Roughly five years ago, Jeremy Grantham said the following about what he calls "quality stocks".
"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."
When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".
He then adds:
"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"
The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*
So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.
From Investopedia:
"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."
So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.
Brett Arends explains it this way:
"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.
This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.
The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."
Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).
The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.
Here's how Howard Marks explains it:
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
Howard Marks on Risk
So risk and return need not be positively correlated.
It's simple, important, and too often ignored.
In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**
"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."
The math is obviously pretty simple but let's quickly walk through this:
A dollar bill is found on the ground by two people.
It's probably real.
It might not be.
One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).
The second is willing to pay 40 cents.
Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.
The second person can make 150%, if real, and lose the 40 cents, if not.
Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.
To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.
It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).
So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.
Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.
Adam
Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
-Defensive Stocks?
* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 31, 2014
Friday, October 24, 2014
Buffett on Investing Mistakes
There have been plenty of headlines lately about things not going Warren Buffett's way -- at least in the short-term -- with some of his investments.
As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:
"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:
"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."
Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.
IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.
Of course, some could fairly argue that IBM has already been a mistake.
It might just prove to be.
To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.
Check out some of the recent headlines:
Warren Buffett just lost about $ 1 billion on this
Warren Buffett just lost ANOTHER $1B on this
Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM
Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.
In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)
I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.
Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.
It's not about quarterly results.
It's absolutely not about what the stock does in the next few days, weeks, or even years.
It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.
My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**
Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***
Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.
Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.
So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.
It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.
Some might choose to focus on investments that went right and gloss over those that did not.
Successful investing requires a serious assessment of what didn't go right and why.
I'd add that few of us are able to understand how to value lots of different businesses.
"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview
For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.
Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.
I'm always impressed when someone responds with something along the lines of "I don't know".
Adam
Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.
Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks
* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:
"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."
IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:
"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."
Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.
IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.
Of course, some could fairly argue that IBM has already been a mistake.
It might just prove to be.
To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.
Check out some of the recent headlines:
Warren Buffett just lost about $ 1 billion on this
Warren Buffett just lost ANOTHER $1B on this
Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM
Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.
In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)
I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.
Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.
It's not about quarterly results.
It's absolutely not about what the stock does in the next few days, weeks, or even years.
It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.
My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**
Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***
Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.
Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.
So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.
It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.
Some might choose to focus on investments that went right and gloss over those that did not.
Successful investing requires a serious assessment of what didn't go right and why.
I'd add that few of us are able to understand how to value lots of different businesses.
"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview
For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.
Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.
I'm always impressed when someone responds with something along the lines of "I don't know".
Adam
Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.
Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks
* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.
** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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.
Adam
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Warren Buffett, earlier this year, said something very similar in a CNBC interview: "...in 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.
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!"
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.
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.
Adam
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Warren Buffett, earlier this year, said something very similar in a CNBC interview: "...in 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.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 10, 2014
Index Fund Investing Revisited
From the 2006 Berkshire Hathaway (BRKa) shareholder meeting:
Warren Buffett: If your pipes leak, you should call a plumber. Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?
Charlie Munger: I can't think of any.
How many years would a novice need to study and practice to be able to perform at a higher level than 80% to 90% of doctors?
I'm guessing most of us would have to study and practice for a very long time just to become reasonably competent (never mind top-tier).
For most other professions the answer will be not be much different.
How many years would a novice have to study and practice to be able to perform at a higher level than 80% to 90% of market participants, including the professionals?
Well, none as long as they stay away from trying to actively trade -- both individual stocks and funds -- and this includes, at least in a lot of cases, relying on others to actively manage their money.
When the pipes are leaking...call a competent plumber. The expertise is likely to be well worth it.
In contrast...
"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers
So what's the right way to fix a portfolio that has underperformed?
Those that buy index funds consistently over time -- and learn to ignore near-term price action -- are in fact likely to perform better long-term than most market participants. There's enough evidence out there to more than suggest that the index fund, with basically little or no skill required, can actually move someone toward top-tier in terms of long-term investment performance. (Top-tier in terms of relative performance but, depending on overall market valuation levels, maybe not absolutely all that great.) It's at least a bit odd that some would consider only matching the market's performance somehow unsatisfactory when that result is better than 80% or 90% of active managers.
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.
So, while there's realistically no way to perform better than vast majority of doctors (or plumbers) without the appropriate skills, knowledge, and experience, the index fund offers a rather straightforward way to perform better -- or, at least, increase the likelihood of performing better long-term -- than the vast majority of market participants including the professionals.
Yet, despite this reality, too many market participants will still try to beat the markets. One of the reasons for this is that investors tend to overestimate their own performance. A study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."
I'm sure many think that overestimating investment results is what someone else tends to do; that it must be someone else's problem.
Maybe.
Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."
The tough part is remaining aware of what is an "observation bias, where people see themselves differently than they really are."
Some will overestimate their own performance to justify the effort when they could have just bought an index fund and focused their energy on something more productive.
Brett Arends recently offered why index funds often make so much sense for investors. It's certainly not because he thinks the markets are somehow efficient (nor do I). Here's how he explains it:
"I believe the market can be wrong, even wildly wrong, for long periods—and often is. So I don't believe a portfolio of random stocks or index funds is necessarily the best investment solution. But it’s pretty good if done right. It involves low costs, and immunizes you from the emotional challenges of investing. And it's especially good for big institutions, as it avoids most value-destroying limitations and complications."
