How I’ve Made 86.86% Since Jan. 1

Truth be told, I’ve been on a roll lately. Two of the stock picks in my trading service Bull Market Alert have soared 86.86% and 81.83% since Jan. 1.

If that sounds impressive, I modestly agree. I don’t think I’ve made this much in any stock I’ve been invested in since the go-go days of the Russian stock market in 1996.

That said, I’m not one to “confuse brains with a bull market.”

That perspective makes the story of how I picked these two stocks more complicated and interesting. It’s also a terrific case study on the challenges of contrarian investing.

Here’s a quick outline of those challenges…

First, going against the grain of popular opinion is tough. We professional investors all like to think we’re contrarians. But we flatter ourselves. Remember when the market was collapsing in August of last year? My phone was ringing off the hook, with concerned clients afraid that their retirement funds would disappear in a repeat of September 2008. Meanwhile, Warren Buffett was buying stock “with both hands.” That’s not the way most professional investors acted.

Second, you have to be right. Just because a stock is beaten down does not mean it ever has to go up again. Consider the fate of Internet incubator CMGI — a company whose stock once boasted a market cap of over $40 billion and that also bought the exclusive naming rights in 2000 to the stadium where the New England Patriots play. As the company’s business deteriorated, it gave up its exclusive naming rights to the stadium in 2002. In 2008, the company changed its name to ModusLink Global Solutions and today boasts a market cap of $250 million. Sure, you could have bought CMGI after its massive plunge. But ultimately, you would have lost your shirt.

Third, even if you are right, your timing could be off. “Don’t catch a falling knife” is one of the tried and true axioms of investing. Yet, if you are a contrarian, you end up buying a stock that may head a lot lower. And here’s a confession: I didn’t recommend my two stocks on Jan. 1 either.

The investment management graveyard is chock full of folks who have held on to a stock that keeps going down and down and down. Even if the money managers end up being “right,” they endure such steep losses that their investors abandon them and they close up shop. Such seems to be the case with former hedge fund all-stars like John Paulson and Phil Falcone, whose major funds endured horrific 40%-plus drops in 2011.

So, what were the two stocks that have soared so high in 2012?

They were two bold bets on European banks — specifically, the National Bank of Greece (NBG) and Bank of Ireland (IRE).

Now, you’d be hard-pressed to come up with two more contrarian bets. After all, both Ireland and Greece are charter members of Europe’s “PIGS” — the troubled countries of Portugal, Ireland, Greece and Spain. And financial institutions are among the unsafe investments during times of financial crisis. Witness the fate of Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual and others in the United States.

And these two European bank stocks were the two leading financial institutions in countries on the verge of bankruptcy. So, why did I recommend them?

My basic investment thesis was that the European Union (EU) is a political, not economic, project and that Brussels ultimately would not let any of its euro-zone members go bust. I also assumed that when push came to shove, the EU had the economic resources to bail out its smaller members.

Could I be 100% sure about this? Of course not!

But importantly, I made the recommendations with the following caveats.

First, I made it clear that you should treat each of these investments as a “lottery ticket.” If they paid off, they would pay off big. But if they didn’t, you’d lose everything.

Second, I said you should treat these investments as you do options — without an expiration period. That situation means enduring stomach-churning volatility, both on the up and down side.

Finally, I urged my subscribers to keep their bets small. Just like you wouldn’t put your entire investment portfolio into lottery tickets, you should only invest as much in these stocks as you could afford to lose.

All of these caveats relate to the importance of position sizing — that is, not betting too much on any single idea, no matter how compelling it may seem. It’s a lesson that a surprising number of top hedge fund managers — apparently including John Paulson and Phil Falcone — do not really understand.

So, after racking up such huge gains, where do these stocks stand today?

First, it’s not as if National Bank of Greece (NBG) and Bank of Ireland (IRE) are in the free and clear. Greece has yet to agree to the terms of the next tranche of its bailout (deadline Feb. 13). If it doesn’t, and Greece goes into “hard default,” the recent gains in National Bank of Greece (NBG) can disappear as quickly as they came.

I am much more bullish on the Bank of Ireland (IRE), which already has attracted investment back in July from billionaire contrarian investors like Wilbur Ross and other sophisticated private equity investors. Ireland, unlike Greece, has probably turned the corner economically, and its economy was the second-fastest growing in Europe in 2011.

Here’s the bottom line? Contrarian investing is a lot harder than it looks. So strap yourself in for a wild ride.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru