Friday, October 17, 2014

John Bogle's "Relentless Rules of Humble Arithmetic", Part II

Back in 2007 at NYU, John Bogle talked what he calls his "second relentless rule of humble arithmetic."

During his remarks he said that: "Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital. Dividend yields, plus earnings growth, account for substantially 100 percent of the return on stocks."

Here's a post on the first rule.

Bogle then references -- with the wording only slightly altered -- something that Warren Buffett once wrote.

Bogle's version:

"The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns..."*

Bogle calls this "the central reality of investing" then goes on to also mention the following from Buffett:

"When the stock temporarily overperforms or underperforms the business, a limited number of shareholders—either sellers or buyers—receive outsized benefits at the expense of those they trade with."

A whole lot of time and energy goes into trying to gain at the expense of other market participants when the focus really should be on what the businesses themselves produce in value over time. Bogle adds:

"How often investors lose sight of that eternal principle!"

Consider this as many expend lots of effort -- while incurring lots of frictional costs -- attempting to speculate on where the stock prices might be going in the near-term. If the emphasis was instead on the cash an asset can produce over a longer time frame (i.e. the fundamentals that determine intrinsic value) many participants would likely end up better off.**

More from Bogle:

"History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense?

Need proof? Just look at the record since the twentieth century began. The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year arose from what I call speculative return, depending on how one looks at it. Perhaps it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the period than at the beginning."

I personally never have any idea what the stock market is going to do nor do I even spend a moment thinking about it. The same goes for macroeconomic factors. Will the market drop dramatically? Will it rally? How will the global economy perform in the next 12 months? The only thing I feel reasonably comfortable with when it comes to prognostication is that's it's usually wise to ignore the prognosticators.

That's why I've not once attempted to forecast or predict anything. The good news is that a sound investment approach doesn't require such forecasting abilities. Lately, the markets have fluctuated a bit more intensely and, as a result, the investing world probably seems to have become more unpredictable, uncertain, and risky. I say "seems" because the future is always unpredictable and uncertain. It's merely the perception of that unpredictability and uncertainty that changes.

No doubt many will continue to try and figure out how the economic outlook might be changing and what the markets will do next despite the futility of doing so.

I think Morgan Housel recently made this point very well:

"The four most important words in investing are probably, 'I have no idea.'

I have no idea what the market will do next.

I have no idea if we'll have a recession this year.

I have no idea when interest rates will rise.

I have no idea what the Fed will do next.

Neither do you.

The sooner you admit that, the better."

Charlie Munger once explained it this way:

"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

Some act as if they can read the macroeconomic tea leaves and reliably make effective investing decisions based upon that reading. Others seem to think it's possible to guess what the markets are going to do in the near-term in a way that will produce attractive overall results (their emphasis is on price action). Of course, it's certainly possible that some participants actually get good results this way. Yet I suspect that those who actually pull it off is a very small number compared to those who attempt to do so.

The good news is that judging macroeconomic factors, and guessing what the markets are going to do near-term, isn't what really matters for those of us who invest with the long-term in mind. What matters is whether you can judge the value of a business and buy it cheap enough so there is enough protection against what might go wrong.
(In many cases the worst possible outcome is unacceptable -- or too difficult to understand -- making avoidance of an investment altogether the right course of action. In other words, no price is low enough.)

Let's say the equity markets do eventually fall dramatically from current levels.***

Well, then the shares of some great businesses should temporarily become much cheaper to buy.

How's that a bad thing unless selling is required in the near-term?

Prices fluctuate far more than intrinsic business values, and reduced prices become an ally when someone is justifiably confident in their estimate of value.

A sound investment process should include the disciplined pursuit of the largest possible margin of safety. Generally speaking, if market participants become unusually concerned about future prospects then the likelihood of finding shares at a big discount to value will increase.

The cheaper the better as long as the intrinsic business qualities have been mostly judged well. It's, in part, learning to ignore the quoted prices of what's owned for the long-term and, instead, focusing on what can be bought at attractive prices. That means being ready to act when others are less inclined to do so.

There may be no way to eliminate investing mistakes but, via things like margin of safety and an awareness of limits, there are ways to reduce the quantity and costliness of those mistakes.

Focus on what businesses can produce in cash over time -- and, as a result, what they're intrinsically worth -- instead of how shares might be trading day to day.


Related posts:
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Warren Buffett, earlier this year, said something very similar in a CNBC interview: " the end, a stock today is worth all of the cash you can distribute between now and Judgment Day."
** With the vast majority of participants underperforming the markets as a whole -- despite all the unnecessary effort -- this seems rather evident. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
*** A near certainty but, practically speaking, attempts to figure out when the market will decline should be viewed as distraction and, again, an exercise in futility.
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