Smead Capital Management letter to investors titled,”Risk Is Not High Math.”
Long term success in common stock ownership is much more about patience and discipline than it is about mathematics. There is no better arena for discussing this truism than in how investors measure risk. It is the opinion of our firm that measuring a portfolio’s variability to an index is ridiculous, because it is impossible to beat the index without variability.
We believe that how you measure risk is at the heart of how well you do as a long-duration owner of better than average quality companies. In a recent interview, Warren Buffett explained that pension and other perpetuity investors are literally dooming themselves by owning bond investments that are guaranteed to produce a return well below the obligations they hope to meet.
Buffett defines investing as postponing the use of purchasing power today to have more purchasing power in the future. For that reason, we see the risk in common stock ownership as a combination of three things; What other liquid asset classes can produce during the same time period, how the stock market does during the time period, and how well your selections do in comparison to those options. Why would professional investors mute long-term returns in a guaranteed way? The answer comes from how you define risk.
The Davis Dynasty: Fifty Years of Successful Investing on Wall Street says its by John; Peters S. Lynch (foreword) Rothchild, I would assume the foreword for a book about Shelby Davis would be the investor Peter Lynch but we were unlear if he had a middle S initial (or if he did not, is that a typo? – obviously can read the book itself but hard to find some of these out of print books and we only have so much time and rsources) in the end we were not sure so would want to exclude it. We will have our list for better or worse soon. We also transcribed the following video – it is not verbatim and is for information purposes only
A Buy and Hold friend of mine recently posted the following words to the discussion thread for one of my blog entries: “You’re confusing high valuations (a fact, historically speaking) with overvaluations (a judgement that the market is wrong, in effect that you’re smarter than Wall Street).
I like the comment because it concisely and clearly reveals the primary difference between Buy and Hold believers and Valuation-Informed Indexers. It is absolutely correct to say that I believe that the market is wrong. That’s the entire idea of Valuation-Informed Indexing. We can know when the market is getting things wrong and how off the mark the market is and we should put that knowledge to good use by adjusting our stock allocations accordingly.
My Buy and Hold friend dismisses out of hand the possibility that the market has gotten things wrong. His comment suggests that the market is comprised largely of Wall Street experts who possess more knowledge about the value of stocks than I possess. So I should just give up this effort to outsmart the market.
“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” — Warren Buffett, 2013 Letter to Berkshire Hathaway shareholders
As Albert Einstein wisely stated, compound interest is the eighth wonder of the world: He who understands it earns it while he who doesn’t pay it. The vast majority of individuals who take the initiative to accumulate savings should follow Warren Buffett’s advice on using index funds and dollar cost averaging to achieve satisfactory returns over time. For those earning at or above the median wage in the United States, it would be very difficult to end up poor if one simply saves ten to fifteen percent of gross income and dollar cost averages into the S&P 500 over several decades.
But what about non-professional individual investors who want to achieve better than average results? In the short run, the stock market resembles a manic-depressive character who bids up prices one day and sends them down the following day without much of a reason for the change in sentiment. Benjamin Graham’s “Mr. Market” character perfectly personifies the psychology of financial markets in the short run.
The stock market has a long history of humbling investors. The Investment Masters understand the need for humility. Ordinarily, when investors have had a good run they risk getting over-confident and letting down their guard, only to have the stock market deliver them losses.
Many of the Investment Masters maintain a psychology of fear.
“It is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind.” Howard Marks
“We are big fans of fear, and in investing it is clearly better to be scared than sorry.” Seth Klarman Continue Reading →
Index investing has become extremely popular in recent years. A lot of new investors have embraced the strategy in recent years. Unfortunately, many investors are embracing the strategy by believing certain myths that are simply not true. I am going to examine several of their problematic thought points, and discuss why they are myths that could hurt those investors in the future. In reality, there is nothing magical about index investing.
I will refute the five myths below:
1) Indexing is passive investing.
Indexing is not passive, because there is a requirement for the investor to exercise judgment as to which index funds to select. It then also imposes forced market timing through buying and selling of assets at certain time periods. In addition, the indexes themselves comprise portfolios of individual stocks or bonds which constantly add or remove components for a variety of reasons.
“There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average” Adam Smith, the Money Game 1968
“Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.” Mason Hawkins
“Empirical testing has proved beyond a reasonable doubt that the “riskiness” of a portfolio of 12-15 diverse companies is little greater than one loaded with a hundred or more” Frank Martin
“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” Warren Buffett
In this interview, Kim Shannon, CFA, president of Sionna Investment Managers, talks with legendary investor Charles H. Brandes, CFA, chairman of Brandes Investment Partners, L.P., about his 40 years of unwavering global value investing. In addition to key lessons on implementing a value investing philosophy, Brandes discusses the current market environment and investment opportunities.
Here’s an excerpt from the Brandes interview on the CFA Institute website:
Kim Shannon, CFA: I would like to begin by noting that you did not start your career on the buy side. Is there a story about your career transitions?
