Picking up Girls? Landing a Job? Contrarian Investing?: George Costanza's "Do the Opposite" Holds the Key

When George Constanza came to the conclusion that every instinct he had, every thought that passed through his mind was simply wrong, he logically reasoned that by doing the opposite he should enjoy  much better outcomes. He tested it out by trying to pick up a hot, seemingly unapproachable woman. It worked. He tried it out by being rude, yet brutally honest with George Steinbrenner in a job interview. It worked. In one fell swoop George figured out that by being a contrarian,  he could achieve much better results than by following his  gut. And the funny thing is, this kind of thing just works, and often-times is the best strategy to follow in investing. Like right now. When it is too painful for most to put fresh cash to work in beaten-up sectors and funds. Unless you're really smart and really liquid like, say, Eli Broad, Hank Greenberg and Goldman Sachs?

Let's consider what I mean when I say "Contrarian investing." Per Wikipedia:

A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Similarly, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or asset class.

Contrarians are sometimes thought of as perma-bears—market participants who are permanently biased to a bear market view. However, a contrarian does not necessarily have a negative view of the overall stock market, nor does he believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more "buy" candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.

It might seem a little stunning that in the face of a $1.4 billion drop in assets of Goldman Sachs Global Equities Opportunities Fund, three investors, including Goldman itself, would pony up an extra $3 billion. In actual fact, it makes perfect sense. This has been a bloodbath. Certain types of funds have gotten hit worse then others, and then the question becomes: are these strategies broken or is this a liquidity-driven price adjustment that is somewhat overdone? Clearly the three investors have great faith in the team and the strategies being managed, so much so that they feel they are making a deep-value bet on a fund that has been a strong performer. Just because many stat arb funds have gotten crushed over the past month, does this mean that stat arb as a strategy sucks or that the managers (like, say, Jim Simonds?) themselves suck? Clearly not. But a lot of people neither have the stomach nor the liquidity to make bets like Hank Greenberg and Eli Broad.

And I'll tell you now that some smart, rich folks are going to make an absolute killing on lower-rated credit spreads. Because so many funds and firms were all playing the same two games, borrowing liquid short and lending illiquid long and going long lower-rated credit spreads and going short either equity or higher-rated credit spreads, often on a highly leveraged basis, the speed and depth of the unwinding that is taking place (and isn't nearly done) will cause out-of-favor asset prices to get overly depressed and present a massive buying opportunity. If you have the guts and the liquidity, that is.

And this reminds me of a quote from Bill Gross of Pimco in last Saturday's New York Times:

“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”

Now I respect Bill Gross quite a bit and generally think he says some pretty intelligent stuff, but this doesn't fall into that category. The problem isn't with the system - it's with the participants. You know how you hedge liquidity risk? By doing one of a few things:

1. Keeping excess cash on hand to cushion statistical anomalies in returns (at least what you might model as statistical anomalies);
2. Diversifying the portfolio such that your asset classes don't approach perfect correlation in market dislocations; and
3. Avoiding too much leverage.

Now if the funds that melted down had followed at least one of these three rules, do you think they would have suffered the same fate? I think not. But if you want to fly high like Icarus, you run the risk of having your wings burned off. The problem is, you know who ends up holding the bag? Jeff Larson? No, his investors. This is why funds like Sowood managed $3 billion (run fast, run hot, put up numbers, get big, rake in fees and blow up - a classic negatively skewed/short option return profile),  while guys like Nassim Taleb can't raise much of anything (run like a turtle, hemmorage theta, bleed until the market craps out and then make a tidy sum - a classic positively skewed/long option return profile). There is no sexiness or appeal about losing most of the time and then winning big, as opposed to "winning" most of the time and then losing big. The issue is that most investors can't get out when the usual winner is about to give it all back, while the principals of such funds still captured a large share of the spoils on the way up. It is what it is, I guess. I just find times like these instructive. If only managers and investors took instruction... 

Comments

[maximo zeledon]

Great post Roger, so thank you! This was very helpful.

[Rob]

Roger,
Great post.

Yaser,
One of the best blog comments ever. Seriously.

Rob

[jason]

"And I'll tell you now that some smart, rich folks are going to make an absolute killing on lower-rated credit spreads."

How can we retail investors play this trade?

[Yaser Anwar]

Rich-

I don't think the need for monthly liquidity nor how liabilities are funded is the key culprit.

The main problem in close to ALL major blow ups (i.e. LTCM, Orange County, Asian Crisis, Tech bubble, Amaranth) is-

Failure to realize adequate investment risk. This failure, call it a curse of good returns, stems from two other

types of HF risks: Operational & Managerial risks. On the operational side the problem can be pricing errors caused

by "mark-to-model"-type P&L accounting and/or poor risk controls. The onus is on the manager and his/her risk mgmt

committee to evaluate positions by stress testing worst-case scenarios.

And by worst case scenarios I mean a modelling process on liquidity, whereby 100% of the assets are drawn down

simultaneously, all of the gates are triggered simultaneously, all anticipated exit costs are applied, and any

comfort letters are not applied. In my experience, many fund managers would be content to pass off the fine print

and go to sleep knowing such a extreme tail event is highly improbable, when in fact they should be preoccupied with

the fact that highly infrequent events are also the ones that cause the most pain.

The best HFMs (the SACs, The Marshall Waces, Caxtons) are constantly trying to optimize returns for a given unit of

risk, whereas most are doing the opposite.

[Rich L]

The liquidity mismatch at the heart of the current problem is that funds are invested in long-dated assets, including perpetuities like common stock. The liability funding these assets are short-dated repos, margin accounts from clearing brokers, and MOST importantly, hedge fund investors who demand monthly liquidity and who in a pinch are extremely loss-averse. This has been going on for several years, and is the reason that episodic panics are baked in the cake.