When Bad Strategies Outperform

Once upon a time there were two investors, Jack and Jill.

Jack is a professional money manager with a disciplined investment strategy. Jill is an orthopedist who manages her portfolio on the side. Jack knows how to analyze balance sheets. Jill knows how to analyze x-rays.

Before buying a stock, Jack spends weeks on thorough fundamental research. He reads SEC filings, analyzes financial statements, runs comps, listens to conference calls, and studies analyst reports. He prides himself on independent thinking.

Jill loves hot stock tips. She buys popular companies and top performers. With a busy medical practice and minimal financial vocabulary, Jill does zero research before investing.

Earlier this year, Jack invested in leading companies that were out of favor. He bought stocks such as Home Depot (HD) and Progressive (PGR), paying on average 12 times earnings--a huge discount to the market. Jack also invested in a number of special situations, such as Western Union (WU) and Broadridge (BR), both spinoffs which he felt were misunderstood by the street. Jack avoided energy and commodity investments due to fears of a bubble. He also avoided banks and mortgage lenders due to their complexity and leverage.

Jill bought Google (GOOG) and Apple (AAPL) at 50 times earnings. "They're unstoppable," she argued. In January, Jill saw that oil, China, and India were all hot the prior year so she piled into those sectors. She also bought commodity producers at all time highs, figuring that "insatiable Chinese demand" made valuation irrelevant.

As a measure of conservatism, Jack avoids options and margin. Jill did pretty well in the market last year so her confidence was high. She increased her buying power by using margin debt and also dabbled with out of the money calls "when I got a really hot tip."

Jack's portfolio is down 7% for the year. His investors want his head. He's not sure his fund can handle all the redemptions. He feels terrible about his losses, but keeps reviewing his portfolio to see quality businesses priced cheaply. Selling now makes no sense to Jack. He wants to add on the way down, but every time he turns around, the stocks he's watching are 10% cheaper, and his investors are clamoring 10% louder.

Jill's portfolio is up 60% for the year. Sometimes she daydreams about trading full time, or selling her practice and launching a hedge fund. "It's easy, it's fun, and I'm good at it," she explains. "The proof is in the pudding--just look at my results."

Jack identifies with Mike Goodson's sentiment, "Work Hard, Buy Good Stocks, Lose Money Anyway." Jill thinks Jack is a sore loser and doubts whether he even knows what he's doing. Jack thinks Jill is cute and wonders if a bright and attractive woman 20 years his junior would ever be interested in a married, short, fat, bald guy like himself.

What's this tale about? The stock market in 2007. Value went down. Hype went up. Momentum outperformed valuation. Recklessness outperformed thoughtfulness.

What's the ending for our tale? Jack fell down and broke his crown. Will Jill come tumbling after? You bet. And with a little patience, we'll see Jack's recoronation as well.

Comments

[Tommo_UK]

Sorry mate, but Jill sounds like a sensible girl who identified safe, large cap earnings growth machines and wisely invested her money in them, knowing the Street was undervaluing their growth potential.
Jack sounds like the kind of fool who thinks buying MSFT and DELL is a safe bet because they used to be earnings growth monsters 10 years ago, and anyway, to paraphrase that old saying, "nobody got sacked for buying Microsoft and DELL.".

The worst strategy is to hold onto your losers and not identify new winners.

Go Jill!

[Jon T]

What nonsense!

There is nothing speculative about Apple and Google exceeding earnings expections quarter after quarter and with every liklihood of continuing that progression.

You used bad examples. Jack just did the wrong research on the wrong companies. Jill may have been lucky by not doing any research, but others certainly have...

[Werlingdervish]

In trading growth stocks like Apple one has to look forward based on fundamentals and developing news in the industry. One most also enjoy trading in a sector and learn to know that sector very well. More important than analysis to growth stocks are good online rumor sites and speciality news sources. For Apple one can do this via AppleInvestornews.com. Jim Cramer suggests at least an hour homework a week for each stock-- I devote at least 2 hours each for my 8 picks as well as skimming a watch list. I've also been known to follow intraday stock prices and excecute trades via an iPhone. So even quick execution is within a part time investor's toolkit.

Professional money managers by contrast can not devote the time to individuals and their unique portfolios nor do they necessarily do the quick execution required. They no longer even have the clear advantage in technical analysis since the part time private investor can get analytical tools ready-made from eTrade or any online brokeridge. The one I like to use on eTrade is appropiately called Second Opinion--as that is it's only real worth in growth stocks.

