7 RULES ON IDENTIFYING INVESTMENT OPPORTUNITIES
BY CULLEN ROCHE
· http://pragcap.com/
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No group or sector in the investment world enjoys
as its birthright the promise of consistent high returns. There is no asset
class that will do well simply because of what it is. An example of this
is real estate. People said, “You should buy real estate because it’s a
hedge against inflation,” and “You should buy real estate because they’re not making
any more.” But done at the wrong time, real estate investing didn’t work.
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What matters most is not what you invest in, but
when and at what price.There is no such thing as a good or bad investment
idea per se. For example, the selection of good companies is certainly
not enough to assure good results — see Xerox, Avon, Merck and the rest of the
“nifty fifty” in 1974.
Any investment can be good or bad depending on when it’s made and what
price is paid. It’s been said that “any bond can be triple-A at a price.
“There is no security that is so good that it can’t be overpriced, or so bad
that it can’t be underpriced.
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The discipline which is most important in investing
is not accounting or economics, but psychology. The key is who likes
the investment now and who doesn’t. Future prices changes will be
determined by whether it comes to be liked by more people or fewer people in
the future.Investing is a popularity contest, and the most dangerous
thing is to buy something at the peak of its popularity. At that point,
all favorable facts and opinions are already factored into its price, and no
new buyers are left to emerge.
The safest and most potentially profitable thing is to buy something
when no one likes it. Given time its popularity, and thus its price, can
only go one way: up.Watch which asset classes they’re holding conferences for
and how many people are attending. Sold-out conferences are a danger
sign. You want to participate in auctions where there are only one or two
buyers, not hundreds or thousands.You want to buy things either before they’ve
been discovered or after there’s been a shake-out.
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The bottom line is that it is best to act as a
contrarian. An investment that “everyone” knows to be undervalued is an
oxymoron. If everyone knows it’s undervalued, why haven’t they bought it
and driven up its price? And if they have bought, how can the price still
be low?
Yogi Berra said, “nobody goes to that restaurant; it’s too
popular.” The equally oxy-moronic investment version is “Everybody likes
that security because it’s so cheap.”
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Book the bet that no one else will. If everyone likes the
favorite in a football game and wants to bet on it, the point spread will grow
so wide that the team — as good as it is — is unlikely to be able to cover the
spread. Take the other side of the bet — on the underdog. Likewise, if
everyone is too scared of junk bonds to buy them, it will become possible for
you to buy them at a yield spread which not only overcompensates for the actual
credit risk, but sets the stage for their being the best performing fixed
income sector in the world. That was the case in late 1990. The bottom
line is that one must try to be on the other side of the question from everyone
else. If everyone likes it, sell; if no one likes it, buy.
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As Warren Buffet said, “the less care with which
others conduct their affairs, the more care with which you should conduct
yours.” When others are afraid, you needn’t be; when others are unafraid,
you’d better be. It is usually said that the market runs on fear and
greed. I feel at any given point in time it runs on fear UorU greed.As
1991 began, everyone was petrified of high yield bonds. Only the very
best bonds could be issued, and thus buyers at that time didn’t have to
do any credit analysis — the market did it for them. Its collective fear
caused high standards to be imposed. But when investors are unafraid,
they’ll buy anything. Thus the intelligent investor’s workload is much
increased.
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Gresham’s Law says “bad money drives out
good.” When paper money appeared, gold disappeared. It works in
investing too: bad investors drive out good. When undemanding
investors appear, they’ll buy anything. Underwriting standards fall, and
it gets hard for demanding investors to find opportunities offering the
return and risk balance they require, so they’re forced to the
sidelines.Demanding investors must be willing to be inactive at times.