The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
“We can’t control the score board; all we can do is keep playing the game…”
“Arrogance and self-awareness seldom go hand in hand.”
Rule Three: PRUDENT INVESTING IS RISK-AVERSE
Rule Two: PRUDENT INVESTING IS ABSOLUTE RETURN ORIENTED
Rule One: PRUDENT INVESTING IS DONE FROM THE BOTTOM UP.
Have you ever noticed how wise coaches seem to be? The good ones, at least. They give us little bits of wisdom that last a lifetime. Even the run-of-the-mill coach will tell you things like: “Practice doesn’t make perfect, it makes permanent; only perfect practice makes perfect.” Or, “There is nothing wrong with getting knocked down as long as you get back up.” Or, “There is no ‘I’ in ‘team’.” The legendary coaches, however, are much more original and impart enough wisdom to fill a book – in some cases, multiple books. Don’t believe me? Go to the self-help and/or business management section of the bookstore and you will find a myriad of books written by coaches.
John Wooden, Dean Smith, Bill Walsh and Vince Lombardi have all written books. One gets the idea that these are truly singular men and special leaders. I know I thought so, and then last fall I agreed to coach my son’s youth basket-ball team. I was born in North Carolina, played high school basketball in Indiana, and went to college on Tobacco Road. In Georgia – where the two most popular sports are football and football tailgating – that makes you a basketball expert. I took the job, and I am not sure how much the kids learned, but their coach learned a great deal.
Mostly I learned that the old cliché about there not being any such thing as great men, only ordinary men who are thrown into great circumstances…it may be true. Within a few weeks of being named head coach of the Sharks (that was the name the kids picked) I started saying all kinds of really deep, life-altering stuff. The most significant moment came in a game when one of our players had scored and the volunteer scorekeeper was not as fast at updating the scoreboard as the guys who work the big television networks. The other team is driving down the court and my star point guard is pointing at the scoreboard instead of playing defense. At that moment in the heat of battle, if you will, I yelled, “Don’t worry about the score, play this possession. Win this possession.”
After the game I had two thoughts. First, there actually is something intrinsic to coaching that brings out the inner philosopher. Secondly, I can write a news- letter on that one. I am certainly not the first person to speak to the importance of always staying in the present. From Buddhism to our Western Judeo-Christian tradition, this is a concept that is universal in major religion and philosophy. You have probably heard the saying, “Yesterday is history, tomorrow is a mystery, but today is a gift. That’s why they call it the present.” Even a long time ago in a galaxy far, far away, this principle held true. Jedi Master Yoda scolds the young Luke Skywalker about his fantasies of the future, saying never was his mind on where he is, what he is doing.
In economics they speak of the concept of sunk cost. An economic decision must be made in the present, with no regard for how we got here. The great example they use is a story about Andrew Carnegie. Carnegie’s steel company was building a new factory. While the factory was under construction, new technology emerged that would make the factory obsolete upon opening. His managers wanted to open it anyway, after all the company had made a large investment in its construction, but Carnegie understood that this past did not matter. That was sunk cost. In other words, it was in the past and there is no way to go get it back. That investment did not matter now, because facts had changed, and Carnegie ordered the factory to be rebuilt with the new technology.
In our world we are not running steel companies and investing in factories and equipment; we are investing our clients’ portfolios in various securities. The concept is still the same. One of our favorite maxims is that long-term investing is a mindset, not a time frame. I think many people struggle with this concept. We hear people all the time who have made investing mistakes and watched the value of their portfolio drop and they say, “Well I’m in it for the long term.” Behavioral finance teaches us that the usual immediate reaction to bad news about an investment is denial. We want to believe we make good decisions and if we have made an investment then it will work out in the end. If the drop is due to nothing but market noise then it will work out, but when facts have changed the rational investor must change with them.
It is really a simple concept. We make a decision today based on what we believe the long-term future holds. Tomorrow we have to do the same thing, and the day after that. The big picture does not change all that quickly, but it does change. There are lots of people who have made good livings on Wall Street by being “consistent.” They are either consistently optimistic, or consistently pessimistic. They are both right about half the time. They come across as brilliant because they will tell you about how they predicted this bull market, or that bear market. What they don’t tell you is that the optimist has predicted twenty of the last twelve bull markets and the pessimist has predicted twenty of the last five major crashes. A broken watch is correct twice every day. A consistent thought process applied to dynamic information will yield dynamic outcomes. Someone who is truly consistent and in the present will accept new information and allow that information to change his mind. One may invest in a company believing that the long-term return will be fifty percent. If the stock of that company then goes up fifty percent over a short period of time, assuming nothing has actually changed at the company, then the long-term investor should sell.
