Letter to a client, 11/25/12

JW,

Here are my ‘big picture’ thoughts about intelligent investing in general.

Risk First

• The best returns come from giving primary consideration to risk
• Risk is a function of price, not tranquility or turbulence
• Risk is permanent impairment of capital, not volatility

(Expected) Return Second

• Intelligent investing demands an understanding of why we’re expecting a given level of return. And though that’s an obvious bit of advice, it’s not widely practiced – at least not with the depth worthy of the fees being charged by my industry
• Where do returns come from? The long-term return on any investment can be broken down into income, growth in income, and changes in valuation levels
• Since I cannot say it any better myself, I’ll quote the legendary Howard Marks: “If you could ask just one question regarding an individual security, asset class, or market, it should be “is it cheap?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity.” – How Quickly They Forget

Success Requires the Proper Temperament

• In the short run (which can be excruciatingly long), the market is a voting machine, a popularity contest in which no one strategy works all the time (if there was such a strategy, everyone would use it, rendering it ineffective). This is why the proper temperament – patience and discipline, patience and discipline – is more important for success than a high IQ
• In the long run, the market is a weighing machine in which well-thought-out investment approaches rise to the top

Focus on the Overall Portfolio, Rather Than Its Individual Components

• Since any benefits of diversification accrue from low correlation among a portfolio’s components, success comes more from concern for the overall portfolio than for its individual investments (whether individual stocks, bonds, or funds). If you can ignore or at least remain ambivalent about the sometimes relatively large ‘wiggles’ of individual holdings, you’ll be rewarded by the lack of such wiggles in the portfolio as a whole

Time Horizon for Performance Evaluation is Key

• Moving synchronously with the medium term crowd, who evaluate performance over ~1-3 years, is one of the key behavioral mistakes that investors make
• It can be shown mathematically that the more frequently you view investment results, the more you’re seeing statistical noise rather than anything of meaning. Even an unusually highly skilled manager would deliver a painful experience when viewing the portfolio minute-by-minute, but a pleasurable experience when viewing the exact same portfolio once per year. This is the same investor following the same strategy

Let me know when we can chat.

Best,

Joe

Q3 2012 Quarterly Letter to clients, 10/29/12

Dear Marie,

There is a small-cap stock portfolio (the Shadow Stock portfolio) managed by the head of an investment education non-profit, James Cloonan, PhD, of the American Association of Individual Investors (AAII), that has a nearly 20 year track record of 16% annualized returns, whereas the S&P 500 has returned 8% over that same time period and a more relevant comparison (benchmark) portfolio has returned 9%. He uses a rules based selection methodology, which is publicly available – and has been since day one. (All transactions, along with quantities bought and sold, are also publicly available.) In his most recent article, Adherence to Rules Helps Shadow Stock Portfolio’s Performance, Dr. Cloonan said this (bolded italics mine):

“I was somewhat sad in March when I had to sell Lithia Motors (LAD) because it had become too large to be a Shadow Stock. The same thing has now happened with CONN’S Inc. (CONN). Both of these stocks looked very strong and their elimination presents an opportunity to discuss the second critical investment management rule. Rule number one is: Develop a consistent, well-defined approach to investing in stocks. Rule number two is: Stick to it. Rule number two is extremely difficult to follow. There is always a reason to deviate. If those two stocks had been in my personal portfolio, I might well have kept them— thinking, “This time is different.”

The Model Shadow Stock Portfolio has had a geometric return of 16.1% a year since inception (almost 20 years). I cannot find a single mutual fund or advisory letter that has done better. It would seem very unwise to think I could make on-the-fly adjustments to the rules and do better. Following your rules doesn’t mean rules can’t be changed over time with evidence of a reason for change. We have looked at the historical impact of our rules and have modified some of them. We monitor the sell rules for market capitalization and for price-to-book ratio and have not found a justification for change.”

Unfortunately, you cannot invest with him in this portfolio. He uses it as a teaching tool. But you can learn from it. The lessons are many.

A broad, general description of Dr. Cloonan’s approach is that his rules seek out “cheap” stocks, stocks trading at low valuations relative to fundamentals such as cash flow, earnings, book value, etc. To put this approach into perspective, here’s what legendary investor Howard Marks, Chairman of Oaktree Capital Management, said in his May 25th, 2011 memo to investors, How Quickly They Forget:

“Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity.

