Two decades of winning by not losing
To some of you, all Americans are exactly alike. I may as well be President Trump. Like him, you have no idea what I’m about to say. Well, check that: it often seems he has no idea what he’s about to say, and that’s a major source of uncertainty in all of our lives, both personally and professionally, that can create an insecurity on which much of the business media preys.
The business media, like President Trump, looks for winners and losers. They’ll highlight the stocks du jour that are either performing really well, and in the next breath, show a graphic of those that tanked. Stocks go up, stocks go down, sectors do well, sectors do poorly. It’s entertainment. Ultimately, I don’t find it very valuable. It’s no more than tabloid reporting. It’s their version of who is sleeping with whom and who has fallen off the wagon. Short-term market price movement does not tell us anything about long-term value.
At any given moment, the media highlights whichever few stocks are driving the stock market. In the U.S. in 2015, it was the FANG stocks – Facebook, Apple, Netflix, and Google. In the UK in 2016, it was just three rebounding commodity companies and one financial that accounted for more than three-quarters of the FTSE’s 14.4% return.
For as long as I’ve been investing, it has generally been the case that just a few stocks drive these indices, and that these few stocks pull the lesser performing stocks along with them. The investing community has come to define this law of financial physics as “positive skew.” “Positive skew” now joins “active share” in that lexicon. Passive management advocates don’t use this phrase to praise the active manager, but rather to poke at us.
What the passive manager would have you believe is that, thanks to exorbitant fees, to transaction costs, and to not picking winners, it's always better to index. I’ve read that maybe just 10% of the managers can outperform the market over time, and the odds that you will find that manager are even lower still. Armed with some selective data, some critics of our approach say that it is unlikely an active manager will consistently own those few stocks that drive stock returns in any given year, let alone year in and year out.
Fundamentally, passive investment is always going to look great during a long-lasting bull market. If an investor wants market rates of return and can withstand some volatility, then passive investing can serve as an efficient, low-cost tool. The further you get away from a bear market, the greater the number of people who have convinced themselves they can handle the downside – until the next time, of course. In the interim, if the indices are performing well, then you can bet that many investors – individuals and professionals, alike – are going to feel pressure to do whatever they can to ride the bull. They fear being different. Tracking error is bad. Owning too many securities in every sector is a sure way to avoid being fired for being different.
I’d rather spend my time surfing than to have to invest like that.
Passive investment will win in a bull market but it also loses when markets turn
Thanks to the accelerated increase of passive investing – now around 40% of the U.S. market – I’m confident that there will be a period when it will look really easy to beat a benchmark – followed by another time when, again, it won’t. I believe this academic argument against active investment is fundamentally flawed because it’s built on a false premise, which holds that only the best performing stocks will drive returns. The argument doesn’t consider the other side - if you avoid the worst performing stocks, you can still put up good numbers. This is a maxim I have taken to heart.
Let me take you back to the late 1990’s when people viewed the internet as a fast-growing disruptive game changer. And so it was. However, internet stocks of that era were largely priced at wholly illogical levels. In spite of this, many smart people couldn’t handle not participating. Maybe they were worried about not making as much as their friends. Or maybe they were worried about being fired. Whatever the reason, if they participated they generally lost badly.
The danger of short-termism
Critics also place too much weight on performance in each year and tend to ignore performance over a full-market cycle. This leads to short-termism, and short-termism is a breeding ground for all sorts of cognitive dissonance to which smart people fall prey when trying to adapt and join the crowd. In 2008, we sat on the precipice of a depression and many investors quickly liquidated their stocks and bonds, believing the economy would get worse, and stocks would continue to decline. It appeared correct to do so - for a time. Some of those who exited the market realised their mistakes and came back to the market, down the road after the economy found firmer footing, but also after prices had already rebounded.
Our approach to investing
Patience, a long-term focus, and avoiding the fads are crucial to successful investing. Some of the most successful stock investors of the last few decades in the United States aren’t known for finding the latest and greatest (Warren Buffett, Seth Klarman, my former partner of two decades Bob Rodriguez, to name a few). Each had their share of winners, but none created their enviable performance by owning those few golden stocks of a given year.
They won by not striking out, rather than by hitting grand slams. In other words, they won by not losing – emblematic of our approach.
