I’ve been having numerous email conversations with readers about my investment philosophy and overall approach to investing. To understand my investment philosophy, you have to first understand the basic investment principles from the four investors who I’ve learned the most from: Ben Graham, Walter Schloss, Joel Greenblatt, and Warren Buffett.
My investment approach is a confluence of ideas that primarily stem from those four investors. Graham is the foundation. Schloss and Greenblatt add important ideas and strategies to Graham’s foundation. Buffett is the greatest of them all, but also the most difficult to replicate. His letters (both the partnership letters and Berkshire letters) have been the single most important aspect to my education as a value investor. I am in the process of rereading them now, after first going through them in 2006. But the foundation was laid by reading The Intelligent Investor, and then Graham’s opus magnum, Security Analysis.
Some investors feel that Graham’s tactics are not as relevant in today’s markets. But these are the investors that typically try to emulate Buffett without a proper understanding of how Buffett really operates. There are many “Buffett clones” who go out and look for “great businesses at a fair price”, eschewing the proverbial “fair business at a great price”. Graham was interested first and foremost in establishing a margin of safety. His method of doing so led him to buying a diversified basket of cheap stocks, many of which represented mediocre businesses. It’s not that he desired to own average businesses (his greatest investment was ironically a growth stock and a great business: Geico), but he felt that great businesses were too often overpriced, even when factoring in their future growth prospects.
One thing that Ben Graham said in the Intelligent Investor that has always stuck with me is this:
“If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue-relatively, at least-companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.”
That is the one sentence that stands at the base of my entire approach to investing. I reduce the quote down to this:
On balance, the market systematically and consistently overvalues companies with great outlooks and strong recent results. Conversely, the market undervalues companies with poor outlooks and weak recent results.
I think most investors would significantly improve their results if they kept this in mind.
The Dangers of High Expectations
Markets are made up of human beings interacting with each other, and humans are prone to act irrationally. We become very excited about stocks when times are good, and in the process we grossly overestimate future returns. One Wall Street Journal survey in the late 90’s (in the midst of an unprecedented run of 5 straight years of 20%+ returns from the S&P 500) asked investors what average return they expected to receive from stocks over the next 10 years….
The results from the survey: Investors, on average, expected 22.2% annual returns over the next 10 years from stocks! Really? The actual results over the next 10 years for the S&P 500: -1.0% annual returns.
This makes me think of something I recently read in Superinvestor Digest regarding Winston Churchill’s warning about the dangers of high expectations:
In the 1930’s, Churchill taught a lecture course at Cambridge on human sociology. One afternoon standing at the lectern and, always prone to the dramatic, he turned to the large class and demanded: “What part of the human body expands to 12 times its normal size when subjected to external stimulation?”
The class gasped. Churchill, obviously relishing the moment, pointed at a young woman in the tenth row. “What’s the answer?” he demanded. The woman flushed and replied, “Well, obviously it’s the male sexual organ.”
“Wrong!” said Churchill. “Who knows the correct answer?”
Another woman raised her hand. “The right answer is that it’s the pupil of the human eye, which expands to 12 times its normal size when exposed to darkness.”
“Of course!” exclaimed Churchill, and he turned back to the unfortunate first woman who answered incorrectly. “Young lady, I have three things to say to you. First, you didn’t do the homework. Second, you have a dirty mind. And third, you are doomed to a life of excessive expectations!”
I’m not sure if Churchill was a Ben Graham follower. He was Graham’s contemporary, and given Churchill’s emphasis on low expectations, he might have been a good investor. But the point is, most investors (I’m talking both amateur and professional) underperform the market because of their inability to discern the relationship between current earnings/valuation and future expectations for growth.
Expectations are overdone in both directions. In 2009 (after the market dropped 50% and after a decade of no returns) nobody wanted to be in stocks. Everyone that loved buy in hold in 1999, hated buy and hold in 2009. Of course, 2009 would probably have been the best time to initiate a long term buy and hold program if you were an index investor, as the market is up around 140% from the March 2009 lows. Most investors allocate their capital using the rear view mirror. This means when returns have been good, they expect future returns to be just as good. When returns have been bad, they expect future returns to be just as bad.
If Value Investing Works, Why Do Some Professional Value Investors Underperform?
