Lessons Learned From A Dangerous Year

In the beginning of the year, a column I wrote for Real Money discussed some lessons of the past year. It never was moved over to the free site, so here is my belated update.

It is a mix of fundamental, economic, technical and even
philosophical lessons that those savvy CEOs, fund managers and
individual investors who were paying attention picked up in the recent turmoil.

1) Ignore market rumors:  It seemed every time some firm was in trouble, the same gossip was floated that Warren Buffett was about to buy them. Time and again, these tales proved to be unfounded money-losers. This year’s most egregious example was Berkshire’s imminent purchase of Bear Stearns (BSC).

That The New York Times Dealbook got suckered into printing this just shows you how pernicious these rumors are. The stock was as high as $123 the day of the rumor.

Anyone who bought homebuilders or Bear Stearns stock on the basis of either of these rumors — or nearly any other stock that had similar rumors floated throughout the year — lost boatloads of money.

2) Buy sector strength (and avoid sector weakness): It’s a truism of real estate: It’s better to own a lousy house in a great neighborhood than a great house in a lousy one. And the same is true for stock sectors: Buying mediocre companies in great sectors generated positive results, while great companies in poor sectors struggled.

The losers are obvious: The homebuilders, financials, monoline insurers and retailers all struggled this year. The winners? Anything related to agriculture, solar energy, oil servicing, industrials, software, exporters, infrastructure plays — even asset-gatherers thrived.

3) Never blindly follow the "big money": Why? Because professionals make dumb mistakes too.  Many people chased the so-called smart money into these trades. Unfortunately, all of these trades have proven to be jumbo losers.

4) Day-to-day stock action is mostly noise: This is blasphemy to some people, but it’s true: Markets eventually get pricing right. But the key to understanding this is the word "eventually." Over the shorter term, markets frequently under- or overprice a stock before settling into the right approximation of value. This process typically occurs over broad lengths of time.

5) P/E matters less than you think: If that sounds like more blasphemy, look at Google (GOOG) , Apple (AAPL) and Mosaic (MOS) — they all sported high P/Es at the beginning of 2007 before going much higher.  On the other hand, back in January ’07, retailers, financials and homebuilders all had reasonably cheap P/Es. (How’d they do over the next 12 months?)

6) Ignore deteriorating fundamentals at your peril: One would think this doesn’t need to be said, and yet it does: When the fundamentals of a given market, sector or consumer group are decaying, profit gains are sure to slow.

7) Nothing is more costly than chasing yield: For fixed-income investors, what matters most is not the return on your money, it’s the return of your money. Reaching down the risk curve for a few bips of additional yield is one of the dumbest things an investor can ever do.

8) Know what you own: This very basic issue was mostly forgotten in recent years, and it was forgotten by pros and individuals. 

Investment banks like Bear Stearns, Morgan Stanley (MS) and Merrill Lynch (MER) , big banks like Citigroup (C) and Washington Mutual (WM) , and GSEs like Fannie Mae (FNM) and Freddie Mac (FRE) were scooping up assets apparently without doing their homework. The complexity of these pools of mortgages almost guarantees that no one truly knows what’s in them (see the next rule). If you don’t know what you own, how can you properly manage risk?

9) Simple is better than complex: Start with a few million mortgages of varying credit-worthiness and create a series of residential mortgage-backed securities (RMBS) from them. Then take the RMBS and stratify them. Then leverage them up into collateral debt obligations (CDOs). Once that bundling is complete, make complex bets on which layers might default, via credit default swaps (CDS).

Gee, how could anything possibly go wrong with that?!

10) Stick to your core competency:

E*Trade (ETFC) is an online broker; what was it doing writing subprime mortgages?

Why was Bear Stearns running two hedge funds?

Isn’t H&R Block a tax preparer? It was making mortgage loans — why?

And exactly what was GM’s expertise in underwriting mortgages? (The snarkier among you might be wondering exactly what business GM’s expertise is in.)

Had these companies stuck to what they did best (or least bad), they wouldn’t be in as much trouble today.

