Tuesday, May 4, 2010

CONTRARIAN THINKING STILL A MISSED HOLY GRAIL?

INTRODUCTION

Contrarian thinking a missed holy grail? Using information that we can gather on a daily basis at Twitter via Exectweets (http://exectweets.com) we came to the conclusion that somehow we all know it due to great quotes by top business men and other thinkers. But still, the wisdom embodied in these small quotes is often forgotten when taking investment or other economic decisions. Analyzing a lot of these quotes - and translating them back to Economic Thinking and Language - it becomes clear that 'overreaction' and 'contrarianism' are two key elements of what is important for all of us when facing tough events that require us to act.

Already back in the 1980s Economics Noble Prize Laureate Prof Richard Thaler (University of Chicago) and Prof Werner de Bondt showed it clearly: If one would rank portfolios of stocks based on their performance during the last 3-5 years, the losers (i.e. the groups with the lowest cumulative returns) would be the winners during the next 3-5 years and vice versa. This 'winners curse' is not only happening in stock investing itself, we also see it back in the selection of investment managers by institutional and private clients. 

Prof Richard Thaler (Noble Prize Laureate Economics)
Showed the value of contrarian investing already some 25 years ago, 
together with colleague Werner De Bondt.



THE WINNER'S CURSE: OUR TENDENCY TO OVERREACT

Once managers are rated top-of-the-bill by institutions like Morningstar, we see them struggle. Of course, there are really good managers out there that are capable of staying 'world class' for a longer period of time. But it is strange that we have to conclude that it is more complicated to find 'the real world class players' in a group of winners than it is to outperform the winners as a group (including the 'real world class players') by simply buying a mix of investment products/strategies from mediocre managers!!

Using the words of some very wise men, we see that all of us actually know this already. Here is a small selection:

Management guru Peter Drucker already knew that ''Knowledge has to be improved, challenged, and increased constantly, or it vanishes.'' Staying abreast is hard work, and it implies a constant reinvention of oneself. The investment process (or any other type of decision process in real life economic situations) can never be treated as 'perfect now and forever'. Constant updating is required. The problem for successful entities or people is that the moment that they are treated by the outside world as guru's or geniuses, is also the time when financial and other personal benefits might lead to situations in which the key decision takers, i.e. driving forces behind the success will be lured away from the decision process into management type of roles. And that is exactly what happened way too often in the financial services industry, where giant corporations selling or buying complicated financial products were lead by people that wanted to be manager. Finance can learn from pharmaceutical and bio-tech sectors where a key role is always played by an engaged content specialist.

Stated differently, we could also use a famous quote by 19th-century American thinker Henry David Thoreau: ''Success usually comes to those who are too busy to be looking for it.'' Once people or organizations start to like the concept of success itself more than the quest for it, one can be sure that the ride is going to be less successful in the future. And the great inventor, Thomas Edison, agreed when stating that '' I find my greatest pleasure, and so my reward, in the work that precedes what the world calls success.''

These statements are directly related to what one of the greatest thinkers of today - Prof Stephen Hawking - had to add: 

''The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.'' 

Prof Stephen Hawking

As long as we think we understand something, and continue to act upon these signals, there is a huge risk that things will go wrong. If you want an explanation, think about the following dice experiment. When we start at the beginning of year 1 with 100 people throwing dice, in such a way that 1-3 implies buying call options on the S&P 500 and 4-6 buying puts, we will have approximately 50 'specialists' that have beaten the S&P itself at the end of year 1 since options provide higher leverage than the underlying stocks. If we then repeat the experiment there are 25 'specialists' left after 2 years who have beaten the S&P twice. After 3 years there are still 12-13 'specialists' left, after 4 years 6-7, after 5 years 3-4, after 6 years 1-2 and probably we are left with one 'super guru' who has beaten the index 7 years in a row. I.e. a whole business cycle! You can imagine that this 'specialist' is treated like God by his environment. The guy is rich (7 years in a row beating the S&P with options!) and money talks, whereas bullshit walks.

The sad thing is that there are far more than 100 people investing in financial markets, also offering their services as a specialty to others be it as investment firm, bank or insurance firm. So, how many of these 'gurus' are really 'guru' and how many of them are just damn lucky? The jokey game where dart-throwing monkeys outperform financial analysts when it comes to stock pics - as reported in many newspapers once a year - is illustrative of the fact that the real number of guru's is much smaller than what their followers and the media make us believe.