In another scenario, a long-term investor invests in the stock of a company that she believes has solid management whose interests are in line with shareholders’ as they hold large quantities of the stock themselves. If that management resigns, gets caught in a scandal or simply sells all their shares, then the facts have changed. She may have just made the investment a week ago, but it doesn’t matter. The long-term view is now different and action is required.
It really is simple. However, many people confuse simple with easy. If staying in the present were so easy there wouldn’t be so much written about it. It is really a very hard thing to do. The past clouds our judgment, and the future can cause problems as well. In sports it is very easy for teams to get ahead of themselves. I can recall clearly one of my most embarrassing moments from my college days. I was in the Dean Dome in Chapel Hill, NC, sitting with several Tar Heel friends while my Wake Forest Demon Deacons built a twenty point half time lead. I could see the future of a wonderful upset victory only made better by the fact that we were in Chapel Hill. The Wake team must have had the same vision because they came out in the second half prepared to ease into the victory. Unfortunately for them, and for me, Dean Smith’s Tar Heels did not stop playing just because they were down big. Slowly but surely they marched back and as they got closer the future began to dim, panic set in, and the thought of “we could blow this” could practically be seen on the Deacons’ faces. Carolina took their first lead of the entire game with seconds remain- ing. It was the largest comeback of Dean Smith’s coaching career to that point – thankfully for our pride the Georgia Tech Yellow Jackets gave up an even bigger lead a few years later.
How does a team get that far ahead and then end up losing? They get out of the moment and are living in the future. It can happen the other way as well – a team gets down and then just gives up. It happens in investing, too. Just like in sports, people think whatever is happening right now is always going to continue. Why did people pile into technology stocks in 1999? Because they saw this fantastic future where everything tied to the Internet turns to gold. Why did they pile into housing in 2006? Because they saw a future just like the past, where no one ever loses money on houses.
It is hard to not allow the past to cloud our decision- making, and it is equally as hard to humble ourselves to realize that we really do not know what the future holds. All we have is today, right now. This is why prudent investing is so important. Who knows what the whole world will look like years from now, but we can know if a company’s stock looks undervalued today. Who knows how long markets will boost up the returns of overvalued assets, but chasing those returns usually ends poorly. What risk will actually raise its head tomorrow, we do not know, but we know the risk is there today and the prudent course is to avoid it. We can’t control the score board; all we can do is keep playing the game one possession at a time.
Play this possession. Win this possession. Go Sharks!
Charles E. Osborne, CFA, Managing Director
~Win This Possession
We live in the world of Facebook and Twitter. My generation grew up with the advent of fast food and McEverything. It is no surprise that today’s technology generation grew up with iEverything, starting with the iPod, iTunes, iPhone, iPad, iMac, etc. “Look at me” is the universal cry, so much so that I constantly see people so busy taking pictures of themselves and their friends in what look like fun places that I wonder if they might be forgetting to actually have fun.
Of course this is nothing new, it is the human condition. Our ancient myths are full of stories of prideful heroes being cut down to size and learning that a little humility is a good thing. Recall the story of Daedalus and Icarus from Greek mythology. Locked in a tower by King Minos, the great inventor, Daedalus fashioned wings for himself and his son Icarus so they could escape their prison. The wings were made of feathers held together with wax. Before taking flight Daedalus told his son, “Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. Keep near me and you will be safe.” Of course we all know how it ended: Icarus, so full of himself and the thrill of flying like a god, went higher and higher as if to reach heaven and his wings melted away. Daedalus, in grief over the loss of his son, made it onto Sicily, where he built a temple to the sun god Apollo and hung up his wings as an offering. The great concession: he was only human after all.
Even today in our often narcissistic culture we can see references to the wisdom of humility. In the 2006 hit James Bond movie “Casino Royale” Dame Judith Dench, playing the role of M, delivers what I think is one of the greatest lines in the whole James Bond series while speaking to Bond: “This may be too much for a blunt instrument like yourself to understand, but arrogance and self-awareness seldom go hand in hand.” C.S. Lewis, in “Mere Christianity,” was a little more blunt than M. He refers to pride as the “anti-God state of mind”. He believed it was the route of all evil. Whether that may be a little over-the-top is a discussion for another time, but he makes one of the most insightful comments I have ever read on the subject. “There is no fault which makes a man more unpopular, and no fault which we are more unconscious of in ourselves,” Lewis writes of pride. There is a reason the word arrogant is frequently followed by another word starting with a, which we won’t publish in our family newsletter, almost as often as the word fool.
