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Profit By Betting Against The Crowd

Asia Confidential's picture




 

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.

UK stock returns

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.

Junior Gold miners

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

commodity-coffee

3) Vietnam. The Vietnamese stock market is down 60% from 2007 highs, though it's recovered somewhat this year, up 17% in local currency terms. Think of China today as where Vietnam was in 2008-2009: a massive credit bubble that unwound in a messy way. But that is now largely behind Vietnam and some reforms are starting to bear fruit (though there's not enough of them). Meantime, the stock market is cheap, especially given the depressed earnings base and potential growth going forward.

4) The Indian rupee. The rupee reached all-time lows versus the U.S. dollar in recent weeks due to broader concerns over emerging market currencies as well as India's large current account deficit. The latter issue seems overblown, particularly after India recorded a large reduction in the deficit in the first quarter of this year. This news, released during the past week, has helped the currency recover somewhat but there should be more to come.

Yes, India has problems but they're well known. There are a number fundamental positives which are being currently ignored, such as extensive reform in the previously dysfunctional power sector, the emergence of pro-business leaders in several key states and caps on subsidies such as fertiliser (subsidies have been a key reason for inflationary pressures). This suggests that India is in a bit better shape than the currency markets given it credit for. The USD:Rupee is shown below.

Rupee

You'll have noticed that this list of potential buying opportunities has some notable exclusions, particularly Chinese and Japanese stocks. No doubt, both are unloved by investors but I'm not sure that we've seen a bottom in either stock market.

China may appear cheap at 8.4x 2013 earnings, but keep in mind that the dominance of banks in the Shanghai Composite warps the figures. These banks are on very lower earnings multiples as investors think they're fudging non-performing loan numbers. A more representative median price-to-earnings ratio puts the index on a much larger 17x on a 12-month forward basis. Not so cheap. And bear in the mind that we've probably not seen anywhere near the worst of the credit bubble unwinding in China.

Japan is another story. It is inexpensive, particularly on a cash flow basis. But as regular readers would know, I have serious concerns about the new government's massive quantitative easing program. I can't see a happy ending and owning any Japanese-denominated asset seems enormously risky under the circumstances. But the big question is whether a worst case scenario is in the price. At this point, I doubt it.

This post was originally published at Asia Confidential: http://asiaconf.com/2013/06/29/betting-against-the-crowd/

 

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Sun, 06/30/2013 - 12:21 | 3707754 criticalreason
criticalreason's picture

history is a poor guide to the future.

 

you cant just look at charts or averages...u need to explain why the price went down, and when and why it will b different in the future.

 

v. poor article.

 

Sun, 06/30/2013 - 11:18 | 3707619 Seize Mars
Seize Mars's picture

Ok, I am supposed to "profit by betting against the crowd."

Consider this: how exactly am I supposed to do it? You mean I need to open an account at a securities dealer, deposit Federal Reserve Notes, and direct them to trade my FRNs for securities. Well that would be great, except for the fact that the securities dealer rehypothecates my holdings and repos some tiny bp spread on my back. Then when that collapses (because the bundle of asset collateral that they're using declines in credit quality) they go out of business. Then they steal my securities. Let's put a finer point on this:

1) I lose the securities because they were pledged as collateral on repos by my friendly securities dealer

2) They (the brokers) just outright steal my securities.

In either case, I no longer believe that there exists "Law" which will protect my investments.

And there you have it.

The whole thing breaks down because agreements are not enforceable and criminal behavior is not held to task. Conclusion: I don't care how good some investments look, I will not be doing it any more. It's over. No more paper bullshit. I am only entering into contracts that I believe have a pretty good chance of being enforceable. That means I will be lending to, and investing with, people I know.

Sun, 06/30/2013 - 10:15 | 3707545 Híppos Purrós
Híppos Purrós's picture

HeadsUp, TylerD, et al...  I think you'll enjoy this one:

 

..."Mr Mandalia, a third generation jeweller widely known as Zaveribhai – or ‘Jeweller-brother’, fears India is being propelled back to the bad old days of goldsmuggling gangsters, whose exploits were a staple of Hindi movies.