Aviation pioneer Charles Lindbergh explained in a slightly different manner why it is not easy to be or stay a winner: ''I don't believe in taking foolish chances. But nothing can be accomplished without taking any chances at all.'' When you become a successful winner, you have more to loose, and the more you have to loose, the less inclined you will be to take any chances. But with reality constantly changing around you, you have to change. Once we understand that losers actually do have to change, it is not so surprising anymore that this category holds more winners of the future than the winner category itself.

And a man who himself was an example of genius, the late ITT CEO Harold Geneen (see picture below) said ''In business everyone's paid in 2 coins: cash and experience. 

 

Take the experience first, the cash will come later.'' ITT was a successful conglomerate with activities in a diversified set of industries ranging from telecom to insurance, hotels, real estate management etc. Geneen grew the firm from a USD 760 million revenues per annum level in 1961 to USD 17 billion 10 years later. He did more than 350 mergers and acquisitions, and was always interested in doing something 'different' if it had longer-term potential. True, he was a shrewd business man who was not always as ethical as one would now want a corporate leader to be (e.g. his Chilean interference in making sure Allende would not win the elections), but the bottom-line was that we are talking about a firm and its leader that were a successful conglomerate at a time when mainstream economic theory in universities taught us that a conglomerate model was an exciting good alternative to specialization. What one might loose by not being the best in everything, due to the fact that managing a large set of totally different activities is complicated, would be compensated for by a diversification effect. ITT under Geneen showed that it could work.

Other conglomerates were later not capable of repeating it, since they did not totally understand how Geneen and ITT did it. It even lead to changes in the university textbooks. Conglomerization was not a feasible business model anymore, since one did not add value by diversification that otherwise could not have been achieved by investors themselves through participation in a set of separate specialist firms. The lack of specialization would in that case simply be a burden on the business model.

The big Japanese 'keiretsu' and 'zaibatsu' were conglomerates that did for some time do a great job, but when they got too big and ended up in situations where the initial successful managers / founders were replaced by career managers, they did not manage to maintain their good track record. It remains to be seen if the same fate will await the now-so-successful Korean conglomerates that actually arose like a phoenix from the ashes after an era with big problems some 10-15 years ago.

Bottom-line: becoming a winner is one thing, and it is often not even that difficult. Sheer luck could be more often a reality than the winners themselves want us to believe.


Picking successful investments and/or investment advisers is therefore a risky exercise. And 'risk' is exactly what we need to turn to now, because part of the explanation of why contrarian thinking might be far more important than a lot of people seem to be aware of lies at the core of our definition of risk.

THE CONCEPT OF RISK

Economics Noble Prize winner Dr Harry Markowitz - who worked together with us on our asset allocation project during the last 10 years - played an important role in defining the concept of risk. Risk, defined as the volatility of a return variable, is normally far bigger than the expected value of that variable itself when we are talking about risky investments in real life. Just to give you an idea: an average monthly stock market return of 1 percent is not bad. Actual returns over the last 30-50 years - depending on period and market - were between 0.5 and 1.0 percent per month, which translates to 6-12 percent per year. Now, when we look at monthly volatility, defined as the standard deviation of return, we see that volatility levels of 3-4 percent per month in developed markets and 6-8 percent in emerging markets are no exception. Far more than the average return itself! It is therefore no surprise that 'failure' is far more of a reality for everyone in the investment game than the 'successful market leaders' may want us to believe. But there are of course exceptional leaders that did and do understand this. For instance, Viacom CEO/Founder Sumner Redstone stated: ''Success is not built on success. It is built on failure. It is built on frustration. Sometimes it is even built on catastrophe! '' And that is true more often than not, otherwise the successful group would stay successful and the losers would stay losers.

''Success is built on failure'' 
Viacom CEO Sumner Redstone

But the problem is that people cannot simply rely completely on mechanical risk definitions when taking decisions in groups. Risk is also about the concept of failure. What will happen if we take the wrong decision? The people that are going to be our judges will look at things on an ex-post basis, using or misusing the hindsight knowledge associated with looking in a rear view mirror. This means that 'risk' is also associated with 'fear'. Fear to take the wrong decision comes in at different levels. Decision takers will not just think about the expected return on their portfolios, i.e. for their clients, they will also incorporate their own personal implications. In-and-of-itself this does not have to be bad. As General Norman Schwarzkopf indicates: ''Fear will keep you alive in a war. Fear will keep you alive in business. There is nothing wrong with fear.'' Maybe, but there is something very wrong with the WRONG TYPE of fear.