Most investors will not outperform, for example, the Dow Jones Industrial Average. I bring up this particular index for a reason. It's the use of the word "average". An index fund might merely guarantee that the investor will match the market, but, maybe the word "average" in this context is what helps create the wrong impression. It may be a market average, but it hardly represents an average performance when compared to the results of all participants.
So matching a market average isn't the same as getting an average outcome. In fact, it's probably better to not think of a market index as an average at all. It implies a result that's in the middle of a normal distribution when the actual outcome is much better than that.
"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
The right kind of temperament certainly helps:
"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger's
Outside of investment management there's no "index fund" equivalent that enables a novice to match -- never mind exceed -- the performance of most professionals.
Investment management is unique in this way.
Far too many who could benefit from this reality end up not doing so.
The bad news is that market valuations have become a whole lot higher in recent years. So that naturally means it's tougher to buy with a sufficient margin of safety. Unfortunately, some will get interested in buying stocks (or a fund) just when they're not nearly as attractive to buy. Successfully timing the market is easier said than done. That reality doesn't make understanding how prevailing market prices compares to per share intrinsic value irrelevant. Attempting to time the market is a waste of energy. Attempting to understand how price compares to value is not. For those who don't feel comfortable with judging value, consistently buying an index over time ends up being more than a reasonable alternative. Unfortunately, history suggests the pattern will often end up being increased buying during the good times (i.e. when stocks are usually more expensive) and selling during the not so good times (i.e. when stocks are usually cheap).
That's a tough way to get results.
At a minimum, considering the current valuations of many stocks, the expectations of future returns need to be much reduced. At least that's the case until the next bear market.
In other words, the next inevitable bear market should be thought of as the long-term investors best ally.
"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis
Ben Graham long ago said that investors should consider themselves "enviably fortunate" the next time a long bear market occurs. For someone with a long time horizon -- let's say 20 years or longer -- lower market prices in the near-term are a very good thing. Buybacks become more effective. More shares can be accumulated at a bigger discount over time. A severely down market is only a bad thing when someone has put money at risk in the equity markets and needs the money now.*
Well, short-term money shouldn't be in the equity markets in the first place.
Attempting to predict when the next bear market will occur is folly. Just remember that bear markets are not at all a bad thing if the investment time horizon is long enough.
Of course, there are many capable individual investors who buy individual stocks and perform very well.
It's just that an investor with the right temperament and an awareness of limits can do just fine lacking the necessary investment skills, knowledge, and experience using index funds. This just doesn't exist for other professions. To me, it's not just the novice investor who should carefully give this consideration. More than a few investment professionals, at least based upon the number who underperform, would be wise to do the same.
(Even if, realistically, justifying and earning fees is a big factor.)
Many will no doubt continue to invest (or, worse yet, actively trade) in individual stocks in an attempt to outperform the markets. The temptation will prove irresistible for some and will likely be, at least for most of them, not necessarily very fattening in a financial sense. Naturally, some are and will be very successful buying individual stocks. Yet, with so many underperforming the market as a whole, more obviously think they are good at balancing investment risk and reward than actually are good at it.
This is why temperament and a realistic assessment of one's own limits comes into play.
Overconfidence is very expensive.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
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
Charlie Munger: Focus Investing and Fuzzy Concepts
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Unfortunately, since market prices have risen a bunch in recent years, that means expectations of forward returns for the market is necessarily much reduced. Less margin of safety (if any) and less potential reward. Those with a long-term investing horizon shouldn't be cheering as the market goes higher. They should be hoping that market prices relative to per share intrinsic values becomes more favorable again. That's why bear markets are a good thing for those with a long investment horizon. So, essentially, indexes are likely to do relatively better than most active participants but it seems wise to assume that the absolute results from these current levels won't end up being all that wonderful. Losses, even if only temporary, are much more likely near current valuations. The market can, of course, go on to become even more expensive but the risks will be increasing. Things seem more risky during a bear market but that's simply not the case. Price can be the great regulator of risk.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Warren Buffett: If your pipes leak, you should call a plumber. Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?
Charlie Munger: I can't think of any.
How many years would a novice need to study and practice to be able to perform at a higher level than 80% to 90% of doctors?
I'm guessing most of us would have to study and practice for a very long time just to become reasonably competent (never mind top-tier).
For most other professions the answer will be not be much different.
How many years would a novice have to study and practice to be able to perform at a higher level than 80% to 90% of market participants, including the professionals?
Well, none as long as they stay away from trying to actively trade -- both individual stocks and funds -- and this includes, at least in a lot of cases, relying on others to actively manage their money.
When the pipes are leaking...call a competent plumber. The expertise is likely to be well worth it.
In contrast...
"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers
Those that buy index funds consistently over time -- and learn to ignore near-term price action -- are in fact likely to perform better long-term than most market participants. There's enough evidence out there to more than suggest that the index fund, with basically little or no skill required, can actually move someone toward top-tier in terms of long-term investment performance. (Top-tier in terms of relative performance but, depending on overall market valuation levels, maybe not absolutely all that great.) It's at least a bit odd that some would consider only matching the market's performance somehow unsatisfactory when that result is better than 80% or 90% of active managers.