“We are very much afraid,” he said. “Even if the government stops imports, the people must buy, and they will buy – from anywhere....

 

[FT] - India’s jewellers become frontline in gold battle

Indian newspapers are breathlessly reporting on gold smugglers’ techniques, and new seizures of bullion. It will certainly take more than Mr Chidambaram’s hectoring, or administrative controls, to change the mindset – and consumption patterns – of young women such as Bhumi Thakkar, 25, and her sister-in-law, Purvi Thakkar, 22.

At her marriage recently, Purvi received gold rings, bangles, earrings, necklaces and other gold ornaments cumulatively weighing about 500 grams. But as gold prices tumbled to a three-year low this week, she accompanied Bhumi – who wore three gold rings on one hand and a large gold pendant of the Hindu monkey god Hanuman on her neck – to buy a new gold ring.

“We have to buy gold and never stop,” says Bhumi. “The price goes up and up and up. The current fall is only temporary. It’s a good chance for buying.”...

Sun, 06/30/2013 - 07:15 | 3707357 casey13
casey13's picture

As far as the junior gold miners are concerned some will have a spectacullar recovery. Many will just dissapear. The problem is government and the constant rule changes that target the industry makes it very difficult to pick who the winners will be.

Sun, 06/30/2013 - 17:54 | 3708435 Roger Knights
Roger Knights's picture

Check out Comstock Mining (LODE). It's got "rich" deposits near the surface of its Comstock Lode mine in Nevada in some spots, which means it can mine them first to ride out the current weak price, and that it can self-finance its exploration in the near future. As a result, it's stock price is "rich" compared to other juniors (based on the numbers) and it hasn't been beaten down nearly as badly recently. Here's an article that explained that:

http://seekingalpha.com/article/1518092

Sun, 06/30/2013 - 00:36 | 3707124 toadold
toadold's picture

Well in my uninformed opinion I wouldn't pick out a whole country to invest in, I'd look for areas in that country. Northern Italy as opposed to Southern Italy for an example.  If the centralized control located in a countries capital goes under then recover will be in regional areas.  Does that regional area have hard working people, education,  transportation, and forward looking politicians? If you pick a "Red" State to invest in you still need to look at regions in the state.  Here in Texas you might want to avoid Austin, I live in the Dallas area but I'd look to the cities and towns outside of it.  Houston may still be a good bet but I haven't beend there in years.  

One interesting area is the "kickstarting" phenom on the internet.  There are several variations on that are interesting.  I took a micro flier by putting down some money on an 80% complete polymer AR-15 upper reciever and a throwawy after using polymer completion jig to go with it.  It wil be interesting to see if I get my product from them.  For 85 bucks I can afford to be a little speculative. 

Sun, 06/30/2013 - 00:26 | 3707114 jeditolstoy
jeditolstoy's picture

I buy my physical gold and silver whenever I can. But sometimes I throw in a little green (raw) coffee as an alt currency. Think about it, if SHTF, coffee would act as a great temporary currency, and you could drink it too.

Sat, 06/29/2013 - 20:52 | 3706798 involuntarilybirthed
involuntarilybirthed's picture

Look for countries to confiscate gold/PM mines when things worsen.  They will not allow gold to flow out of their countries while their people (aka regimes) suffer.  At a point in time listed miners in foreign countries are risky no matter the agreements/international law.

Sat, 06/29/2013 - 20:07 | 3706721 yabyum
yabyum's picture

I love to buy and own miners. Humility and butt rape keep me humble.

Mon, 07/01/2013 - 00:09 | 3709210 bilbert
bilbert's picture

+ 1000

THAT was the funniest comment I've read in a good, long, time!

OOoops.......... maybe not too many "buy and holders" of miners, here. 

