Thursday, September 15, 2011

Davis New York Venture Fund Update: Financial Innovation, Fishing Tackle, Destructive Investor Tendencies, Equities, & Bonds

Some excerpts from the latest Davis Funds semi-annual review:

Davis New York Venture Fund Top Five Holdings: American Express (AXP), Costco (COST), Bank of New York Mellon (BK), Occidental Petroleum (OXY), and Wells Fargo (WFC).

Financial Innovation
...the fact that successful investors are constantly adapting to new information does not mean that the underlying principles of economics and investing are called into question or that common sense has been repealed. While we have our biases, it seems to us that many of today's "innovations" are simply ways for promoters of one type or another to generate more transactions, charge higher fees or simply make more money at the expense of the investing public.

Well, it's usually either a way to generate fees or a new form of leverage in some new form. From John Kenneth Galbraith's bookA Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith

More from the semi-annual review...

Fishing Tackle
..hucksters market so-called "tools" and "strategies" for trading stocks, options, ETFs, commodities, and more. What these tools and strategies have in common is that the people selling them will get paid whether the buyer makes or loses money. Get-rich-quick schemes and day trading strategies in which promoters capitalize on hopes, dreams and greed are nothing new. Investors would do well to remember Charlie Munger's wonderful story in which he says "I think the reason that there is such idiocy is best illustrated by a story I tell about the guy who sold fishing tackle. I asked him, 'My God, they're purple and green. Do fish really take these lures?' And he said, 'Mister, I don't sell to fish.'"

A study* was published this year by professors at Harvard and Emory. It concluded that the "timing and selection penalty" cost hedge fund investors 3% to 7% per year from 1980 to 2008. These destructive investor tendencies come from chasing performance: 

Timing and Selection Penalty
According to the study, "We find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns [earned by hedge-fund investors] are reliably lower than the return of the S&P 500® Index and are only marginally higher than the risk-free rate…

On Equities
...we think long-term investing in a carefully constructed portfolio of high quality equities is still the best way to build and protect wealth over decades. We would even argue that the very fact that it has become unfashionable increases the likelihood of a satisfactory outcome given that investment fads are a notoriously reliable contrary indicator.

Bonds = "Return-free Risk"
...it seems certain that a significant amount of optimism and euphoria is incorporated in bond prices, presaging the likely demise of the long bull market in bonds. My grandfather Shelby Cullom Davis referred to bonds as "certificates of confiscation."

His dislike of bonds stemmed from the fact that for almost three decades ending in 1982, investors in bonds lost money on an inflation adjusted basis. While it is impossible to predict the short-term direction of interest rates, the fact that they are close to their historic lows at a time when deficits and commodity prices are soaring makes it almost certain the long-term direction will be up. To use Jim Grant's phrase, at today's prices, bonds represent "return-free risk."

I've always liked Paul Volcker's quip late in 2009 that automatic telling machines were the "single most important contribution" in the past 25 years because, unlike most financial innovation, at least they're "useful".

ATMs the Peak of Financial Innovation

Now, these new innovative tools and strategies peddled on the business news networks seemingly all day long no doubt benefit those who are selling them.

Whether they actually benefit the individual investor remains to be seen. I'm skeptical to say the least.

The "timing and selection penalty" noted above must be one of the costliest behavioral patterns in investing.

It continues to amaze that, often en masse, investors have this reliable pattern of buying large amounts of an asset class when it becomes popular (usually near the top) while avoiding buying the unpopular ones (near the bottom).

It's worth mentioning that Isaac Newton fell prey to this very pattern during the South Sea Bubble. So it's certainly not a lack of IQ that gets investors in trouble.

Isaac Newton's Nightmare

Here's essentially what happened: 

- Newton invests a small amount prior to the bubble 
- Newton exits happy in the early stages before the bubble really gets going having made some money 
- Newton sees his friends getting rich as the bubble does really get going 
- So Newton re-enters near the peak of the bubble with a lot of money 

Then, of course... 

- Newton exits broke after the stock then falls roughly back to where he had initially invested just a small amount of money

Previous post: Isaac Newton, The Investor

Assets not in vogue are more likely to have prices that provide an investor the crucial margin of safety or discount to value that is needed to manage risk.

So it would seem to be pretty straightforward then that investors would not generally get adequate compensation for the risks being taken when something is all the rage.

These days, things like bonds and gold most certainly seem very popular.

Equities, at least some of them, not so much.

That, of course, does not mean equity prices won't go down even further in the short or even intermediate run.

In fact, Jeremy Grantham points out that sensible value investors tend to "...buy too early in busts" and this post (Buffett Buys "Too Early", Again) covers how historically Buffett has, at times, done just that.

Still, buying a sound asset that you understand at a discount when out of favor improves the probability of attractive long run returns relative to the risks involved.

Adam

Long AXP and WFC

* Dichev, Ilia D. and Yu, Gwen, Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn (July 1, 2009). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN:http://ssrn.com/abstract=1354070
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