The Point of Maximum Despair

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Is there a chance that the resolution of Australia’s election will be good for stocks? Of course! Stocks, and the investors who buy them, hate uncertainty. By Saturday night, we’ll know for certain who the next do-gooder in Chief will be in Australia.

Although we’ve never passed a gall stone, it must be a little like enduring the platitudes of two insipid politicians making bland promises and trying desperately to conceal their true selves from voters until after they secure power. Only masochists and egoists would run for high public office, and neither quality makes for a good leader!

But stocks…what about stocks? Well, a Liberal win most likely means the end of the Mineral Resource Rent Tax (MRRT). You’d think the market would like that quite a bit. On the other hand, a Labor win would mean some version of the tax, and maybe a carbon tax as a concession the Greens and in exchange for their support.

We’re not commenting on the wisdom of these policies. But it’s not a big stretch to say that they won’t attract a whole lot of global investment capital.

But here’s an important point: the point of maximum despair (PMD) is usually a great time to be bullish. And by bullish, we mean optimistic. About anything in life. It’s a kind of psychological survival strategy. Please allow us explain.

What is the PMD and when do you know you’ve reached? It’s a little like U.S. Supreme Court Justice Potter Stewart’s definition of hard-core pornography. “It’s hard to define,” he said, “But I know it when I see it.” The PMD is like that too. It’s hard to define. But you know it when you feel it.

You feel it when you feel like things just can’t get any worse. You’re tired. You want to give up. Maybe you have given up. That’s the PMD.

We used to reach the PMD early in our career trying to write recommendations for small-cap stocks. Having come from a Liberal Arts program where we studied the Classics, it was a big-ask. We had yet to unleash our inner an inexhaustible energy and enthusiasm.

We failed a lot back then. Repeatedly. One particular story took eight drafts before our editor was satisfied. It was a story about a small U.S. company that owned the merchandise licensing rights to a Japanese children’s TV programme. The program became controversial in Japan because its rapid flashing bright lights were causing children to vomit and, in some cases, fall into epileptic fits.

We were intrigued.

The U.S.-based company we were writing about owned the rights sell merchandise licenses in America for the Japanese brand. The folks running the company had brought the Science Fiction channel to the American public. The channel catered to Star Trek geeks (like your editor) and other social misfits. It was a huge success (proving there are more misfits in the world than you might think) and its creators sold it for a profit and moved on to their next venture.

We don’t’ remember the exact headline we used when we recommended the stock as a buy in 1998. It could have been something like “Fat Yellow Alien-Looking Japanese Children’s Toy/Doll/Apparition to make small U.S. company millions.” We wrote that headline over and over until we were sure the story would never see the light of day.

“That’s good. You’ve reached the point of maximum despair. Your story’s done,” our editor said. “Let’s print it.”

We did. And the rest, as they say, was insane. You can see what happened based on the chart below, although that only tells part of the story. Recommended at around a dollar, it spilt 3-2 near $10 and then 2-1 at around $35. By the time it closed above $90 it was up nearly 5,000% on a split-adjusted basis from the original recommendation price.

What went right with the recommendation is that Pokémon – the Japanese property to which the U.S. company owned licensing rights – went supernova, in pop cultural terms. This taught us to never ridicule the outcome produced by a free market just because you don’t like it. The market is what it is. It produces outcomes that result from the decisions made by free people buying what they want at the price they’re willing to pay.

It was 1998. There was a lot of irrational exuberance going on. People wanted fat Pikachu figures. And to be honest, when you have a close look, who wouldn’t want on? Kids loved it. The stock price soared.

Pika…Pika…Pikachu!

In retrospect, what happened with the stock was emblematic of what happened to investors in the late 1990s: insanity. The stock became a proxy for the popularity of the merchandise. Its value was not tied, in anyway, to realistic earnings projections based on actual product sales. All of that is painfully obvious when you see how quickly the stock fell from its highs.

But your editor learned another valuable lesson from the exercise: let your winners ride. Convinced we were luckier than we deserved to be, we recommended a sell on the position after a quick double and before the stock split. It was the amateur decision of a rooky adviser scared by his own success (and not believing people would pay much more for a stock that, at the end of the day, was riding a crazy children’s fad that caused vomiting and epilepsy in extreme cases).

The world is a complex place. If you think you know what should happen, you’re probably wrong. That’s why trailing stops are so handy in shares. They take some of the emotion and human fallibility out of your sell decision. You let your winners ride and you move your stocks up. Lesson learned.

Since then, we have learned to embrace the point of maximum despair (PMD). Until you’ve reached it, it means you haven’t worked hard enough. And more importantly, once you’ve reached it, it usually means things are about to get better. Either that, or terminally worse, and there is nothing you can do about that anyway.

But the biggest lesson we learned from the Pikachu affair is that you should never underestimate the spirit of enterprise. It just doesn’t quit. That’s why, despite having to listen to the depressing and spirit-killing admonitions of professional politicians, we are essentially an optimist.