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.
So, while there's realistically no way to perform better than vast majority of doctors (or plumbers) without the appropriate skills, knowledge, and experience, the index fund offers a rather straightforward way to perform better -- or, at least, increase the likelihood of performing better long-term -- than the vast majority of market participants including the professionals.
Yet, despite this reality, too many market participants will still try to beat the markets. One of the reasons for this is that investors tend to overestimate their own performance. A study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."
I'm sure many think that overestimating investment results is what someone else tends to do; that it must be someone else's problem.
Maybe.
Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."
The tough part is remaining aware of what is an "observation bias, where people see themselves differently than they really are."
Some will overestimate their own performance to justify the effort when they could have just bought an index fund and focused their energy on something more productive.
Brett Arends recently offered why index funds often make so much sense for investors. It's certainly not because he thinks the markets are somehow efficient (nor do I). Here's how he explains it:
"I believe the market can be wrong, even wildly wrong, for long periods—and often is. So I don't believe a portfolio of random stocks or index funds is necessarily the best investment solution. But it’s pretty good if done right. It involves low costs, and immunizes you from the emotional challenges of investing. And it's especially good for big institutions, as it avoids most value-destroying limitations and complications."
Most investors will not outperform, for example, the Dow Jones Industrial Average. I bring up this particular index for a reason. It's the use of the word "average". An index fund might merely guarantee that the investor will match the market, but, maybe the word "average" in this context is what helps create the wrong impression. It may be a market average, but it hardly represents an average performance when compared to the results of all participants.
So matching a market average isn't the same as getting an average outcome. In fact, it's probably better to not think of a market index as an average at all. It implies a result that's in the middle of a normal distribution when the actual outcome is much better than that.
"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
The right kind of temperament certainly helps:
"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger's
Outside of investment management there's no "index fund" equivalent that enables a novice to match -- never mind exceed -- the performance of most professionals.
Investment management is unique in this way.
Far too many who could benefit from this reality end up not doing so.
The bad news is that market valuations have become a whole lot higher in recent years. So that naturally means it's tougher to buy with a sufficient margin of safety. Unfortunately, some will get interested in buying stocks (or a fund) just when they're not nearly as attractive to buy. Successfully timing the market is easier said than done. That reality doesn't make understanding how prevailing market prices compares to per share intrinsic value irrelevant. Attempting to time the market is a waste of energy. Attempting to understand how price compares to value is not. For those who don't feel comfortable with judging value, consistently buying an index over time ends up being more than a reasonable alternative. Unfortunately, history suggests the pattern will often end up being increased buying during the good times (i.e. when stocks are usually more expensive) and selling during the not so good times (i.e. when stocks are usually cheap).
That's a tough way to get results.
At a minimum, considering the current valuations of many stocks, the expectations of future returns need to be much reduced. At least that's the case until the next bear market.
In other words, the next inevitable bear market should be thought of as the long-term investors best ally.
"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis
Ben Graham long ago said that investors should consider themselves "enviably fortunate" the next time a long bear market occurs. For someone with a long time horizon -- let's say 20 years or longer -- lower market prices in the near-term are a very good thing. Buybacks become more effective. More shares can be accumulated at a bigger discount over time. A severely down market is only a bad thing when someone has put money at risk in the equity markets and needs the money now.*
Well, short-term money shouldn't be in the equity markets in the first place.
Attempting to predict when the next bear market will occur is folly. Just remember that bear markets are not at all a bad thing if the investment time horizon is long enough.
Of course, there are many capable individual investors who buy individual stocks and perform very well.
It's just that an investor with the right temperament and an awareness of limits can do just fine lacking the necessary investment skills, knowledge, and experience using index funds. This just doesn't exist for other professions. To me, it's not just the novice investor who should carefully give this consideration. More than a few investment professionals, at least based upon the number who underperform, would be wise to do the same.
(Even if, realistically, justifying and earning fees is a big factor.)
Many will no doubt continue to invest (or, worse yet, actively trade) in individual stocks in an attempt to outperform the markets. The temptation will prove irresistible for some and will likely be, at least for most of them, not necessarily very fattening in a financial sense. Naturally, some are and will be very successful buying individual stocks. Yet, with so many underperforming the market as a whole, more obviously think they are good at balancing investment risk and reward than actually are good at it.
This is why temperament and a realistic assessment of one's own limits comes into play.
Overconfidence is very expensive.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
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
Charlie Munger: Focus Investing and Fuzzy Concepts
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
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again
* Unfortunately, since market prices have risen a bunch in recent years, that means expectations of forward returns for the market is necessarily much reduced. Less margin of safety (if any) and less potential reward. Those with a long-term investing horizon shouldn't be cheering as the market goes higher. They should be hoping that market prices relative to per share intrinsic values becomes more favorable again. That's why bear markets are a good thing for those with a long investment horizon. So, essentially, indexes are likely to do relatively better than most active participants but it seems wise to assume that the absolute results from these current levels won't end up being all that wonderful. Losses, even if only temporary, are much more likely near current valuations. The market can, of course, go on to become even more expensive but the risks will be increasing. Things seem more risky during a bear market but that's simply not the case. Price can be the great regulator of risk.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 3, 2014
Buffett: We Ignore the Macro Factors
Buffett on CNBC yesterday:
"We look at opportunities, as they come along, we try to figure whether we can understand the long term economic prospects of the business. A lot of times the answer is no, then we forget it. We are not making any judgment about where the market is going or we are not looking at any macro factors.
