, Gerry Weber, Asian Bamboo and Kernel.