The DOPE-DUD Cycle: A Reason to Avoid Financials

The big thing in investing these days is behavioral finance and the message that investors need to tame their emotions. But investors can also gain from a greater awareness of behavioral tendencies in companies, particularly with regard to disclosure and raising capital.

For example, the arrival of a new CEO may be a period at risk for bad news. Getting the bad stuff out at the front end of one’s term is seen by some as good politics. Company problems are implicitly attributed to the former CEO, a sense of urgency is created within the company, and the stock price is reduced to a level from which it is easier to raise.

The 2007 Annual Report from the Chou Group of Funds reminds us of another corporate behavioral pattern. Francis Chou called it the DROP principle, but taking liberties with his nomenclature, I would like to call it the DOPE rule: Dribbling the bad news out slowly with the most Optimistic Projections while raising as much money as possible from Every investor. This is followed by the DUD phase: Divulging all the Unpleasant news and Dousing investors with a big bath.

Mr. Chou cites the “DOPE-DUD” cycle as an explanation for why he is avoiding financial stocks currently. He thinks they are still in the dribbling and money raising stage, which will later be followed by disclosure of the full deterioration. But that is not to say he is passing on “companies that are not involved directly with financials but, instead, have been somewhat tainted by association.”