In my 32 years in the investment business, success in common stock investing seems to come down to math, history and psychology. At Smead Capital Management (NYSE:SCM), we have built our investment discipline and our eight proprietary criteria around these academic subjects. With the stock markets gyrating wildly the last few weeks, we thought it would be helpful to see where we are today in each of these disciplines. We will start with our view on the math section.
We believe the math of common stock investing is pretty simple. Without leverage, you can only lose your original investment. Your gains can be unlimited over the longest term (long duration). Most of the benefit (90%) of diversification is reached by owning a twelve-to-eighteen stock portfolio. Valuation matters dearly to portfolio results. Stocks purchased at depressed prices (as a group) outperform those which are more expensive over both shorter (1 year) and longer-run time periods.
Turnover creates expense and is the enemy of performance. Long-term common stock performance fits on a bell curve. In a portfolio of well-selected common stocks, most of the long-term gains are going to come from 20% of the portfolio. This is only true if the most successful shares are held to a fault. Every stock which goes up ten-fold, must have first doubled, tripled and quadrupled. The only good reason to sell shares in a successful common stock of high quality is if it gets what we call "maniacal" pricing or if it no longer meets our eight proprietary criteria. Maniacal pricing to us means a PE ratio more than two times the average of the prior ten years.
One hundred percent of the stocks that go to zero fell by 20%, 40% and 60% before ultimately losing 100% of their value. Poor stock price performance among our portfolio holdings requires us to refocus on the fundamentals to preserve capital. Other than maniacal pricing, worrying about price performance of fundamentally strong businesses is damaging to performance and success.
Our observation over 32 years is that no one can consistently predict either the stock market or the US economy. Therefore, breaking any of the mathematical disciplines mentioned above, based on stock market or economic predictions, has the potential to ruin the benefit of common stock investing. Paying someone to make directional stock market or economic predictions automatically reduces portfolio results by its cost. Stocks, as measured by Ibbotson and Associates, have outperformed the other major liquid asset classes over long stretches of time (30-50 years). However, to get this added return you must accept some extreme variability of returns.
In the view of SCM, most of the best mathematicians in the investment business spend their time trying to predict the direction of the stock market or the size of the GDP of the US economy. This over-crowded playing field should function like all other crowded playing fields have over the last 32 years. Use of macroeconomic forecasting should make for very low returns in the stock market and in asset allocation because too many people are "trying to squeeze blood out of a turnip". We believe individual security analyses is as unpopular as it just about ever gets and will have a much easier time than it normally would in providing additional return for those who use math to practice it.
Next we will focus on history and the importance of that academic discipline to us as common stock portfolio managers here at Smead Capital Management (SCM).
Edmund Burke said, "Those who don't know history are doomed to repeat it." We at SCM like to think in terms of taking advantage of what we know about history to make money owning good quality common stocks. Mark Twain said, "History doesn't repeat itself, but it does rhyme!" We believe these are the most important statements on how history should affect portfolio management decisions. In our opinion, you must know the history of the markets and you must trust the "rhymes" to be effective and successful.
We will use some historical examples to back up Burke and Twain's argument. History shows that there have been regular bouts of financial euphoria. In his book, "A Short History of Financial Euphoria", John Kenneth Galbraith used the Tulip Mania of the 17th century and the "South Sea Bubble" of the 18th century to help people understand how dangerous excessive optimism is in business. The aftermath of these speculative episodes was drastic and debilitating losses. Here is how Galbraith described the lead up into the height of the euphoria:
"The price of the object of speculation goes up. Securities, land, objects d'art, and other property, when bought today are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted; yet buy; the increase continues. The speculation building on itself provides its own momentum.
This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall."
History shows that these speculative episodes will happen and those who know history are to avoid participation in these episodes. It was tulips in the Netherlands, common stock in the South Seas, Western Railroads in the 1860's and 1870's, technology like cars, planes and radios in the 1920's, the internet in the late 1990's and residential real estate in 2005. We believe you must understand and know the history of these events and avoid participation in them once they get speculative!
Folks have wondered why we believe that China's economy and their miraculous last thirty years of economic growth aren't sustainable. The answer is simple. CHINA HAS ALREADY QUALIFIED AS THE BENEFICIARY OF A SPECULATIVE EPISODE. THIS KIND OF UNINTERRUPTED ECONOMIC SUCCESS HAS ALWAYS ENDED BADLY IN ALL RECORDED ECONOMIC HISTORY! China has not had an economic contraction in thirty years. As Galbraith pointed out, China is in a new world of greatly, even infinitely increasing returns and resulting values. In China, it's all about GDP growth, because their internal stock market broke down four years ago and even that has not stopped the euphoria associated with China's future. The speculative episode just moved to houses from stocks in China.
