The 2-Minute Thought: Avoiding Crowded Exits

Since volatility and fear have returned to the market, there has been a lot of talk about where you might hide if things get really bad.  Suggestions span the gamut: Cash, gold, put options, and various selections of large-cap “safe” stocks are some recent ones I’ve read about.

Here’s another thought -- not just for now, but as a general principle: Avoid crowded exits.  In other words, avoid those popular places where things could get ugly if everyone tries to escape through the same tiny door at the same time.

The problem is that there are a lot of crowded places now: Passive index funds, bonds, and FAAMA (Facebook, Apple, Amazon, Microsoft, Alphabet), to name a few if you’re looking for examples. 

Last October, The Economist featured a cover with the title “The bull market in everything,” and for some time, there has been talk of an “everything bubble.”  Stocks around the world have done well.  Bond credit spreads have narrowed.  Then there’s London and New York real estate.  

It may seem like there aren’t a lot of uncrowded places, but there always are.  Not too many people talk about commodities now -- or certain bricks-and-mortar retailers.  And there always are those tiny stocks that aren’t in the news and are too small for big investors but can work fine for individuals.

The thing is, it takes hard work to find uncrowded places.  That work doesn’t show so well when indexes keep rising without hiccups – but it can when the hiccups start.

Value investing has always been our way for finding uncrowded places.  As value investors, we’ve always practiced looking for what is unpopular.  The principle is simple: Unpopular assets are already so cheap and beaten up that more bad news means they don’t get punished too much more, while any positive news is so unexpected that gains can be outsized. 

Low expectations are a wonderful thing, and there’s good reason to think that investors of all stripes should start paying more attention to value.  But the warning is that the practice is not so simple.  Value investing is not just a matter of looking for low price-to-book or price-to-earnings stocks.  That would be too easy.

In a recent interview with investor community SumZero, Michael Mauboussin pointed out that “there has been a simplistic association between value investing and the basic idea of buying statistically cheap stocks.”  But that isn’t quite right.   

His point is that people often equate value investing with the low price-to-book or price-to-earnings ratios that Fama and French identified in their famous 1992 paper as factors associated with excess returns.  But value investing is really just about buying something for less than it’s worth.  

Focusing on cheap price-to earnings or price-to-book ratios, Mauboussin says, leads to two mistakes: “The first is buying a statistically cheap stock that deserves to be even cheaper.  That’s a value trap.  The second one is shunning a statistically expensive stock that represents a good value.” 

Avoiding these twin errors is what takes such hard work.