Hedging Your Bets

As these examples illustrate, crisis brings enormous opportunity, but there is always the fear that something can go wrong. Any one of the banks, even though they appeared 8 1 undervalued by our value criteria, could have made a mistake on its loss reserves, thus putting it into greater financial difficulty than was apparent. In fact, this happened in one or two cases, which was a remarkably low percentage of the thousands of the banks that were publicly traded.

Still, if youre conservative, you want to guard against this risk. The best way is to have adequate diversification. As a money manager, I did this by buying a fairly large number of banks, with none accounting for

One of the most important characteristics of a crisis-at least to the contrarian investor-is the abundance of opportunities. Sometimes excellent stocks collapse when there is nothing wrong with them. Take the case of Federal Home Loan Mortgage Corporation, referred to on the Street as "Freddy Mac." (This company and the Federal National Mortgage Association-"Fannie Mae"-are the countrys two largest originators of mortgage securities on housing.) To 1990, Freddy Mac had a record of eamings growth that would make many a CEO of an emerging growth company envious. For the previous 15 years its income increased at a better than 20% clip. Eamings continued to move ahead in 1990, but the stock dropped off tiie charts with the other financial stocks during the panic. Then, in the fourth quarter of 1990, the company reported it would take a one-time charge on a small part of its multifam-ily mortgages.

Horror of horrors, a negative eamings su rise in an industry where the password was panic. When the smoke cleared, the stock had dropped from $8 a share in late 1989 to under $2/, or almost 70%. At its low it was trading at a P/E of about 4.5 times eamings and yielding 5%, even though eamings after the write-off would still be 5% higher in 1990 than in the previous year. Careful analysis indicated that there was nothing wrong with the company, and that the growth rate of the past was likely to continue.

Management statements corroborated this analysis. We bought the stock, and growth did continue at an above-average rate. Eamings increased 33% in 1991 and more than doubled by 1994. Dividends also rose Over 100% in the same period. The stock moved up to $11 by early 1994, on its way to $42 in late 1997, or more than 15 times its price at the 1990 low.

Panic

In a market crisis, panic occurs frequently. Enrico QuaranteUi writes in The Nature and Conditions of Panic that the most important condition for the emergence and continuation of panic is a feehng of entrapment with an impending threat.* Whether the person is independent or part of a group, the feeling of being trapped predominates.

* As it tumed out, $17 for First Fidelty Bank wasnt so bad after all. It was taken over by First Union at $65 in late 1995 and, adjusted for the takeover by First Union, was $134 at the end of 1997.

more than 2% of our overall holdings (ahhough we had over 25% of our equity portfolios in this industry, and over 35% for the Kemper-Dreman High Retum Fund). We expected to lose one and possibly two banlcs as a result of management underesdmating real estate losses. Even given this loss rado we beheved we would do significantly better than the maricet.

As it tumed out, thanks to the financial screens oudined above, we did not own a single bank that went under. Our retums in this area were exceptional. From die fourth quarter of 1990 to the end of 1997 the banking index outpaced a rapidly rising market, increasing 578% vs. 231% forthe S&P500.

In looking back, it may look like a cakewalk (due to hindsight bias), but at the time it was anything but easy. In my case, I had reasonably good background, I knew about overreaction, cognitive errors, group decision errors, and theoretically should have been battle-hardened by the similar crises I went through in the previous three decades. So when the financial crisis of 1990 exploded it should have been a layup.

Nothing could be furtiier from the tmth. Tme, I moved in with relish snapping up bargain after bargain. Trouble was, this was not the bottom, as it almost never is. Some of the temporary reverses were stunning.

First Fidehty Bank, which we bought after it dropped from $45 to $17, and met all the criteria outhned above, was under $13 two weeks later. Thats right, the stock dropped another 25% in ten trading days. The thought crossed my mind that three more weeks of this and it could be valueless.* Other bank and financial stocks we bought behaved the same way. In spite of my background, the nagging question of whether this time it was different still went through my mind. None of us can escape the anxiety and doubt that permeates a crisis.

Psychological experiments have duplicated conditions of near panic. In one experiment, corks were placed in a bottle attached to strings. The neck of the bottle was so narrow that only one cork could be passed through at a time. The subjects were told the bottle would be filled with water and they would have to get their cork out before this occurred or they would receive an electric shock. As the bottle filled with water slowly, there was adequate fime to do this if each subject went in order. This, of course, did not happen. A wild melee ensued, similar to panic in a theater fire, and very few got their corks out in time.

Quarantelli, although discussing physical panic, accurately describes conditions observed in the securities market. People see the threat as immediate and believe that their survival depends on taking instant action. In a panic there is a total collapse of the constraints to flee. In the overwhelming desire to save oneself, self-control is overcome by fear and actions become highly self-centered.

In a financial crunch, for example, when a new consensus occurs there is a sense of entrapment in these stocks, a realization of the danger, and a desire to run. Even with the knowledge that their actions could trigger a stampede (because their selling would dwarf normal buying), large numbers of professionals rush for the exit at the same time, only to be trampled by the crowd.

The psychological barriers against following contrarian strategies in times of crisis are high. Panic doesnt just affect sellers, it often keeps even experienced buyers away. But it is surmountable. I related the missed-bottom incident to a seminar I was conducting on "The Psychology of Markets" at the Harvard Medical School Conference in 1995 to show how powerful psychological forces could be even on supposedly well-trained experts.

A psychologist in the audience then made what I thought was an excellent suggestion. She pointed out that people are being taught to cope with trauma in other areas, and suggested similar training for investors. Individuals, psychologists believe, can be trained to cope with panic by analyzing the fears leading up to it, thereby reducing their potency and allowing the person to deal with them. This is done in fields where crisis can be deadly if not handled properly.

This kind of training starts by exposing the student to all aspects of the potential trauma-producing situation. The subject is taught to understand that in panic his perceptions are distorted by fear, and that he should tick off the points covered by the training to see how many of them apply to the current event. Flight simulators, which allow airline and combat pilots to apply their skills and experience in unexpected