The most successful economy of all time, the US economy, grew 9% compounded from 1800 to 1900. However, there were 18 recessions, 3 depressions and 3 all-out panics. The economy was cleansed of its sins by regular economic contractions. As Warren Buffett says, "Only when the tide goes out do you discover who is swimming naked." In China, the tide has never been allowed to go out. Bad loans, fraud and poor investments have never been exposed and the masses have not been forced to learn and improve their economic behavior.
This is why Twain's quote about history rhyming is so important. Every time that one of these episodes comes along, investors and professional portfolio managers focus on the difference in the current episode to the past ones. History repeats itself, but not identically! Therefore, the temptation is to focus on the difference and repeat the mistakes. This is true at both positive and negative extremes. A few examples might be helpful.
We were in a deep recession with as high as 10.8% unemployment in 1981-82. Incredibly high interest rates crippled the economy and smokestack America. Budget deficits were high and the US national debt grew immensely. Stocks were out of favor and 1981-82 was a great time to buy many good quality common stocks.
Along came the meltdown of 2007-2009, with a deep recession which included 10% unemployment. Very few professional investors were buyers or holders of good quality common stocks back in late 2008 or early 2009. The 2009 market bottom was triggered by too much debt and the massive deleveraging which has occurred since then. Everyone told us not to buy because, "It's different this time." In 1981-82 it was the price of money which crippled the economy and in 2009 it was the huge principle balances which crippled it.
Fortunately for us and unfortunately for those who couldn't sense the rhyme, 2009 was a great time to buy good quality US common stocks. Those who focused on the differences and ignored the rhyme missed the entire comeback the stock market has made since March of 2009. It grieves us to see the massive amount of capital which resides in doomsday-oriented mutual funds and ETFs, whose path to success would be our country's failure to make a full comeback in this deleveraging process. So far, the optimists have outperformed and the 1982 playbook proved to be effective.
We believe the latest history to trust is the rhyme between the US economy and stock market in 1952 and today. In both cases, the US economy had high unemployment, huge government debt, massive recent stimulus, the Federal Reserve Board capping long-term interest rates, historically high profits as a percentage of GDP and what we believe are cheap large-cap stocks. Back then we funded the Marshall Plan to help Europe and Japan, as well as the GI Bill. Today, it is enormous unemployment compensation and deficit spending. Despite all those headwinds and a reversion to the mean in corporate profits as a percentage of GDP, the Dow Jones Industrial Average rose from 260 in 1952 to near 1000 in 1966. Those who ignored the headwinds created wealth and those who sat on the sidelines or hoped to make money from the misery of others ended up poorer. Will those circumstances play out differently this time? Or will this situation rhyme with 1952? At SCM, we are paid to trust the rhymes!
Here is how Galbraith concluded his thesis on the history of euphoria:
"At the risk of repetition-restatement of what one hopes is now evident-let the lessons be summarized. The circumstances that induce the recurrent lapses into financial dementia have not changed in any truly operative fashion since the Tulip Mania of 1636-37. Individuals and institutions are captured by the wondrous satisfaction from accruing wealth. The associated illusion of insight is protected, in turn by the oft-noted public impression that intelligence, one's own and that of others, marches in close step with the possession of money. Out of that belief, thus instilled, then comes action-the bidding up of values, whether in land, securities, or, as recently, art. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. This last, it will now be sufficiently evident, never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out."
Over the years, we have heard Charlie Munger state that Psychology is the most underrated and underutilized of the major academic disciplines in business and investing. Andy Grove backed this up in a Fortune magazine interview by telling about the best business advice he had ever received. His City College of New York professor told him, "When everybody knows that something is so, it means nobody knows nothin'." At Smead Capital Management (SCM), we like to say that successful investing is the defeat of human nature. We will dig into the academic discipline of psychology and speak to using it to invest successfully.
