Thursday, March 11, 2010

Contrarian Views

As several of my recent blog notes have indicated, my current investment thinking is in the minority of my investment brethren.

The consensus view is that interest rates are heading higher; the economy is about to dip lower; and the stock market is due for a massive correction.

While I understand the logic of these views, I do not agree with any of them. I think the bigger risk to bond investors is for lower interest rates, for example.

Stocks could certainly have a correction, but for any investor with, say, a 5 year time horizon, it is hard to make a strong case for piling into bonds yielding less than 2% - yet it seems that most people are doing just that (which is why the yield curve is so steep).

It seems to me that in order to make money in anything, you have to willing to entertain a different opinion than the consensus. After all, for every person who sells a stock, there is another one that thinks that current prices are attractive.

It is also true, it seems to me, that most people in the investment business like to think of themselves as contrarians, yet in fact usually hold views that lie in the mainstream of current investment thinking.

For example, in March 2000, you would have been hard-pressed to find anyone who would be a seller of stocks (especially technology stocks) and yet that in retrospect was clearly the correct decision.

More recently, in March 2009, virtually no one was a buyer of stocks, yet the S&P 500 has soared by more than +50% in the last 12 months.

And so today, in March 2010, it seems reasonable to at least challenge the conventional wisdom to see what opportunities might be available.

This is what leads me to be more bullish on stocks than most. I don't know how sustainable a rally might be, or how long, but with so much bearish sentiment around one really has to question how much "bad news" is already in stock prices.

Consider two data points. Early this week (on March 9) I posted an article from the New York Times discussing the incredible news that pension funds - supposedly funds that should have a long term time horizon - were reducing their stock exposure in favor of short maturity bonds or alternative investments.

Why? Because stocks have done poorly for the last decade, especially in 2008 and early 2009. Thus, with their eyes fixed firmly in the past, pension managers are trying desperately to make up their pension shortfalls by investing in low yielding bonds or illiquid hedge funds.

Put another way, they are avoiding the one asset class that might give them the chance to actually make up the pension deficits.

Then there is the so-called professional investors. Barron's a couple of weekends ago carried a table showing the investment advice from 14 of the largest investment companies in the US. Their advice? Underweight US stocks significantly in favor of international stocks, especially the emerging markets (and, of course, don't forget a generous dollop of bonds yielding 1%).

Never mind valuations, or improving fundamentals. No, this group believes that you should position for higher interest rates and a weak economy.

Is it possible that my contrarian views are wrong?

Of course. Leaning against the tide can often lead to poor results. That said, it is also true that I've never known of a truly successful investor that didn't "bet against the crowd".

Which of course leads to the most successful investor of them all, Warren Buffett.

In a call earlier this morning I was reminded of two articles that Buffett wrote for Fortune magazine more than a decade ago. The first was in 1999, at the peak of the stock market bubble, when he cautioned that stocks could not possibly continue on the rapid rise they had been, and that investors ought to be reducing stock allocations.

The second was in 2001, after stocks had in fact experienced the nasty correction Buffett had forseen. Then he argued that investors had turned too cautious, and that stocks were due for a move higher.

I wanted to post just an excerpt from the second article written in 2001, because it reminded me of what pension managers are doing today. I have posted the complete link below (although both articles are worth a re-read):

Don't think for a moment that small investors are the only ones guilty of too much attention to the rear-view mirror. Let's look at the behavior of professionally managed pension funds in recent decades. In 1971--this was Nifty Fifty time--pension managers, feeling great about the market, put more than 90% of their net cash flow into stocks, a record commitment at the time. And then, in a couple of years, the roof fell in and stocks got way cheaper. So what did the pension fund managers do? They quit buying because stocks got cheaper!

Private Pension Funds % of cash flow put into equities

• 1971: 91% (record high)

• 1974: 13%

This is the one thing I can never understand. To refer to a personal taste of mine, I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the "Hallelujah Chorus" in the Buffett household. When hamburgers go up, we weep. For most people, it's the same way with everything in life they will be buying--except stocks. When stocks go down and you can get more for your money, people don't like them anymore.

That sort of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizon of any investors. These managers are not going to need the money in their funds tomorrow, not next year, nor even next decade. So they have total freedom to sit back and relax. Since they are not operating with their own funds, moreover, raw greed should not distort their decisions. They should simply think about what makes the most sense. Yet they behave just like rank amateurs (getting paid, though, as if they had special expertise).

In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war approach has proved costly in the past and will likely prove equally costly this time around." That's true, I said, because "stocks now sell at levels that should produce long-term returns far superior to bonds."

Consider the circumstances in 1972, when pension fund managers were still loading up on stocks: The Dow ended the year at 1020, had an average book value of 625, and earned 11% on book. Six years later, the Dow was 20% cheaper, its book value had gained nearly 40%, and it had earned 13% on book. Or as I wrote then, "Stocks were demonstrably cheaper in 1978 when pension fund managers wouldn't buy them than they were in 1972, when they bought them at record rates."

At the time of the article, long-term corporate bonds were yielding about 9.5%. So I asked this seemingly obvious question: "Can better results be obtained, over 20 years, from a group of 9.5% bonds of leading American companies maturing in 1999 than from a group of Dow-type equities purchased, in aggregate, around book value and likely to earn, in aggregate, about 13% on that book value?" The question answered itself.

Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.

But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale.

By my thinking, it was not hard to say that, over a 20-year period, a 9.5% bond wasn't going to do as well as this disguised bond called the Dow that you could buy below par--that's book value--and that was earning 13% on par.