Contrarian Investing

Baruch has a corker of a post over at Ultimi Barbarorum on hedge funds, and why it is that they’ve unravelled so spectacularly this year despite largely escaping the bursting of the dot-com bubble unscathed. Go read the whole thing, but here’s a tiny taster:

The hedgies are hanging onto the winners of the Great Moderation, and instead of selling them when they go wrong, their first impulse is to defend, manipulate, and hang on.

Baruch also talks about how difficult it is to go short a stock or asset class which everybody else is long:

This is harder than you think. It means going against everything everyone in Wall Street tells you to do… It is lonely being short QCOM with no friendly sell siders to hold your hand and tell you it will be OK in the end.

I was reminded of Michael Lewis’s article in the last issue of Portfolio magazine, which spends a lot of time on a fund manager named Steve Eisman who was similarly bearish among a crowd of bulls:

There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria–to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded–without actually being insane…

Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. “It wasn’t that hard in hindsight to see it,” she says. “It was very hard to know when it would stop.” Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. “You needed the occasional assurance that you weren’t nuts,” she says…

There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. “The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?” Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. “Then he came back,” says Grant, “and said, ‘I can’t figure this thing out.’ And I said, ‘I think we have our story.’ßø”

Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. “When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm.”

The thing to note is that for all Eisman’s self-confidence and ability to make his own decisions, he’s still human: he surrounded himself with like-minded professionals at his hedge fund, and would hugely value confirmations and affirmations of his investment thesis from the likes of Zelman and Grant.

Eisman would also badger the bulls, asking them question after obnoxious question. He obviously wasn’t trying to persuade them that he was right and they were wrong — but he was trying to persuade himself. So long as other smart people couldn’t give him simple answers to simple questions, he reckoned, he was much more likely to be on to something.

This is the human element of investing. It’s always easier to be long than to be short; it’s always easier to do what everybody else is doing than to do the opposite. Certainly all responsible investment advice says pretty much the same thing to pretty much all people: buy index funds, rebalance occasionally, don’t trade, don’t try to time the market (beyond rebalancing), over the long term stocks will outperform. Is that, now, a crowded trade? The only reason that so many people are doing it is that it has generally worked in the past. But as we’re reminded daily, everything works until it doesn’t.

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