Value Library

The following is an excerpt from the ABC Perspective - January 2012 - Pg. 16

Risk, Reward and Crowd Psychology

Investing offers a direct relationship between risk and reward. In simple terms, the greater the risk an investor takes, the greater the reward should be. While there may be occasional exceptions to this rule, the general connection normally holds. The point is that while investment managers typically seek a return that exceeds their relevant benchmark, they accept the inevitable risks. In certain circumstances, this may result in a reported capital loss – which may either be realized or unrealized (i.e. “mark to market”), depending on whether the manager decides to exit the position.

To put this into context, sometimes winning investments can initially show a loss until a positive catalyst occurs – which can suddenly turn a losing position into a profitable one. In fact, three ABC Funds stocks that were taken over in 2011 initially showed losses until their fundamental, intrinsic worth was unlocked by a strategic acquisitor. These companies included: Vector Aerospace, Daylight Energy and March Networks. In retrospect, we took a different perspective with regard to the purchase of these undervalued securities. However, we were severely tested by all three stocks despite their frustrating, deeply discounted valuations. In effect, we took a minority view and were forced to be remarkably patient until a positive transformational event occurred. This critical point leads us to a prime secondary but all-important issue of crowd psychology:

“For most people there is a tendency to be influenced by the opinions and judgments of others. Human nature dictates that we seek approval from our peers. Thus people develop similar thought and behavior patterns. Majority opinions therefore constitute the mainstream point of view. Unfortunately, the investment process does not accommodate the majority. Financial success appears to be reserved for the creative minority; in other words, those who dare to be different seem to receive the rewards.”

Carroll D. Aby Jr., Point & Figure Charting

In summary, a successful investment process is neither easy nor straight line. Investors are constantly tested by a fickle marketplace fraught with conflicting micro and macro issues. Accordingly, it should be remembered that the road to investment success can be long and arduous. It is a marathon and not a sprint. Moreover, having conducted significant fundamental research and analysis, one should not be dismayed by unrealized initial losses, particularly with regard to contrarian investments. Invariably, a heavy dose of patience and stamina are required to go against the popular crowd psychology.

2011 was an extraordinarily difficult and complex investment year. The negative macro financial events in Europe and the constant fear of a double dip North American economic recession enervated investors. As we enter 2012, we remain remarkably upbeat with respect to our deep-value stock selections and the general economic outlook. In short, we believe that the current perceived risks are well worth the future significant rewards.

Irwin A. Michael, CFA