Politicians don’t’ create. And most of them have never spent a productive day of their life in private enterprise trying to create value. They wouldn’t understand the relentless spirit that drives people to improve their lives or go into business to accomplish their personal ambition and passion in life.

That’s why the first newsletter we decided to publish in Australia in 2007 was the Australian Small Cap Investigator. It wasn’t because we were trying to capture lighting in a bottle by starting up another small cap newsletter. It was because lightning is always striking in the small cap market.

The small-caps are the research and development laboratory of the free market. It’s the small companies out there on the margin and the frontier doing all the interesting things. “From little things, big things grow,” goes a catchy TV jingle. That’s true too.

For an economy to produce a steady stream of new starts up in ventures, the right conditions must exist. In fact, for an economy to produce an astonishing variety of products and sheer abundance, you have to have certain conditions. Namely: the rule of law (not men and women), honest money, secure private property, and low taxes. The further an economy moves away from those things, the less prosperous it will be.

If you thing complexity can’t come from simplicity, play chess! There are only about two dozen rules that govern how the 32 pieces can move on a 64 squares of a chessboard. People have been playing it for thousands of years. Yet these few simple rules, easily understood by anyone, produce a nearly infinite variety of chess games. Simple systems produce a huge variety of complex results.

The economic is not a chess game. But to the extent that it has simple rules understandable to everyone, it IS a complex adaptive system. And in that system, the most interesting and potentially profitable companies are often the newest, riskiest, most disruptive, and most unproven. Perhaps that is why we’ve always had a soft spot for the small caps in our sceptical heart.

Even at points of maximum despair in markets, the sheer energy of innovators is hard to suppress. Twice in the last two years, Kris Sayce (the editor of the small-cap letter) has decided to buy stocks at the height of a global financial panic, when everyone else despaired and was frozen by inaction. Kris kept it simple both times and some of his readers made gains both times.

We’ve asked Kris how he spots a good small cap punt. But he answers the way Justice Stewart answered: “I know it when I see it.” We have deduced from this oracular answer that Kris is doing three things every time he makes a successful recommendation. We’ll present them to you now.

First, he’s finding a big, disruptive idea where future profits are driven by a particular set of events. In 2008, for example, it was the emerging coal-seam-gas (CSG) boom in Queensland. It was not on any one’s radar. And Kris got nasty e-mails from readers accusing him of flim-flammery for promising to show them how to make money out of “thin air.”

“Thin air” referred to liquid natural gas. And Kris’ big-picture observation was that Asian utilities were signing long-term LNG deals with conventional suppliers. The unconventional LNG sources like coal-seam-gas were being unveiled. And Kris rightly took a punt on them.

But then he did something unusual. He kept punting. This is what we now refer to as “owning a portfolio of experiments.” Rather than put all his eggs in one CSG basket, Kris recommended several stocks. Each had different risks and different prospects. Finding a potential valuation of a start-up company that doesn’t have a product or customers is a bit iffy.

However the strategy (CSG) and the tactic (own a few plays instead of just one) both worked. Kris’ readers could have banked triple digit games on any number of stocks. He had correctly – at the point of maximum despair in the market – picked a great new idea that he reckoned was both a good business and a good punt.

The third and final part of his method came from experience: trailing stops. There’s no use being right and making a big gain if you give it all away when the market falls. So Kris told his readers how, if they weren’t already using them, to use trailing stops to “lock in” profits on open positions.

Despite your editor’s general belief that in a deleveraging world it’s going to be very hard for “the market” to go up, Kris managed to replicate his LNG feat recently with another industry sector. In this case, the dynamics driving the shares up were almost totally different to LNG. But you find that in the small cap universe, each and every business is unique.

What the good ones (the survivors) all have in common is that you can easily understand what they do and how they will make you money. Kris seems to be able to lock onto these two question and they figure in all the stories he writes. And he is not daunted when everything else seems to be going to hell, which is good.

Geeky or learned students of Austrian Economics will recognise profiting from financial disaster in Joseph Schumpeter’s phrase “creative destruction.” Schumpeter was referring to the incessant process by which winners are made and losing businesses are punished a truly free market. This great threshing of the business world produces better companies, more profits for shareholder, and ultimately, more and better goods and services for consumers and cheaper prices.

Critics of the free market – generally unhappy with specific outcomes – are wholly ignorant of the incredible variety and wealth of choice it produces. That’s why they are usually so busy going about reducing your choice and freedom; to save you from a complex world, and probably from yourself.

Trust them. It’s for your own good.

So the election is coming. And probably the result will be a disaster. And if not now, then surely Australia will be caught up in the violent death throes of heavily armed fiat-money driven Welfare State. It’s a dangerous disastrous world we live in. It’s going to be a premium on financial survival strategies that actually work.

But don’t’ despair! Or if you do, rejoice! It means things can get better faster than you think. You can’t keep a good idea down, thank goodness.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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