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How to Protect your Wealth by Investing in AI Tech Stocks

Contrary Stock Market Investing

InvestorEducation / Learning to Invest Sep 30, 2007 - 04:26 PM GMT

By: Roger_Conrad


Best Financial Markets Analysis ArticleGood businesses are what I like to buy. That means stocks, bonds, preferred shares and other securities backed by healthy, growing companies, which are becoming more valuable over time.

Even buying good businesses won't save you entirely from bear markets. The best companies can and do occasionally stumble. And no matter how well you research something, you're going to get it wrong sometimes—with the result that you're stuck with a dog.

Buying good businesses, however, does ensure you're always in the game. If you buy in at a bad time, the returns will be slower in coming, but they will come. And no matter how bad times get for the economy and overall market, stocks of good businesses will always bounce back when the storm passes and the sun comes out again.

Contrary to popular belief, good businesses can be found in virtually any sector of the market. So, in fact, can bad ones. That's why you never want to fall in love and overload your portfolio on any particular investment class or, conversely, to completely shun an area.

Rather, the secret is to own the best companies in a wide range of sectors. Because different sectors perform well at different times, your overall portfolio will always remain steady, and it will gain value over time as the individual companies grow.

Remembering that good businesses can be found in every sector is particularly important when a group or industry comes under attack. One old saw on Wall Street is that more than 90 percent of the return on any particular stock comes from how the overall market does, plus how its individual sector performs.

There's definitely a grain of truth here, particularly when it comes to near-term action. For example, virtually every stock in the financial services industry has taken some kind of hit this year in the wake of the subprime fiasco.

But over the years, there's been a wide divergence in performance between stocks in the sector. Some companies have grown larger and more profitable, finishing every industry crisis in a stronger market position than ever. Some are no longer in business.

The sector had its ups and downs, but the best have steadily enriched their investors. Wise stock selection—not timely sector switching—was the key to wealth building.

There's one way, however, that long-term investors can use market swings to their huge advantage: by thinking contrary.

In the markets as in the outdoors, it's always darkest before the dawn. People are always ready to throw in the towel when things look their worst. And ironically, that's usually where the bottom forms.

Talk all you want about rational markets, true value, quantitative analysis, trend lines, automatic stop/losses or any other system that's supposed to take the emotion out of investing. The stock market is about people. That means it's all about emotion. People go from emotional highs to lows and back again, and so do markets.

Contrary investing is all about using those emotional swings to your advantage. It's also the title of probably my favorite investment book of all time, including those I've worked on personally. Written by Richard E. Band—the editor of Personal Finance when I began working there in the mid-1980s—the book posits one basic tenet: Think for yourself; don't let the crowd do it for you.

“Contrary Investing” goes on to describe various techniques for analyzing the market mood and detecting when the emotional highs and lows have gone to extremes. The ideal is to buy when the overall market or a particular sector is at an emotional low and to sell when it's at a manic high.

The most dramatic emotional peaks and valleys come only rarely on Wall Street. For utility stocks, the last big one was in late 2002/early 2003. At that point, investors had just endured a two-year, crushing bear market. Some two dozen companies were at risk to bankruptcy, and the ENRON implosion had everyone looking over their shoulder for the next disaster.

Few wanted to touch utility stocks at that time. In fact, the VANGUARD family changed its long-running utility fund into a “dividend growth fund.” That was the bottom.

Virtually any utility stock, bond or preferred stock purchased then has been a huge winner since. The most battered companies—such as AES CORP, CMS ENERGY and WILLIAMS COS—have returned five, 10, even 20 to one.

It was a very hard thing to go against the hugely negative prevailing emotion in early 2003 and buy utility stocks. But even those who lost big in 2001-02 have since made their money back several times if they bought or even just held on at the bottom.

To be sure, the utility sector had problems in early 2003. The key is that market emotions were way ahead of reality at the bottom. And with people writing off the entire industry forever, it didn't take a whole lot for utilities to start beating those extremely negative expectations.

In 2003, the industry had a very long way to go to full financial recovery, and in fact, some companies are still fighting their way back. For investors, however, the important thing was that market emotion was at such an extreme that utility stocks were pricing in an industry meltdown that even after two years of horrible setbacks, was unlikely to occur. It didn't take a whole lot of positive news to dispel that notion and start share prices on an upward curve again.

Contrary Investing 2007

Market history never repeats itself exactly. But it does often rhyme, mainly because we're still the same emotional creatures we've always been.

We're still prone to exuberance when our stocks rise and disappointment when they fall. We're still perpetually at risk to overreacting to market moves for fear of either missing out on a bull run or getting wiped out in a further downturn.