We allow ourselves the opportunity to participate on the upside while protecting ourselves on the downside. Our focus is on fundamental research to identify companies that can create value over time. Some of the best investment decisions in my career have been acts of omission – avoiding those securities, industry sectors, and asset classes that we believed offered a poor risk versus reward opportunity. FPA’s Contrarian Value Strategy (CV strategy) – in line with which the Nedgroup Investments Global Flexible Fund is managed - operates with a global, go-anywhere mandate and invests across the capital structure, using mostly stocks and corporate bonds to seek equity rates of return, while at the same time seeking to avoid a permanent impairment of capital.
In this age of Instagram and Snapchat when immediate gratification seems to rule our lives, few portfolio managers have the patience to remain disciplined through their inevitable difficult periods, and even fewer clients are willing to stay with their underperforming managers. This cautious stance can bruise a business in the near-term, but in the long-term, it benefits those clients who stick around. As I wrote when Bob Rodriguez retired from FPA this past December, “He taught all of us what it’s like to put investors first, whether they like it or not.”
The only certainty we offer is that we put investors first
There’s risk to operating in our unconstrained idiosyncratic fashion. We won’t be fully invested at all times regardless of valuation. And although we may be avoiding losers, there will be times when our winners aren’t keeping up with the market. This will periodically lead to relatively poor performance and, we will invariably lose clients as a result. We will avoid whole sectors of the market for years, if not decades. We benefited by not owning technology stocks when they declined 78% from 2000 to 2003. It also helped that we didn’t own much by way of financials in the 2007 to 2009 time frame, as they collectively declined 76%. Since we aren’t closet indexers, our returns will therefore usually look vastly different than our benchmarks – for better and worse. As an unconstrained manager, we don’t have to do anything… and we certainly don’t have to do everything. Sometimes, it means that we do nothing. For some, that’s hard to do and for others it’s impossible.
We were hired to do what we think is right, which is the best way to protect one’s business (and reputation) – recognizing that sometimes we will be wrong. Therefore, we shop when goods are on sale, and when product is marked up, we look for what we might want to buy in the future. More importantly, consider how cash performs when there are historically high valuations, typically the time when we have more cash than usual sitting on the sidelines (as determined by a purely bottom-up analysis, not because of a macro view). Historically, when the CAPE ratio was above 25x, cash outperformed in the subsequent rolling 5-year periods 77% of the time. The CAPE ratio is at 29x today.
Since I started the Contrarian Value strategy, cash has outperformed the market almost half the time over rolling 5-year periods. Having cash when assets are priced to perfection generally has not been a bad idea, although it may not serve one well over the near-term. So, in addition to avoiding the losers, having the ability to not be fully invested has allowed us to win by not losing. I’m not arguing that holding equities for the long-term is a bad idea, but it does assume one actually holds them and doesn’t panic sell at inopportune times, an affliction of both professional and personal investors alike.
I'm an optimist. Over time, I expect that there will be global economic growth and that will translate into higher asset values. We expect however, that there will be bumps in the road and we want to make sure our portfolio has decent shocks on its chassis to absorb them. It will be important to stay the course when the going gets rough, but all the better to have some liquidity to put to work when others want, or need to sell.
After three plus decades of investing, I’m left with the following conclusions:
- Think long-term, in rolling seven to ten year blocks. It’s too hard to make good things happen every year, so why bother trying.
- Keep your own counsel. Relying on others just gives you someone else to blame.
- Don’t pay up. It’s the surest way to lose by not winning.
- Do your homework. Understanding a business will save you from mistakes.
And to those of you with the patience and fortitude to resist the temptations of the moment, to those of you who don’t want to be the mosquitoes that bang into every bulb that’s illuminated, you may not only not lose, you might just win more than you’d ever expected.
 Royal Dutch Shell A; Royal Dutch Shell B, BP, HSBC Holdings, and Glencore contributed 11.1% to the FTSE Index 2016 return.
 Steven Romick and Ryan Leggio, “The Importance of Full Market Cycle Returns.” See: http://fpafunds.com/docs/special-commentaries/2015-04-29-market-cycle-performance-final.pdf?sfvrsn=2
 Russell 3000 Technology sector declined -78.14% from 3/22/00 to 3/11/03. Source: Morningstar.
Russell 3000 Financials sector declined -76.18% from 10/7/2007 to 3/9/2009. Source: Morningstar.