What’s Working in 2011?

2011 has been a rough year for investors.  Stocks, as measured by the S&P 500, are down nearly 8% for the year and down 14% from the April highs.  And while 14% may not sound like all that much in the grand scheme of things, investors felt every point in a surge of volatility that brought back discomforting memories of the 2008 meltdown in which the major stock indices lost half their value.

Still, some market sectors fared better than others.  Let’s take a look at Figure 1.

Figure 1

Three sectors are in the black year to date—utilities ($XLU), consumer staples ($XLP), and health care ($XLV).  (Note: these figures do not include dividends.)  Consumer discretionaries ($XLY), technology ($XLK), and telecom ($IYZ) are down for the year, though less than the broader market.  After that, it gets ugly.  Energy ($XLE) industrials ($XLI) are down 10% and 14%, respectively, but the real losers for the year have been materials ($XLM) and financials ($XLF)—down 18% and 23%, respectively.

Investors who underweighted the highly-cyclical sectors and focused instead on the less-sexy, dividend-paying value plays haven’t had a bad year.

So WHAT if I bet the farm on banks and gold?

But what is remarkable about this year’s correction is that so few investors seemed to see it coming, and this included high-profile professionals.  John Paulson, the hero of 2008 who used the subprime meltdown to make the most successful trade in history, has had an abysmal year.  Due primarily to his overweighting to financials and materials—the two worst-performing sectors by a wide margin—Paulson’s flagship fund was down by as much as 40% this year. (See John Paulson’s portfolio holdings here.)  And over the past two weeks, his largest single holding—gold—has taken a tumble and may have much further to fall. (see “Is It Time to Call a Top in Gold?”)

No investor should be judged by a single nine-month period, and perhaps Paulson will ultimately prove to be “right” about financials.  Many banks appear cheap on paper, and sentiment is almost universally bearish towards them.  It’s entirely possible that he will eventually recoup the losses he took this year.

Still, Paulson’s heavy losses on his leveraged, concentrated portfolio should stand as a warning to investors.  Paulson ignored low-hanging fruit that was ripe for the picking—such as telecom and pharmaceutical shares trading at multi-decade lows based on earnings and dividends—and instead swung for the fences with a massive leveraged bet on an inflationary expansion.  Paulson risked his career and the wealth and livelihood of his clients without ever asking that all-important question: “What if I’m Wrong?”

Sir John Templeton

There is nothing wrong with betting big on a concentrated position.  Great value investors like Warren Buffett have made careers of doing so, and over-diversification is a recipe for mediocrity.   As the great Sir John Templeton said, “By definition, you can’t outperform the market if you buy the market.”

But the second half of Sir John’s quote is also quite illuminating: And chances are if you buy what everyone is buying you will do so only after it is already overpriced.”

If you’re going to take a large, concentrated position, two conditions should be met:

  1. You stand to make a bundle if you’re right.
  2. You won’t lose your shirt if you’re wrong.

Value investor and financial guru Mohnish Pabrai  compares the investment decision to a coin toss in which “Heads I win; tails I don’t lose too much.”  I tip my hat to Mr. Pabrai, and I only wish I had thought of that quote first.

Unfortunately for his investors, Mr. Paulson did not apply the same logic.  He loaded up on gold after it had already been in a bull market for the better part of a decade and had become trendy.  And he bet big on financials even after watching what happened to them in 2008.  He swung for the fences…and struck out.

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