Investment PhilosophySuperinvestorsThink DifferentlyWalter SchlossWarren Buffett

Value Investing: Luck vs Skill Part 2

Earlier this week I responded to a comment that centered around the role of luck in long term outperformance. Feel free to read my response to the comment in Part 1 of this post where I list the #1 main reason why most people don’t replicate the results of Walter Schloss. It’s a very simple reason demonstrated by the results of Schloss himself.

Today, I’ll discuss luck in Part 2 of this post.

Does Luck Play a Role in Great Results?

I do think there is a lot of luck that goes into short term results. Luck is involved maybe even over 2-3 years. But over 5 years or 10 years, luck plays less of a role. I find it very amusing when luck is assigned as a reason for Buffett’s or Schloss’ results. I think it must be because it’s the stock market as opposed to real estate, steel, technology, media, manufacturing, etc… I’ve never heard luck as the reason for a business mogul’s success, but if you think about it, billionaires who made their fortune in industry by building or developing businesses outperformed others that were trying to do the same thing. I’ve never heard that pure chance was the reason that Murdoch, Trump, Gates, Walton, etc were able to achieve their results.

I suppose we’re all lucky to a certain degree from a general point of view. But I don’t think luck (i.e. random chance) can be seriously assigned to investors who outperformed throughout the course of their careers. After all, Buffett is a business owner. And as stock investors, we are business owners. Some are simply better at valuing, buying, and owning businesses than others. It’s really that simple.

When Stocks Are Thought of As Businesses, Your Mindset Changes

I think luck is given as a reason by those who think of the stock market in a completely different manner from the way I think of it. If you think of it as a casino, then you might assign luck to those who outperform. I simply think of the stock market as a place where I can find businesses (pieces of businesses) for sale at a wide variety of prices. Sometimes the prices as a whole are very attractive, other times they are not. But usually there are a few that are priced in such a way that my estimated future cash flows will be significant relative to the amount of money it takes to buy that business.

I think once a person really starts thinking about businesses as opposed to stocks, they will get to a different level of thinking. Buffett talked a lot about beating the market, but I don’t think he necessarily gave it much thought when he was looking for investments. I think he was thinking about the business, and the assets it had and the cash flow it was producing. And he thought about how much cash flow it would give him relative to the investment he would have to put in.

Just like an apartment building. When Sam Zell was building his empire, I doubt he ever compared his results to some arbitrary economic metric or some multifamily index. He just looked at each individual building and determined what it was worth to him based on the long term earning power of that building. Imagine if someone said he was lucky because his results outperformed GDP and said that his outperformance was due to pure chance. No one would take that seriously.

Is Business Outperformance Due to Luck?

Extending this example, the GDP is simply a number that measures the total value of all the goods produced and services provided in a country during the year. The change in GDP simply is the change in that overall amount of “sales”. It’s obvious that if GDP grows at 4%, there are plenty of businesses that grew their sales at much more than 4% that year and plenty that grew sales at much less than 4% that year. I’ve never heard someone say Google is lucky because they’ve managed to grow their sales at greater than 30% per year over the past decade and Alcoa is unlucky because their sales have declined at an average rate of 1% over the past decade. Most would say those results aren’t due to luck, but due to the fact that one business is better than the other at generating sales and growing their business.

One might say that Google is in an easier industry. Internet search is a faster growing industry than aluminum. But what about two companies in the same department store. Kohl’s has grown its revenues at around 9% annually over the past decade, well in excess of GDP growth. J.C. Penney, on the other hand, has seen its sales decline about 9% annually over the past ten years. Is Kohl’s simply luckier than JCP? I would say Kohl’s is a better business than JCP.

And I would extend the argument that if some businesses are better than others (and not simply luckier), then it would make sense that the owners of those businesses made corresponding good/poor business decisions when they decided to own them.

Note: One of my favorite anecdotes surrounding the efficient market and “luck” discussion is how Paul Samuelson, who won a Nobel Prize and was one of the most vocal advocates of efficient market theory ended up investing a large amount of his own money with Warren Buffett and got rich in the process! So even Samuelson deep down must have thought that some business owners (i.e. stock pickers) are better than others (skill was more important than luck). 

