In the last post, I covered a few of Seth Klarman’s investing principles from a presentation he gave to a Columbia MBA class. He briefly discussed one place he looks for opportunities. Klarman likes to take advantage of mindless selling.
One of the downsides of mutual funds and index funds are the rules defining what a fund can and can’t own. The rules dictate what gets bought or sold. Klarman offered up a couple examples:
When a bond suddenly gets downgraded from investment grade to not…people actually panic or can’t hold the bonds.
Think about an index fund. If a stock is in an index, something like 10% of the market has to own it, because that’s how much the indexing activity is in the U.S. for say the S&P. If the stock gets kicked out of the S&P 500, 10% of the company has to be sold.
Some funds can’t own lower grade bonds and are forced to sell, even if there are no buyers. The same happens with stocks removed from an index (the 10% number may or may not be accurate, I don’t know). In both cases, if the stock or bond is already hated, the price will most likely fall lower because:
Selling has to happen, buying may or may not happen, but doesn’t have to.
Downgraded debt, stocks booted from an index, and spinoffs are regular events that could lead to mindless selling. At least in the last two, the announcements are made weeks or months in advance (of course, mindless buying exists thanks to the advanced notice).
The S&P 500 has 18 new stocks so far this year. A similar number got the axe.
This doesn’t make every stock outcast a great opportunity. Sometimes it’s warranted. Maybe the outcast is worth looking into. Maybe it’s not. At the very least, it’s worth understanding how funds operate and how it might impact the market.
If you don’t understand the psychology out there, you may be buying something at a very inopportune time. To understand what the other people in the market are doing, why its coming under huge pressure, or why its about to come under huge pressure, is really helpful.
(None of this accounts for changes in index methodology – rewriting of the rules – over the years that happen just as regularly and have a similar impact on holdings).
- A Buffett Disciple on What to Do About Market Turmoil – G. Spier
- How to Ruin Your Financial Life – B. Ritholtz
- Examining the Results: Lower-Cost Active Management – Morningstar
- Taxing The Yale Model – L. Swedroe
- Richard Thaler: The Less Attention You Pay, the More Money You’ll Have – MoneyWeek
- The Story Behind the Emerging-Market Meltdown – N. Smith
- The China Syndrome: Lessons from the A-Shares Bubble – Research Affiliates
- The Future and How to Survive It – HBR
- So What? Being Selective and Connecting the Dots – M. Housel
- Masters in Business: Jason Zweig (Podcast) – BloombergView