So if you could ask just one question regarding an individual security, asset class or market, it should be “is it cheap?” Oaktree’s investment professionals try to ask it, in different ways, every day.”

In my last letter, I touched on the building blocks of return – income, growth in income, and changes in valuation – and the significance of price in the expected return thought process. In this letter, I’m going to focus on another building block of return: individual behavior.

Develop a consistent, well-defined approach to investing

Asking the question ‘is it cheap?’ represents an investment approach that separates the price of an asset from its value. Since it’s not possible for an asset to be a good investment regardless of the price paid, this approach says that low price in relation to fundamentals is associated with high future returns and high price in relation to fundamentals is associated with low future returns. This relationship makes the most sense to me.

Therefore, the key question becomes, what is a fair valuation, and what is expensive? Unfortunately, you may get as many different answers as the number of people you ask. Therefore, it is incumbent upon you or your advisor to know what your answer is, and why. And, ultimately, the answer to this question is the answer to a related question: At the asset class level, is it different this time?

Are corporate profit margins in the aggregate going to permanently remain substantially higher than their long term average? Is the long term growth in corporate earnings going to permanently increase or decrease from its average of the last 70+ years, during which we saw recession/expansions, inflation/stagflation, bull/bear markets, war/peace? Are interest rates going to remain permanently at historical lows?

If you can answer these types of questions, you know everything you need to know to earn above average returns as a diversified investor. However, the key to actually earning those returns is less about this knowledge than it is about having a different psychology from investors generally. You must be willing and able to act differently with this knowledge. Here’s what Howard Marks said about it in his September 10th, 2010 memo, Hemlines:

“…investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, “. . . people get into trouble when they forget that in the long run, stocks won’t appreciate faster than the growth in corporate profits.” Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation (Joe Almon: i.e., changes in valuation). People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios (Joe Almon: price to earnings ratios, or price divided by earnings) described above and thus was unlikely to continue unabated. Rather than healthy performance that could be extrapolated, this swollen return should have come as a warning that valuations were unsustainable and likely to regress toward the mean. But investors consistently fail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses. The tendency on the part of investors toward gullibility rather than skepticism is an important reason why styles go to extremes.

Wharton’s Professor Jeremy Siegel, the author of Stocks for the Long Run, used historical data (a) to demonstrate that there had never been a long period when stocks didn’t outperform cash, bonds and inflation, and thus (b) to argue that most people of average risk tolerance should have roughly 100% of their capital in the stock market. But Siegel, like many laymen, failed to pursue the most critical line of inquiry. The right question to ask in the late 1990s wasn’t, “What has been the normal performance of stocks?” but rather “What has been the normal performance of stocks if purchased when the average p/e ratio is 33?”

At the asset class level, a consistent, well-defined investment approach which distinguishes between price and value is driven by the answer to one question: Is it different this time? Once you’ve come to terms with your answer to that question, you arrive at Dr. Cloonan’s rule number two: stick to it.

Stick to it

Rule number two is extremely difficult to follow. There is no way to overestimate the difficulty of sticking to it. The evidence of this should be obvious from the opening of this letter, where Dr. Cloonan says, “The Model Shadow Stock Portfolio has had a geometric return of 16.1% a year since inception (almost 20 years). I cannot find a single mutual fund or advisory letter that has done better.” Think about that for a minute, then consider this. In an industry where the smartest, most sophisticated equity portfolio managers are considered elite if they outperform their benchmarks by 2% annualized, and stratospherically elite if they outperform by 3% annualized, Dr. Cloonan’s portfolio outperformed its benchmark by 7% annualized.

Too good to be true? No, just proof of how incredibly difficult sticking to it really is – and the incredible value of extremely rare, and disciplined, behavior. I’ll repeat here the quotes from three legendarily successful investors which I included in my last letter:

The investor’s chief problem and even his worst enemy is likely to be himself. – Ben Graham

Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. – Warren Buffett

It’s not supposed to be easy. Anyone who finds it easy is stupid. – Charlie Munger

The right question to ask at this point is, how much risk did Dr. Cloonan take to achieve such dramatic outperformance? Did he take an amount of extra risk commensurate with his extra return? More? Less?

Distinguishing between risk and volatility

In my last letter I told you my definition of risk is permanent impairment of capital, not volatility, and I explained why this is the case.