Stocks Are Just Pieces of Businesses-Some Better Values Than Others

So I think it’s possible to make reasonable conservative assumptions about the values of various businesses by reasonably approximating the quality of those businesses combined with the price that those businesses are being offered at. The stock market is really just that–it’s a market place where you can go to buy pieces of businesses.

Investing in stocks is really the same thing the local entrepreneur does that owns the McDonald’s or Subway franchise in town. How much do I have to pay to acquire the business and how much cash flow will I get in return over time? Some are better at business than others, and that’s really the simplest way to explain it.

I really don’t think luck has much to do with long term results of successful entrepreneurs, at least not relative to their competitors (I’ve often heard the following argument: “Well, Buffett invested during the greatest period of prosperity in US history”… okay, well that’s true, even though he’s seen 3 different 50% bear markets. But in that case, everyone has been lucky to have participated in the same market. How come Buffett, Schloss, and others did so much better than everyone else if everyone else had the same tailwind?)

Anyhow, it’s an interesting topic to debate. I’m obviously a firm believer that while luck plays an overall role in our lives in general, it’s skill that separates some business owners from others. It’s no different in the stock market, athletics, Hollywood, medicine, music, or any other field where some are significantly better than average.

Feel free to share you own ideas. It’s an interesting debate.

14 thoughts on “Value Investing: Luck vs Skill Part 2

  1. To be honest, luck doesn’t exist good thing happen, bad things happen, that’s why its best to spread your bets across a moderate ( not excessive) number of securities.

  2. One of the questions that I have to ask is this: Has value investing worked for you personally? Has it proven to be very profitable for you compared to other strategies? I have studied the art of value investing for awhile now, and I get the concept. There is always some doubt though, that why not go into other strategies. What is my opportunity cost? Value investing in my opinion is the best way to make money over the long term. Has it worked for you?

    1. Hi Lelonado… yes, value concepts have worked very well for me, and I anticipate that over time, the principles will always work. Value principles are basically the same principles that businessmen use when building their fortunes. As Munger says “All intelligent investing is value investing”. We’re all really trying to buy something for less than what it’s worth. Different investors employ different tactics, but it’s the same goal. The key is really thinking of stocks as businesses… and let the market serve you, not enslave you. I really divide market participants into two broad categories: speculators and investors. Speculation is not wrong, and it can (very, very rarely) be profitable. But it’s a completely different game that relies more on predicting and anticipating behavior as opposed to investing which is more grounded in boring basic facts about businesses. I found the latter to be a more reliable way of allocating capital. And if you’re in the “investing” camp, then you should be focused on value. Value can be interpreted in many ways… some like franchise businesses with great durability, some like growth businesses with long runways, others like cheap assets… but the key is to figure out the value of something you’re buying, and try to pay a lot less for it. Do that over and over again…

  3. Interesting posts responding to my comment on skill v. luck though I think luck in the form of regression to the mean plays a bigger role than you ascribe it, even in long-term results. See Bill Miller is a good example of one who had a great long term performance record…until he didn’t. And remember while he had his stellar record, he was the ONLY manager to have beaten the S&P for so many years in a row. Indeed, as Kahneman argues, we make incorrect causal interpretations of regression effects. This is evident also in the business world. Sure CEOs management practices influence business outcomes, but much less than you argue. Remember the books Built to Last and In Search of Excellence? As Kahneman points out, the profitability levels of the outstanding firms identified in these books dropped dramatically a short time after the respective studies were conducted such that the difference between these firms and the ones not classified as “built to last” or “excellent” shrank to almost nothing. The so-called magazine cover “jinx”–whether of superstar CEOs or athletes– is another example of the power of regression to the mean. This all may sound depressing but it is what it is and we should not delude ourselves otherwise. The investment world is uncertain even in the long term and is unknowable in advance.

    1. Thanks for the comment Dave… some more good points. Just as a counterpoint, here are a few more thoughts…

      I firmly believe in reversion to the mean… especially when it comes to growth and corporate profitability. (Although you should check out the Credit Suisse white paper on quality companies–it’s very interesting and shows how most good businesses remain good over time and most poor businesses with poor economics remain that way). But overall, I think capitalism at large promotes a reversion to the mean through observation of what’s working and competitive nature of business and the quest to make profits.

