When Bad Strategies Outperform

Nov. 14, 2007 5:46 AM ETHD, PGR, WU, BR, GOOG, AAPL, QQQ, DIA, SPY7 Comments
Valulicious profile picture

Once upon a time there were two investors, Jack and Jill.

Jack is a professional money manager with a disciplined investment strategy. Jill is an orthopedist who manages her portfolio on the side. Jack knows how to analyze balance sheets. Jill knows how to analyze x-rays.

Before buying a stock, Jack spends weeks on thorough fundamental research. He reads SEC filings, analyzes financial statements, runs comps, listens to conference calls, and studies analyst reports. He prides himself on independent thinking.

Jill loves hot stock tips. She buys popular companies and top performers. With a busy medical practice and minimal financial vocabulary, Jill does zero research before investing.

Earlier this year, Jack invested in leading companies that were out of favor. He bought stocks such as Home Depot (HD) and Progressive (PGR), paying on average 12 times earnings--a huge discount to the market. Jack also invested in a number of special situations, such as Western Union (WU) and Broadridge (BR), both spinoffs which he felt were misunderstood by the street. Jack avoided energy and commodity investments due to fears of a bubble. He also avoided banks and mortgage lenders due to their complexity and leverage.

Jill bought Google (GOOG) and Apple (AAPL) at 50 times earnings. "They're unstoppable," she argued. In January, Jill saw that oil, China, and India were all hot the prior year so she piled into those sectors. She also bought commodity producers at all time highs, figuring that "insatiable Chinese demand" made valuation irrelevant.

As a measure of conservatism, Jack avoids options and margin. Jill did pretty well in the market last year so her confidence was high. She increased her buying power by using margin debt and also dabbled with out of the money calls "when I got a really hot tip."

Jack's portfolio is down 7% for the year. His investors want his head. He's not sure his fund can handle all the redemptions. He feels terrible about his losses, but keeps reviewing his portfolio to see quality businesses priced cheaply. Selling now makes no sense to Jack. He wants to add on the way down, but every time he turns around, the stocks he's watching are 10% cheaper, and his investors are clamoring 10% louder.

Jill's portfolio is up 60% for the year. Sometimes she daydreams about trading full time, or selling her practice and launching a hedge fund. "It's easy, it's fun, and I'm good at it," she explains. "The proof is in the pudding--just look at my results."

Jack identifies with Mike Goodson's sentiment, "Work Hard, Buy Good Stocks, Lose Money Anyway." Jill thinks Jack is a sore loser and doubts whether he even knows what he's doing. Jack thinks Jill is cute and wonders if a bright and attractive woman 20 years his junior would ever be interested in a married, short, fat, bald guy like himself.

What's this tale about? The stock market in 2007. Value went down. Hype went up. Momentum outperformed valuation. Recklessness outperformed thoughtfulness.

What's the ending for our tale? Jack fell down and broke his crown. Will Jill come tumbling after? You bet. And with a little patience, we'll see Jack's recoronation as well.

This article was written by

Valulicious profile picture
Valulicious is a pseudonym. Note: Seeking Alpha editors have contact information for all contributors to enable ongoing communication regarding articles published.

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