by David Dreman
Another important rule is to sell a stock immediately if its long-term fundamentals deteriorate significantly. No matter how painstaking the research, something can go wrong, worsening a company’s or an industry’s outlook dramatically. I’m talking not about a poor quarter or a temporary surprise that a stock will snap back from but about major changes that weaken a company’s prospects, as the financial crisis did with scores of financial stocks. Under these conditions, I have found that taking your lumps immediately and moving on usually results in the smallest loss.
To summarize: don’t be stubborn, don’t be greedy, and don’t be afraid to take small losses. Above all, when you buy a stock, make a mental decision as to the level at which you will sell it—and stick to that decision. You may lose a few points at the top, but in the long run you’ll make a lot more than you’ll lose.
A further question may arise with sell strategies using the eclectic approach. Suppose you have a portfolio of thirty to forty stocks and find a new one that ranks much higher by our indicators, while trading at a lower contrarian ratio than stocks you already own. A switch might then be made, but keep in mind the principle of a fixed number of stocks in the portfolio: each time one is purchased, another should be sold. Because you are bringing in more judgment in switching, and therefore more opportunity for error, changes of this sort should be relatively rare in order to avoid the dangers of overtrading. Or, as horse players like to say, “Stay away from the switches.”
A supplementary rule, which I followed for years, was not to sell a stock that attained a high P/E multiple solely because of a decline in earnings, either through a large onetime charge or because of temporary business conditions. I’ve mulled this rule over since the 2007–2008 market meltdown and have revised my thinking. Unless you know for certain it is a onetime charge and will not recur, I think it is wiser to sell immediately. What the crash showed us was that a onetime charge could often be only the beginning of a series of crippling charges. “Onetime charges” felled the financial sector and hurt a lot of value managers’ clients, including my own. It is better to take a onetime charge immediately and, if you still like the stock, buy it back when the company restores its earning power. Further reflection led me to remember, in choosing our low-P/E portfolios, that our computer simulation always dropped stocks that had no earnings in a given quarter; it adhered to the reevaluation I am making here.
Having examined this key set of new risks and opportunities, let’s now turn to a topic that’s been needing urgent attention for some time: a better theory of risk to replace the bankrupt theory so widely used today.
Chapter 14
Toward a Better Theory of Risk
RISK CAN BE a temptress or a savage god. It beckons us to casinos or markets and sometimes provides us with amazing rewards that defy all odds. When we win, we often don’t pocket the money and walk away. Rather, we play on, too often giving back everything we’ve won and more.
History is replete with great generals who won repeatedly against staggering odds: think of Napoleon, Robert E. Lee, and Erwin Rommel. But the odds—that calculation that mixes the might of armies, the will of warriors, and the economic power of a nation’s industries—always came back one time too many and too powerfully and in the end overwhelmed them all. In the civilian world, the investment media feature interviews with money managers, analysts, and investment managers who have had a superb run of three months, one year, maybe even three years. Every word they utter, no matter how nonsensical, is taken as the new gospel—until the law of probabilities sinks their records and, as in vaudeville, the long hook comes out from the wings to pull them off the stage. New stars with similar spectacular short-term records replace them as the audience roars its approval. But the Great Show of defying risk goes on.
Most of us are more than a little ambivalent about risk. We love to see the underdogs triumph and repeatedly root for them, delighted when they upset the favorites, more so if an underdog is a team we like or bet on to win. But in markets we want none of that. We want to stay with the odds, the higher the better. The only objective, naturally, is to win. The trouble today is that with complex situations we often have difficulty determining what the odds really are.
It all seemed so simple under efficient markets. Mr. Risk, aka Mr. Volatility, was a real mensch. He told you exactly who he was and what he did, and for decades we loved him for telling us expressly how much risk we could take to fine-tune our portfolios as precisely as a violin virtuoso tunes his strings. We thought we had finally caged the risk devil that had run amok since the beginning of history.
But then things began to change. We are increasingly finding out in this new, more difficult investment world that Mr. Volatility is not the mensch he claimed to be. In fact, he began to seem more like a heavy, a wise guy who ordered investors around, threatening them when they asked why their returns weren’t what was promised if they followed his recommendations.
Let’s translate that into slightly more technical terms. As we’ve discussed, beta and other volatility measures were introduced as objective gauges of risk, promising no more messy, inaccurate human guesses, and beta in particular became the touchstone calculation of risk in efficient-market theory. That was all to the good, except for one small problem that became apparent from the long-term performance data of the stock market: greater (or lesser) volatility did not correlate with the actual returns. Mr. Volatility’s numbers just didn’t work. Oh, he was more than articulate, and he proposed an elegant theory that was so easy to understand that most investors happily anchored their portfolio strategies on it. But he encountered the same argument made by Thomas Huxley, who defended Charles Darwin’s theory of evolution against avid creationists more than 150 years ago. Huxley said back then of creationist thinking, “The great tragedy of Science [is]—the slaying of a beautiful hypothesis by an ugly fact.”