At the asset class level, such as a broadly diversified index fund or a broadly diversified actively managed fund, such permanent loss is the result of buying high and selling low, plus the possibility of default in the case of bonds. In a less diversified portfolio, it is possible to so grossly overpay for a group of assets as to permanently impair the value of your investment, as happened with many portfolios of internet stocks in the Dotcom Bubble.

In the case of Dr. Cloonan’s Shadow Stock Portfolio, since the stock selection criteria requires financial health and a bargain price, as do the ongoing monitoring criteria, it’s hard to argue he’s taken more risk to achieve his excess return. His portfolio is more volatile than its benchmark and the S&P 500, but less than commensurate with his outperformance. So even by that measure, he’s in a class by himself.

But that isn’t his point, and it isn’t mine. The point is, as I said in my last letter, having the right general principles and the character to stick to them. Ben Graham said exactly that in his last interview with the Financial Analyst’s Journal, after nearly 60 years of experience. Now Dr. Cloonan is making the same point via a track record that begins nearly 80 years after Graham ‘s career began. Maybe there’s something to this advice both men are emphasizing…

There is always a reason to deviate

Rich forward-looking risk compensation typically prevails when investors are terrified, as they were in early 2009. Poor forward-looking risk compensation typically prevails when investors are unafraid, as they were in 1999 and again in 2007. If you want to alter your allocation over time to own more stocks when they seem relatively cheap (when others are afraid) and less when they seem relatively expensive (when others are unafraid), you’ll likely get better results than the vast majority of investors, but you’ll need unusual patience, discipline, and psychology to do this. There is always a reason to deviate.

It is typical for some of the world’s greatest investors to disagree about the outlook for inflation/deflation, whether stocks are fairly valued/undervalued/overvalued, whether we’re in/about to enter/about to exit a recession, whether the EU will breakup or stay together, etc., etc., etc. Rather than try to predict such things, focus on where returns come from and what you should reasonably expect going forward given the price you’re paying today. You must decide what you believe – decide what your rules are – and stick to it. There is always a reason to deviate. You cannot flip flop and expect to win over the long run.

If you’re going to ignore the market until it either excites or terrifies you, and you buy when excited and sell when terrified, you’re in big, big trouble. If you can ignore it altogether, you’ll get market returns, which is better than most investors get. Over full market and economic cycles, returns come from the coupon payments of bonds and the growth in earnings and dividends of stocks, and from your behavior. The only thing you control is your behavior. There is always a reason to deviate. Doesn’t that warrant more attention and effort than something you don’t control?

Develop a consistent, well-defined approach to investing – and stick to it.

I will write to you again in January. As always, call or email anytime with questions or concerns.

Best regards,

Joe

Letter to a client, 10/21/12

Dear Karen,

As I re-allocate your portfolio, I wanted to share my thought process in determining both the asset class weights (relative proportion of stocks, bonds, etc.) as well as the choice of specific mutual funds/ETFs. I begin by determining asset class weights, then choose funds/ETFs to fulfill them.

Asset Class Weights

Asset class weights are the result of the intersection of two assessments:  1) the client’s ability to tolerate volatility and lagging performance and, 2) the expected return of the asset class in question. Let me briefly explain.

Research indicates that volatility and lagging performance are the two major reasons why investors tend, in the aggregate, to buy high and sell low. In the case of volatility, at some point significant downside volatility, such as seeing their stock portfolio decline by 50% or 60% – or 80% in the case of the Nasdaq when the dotcom bubble finally burst – causes most people to wonder, ‘I’ve lost half my assets. How hard would it be to lose the rest?’ Unprepared to start over, they sell.

In the case of lagging mutual fund/ETF performance, most investors sell recent ‘laggards’ to buy recent ‘performers.’ Unfortunately, this amounts to selling low and buying high. The reason is that even highly accomplished investment managers lag their benchmarks (and unaccomplished ones outperform theirs) for prolonged periods of up to ~3 years, yet outperform over longer periods of 5-7 years (while the unaccomplished lag over the longer term). Tolerating underperformance for up to three years can be difficult for anyone, but it’s nearly impossible for investors who feel they are paying their advisor to avoid such a scenario. Just last week, a bright, well-educated client emailed me to ask, ‘what’s up with this commodities fund that’s down 20%?’ His gut was telling him to sell. Of course, it would ‘make sense’ to replace it with something that had done better.

