Chris Mayer wrote about an interesting thing from Barton Bigg’s “Hedgehogging” book. Biggs looked into the track records of the 10 investment management firms in Buffett’s “The Superinvestors of Graham-and-Doddsville”, and spotted something interesting: the superstars lagged the S&P 500 in about 30 to 40 percent of the years studied. None of the group always beat the S&P 500 and some of the greats had relatively long periods of time, three of four consecutive years, where they lagged the market. Almost invariably, sustained bursts of spectacular returns either preceded and/or followed those bad periods.
I think the outcomes illustrated the value investing approach well:
- Value investing tend to be contrarian, buying stocks when they are beaten down to a value well below their intrinsic value, giving it a margin of safety (or you can think of it has being an investment with a high IRR).
- There is a tendency to end up going in early, not because by choice, but because i) the valuation has reached an attractive level, ii) you do not time the market (i.e. you do not hold off from buying because you THINK that the market is going down), iii) you believe that the fundamentals of the company are still good to warrant the purchase.
- Because of the problem of going in early (relative to the market’s lowest point), and the fact that in a crash, the market really tumbles, the performance of value investing funds suffer.
- Where the real money is made, is when a value investor averages down at lower and lower prices. One of the common things that people learn is that when they lose money, its hard to make it back (e.g. if you lose 50% of your money, you need a 100% return to break-even). This very same amazing effect comes into play when you average down. The returns that you make really shoots up the cheaper you can buy the stock. The returns from buying a stock at a 50% discount is drastically different from a 60% discount, and a 70% discount. Imagine spending $X to buy a stock and you can buy 50,000 shares of it, compared to spending the same $X and only being able to buy 30,000 shares of it. When the stock recovers, the difference in the gains is very very significant.
- That is why after lagging the market, there would be sustained bursts of outperformance.
- The fact that most value investors makes money on the recovery reminded me of an interesting situation where Bill Ackman and Martin Whitman, on the surface, took opposing sides on MBIA. Ackman shorted MBIA and made money as it went down. Whitman bought into MBIA and made money as it recovered. Both were right and made their money in different ways.
There is a related point that is interesting:
- In a typical fund with short-sighted investors, in a bull market, the investors pile more money into the fund and fuel ever higher prices. And by definition, in a market top, it is the situation where there are many more buyers than sellers -> i.e. most people buy high.
- When the market crashes and at a market bottom, it is by definition a situation where there are many more sellers than buyers -> i.e. most people sell low. Investors panic and start pulling money out of investment funds at precisely a time when they should not be doing so. And because of redemptions, funds are forced to sell low.
- In this way, most people and funds end up buying high and selling low.
Finally, some last points on market timing:
- Buy with a margin of safety
- Reduce when it reaches valuation and sell off when significantly above (e.g. 20%). Another disciplined way is to set a maximum position size for a stock (e.g. 15% of portfolio) and be forced to reduce the position if the stock goes up too much.
- When the price is in-between, don’t do anything so long as the investment thesis holds and there are no better opportunities for the funds.
- NEVER EVER buy or sell because you THINK the market will go up or go down.
- Staying fully invested all the time is not equivalent to not doing market timing. It would not make sense to hold on to a ridiculously overvalued stock, or to buy into stocks with low or no margin of safety for the sake of being fully invested. While Warren Buffett holds on to many major companies through peaks and trough, that is more because of his position size that prevents him from moving in and out of companies easily without disrupting the company’s operations. One interesting benefit is the amount of intel that Buffett gets from his portfolio companies that allows him to feel the pulse of many segments of the industry as seen from a recent interview.