As a part timer this is my daily pattern. At seven I Tivo CNBC's Sqawk Box for about 40 minutes of skimming breaking market news each morning. I then get online to setup any early morning trades CST--sometimes I use before/after hours trading. I check my portfolio at lunch time to get any midday bargains. At night I look at good rumor sites and speciality news for the following day.

In short the Jills of this modern world can be real winners right in face of the professionals if they are serious part-timers. Getting 60+% gains in the current market can be and is done by part-timers like myself. It is NOT luck.

[Daveed]

Jill may be driving blind and may be headed for disaster (or not).

However, Jack isn't in a better boat if he equates "fundamental research" with "reads SEC filings, analyzes financial statements, runs comps, listens to conference calls, and studies analyst reports." Those things are useful to avoid be cued about financial mismanagement, but it doesn't necessarily help Jack understand the business he's buying into.

E.g., Apple and Google are technology companies, but a surprising number of "analysts" don't appear to really understand the nuts and bolts of these companies core business. If I look at their balance sheets, filings, etc., sure I conclude they're "expensive" and sure there is always the risk of a really bad lawsuit that'll crash their business. But that's not unlike saying that a Ferrari is expensive and dangerous: In the end it's still a faster and more desirable car than a minibus. Of course that doesn't mean the Ferrari is the car to get, but it may be.

[Daveed]

Jill may be driving blind and may be headed for disaster (or not).

However, Jack isn't in a better boat if he equates "fundamental research" with "reads SEC filings, analyzes financial statements, runs comps, listens to conference calls, and studies analyst reports." Those things are useful to avoid be cued about financial mismanagement, but it doesn't necessarily help Jack understand the business he's buying into.

E.g., Apple and Google are technology companies, but a surprising number of "analysts" don't appear to really understand the nuts and bolts of these companies core business. If I look at their balance sheets, filings, etc., sure I conclude they're "expensive" and sure there is always the risk of a really bad lawsuit that'll crash their business. But that's not unlike saying that a Ferrari is expensive and dangerous: In the end it's still a faster and more desirable car than a minibus. Of course that doesn't mean the Ferrari is the car to get, but it may be.

[parker]

Momentum trading and investing in high growth stocks, while riskier than Jack's strategy, does not make it a bad strategy. It's just different by nature and not as safe. If all you are looking for is low volatility (and likely low returns), Jack's strategy will do and you can be happy with low risk/low reward. If you have a longer investment horizon and a higher risk tolerance, I'd go with Jill's strategy every time. If Jill can learn to master the art of taking profits, I think Jill will outperform every time, not just in markets like the one we've had in 2007.

But to say that momentum investors are thoughtless, reckless, and do zero research is just plain false. The value vs. growth debate lives on. Ultimately, what investors are willing to pay is all that matters. The fact that a stock, say Apple, has a higher P/E relative to your safe value stock only means that investors have more confidence in a company like Apple to continue selling Mac's, iPod's, and iPhones at an amazing clip and will continue to rake in profits over the near term, especially when compared to a company like HD. You're right though, I'm sure HD and others like it will one day be back on top as the cycle reverses over the next 5-10 years, but why would you want to suffer the almost guranteed losses over the near-term? You'd be better off in cash. If Jack is as educated as you make him out to be, I'm sure his research takes into account the fact that his value stocks are probably out of favor and cheap on a historical basis for good reason, and that there is likely no near-term event/catalyst that will send them flying higher, at least for the time being. So, Jack - be patient with your strategy, because history has shown that your strategy will work over time as well. In the meantime, why don't you try to adapt to current market conditions instead of wasting your time ridiculing strategies that happen to be outperforming yours in today's market. You won't see me crying when value starts to outperform growth because hopefully I'll be smart enough to adapt to what is working at the time and still make money (or at least lose less). In the end Jack and Jill should both make money as long as they both stay in equities...as I'm sure you are aware, asset allocation is really all that matters.

[mkreisel]

The so called "value investors" more often than not are stuck in value traps, driving their portfolios through rear-view mirrors instead of windshields.

For small investors, who enjoy excellent liquidity, momentum (both earning and price) investing is really the best way to go, as long as they know how to control the downside and take profits.