My partner Charlie Munger and I have been working together now 55 years. We've talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn't come up."
He then added:
"We don't get into macro. It just doesn't make any difference. We do decide whether we think we know where that business will be in 10 years or 20 years, and we know what we'll pay in terms of valuation."
Video: We don't look at macro factors: Buffett
With the above in mind, just consider all the time and energy that seems to be spent by experts who are trying to understand and predict what's going to happen based upon macro factors.
Munger once said "there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong."
and
"...I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.
So the two people who've had the most long-term investment success essentially ignore macroeconomics and focus on things can be understood.
That's hard enough to do reliably well.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"We look at opportunities, as they come along, we try to figure whether we can understand the long term economic prospects of the business. A lot of times the answer is no, then we forget it. We are not making any judgment about where the market is going or we are not looking at any macro factors.
My partner Charlie Munger and I have been working together now 55 years. We've talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn't come up."
He then added:
"We don't get into macro. It just doesn't make any difference. We do decide whether we think we know where that business will be in 10 years or 20 years, and we know what we'll pay in terms of valuation."
Video: We don't look at macro factors: Buffett
With the above in mind, just consider all the time and energy that seems to be spent by experts who are trying to understand and predict what's going to happen based upon macro factors.
Munger once said "there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong."
and
"...I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.
So the two people who've had the most long-term investment success essentially ignore macroeconomics and focus on things can be understood.
That's hard enough to do reliably well.
Adam
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, September 26, 2014
The P/E Illusion
"...alternative frames evoke different mathematical intuitions, and one is much superior to the other." - Daniel Kahneman in Thinking, Fast and Slow
This recent post covered why the long-term investor should actually prefer that the stocks they own for the long-term will underperform in the near-term and even intermediate term. In fact, maybe somewhat oddly, that investor shouldn't mind this even if (annoyingly) the stock drops meaningfully right after it has been bought.
Now, when a high price is paid, and the long-term outcome is dependent on speculative assumptions, this won't work. Assumptions that, while possibly even not unreasonable, cannot be known with enough certainty to narrow the range of outcomes.
Yet the real problem might be more about mathematical intuition and framing effects.
Think of it this way. Consider a stock with a price-to-earnings (P/E) of 100. Naturally, a stock like that must have significant growth prospects if it's going to work out well for owners. There's just not enough current earnings relative to price to provide a meaningful tailwind or sufficient return for the capital at risk. If earnings, for example, were to unexpectedly flatline, it'll be 100 years before the cumulative earnings will equal the price paid. Let's say, as a result of this disappointment, the stock were to fall by 50%. Well, it would still require, without growth resuming, 50 years of earnings to equal price. So, even after a quite large decline, without some real future growth, the price paid will still lead to a very unattractive outcome. The continuing shareholders who decide to hang on and wait for growth to resume, unfortunately, can't rely on buybacks to help the situation very much either. Here the investor is dependent on things not controllable: whether growth will return and will be sustained for a rather long time into the future.
Figuring this out may not be impossible but, to me, sure seems like a recipe for making some big mistakes.
Here's where the framing effects and their critical impact on decision-making becomes more apparent:
A 50% drop from 100 times earnings only increases the earnings yield from 1% to 2%.
In contrast, pay 10 times earnings for something with modest or even no growth prospects and every ten years or so it produces in earnings what was paid. If the stock price were to drop 50% for some reason, each incremental purchase makes a big difference whether via buybacks or through incremental purchases by the owner.
A 50% drop from 10 times earning increases the earnings yield increases from 10% to 20%.
In both cases, it was a 50% drop in price but the improvement in earnings yield is vastly different.
Framing in terms of earnings yield instead of price-to-earnings makes this more intuitive.
This is a big part of the reason why paying speculative premiums on stocks can be so dangerous. It's why I prefer to think in terms of earnings yield instead of price to earnings. Some will choose to discount the importance of framing effects, but I think some familiarity with what's known as "The MPG Illusion" just might change that.
Below is a quick explanation of "The MPG Illusion" but it's well worth reading up further on the subject:
Let's say you and a friend each have a car.
The one you own is a gas guzzler that gets 6 MPG. Your friend's current car gets 20 MPG.
Both of you are about to purchase new ones.
Both of you happen to drive the same number of miles each year.
The car you end up buying gets a still rather paltry 8 MPG.
Your friends new car gets 40 MPG.
Which decision results in more fuel savings?
Seems straightforward enough.
Your car only improves MPG by 2 or 33%.
The other car improves MPG by 20 or 100%.
This seems like a no-brainer: trading in your car improves gas mileage by only 2 mpg (33%), while your friends car improves gas mileage by 20 mpg (100%).
So the intuition points us to what seems an obvious answer. Well, it's not so obvious.
Here's the math. If each car drives 12,000 miles a year...
Then you used to use 2000 gallons per year (12000 miles/6 MPG).