Sat, 06/29/2013 - 19:35 | 3706652 Mentaliusanything
Mentaliusanything's picture

shoot and here is me worrying that my GM stock certificates were a little rough on my Anus.

Buy the dip dipshits

Sat, 06/29/2013 - 19:16 | 3706620 russwinter
russwinter's picture

The false narrative beyond gold price drop reasoning.

http://winteractionables.com/?p=3959

Sat, 06/29/2013 - 19:33 | 3706648 Lets Buy The Dip
Lets Buy The Dip's picture

The breadth chart in gold, has never been lower in the prices since 5 years. This means that right now, even if we drop a little more on gold, this is a buying opportunity that we have not seen for at least 5 years, and telling the price is months away from rocketing up again. Just a guess, but the CHARTS NEVER LIE!  The SPX chart here ==> http://bit.ly/14Ey1Xa  is also being manipulated down, for the next run up. 

Sat, 06/29/2013 - 18:47 | 3706568 lakecity55
lakecity55's picture

"Only the Celestials will have the funds to invest in the American Spring."

Sat, 06/29/2013 - 18:08 | 3706493 SAT 800
SAT 800's picture

Utter rubbish. The Indian Rupee and "Vietnam. Ridiculous. Judgement and study is required not just a low price. Russian Bonds were once a bargain too; that;s what got that congenital idiot Corzine fired from Goldman Sachs in the first place. They went to zero in case you don;t know.

Sun, 06/30/2013 - 19:24 | 3708674 infiniti
infiniti's picture

USD denominated Russian debt did not go to zero. It fell 80% in three months (in 1998), and if you purchased it at the low, you're up 25% annualized since then.

Sat, 06/29/2013 - 17:57 | 3706466 Dr Benway
Dr Benway's picture

One line summary:

"Buying assets that have fallen a lot is great, except in cases where it isn't."

Stupid. Fucking. Article.

Also, every fucking stock shill pays lip service to the concept that "past prices cannot predict future prices", to the point where the shills even state this upfront on their sales pitches, right before they use past prices to predict future prices.

Sat, 06/29/2013 - 17:06 | 3706390 Stuck on Zero
Stuck on Zero's picture

Investment opportunities:

Buggy whips - Down 80%

Vacuum tube TVs - Down 95%

Amiga Computers - Down 90%

Windows Vista - Down 99%

 

Sat, 06/29/2013 - 18:08 | 3706495 SAT 800
SAT 800's picture

Exactly.

Sun, 06/30/2013 - 09:56 | 3707523 WakeUpPeeeeeople
WakeUpPeeeeeople's picture

If oil ever gets high enough there could be a run on those buggy whips

Sun, 06/30/2013 - 13:35 | 3707888 RaceToTheBottom
RaceToTheBottom's picture

Technology transfer might yet resurrect the Buggy Whips.  Think of them as People incentive devices for the 1%'er to use against the rest of us...

 

Sat, 06/29/2013 - 15:06 | 3706249 ebear
ebear's picture

1) Junior gold miners [.........] many of whom are now priced for oblivion.

And rightly so, since many of them will disappear before the cycle turns.

Sat, 06/29/2013 - 18:05 | 3706488 Stanley Lord
Stanley Lord's picture

Exatly right ebear, there is massive consolidation ahead for the miners of all sizes.

Sat, 06/29/2013 - 20:43 | 3706776 philipat
philipat's picture

If in these days of Central Planning, it can still be assumed that value is function of earnings, I see no way that the Junior Miners can be profitable and have value. The marginal cost of producing Gold is higher than the paper futures price so unless Gold recovers the junior miners are toast. Yes, I know that the miners usually lead the Gold price, but I suggest not when the present price dynamic exists.

Sat, 06/29/2013 - 13:28 | 3706130 disabledvet
disabledvet's picture

right now the biggest undervalued asset is still the USA. I still might have to leave as a consequence of this "glorious victory" but that's not a sell order either.

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