by David Dreman
But never fear: the croupiers in the Chicago markets have devised many ways for you to bet on this fast-moving action. After all, the house has to be rewarded for its ingenuity. A number of VIX derivatives allow traders to take positions on the VIX without owning the underlying index; these positions include VIX options, standard VIX futures contracts, the recently added mini-VIX futures, and other more exotic variations.
Buyers make money if volatility goes up; sellers win if it goes down. This is an interesting instrument but is again more of a speculative tool run primarily by sharks on the trading floor. I think one example should be more than enough to show why. On January 30, 2009, a new exchange-traded fund, the VXX ETN, started and bought the VIX options. Since that time to now (June 2011) the fund has dropped 94.9 percent. The VIX index, with which it is calibrated, has fallen 63.2 percent. The calibration disappeared because of the cost of contract expirations, commissions, and the high markups on buying each new contract. The fund, as a result, lost an additional 31.7 percent. VIX options have no place in a conservative portfolio—or, come to think about it, in any sane account.
PROTECTIVE ACTION 2: EXCHANGE-TRADED AND INDEX FUNDS
An exchange-traded fund (ETF) normally has smaller charges than the great majority of mutual funds. It usually has a fixed portfolio, so transaction costs are also normally lower. Unlike a mutual fund, it is not redeemed but sold on the open market. There are literally hundreds of ETFs that are set up to do everything from short-selling 30-year Treasury bonds*73 to buying and selling gold to investing in a particular industry. An ETF can help you accomplish your investment objectives if you carefully examine its portfolio, by providing you with diversification in a volatile industry that you believe has potential. Diversification is important in a volatile market, as there is more than enough danger in owning any one industry. Owning a single stock in that industry is often too risky. Not only are you taking the industry risk, which can be substantial, but if you put all your eggs into one basket, you increase that risk significantly.
Two examples here: First, if you had bought financial stocks outright in 2008, you would have suffered major losses; if you owned the wrong stock, you were gone. However, had you bought an ETF, such as the XLF, a weighted average of all the financial stocks in the S&P 500, then, although you would have taken devastating losses—the XLF dropped 83 percent from its 2007 high to its early-2009 low, the worst drop since 1929–1932—your investment would have rebounded since then. It was up more than 158 percent from its March 2009 low to June 2011. This is an industry that I believe will recover strongly over time.
Another example is the SPDR S&P Oil & Gas Exploration & Production ETF (ticker symbol XOP), which consists of a fairly broad portfolio of oil and gas exploration and development companies. After hitting an all-time high of $71.38 in late June 2008, the index free-fell, reaching a low of $23.01 on November 20, down almost 70 percent in less than five months. Since then it has recovered smartly, along with oil, up 161 percent to June 2011. These two ETFs are good examples of what’s out there that can give you more diversification in an industry you like. Just be aware that these ETFs will have wider fluctuations in the volatile markets we just experienced and may experience again, hopefully without the ferocity of 2008 to early 2009 or of August/September 2011.
Another word of caution: many ETFs are small and thinly traded and are best left alone. Make sure the daily trading volume is sufficient to make your order inconsequential to it. Also, check the asset value, which you can determine each day, and be careful to check that the market price is within pennies of it.
PROTECTIVE ACTION 3: SECTOR FUNDS
Industry-sector funds are different from ETFs in that they have a money manager select the stocks. Here you are faced with higher fees in almost all cases and are dependent on the performance of the manager. Still, there may be good opportunity in some. I would recommend you first look at the manager’s performance over at least a ten-year period. If he outperforms his industry, he is certainly worth looking at. It’s also a good idea to check the fund’s fees. High fees are a major cause of underperformance over time.
PROTECTIVE ACTION 4: MUTUAL FUNDS THAT BEAT THE MARKET
As we have seen, only 10 percent of managers have beaten the market in any ten-year period since performance measurements began to be used. Those are not great odds. Mutual funds do give you the diversification you need if you don’t want to invest on your own, but we all want performance, too. Fortunately, there are a couple of good answers. The first is to buy a mutual fund with a long record of outperforming the market after fees and costs; I would suggest a record of at least ten years. Make sure the fund is still run by the same manager who created the record. Many times it isn’t.
With limited funds, the best approach would be to purchase a mutual fund with a broad portfolio. There are a large number of sources to help you in the selection process, including Lipper, Morningstar, Value Line Mutual Fund Service, Forbes, and Barron’s.*74 These will provide you with quarterly information on the fund’s performance and its record over the number of years it has been in public hands. Select a fund that has a strategy you are in tune with and that has outperformed the market for a significant period. This will narrow the bewildering number of funds down to a handful. Table 13-1 gives you the returns of some of the better-value large-cap mutual funds through bull and bear markets in the last ten years. The results are taken from Lipper.