Doing the same math, the new car will use up 1500 gallons per year.
So the saving is 500 gallons per year.
Your friend, on the other hand, used to use 600 gallons per year (12000 miles/20 MPG) but, doing the same math, now uses 300 gallons.
So the saving that comes out of this decision is only 300 gallons.
It turns out that gallons per mile (GPM) is more intuitive. The inverse framing make this dynamic more plain and less likely to lead to misjudgments.
The 40 MPG car obviously still burns less gas overall, but the decision to go from 20 MPG to 40 MPG versus from 6 to 8, counterintuitively, does not save as much fuel.
So how something is framed matters a lot.
Price to earnings functions much like MPG.
Earnings yield functions much like GPM.
So the high P/E stock is like the fuel efficient car. It's the better story to tell but much more is needed than intuition would suggest.
The low P/E stock is like the gas guzzler. It's still a lousy story but not much is needed for good things to happen.
Incremental earnings yield (as price drops) is a big advantage for the low P/E stock.
Incremental reduction in GPM (as efficiency increases) is a big advantage for the gas guzzler.
The more intuitive way to guide fuel economy decision-making is GPM.
The more intuitive way to guide investment decision-making is earnings yield.
This doesn't mean no high P/E stock deserves to sell at such a premium.
This does mean investors might decide to take more risk than they need to, in part, because of the way the information is framed.
So MPG is not the best way to frame fuel efficiency, and P/E is not the best way to frame business valuation.
For investors to consider the risk and reward appropriately, they need to be careful that how something is framed isn't getting in the way of sound judgments.
I suspect that one of the reasons market participants tend to overpay for growth is at least partially caused but this. I also think sometimes those who learn the higher and more complex maths forget the power of good old-fashioned arithmetic.
There's certainly nothing at all wrong with attempting to get attractive investment results through something that has exciting growth prospects.
The problems begin when a premium to current value is paid -- even one that seems warranted because of the excellent prospects -- in an always uncertain world. When the range of future outcomes is very wide (i.e. when judging what the future cash flows will be is difficult at best) it's tough to determine what's an appropriate margin of safety to reduce the likelihood of permanent capital loss.
Those that can avoid the big losses meaningfully improve their chances of doing well. This requires, at the very least, that a reasonable price is paid in the first place. This depends on owning long-term only what's truly well understood.
When the multiple of earnings paid is low, all that has to be judged is whether those earnings are mostly sustainable* to get a good or better investment outcome. That's not necessarily easy but, compared to judging which high flyer will live up their long-term potential, it sure seems more reliably doable.
With lower multiple stocks -- those, for example, with maybe modest or no growth but at least some sustainable advantages -- the end result can be an attractive one as long as capital allocation is done reasonably well.
Of course, that's hardly a given.
Some might argue that P/E is very different than MPG because the E can change significantly.
While that's clearly not wrong, it is a distraction from how the illusion contributes to misjudgments.
Adam
Related posts:
Multiple Expansion, Buybacks, & The P/E Illusion (Follow-up)
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
* At extremely low earnings multiples, a decline in earnings may not even be a problem if the capital is well allocated and the business is otherwise sustainable. Of course, it's important that the business not be collapsing and will be around for a long time with, at least, similar core economics. Growth is either irrelevant or a bonus.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
This recent post covered why the long-term investor should actually prefer that the stocks they own for the long-term will underperform in the near-term and even intermediate term. In fact, maybe somewhat oddly, that investor shouldn't mind this even if (annoyingly) the stock drops meaningfully right after it has been bought.
Now, when a high price is paid, and the long-term outcome is dependent on speculative assumptions, this won't work. Assumptions that, while possibly even not unreasonable, cannot be known with enough certainty to narrow the range of outcomes.
Yet the real problem might be more about mathematical intuition and framing effects.
Think of it this way. Consider a stock with a price-to-earnings (P/E) of 100. Naturally, a stock like that must have significant growth prospects if it's going to work out well for owners. There's just not enough current earnings relative to price to provide a meaningful tailwind or sufficient return for the capital at risk. If earnings, for example, were to unexpectedly flatline, it'll be 100 years before the cumulative earnings will equal the price paid. Let's say, as a result of this disappointment, the stock were to fall by 50%. Well, it would still require, without growth resuming, 50 years of earnings to equal price. So, even after a quite large decline, without some real future growth, the price paid will still lead to a very unattractive outcome. The continuing shareholders who decide to hang on and wait for growth to resume, unfortunately, can't rely on buybacks to help the situation very much either. Here the investor is dependent on things not controllable: whether growth will return and will be sustained for a rather long time into the future.
Figuring this out may not be impossible but, to me, sure seems like a recipe for making some big mistakes.
Here's where the framing effects and their critical impact on decision-making becomes more apparent:
A 50% drop from 100 times earnings only increases the earnings yield from 1% to 2%.
In contrast, pay 10 times earnings for something with modest or even no growth prospects and every ten years or so it produces in earnings what was paid. If the stock price were to drop 50% for some reason, each incremental purchase makes a big difference whether via buybacks or through incremental purchases by the owner.
A 50% drop from 10 times earning increases the earnings yield increases from 10% to 20%.
In both cases, it was a 50% drop in price but the improvement in earnings yield is vastly different.