I do not know if C.S. Lewis is correct about pride, arrogance, hubris or whatever you wish to call it, being the greatest sin overall, but I can guarantee you that it is the greatest sin in investing. It is incredibly dangerous, largely because it is so hard to see in ourselves. As a result it is the number one mistake made by professional investors. Amateurs make all kinds of mistakes; pros usually make only one, but it is a big one. The most notorious example was of course Long-term Capital Management, otherwise known as the hedge fund that almost destroyed the world. If you are interested you can read the book “When Genius Failed” by Roger Lowenstein. The short version is: Two Nobel laureates run a hedge fund that did great until it blew up and required a $3.6 billion bailout to keep the entire financial world from collapsing. It happened in the late 1990s, so much of the world was too wrapped up in the internet bubble to care, but those of us in the industry will never forget.
Not forgetting and learning are too often two different things. In the Spring of 2007, I attended a lunch presentation delivered by a money manager from Chapel Hill, NC. He was a great presenter. He said several things that were just plain wrong, but he said them with such confidence it was amazing. He was running a strategy that was popular at the time: purchasing mortgagebacked securities, which he promised were completely safe, and he was using leverage – which is industry speak for borrowing money for the purpose of investing it – to raise the rate of return to whatever percentage you wanted. To understand how this works let’s assume you had $100,000 to invest. You want to get a 10 percent return which would be $10,000 on a $100,000 investment. Mortgage-backed securities were paying approximately 5 percent. He then suggested you could just borrow another $100,000, invest the $200,000 in 5 percent mortgage bonds (5 percent of $200,000 would be $10,000) to make your $10,000 “without risk.” Of course you would also have to factor in the cost of borrowing the money etc., but this is the basic idea behind leverage.
There was just one problem: Mortgage bonds were not risk-free. Some went down in value well over 50 percent, and in this scenario that means your $200,000 investment would be worth less than $100,000, which is the amount you borrowed. You end up losing more than you ever had. I was in shock hearing this presentation, and then the person next to me looks over and says “Isn’t this guy great?” I told my fellow audience member as politely as I could – which in all honesty was probably less polite than I should – that our speaker was an arrogant fool. I don’t know if the gentleman next to me invested or not, but he was sold.
I have often wondered what ever happened to the speaker from that day in the aftermath of the financial crisis. I don’t wonder about his clients, because I know what happened to them. I do wonder about the arrogant fool. My guess is he is back at it. In my experience the problem with arrogant fools is that they never admit to themselves that they are arrogant or fools, and therefore no matter how many times it comes back to haunt them, they never cease to be either.
The other problem, especially in my business, is that arrogance can often be convincing. As Mohammed Ali once said, “It ain’t bragging if you can back it up.” He did back it up, and many people loved him for it. This is what happens on Wall Street. There has been a loud theme over the last several years that what caused the financial crisis was greed. I have worked in the investment world my entire adult life, and frankly I have not seen much greed. Sure I have seen some, but not like most claim and certainly nowhere near as much as I have seen pride. I could be accused of splitting hairs here, but even the seemingly never-ending appetite to make more money isn’t always rooted in greed. So many of them never spend the money, because that is not what it is about. It’s about pride – being able to claim that you are the best in a game where money is not something you make to enrich yourself but simply a way of keeping score. You are, as Ali was also fond of saying, the “Champ of the world!”
Some may not see the difference between pride and greed, but I think it is an important point. There are not nearly as many greedy crooks in my business as there are prideful fools who really begin to believe that they can do no wrong, and then all of a sudden they meet Joe Frazier. They get stunned in the 11th round by a left hook and then in the 15th another left and “Down goes Ali, down goes Ali!” They don’t intend to hurt anyone; they truly believe their own propaganda. They are blind to their hubris right up to the point when Frazier hits them with that left hook, or until the sun melts the wax on their wings, or until it turns out that even virtual companies have to make actual money, or when people who can’t afford the house they bought stop paying their mortgages.
One of the best salesmen I have ever known used to tell me all the time that he was often wrong but never in doubt. I would laugh and respond that I try to be seldom wrong, but always in doubt. That is the way one must be if they are going to be making decisions about money, especially other people’s money.
Western culture used to value age. Youth was associated with arrogance, and “coming of age” often meant being humbled. With age comes humility and wisdom, and that is what we strive for everyday at Iron Capital. We will never be perfect but we keep striving, keep making progress. One might wonder why we would choose to write such a newsletter now. Certainly this message would be better suited for the end of 2008 than the end of 2013? Well, pride comes before a fall, and that is when one must be on guard. 2013 was a great year, but as Han Solo told the young Luke Skywalker after Luke shot down an imperial fighter, “Way to go kid. Now don’t get cocky.”
Charles E. Osborne, CFA, Managing Director
~Pride Comes Before a Fall
RULE THREE: PRUDENT INVESTING IS RISK-AVERSE
Defense wins championships! I don’t care which sport you are playing, the best always understand that defense is what makes the difference when it really counts. Everyone loves the homerun hitters, but come October it is usually the team with the best pitching staff that wins the World Series. Everyone loves scoring touchdowns and watching teams score 50-plus points, but in the BCS National Championship game it is almost always the team with the best defense that wins. Everyone loves the team that can run the fast break and punctuate it with the awe-inspiring slam dunk, but whether it is March Madness or the NBA Finals it is almost always the team that plays the best defense that wins. I could go on and on.