I'm no different from anyone else in that regard. But I've found that thinking contrary—combined with focusing on only the highest-quality companies in a wide range of sectors—does leaven things out for me. Not only are my emotions calmer in wild markets, but my portfolio is steadier as well.

Of course, I don't want to be caught up in a sector or marketwide collapse. But diversification and quality always limit the initial damage. Meanwhile, thinking contrary has me back on offense. I'm looking to spot the emotional extreme for the market and, therefore, the best chance to pick up shares of a high-quality company on the cheap.

The last several months have been difficult for pretty much everyone in the market. First, rising interest rates took a bite out of income-oriented stocks, bonds and mutual funds. Then, the subprime mortgage industry blow-up and resultant recession fears battered virtually anything considered “risky.”

The result is a lot of stocks are selling at much lower prices than they were just a short time ago. In addition, market emotions continue to run high.

Some days, investors are ecstatic and the money seems to flood into stocks.

The day Federal Reserve Chairman Ben Bernanke announced the half-point cut in the fed funds rate, for example, the market averages had their best performance in months. After weeks of fretting about recession, investors seemed to decide en masse that their worries were over and backed up the truck.

Other days, however, the market has seemed to be equally convinced that everything is headed to hell in a handbasket and prices have plummeted.

The fact that the primary catalysts for trading are economic reports—most compiled on survey data subject that's periodically revised and fairly old—is further evidence of how raw emotion has become. Clearly, many, if not most, people are completely unconcerned with the quality of the underlying companies they own. In contrast, they're obsessed with macro matters that may or may not have anything at all to do with their companies' success.

Will it matter to a strong company if US GDP growth is 4 percent, 1 percent or even negative in the fourth quarter of 2007 or early part of 2008? Not really.

Sales may slow temporarily. But in reality, the strong gain ground when conditions slacken. That's because the weak and leveraged invariably flounder, opening up more opportunity for them. Then, when the cycle turns up again, they're in better shape to profit than ever.

Obviously, a slowing economy and market can be a disaster for a weak, heavily indebted company. But again, if you're focusing on the highest-quality securities in the sectors you invest in, there's little to worry about.

As we enter the fourth quarter, financial services are clearly the market's weakest sector. It's not hard to see why.

Mortgage lending conditions—even for the companies that avoided the subprime mess—have become considerably more difficult. New home building loans, long a primary source of growth, are falling off a cliff. Consumer credit worries have increased as tightening conditions and rising rates have increased the risk of higher bad debt expense and loan write-offs.

We've already seen several blowups in this sector. Even Countrywide Financial , one of the biggest and strongest of the mortgage lenders and recipient of a huge investment from Bank of America , is struggling. Smaller, weaker players like AmericaN Home Mortgage have been going belly up in droves.

Unfortunately, there's equally little doubt that we're going to see more disasters. The damage from a huge amount of collateralized debt obligations is still yet to be accounted for. The housing market continues to slow, as does consumer spending.

As for corporations, conditions are still generally strong, and some of the yield spreads between bonds based on credit quality have narrowed from recent peaks. But if the economy slows enough, there will be trouble here as well.

As a result, it's not yet time to bet on the weakest financials—and that means it's not a good idea to make sectorwide bets either. To be sure, prices are down, and financial services are as essential as ever.

The best of this industry has a very bright future. But some of the players can still be taken down, and unlike utilities, there's no guarantee they won't disappear from the face of the earth entirely.

That's also true of real estate investment trusts (REITs). After an almost uninterrupted seven-year run, US REITs have crashed back to earth in recent months.

Valuations, however, remain astronomical for a wide swath of the sector. REITs that once sold for barely book value and yields of 7 percent or more now sell for three times book and yields of less than 3 percent. Clearly, there's a value gap here, and there's nothing like a good tightening of industry conditions to bring things back into balance.

There are, however, selected values in both of these battered camps. In the financial services area, the really big banks have what amounts to a “put” option from the Fed.

In essence, no matter what they do, they're too important to the financial system for the Fed to allow them to fail. They can go through tough times, particularly if they really put their foot in it. But at the end of the day, they'll be able to borrow from the nation's central bank at a rate low enough to keep them whole.

I'm not ready to recommend any big banks yet, at least not outside of Wells Fargo , which has consistently been more conservative than its peers. It's obviously exposed to the California real estate market but, in my view, will gain a lot more ground than it gives up during these tough times.