Why is psychology an underrated and under-utilized discipline in business? We believe there are four reasons. First, it is counter-intuitive. Psychology requires you to toss out logic and rationality. When there are either seemingly unsolvable economic or business problems, psychology demands at the extreme that you bet against the obvious. When a never ending stream of good news causes logical and rational experts to predict more of the same, you must "circle the wagons" (John Kenneth Galbraith-A Short History of Financial Euphoria). Currently, the US stock market suffers from what Randall Forsyth at Barron's calls "rational despair". It is an unhealthy pessimism in the same way that 'irrational exuberance" was a destructive optimism. These are psychological phenomena.
Second, psychology never got the best scholars or professors. In the late 1970's, psychology was considered an easy class and a default major for those on rehab from economics or math or history or chemistry. Psychology has been considered somewhat of a "voodoo" discipline. It helps us explain things, but can it really solve anyone's problems. Psychology is the unwanted step-child of higher academics.
Third, psychology kills the ability of intelligence to equate to successful investing. A PhD in Economics or Math and a librarian are likely to know math and history better than anyone you know. However, the math you need to be a successful investor is learned by the end of the seventh grade, in our opinion. If you are comfortable doing percentages and have the ability to understand crowd psychology, you can be a wealth creator in the US stock market. Over-educated people have a tendency to over think situations. Ben Graham said that as soon as the complex math gets thrown into the situation, you know that trouble is brewing. Here is how he said it in 1958:
"Mathematics is ordinarily considered as producing precise, dependable results. But in the stock market, the more elaborate and obtuse the mathematics, the more uncertain and speculative the conclusions we draw there from. Whenever calculus is brought in, or higher algebra, you can take it as a warning signal that the operator is trying to substitute theory for experience."
Just ask the folks at Long-Term Capital Management or analyze the investment returns of all the money being run today based on macroeconomic/mathematical genius in mutual funds, ETFs and hedge funds. Is the average institutional investor getting what they are paying for? Is there any chance the category is going to do well when it reaches down into the retail investment world? It is one of the psychological signs that we look for.
Lastly, psychology is hard to measure. At SCM, we look at sentiment polls, insider buying, media coverage, asset allocation, anecdotal evidence and just about anything else which confirms that the crowd has moved to one side of a market. Reading the psychology is mostly learned by participating in the markets and through years of experience. The primary benefit of experience is having been in similar situations before. Professional golfers talk about dealing with the psychology of being the leader on Sunday in a pro golf tourney. Professional investors measure psychology in the same way. It is a gut feel and a learned discipline.
Andy Grove's thought points out that psychology in business is most valuable at extremes. At SCM, we operate under the assumption that if 80% of the participants in a market are bullish or bearish, the exact opposite of their opinion is the right bet. A few examples would be helpful. Everyone knew by 1999 that the internet was "going to change our life" and that you must own companies which would benefit from that huge secular trend. They couldn't have been more wrong. The sentiment polls showed historically high levels of bullishness among individual and institutional investors. A Paine Webber/Gallup poll of their clients with less than five years experience showed that they expected 22.6% compounded returns over the next ten years. They got two 40% bear market declines and a lost decade in the stock market.
A Bespoke website poll at the bottom of the stock market on March 9th of 2009 showed that 89% of those polled felt that the US stock market was headed lower and 59% felt that it would bottom at or below 5000 on the Dow. It was trading at 6480 at the time. One year ago, the Barron's "Big Money Poll" showed that 73% of those polled were bearish on US Treasury Bonds and only 5% were bullish. The tiny minority was the big winner over one year. At the risk of being repetitive, psychology is very useful at extremes.
This same psychology is useful in the shares of individual common stocks. We have a rule at SCM. Whatever we own that gets questioned, objected to or made fun of by those we come in contact with, is likely to outperform in the following three years. In 2008, we got a regular diet of criticism for owning Starbucks (NASDAQ:SBUX). Every day, someone would call us and say, "Nobody is going to want to pay $4 for a cup of coffee" or "those guys will never get their mojo back".
We've received the most questions recently on Bank of America (NYSE:BAC) and Gannett (NYSE:GCI). Quite a contrast, since Warren Buffett seems to be buying up every community newspaper in the country and pumped $5 billion into Bank of America preferred stock with warrants to buy the common attached. We have been questioned for avoiding energy, basic material and heavy industrial shares in light of the secular crowd belief in the "global synchronized trade". China's secular trend smells, feels and acts like the internet bubble to us, so we have to sit it out.
In summary, we at SCM believe that the academic disciplines of Math, History and Psychology are important to undergirding the investment discipline of those who seek to create wealth in common stock investing. All three in concert is our preference and don't forget to pay psychology its proper respect.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. All of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.