PROTECTIVE ACTION 5: INDEX FUNDS
Unless the mutual fund you chose has a solid record of outperforming the market over time, I would suggest you buy an index fund that replicates the S&P 500 and has very low fees. The Vanguard 500 Index Fund Investor Shares*75 ($112.6 billion in assets) is such a fund with costs and fees of just 0.17 percent annually. It is a low-cost index mutual fund that replicates the S&P 500. Another choice is an S&P 500 ETF. The largest is the SPDR S&P 500 ETF, with $94.2 billion in assets and an expense ratio of 0.15 percent.*76 If you prefer a large-cap value index, one of the largest is the iShares Russell 1000 Index Fund, $12.0 billion in assets, expense ratio 0.15 percent. The Russell 1000*77 is the most widely followed domestic value index today.
Some of you may prefer a smaller-cap index. Here are two to look at: the iShares Russell 2000 Index Fund, with $15.6 billion in assets and 0.20 percent expense ratio; and the Vanguard Small-Cap Index Fund, with $22.6 billion in assets and 0.26 percent expense ratio. Both are small-cap index funds holding both value and growth stocks.
There is one other intriguing strategy for the investor, another, newer variation of contrarian strategies, which we will look at next.
Buy-and-Weed Strategies
We’ve looked at the success of buy-and-hold strategies. A twist to this approach is to buy a portfolio of contrarian stocks and weed it periodically of stocks if they move up to or above the market ratios or if they fail to perform as well as the market after a certain time, at the same time replacing the stocks sold with new contrarian stocks. If, for example, you owned a low-P/E portfolio of forty stocks with roughly 21/2 percent in each holding and sold 10 percent of it, you would replace the 10 percent with four low-P/E stocks each with about a 21/2 percent portfolio weighting. An overview of the studies indicates that returns normally diminish with long holding periods (five to six years or more). Some methods, such as this, should raise overall return above that of the simple buy-and-hold strategy.
The pruning process should also allow you to maintain a portfolio of contrarian stocks with above-average yields. In any case, whichever strategy you choose, you should have a good chance of outdoing the market while taking below-average risk and spending minimal time making selections.
Other Alternatives to Contrarian Strategies
FOREIGN AND COUNTRY FUNDS
Until recently, with the stumbling domestic economy, foreign markets were all the rage. Billions of dollars were flowing into China, the Pacific Rim, Latin America, Brazil, and Argentina, while more conservative investors bet
on the European and Japanese markets. Should you get into the act? Yes, but be careful.
First, foreign markets have already had enormous moves. Second, pessimism, though improved from 2008–2009, when it was at the highest level since the Great Depression, is still widespread. There’s no question that people are very frightened, though the U.S. economy should pull out of this morass within a few years. If this is correct, we have a very powerful domestic bull market ahead, particularly if inflation begins to move up rapidly several years out; as we’ll see, this is a distinct possibility.
Still, foreign markets do present more potential than at any time in the past because of their growth, financial strength, and increasingly more responsible investment regulation. Remember, the same investment guidelines apply abroad as they do domestically. First, don’t jump in just because the concept is exciting. Speculative activity in China, Hong Kong, Russia, and Mexico has cost investors billions of dollars in the not-so-distant past. Lesson one, then, is that foreign investing is not a panacea. You have to apply the same contrarian principles you apply in U.S. markets. The 1997 debacle in the Pacific Rim markets is a classic example of investors’ not doing so. Be extra careful to avoid the waves of speculation that often dominate in these areas.
Another important consideration is that when you buy foreign companies, you are taking an exchange-rate risk that can greatly add to or detract from your total return. In the years that foreign markets outpaced those in the United States, the gains were often more a consequence of a weak dollar than of strong markets overseas. Thus, when the dollar dropped in recent years, a good part of the fabulous returns on foreign portfolios—trumpeted in many funds’ advertising—was not from the markets themselves but from the fact that stocks were simply worth more because of the cheaper U.S. dollar, as may be the case again today. If the dollar gets stronger, the situation is likely to reverse.
Table 13-2 gives you the returns of domestic and foreign stocks taken from the S&P 500 and the MSCI EAFE index data. The MSCI EAFE (acronym for Europe, Australasia, and Far East) index is designed to measure the equity market performance of developed markets outside the United States and Canada.
Look at the six performance columns. The performance of foreign stocks, as measured by MSCI EAFE against the S&P 500, is mixed. The two indices changed lead in four out of the six periods measured. What is clear is that these two indices are in a real horse race. Which will do better over time may involve a photo finish.
But let’s make the choice even more difficult. Stocks, as we know, are exceptionally ornery critters, and their behavior in different time periods is unpredictable. There are other factors that you as an investor should consider. Owning domestic stocks allows you to avoid the worries of currency fluctuations and also stay clear of thinly traded speculative markets and geopolitical considerations.
The results are a standoff. There’s no question that foreign markets, with the exception of the European Union, are healthier today, but should we bank on this indefinitely? As the chart shows, they are pricey by P/E but have smaller market caps.
Remember, too, that not all foreign countries are equally safe. I feel more comfortable investing in Western Europe and Canada or, if the P/Es come down, in Japan. I would invest much more sparingly in China, the Pacific Rim, South America, or Russia. Banks and foreign investors have taken a whipping in Brazil, Argentina, and Russia because of their record of defaults and restructurings; these investors often lost 50 cents or more on the dollar. The underwriters of foreign securities assure us that things are different now. Maybe, but who can say that a government that has defaulted on its debt once won’t do so again?
