The cover story of this week’s Barron’s is titled “What’s Ahead for Stocks” and it is accompanied by a cartoon of three strategists who are drawing curves on a white board (three different curves, I should add). The author, Kopin Tan, asks ten Wall Street strategists to predict what will happen to stocks in the near future based largely on their predictions of economic activity. It immediately brought to mind something Buffett once said:
“I’ve never made a dime predicting economic activity. We just try to buy businesses we understand at sensible prices.”
Of course ignoring market prognosticators and buying good businesses at sensible prices is what all good value investors do. They search for companies that they can buy for significantly less than they are worth and then patiently hold them until the rest of the market figures it out. If the market averages plummet after they buy, value investors are comforted in knowing that their portfolios are likely to outperform the market in the long run and another drop in price often means it is a good time to buy more.
This portfolio selection process is why value investing is sometimes called bottom-up, contrarian investing. It is an easy strategy to understand, so the efficient-market aficionados tell us that it cannot possibly succeed. Yet, it has had persistent long-term success. Why? Well, it may be easy to understand, but it is difficult to execute. For example, how many investors were buying shares in Transocean (NYSE: RIG) in the weeks after April 20 when its Deepwater Horizon platform exploded in the Gulf of Mexico?
Judging by the actions of Marsico Capital, a well-known “growth” investor and RIG’s largest shareholder before April 20, the answer is: not many. Marsico dumped its entire seventeen-million share position in the second quarter. Investing in good businesses for less than they are worth and then holding them can be very difficult. GE Asset Management and Eaton Vance can also attest; they each dumped all or almost all of their shares, too. (Full disclosure: I currently own RIG).
Meanwhile, Value investors such as Legg Mason, Franklin, and Davis Select were happy to gobble up shares or maintain their already large positions. And, by the way, Transocean Inc. became the largest RIG shareholder when it bought over sixteen-million RIG shares in the second quarter according to Thomson-Reuters’ StreetSight; another good sign. This is not to say that RIG is a sure thing; nothing ever is. But, portfolios of ten- to twenty-companies like RIG—companies with solid balance sheets, a niche, high barriers to entry, and solid free-cash flow yields that trade at less than their book value—are likely to do very well in the long run.
A value-investing philosophy has been the key to the success of Buffett, The Superinvestors (see page above), Seth Klarman, David Einhorn, Peter Lynch, and many others. When so many great investors ignore prognosticators, it is a wonder why any investors try to guess where the economy or the market is heading. Clearly, no one knows where the market is heading in the short term, so that is a loser’s game. Still, Barron’s puts out a cover story like this one about once per quarter, so someone is buying it.
Having just finished re-reading Peter Lynch’s One Up on Wall Street, it is worth quoting a few passages relating to this topic. One Up’s chapter five is titled “Is this a Good Market? Don’t Ask;” each of the following quotes is from that chapter:
“If you forecast, forecast often.”
“All of the major advances and declines (in the market) have been complete surprises to me.”
“Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it is too late.”
“We always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This ‘penultimate preparedness’ is our way of making up for the fact that we didn’t see the last thing coming along in the first place.”
“The day after the market crashed on October 19 (1987), people began to worry that the market was going to crash…Those who got out of the market to ensure that they wouldn’t be fooled as they had been the last time were fooled again as the market went up.”
“I don’t believe in predicting markets. I believe in buying great companies—especially companies that are undervalued, and/or underappreciated…The market ought to be irrelevant. If I could convince you of this one thing, I’d feel this book had done its job…I’d love to be able to predict markets and anticipate recessions, but since that’s impossible, I’m as satisfied to search out profitable companies as Buffett is.”
“That’s not to say there isn’t such a thing as an overvalued market, but there’s no point in worrying about it. The way you’ll know when the market is overvalued is when you can’t find a single company that’s reasonably priced. The reason Buffett returned his partners’ money (in 1969) was that he said he couldn’t find any stocks worth owning…The only buy signal I need is to find a company I like. In that case, it’s never too soon or too late to buy shares.”
So, with all of the world’s great investors lining up on one side of this issue, why do some investors take the other side and pay attention prognosticators? The answer can be summed up in two words: Political cover. When the manager for XYZ pension fund has to answer to his board for subpar performance, he can say: “Why, no less an authority than Bob Doll (or one of the other nine strategists quoted in Barron’s) agreed with my position.” This is also why institutional investors love it when Wall Street strategists disagree, as they usually do. Then they can always point to at least one strategist that they can use for political cover. Welcome to the world of institutional investing.
One last observation about the recent horrific recession from a long-time market watcher:
“(It) was a (long) recession…Actually, this was the scariest time in my memory. Sensible professionals wondered if they should take up hunting and fishing, because soon we’d all be living in the woods, gathering acorns. This was a period when we had (high) unemployment, but I never got a phone call saying any of this was going to happen…After the fact a lot of people stood up to announce that they’d been expecting it, but nobody mentioned it to me before the fact.”
Did you guess that the quote was from Howard Marks talking about 2008-10? No, it was Lynch again talking about the 1981-82 recession. Lynch followed with this:
“Then, at the moment of greatest pessimism, when eight out of ten investors would have sworn we were heading into the 1930s, the stock market rebounded with a vengeance, and suddenly all was right with the world.”
If I had a dollar for every time in the last two years that I heard “heading into the 1930s…”
The point is that we can never predict when an economy will get back on the path to prosperity, but absent anarchy, revolution, and the dissolution of free, democratic institutions, it always does. Matt Ridley has demonstrated as much in his outstanding book, The Rational Optimist: How Prosperity Evolves, which outlines a long arc of progress for the human race; exponentially so since the birth of US-style democracy and free-market capitalism. I will have much more to say on that book in another post.
 Transcript of a CNBC interview with Buffett on February 12, 2008. Coincidentally, this interview took place at a time that the market was approaching a bottom, but this is a statement that Buffett had made many times. http://www.cnbc.com/id/23129487/Buffett_Sees_Stocks_In_General_Range_of_Fair_Value_CNBC_Interview_Transcript_Part_2