Framing in terms of earnings yield instead of price-to-earnings makes this more intuitive.
This is a big part of the reason why paying speculative premiums on stocks can be so dangerous. It's why I prefer to think in terms of earnings yield instead of price to earnings. Some will choose to discount the importance of framing effects, but I think some familiarity with what's known as "The MPG Illusion" just might change that.
Below is a quick explanation of "The MPG Illusion" but it's well worth reading up further on the subject:
Let's say you and a friend each have a car.
The one you own is a gas guzzler that gets 6 MPG. Your friend's current car gets 20 MPG.
Both of you are about to purchase new ones.
Both of you happen to drive the same number of miles each year.
The car you end up buying gets a still rather paltry 8 MPG.
Your friends new car gets 40 MPG.
Which decision results in more fuel savings?
Seems straightforward enough.
Your car only improves MPG by 2 or 33%.
The other car improves MPG by 20 or 100%.
This seems like a no-brainer: trading in your car improves gas mileage by only 2 mpg (33%), while your friends car improves gas mileage by 20 mpg (100%).
So the intuition points us to what seems an obvious answer. Well, it's not so obvious.
Here's the math. If each car drives 12,000 miles a year...
Then you used to use 2000 gallons per year (12000 miles/6 MPG).
Doing the same math, the new car will use up 1500 gallons per year.
So the saving is 500 gallons per year.
Your friend, on the other hand, used to use 600 gallons per year (12000 miles/20 MPG) but, doing the same math, now uses 300 gallons.
So the saving that comes out of this decision is only 300 gallons.
It turns out that gallons per mile (GPM) is more intuitive. The inverse framing make this dynamic more plain and less likely to lead to misjudgments.
The 40 MPG car obviously still burns less gas overall, but the decision to go from 20 MPG to 40 MPG versus from 6 to 8, counterintuitively, does not save as much fuel.
So how something is framed matters a lot.
Price to earnings functions much like MPG.
Earnings yield functions much like GPM.
So the high P/E stock is like the fuel efficient car. It's the better story to tell but much more is needed than intuition would suggest.
The low P/E stock is like the gas guzzler. It's still a lousy story but not much is needed for good things to happen.
Incremental earnings yield (as price drops) is a big advantage for the low P/E stock.
Incremental reduction in GPM (as efficiency increases) is a big advantage for the gas guzzler.
The more intuitive way to guide fuel economy decision-making is GPM.
The more intuitive way to guide investment decision-making is earnings yield.
This doesn't mean no high P/E stock deserves to sell at such a premium.
This does mean investors might decide to take more risk than they need to, in part, because of the way the information is framed.
So MPG is not the best way to frame fuel efficiency, and P/E is not the best way to frame business valuation.
For investors to consider the risk and reward appropriately, they need to be careful that how something is framed isn't getting in the way of sound judgments.
I suspect that one of the reasons market participants tend to overpay for growth is at least partially caused but this. I also think sometimes those who learn the higher and more complex maths forget the power of good old-fashioned arithmetic.
There's certainly nothing at all wrong with attempting to get attractive investment results through something that has exciting growth prospects.
The problems begin when a premium to current value is paid -- even one that seems warranted because of the excellent prospects -- in an always uncertain world. When the range of future outcomes is very wide (i.e. when judging what the future cash flows will be is difficult at best) it's tough to determine what's an appropriate margin of safety to reduce the likelihood of permanent capital loss.
Those that can avoid the big losses meaningfully improve their chances of doing well. This requires, at the very least, that a reasonable price is paid in the first place. This depends on owning long-term only what's truly well understood.
When the multiple of earnings paid is low, all that has to be judged is whether those earnings are mostly sustainable* to get a good or better investment outcome. That's not necessarily easy but, compared to judging which high flyer will live up their long-term potential, it sure seems more reliably doable.
With lower multiple stocks -- those, for example, with maybe modest or no growth but at least some sustainable advantages -- the end result can be an attractive one as long as capital allocation is done reasonably well.
Of course, that's hardly a given.
Some might argue that P/E is very different than MPG because the E can change significantly.
While that's clearly not wrong, it is a distraction from how the illusion contributes to misjudgments.
Related posts:
Multiple Expansion, Buybacks, & The P/E Illusion (Follow-up)
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?
* At extremely low earnings multiples, a decline in earnings may not even be a problem if the capital is well allocated and the business is otherwise sustainable. Of course, it's important that the business not be collapsing and will be around for a long time with, at least, similar core economics. Growth is either irrelevant or a bonus.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, September 19, 2014
Howard Marks on Risk
From the latest memo by Howard Marks of Oaktree Capital:
"Volatility is the academic's choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory."
He then adds, not surprisingly, that volatility can "be an indicator or symptom of riskiness and even a specific form of risk" but "it falls far short as 'the' definition of investment risk."
The primary investment risk is the permanent loss of capital. Investors must be compensated sufficiently for that possibility. Well, volatility reveals nothing of real utility when it comes to making that assessment.
The problem is that, unlike volatility, actual risks can't really be quantified. Now, some will contend that risks can in fact be quantified but Marks argues, I think convincingly, that they cannot be. My view is that risk can be, best case, estimated in a meaningful but, more or less, qualitative way and cannot be known with any precision.