The reason this cliché represents a nearly universal truth is because it is based on the combination of simple math and human psychology. If you hold your opponent to fewer points scored, your offense doesn’t have to score that many to win. It isn’t a difficult concept to understand. In most sports defense is primarily about attitude and effort, which one should be able to manage with a degree of consistency. Offense, on the other hand, usually requires timing and touch, which can from time to time just disappear even in the most gifted of athletes and especially under the pressure of competition. The excitement of the championship usually makes it easier to “get up” for the moment, have the right attitude and give a full effort. That same excitement, however, often wreaks havoc with timing and touch, leading commentators to often use yet another cliché and explain that the offense just needs to “settle down” and get back to playing their game. The greater the pressure moment, the greater the advantage of the defensively minded team or athlete. Hence the reason for the cliché: Defense really does win when one is under the most pressure – during championships.
The same is true in investing. Defense wins in the end, and in the investing world that means being risk-averse. I know what you are thinking: you are thinking this means having to settle for lower returns, but that is not necessarily the case. Defense can often lead to offense, and I will get to that, but first we need to discuss why people think there is such a strong relationship between risk and return.
This confusion stems from modern portfolio theory. This is the theory that dominates academia, most regulators and the mass educational material that is disseminated from Wall Street. Modern portfolio theory defines risk as beta. Beta is a mathematical term that describes the relationship between the overall market and one particular investment. For those who remember introductory algebra, beta is the slope of the line. What that means is that if the market goes up 10 percent and the investment in question also goes up 10 percent then the beta of that investment is 1. If the investment goes up only 8 percent then its beta 0.8, and if it goes up 12 percent then it has a beta of 1.2 percent.
Any investment that outperforms in an up market by definition will have a high beta, which means that if beta is your definition of risk, then any investment that performs well when the market is up is risky. Conversely, should the market go down and the investment goes down less, it is deemed to have a low beta and therefore labeled safe.
The problems with this definition of risk are manyfold. First, beta is not causal. In other words the investment did not have a higher rate of return because it had a high beta; in fact it is just the opposite. It had a high beta because it had a high rate of return. Secondly, beta is not constant. The beta of an investment is calculated by historical returns, and those return patterns can change at any time. It is probable that an investment that outperforms in the future has a low beta today because most investments, particularly stocks, tend to go along with fairly flat returns for long periods of time until some positive developments occur and the market realizes that this investment is worth more, and then the price shoots up rather quickly. The opposite can happen as well. The point is that beta changes over time and always reflects things that have already happened, not what might happen in the future, which is what we care about as investors. Beta simply tells us what an investment looked like relative to the overall market in the past. It tells us nothing about the future riskiness of an investment and is therefore a poor measure of risk.
Another common measure of risk is volatility. Technically we call this standard deviation, but the concept is simple: the more an investment’s price moves from day to day, the higher the risk. If one uses this definition of risk, then there probably is a relationship between risk and return. The most attractive long-term investments are often companies facing short-term distress. Their prices can swing wildly as little tidbits of news flow regarding the stressful issues at hand. The problem with using volatility as a measure of risk is that volatility goes in both directions. In my experience no client is ever upset by upside volatility; the downside is what people care about.
The other problem is that one is once again defining risk by looking backward, and saying that any investment that had a large return – high volatility = large price movement – is risky. Once again we are defining things as risky after the fact. The level of risk did not determine the return; the return determined what we are calling the level of risk. Just like with beta, it is probable that highly volatile investments were not so volatile before the big move in price. For example: Let’s look at bank stocks as an investment. For much of our history bank stocks were considered boring, safe, usually high dividendpaying stocks. This was true right up to the beginning of the financial crisis. These stocks hardly moved unless there was a merger, and many shareholders owned the stocks for years just collecting the steady dividends. In the beginning of 2007 banks stocks had low volatility and low beta; they were labeled safe. Then the financial crisis hit and these stocks took the worst of it right to the bottom in March of 2009. At that point their standard deviations and betas were very high and they were labeled risky. Wachovia’s stock fell to $2 before Wells Fargo bought them for $6. Wells Fargo, which trades for $40 today, went down to $7 per share. In March of 2009 the selloff had been overdone and these stocks came bounding back. Since then the volatility has been on the up side. It seems to me that in reality banks were risky in 2007 and safe in March of 2009, but these traditional measures had it the other way around.