Again an example; if I am decision taker in a big bank or pension plan and I - or my investment manager - have to buy stocks, knowing that my decisions will be carefully analyzed and scrutinized later by my often non-specialist supervisors/managers, I will take decision that incorporate the simple fact that it is easier to 'sell a wrong decision' that involved buying a winner than a wrong decision that involved going contrarian. If I buy a stock or give business to an asset manager that scored a large outperformance during the last 3-5 years, and that result track record turns sour afterward I could probably get away with statements like 'Look how successful they have been, how could I know that something like this could ever happen!'. On the other hand: suppose I go contrarian and I am not so lucky as to get the 'average' (i.e. good) result predicted by the research of Thaler and De Bondt, the reason being that I am picking ONE manager or investment instead of a diversified mix of a series of similar investments or managers. In that case I can be sure that the reaction of the supervisor will be something like 'Who was the idiot buying this crap in the first place! We should fire him'. 

Result: there is always a tendency to prefer winners over losers.


ADAPTIVE EXPECTATIONS

To some extent we can therefore say that there is an element of 'rational decision taking' in the adaptive expectations that are formed by investors and their supervisors about what will happen in the future. However, it is the wrong type of rationalism, namely one that is linked to non-investment factors. Actually, this type of reasoning is more related to the so-called AGENCY PROBLEM, that results when decision takers are managers that act on behalf of the ultimate beneficiary.

Another problem associated with picking the right investments and asset managers on an ex-ante basis is that humans do have a strong tendency to extrapolate what they already know. Things that are not (yet) or less well known tend to be either not incorporated in the extrapolation at all, or without the correct trend. Things that we 'seem to understand' and that had a clear trend in the past are extrapolated with that same trend and with a stronger belief that things will continue in the future. See for instance this quote by aviation pioneer Wilbur Wright: ''I confess that in 1901 I said to my brother Orville that man would not fly for fifty years.'' Their flight took place in December 1903 (!). We are convinced that part of the whole debacle of the climate change lobby is related to the fact that both its adepts and its scientists were good in extrapolating trends and had issues with the incorporation of exactly those elements that are not so easy to see (yet), i.e. the impact of new scientific research across the ages. More or less in similar fashion as the confession of Wilbur Wright above. Not incorporating what science can do in the next 50 years might look 'prudent', but we should understand that that is the same - when doing it the way the climate change adepts seem to be doing it - as stating that history will repeat itself and continue its trend without scientific developments breaking trends and/or improving our ability to fight bad developments. If there is one things that can be learned from the progress of man and his creation of wealth and growth (either economic or scientific) in the past, it is that there will always be a next generation of new scientists that started on the shoulders of the previous generation with new technology as a result. Technology that will make the future look totally different. A future in which the problems of today might be the irrelevance of tomorrow.

WHO DARES TO BE CONTRARIAN WHEN KNOWING ALL THIS?

So back to the theme of this contribution. The possibility to do well in financial decision taking using a relatively simple contrarian approach.

The English writer and philosopher, G.K. Chesterton (who was called The Prince of Paradox) wrote: 

 ''I owe my success to having listened to the very best advice, and then going away and doing the exact opposite.''  - GK Chesterton, The Prince of Paradox

Most people would define fear not in the Schwarzkopf way, but in a way where contrarian decison taking is out of the question. Just the real geniuses would dare to be out there alone: acting and buying where others are either selling or waiting at the sideline, or vice versa. And Microeconomic Theory of Markets is then making it totally understandable why winners underperform and losers outperform. In this kind of decision frame, the large majority buys winners so as to avoid problems with supervisors or peers, thereby pushing up price levels for these investments. With acquisition prices being relatively too high, lower expected future returns are actually quite normal. The other way round: if no one is really interested in the losers, their price will fall to such an extent that expected future returns will be relatively higher!

Make sure to incorporate at least a strong element of contrarian thinking in your decision process, especially when having to deal with more exotic markets like the ones that we at LMG Emerge are dealing with. Smart money investors in Emerging Markets do already know this. Result: those of us in the developed world that are enthusiastic now about the fantastic structural growth opportunities in Emerging Markets but enter them with a 'western' decision framework focused on 'winner picking' will be terrible losers. It is therefore no surprise that it is easier to find world class managers / advisers that specialize in Emerging Markets than it is to find top specialists in more efficient, advanced Western markets. Only problem: you will need to know how and where to find them and have the right mindset to dare invest with them.

And this is exactly why we specialized in these markets at LMG Emerge....

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