Marks writes that not only are risks not quantifiable a priori, they can't even really be known afterwards. This might seem odd but think of it this way: When an investment is sold, the investor knows specifically what the return ended up being. That doesn't mean that investor really understands the actual risk that was taken in order to get the now known result. The actual outcome was just one possible outcome among many. The risk and likelihood of a loss remains not quantifiable even after the sale is complete.
There's just no easy way to quantify the risks beforehand. Worse yet, it's not even really possible to quantify the risks after something has happened. Marks mentions that John Kenneth Galbraith believed that forecasters could not reliably predict the future and, as a result, necessarily fell into one of two categories:
"Those who don't know -- and those who don't know they don't know."
The same could be said about those who think most risks can actually be meaningfully measured.
This might at first all seem a bit unworkable, but I believe investing well requires getting comfortable with the subjective and qualitative nature of risk assessment. Time and energy should be directed at what an investor can actually control. Evaluating risk effectively is terribly important but the limits on what can be known and predicted are significant. Recognition of this should logically lead to less attention being paid to the many prognosticators and, instead, more focus on improving the investment process. Every aspect of investment decision-making needs to be continuously developed. Forecasts are mostly distraction.
It is possible to effectively deal with an uncertain future even if there's no reliable way to predict what's specifically going to happen. The many uncertainties can be dealt with by learning to roughly, but meaningfully, estimate the range of possible future outcomes and approximate probabilities.
Marks says that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."
Volatility is totally insufficient as a measure of investment risk but has the advantage of being easily quantifiable. It's widespread use comes mostly down to that and not validity. Here's how Charlie Munger explained it once in a speech at UC Santa Barbara:
"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
Later in the memo Marks mentions a quote by Elrod Dimson:*
"Risk means more things can happen than will happen."
Marks then refers to something he wrote back in 2007:**
"...the history that took place is only one version of what it could have been."
So that means "the relevance of history to the future is much more limited than may appear to be the case."
With so much necessarily unknown and unknowable it quickly becomes clear -- or should become clear -- why, for investors, margin of safety is such a crucial principle. Buying an asset far below a conservative estimate of value offers some protection, up to a point at least, against uncertainties. This usually means lots of waiting since, under normal economic conditions, assets don't generally become extremely mispriced on the low side. Some real economic difficulties is usually required. This also means that it's crucial to be able to act decisively when something finally sells at a big discount. You can bet that there'll either be broad-based economic turmoil or troubles that are specific to the asset itself. So the analytical work has to be done well in advance. Temperamental factors will also play a big role. Those who can't resist being influenced by things like the media echo chamber -- whether cognitively, emotionally, or both -- aren't likely to make great investment decisions when it counts.
Sometimes the worst case scenario is so intolerable that it's necessary to avoid an investment with otherwise lots of potential upside. In other words, even a very large margin of safety would prove insufficient. The example of a skydiver who's successful 95% of the time is mentioned in the memo. That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.
A more or less traditional view is that taking more risk is the path to outsized returns. Well, that's just not correct. Those that continue to think along these lines are likely to end up with rather disappointing results. More from Marks:
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return. The first graphic shows the rather conventional -- if not necessarily correct -- positive correlation between risk and return.
Well, the correlation between risk and return is sometimes positive, it's just not inevitably positive. I've covered this in prior posts but, as far as I'm concerned, it can't be repeated or emphasized enough.
The second graphic portrays the risk-return relationship in a much more useful fashion. It shows that increased risk increases the range of outcomes...not necessarily returns.
So volatility happens to be totally deficient as a measure of investment risk but that doesn't mean it's inconsequential:
"When you're under pressure, the distinction between 'volatility' and 'loss' can seem only semantic."
Price plays the key role in managing the many mostly not quantifiable risks that are an inevitable part of the investment process:
"...the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that's irrationally low (ditto). A low price provides a 'margin of safety', and that's what risk-controlled investing is all about. Valuation risk should be easily combatted, since it's largely within the investor's control. All you have to do is refuse to buy if the price is too high given fundamentals.'Who wouldn't do that?' you might ask. Just think about the people who bought into the tech bubble."
The following from Warren Buffett's The Superinvestors of Graham-and-Doddsville comes to mind:
"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."
I think Howard Marks writes about risk just about as good as, if not better, than anyone else. In the memo, he walks through no less than 24 different forms of risk. Many of these are related to the "main risk" -- that being the possibility capital will be permanently lost. Sometimes, trying to minimize one type of risk increases another type of risk. That's part of what makes the investment process so challenging and, well, so enjoyable.
Overall, Marks has produced an impressively comprehensive memo.
Reading it is time well spent.
Some will want to focus on how to generate the biggest possible returns.
That will usually be a mistake.
The focus should be on, first and foremost, investment risk and how to deal with it.
Adam
Related posts:
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* Dimson is a professor at London Business School.
** From No Different This Time -- The Lessons of '07 (December 2007).
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
"Volatility is the academic's choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory."
He then adds, not surprisingly, that volatility can "be an indicator or symptom of riskiness and even a specific form of risk" but "it falls far short as 'the' definition of investment risk."
