Tackling 2 Threats to Your Portfolio

Harry Long is the managing partner of Contrarian Industries, which specializes in alternative asset management, algorithmic system research and development, and strategic consulting. Continuing our previous conversation on smart stock selection, Harry and I also discussed two great challenges for today's investors: dealing with global competitiveness and surviving bear markets.

Toby Shute: Before an investor even gets to the point of evaluating an individual security, he or she needs to decide which ones are worth looking at. For Buffett, the answer is to "start with the A's" -- i.e. look at everything -- but that's hardly practical for most humans. And as Seth Klarman has written, investors following this approach "will spend virtually all their time reviewing fairly priced securities that are of no special interest." How do you resolve this issue?

Harry Long: I love the question. It highlights my own struggle. When I was younger, I went through every non-bank SEC reporting company in the U.S. below $100 million in market cap. I barely slept, and it nearly killed me, but I found companies like Crown Crafts that returned around 6.5 times my money.

There was a lot of low-hanging fruit to pick from in Warren Buffett's youth. There is almost none today in the U.S.

Shute: I know that one of the primary criteria you seek in a business is a strong competitive position. Some Fool favorites, including Best Stock for 2010 nominees Intuitive Surgical (Nasdaq: ISRG  ) and Intel (Nasdaq: INTC  ) , certainly fit the bill here. Why is this attribute so important?

Long: The world has changed. Up until the mid 1980s, you could pick a group of mediocre companies that were cheap and heavily diversified and make 17% a year before foreign competition destroyed every smokestack industry, as Buffett famously prophesied.

The public is slowly beginning to understand that the process of brutal foreign competition is only accelerating. GM might think Toyota (NYSE: TM  ) is brutal, but I assure you, Toyota will look like a fuzzy teddy bear compared to what the Chinese are going to do to the auto industry. The margins in every single industry will be destroyed. Absolutely decimated. The equivalent of the $5,000 car will be introduced in every heavy industry, and it will destroy companies which lack protection from competition, or aren't low-cost leaders.

If you really want a nightmare, think of the coming competitive progression in autos from Japanese and Korean to Chinese and maybe eventually Vietnamese competition. It will never end. That process will probably continue for well over 100 years, until world wage rates begin to converge with free trade and unfettered competition.

The public thinks that recession is the problem, but that's totally backward. The problem is prosperity. Aggregate demand will increase over time, but each individual firm, if it lacks protection from competition, will see the individual demand for its products decrease, as the number of competitors explodes.

Shute: How might our readers uncover such competitively advantaged companies using a stock screener like the one we offer over at Motley Fool CAPS? Contrarily, what might cause a screen to miss such great businesses?

Long: Your readers should ask themselves, "What makes a great company?" Then they should tinker with every screener they can get their hands on. Ideally, not only would they ask normative questions, but they would also backtest, or find people who have. Then they should ask themselves what would change the relationship between variables going forward.

No database is complete, or 100% accurate, so you have false positives and false negatives. Also, there are certain wrinkles in accounting that can lead to errors as well. So optimally, you're using multiple databases to plug as many holes as possible.

Shute: Would the market be significantly more efficient if someone like Google (Nasdaq: GOOG  ) or Morningstar (Nasdaq: MORN  ) made publicly available all the financial data and screening tools that institutional investors have access to?

Long: Yes, undoubtedly, but only to the extent that the public became well informed about the most predictive factors and actually used them, as opposed to gambling.

Shute: Garry Kasparov lost to IBM's (NYSE: IBM  ) Deep Blue in 1997, which rocked the chess world. Do purely mechanical investment systems have a shot at beating active fund managers like Legg Mason's (NYSE: LM  ) Bill Miller over a multidecade time frame, or will they merely augment human judgment?

Long: My sense is that, over time, good systems will beat most discretionary traders, but there are always a few extraordinary individuals out there who challenge one's notions about human potential. Over a multidecade time frame, I believe people will do best when they combine human judgment with systems.

Shute: Thus far we've talked about systematizing the process of security selection. You've also implemented a system to automatically take positions, long or short, based on an algorithm that evaluates long-term market direction. Is this a big leap, philosophically or in practice, from using quantitative methods to pick stocks?

Long: It is a huge leap. Most quantitative equity managers screen for P/E ratios and P/B ratios and call it a day. That did not save them from the carnage of 2008. An accurate system for market direction is key.

Why should today's investor be content to be ignorant about market direction? Market direction is an entirely worthy subject of intellectual inquiry. It is a mistake not to study it systematically. Investors cannot afford to be closed-minded, unless they can afford to periodically see their portfolio cut in half, or worse.

Just imagine how terrifying it would have been to be a Japanese equity investor for the past 20 years. They lost more than two-thirds of their money. Does the same thing need to happen here before people are willing to rigorously explore serious questions about markets?

Shute: One clear advantage of having a system to identify market direction is that it frees up one's time to stop worrying about the macro and just focus on security analysis. What are the other potential benefits of
this approach?

Long: Our understanding is that it has the potential to lower drawdowns. However, while drawdowns can be reduced, they never, ever, go away. The wonderful thing about a system is that unlike a human, it doesn't care which direction the market moves -- it just cares about movement. You can take a year like last year, which devastated most investors, and a system could do very well. The most important thing for people to remember is that people's behavior does not have to be rational in order to deal with it systematically -- it can be highly irrational, as long as it repeats in a statistically measurable way.

In addition, the same method which picks markets direction can be used systematically to enter and to exit stocks that have been chosen by more traditional fundamental algorithms.

Shute: Any last words?

Long: Trust no received wisdom, test everything, and build something useful that lasts. Has it ever worked any other way?

You've heard Harry's approach to tackling these two threats to your wealth. How do you deal with them? Have you systematized your approach to picking great companies? Sound off in the comments section below.

Harry Long's comments are purely his personal opinions and should not be construed as financial or investment advice.

Intel is a Motley Fool Inside Value selection. Google and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Morningstar is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Legg Mason and Morningstar. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. The Motley Fool has a disclosure policy.


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  • Report this Comment On January 12, 2010, at 3:15 PM, TMFOpie wrote:

    Thanks Toby. The best line in your piece: "GM might think Toyota (NYSE: TM) is brutal, but I assure you, Toyota will look like a fuzzy teddy bear compared to what the Chinese are going to do to the auto industry." Classic.

  • Report this Comment On January 13, 2010, at 1:57 AM, XMFSmashy wrote:

    Thank Harry for that one!

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