Here is a fun fact about the Sequoia Fund, the legendary mutual fund run by Bill Ruane and Richard Cunniff (for those of you familiar with Warren Buffett's history, you know that this is the mutual fund that Buffett recommended his investors put their money into when he shut down his partnership to pursue Berkshire Hathaway (NYSE:BRK.B)). The Sequoia Fund, which has returned 28,818% since 1970 (this is not a typo) outperformed the S&P 500's performance of 6,710% since that time (again, this is not a typo). But here is what you may not know about the year by year performance of the fund: it underperformed the S&P 500 every one of three years, sometimes drastically so.
In the early part of the 1970s, the S&P 500 member companies completely demolished the performance of the Sequoia Fund's holdings. In 1970, the S&P 500 outperformed the Sequoia fund by 8%. The next year, the S&P 500 outperformed the Sequoia Fund by 1%. By 1972, the S&P 500 outperformed the Sequoia Fund by 15%. And then in 1973, the S&P 500 outperformed the Sequoia Fund by 10%. Reflect on that for a minute. From 1970 to 1973, the old bogeyman "Mr. Market" was able to make a mockery of arguably the most successful mutual fund investors of the latter half of the 20th century.
At the time, the Bill Ruane had to deal with this fact: they had inherited a bunch of investors that were used to trouncing the market (seemingly with ease) every year under Mr. Buffett's stead, and now, they were trailing the market substantially in their first four years with Ruane and Cunniff in the Sequoia Fund. It takes a special kind of person to stick to the same strategy after four years of severe underperformance.
After all, it was not until 1975 and 1976 that Ruane and Cunniff's strategy started to pay off. In 1975, the Sequoia Fund returned 61% while the S&P 500 returned 37%. In 1976, the Sequoia Fund returned 72% while the S&P 500 returned 24%. There a couple of things we can learn from their deep value investing strategy. First, investors can do well over the long-term once they abandon this notion that stocks are supposed to move up by this nice, linear amount each year (be it 10% or whatever). The Sequoia Fund lost a quarter of its money in 1973, and made 72% in 1976.
Some investors like to see smooth 10% increases in their net worth each year. Long-term investing in common stocks (particularly as part of a value investing strategy) will not satisfy that desire. If you are someone who likes to see forward progress constantly, the best approach is likely to become a dividend growth investor and embrace the old British form of measuring wealth by the amount of private income generated. That way, if you got your portfolio stuffed with companies that have been raising dividends since the 1950s and 1960s (think Colgate-Palmolive (NYSE:CL), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), and Coca-Cola (NYSE:KO)), you can be reasonably assured that you will be receiving larger and larger dividend checks every year. If linear progress is important to you, choosing to own dividend growth stocks and measuring success as income growth is likely the best way to go.
The second, and perhaps more important, lesson to learn is that strategies may take years to realize the amount of value desired. We all know that in theory: if we buy a company that we believe is worth $35 and pay $20, the company does not automatically begin its march to $35 the day after we buy it. But in the case of Cunniff and Ruane, it is important to keep in mind just how long it took them to see the fruits of their labor: they had to wait four full years (48 months!) of drastic underperformance before the fruits of their strategy started to pay off. A less disciplined manager may have aborted the deep value investing strategy when everyone appeared to be getting richer.
At the old meetings for Wesco Shareholders, Charlie Munger would begin each meeting with something he called "Socratic Solitaire." He would ask himself a question and then answer it. During this introductory session, he said that what separates investors like he and Buffett from someone like George Soros is that Munger and Buffett are content to be lagging the performance of others. Munger said George Soros can't stand it when other investors are getting rich at a faster pace than him, and that led Soros to make ill-timed purchases in Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Cisco (NASDAQ:CSCO) during the height of the dotcom mania. If your eye is constantly trained on the performance of something like the S&P 500, it probably means that business fundamentals are not your top priority.
For me, the secret is to focus on earnings growth, and, as applicable, dividend growth. I have no idea what the S&P 500 is going to do, or will do. But here's what I do know: Colgate-Palmolive has grown earnings by 9-12% annually over the past decade (depending on how you choose to account for currency translations), and the company appears likely to do that for the next decade (by increase top-line growth at 6%, and by decreasing long-term costs by 4-5%, plus dividends and buybacks). If I pay a an intelligent price for Colgate-Palmolive, my next job is to monitor the operational results of the company, not focus on its stock price performance in relation to the S&P 500. It's not a problem if the earnings grow by 10% but the stock price only grows by 4%. That is a short-term problem that will correct itself, and if it does not, the company can then opt to buy back shares to create value.
Ruane and Cunniff delivered outstanding returns for Sequoia Fund shareholders under their stewardship. Even they had to tolerate four years of drastic market underperformance. The second you stop focusing on business fundamentals and start putting your finger to the wind to see what others are doing, you're asking for trouble. Every strategy will endure a period of underperformance. That is part of the cycle. Getting upset that others, be it the S&P 500 Index or a particular sector of stocks, are making more money than you at a given time is a recipe for disaster. If you focus your time on finding companies that will generate high future profits relative to what you pay today, you should not ever feel the pressure to beat the market.