140 The World of Contrarian Investing RULE 1 3

Favored stocks underperform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

It is this reevaluation process that is the key to large and consistent profits in the marketplace. For decades, investor reaction to "best" and "worst" stocks has been consistent and predictable. And here we come to the bottom line for the practical reader. Investor behavior is so predictable, in this respect, that the average reader can take advantage of it. There are proven yet uncomplicated contrarian strategies that should allow you to outperform the market handily, with relatively little risk.

Sounds a little heady, doesnt it? Now lets start at the beginning and see exactly whats behind these assertions. A bit of intellectual discussion, if you will, to reveal the elemental structure, function, and statistical justifications of the four variations on the contrarian strategies that have been highly successful to date. Using our "key," youll see how the pieces of the puzzle rapidly fall into place-although Im afraid it wont get you a discount on one of those Armani suits.

The WorU Turned Upside Down

What seemed apparent from our review of expert forecasts is that the companies they liked the best tended to be the wrong ones to buy. Therefore, ask another question: Should you avoid the stocks the experts or the crowd are pursuing and pursue the ones they are avoiding? The answer, as we shall see, is an unqualified yes. We can document the consistent success of these investment strategies going back sixty years-strategies that dramatically oppose conventional wisdom-and the reasons they work.

For the findings show that companies the market expects the best fii-turesfor, as measured by the price/earnings, price-to-cash flow, price-to-book value, and price-to-dividend ratios, have consistently done the worst, while the stocks believed to have the most dismal fiitures have always done the best. The strategy is not without an element of black humor. In fact, to the true believers at the shrines of efficient markets or other contemporary investment methods, the approach may appear to be a form of Satan worship: the best investments turn out "bad," and the bad ones turn out "good."

In Visibility We Trust

As we have seen, estimating a companys outloolc years into the future is an article of faith among Wall Street experts. The clearer the companys prospects and the better they look, the better the "visibility." Companies with the clearest "visibility"-i.e., best eamings prospects and fastest growth rates-are normally accorded high valuations (whether evaluated by price-to-eamings, price-to-cash flow, price-to-book value, or price-to-dividends). Similarly, those companies with poor or lackluster visibility are banished to the lower valuation tiers.

In order to make such evaluations, forecasts extending growth well into the future must be made with extreme accuracy. We know, however, that the reliability of these forecasts is very low. We also know, when eamings of a favorite company fall below the forecast, the su rise, even if it is minute, has a devastating effect on its stock prices. Not su ris-ingly, investment strategies based on precise estimates have performed erratically, to say the least.

There are many reasons why companies show outstanding eamings and sales growth for years and then slow down. Sometimes it is simply accounting gimmickry (which we looked at in chapter 3). Or a company might have a short-term competitive advantage, which the market, enraptured by the high profit margins and eamings, 1 1 18 as a long-term trend.

Today, a large percentage of the hundreds of high-flying, aggressive growth stocks-franchising, Intemet access, telecommunications-fall into this category. AST Research was a rapidly growing manufacturer of IBM-compatible desk-top and notebook computers. ASTs "edge" was its direct marketing to the public, thus avoiding the middleman and providing low-cost products. Rapid technology change and competition

However, the findings are not in the least magical. Most investors do not recognize the immense difficulty of predicting earnings and economic events, and when forecasting methods fail, a predictable reaction occurs.

Here we confront the main irony: One ofthe most obvious and consistent variables that can be harnessed into a workable investment strategy is the continuous overreaction of man himself to companies he considers to have excellent or mundane prospects. This worlcs just as surely with the investor today as it has with investors in all marlcets of the past.

In the Beginning...

Beginning in the 1960s, researchers began to wonder if visibility-that cmcial pillar of modem security analysis-was actually as sohd as generally believed. The original studies were done with price-eamings ratios because of their availability in the early databases. One of the first of these researchers asked: "How accurate is the P/E ratio as a measure of subsequent market performance?"

Francis Nicholson, then with the Provident National Bank, was the interrogator. In one comprehensive study done in 1968, measuring the relative performance of high versus low P/E stocks, he analyzed 189

caught up with it within a few years, and its eamings plummeted from a peak of $2.61 a share in 1992 to a loss of $3.00 in 1996, accompanied by a drop in the price from $40 to $5.

The more successful a company becomes, the more difficult it is to continue the record: Competition, govemmental controls, and increasing market saturation all play a role in slowing growth. Too, a management team skilled at running a rapidly growing $50 or $100 million 11 may be lost at the $300 to $500 million sales level. Products and markets seemingly invulnerable to competition are suddenly inundated by it. Untouchable patents are circumvented by new discoveries. Costs cannot be controlled and prices cannot be raised, so profit margins are squeezed. Markets that appeared open for years of brisk growth become saturated. Political or economic events occur, such as an oil embargo or a sharp recession, totally beyond the control of even the most astute management, wreaking havoc in the marketplace. History constantly reminds us that in an uncertain world there is no visibility of prospects. Future eamings cannot then be predicted with accuracy. As we have seen with high-expectation companies that have negative surprises, the best companies can be terribly ove riced and can be drastically reappraised.

The term "best," used by so many professional and individual investors, also filters out the inherent risk of the situation. Conversely, the lowest-visibility stocks have been shown to be significantly unde riced and, when they have positive su rises, are subject to 8 upward reappraisals. Just as the inherent risk is understated for high-expectation situations, it is often exaggerated, sometimes dramatically, for low-expectation stocks. This puts the master key of the book in our hands- why the investment strategies that well examine work remarkably well over time.