      But when it comes to investing… keep one thing in mind. Mutual fund managers have a huge uphill battle to climb. They first have a ton of capital to move around. Second, they have their own emotions to deal with (It’s hard for professionals just as it is for amateurs, sometimes for different reasons). Professionals have businesses and clients to worry about, meaning there is an inherent conflict of interest that exists in the mutual fund world (and much of that carries over to most hedge funds as well). Assets Under Management (AUM) is the raw material that managers use to produce huge paydays. It is their number one interest to keep clients. This inherently (although they would never admit this and probably don’t consciously believe this) promotes an incentive to be average. In this case, being average means likely not losing many clients and continuing the process of turning raw material (AUM) into large paydays in the form of management fees.

      There are very few fund structures where the incentives are completely aligned. They are usually in small investment partnerships around the country that you’ve never heard of, because the managers are quietly managing a small amount of money.

      I personally know of numerous managers with 10-year track records or more that manage their own capital alongside a small base of client capital in private partnerships where the results have ranged from 20-35% annually in a time where the S&P has gone really nowhere. These are just some guys that I know of… there are plenty I’ve never heard of… of course, some of these guys are becoming more well known and their funds are growing. Even some well known guys like Greenblatt produced 50% returns for 10 years, and 40% returns for 20 years managing a relatively small amount of capital that gave him the freedom to manage capital in the way he did. But the tactics that achieve this type of performance are viewed by the majority as atypical (risky) and thus wouldn’t be tolerated at the first sign of underperformance (which does happen even with those types of returns over a short period of time). I’ve talked to a few of these private managers and have observed how they’ve managed their portfolios. It’s not even close to the same way that Bill Miller or other well known mutual fund managers ran theirs. Berkowitz is the only mutual fund manager that I know of that runs capital this way, and even for him it’s tough because at the peak he had to move around close to $20 billion. His returns are absolutely remarkable given his size, and I think he’ll continue to do well over time because he doesn’t allow himself to be susceptible to many of the same forces that other managers are bound by. But look at Berkowitz in 2011 (down 33% or so). He lost 67% of his capital via the drawdown but even more so due to the withdrawals he faced. Most smaller funds couldn’t survive that type of performance, and so the managers aren’t incentivized to manage their capital in a way that has a chance of producing a one year result like that. But the problem is: to achieve big returns over time, you often have to not worry about the crowd (or your results) over the short term (1-2 years or less).

      So index hugging is promoted in the fund business and that’s why only 1 out of 200 managers beat the S&P by 3% or more over an extended period of time (according to Vogel’s research).

      In the end, I would say one more thing: if you’re interested in pursuing outsized returns from investing in stocks, I’d stop reading things that say these types of results are not possible (or lucky) and study the guys who have achieved long term statistically signicant records like Graham, Buffett, Schloss, Greenblatt, and others. This is not intended to be insulting to the author you mentioned, it’s just a general observation I’ve noticed over time: most of the guys who write this type of stuff can’t beat the market for some reason (they don’t have the emotional makeup perhaps, they aren’t practicing the same concepts perhaps, I’m not sure). But these are usually the guys who write the efficient market stuff. They assume since they can’t do it, it can’t be done or it is simply lucky.

      But at the same time, there are always people out there quietly going about their business beating the market and ignorning this debate. It will go on forever. Like I mentioned in the post, investing is like any other profession. Luck plays a role in life, but so does skill. And in investing (like medicine, music, sports, etc…) some are better than others.

      Luck plays a role in life for sure, but not in the way the EMH guys say it does in terms of ultimate long term results… This would be like one of us saying Michael Jordan is lucky because he was so good at basketball and we’re not. And extending that example, it would be like us saying LeBron James is lucky, and at some point his performance will revert to the mean and he’ll be no better than the average Joe at shooting hoops.

      This is a comical example, but for some reason in the stock market, it gets a lot of credence. I’ve never understood it. This logic promotes a “casino” type mentality and I think that’s like the reason behind it. The thought process the EMH guys have is completely different than how really talented investors think… it’s all about business, and less about beta, portfolio metrics, Sharpe ratios, and other nonsense. Some investors are better than others at valuing businesses, and thus the varying degrees of results.