I believe there is a better definition of risk. Risk in my opinion is the probability of losing money over a reasonable holding period. What constitutes a reasonable holding period can be in the eye of the beholder, but I would say for an investment it should be three to five years. I like this definition because it is real and constant. Losing money is what real people care about; I have never had a client call me to complain about making too much money. Not once have I had someone say, “Man, this upside volatility is driving me crazy!” When the market goes down, on the other hand, risk becomes important. This leads many people to think that they should alter their risk tolerance with the swings in the market. However, if one understands risk as the probability of losing money, then one will never ask for more risk regardless of what the market is doing. That makes it a better definition and one we can use.
That raises an interesting question: What does it mean to lose money? One might think that is an easy concept, but I can promise you that such a person has never managed someone else’s money. Many people think that one has not lost anything until he “realizes” that loss by selling the investment for less than he purchased it. This mentality leads to all sorts of investing mistakes, which could fill an entire newsletter. For now let’s just go with a definition of a loss as meaning the current market price is below what we originally paid.
This is important because even prudent investments with a low probability of losing money over three years are going to face short-term fluctuations, and clients do need to be able to withstand those fluctuations. This is why we ask our clients how much they are willing to lose over a twelve month period of time. We often then get asked what the right answer is. I have always refused to answer in the past but since I’m writing this newsletter on risk, I will tell you: The correct answer is approximately 20 percent. Why 20 percent? This is step one of why defense wins championships.
Math! To keep things as simple as possible we will assume a $100 portfolio. If we lose 10 percent, that is $10 so now we have $90. To get back to $100 we need to gain $10, which is an 11 percent return on $90. The gain needed to get back to even is not much greater than the loss. Let’s say we lose $20 which would be 20 percent of our original $100. That leaves us with $80 and needing a $20 dollar gain, which is a 25% return, to get back to even. This gain is a little higher percentage than the loss but still in the same ballpark. If we lose $30 or 30 percent, we then need to make $30 from the $70 left, a 42 percent return. If we lose $50 or 50 percent, we then need a 100 percent gain on the $50 remaining to get back to even. All that does is get us back, still not progressing to our ultimate goals. This is why defense wins championships.
As I mentioned there is a psychological advantage in many sports to being defensively minded, and the same is true here as well. Investors make their biggest mistakes when they let emotions control their decisions. After the market goes up they get greedy and tell their advisors that they want to take more risk. When the market goes down they get fearful and in a panic sell everything. Defining risk the way we do leads to the opposite behavior. The probability of loss is largely calculated by what Benjamin Graham called the margin of safety. This was also the title of Seth Klarman’s book that inspired this newsletter series. The margin of safety is the difference between what an investment is worth and the price at which it is currently selling. The larger that margin, the less likely one will lose money. Interestingly that is also how one calculates the expected return on an investment. Perhaps the relationship between risk and return is not as simple as we have been led to believe.
At Iron Capital we believe in prudent investing. To be prudent one must select investments from the bottom up, one at a time; one must have an absolute return mentality, largely ignoring the market; and, one must be risk-averse, avoiding meaningful losses of more than 20 percent. Investing prudently takes discipline and patience. Prudence can be out of style for seemingly long periods, but in the end the prudent investors usually win. After all, defense wins championships.
Charles E. Osborne, CFA, Managing Director
~The Three Rules of Prudent Investing
RULE TWO: PRUDENT INVESTING IS ABSOLUTE RETURN ORIENTED.
“No-one will ever have golf under his thumb. No round ever will be so good it could not have been better. Perhaps this is why golf is the greatest of games. You are not playing a human adversary; you are playing a game. You are playing old man par.” ~BOBBY JONES
I LOVE GOLF. Growing up I loved just about any game. I have fond memories of playing gin rummy with my father when I was as young as eight years old. We had a ping pong table and the family tournaments could get intense. I was never a star, but I played “all the sports,” according to my mother, and for her generation that means football, basketball and baseball. I played tennis and golf in addition to “all the sports.” What I lacked in actual athletic ability I usually made up for with heart and competitive fire. I loved being part of a team and I loved competing. A young person learns a lot of life lessons on the athletic field. Sports are great.
I remember my uncle taking me aside when I was still in junior high and telling me that I should spend more effort on golf. His reasoning was that golf, unlike the other sports I participated in, could be played for the rest of my life. At the time I didn’t listen; after all, high school football players were a lot cooler than high school golfers. Now, well into the “rest of my life,” few days go by when I don’t regret ignoring that advice. All sports teach life lessons, but there is something special about golf. One of the unique things is that golfers don’t actually play against each other, at least successful golfers don’t. Their real opponent is the course and, as Bobby Jones famously stated, old man par.
The same is true about investing, which brings us the second of the three rules of prudent investing: Prudent investing is absolute return oriented, not relative return oriented. We live in a relative return world; it is all about beating your market benchmark and/or beating your peers. Prudent investors, however, are interested in returns only insofar as they relate to the achievement of their own investment goals. In other words, beating old man par.
