Overvalued stocks and Ponzi schemes

By David Tice

 1. Study stock market history – recognize where you are in the long-term secular cycle.

Most investors remember and learn from what has occurred in the recent past. Investors must realize that they must learn from periods that might extend beyond their own memory. Market cycles can last a long time, and people have too much at stake to make all the mistakes themselves, so they must learn from market history.

Most of the money in the stock market over the last 104 years has been made in secular bull markets. However, being invested at the tail end of secular bear markets can result in very poor investment performance for a very long period of time. Recognize that the greatest contributor to stock market performance is the P/E multiple afforded to earnings, and that in bull markets, the P/E multiple expansion is what drives stock prices.

2. Uniform opinion among analysts about an individual stock is dangerous.

When many Wall Street analysts are unanimously positive on a company, the stock price tends to be too high and reflects very favorable expectations. The key to making money in stocks is selecting companies where your analysis of fundamentals shows better prospects than the current Wall Street expectations. However when all analysts have very high expectations for a company, then it becomes very difficult to beat lofty expectations.

3. There are elements of Ponzi schemes in many areas of investment.

Always keep your eyes open for investments that require a bigger fool to continue to pay a higher price to have the investment make sense. These investments are dangerous, as eventually you run out of buyers willing to continue to pay a higher price. Determine that there are underlying economic fundamentals that justify the investment based on future cash flows, not just that someone is willing to pay a higher price.

These ponzi-like situations can be found both in the investment markets as well as in the fundamentals of real businesses. For example, the recent telecom boom was founded not on the ability of companies to make money, but on their ability to sell the bandwidth they developed on to a bigger company. This was a classic Ponzi scheme. When it was realised that the bigger telecom companies couldn’t buy all the bandwidth that was being developed, stock prices crashed because the business models were not viable on their own merit without the benefit of a bigger fool buying them out.

4. Buy low, sell high – don’t buy high, sell higher.

This advice seems straight forward, but is always difficult to follow. Attractive sounding growth stories have the most intrinsic appeal, but are always the highest priced in the market. These companies have the highest expectations, and it normally requires a bigger fool to keep paying a higher price to keep the stock price rising. Also, there usually exists very little downside asset value support in those cases where the growth story does not come through.

5. Consider selling short to reduce exposure and to create outperformance.

There are always many stocks which reach outrageous price levels and can be sold short. One great attribute of selling short is that it reduces overall equity allocation which reduces portfolio risk and equity exposure. Short exposure of 15% offsets long exposure of 75%, thereby resulting in net long equity exposure of 60%. Reduced equity exposure means lower risk, thereby helping investors generate improved risk-adjusted returns if stock selection is done well.

6. Be a contrarian and independent thinker

Always attempt to challenge the conventional wisdom which is normally wrong. Following the crowd is not normally the way to get rich. Great riches are typically earned by people who identify an opportunity before anyone else and who exploit those opportunities successfully. You should invest in the same manner.

7. Have a long time horizon – it’s the key to riches.

Look for companies that are experiencing short term disappointment. Most investors attempt to chase short term performance which is very difficult to achieve. Earning a 50% performance return over three years, is equivalent to a 15% annual return. The chance of earning that 50% return is higher if all the other investors ignore a stock because they see the performance being too far in the future.

8. Look at micro-cap companies. The market is more inefficient, and the profits can be huge.

Companies with smaller market values are followed less by Wall Street and therefore generally carry lower expectations. If you can identify companies with great prospects before others do, your chances of generating outstanding returns are much greater.

9. Always think about risk vs. return.

Always seek the optimal trade-off between the two functions. Stocks that most people already know about generally possess lesser return potential. Companies that sell at significant multiples of revenue, possess the highest risk in case of disappointment or in a bear market. In a mania bull market, stocks with the highest risk can earn the highest returns for a while, but if market conditions change, they will decline the most.

10. Follow the smartest analysts who are indepedent thinkers.

Read and follow the advice of the most insightful analysts you can find. Sometimes those analysts with the best short term track record have been the ones taking the most risk. This should always be assessed. Look for analysts who make sense and who consider downside support as an important element of the investment strategy.