The Worst Possible Investing Mistake

There are many mistakes people make that ensure they won’t get rich investing. In 2011, I think one in particular mistake will hurt more than others. I can sum it up by citing the phrase, “Generals fighting the last war.”

I have come across many people in my travels who, despite a 50%-plus drop in the stock market from its peak in October 2007 to the March 2009 bottom, are still waiting for the market to crash. They missed one of the greatest rallies in the history of Planet Earth because they looked backward when they should’ve been looking ahead.

I know people who still think the housing market will crash. Yet housing prices are already down 30% from the peak nationwide. Housing is now more affordable than it’s been in a generation, as we’ve seen.

I know people who still won’t touch a tech stock, even though the tech bubble burst and hit bottom eight years ago, or who won’t even think about owning a Brazilian stock, because they lost money on one when Brazil blew up in the 1990s.

These are not dumb people. Most of them are successful in their chosen fields. But even smart people can get stuck in their views…which become outdated – and unprofitable – as the world changes around them.

It is like Mark Twain’s old dictum about the cat and the stove. “She will never sit on a hot stove lid again – and that is well,” Twain said, “but also she will never sit down on a cold one anymore.”

Over the holidays, I read a good paper on this subject entitled, “Investment Strategy,” by Barton Biggs in January 1977. Biggs was a well-known strategist for 30 years at Morgan Stanley. More recently, he wrote a very good book about investing called Hedgehogging, which I would recommend. Anyway, Biggs wrote his paper as a sort of New Year’s address to the money managers under his charge.

He began by talking about all the experiences an investor accumulates over a career, even a career as short as 10 or 15 years. “He has had his share of winners and bloody noses,” Biggs writes, “his back is permanently twisted from whipsaws and he has gotten whatever benefit there is to get from being run up and down the market flagpole countless times.”

As the old saying goes, “Experience is a comb that life gives you after you lose your hair.” But seriously, that experience is important, especially if you have a few hairs left. Experience gives you a sense of the market’s habits, its moods and conventions. You have a working knowledge for some of its industries and stocks. And you’ve probably learned a great deal about yourself, such as your tolerance for risk.

But that experience also comes with barnacles that latch onto your hull. Biggs captures it eloquently:

The problem is that in accumulating experience, he also acquires prejudices against industries and stocks because he has lost money in them. It is easy to…become an investment bigot with a closed mind on many subjects… A fresh, opportunity-minded mind, uncluttered by prejudice, is crucial for superior investing in an environment where the one constant, the one inevitability is change and industry group rotation. By definition, there can be no uninvestable industries.

In short, an investor should never say, “Never.” As in, “I’ll never buy a housing stock,” or “I’ll never buy an airline stock.” Biggs calls that kind of thinking “pure, fat, unadulterated laziness.” There is a time and place for all things.

I know I have to work hard to cultivate an open mind about all things investing. I try to change as the market changes. I don’t want to be one of those guys who say the same thing every year even though the market has clearly changed.

So while I always insist upon a favorable risk/reward proposition, I do not care what shape or structure that proposition takes. For example, I was bullish on fertilizer stocks in 2005 when I recommended Agrium to the subscribers of Capital & Crisis. After the stock tripled, I urged subscribers to sell the stock. I subsequently turned bearish on fertilizer stocks in 2007. In 2008, after the fertilizer stocks had collapsed, I told my subscribers to buy them once again. Since these 2008 recommendations, PotashCorp has more than doubled, while Mosaic (NYSE:MOS) sits atop a 57% gain. But I suspect we’ll exit this position once again in 2011, as the grain story reaches a feverish pitch.

Also in Capital & Crisis, I recommended various hotel, real estate, insurance and bank stocks in 2004-2005. I told subscribers to exit these positions – usually very profitably – in 2006. I did not recommend any stocks from these sectors after 2006, since I was worried about the housing bubble. But now that real estate prices have tumbled, this sector and the industries that support it, may be serving up some investment opportunities in 2011.

As Roy Neuberger, who didn’t suffer a single down year in 68 years on Wall Street, once said, “Fall in love with people…the last thing to fall in love with is a particular security. It is, after all, just a sheet of paper indicating a part ownership of a corporation. Its use is purely mercenary.”

Knowing this, I still have to fight not to make the very same mistakes I am warning you to avoid. I got burned badly investing in a master limited partnership (Atlas Pipeline) and that experience has hardened me against those structures. I got blasted investing in an oil refinery (CVR Energy), which prejudices me against that model. So I work at this too.

But I think Biggs’ message is going to be particularly important in 2011. That’s because the wind has shifted…and some areas that have been hot will cool. And some areas that I’ve avoided look promising once again.

Mining stocks, for instance, have been red-hot. Miners are flush with cash and spending lots of money on new projects and mines. That’s the problem. In 2011, mining companies will pour a record $115-120 billion toward creating new supply. Companies that sell the picks and shovels have also been en fuego. “Exhibit A” is Joy Global, a mining equipment company. Its stock is up 300% since January 2009. With a few exceptions – such as in uranium and gold – I think there is too much optimism around mining-related stocks. The sun shines on no dog for long.

Conversely, there are rafts of small banks trading for 60%, 70% or 80% of tangible book value, when acquirers are paying premiums as high as 148% of book to own them. These are sleepy local institutions that typically hold onto the loans they make. They didn’t participate in the shark fest that hobbled the big banks. They have loads of cash. There is a lot of insider buying. Yet investors are ignoring these stocks out of prejudice stemming from the financial crisis…and hence, I think there is opportunity here.

These are but two examples on either ends of the spectrum. The world changes and your views need to change with it. Don’t get stuck. As Biggs said, “Successful investing is like riding a bicycle – either you keep moving or you fall down.”

Regards,

Chris Mayer

for The Daily Reckoning