I told him I cannot predict when a skilled manager is about to enter a period of short term underperformance – but they all do. What I can do is identify what works in investing and why, and who practices it with intense discipline. Then I stick with them through the inevitable thin periods, protecting my clients from the intuitive though highly wealth destructive pattern of sell low/buy high. 

The other determinant of an asset class weight is the expected return of the asset class itself. For example, the expected return of the S&P 500 is much higher if you’re paying 1982 valuations of approximately 8x’s the earnings from the 500 stocks, and over a 5% dividend yield, than if you’re paying 1999 valuations of approximately 33x’s the earnings and less than a 2% dividend yield. Since it’s not possible for something to be a good investment regardless of the price paid (in relation to fundamentals such as dividends, earnings, free cash flow, etc.), it makes sense to allocate more when you’re paying 1982 valuations and less when you’re paying 1999 valuations. Low price in relation to fundamentals is associated with high future returns. High price in relation to fundamentals is associated with low future returns. 

A quick note about asset class expected returns. My ongoing research always includes the work of both academics and practitioners who study asset class valuation, such as GMO, AQR, Research Affiliates, PIMCO, etc. Not surprisingly, they don’t always agree. Therefore it’s incumbent upon me to have some ‘bottom line’ belief about how finance works at the asset class level in order to decide the debate at such times. Here it is: In our fiercely competitive global economy, reversion to the mean is the dominant economic force. Competitors attack excess returns and change agents attack deficient returns. From either direction, over the long term, things return to normal. At the asset class level, it’s never different this time.

Specific Mutual Funds/ETFs

Choosing specific funds/ETFs to fill the asset class weights is a function of my direct experience as an investor and professional trader, as well as staying consistent with my bottom line belief about how finance works. I blend actively managed mutual funds together with lower cost index funds/ETFs in pursuit of more attractive risk-adjusted returns than passively managed index funds/ETFs alone can provide.

In addition to running run my own hedge fund and trading options and futures professionally in Chicago, I’ve invested in traditional mutual funds as well as privately held businesses, farmland, and other hedge funds. Humbly, I will tell you I’ve learned far more from my mistakes, of which there have been plenty. This is why, if you recall the long conversation that ensued when you first interviewed me, I told you my focus was on avoiding large losses. If you do that, the gains take care of themselves. That is the magic of compounding.

My personal experience, and that of others, suggests that it is possible for a small minority of investors to do better than the average. Two conditions are necessary for that.One is that they must follow some sound principles of security selection which are based on value in relation to fundamentals, not market price action (buy XYZ/the market because it has gone up, sell XYZ/the market because it has gone down). The other is that their method of operation must be basically different than that of the majority of security buyers. They must essentially be constitutionally different from the average investor – a difference in psychology from investors generally. In this regard, many are called, few are chosen.

In deciding to pay active equity management fees, I require the two conditions above, which typically manifest in one or a combination of ways:

1. A mandate allowing a disciplined focus on the value of stocks in relation to their fundamentals to result in the fund holding substantial levels of cash or cash equivalents when the managers can’t find stocks meeting their buy criteria
2. A philosophy which stays fully invested but employs hedges when deemed appropriate
3. A mandate which concentrates portfolio holdings in businesses with superior economics (those with a durable competitive advantage)
4. A philosophy under which the managers significantly alter their position sizes based on their assessment of risk/reward
5. A ‘go-anywhere’ mandate allowing the managers to own the best bargains available in a company’s capital structure, whether equity or debt, or the securities markets generally, whether equity or debt

Basically, if I’m going to pay active equity management fees, I’m paying to be different, with both theory and historical evidence on my side. Similarly, if I’m going to pay active fixed income management fees, I typically require niche expertise and/or superior capital protection (in the form of lower default rates).

Other categories of funds for which I’m willing to pay active management fees are commodities/managed futures and absolute return funds. In all cases, I require a combination of theory and supporting evidence, either in the form of a track record or discriminating research, to invest. Otherwise, I’ll use low cost index funds/ETFs.

To conclude, I am confident in the investment plan set out for you, and in my ability to execute it. The plan is low in cost and high in value. I will adjust to opportunities as they arise, keep you informed of my thinking, and serve your needs any way possible.

Best regards,

Joe