Having talked about the dangers involved in investing abroad, I should note that there are opportunities in foreign stocks. One of the best strategies for individual investors is to buy foreign securities traded on the U.S. markets that fit in with a contrarian strategy. The latter is something I have often done with the portfolios I manage, with good success.*78
This avoids the higher costs of overseas brokerage and safekeeping charges and converting small amounts of foreign exchange at high spreads. American Depository Receipts (ADRs) represent a stated number of shares of a foreign stock traded in the United States. Many of the larger ADRs, such as Royal Dutch/Shell, Sony, and Koninklijke Philips Electronics, are listed on the New York Stock Exchange, and most have detailed financial information available—in English.
The mechanics are simple, since a large number of foreign stocks, funds, and other financial instruments are actively traded here. Foreign stocks can make good sense because they sometimes trade at lower values, using contrarian indicators, than do domestic companies in the same industry. For example, Unilever, the giant Dutch-based consumer products company, is about half the size of Procter & Gamble; nevertheless, with a market value of $90 billion, it is huge. The company has a lower P/E ratio and a higher yield than the U.S. consumer products companies, with similar growth rates expected by analysts over the next several years. Other foreign companies that present better value than their U.S. counterparts can be found by looking through the Value Line Investment Survey and the Morningstar Web site, while professionals can use Bloomberg, FactSet, or other systems.
You might use these stocks, as I do, to find better values in a particular industry than are available domestically, or else to produce a diversified portfolio both by country and by industry. Using ADRs, you can structure a well-diversified foreign portfolio. By coincidence, many of these large, well-established ADRs pass the contrarian criteria easily. But remember, the currency risk doesn’t disappear. If the dollar spikes up against the currency the stock was issued in, the price will drop; and if the dollar drops, the price will rise.
There are a number of conservative ways, then, to approach markets abroad. The first is to buy an index fund, or a close substitute, that represents the weighted value of stocks outside the United States. If I were to buy a foreign fund, my preference would be an index or a contrarian fund with an acceptable record in foreign markets.17
A second alternative that sometimes proves quite lucrative is to buy closed-end funds that invest in major countries with good outlooks and political stability when these funds are unpopular.
The first rule of investing abroad is identical to the first rule of investing at home: buy ’em when they’re cheap, not when everybody is already on the bandwagon and the media hype is in full swing. Just as with hot IPOs and concept stocks at home, we know that after a euphoric price run-up there is an inevitable hangover.
Finally, we’ll turn to one of the toughest questions that must be addressed using contrarian strategies—or for that matter any other strategy: when should you sell?
When Should You Sell?
Regardless of the strategy you use, one of your most difficult decisions is when to sell. There are almost as many answers to the problem as there are investors, but even among professionals, few religiously follow their own sell rules. Psychological forces misdirect most sell decisions, often disastrously. I have seen many a money manager set stringent sell targets and did so myself in my earlier years. But as the stock moved rapidly toward the preset price, more and more good news usually accompanied its rise.
If the stock was originally purchased at $20 with the sell target at $40, and it shot through $40, a manager would often bump the sell price higher. Forty would become $50; $50 would be stretched to $60. This frequently resulted in the manager’s taking the “round trip”: riding a stock all the way up, only to ride it all the way down again.
Given what we know, it seems that the safest approach, once again, is to rely on mechanical guidelines, which filter out much of the emotional content of the decision. The general rule I use is this, which I’ll call a Psychological Guideline.
PSYCHOLOGICAL GUIDELINE 27: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable its prospects may appear. Replace it with another co
ntrarian stock.
For example, assume we are using the low-P/E strategy and the market P/E is 16х. If one of our stocks (say, Chevron), bought at a P/E of 10х, went up to 16х, we would sell it and replace it with another low-P/E stock.*79
The first guideline, then, is simple: pick a sell point when you buy a stock. If it reaches that point, grit your teeth, brace yourself, and get rid of it. You will probably be unhappy because the issue will often go higher. But why be greedy? You’ve made a good gain, and that’s what the game is all about. (The only exception is when you have an almost sure takeover situation.)
Picking a sell point, however, doesn’t necessarily mean selling a stock just because it has gone up. If you are a low-price-to-book-value (P/BV) player, you may find that even after a stock has risen sharply it still sells at a below-market P/BV because its book value has continued to go up. Often, stocks remain at low P/BVs for years, despite doubling or even tripling in price, because their book value has also doubled or tripled, keeping the P/BV ratio low. The same is true for low-price-to-earnings and low-price-to-cash-flow ratios, and high dividend yields.
Another question is how long you should hold a stock that has not worked out. Investors all too often fall in love with their holdings. I have seen portfolios loaded with dozens of companies that look good on paper but have long been dogs in the market, resulting in poor returns.
Again, there are many partial answers to this problem, but I think two and a half to three years is an adequate waiting period. (For a cyclical stock with a drop in earnings, this might be stretched to three and a half years.) If after that time the stock still disappoints, sell it. The late John Templeton, one of the masters of value investing, used a six-year time span. You be the judge, but stick to your time frame and don’t be stubborn.