Prudent investors are investing for some higher purpose. They invest to fund retirement, or college for their children. They invest to endow a worthy charity or to provide a legacy for their children and their children’s children. They do not hold assets for the sake of having assets; there is a purpose, even if that purpose is shallow and dare we say greedy. Warren Buffett is known as the greatest investor of our time, at least in part because that was his purpose. By most accounts Buffett wanted to be wealthy and famous, and his achievement of that status is no accident. There are actually a handful of other investors who have achieved long-term track records similar to Buffett’s, but most of them remain completely unknown to the general public, largely because they wanted it that way.
Buffett is a great example of the focus on absolute returns. We have short memories in our society today, but almost twenty years ago the conventional wisdom was that Warren Buffett was washed up, a dinosaur out of touch with our modern world. We were in the midst of what we now know as the dot-com bubble, but at the time no one was calling it that. Buffett, who had done so well on a relative basis for most of his career, was underperforming the market and other money managers by dramatic amounts. He didn’t care. He was still growing his nest egg year in and year out, and he knew what a bubble looks like. Today he is once again considered a genius.
Buffett had stated his goal early in his career before Berkshire when he was still managing what today we would call a hedge fund. His stated goal was a nine percent return. Similarly, all prudent investors should have a stated goal – after all, we have to know what old man par is. This gets investors focused on what’s important: achieving your actual purpose. So if retirement income is one’s goal, then we need to calculate what return must be achieved, based on the size of one’s portfolio, saving rate, and time to and/or in retirement,in order to reach that goal. This is the financial planning process and it is the same process for the average worker saving for retirement as it is for the wealthy family or college endowment or large corporate pension plan. There may be more moving parts for some investors and less for others, but ultimately it boils down to a number. In order to achieve one’s goal one must get a six percent return, or maybe it is eight, or only four. Whatever it is, that is your personal par. It is the return you need to get for all of your goals to be achieved, and that is the only return that matters. Not what the market does; not what your neighbor says he did (he’s lying by the way – not just to you but to himself – but that is a whole other article); but your old man par.
If your number is six percent, then the prudent action would be to build a portfolio that maximizes the probability of achieving that return and minimizes risk. (In practice it is wise to give some room for error so one may actually aim slightly above what is actually needed). This means if you can get the desired return from Treasuries, then you should have most if not all your assets in Treasuries. If you can’t, which is likely the case, then you should make prudent investments that will hit that mark with a reasonable amount of certainty over a reasonable holding period. This brings us to another big advantage of an absolute return focus: Investors who are thusly focused tend to be very patient. They care about achieving their return over their time frame and because, as we discussed last quarter, they have selected investments prudently from the bottom-up and know what they own, they have great confidence that everything will work out over time.
Relative result focused investors, on the other hand, are constantly comparing their results to the market, to other investment managers and to the inflated bragging of their neighbors. They are like the person stuck in traffic constantly changing lanes just to see the lane they had been in start to move. We all know that this is not the right thing to do, but it is a very hard habit to break. The financial world reinforces this view in almost every way. Wall Street firms are in the business of making transactions, and in order to get investors to transact, one must convince them that they could do better elsewhere. So Wall Street has created an atmosphere of what I call competitive investing: They have convinced people that the right thing to do is to constantly compare your return to what else is out there, and why not – after all, there will always be something that did better; which means investors must constantly transact; and that is how Wall Street makes money.
It isn’t just Wall Street though. CNBC and similar channels always celebrate whoever is doing well at the time, which is always fleeting – even for the best in the business. So-called consumer experts often tout indexing, and indexing may very well be the ultimate form of relative investing. If you are constantly comparing yourself to the market and other investors, ultimately you are just going to look like the market. The problem is that this focus on return and ultimately short-term return is that it ignores risk. It ignores prudence. Markets outperform prudent investors usually during times of bubble creation, and bubbles eventually pop. Warren Buffett once again looks like a genius, and those who wrote him off are forgotten.
Ultimately the relative return culture is about coveting what we perceive others to have. Wall Street is in the business of selling things, and coveting is a powerful force in making people purchase whatever it is one is selling. However, there is a reason coveting made it on God’s top-ten list, right up there with murder and adultery. Coveting will ruin one’s life. Nowhere is that more obvious than in investing. Studies show that investors buy high and sell low. To be more accurate investors tend to buy high, then ride the investment all the way down until they finally capitulate, and this isn’t just unsophisticated retail investors.
When one is constantly worried about being compared, one does imprudent things. Earlier this year we received a paper written by one of the largest and most respected fixed income managers in the industry. The paper was on what to do when interest rates begin to go higher, and they listed different options and their potential risks. There was one strategy that they deemed to be the most effective should rates rise, but the risk of that strategy was tracking error. They went on and on about not looking like everyone else and the problem that would cause should it take longer than expected for rates to begin to rise. Today investors in these funds have done worse than need be because the managers were more worried about being different than about getting the best absolute return.
