Tuesday, September 27th, 2011
broken charts

They are everywhere.  The charts of broken dreams.  OK, not everywhere, since “there’s always a bull market somewhere.”  Those that only own long bonds haven’t had the recent experience that others have had, although their time in the barrel will come one day.

What to do in response to that broken chart in front of you?  Well, there are sites galore that will give you advice on that.  If you’ve read the research puzzle before, you know you won’t get it here.  Instead, we’ll turn the tables and say that what you do with that broken chart will speak volumes as to what your real investment style is.

Thus, the timing of the recent brokenness is propitious, in that there’s a series in progress on this blog regarding indicators of investment style that are outside of the normal ones that you read about.the research puzzle | This PDF will be updated through the end of the series as each new posting is written. This posting can be boiled down to a question to ask of investment managers (regarding a current holding), “What do you do when faced with a broken chart?”

Those with strict price momentum disciplines should say that they get out.  More importantly, if you track their trades, they should demonstrate that they do just that.  The same goes for most technical traders, even if they don’t apply the momentum moniker to what they do.  If that’s not the case, then you have the workings of an important due diligence angle.

It is, however, the actions of fundamental investors in response to price breaks that are the most interesting.

There are some who profess a sales discipline that amounts to selling when a chart breaks.  I recall one former investment manager who came to a finance class I was teaching with a list of rules that his firm always followed in managing stock portfolios.  One of them was that if something went down 15% after purchase, it was sold.  Period.  (I often have wondered how that actually worked out in practice.)

Usually, fundamentalists resist that approach — and buy aggressively if they think that the thesis is still intact and they have cash on hand.  That results in famous stories like those about managers who stepped up during the crash of 1987 to buy good companies at very cheap prices.

Unfortunately, there are lots of examples on the other side of the ledger.  The dot-com crash provided a host of them, as some managers kept buying the stocks as they went lower and lower.  It happened during the same time frame with lots of big cap names, many of which subsequently fit the description of “yes, the thesis was still intact but we didn’t realize that the ridiculously high valuations could revert to more normal levels.”

And then there were a few calamitous examples of big-name asset management firms who didn’t see Enron for what it was and bought it all the way down.  Their reputations — and those of analysts who liked the company — were damaged greatly as a result.  Conversely, those who avoided the mess thrived, including fundamental analysts who figured out the ruse, momentum traders who sold the broken chart, and quantitative research firms and portfolio shops whose factor models essentially said, “price declines + cash flow issues = trouble.”  (For some of those quant research outfits, that one action provided years of marketing advantage versus their fundamental brethren.)

What is surprising to some is how important the technical picture is to many investment managers that are thought of as fundamental players.  I listened to a conference call the other day where the fact that “the chart looked like death,” to use the manager’s description, clearly affected his unwillingness to even look at the investment in question.

Broken charts are fodder for some very fruitful due diligence investigations.  What do managers say they’ll do in response to one?  Will there be an automatic action?  Will there be a more intense look at the investment, with new sources of information and an examination of theses contrary to theirs?  Or will there be reflexive buying?

Then, what do they actually do in comparison to what they said they’d do?

If you want a way to classify managers that gets at what differentiates one from another, you could do worse than starting with those questions and the subsequent evidence found on a trail of broken charts.