11) Fess up! Whenever a company runs into trouble, they seem to take a page from the same PR playbook: First, they say nothing. Second, they deny. Finally, they make a begrudging, pitifully small admission. Eventually, the full truth falls out, and the stock tanks with it.

12) Never forget risk management: Consider what could possibly go wrong, and have a plan in place in the event that unlikely possibility comes to pass. If there is to be upside, then there must also be a corresponding and proportional downside.

13) The trend is your friend: Despite the year’s parade of horribles, this market cliché was proven true once again. The Dow, S&P 500 and Nasdaq are all higher this year, as their long-term trends have been tested but remain intact.

The exception, the Russell 2000, broke its trend earlier this year. That made trend traders abandon the small-cap index, which has since fallen even further. This confirms the corollary: "except for the bend at the end." As long as the index trend lines stay intact, investors can sleep easy. But once those trendlines break, well, then you better apply some of the earlier lessons (see numbers 2, 3, 4, 6, 7 and 12!).

Looks even truer 8 months later!


>

Source:
Lessons From 2007: A Baker’s Dozen
Barry Ritholtz
RealMoney.com, 1/2/2008 6:54 AM EST
http://www.thestreet.com/p/rmoney/investing/10396497.html

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What's been said:

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  1. kcowan commented on Aug 10

    Great list of advice. I think some of these can even be turned into lessons for personal investors. I have avoided the financial sector for 2 years owing to my concern about declining fundamentals. Even I had no idea how bad it was going to get. I am still surrounded by cheerleaders who are buying on weakness. To which I reply: “You ain’t seen nothin’ yet!”

  2. leftback commented on Aug 10

    I would add:

    1. “watch what the insiders are doing with their stock”. The Tan Man was not exactly loading up on CFC stock in the summer of 2007.

    Incidentally Mish has a story about a margin call on an insider at a commercial RE firm – this sector may not look very clever if Tuesday’s retail sales are as bad as I am expecting.

    The shocking increase in consumer credit was discussed here by Steve Barry yesterday. My guess is that an enormous amount of this was due to people filling up gas tanks on their credit cards and that this was the only thing holding up retail sales. As gas prices fall we may not see the effect on retail that Friday’s buyers were expecting (RTH up 5% Friday, WTF?)

  3. mark mchugh commented on Aug 10

    ….And that’s why you are the man.

    I don’t think I’ve ever seen a better boiled-down list of investing truth and wisdom. If you fluffed it up to 300 pages, you’d have one hell of a $26.95 book on your hands.

    It reminds me of a line from “Mr. Mom”, “It’s easy to forget what’s important, so don’t.”

  4. OkieLawyer commented on Aug 10

    Barry:

    Considering the importance of investing in the right sector, what are the best sources for discovering what sectors are the strongest, or even better, what sectors are on a rebound?

  5. VJ commented on Aug 10

    SMACK.

    Brokaw repeatedly splashes Paulson in the face with reality on this morning’s Meet the Press:

    * Tells him the stimulus checks that his Treasury sent out “had about as much effect as a BB gun on a bear“.

    * Displayed his ‘CONTAINED’ quote up on the screen, “I don’t see [subprime mortgage market troubles] imposing a serious problem. I think it’s going to be largely contained.

    * Showed the video of Chimpy saying that “Wall Street got drunk“.

    Paulson said that in 5 months, he exits, stage Right.

  6. Marcello commented on Aug 10

    > Markets eventually get pricing right. But
    >the key to understanding this is the word
    >”eventually.” Over the shorter term, markets
    >frequently under- or overprice a stock
    >before settling into the right approximation
    >of value. This process typically occurs over
    >broad lengths of time.

    good post, but the above line bugs me. How are you so sure ? What is the _definition_ of ‘getting the pricing right’ ? What constitutes a “broad length of time” ? “eventually” we are all dead – will the “pricing be right” before or after that ? and since new shocks and crises happen all the time, is the clock continuously reset so that “eventually” falls ever further into the future ?

