Chasing Heat

When I was a young football fan the Miami Dolphins were unbeatable and the New England Patriots were a joke. As the years went by their fortunes have changed. This pattern holds throughout the sports world–the mighty fall, and the meek inherit the championship. Occasionally you find a team that outperforms over many decades, such as the Kentucky Wildcats basketball team, but such gems are rare. The same pattern holds in the world of stocks, though the cycles often play out over a longer time horizon. You might find a Kentucky Wildcats stock like Berkshire Hathaway, but most companies have their ups and downs.  

Ken Fisher, one of the few money managers I truly respect, warns against buying the hottest performing sector or fund of the last few years. By the time you get there, the party’s over–it reverts to the mean. The next few years’ performance will not be so stellar, and it will probably underperform. Those who chase heat end up buying high, selling low, and repeating the cycle until broke. Fisher advises that you pick a fund (whether small cap, value, growth, tech, or whatever) and stick with it, as they all do about the same in the long run.

People tend to extrapolate from trends. If a stock, fund, sector, or money manager has been doing well, they think that performance will continue. This might work in the very short term, which is why momentum traders do what they do, but it is not a value investing strategy. It is not sustainable in the long term.

A good company that has had a few subpar years has a better chance of outperforming in the next few years than a company on a hot streak. This is not true of every company, but it is true for a basket of underperformers. This is why value investors like beat up, unloved companies. They are fundamentally sound, have hit a rough patch, and are likely to come back strong. This is essentially the rationale behind the Dogs of the Dow strategy, which has beaten the market over the long term. But why be limited by the Dow? Given a choice between two similar companies, I prefer the one that has been disappointing of late rather than the one that’s on fire (all things being equal, which they never are). It’s better to have the next big thing than the last big thing.

A long term value investor should not assume the good times will keep on rolling and jump on the bandwagon. Instead, he should keep his eyes open for companies that have fallen but are likely to come back strong.

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