“Gladstone.. spent his declining years trying to guess the answer to the Irish Question; unfortunately, whenever he was getting warm, the Irish secretly changed the Question.” - 1066 and All That, by WC Sellar and RJ Yeatman.
The Holy Grail for investors, akin to solving the Irish Question, would be some methodology by which one could extract continued additional value from the market, relative to the market itself. That such a Holy Grail is seemingly elusive might be a problem of framing bias: perhaps the answer is not to try and beat the market every year, because no such investment strategy exists. Rather, perhaps the pragmatic solution might be to try and combine two objectives: to try and beat inflation and simultaneously to try and preserve capital; successfully combining these twin objectives over the long haul might ultimately end up giving investors a fighting chance of beating the market too.
In one of our favourite pieces of market analysis, Research Affiliates published their piece ‘How not to get fired with smart beta investing’ earlier this year, pointing to those stock market attributes which tend to outperform over the long run:
It feels, with Research Affiliates’ help, like we’re already part way there to finding the Holy Grail. ‘Value’ and ‘momentum’ tend to outperform over the long run, whereas ‘quality’ and ‘growth’, whilst perennially popular, invariably end up biting the big one.
A case in point. General Electric, the iconic US industrial bellwether, just announced that it would be cutting its dividend, for the second time since the Global Financial Crisis, and exiting a number of businesses, including its lighting division. GE’s shares have lost 42% of their value this year. General Electric is a popular stock within the ‘quality’ [sic] universe, and is a major holding for a number of ETFs, including the iShares Edge MSCI Multifactor Industrials ETF, the Fidelity MSCI Industrials Index ETF, the Vanguard Industrial ETF, the Industrial Select Sector SPDR Fund, First Trust Morningstar Dividend Leaders [sic], PowerShares Buyback Achievers [whether high achievers or low achievers is not immediately clear], PowerShares S&P 500 High Quality [sic] Portfolio.. the list goes on.
John Authers for the Financial Times points out just how much market value GE has destroyed since the turn of the Millennium, and he compares the company’s fortunes to those of its industrial rival Boeing:
John Authers cites the two words that are perhaps the most important in investing:
It doesn’t matter how (subjectively) ‘good’ a company’s products, services or management might be – beyond a certain threshold in share price terms, its stock can simply be too expensive. How to define ‘expensive’ ? Benjamin Graham effectively did so when he offered his definition of investment versus speculation:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
These should not be viewed as moralistic judgment calls, simply an expression of the distinction between ‘safe’ and ‘unsafe’ investment choices. (Note, too, that by Benjamin Graham’s definition, the bond market, with its entirely miserable yields, can only be regarded as speculative today.)
Lou Simpson, the former CIO of Berkshire Hathaway subsidiary Geico, was recently interviewed by Robert Korajczyk of the Kellogg School. Korajczyk asked him which factors he considered when worried that an investment might blow up and damage the portfolio:
There are a few factors that we look at. First, is this the business we thought it was? If you figure out that a business is not what you thought it was, that’s a bad sign.
The second factor is the management, which can also differ from what you thought. Unfortunately, a lot of managements are very short-term oriented, and that can be another reason to sell. This goes back to the basic integrity and the focus of people in charge.
The third factor is an overly high valuation, and this is often the most difficult, because you’re investing in something you wouldn’t buy at current prices, but you don’t want to sell because it’s a really good business and you think it’s ahead of itself on a price basis..
Morgan Housel also addresses the investor’s version of the Irish Question:
What’s a good investing formula? Finance attracts some of the smartest people in the world, so you’d think we’d figure it out by now. But by and large, we haven’t. And that’s because, unlike g-forces on an airplane’s tail, things adapt over time. There are strategies that work extremely well for years on end before, one day, they stop. Momentum is one. Buying stocks for less than tangible book value is another. 1999’s lesson was “Don’t buy Amazon at what looks like a crazy, valuation.” Which has been painful advice for the last decade. Value investing, on the other hand, works – sometimes. Ben Carlson recently showed that only buying stocks when they trade at below-average P/E ratio leaves you with below-average returns, and how below average those returns are has changed tremendously over time. I have spent considerable time with quantitative investors over the years. A question I always ask is “How do you know when your strategy has permanently stopped working?” It’s the hardest question for them to answer, and I can’t blame them. How hard would NTSB’s [the National Transportation Safety Board – broadly the US equivalent of Britain’s Civil Aviation Authority] job be if aerodynamics went in and out of favour?
..I think I’m more open-minded than I’ve ever been as an investor. I’ve seen too much stuff work that technically shouldn’t have worked, and too much stuff fail that technically should have worked.
Some things are timeless. Bubbles will always occur. A handful of companies will dominate industries. Things won’t be fair. Patience will be rewarded, stubbornness will be penalized, and we’ll never be able to tell which is which.
But I’m not optimistic on learning specific lessons from individual events. We are not the NTSB. There’s a limited amount we can learn from one event that makes us better prepared to handle the next event.
I think it’s rare that we can say, “Always do this.” Or even, “Never do that again.” Unless it’s flagrantly obvious or reckless, “I have an evidence-based strategy but I am perpetually open to amending those views as our ever-evolving world adapts, and I know I’ll occasionally be wrong even when I technically should have been right” should be your position on almost every business, investing, and economic topic.
So there may be no specific Holy Grail, but a pragmatic combination of ‘value’, momentum and genuine asset diversification may be about as good as we are ever going to get. Given the unique challenges of our time, that is certainly good enough for us.
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