The primary investment risk is the permanent loss of capital. Investors must be compensated sufficiently for that possibility. Well, volatility reveals nothing of real utility when it comes to making that assessment.
The problem is that, unlike volatility, actual risks can't really be quantified. Now, some will contend that risks can in fact be quantified but Marks argues, I think convincingly, that they cannot be. My view is that risk can be, best case, estimated in a meaningful but, more or less, qualitative way and cannot be known with any precision.
Marks writes that not only are risks not quantifiable a priori, they can't even really be known afterwards. This might seem odd but think of it this way: When an investment is sold, the investor knows specifically what the return ended up being. That doesn't mean that investor really understands the actual risk that was taken in order to get the now known result. The actual outcome was just one possible outcome among many. The risk and likelihood of a loss remains not quantifiable even after the sale is complete.
There's just no easy way to quantify the risks beforehand. Worse yet, it's not even really possible to quantify the risks after something has happened. Marks mentions that John Kenneth Galbraith believed that forecasters could not reliably predict the future and, as a result, necessarily fell into one of two categories:
"Those who don't know -- and those who don't know they don't know."
This might at first all seem a bit unworkable, but I believe investing well requires getting comfortable with the subjective and qualitative nature of risk assessment. Time and energy should be directed at what an investor can actually control. Evaluating risk effectively is terribly important but the limits on what can be known and predicted are significant. Recognition of this should logically lead to less attention being paid to the many prognosticators and, instead, more focus on improving the investment process. Every aspect of investment decision-making needs to be continuously developed. Forecasts are mostly distraction.
It is possible to effectively deal with an uncertain future even if there's no reliable way to predict what's specifically going to happen. The many uncertainties can be dealt with by learning to roughly, but meaningfully, estimate the range of possible future outcomes and approximate probabilities.
Marks says that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."
Volatility is totally insufficient as a measure of investment risk but has the advantage of being easily quantifiable. It's widespread use comes mostly down to that and not validity. Here's how Charlie Munger explained it once in a speech at UC Santa Barbara:
"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
Later in the memo Marks mentions a quote by Elrod Dimson:*
"Risk means more things can happen than will happen."
Marks then refers to something he wrote back in 2007:**
"...the history that took place is only one version of what it could have been."
So that means "the relevance of history to the future is much more limited than may appear to be the case."
With so much necessarily unknown and unknowable it quickly becomes clear -- or should become clear -- why, for investors, margin of safety is such a crucial principle. Buying an asset far below a conservative estimate of value offers some protection, up to a point at least, against uncertainties. This usually means lots of waiting since, under normal economic conditions, assets don't generally become extremely mispriced on the low side. Some real economic difficulties is usually required. This also means that it's crucial to be able to act decisively when something finally sells at a big discount. You can bet that there'll either be broad-based economic turmoil or troubles that are specific to the asset itself. So the analytical work has to be done well in advance. Temperamental factors will also play a big role. Those who can't resist being influenced by things like the media echo chamber -- whether cognitively, emotionally, or both -- aren't likely to make great investment decisions when it counts.
Sometimes the worst case scenario is so intolerable that it's necessary to avoid an investment with otherwise lots of potential upside. In other words, even a very large margin of safety would prove insufficient. The example of a skydiver who's successful 95% of the time is mentioned in the memo. That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.
A more or less traditional view is that taking more risk is the path to outsized returns. Well, that's just not correct. Those that continue to think along these lines are likely to end up with rather disappointing results. More from Marks:
"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."
On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return. The first graphic shows the rather conventional -- if not necessarily correct -- positive correlation between risk and return.
Well, the correlation between risk and return is sometimes positive, it's just not inevitably positive. I've covered this in prior posts but, as far as I'm concerned, it can't be repeated or emphasized enough.
The second graphic portrays the risk-return relationship in a much more useful fashion. It shows that increased risk increases the range of outcomes...not necessarily returns.
So volatility happens to be totally deficient as a measure of investment risk but that doesn't mean it's inconsequential:
"When you're under pressure, the distinction between 'volatility' and 'loss' can seem only semantic."
Price plays the key role in managing the many mostly not quantifiable risks that are an inevitable part of the investment process:
"...the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that's irrationally low (ditto). A low price provides a 'margin of safety', and that's what risk-controlled investing is all about. Valuation risk should be easily combatted, since it's largely within the investor's control. All you have to do is refuse to buy if the price is too high given fundamentals.'Who wouldn't do that?' you might ask. Just think about the people who bought into the tech bubble."
The following from Warren Buffett's The Superinvestors of Graham-and-Doddsville comes to mind:
"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."
I think Howard Marks writes about risk just about as good as, if not better, than anyone else. In the memo, he walks through no less than 24 different forms of risk. Many of these are related to the "main risk" -- that being the possibility capital will be permanently lost. Sometimes, trying to minimize one type of risk increases another type of risk. That's part of what makes the investment process so challenging and, well, so enjoyable.
Overall, Marks has produced an impressively comprehensive memo.
Reading it is time well spent.
Some will want to focus on how to generate the biggest possible returns.
That will usually be a mistake.
The focus should be on, first and foremost, investment risk and how to deal with it.
Adam
Related posts:
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
* Dimson is a professor at London Business School.
** From No Different This Time -- The Lessons of '07 (December 2007).
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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