Look where few others are looking

In order to come up with investments that will out-perform the market, an analyst must do two things:

1. Have an opinion that differs from the market consensus.

2. Be correct in that opinion.

 This probably seems absolutely obvious when I put it on the page in front of you, but when it comes to investing, few people follow these tenets.  First of all, by definition, most people *can’t* have a nonconsensus opinion; if they did, then that opinion would be consensus.  It’s a catch-22.

 Also, it is simply emotionally difficult for most people to hold an option that differs from their friends and family.  As my mom once said, “Everyone likes to be validated.”

 It may be great for your social life to agree with the people around you, but it’s a lousy way to invest.  Here’s why: when most market participants think that a particular stock or sector is a good buy, then a lot of them have already bought and are waiting for it to go up.  There aren’t many people left to buy.  When the stock or sector becomes less popular, the same people will start to sell, and it will decline.

 To produce above average returns, you have to buy before everyone else has, and sell before they do.  This means buying something when it still can become more popular, and selling while most market participants are still excited about it.

 How can we do that?  By developing an understanding of consensus opinion (the popular press is great for this), and figuring out where they are wrong (which can be accomplished by paying attention to sources of information outside the popular press (when was the last time you read a cutting-edge academic paper) or by putting together lots of different pieces of information that others have yet put together.

It’s not enough to simply hold an unpopular opinion.  Unpopular and wrong can lose you a lot of money as well.  For instance, if a little birdie told me that the whole mess in Iraq would resolve itself tomorrow, I’d probably sell the stock of a bunch of defense companies.  If instead the mess over there gets worse (which is pretty close to consensus opinion in my circles,) and the Pentagon puts in more orders for munitions, all those stocks I just sold would go up, and the person who sold those stocks expecting a spontaneous outbreak of peace wouldn’t be a very happy investor.

 When considering investing in the Energy sector, the first question to ask is, is the market over- or underestimating future energy prices?  If you think the market (by which I mean the consensus of opinion of market participants) is overestimating, then you should sell or stay out, if you think the market is underestimating, then it’s time to increase your energy allocation.

What do I think?  In the long term (a decade or two) I’d say the market is underestimating, but in the short term, it’s probably overestimating.  Conclusion: it’s probably best to wait for a pullback before allocating a serious amount of money into the energy sector, but it’s probably worth slowly dribbling a little money in, which I like to do using Cash Secured Puts , while I wait for a pullback in energy stocks.

Renewable energy has been getting a lot of press recently, so this also makes me shy away from stocks that are obviously in the sector… if the company has “Solar” or “Ethanol” or “Wind” in its name, I think it’s time to stay away, even after the recent small pullback.   I prefer the suppliers to the renewable energy companies, and companies involved in energy efficiency (which not only has better economics than most renewables, but fewer people are excited about it. A search on Google News just turned up 4370 articles that mentioned “renewable energy” without mentioning “energy efficiency”, while there were only 2340 that mentioned “energy efficiency” without mentioning “renewable energy.”  Even renewable energy advocates say (occasionally as an afterthought) that you should consider energy efficiency measures before investing in renewable energy, so the fact the renewables are so much more popular is a sign that the consensus is confused: hence it makes more sense to invest in Energy Efficiency companies now, than it does to invest in renewables.

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