There are promising investment themes. Some of these ideas are in a nascent stage. That is fine. It is riskier for me to discuss these, but more interesting for readers to consider.
I am often asked about the process of stock picking. There is a simple starting premise:
I do not believe in the efficient market hypothesis.
Warren Buffett has said that he would be on a corner selling pencils out of a tin cup if this were true. Ben Graham used the allegory of "Mr. Market" to describe the sometimes silly prices he was offered for his stocks.
In this tradition, I join the many investment managers who are looking for contrarian themes. The biggest edge comes when stock mis-pricing is the greatest.
Ideas Worth Watching
Here are a number of themes worth watching. If I had more time, I might write an entire article on each subject.
- Europe. The key announcement has now been delayed until Wednesday. As I noted in my weekly preview there is near-unanimity in the predictions: Failure now or failure later. The issues are the haircut on Greek debt, the size and leverage of the EFSF, and added capital to European banks. I was going to write on this subject tonight, but it is all redundant. Everyone is expecting disappointment on one or all of the various criteria. The expected trade is to "sell the news" since the market has rebounded on hopes of a solution.
The Contrarian Trade? Use the expected selling as an opportunity to buy. The European solution is not a single bold plan, but a patchwork of negotiations and bargains. I thought that I was the only market observer with this viewpoint, but I now see that David Goldman has a similar idea, writing as follows:
There’s no crisis, just a negotiation over 1) how much governments will kick in, 2) how badly senior bondholders will be dinged (forget holders of common equity), 3) the price at which foreign investors (Wilbur Ross, sovereign wealth funds, China) will put new equity into European banks, and so forth. Because the European banking system is hard-wired into political patronage, the negotiation requires a great deal of theater. But this is theater. This IS a drill. This is NOT the real thing.
- Apple. I have written about Apple many times, mostly because it illustrates the difficulty of market timing. We have a great growth stock, with plenty of cushion in the PEG ratio if you back out cash (as you should). Most people trade the stock on words, not numbers. Any dip is an opportunity, since the rebounds come in chunks. If you sell, you are left behind, wondering whether or not to chase.
The Contrarian Trade? This is one to buy and hold, at least until it gets closer to fair value on a fundamental basis. If you were chased out, suck it up and get back in. I am buying this stock for new accounts tomorrow.
- Dr. Copper. There have been a lot of big market calls based upon plummetting copper prices. In a single day the copper market made up weeks of decline.
The Contrarian Trade? Probably it is to fade (play opposite) the copper followers. There were a lot of bogus spikes and correlations in the QE II era. Without revisiting why this happened, let us just say that many commodities reached prices that did not reflect true economic prospects. A return to normalcy does not imply a recession. The contrarian play is to buy some deep cyclicals, starting with CAT.
- Netflix. This is an illustration of danger. When you have a high P/E growth stock there are many ways to lose. With Netflix I can predict neither earnings nor the growth rate. This means that I have no basis for my intrinsic valuation.
The Contrarian Trade? I do not have one, since I cannot get a handle on valuation. You need to know when you should not play.
- Value Trap Stocks. There is an entire group of stocks that everyone agrees are cheap and everyone hates. There is a trader consensus that these stocks will never move higher. The result is that earnings to up, the price remains stagnant, and the P/E multiples move lower each year. To those with a trading mentality, it seems silly even to look at these stocks. Someday this will end.
The Contratrian Trade? Look for the former growth names that have fallen out of favor with traders. Check to see if the 50-day and 200-day moving averages are threatened. Consider whether there is any change in the business model that might lead to higher prices. Ideas include CSCO and MSFT. There are many other candidates breaking out on your charts.
- CDS Spreads. These credit default swap (CDS) spreads have become misleading, one-sided markets. It is like what happened to put-selling after the crash of 1987. There were dramatic restrictions on who could sell puts and the haircut and margin requirements. Something similar has happened now. Too many have embraced this indicator since it was relevant in 2008. In those days you had AIG and others taking one side of the market while putting up no collateral. Today we have the opposite. It is a relatively thin market with few sellers. Someone needs to study how much capital it takes to run up these spreads, call Bob Pisani or Rick Santelli, and profit from a position on the underlying bonds.
The Contrarian Trade? The actual policy authorities are not responding to these prices. There are even proposals to limit or end the trade. Aggressive traders could dip into European banks. I think there is plenty of edge with more conservative plays like JPM.
I hope readers appreciate the theme of this article. The ideas may not be right for everyone. I own AAPL, MSFT, CSCO, CAT, JPM and similar stocks in client portfolios, depending on suitability. I welcome suggestions about new contrarian themes and new stocks that fit the stated themes.