As if the data were not enough, we saw in chapter 2 that the untested economic theory of risk collides head-on with Affect research findings about risk behavior. Over a number of experiments, Affect research has found that risk and benefits are negatively correlated. Taking on higher risk results in lower, not higher, perceived benefits, and conversely, taking on less risk results in higher perceived rewards. These findings are the direct opposite of core EMH risk beliefs.
Finally, the headlong charge into aggressive stocks in mania after mania, stocks that were characterized as low risk but were actually highly volatile, certainly at least partially documents the validity of the recent findings in Affect research. From the beginning, then, this hypothesis of risk seemed unrealistic. And with time its problems only became larger. Once again, and from a surprising source, modern risk theory is being questioned.
Nonetheless, as we discussed, when the assertion that volatility is the best measure of risk couldn’t be proved, rather than giving up on the concept, its advocates started altering their calculations of volatility in the hope of finding a new correlation between the two. They continued to put forward new risk models, but, as we saw, none of them worked reliably, and at best the scientific methodology used was questionable. In the meantime we’re left with one of the most glaring problems of today’s investment world: that the risk analysis most investors rely on is . . . specious.
Toppling Stalin’s Statue
Most of us recall dozens of scenes of statues of Joseph Stalin being toppled throughout Eastern Europe after the Soviet Union collapsed in 1989. The smaller ones were knocked down by workingmen using ropes and chains, the larger ones with tractors or other heavy construction equipment. Russia’s future was unclear, but there was no turning back. As with the fall of communism, we must ask: if volatility is toppled, what will take its place? The essence of this chapter is to provide you with risk measures that will hold up under many differing circumstances.
Let’s start with some of the key elements that were ignored in the old risk paradigm. We’ll see the damage each of these has inflicted for hundreds of y
ears, if not longer. More important, we’ll also see that much of the damage can be halted for both investors and the economy.
Yes, there is life after beta, and we can begin to put together some far better principles for today’s investor. Let’s start by looking at risk factors that, as we saw, caused significant damage to our portfolios in recent decades but have on the whole been ignored by investors to the present time.
Liquidity: The First Horseman of the Financial Apocalypse
To begin, we’ll look at one of the most serious risks contemporary investors face: the improper understanding and treatment of liquidity. In chapter 5, we examined in some detail the major role the almost absolute lack of liquidity played in three major crashes, driving illiquid stocks and futures down sharply lower and resulting in market panics.
The lack of liquidity is anything but a new risk; it’s probably been around since the birth of markets. Just the whisper of a lack of liquidity in the nineteenth century in England and other countries was enough to make depositors rush to withdraw their funds from banks, often sending the banks into insolvency. And of course we’ve all read about the bank holiday of 1933, with the long lines of depositors, waiting to withdraw whatever money they still could.
The damage that lack of liquidity can cause, of course, extends well beyond banks. A recent example is loans to housing and real estate companies in the past few years. Because a good part of the credit received by home builders and other real estate companies is originated by banks or other commercial lenders, if loan levels are cut sharply or not renewed, the borrower is often in an impossible situation. He can either try to dispose of his inventory, at fire-sale prices, or, if prices have dropped dramatically, go into Chapter 11 bankruptcy or make a deal with a bank that is not much better. The same situation has also occurred in the past year with some commercial property loans.
Throughout 2007–2009, U.S. companies, particularly those with less than a hundred employees, where most jobs are created, were plagued by the problem both of not being able to hire because bank capital was unavailable for expansion and of being forced to cut back operations because they could not get the credit they had always relied on. Lack of liquidity, then, is far more than a subprime problem, although the subprime crisis magnified its effects immensely; it is an ongoing problem even for safer and healthier companies.
The damage we are primarily concerned with in this section occurs in periods of abundant monetary availability. In such periods banks and other financial institutions ease their lending standards significantly. The lending standards on subprime mortgages, as we now know, were wretched. Hedge funds and other lenders were supplied with large amounts of leverage on loans of very poor quality, and the lenders, at best, made cursory examinations of the toxic mortgages they were lending against.
We’ve seen this also with commercial real estate in periods of booming prices, such as the late 1980s and early 1990s, when bankers failed to adequately scrutinize the economics of major projects. Builders were given up to 105 percent of the cost of a project because of the intense competition by banks to issue these loans. Such real estate bubbles have occurred almost once a decade since the 1960s.
Their endings have all been remarkably similar: At some point the banks and other financial institutions woke up to the fact that projects would not be nearly as profitable as originally projected. Worse, they were highly illiquid, as nobody wanted to touch them except at a huge discount, and the borrower was often completely illiquid, as in the case of Donald Trump circa 1992. Financial institutions were stuck big-time as in the bank crisis of the late 1980s to early 1990s; President George H. W. Bush organized the Resolution Trust Corp. to take over insolvent banks and thrifts and raised capital for some struggling institutions. Bank stocks tumbled as much as 50 to 60 percent on the dollar, and the real estate market crashed.
