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Saturday, June 29, 2013

Profit By Betting Against The Crowd

by James Gruber on June 29, 2013

What happens when you buy assets down 80%?
Other supportive evidence
Cons to the approach
Assets that qualify

There’s a traders saying that warns against trying to “catch a falling knife”.

That is, you shouldn’t buy assets which have sharply declined as they’re likely to go down further before there’s any recovery. I’m not sure when this saying gained popularity but I suspect it speaks a lot to the short-term mentality of most investors today. 

Because history suggests that you should do the opposite – buying assets down 60% or more has delivered fantastic results on 1, 3 and 5 year timeframes. And intuitively this makes sense. If almost everyone has sold out of an asset and there are only buyers left, there’s usually only one way for prices to go.

Given this, I thought it’d be worth taking a look at the assets which have been pummelled and may be due for a comeback. Globally, the most obvious standouts are Greece and junior gold miners. There are others though, particularly in agriculture, where sugar and coffee are still down 75% and 65% respectively from their all-time highs in the 1970s. In my backyard of Asia, stocks in China and Japan qualify, down two-thirds from their all-time highs. 

Vietnam is also a contender, having fallen 60% from its 2007 high. And among currencies, the Indian rupee is worth considering, given that it hit all-time lows versus the U.S. dollar in recent weeks. Of the above, gold miners, coffee, Vietnam and the rupee look the most interesting.
What happens when you buy assets down 80%?

Over the past week, global fund manager Mebane Faber wrote a brief article with the aforementioned title. Specifically, he looked at the performance of sectors, industries and the total stock market in the U.S. after they’ve been hammered. And here’s what he found:

Average 3 year nominal returns when buying a sector down since the 1920s:
60% = 57%
70% = 87%
80% = 172%
90% = 240%
Average 3 year nominal returns when buying an industry down since 1920s:
60% = 71%
70% = 96%
80% = 136%
90% = 115%
Average 3 year nominal returns when buying a country down since the 1970s:
60% = 107%
70% = 116%
80% = 118%
90% = 156%
Faber went on to conclude:
“It’s hard to buy something down 80%, especially when you owned it when it was down 30%, 50%, then 80%. But usually that is a great time to be wading in … Some recent examples of assets that have got clobbered include tech in 2002, homebuilders in 2009, and Greece and (Junior) Gold Miners now.”
Other supportive evidence
Faber isn’t the first to notice this phenomenon. Some years ago, two U.S. professors, Werner DeBondt and Richard Thaler examined the investment performance of U.S. stocks with the worst and best prior investment results. In each year from 1932-1977, the professors selected the 35 best and worst performing stocks over the preceding five year period. And the results were compared to a market index, namely all of the stocks on the New York Stock Exchange.

They found that the worst performing stocks over the preceding five-year period produced cumulative returns 18% better than the market index some 17 months after formation. Meanwhile, the best performing stocks in the five years prior produced returns 6% below the market index over the subsequent 17 month period...Finish reading>>