Solid regional banks are usually the best subsector to focus on during tough times for the industry. They tend to avoid the biggest macro messes that the money center banks always step into. This time around, however, one of the regional's biggest markets—mortgages—is at the epicenter of the shakeout. As a result, investors should tread with the utmost caution.

One I think is worth dipping into is Alabama-based Regions Financial . The bank actually sold what was then a successful subprime mortgage operation earlier this year to Barclay's , which has since been forced to scale back operations and lay off personnel. That's a pretty good sign management has a good idea of what's going on and isn't afraid to make a move to take advantage—or in this case, to get out of the way.

For the past few quarters, the bank's most exciting division has been regional investment bank Morgan Keegan . Profits have continued to climb as Regions integrates the unit with its commercial banking operations, which it's continued to add to with timely acquisitions in the mid-South. The mortgage portfolio is extensive but extremely well diversified, with only limited exposure to the country's truly battered markets.

Again, that demonstrates good management that sets the bank apart from its peers. And it's why Regions is a great way for someone to take a stake in financials' recovery from an emotional market low, without taking on the risk of blowing a major hole in his/ her portfolio.

As for REITs, the obvious beneficiary of trouble in other property sectors is multifamily housing. We were already seeing a robust increase in rents and occupancy rates before the subprime crisis, as more would-be property buyers realized the cost of renting was far lower than even taking out a low-priced mortgage--and far less risky as well. Now with foreclosures on the rise and new buying dropping, rents and occupancy are rising even faster.

Ironically, apartment-focused REITs have fared little better in the stock market than those in other sectors. That's emotion, pure and simple, and a pretty good sign there are brighter days in the very near future.

This is a wide-ranging sector, and there are plenty of choices. My favorite, however, is still Mid-America Apartment Communities , mainly because of its focus in the South and Midwest.

These regions never saw the peaks and valleys of popular states such as Florida and Nevada. Property values have sagged some to be sure, but again, that's only played into the hands of the apartment REITs, as quarterly profit numbers make clear again and again.

Perhaps the most emotionally charged market today is energy. I talk to a lot of people in my job and listen to even more by reading. And energy is one of those subjects about which everyone seems to have an opinion.

Some have completely bought into the idea that the world is running out of conventional oil supplies and that prices are heading well past $100 a barrel. Others are equally adamant that “hedge funds” have bid up the price of the fuel well beyond what it's worth in the fundamentals, that we're really awash in energy and that a great day of reckoning is coming.

One thing all writers know—as do all lawyers and especially politicians—is you can make a good argument about anything. The more facts you can muster to support your case, the more convincing you can make it.

The biggest risk is not having the discipline to challenge your own assumptions periodically, whether things are moving your way or against you. And unfortunately, emotion can make that increasingly impossible to do the more you buy into your own arguments.

The way the oil argument has evolved, both bulls and bears are at growing risk to becoming slaves of their emotions. If oil goes to $100 or even $200 a barrel, an emotional bull will be less and less able to take profits, even as the market emotion moves to a crescendo and, ultimately, a dramatic reversal.

That's why so few technology investors really took any money away from the '90s bull market and why gold stock buyers held onto their astronomical gains from the mid-'80s. They couldn't walk away from a winning streak. They became more and more emotionally convinced the trend would never end and evolved their arguments to justify their inertia.

On the other hand, the emotional bear has been becoming increasingly distraught during the past several years. Even if he or she hasn't been losing money by betting directly against black gold, the temptation is growing to throw in the towel and join the bulls.

That, incidentally, is one of the primary signs that a bull market is coming to an end: Long-term pessimists suddenly “see the light” and jump on board. Everyone left to buy has now made the leap. A near unanimous consensus has been achieved, and there's no room left for anything but inevitable disappointment and the end of the bull market.

That, of course, also happened during the technology stock boom of the latter '90s. There were some who steadfastly refused to join the crowd that was bidding Nasdaq to a double in 1999.

But by the end, the skeptics were either leaving the business or adding tech to their portfolios. Even Warren Buffett actually made a few bets, notably Level 3 Communications . Literally, the emotional zeitgeist had become so powerful that none could resist.

In my own case, I began to bullishly follow two utility-related technology groups in my advisory Utility Forecaster: fuel cells and data storage companies. I tracked them as well as competitive local exchange carriers (CLECs) in the How They Rate section of the letter—which analyzes some 200-plus essential service companies from power and pipelines to water and communications—with buy recommendations.

All three sectors were supposed to be on track for mammoth growth and profits for years to come. Fuel cells were forecasted to be ubiquitous in America by late this decade, replacing central station electricity in most homes. Data storage companies were predicted to grow as fast as the Internet. And CLECs were supposed to replace conventional phone companies by virtue of having better technology and more nimble management.