    That line sounds more like clinging to the last thread of a theology that has otherwise come apart at the seams. Given how gamed the major markets are from the inside and big players, and the almost complete absence of the textbook conditions required for an efficient market (perfect info, quasi-infinite independent players, etc etc), I’d really like to hear some solid evidence to the contention that “markets eventually get the pricing right”.

  7. Vic commented on Aug 10

    Except for 2. Sector strength is ephemeral in a global credit bust. High flyers eventually get taken out with everyone else. Just watch as energy, ags and metals all are getting shot now.

  8. Lee commented on Aug 10

    Thank you Barry for sharing your insight and experience with us. I hope that you are making good money as you help the rest of us save ours from a bubble-driven market and the lapsed ethics of people in positions of privilege who often claimed to protect the interests of small investors/savers. Whatever your deepest motivations for blogging may be, I for one very much appreciate your postive public service. It’s also nice to see that as your star has risen you have not dulled your sharp-edged wit, which usually happens when people become famous and start to avoid controversy.

  9. PHB commented on Aug 10

    What? Nothing from THE man, Ken Fisher? He says you only need to know three things. I think he even wrote a self-promoting book with his puffery describing such. Would love to hear your take Barry on his supposed brilliance before I receive another one of his packets of information “that every investor should know.”

  10. Marcello commented on Aug 10

    Mr Ritholtz,

    exactly. Shiller and Krugman are bang on IMHO.

    (aside : I argued with Krugman in part about this during the Q&A after one of his talks at MIT back in 98 or so. His minions nearby later acted towards me like I was from Mars).

    Given all the deadly reasons why the EMH cannot possibly reflect the real world, I do not see how one can still say that “eventually” markets get “pricing right”.

    How can a badly flawed model get the answer right ?

    (BTW, a question to ask the Fed, AMBAC, Fitch, etc etc as well …)

  11. jms185 commented on Aug 10

    Regarding comment
    * Tells him the stimulus checks that his Treasury sent out “had about as much effect as a BB gun on a bear”.

    What if the intention of the Stimulus checks was for consumers to pay down debt? Returning $100 or so billion to issuers at the future expense of tax payers is a stealth bailout?

  12. Max Rockbin commented on Aug 11

    Most of these lessons could be summed up by saying “stay away from the subprime business, subprime mortgages, subprime investments, subprime stocks.” Barn door open. Animals gone.
    Lesson: Close barn door.

    Got it.

    ~~~

    BR: No, I don’t think you get it.

    These were written in Q4 2007. They were as general lessons to be learned as possible form the prior year.

    If you want to focus on just the Mortgage aspects and ignore the larger investing issues, well, hey, feel free to miss the larger points involved. (Its your money to lose — feel free to remain as narrow minded and ignorant about managing it as you want).

    Someone has to be on the losing side of the trade…why not you?

  13. Barry commented on Aug 11

    Markets eventually approximate fair value because over time, the truth about companies, economies, etc. eventually is found out.

    Its an imperfect process, but with companies especially, eventually reality wins . . .

  14. ben commented on Aug 11

    Good post, I heard a recent WB rumor that he was going to buy the rest of AXP, any takers?

    On the know what you own, Barry, you should send this post to mutual fund managers who are buying (and have been buying for a year) financials, given the accounting rules, they do not know what they own and have cost investors a ton of money, see John Hancock Classic Value for an example.

  15. DaveinHackensack commented on Aug 11

    Ben,

    A lot of value investors got their heads handed to them on financials over the last year. A couple of exceptions that come to mind are Bruce Berkowitz and Ken Heebner (who has been long Brazilian banks but short some U.S. financials).

  16. ben commented on Aug 11

    DaveinHackensack,

    Very familiar with Heebner, he’s solid, Barron’s talks about him this week as well. Berkowitz I don’t know much about. I’d also add plenty of other good managers made a ton of money, by shorting financials.

  17. MiningOilGasGuru commented on Aug 11

    These are very good guidelines to follow as an investor. Sadly for most investors, it is hard to avoid breaking these rules as we all are human and act on emotion.

Read this next.

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