With the repeal of the Glass-Steagall Act in November 1999, which resulted in far more liberal bank lending, the illiquidity problems began to become significantly worse. Yet most banks and many other classes of professional investors completely dismiss this serious threat from their risk screens.
Liquidity Does Not Beget Liquidity
As we’ve discussed, liquidity played the crowning role in the 1987 crash. A serious but little realized problem is that liquidity can vary sharply with changing market conditions. The efficient-market hypothesis assumes that “liquidity begets liquidity,” meaning that as prices fall, swarms of buyers will appear. However, there is no proof that this has ever been accurate, but a good deal of evidence that in periods of severe strain, liquidity dries up, in the face of sharp drops in price. Recall that this occurred with S&P 500 futures markets during the 1987 crash. Still, this untested EMH assumption is held as a cardinal principle of markets, even after the crashes we have discussed. Other crashes, as well as the flash crash of 2010 and the July–August/September 2011 panic, also clearly showed that liquidity does not beget liquidity. Quite the opposite: as a result of rapid downward movements in stock or index futures, liquidity can decrease sharply and, in worst-case situations, dry up almost completely, significantly increasing the magnitude of the downturn, as the above examples demonstrated. A new Psychological Guideline should prove helpful here.
PSYCHOLOGICAL GUIDELINE 28(a): Liquidity does not increase as stocks fall sharply; quite the opposite. In rapidly falling markets, liquidity can decrease significantly; the less liquid a stock or other financial instrument, the greater the negative effect this will have on its price.
PSYCHOLOGICAL GUIDELINE 28(b): Increasing liquidity normally occurs in rapidly rising stocks or other financial vehicles in a sharply rising market.
Leverage: The Second Horseman of the Financial Apocalypse
Leverage is on a par with liquidity for the damage it can render. High margin by itself has been a major cause of crashes. Like liquidity, leverage is difficult to handle because of the similarity of interactions with Affect and other psychological forces. As we have seen, when the two work in tandem, as was the case in the 1987 crash, in that of 2007–2008, and with Long-Term Capital Management, the results are disastrous. As Psychological Guideline 29 warns, leverage is a risk that the conservative investor should avoid.
A point worth repeating on leverage: buying the S&P 500 and other financial futures requires significantly less margin than buying the stocks themselves (7 percent initial margin on hedging S&P 500 futures positions versus 50 percent margin on S&P stocks). This is less than the 10 percent margin allowed in 1929, cited by Congress as a major factor in that crash. In fact, in 1934 Congress allowed the Federal Reserve to set margins on stocks. Since that time, margin requirements have been set by the Fed, from 50 percent to as high as 100 percent of stock purchases. Allowing the Chicago Mercantile Exchanges and other exchanges to set futures margins as low as 7 percent—5 percent prior to the 1987 crash—has encouraged both greater speculation and more volatility in markets, as shown by both the 1987 crash and the flash crash.
Liquidity and Leverage: A Deadly Combination
We are not likely to soon forget the financial panic of 2007–2008, in which liquidity and leverage played a major role in almost annihilating financial markets in the worst credit crisis in modern history. The combination of high leverage and enormous illiquidity almost wiped out the financial system. Leverage also played a major hand, working in tandem with the lack of liquidity, in crashes from 1929 through 1987.
HOW CAN YOU PROTECT YOURSELF AGAINST ILLIQUIDITY PROBLEMS?
Because of the numerous forms of illiquidity, there is, unfortunately, no catchall answer. In a crash, there’s not much you can do but ride it out. Normally stocks come back fairly quickly, when it is realized that the crash was liquidity-driven. This happened with the 1987 crash, when stocks regained virtually all of their liquidity-driven losses in a little over one year, and in the flash crash last year, when stocks gained back most of the losses the same day and the entire amount in a matter of months. In a liquidity-drive
n market crash, do not sell your stocks.
HOW CAN YOU DEAL WITH LIQUIDITY AND LEVERAGE?
Unfortunately, both liquidity and leverage are very tempting in rising markets and hard to resist, particularly if credit is easy. The more we like an illiquid stock or bond or a group of them and the better the returns, the greater the temptation to buy additional amounts, using more leverage to enhance the upside. Both using too much leverage and having too little liquidity seem to be by-products of strong positive Affect. It is almost like a psychological addiction for many thousands of investors, including hedge funds, banks, and investment banks.
The only way to defend against the liquidity and leverage problem is to strictly limit your leverage and your ownership of securities that are not liquid, particularly if the latter are in the same sector of the market. For most people it is a good idea to go cold turkey. A Psychological Guideline as good now as it was in the 1920s is:
PSYCHOLOGICAL GUIDELINE 29: The prudent investor should stay away from leverage or margin and hold only a small part of his or her portfolio in illiquid securities.
Following are some booby traps to avoid.
1. If you do decide to use futures, make sure you don’t get in over your head. First decide how much stock you want to buy or sell. If, say, it is $20,000, and the smallest contract available is $200,000, run for the exit or you will have to buy ten times the amount you actually want. You’ll be surprised at how many people sink themselves by not following this simple rule.