This week, I compared a 1999 version of How They Rate to one from the current October issue, which is available to subscribers online beginning tomorrow morning. What I found certainly wasn't pretty: None of the data storage companies still exist. The only CLEC is a vastly depleted Level 3, which has essentially diversified itself into survival.

The major fuel cell companies yet survive: Ballard Power , Fuel Cell Energy and Plug Power . But they're literally living hand-to-mouth, as powerful backers supply cash in return for gradually diluting other shareholders' stakes.

In short, even a value-first, buy-the-business guy like me found that tidal wave of market emotion impossible to resist. And although I'm a little older and hopefully a bit smarter now, I have no illusions that I'm not as susceptible as anyone else.

As readers of Utility & Income—as well as subscribers to my paid services Utility Forecaster and Canadian Edge—well know, I'm quite bullish on energy now. And some readers have rightly asked me whether I'm not myself getting caught up in the emotion of having been right the past several years and being blinded to a coming turn.

That's a question, of course, that's not easily answered. My view on energy is, before this is over, we'll have to see at least some combination of the four factors that ended the '70s bull market. Those are a massive increase in conservation, a major switch to alternatives from fossil fuels, at least one major new discovery of conventional oil and gas reserves and very likely a demand-killing global recession.

It took several years of all four factors working in concert to bring the curtain down on energy. The periodic economic ups and downs during the '70s created volatility.

But each time, energy prices recovered to higher levels. Only when there was permanent demand destruction and supply increases was the balance of market power shifted from producer to consumer. And there it stayed until bull market conditions returned again this decade.

In the '70s, Americans switched en masse to smaller cats using less gas. Today, there are a few hybrid vehicles on the road. But rising gas prices actually seem to be encouraging purchases of SUVs and other large cars because their prices have come down in the wake of rising gasoline prices.

Nuclear plants coming on line in the late '70s and early '80s replaced a huge volume of oil used to generate electricity. And the discovery of North Sea oil ended the Organization of Petroleum Exporting Countries' (OPEC's) monopoly on production.

This time around, more nuclear plants are on the way. NRG ENERGY is building the first merchant nukes in the US, and the utility giants that dominate current production all have major construction plans in the works. These plants, however, are a decade from producing power at best.

Biofuels are frequently touted as the best way to reduce oil imports. But even proponents concede it takes nearly as much energy to produce ethanol, for example, as is created.

Moreover, it's put upward pressure on corn prices, driving up food costs. And a new study has asserted that biofuels actually create more carbon dioxide than conventional gasoline.

Biofuels like ethanol enjoy immense political support. That should keep the subsidy flow going, though overbuilding ethanol plants in the US remains a threat.

It's also worth noting that Brazil's biofuels program—often touted as a model for the US—actually began as a bailout for the sugar plantations of the country's northeast. And it continues to suck down subsidies, which benefit those who still own the plantations.

As for a discovery of conventional oil and gas reserves, Super Oils are still looking hard. And despite billions spent, they're not finding it anywhere.

Instead, they're plowing money into unconventional resources, such as deepwater drill wells miles under the ocean floor and Canada's oil sands. These require higher baseline oil prices to be economic. Using them effectively sets a higher floor under oil prices.

Every commodity price cycle in history has ended. This one will, too. But it won't end when someone waves a magic want. Rather, it's going to take a lot of adjustment and hard work. And in my view, we've got a long way to go.

Those have been my views for quite some time. And they're why I've advised sticking with energy positions despite the ups and downs of the past few years. They're why I expect to see a rebound in natural gas prices, which are substantially higher than they were at the beginning of the decade but have less than their traditional value compared to oil.

I'm protecting myself from emotionally getting this wrong in two ways. First, I own a lot more than just energy, which is just one sector of many. Second, I own only high-quality companies in the sector.

Sure, the Super Oils and top-quality Canadian trusts don't score the biggest gains when energy prices move higher. But they certainly ride out the ups and downs a lot more smoothly and—if I'm dead wrong—they're going to be there at the end of the day. The leveraged bets offer no such assurance.

Finally, the best way to guard against sticking around too long in a bull market is to periodically take some money off the table as prices rise. We haven't had much opportunity to do this over the summer because energy stocks have generally lagged oil prices because of subprime fears. Those producing gas have fared considerably worse.

I did offer that advice at the peak in summer 2006, however, and those who took it were able to book a nice profit. We'll get there again in my view. In the meantime, stick with high-quality energy stocks—as one part of your portfolio.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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