It's 2008, and the horse-racing world's set afire by Big Brown. So begins a curious tale of misbegotten statistical practice, human folly, and the sometimes-emotional nature of market-pricing mechanisms in Michael Mauboussin's Think Twice.
A caramel-hued, perfectly muscled mass, Big Brown loped to easy victories in the Preakness and Kentucky Derby -- winning by four-and-three-quarter and five-and-one-quarter lengths, respectively. As a contender for the Triple Crown, the horse would sit in hallowed company if he could win the Belmont. Only 11 horses have accomplished this feat in the past century, and none in the past 30 years.
What's interesting isn't that Big Brown lost the Belmont, and somewhat spectacularly, but that the odds-makers' assessment of his chances were so favorable. Eleven of 29 Triple Crown contenders won this honor in the past 100 years, a 40% probability. Perhaps more telling, only three of 20 contenders since 1950 succeeded, a 15% win rate. But the odds placed on Big Brown at Belmont didn't correspond: Bettors gave the horse a 75% probability of winning.
Mauboussin attributes this seemingly obvious mispricing to what he calls the inside view, in which people assess a problem by focusing on "information that is close at hand ... predictions based on that narrow and unique set of inputs." The outside view, by contrast, favors an analytical and empirical assessment of the problem by considering similar situations.
An inside-out view
On a cursory assessment, you might think the past weeks' volatility represents a buying opportunity. This mentality is, to a degree, reinforced by the U.S. economy's and equity markets' historically strong performance.
But this strategy -- "buying the dip" -- presupposes an important condition: a typical recessionary environment, characterized by emotional selling, brief economic malaise, and a subsequent speedy recovery. Classifying the market's recent declines in these terms risks ignoring the broader picture -- it's an inside view. The U.S. and world economy face serious near-term challenges and longer-term structural issues, if history's (even loosely) indicative.
In the near term, consumers are hamstrung by still-levered balance sheets and uncertain employment prospects. On the other side of the ledger, employers aren't hiring because consumers aren't spending. It's a classic chicken-or-egg problem: How do consumers spend, which should help the economy regain its footing, if employers aren't hiring? And if consumer spending isn't picking up, how can employers be expected to hire?
Longer term, the U.S. and eurozone economies face structural issues that stem from chronic budget deficits and high debt-to-GDP ratios. U.S. banks such as Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) have needed recapitalization. The risk of widespread eurozone crises of confidence and possible bank recapitalizations—at French banking giants BNP Paribas, Societe Generale, and Credit Agricole -- could result in even more pain. It's essential that these economies deleverage their national balance sheets alongside the private sector. Painful spending cuts and tax increases -- both of which will, in all likelihood, cut into GDP growth -- are a necessary cost of the past decade's excesses.
That gets us to the outside view: I don't think this is a garden-variety recession and recovery, but until recently, the market's priced it that way. On that basis, stocks on average still aren't that cheap. The past decade's excesses will require a fairly lengthy deleveraging period, for consumers and the government. Historically speaking, large-scale deleveraging cycles encompass a six- to seven-year period, according to the McKinsey Global Institute and to Rogoff and Reinhart's study of 800 years of credit crises, This Time Is Different. And we've only been through about three years.
The Special Ops answer
If the past decade's experience has taught us anything, it's that macro matters. This may seem odd, because I spend my days (happily) toiling as senior analyst at Special Ops, the Fool's special-situations and opportunistic-value stock-picking service. At Special Ops, we can't and won't pretend to know exactly what will happen. But we do think that rigorous examination of the data and history, and an accordingly informed opinion, should factor into our strategy.
First, the bad news: We don't think plug-and-play strategies will work as they did before -- at least not for the foreseeable future. Now the good news: A sluggish economy, and lingering risks, needn't correspond with a stagnant portfolio. At Special Ops, our strategy remains unchanged: We pursue special situations and opportunistic value with catalysts. This is the environment that especially calls for special situations. Our job is to be very selective for you.
We believe that the market and economy won't hand us the growth of yore (at least not for a while), and that in sideways markets, what we do matters more than ever. Historically speaking, an event-driven portfolio of stocks has shown very low correlation to the markets at large. We're not managing a 100% event-driven portfolio, but we are very focused on catalysts, situations that don't depend on the economy, and contrarian high-reward-to-risk opportunities. With this in mind, we'll retain (and even heighten) our focus on catalysts and buying very, very cheaply.
Consider a representative example, Charles River Laboratories (NYSE: CRL). A leading early-stage contract researcher to pharmaceutical companies (basically, outsourced R&D for the still-nascent drugs) and the dominant purveyor of lab rats, Charles River is only second to competitor Covance (NYSE: CVD) in early-stage. Amid the credit crisis, uncertainty over health-care reforms, and merger activity at big pharmas, big pharma put the brakes on R&D and Charles River's profits were hit hard. They still haven't recovered, but they appear poised to; big pharma's facing a huge patent cliff and needs to reinvest in early-stage drug development. With declining returns on R&D dollars, we expect contract researchers -- like Charles River, Icon (Nasdaq: ICLR), and Pharmaceutical Product Development (Nasdaq: PPDI) -- to benefit as pharmaceutical companies adopt an increasingly cost-conscious posture.
And of course, there's a kicker, which makes the likelihood of share appreciation incrementally higher. Activist investor JANA Partners owns a sizable stake. They don't play games. They've agitated for share repurchases, cost-cutting, and the sale of underperforming business units -- and in doing so, delivered value to shareholders. They've also considered the prospect of an outright split of the company's lab-rat and contract-research business, a move which would, in my opinion, push shares even higher.
That's just one example of how we at Special Ops try to take the economy out of the picture. And that's our outside view. Next week, the service is being opened -- for the last time this year -- and you'll receive an invitation and an investing kit if you enter your email address in the box below.
