Prudence: pitiful performance persists in 2010

Markets move in mysterious cycles that no one can predict with accuracy.  For several years value beats growth, or large companies beat small, and then the trend reverses.  Markets are one of the most mean reverting data series known to man, so you always know such trends will reverse, but never precisely when.

2010 was a particularly frustrating year to wait for trends to reverse, especially for those who were prudent. 

2009 was an understandably great year for junky versus prudent investments.  Junk had tanked in 2008 and prudence had dropped little, setting up a spectacular rise for junk in 2009 versus a mundane rise for prudence.  Once the government vowed to support any company large and imprudent enough to be in severe trouble, junk’s star was destined to be born.  It was in 2009. 

However, junk’s stardom seldom lasts because investors become understandably nervous as junk’s star gets too high.  I naively expected investors to become nervous in 2010, but was in hindsight much too early.  A quick look at the data (from Bespoke) highlights my naivete.

Companies considered junk by the rating agencies rose 19% in 2010.  Double-A and above rated companies returned a mere 6%.  2010 rewarded this form of imprudence with 3.2x the return.

The most expensive tenth of stocks, as measured by price to earnings ratios, returned 23% in 2010, versus 8% for the cheapest tenth of stocks.  Once again, 2.9x the return for jumping into junk instead of piling into prudence.

Buying the top tenth of stocks most sold short (where short sellers expect to profit from price declines) returned 26% versus the 17% performance earned from the bottom tenth with the least short sellers.  It was a mere 53% better to bet on this particular form of imprudence.

Investing in cyclical companies, those most impacted by economic cycles and thus hardest to predict, returned 25% against 11% for the non-cyclicals that perform regardless of cycles–2.3x better to hope instead of plan.

Finally, small companies (small ships are more easily toppled by storms than large ones) beat large 24% to 11% in 2010, giving those who bet the trend was their friend a 2.2x edge over those who expected trend reversal.

My naivete was on prominent display in 2010, but I’m not bitter.  I find solace in the certainty that markets mean revert.  Plus, I’ve been given the opportunity to buy prudence at even lower prices. 

Will 2011 be my year of redemption.  I don’t know for certain, but in the choice between junk and prudence, I can’t say I’m even remotely tempted to follow the junky crowd of 2010.

Thank you for reading my blog, and may you have the Merriest of Christmases.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Prudence: pitiful performance persists in 2010

The dash to trash

When the stock market climbs or falls, it’s always interesting to see which segments are doing best or worst.

Not surprisingly, the stocks that have done best since the March bottom are some of the junkiest companies out there. This makes some sense because such companies were priced for bankruptcy last spring.

As early investors realized junky companies weren’t going under, they jumped at the chance to bag 200%, 300% and higher returns.

The problem with staying with such an approach, now that the trash rally has had its day, is that it’s hard to see how it can continue. Junky stocks have junky business models with weak competitive advantages, low margins, too much debt, etc. From here, there isn’t a lot of upside, and the downside is becoming more perilous.

In contrast, the best-run companies have hardly participated in the rally since March. Granted, they didn’t go down as far, but it’s nonetheless surprising that investors haven’t turned back to them now that the dash to trash has become stretched.

This is most likely due to the pervasive influence of momentum. Momentum investing is the process of buying what’s moving. If it’s climbing, buy it. If it’s sinking, sell it or sell it short. This process can continue for quite some time…until it doesn’t.

Predicting when is impossible, but predicting that it will end is a given. Or, as Herb Stein put it, “If something cannot go on forever, it will stop.”

At some point in time, investors will realize that junky companies have problems and aren’t delivering. That’s when investors will fall over each other trying to buy franchise, high-quality businesses that make money regardless of how well or poorly the economy is doing.

It’s no fun to be under-performing as the market makes a continued mad dash to trash. But, I’m not foolish enough to chase the heard, and I know it doesn’t work over the long run anyway. Or, as our mothers rhetorically asked us, “if your friends jumped off a bridge, would you follow?”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.