Charles H. Brandes, CFA: Well, it was somewhat serendipitous. The overall stock market was down 45% from top to bottom in 1970, which was understandably debilitating to investors, and there was very little activity in our office. An older gentleman walked in to open an account. When he told me his name, I knew who he was—Benjamin Graham, the father of value investing and a teacher of Warren Buffett, who had already done pretty well in investing.
He purchased a thousand shares of National Presto Industries, a company that had been an example in his most recent edition of The Intelligent Investor. The example had been of a net–net current asset value issue, which had been one of Graham’s famous criteria from the 1930s for investing. The goal was to buy companies at a price no higher than two-thirds of their net–net current assets. Thus, the investor gets the whole company at a cost below that of its net liquid assets.
This month’s issue of Value Investor Insight contains an interesting interview with Frank Martin of Hummingbird Partners.
Since his Martin Capital Management embraced equity investing in 2000, Frank Martin has achieved a truly impressive record of outperformance. His firm’s equity composite has beaten the S&P 500 by some 700 basis points per year since inception. However, thanks to his cautious stance, Martin has underperformed. Throughout the period he has only been 30% to 70% invested.
Still, Martin’s new venture, long/short hedge fund Hummingbird Partners, which he co-founded with Peter Wong, promises to replicate his strategy and help investors recognize his stock-picking acumen. Hummingbird is looking for opportunities in such areas as jet engines, agriculture and industrial and auto supply. Here are some of the key takeaways from the Hummingbird Partners interview.
Frank Martin of Hummingbird Partners on Cyclical Investing
Martin starts the conversation by discussing what makes a good business. He believes, along with many other investors that the key to a lasting business model is “structural competitive advantages, those inherent features that prevent rivals from entering a company’s business and/or competing effectively with it.” He goes on to give some examples such as “monopolies or oligopolies, razor/ razorblade businesses, enduring brands, network effects, high switching costs and economies of scale. Perfect business models don’t exist, but many come close to varying degrees.” An example of which is Gentex, which owns the market for auto-dimming mirrors and lights:
“It has such a strong position in a small-enough niche that companies trying to wedge their way into the market are likely to have a terrible return on capital for many years. It’s run by an owner-operator, Fred Bauer, who founded the company in 1974 and is just a first class operator who funds very-productive R&D and maintains a balance sheet with what some might call too much cash, but which we love because of the optionality it provides. That’s part of being anti-fragile.”
But Hummingbird’s co-founder isn’t just attracted to good businesses in niche markets; Martin is also interested in large companies trading at attractive valuations where he can act as a contrarian:
“For instance, we took advantage of the fairly recent break in oil prices to invest in energy-services companies like Baker Hughes. Rather than try to figure out which of the exploration companies to bet on, we went for “picks-and-shovels” type companies…We will also at times walk toward controversy when others are running away. In 2010 I bought BP in this case primarily as a trade, right in the middle of the Gulf-oil-spill mess…Sometimes the impetus is less dramatic. With Wal-Mart, we’ve seen sentiment ebb and flow over the extent to which Amazon is going to eat its – and everyone else’s – lunch. Our basic view is that there will continue to be space for Wal-Mart, especially given that 50% of its revenues come from groceries, which has proven a tougher sale online.”
Cyclical businesses are also an area of interest for Martin. While most investors would shy away from cyclical businesses fearing earnings volatility, Martin and team like to make the most of volatile earnings and the favorable share price movements they produce:
“Many people associate cyclical businesses with bad businesses because they don’t produce stable, consistent cashflows like bonds. We disagree. A good business to us is one where we can assess its earnings power over a full cycle and buy it when its shares are attractively priced relative to that earnings power.”
Agriculture is one such industry. The sector is currently suffering from an earnings recession “since the cycle turned in 2013, farm income in the U.S. is down approximately 40%, ” yet the “U.N. projects that world population by 2050 will grow by a third, to 9.7 billion. Nearly all of the increase will come from developing countries, where income levels are growing.” Farms will have to think up new ways to increase yield to get meet this growth. “Estimates are that crop production will have to grow by at least 60% from current levels to meet estimated demand by 2050…all of the 60% increase in crop production will have to come from increasing yield.” The best way to play this trend Martin believes is via “agricultural companies that reliably prove capable of facilitating yield growth.” Hummingbird’s goal: buy the best ones when they’re out of favor.
Martin’s entire investment strategy is based around business cyclicality. When it comes to valuation and timing acquisitions, he says:
“I’ve always found the best place to start is where the company has been priced over its history, relative to itself and to its industry. From there, we try to buy against some reasonable estimate of earnings power when it’s out of favor and to sell when it’s in favor. We use as a threshold that the price can at least double in five years through a combination of business performance and improved valuation.”
From all of the above, it’s clear Hummingbird’s investment strategy is a contrarian one so it could come as no surprise that the fund currently owns some down-and-out businesses. On top of Gentex above, Martin likes Rolls-Royce and Fastenal, both of which have seen their shares slide recently.
The original article appears on ValueWalk.com and is available here.