      Anyhow, I’ve spent a lot of time thinking about it and there is no doubt that some investors will be able to consistently outperform the averages because they are just better than others. But it doesn’t mean everyone can (just like not everyone can play professional basketball–although beating the market is much more possible than getting drafted by an NBA team!).

      But in all seriousness, those who can’t or don’t have an interest in doing the work that is necessary (it is a LOT of work by the way), they are absolutely better off in index funds. I actually agree with some of the EMH guys when they say that index funds are actually a great investment for most people. This is not investment advice, and it’s not a recommendation–but it’s just an observation that index funds outperform most mutual funds because of the reasons I described above.

      Great thoughts… and I enjoy the discussion.

    2. I see my comment got to “post-type length”! I guess I’ve exhausted the topic on the blog posts, so we’ll continue the discussion here if anyone wants to.

      Thanks again for the links and your points Dave. Interesting topic to think about.

  4. John Huber,

    I believe you read the Greenblatt notes. There was a presentation made by Richard Pzena, (an investor with a great track record who normalizes earnings,) that mentioned that reversion to the mean always happens with companies with high returns or companies with low returns

    If a company is making high ROEs then it’ll attract other competitors and drive the returns down. A common bias is assuming that high ROEs will remain to have high ROEs. What actually happens is that companies that are doing very poorly with low returns, are desperately trying to get out of their situation. They’re much more incentivized to bring their company out of the hellhole it’s in. The piss poor companies get out of their situation and achieve normal situations. It’s similar to buying a hated company with low expectations. 1% of those poor companies go bankrupt, which is a small number

    I disagree with the fact that good always stays good, and bad always stay bad. The returns have to be sustainable.

    1. Yeah I remember watching a video of Greenblatt where this topic came up in the class… one time Greenblatt was actually asked this very question: What about the reversion to the mean in returns on capital (i.e. are you concerned about high ROC companies seeing their returns deteriorate). He basically said yes that can happen, but he’d still rather own a good business than a bad business.

      The study I mentioned is interesting… it provides some detailed research on a lot of firms and provides evidence that while there certainly is some mean reversion, the majority of good companies remain good and the majority of bad companies remain bad.

      But one can profit from investing in low ROC companies, it just depends on price. The problem with low ROC is that time doesn’t work in your favor. But on balance, cheap stocks can do well over time.

      In the end, it’s all about value. What are you getting and how much do you have to pay?

      1. John – Just read this article and wanted to thank you! Also, great comments! Just my two cents here:

        I read the Credit Suisse article on how companies with high ROIC tend to maintain it, while those with low ROIC tend to maintain it — saw the grid chart they did for the different quartiles. However, to me the more interesting part of that chart is how 49% of companies in the highest ROIC quartile see declining ROIC over the next five years, while 44% of companies in the lowest ROIC quartile see improving ROIC over the next five years. In other words, low ROIC companies have a built-in positive catalyst: improving cap management. High ROIC companies have a built-in negative catalyst: worsening cap management.

        Also interesting to me is Tobias Carlisle’s point in “Deep Value” (based on long term studies) that a dual/simultaneous focus on low price and high ROIC — and trying to get both at the same time — tends to hurt returns. Carlisle found that an exclusive focus on low price relative to earnings or cash flow produced better returns than a dual focus on low price and high ROIC. Looking at the Credit Suisse study, I think that’s because so many low ROIC companies improve while so many high ROIC companies get worse.

        I guess the lesson for me is that if I’m buying a spread of cigar butt companies — a la Walter Schloss or Ben Graham — I’m not willing to pay a higher average earnings multiple for a basket of high ROIC companies. Because of mean reversion, I’d rather ignore ROIC — or give it minimal attention — if it allows me to buy a group of stocks with a lower average earnings multiple.

        As a general matter, if you’re following a Graham/Schloss “group of stocks” strategy, I think you have to pay more attention to mean reversion with both ROIC and growth rates. That means not over-emphasizing low/high ROIC or low/high growth rates.

