Resolutions for the New Year
(Guest Commentary by Rick Konrad - December 28, 2006)
Dear Subscribers and Readers,
I apologize for the week's delay in reaching out to you in Marketthoughts.com. I have been extremely busy with my eldest daughter's wedding, a number of related receptions, a growing influx of new clients, the closing of a Spanish private placement investment and related trip, and finally the holidays. But enough about busy-ness and on to more important business. Let me take this opportunity to wish you and yours the best of holidays and a healthy and happy new year!
A new year elicits many resolutions. For most of us, this includes resolutions of health and fitness. Certainly, financial health and fitness need to be addressed as well! I think this is always a great time of year to examine portfolios, to understand what it is you are “rooting for” and to understand the biases that we all bring to our portfolios.
Most of us pride ourselves in our security selection, our stock-picking. Yet, our portfolios often reflect very mainstream conventional names, stock-picking often entails merely portfolio mimicry. This tendency is probably greater for my value investing crowd than for the growth crowd. So often, an innate human tendency to find favor with others causes us to reproduce or re-create their portfolios. Websites like Gurufocus.com and Stockpickr.com rely on our desire to resemble the “smart money.” Yet, so often the smart money can be wrong. Though it sounds blasphemous, even Buffett himself has made some rather silly investments. Those who believe otherwise should examine the history of The Dexter Shoe Company, a wholly owned subsidiary of Berkshire where the transaction was actually monetized in precious Berkshire Hathaway stock rather than cash, or Handy and Harman, a silver processor that Berkshire endured for almost a decade. I could publish a rather long list of my bone-headed mistakes, but unfortunately I am limited by time and available space!
Some of our worst errors in investment judgment occur as a result of unquestioned acceptance of theory as fact, blind following of conventional wisdom.
How do we know what others don't. Ken Fisher in his recently published book,”The Only Three Questions that Count” cites the three important questions that investors should ask themselves as:
- What do you believe that is actually false?
- What Can you Fathom that Others Find Unfathomable
- What the Heck is My Brain Doing to Blindside Me Now
Bottom line, these questions all address the issue of self-deception. Do we deceive ourselves into a false belief because of conventional wisdom.? Is there a reasoned conclusion or is that merely the point at which you got tired of thinking?
But Ken Fisher's views, though very well written and presented in his excellent book, are hardly fresh. In fact, Charlie Munger had recommended a similar book , “How We Know What Isn't So” at a Berkshire annual meeting many years ago. The book, authored by Tom Gilovich is still a worthwhile read in my opinion.
The book, published in 1993 examines self-deception in many facets of life. For example, some 94% of all college professors think they are better at their jobs than their colleagues. Some 84% of medical residents thought that their colleagues were influenced by gifts from pharmaceutical companies, but only 16% thought they were similarly influenced.
Be honest with yourself. Understand why you have a certain security in the portfolio and your original contention for including it. Does it live up to your original premise? Are you merely treating it like an appendage to the portfolio rather than a core of your thinking?
Conventional thinking leads to conventional results. Stocks always compensate you for the risk you undertake, right? WRONG! For ten years in the early 80's through early 90's, Canadian long bond returns were far superior to those of the Toronto stock indices. This outperformance of bonds relative to stocks persisted for only about 5 years in the States, nevertheless, financial theory suggests that this really should not happen.
Robert Arnott in a recent Financial Analysts Journal reflects on how much of modern finance assumes a 5 percent risk premium for stocks relative to bonds…simply because that extrapolates a historical trend that has persisted for 80 years. But the past is not prologue to the future…if markets assume “it,” “it” is often already discounted.
Gilovich warns that we should be on guard to avoid, the tendencies to
- Misperceive random data and see patterns where there are none;
- Misinterpret incomplete or unrepresentative data and give extra attention to confirmatory data while drawing conclusions without attending to or seeking out non-confirmatory data;
- Make biased evaluations of ambiguous or inconsistent data, tending to be uncritical of supportive data and very critical of unsupportive data.
Accepting evidence that confounds your conventional beliefs is not much fun, yet it is a necessary part of investing. Many examples abound where conventional thinking may be completely false. Take a scientific approach and do what Fisher suggests, “Understand the Truth rather than the Mythology.”
Here's one that we all believe, I think. High P/E's lead to below average returns, right? In fact, the scariest double-digit declines for the stock market have occurred when P/E's were below 20, NOT when they were very high. According to Fisher, in the last 134 years there were 19 times when the market's return was below minus 10%. Thirteen of those times, the market was at a middle to low range of its long term average valuation of 16.5 times. Only twice, in 2001 and 2002 did a large drop coincide with a P/E over 20!
Henry To of this fabulous publication has written considerably on budget deficits and the dollar. A lot of investors view a federal budget deficit as a horrible sinkhole that sucks in capital from equity markets. Yet, when the actual evidence is examined, since 1947, investors who bought stocks at federal budget deficit extremes had one two and three year returns much higher than long term averages. Stocks bought in the aftermath of budget surpluses provided materially below average returns.
Another old saw that many investors believe relates to the “benefit” of a political impasse, I examined this false conventional wisdom in a Value Discipline post in October:
Political Gridlock…Is Impasse Good for Capital Market Returns?
The answer probably ain't what most of us think it is.
Financial theory, and certainly conventional wisdom teach that low payout ratios (or ideally, no dividend at all) suggest faster earnings growth. Market observers often view low dividend payout as a signal for high future earnings growth. The rationale is that companies will pay fewer dividends or retain more earnings when growth opportunities abound, so that low payout indicates strong future earnings growth.
Yet, evidence by Arnott and Asness (Financial Analysts Journal , January/February 2003, Surprise! Higher Dividends = Higher Earnings Growth) and by Zhou and Ruland (Financial Analysts Journal, May/June 2006 Dividend Payout and Future Earnings Growth) suggests the contrary. High dividend payout companies tend to exhibit strong, not weak earnings growth! What explains the positive relationship between current payout and future earnings growth? A possibility is the overinvestment of free cash flow by companies with low dividend payouts.
Guard yourself against the possibility of self-deception. Wishful thinking is not a subset of thinking; it is merely a substitute for thinking. Don't succumb to the seduction of conventional wisdom and elegant theories. Mankind has subscribed to a belief in a flat earth for much longer period of time than the modern viewpoint. Theories tend to rely on simplifying assumptions…theories represent an approximation of reality.
Mimicry and camouflage exist in the biological world as protection from predators. This is a useful and widely practiced technique for portfolio managers who wish to deceive pension consultants and committees. Failing conventionally is a lot easier than succeeding unconventionally. Don't just own something because you think someone smart also does. Understand what it is you are rooting for, why you own it and what you expect from it. When it no longer satisfies those requirements, see that you don't own it!
Keep an open mind. Call into question the ideas that you and others may have held dear. Test the boundaries of your thinking. Don't ignore the countervailing evidence because of your own stubbornness and closely held beliefs. But stay on top of your portfolio, portfolio management is an ongoing process of assessment, renewal, and redemption.
Finally, if your thoughts about your portfolio resemble, “the glass is half-empty or half-full,” the problem is that your glass is twice as big as it should be. Portfolios that I often come across either are way too concentrated in a single sector or meaninglessly diversified across too many securities, as I call it, a collection rather than a portfolio. Diversify your bets across industries and sectors but concentrate those positions.
As always, I appreciate your feedback, commentary and perspective.
Have a happy, healthy and prosperous New Year!