This 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% might 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 the chart below:
Three sectors are in the black year to date — utilities, consumer staples and health care. (Note: these figures do not include dividends.) Consumer discretionaries, technology and telecom are down for the year, though less than the broader market. After that, it gets ugly. Energy and industrials are down 10% and 14%, respectively, but the real losers for the year have been materials and financials — 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.
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 mortgage 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 during the past two weeks, his largest single holding — gold — has taken a tumble and might have much further to fall.
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 technology 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?
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:
- You stand to make a bundle if you’re right.
- 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.
Enough beating up on Mr. Paulson. We all make mistakes. To my everlasting shame, I went short gold at $1,200. (Thankfully I covered the short with only modest losses. Remember, “Heads I win, tails I don’t lose too bad.”)
The more important question is where to invest today. Where are those investments that offer great upside with only modest downside?
I continue to see a lot of value in prosaic “old-school” tech giants like Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC). I also like high-dividend consumer products and health care giants like Johnson & Johnson (NYSE:JNJ) and Pfizer (NYSE:PFE). All of these companies pay high and growing dividends, and all but J&J trade at single-digit P/E ratios (J&J is close; it trades at a modest 12 times forward earnings). All four could double from current prices and still be reasonably valued.
The downside? Not much from a business standpoint. Intel and Microsoft have some degree of exposure to the business cycle as consumers and businesses tend to put off new computer purchases during tough economic times. But neither is at serious risk of seeing its revenues fall or seeing its dividend cut. And Johnson & Johnson and Pfizer are about as defensive and recession resistant as they come.
The market has been rallying hard this week as investors slowly come to realize that maybe — just maybe — the world isn’t going to stop turning because of Europe’s sovereign debt issues. Use any pullbacks as an opportunity to accumulate new shares of solid dividend payers that you know can survive Armageddon. Heads, you win. And tails, you’re not likely to lose too much.