        If I’m concentrating a la Warren Buffett, I’m definitely more individual business-focused and am not as wrapped up in the idea of how companies generally mean revert. I just want: (1) “sure thing” companies where I’m 100% certain that earnings are going to stay the same or consistently grow over a long period of time — basically taking luck out of the equation; and (2) clear undervaluation based on a very conservative DCF analysis. Very few companies meet these two requirements — Coca Cola is the only one that comes readily to mind, particularly in today’s high tech, rapidly changing world.

  5. i think if i own some skills through which i can choose good stocks with great potential, the other things are decided by luck!
    as you know, there are many great investors that beat market in the long run. so i believe if you can grasp their some crucial skills you can do better! in addition, small investors can beat the market! i focus on deep value and invest in “bad company”.

  6. Actually it is much harder to be a good investor over the long term than to be in the NBA, there are up to 460 players in the NBA, I doubt that many good investors around, everybody keeps quoting the same 10 or so, I know many we have not heard of, but it is very rare to find a person who can beat the market year after year.

    There are lots of guys who practice value investing, and many who look at stocks as businesses, yet few have market beating returns over a long period. I bet you 100 million people have studied value investing at one time or another, now most only did it part time or a few months etc, but the competition is hard indeed.

    In the 90’s if you were to ask me how to beat the market and said value investing I would have said yes…

    Today I would say that is a starting point only. The ones who beat the market yes they knew value investing, but there is alot of other factors one has to look at to see why a guy like buffet was able to do what he did that others who also know value investing are not doing. Buffett is on a different level for many different reasons, thus the real reasons for his incredible returns over such a long time….

    1. It’s definitely not harder than the NBA. I don’t know how you would quantify that. More people can participate in markets than try out for the NBA, so that would skew the results. It doesn’t take a genetic beast to be a smart investor. There are plenty of good investors around, but there isn’t just some list of every great investor in the world. There are probably great private investors no one knows about. Something to think about is why most “investors” do poorly.

  7. John,

    In your discussions with these outperforming managers, have they mostly been concentrators? Have they focused on specific sectors? Do they use leverage? Are there portfolios more volatile than the market? Are there any common characteristics you find amongst them? Thanks.


    1. Packer, most of the managers with really high long term returns are concentrated (10-15 positions at most, a select few like Mittleman has a max of about 20 positions, with the top 3 representing 30% or so). But for the most part, to produce really high returns, they own just a few stocks. Some, like Mecham, have the majority of their portfolio in 3 stocks.

      I’m not endorsing concentration vs diversification per se, but its clear that looking at guys that have made 25-30% annual returns, they are all concentrated (Lampert, Pabrai, Mecham, and others). I think Mittleman’s averaged about 20% per year with slightly more diversification. I don’t know of any Schloss type investors today that maintain 50-100 positions and have averaged 20%, although there might be a few. Tweedy Brown ran a diversified fund back in the day that made those types of returns.

      As for volatility, I don’t have any stats on it, but my guess is they are more volatile. Mittleman was down 64% in 2008, and was up well over 100% in 2009, but that is the widest peak to valley swings I’ve seen. Some are not quite as volatile. Zeke Ashton has great results (I think he’s averaged close to 20% per year since 2002 and was only down around 8% or so in 2008). I don’t really pay much attention to volatility. I’m more interested in the long term results and the process they used to achieve the results.

      As for leverage, most of the guys I’ve talked with and most that I’ve researched use little leverage (many use no leverage at all). Some gain their leverage through the stocks that they own, but few use leverage. Greenblatt said you need to survive the downturns, and so its wise to not lose leverage. You never want to be taken out of the game.

      As for industries, no…most are generalists.

      As for common characteristics, I have a whole file of notes I’ve kept on top performing long term managers, but the summary is that they look for a select few obvious undervalued situations and they own relatively few stocks. There are some different tactics… many like free cash flow yields, quality businesses, but in the end, the one thing they have in common is they want to buy really undervalued situations. Sounds obvious, and I guess it is. There really isn’t any secret to it, it’s just that they have the mindset and the patience to implement that type of strategy, with is vastly different (and vastly superior) to what the average fund manager or average investor thinks about investing and portfolio management.

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