For much of my career I was part of this problem. I was trained in the institutional mindset of beating the benchmark and peer group. Early in 2009 I had lunch with my former boss from Invesco. He was retired and enjoying it, and I looked forward to updating him on our success. I knew he would ask how we did during the downturn and I couldn’t wait to tell him: our core equity strategy had outperformed its benchmark, the S&P 500, by ten percent. No one does that in the relative performance world. If one compared our strategy to the entire Morningstar domestic equity universe regardless of specific style, we were in the top ten percent; better then ninety percent of our peers. I told him all of this and he just looked at me and said, “So you were down thirty percent or so? That isn’t very good is it?” No, it wasn’t.
That day and over the days that followed my eyes began to open and I began to realize that our industry has it all wrong. We need to be focused on achieving clients’ goals and not beating one another. Or perhaps this realization just comes once one has enough experience. Arnold Palmer has said he didn’t get good at golf until he finally realized that you play the course not the man. There is a great story about Jack Nicklaus in the first round of the 1967 U.S. Open. He was partnered with a rookie and they were both right around even par on their first nine holes. As they made the turn they looked at the leader board and the leader was in the clubhouse at five under par. The rookie turned to Nicklaus and said we better get going the leaders are already five strokes ahead. Nicklaus responded by saying this is the U.S. Open and four under will win, we are doing just fine. He finished that day at one over par, six strokes behind the leader. Three days later Jack Nicklaus won the U.S. Open with a total score of five under par; four under would have been good enough indeed.
It is easy to be absolute return focused when you are steady and the market is going down, but when the leaders seem like they are so far ahead it becomes difficult to just stay the course. That is human nature. That is when one must channel their inner Jack Nicklaus and remember that this is equity investing, and ten percent is what the market does over the long-term. Eventually everyone comes back to old man par. Prudent investors choose to get there taking the least amount of risk, and that is next quarter’s lesson.
Charles E. Osborne, CFA, Managing Director
~The Three Rules of Prudent Investing
RULE ONE: PRUDENT INVESTING IS DONE FROM THE BOTTOM UP.
My brother-in-law loves to ski. He and my sister had a winter wedding and honeymooned at a ski resort. Both were inexperienced skiers at the time but they thought it would be good fun to learn together. My brother-in-law took to skiing like a duck to water; my sister, not so much. My sister loves to tease about their “romantic honeymoon” with her groom skiing by every once in a while to see how she was doing on the bunny slopes. In my brotherin- law’s defense they have been happily married for 27 years so it couldn’t have been that bad. Their kids fell in love with skiing too, and later snowboarding as they grew up. Year after year they went on family ski trips where everyone had fun except for my sister, who just couldn’t get it. She tried, and would take lessons, but somehow it just didn’t click. Then about five years ago my whole family went on a ski trip together and my wife convinced my sister to take one more ski lesson together with her.
That evening when we all circled back together my sister was overjoyed. This instructor, for whatever reason, was able to communicate the art of skiing to my sister in a way that finally clicked (to this day neither my sister nor my wife has revealed his “secret”). She got it, and she finally had a great time skiing. I can only guess what the secret is – seriously, they won’t tell – but I suspect he didn’t say anything that the dozen or so other instructors hadn’t said. He just had a way of saying it that resonated with my sister at that moment.
It is funny how those things happen in life: Someone says something in a different way and it unlocks your understanding of a subject with which you had struggled. Or, sometimes you may be the teacher and you hear or read someone else’s description and you say, “Yes! That is exactly what I have been trying to say.” I had one of those moments earlier this year.
A friend loaned me the book, “Margin of Safety,” by Seth Klarman. Klarman is as famous as most investors ever get – with Warren Buffett being the glaring exception. He has an extraordinary track record of success with his firm, The Baupost Group, and he wrote this book about his investment philosophy in 1991. The book is famous not only because of Klarman’s reputation but also because he has refused to approve any more printing runs after the first, so it is hard to get and can sell for as much as $2,500. (Yes, I returned it.)
Klarman, like Buffett and many other very successful investors, is hugely influenced by Benjamin Graham and David Dodd; in fact the name of the book is directly borrowed from Graham, who coined the phrase “margin of safety.” As I suspected there was nothing in Klarman’s book that was actually new to me. However, just like my sister’s ski instructor, Klarman had a slightly different way of saying the same thing, and in one of his chapters in particular I heard something I have always known in a way I had never heard it.