It’s my opinion that even most value investors overpay for growth, and this causes them to buy good businesses at prices that are too high. We look at Buffett buying Coke in the 1980’s, and we understand his thesis, but then we try to replicate that type of investment with another franchise company that is too often priced too high. Everyone wants to own great businesses. That’s why it’s so hard to find them at reasonable prices. It’s true that good things happen to good businesses, and over time, the holder of a good business will likely achieve positive results. But their results might only match the market’s average return if they pay too much.
At Base Hit Investing, our main goal is to protect capital and minimize the risk of permanent loss of capital. Our second goal is to achieve returns that are significantly higher than the return of the S&P 500 over a long period of time (5 years or more). We want higher returns, but we demand lower risk. (Doesn’t everyone?) But to do this is difficult. You have to occasionally invest in stocks that other people hate, or that have well known short term problems. The media is likely telling you to stay away from these stocks….
My sister told me she read an article at the end of last year in some magazine that mentioned “4 retailers that will go out of business in 2013”. The piece mentioned J.C. Penney (JCP), Best Buy (BBY), Barnes and Noble (BKS), and Sears (SHLD). Here are the returns in just the last few months since 12/31/12 for those 4 hated stocks:
- BBY: +91.7%
- SHLD: +26.6%
- BKS: +11.7%
- JCP: -17.7%
If you invested equal amounts in these four stocks, your basket would be up 28.1% so far in 2013. These stocks were left for dead at the end of the year. Only JCP is down, and BBY has almost doubled in the last 2 months.
Now, I’m not recommending these stocks and I’m not saying that none of them will end up having problems. I’m just using the article my sister read as an example that often times, great investments comes from stocks that the public at large doesn’t like. Why? Low expectations cause markets (humans) to price things inaccurately. The market is very inefficient in the short term, but is much more efficient in the long term. Also, when a stock is priced for everything that can go wrong and just one thing goes right, the stock can dramatically increase in price. Conversely, when a stock is priced for everything that can go right, and just one thing goes wrong, the stock can get crushed.
It’s not that the intrinsic value changed that much, it’s just the expectations changed. Expectations (both high and low) cause market inefficiencies (read: opportunities for patient value investors).
Being Contrarian Helps, But You Have to Implement a Strategy That Has an Edge
Joel Greenblatt wrote a book in 2006 called The Little Book That Beats the Market. In his book, he lays out a now famous “formula” for not only beating the market, but achieving incredible results (at least that’s what his backtest shows us):
A lot of people question whether 30% annual returns are possible using his simple strategy (I do as well), but the point is that buying above average companies at below average prices works over time.
Greenblatt updated his study in 2010 and found that his strategy made about 13% per year from 2000-2009 vs the S&P 500’s -1%.
I use the magic formula as one of the inputs to my overall approach in my own investing. I don’t follow it exactly, but I use the principles and often invest in many of the same stocks. Many people have asked about the Magic Formula, and for those that don’t know about it, read the book. I’ll do a post on the two main factors from the formula soon. For those that don’t know, you’ll be amazed at how basic it is. There is nothing “magic” about it. It’s an extremely (almost ridiculously) simple strategy that most individual investors would benefit from if they simply followed it and did nothing else with their equity portfolios.
A common question is: If it’s so great, why doesn’t everyone use it? That’s a good question. The answer that Greenblatt gives us is that the formula is emotionally hard to follow. Although it significantly outperforms the market over time, it underperforms the market over shorter periods of time. About a third of the time, the market beats the formula in individual years. There was even a painful three year period that the formula underperformed the market. Most people give up on a strategy after a year or so of subpar performance. That’s why it continues to work over time.
To Sum Up This Post
My investment philosophy stems from the fact that markets price stocks inaccurately in the short term. By patiently valuing companies and buying undervalued stocks, I can gain an edge over the market. Many investors call this time arbitrage. I just call it simple, methodical value investing.
Buy things for less than what their worth, adequately diversify, and over time, good things might happen to you.
This post has gotten long and I can talk about these concepts all day, so I’ll leave it here for now… but I’ll discuss more ideas from Graham, Buffett, Schloss and Greenblatt soon. One of the things I want to do with this blog is discuss ideas that can benefit individual investors. Doing this also helps me clarify my own ideas, and in the process we can all learn and improve. In the next few weeks, I’m going to be starting a transparent portfolio and we’ll be discussing individual ideas in addition to the concepts I’ve been posting about. There is a lot to learn in investing, but understanding the principles will allow you to create simple methods that will give you a great chance to beat the market over time.