Chapter seven: “At the Root of a Value-Investment Philosophy.” In an attempt to clear up some investment speak I am going to refer to it simply as prudent investing. There is a bit of editorial in that description but beyond that I think it is important to distinguish the difference between a value philosophy and “value style” which is often discussed. I have written about this in past newsletters, but for our purpose here let’s just say Klarman is describing what he and I would both agree is the prudent way to invest, which could accommodate various “styles.”
Klarman defined three central elements to this philosophy. First, prudent investing is a bottom-up strategy entailing the identification of specific investment opportunities. Second, prudent investing is absolute return, not relative return oriented. Finally, prudent investing is a risk-adverse approach where, as Klarman says, “attention is paid as much to what can go wrong (risk) as to what can go right (return).” Over the next three quarters I am going to discuss Klarman’s three rules, starting here with prudent investing always being done from the bottom-up.
The easiest way to understand what it means to invest from the bottom up may be to first understand the opposite approach, investing from the top down. Top-down investors start with economic analysis. They project what the big picture is going to look like; how the environment will affect specific industries; and then how an industry’s environment will impact the company in which one might invest. Today many of these types of investors don’t even invest in companies; instead they choose exchange-traded funds (ETFs), which represent industries or sectors of the economy. These investors must be correct about their economic forecast, which is nearly impossible; then they must correctly assess how that forecasted environment will actually impact any particular sector of the economy. Then they have to pick which specific industries will be the real winners, and if they still own stocks they have to pick which companies within the industry are best positioned. Not only do they have to do all of that without having any errors along the way, but they must do it faster than anyone else, otherwise the whole opportunity will be lost. Sound impossible?
Well there is a better and much easier way. The investor can look for quality companies one at a time, from the bottom up. We have often referred to this strategy as being owners of companies instead of traders of stocks. The common sense of this approach is pretty clear: It is much easier to understand a single company, its track record of results, the products it sells or services it provides, the strength of its balance sheet etc, then it is to know how much the entire global economy will grow. Once a company is understood it may be difficult to pin down an exact value for that company, but certainly one could come up with a range of what that company is actually worth. Then all one has to do is have the patience and discipline to buy the stock of that company when the stock is selling for less than the actual value of the company, and the further patience to wait for the market to realize that value. As Klarman puts it, “The entire strategy can be concisely described as buy a bargain and wait.”
This bottom-up philosophy is almost universal among successful investors. In fact, John Maynard Keynes, the famous and still controversial economist, was a fantastic investor and he paid no attention to his own economic forecast when managing the endowment of King’s College, Cambridge. Peter Lynch, the famous manager of the Fidelity Magellan Fund, is quoted as saying that “if one spends thirteen minutes reading a market forecast than he has wasted ten minutes.” True investing success is about making prudent investments from the bottom up.
Doing so, however, is far more difficult than one might imagine. All of Wall Street is geared towards a top-down approach, and for good reason: top-down economic forecasts change almost constantly, meaning those who use these forecasts as reasons to invest must trade constantly. Wall Street is in a transaction-oriented business; constant trading pays their bills, so they are more than happy to provide everyone with top-down oriented research. Bottom-up investing, on the other hand, involves patience. The market could recognize value shortly after one makes an investment (remember being a long-term investor is a mindset, not a timeframe), but usually one must wait for the value of a company to be recognized. While the prudent investor is waiting, Wall Street is not making a dime.
Bottom-up investors have little use for CNBC or any of the other 24 hours-a-day investing channels; what they say is of little value unless they happen to be talking about the specific company you have invested in, and the odds of that are fairly slim. Moreover, the fundamentals of a company really do not change very quickly, and things that do not change quickly make for bad television. Economic data, on the other hand, can bring excitement, and the more they can convince you that every piece of data is vital, the longer you will watch and boost their ratings. Yet most of what comes from these sources in really noise, not news.
This is not to say that economic data has no value; even Peter Lynch thinks that forecasts are worth three minutes of your time. Knowing what is happening in the economy gives one a better frame of reference when judging how well an individual company is performing. For example, Apple has grown at a rate of nearly sixty percent a year over the last five years; knowing that the last five years have been marked by anemic overall economic growth makes that accomplishment stand out all the more. Many technology companies saw that kind of growth in the roaring 1990s, but for a company to do that during the Great Recession is far more impressive.
At Iron Capital, we take it a step further. Our top-down forecast is actually built from the bottom up. While we track the macro economic data, what we pay the closest attention to is the fundamental valuation of various assets and the current dynamics being reported by individual companies within the various sectors. Are the mutual fund managers we like finding opportunities in their space or are we finding bottom-up opportunities? We have found this ground level data, so to speak, to be far more valuable in making asset allocation decisions than any economic or market forecast. We try to be prudent in everything we do, and the first rule of prudent investing is that it is built from the bottom up.
Charles E. Osborne, CFA, Managing Director
~The Three Rules of Prudent Investing