When it comes to bad ideas, finance certainly offers up an embarrassment of riches – CAPM, Efficient Market Hypothesis, Beta, VaR, portfolio insurance, tail risk hedging, smart beta, leverage, structured finance products, benchmarks, hedge funds, risk premia, and risk parity to name but a few. Whilst I have expressed my ire at these concepts and poured scorn upon many of these ideas over the years, they aren’t the topic of this paper.
Rather in this essay I want to explore the problems that surround the concept of shareholder value and its maximization. I’m aware that expressing skepticism over this topic is a little like criticizing motherhood and apple pie. I grew up in the U.K. watching a wonderful comedian named Kenny Everett. Amongst his many comic creations was a U.S. Army general whose solution to those who “didn’t like Apple Pie on Sundays, and didn’t love their mothers” was “to round them up, put them in a field, and bomb the bastards,” so it is with no small amount of trepidation that I embark on this critique.
Before you dismiss me as a raving “red under the bed,” you might be surprised to know that I am not alone in questioning the mantra of shareholder value maximization. Indeed the title of this essay is taken from a direct quotation from none other than that stalwart of the capitalist system, Jack Welch. In an interview in the Financial Times from March 2009, Welch said “Shareholder value is the dumbest idea in the world.”
James Montier: A Brief History of a Bad Idea
Before we turn to exploring the evidence that shareholder value maximization (SVM) has been an unmitigated failure and contributed to some very undesirable economic outcomes, let’s spend a few minutes tracing the intellectual heritage of this bad idea.
So what exactly is this value investing that led Warren Buffett to be so rich?
In Value Investing, you are essentially buying stocks — which essentially is a part ownership in a business — that is worth $1 for 50 cents (this is just an analogy). There are many reasons why you can buy a stock that is worth $1 for 50 cents.
One of the reason is that many stock investors do not understand what they are buying or selling — they simply buy and sell stocks based on hot tips or based on chart patterns.
That forces them (at times) to sell a good stock at a cheap price.
In which, the practitioners of value investing will take advantage of that by buying the stock they sold.
“Value investing in fundamentally different from stocks trading.While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price relative to the business value. This is done by first determining the rough intrinsic value of the business.” – Chris Lee Susanto
Value investing works because simply put, the stock market is not efficient.
That means that the stock market at points in time does not accurately reflect the true value of the business behind the stock.
“If you wake up thinking about a position, it’s too big” Steve Clarke
“Make your position size more a function of not how much you can make, but really how much you can lose. So manage your position based on your downward loss perspective not your upward potential.” James Dinan
“We will make something a large position if we think there is an extremely low chance of losing money on a permanent basis. Even if we think it might be a 4X return, if the idea could be a zero, it’ll be a small position” Ken Shubin Stein
“I’ll limit position sizes when potential outcomes are too binary” Chris Mittleman
“We do not bet the ranch on any single investment; few positions have exceeded 5% of assets in recent years” Seth Klarman
“We size things based on how much we think we can make versus how much we think we can lose. We’ll probably be willing to lose 5-6% of our capital in any one investment” Bill Ackman
The most important factor which determines if you successfully deal with a selloff is how you are positioned before one. When faced with a correction or a bear market your portfolio’s risk needs to be properly set to your personality, age, goals, savings and overall position in your life. It’s very tempting when starting a portfolio to take more risk when stocks are moving up and less risk when stocks are moving down. However, if you’re investing for the long term, there will be many of both scenarios. You need to visualize how you’d react when you make 20% in a year or lose 30% in 6 months. When deciding on the amount of risk you’re willing to take, one of the most important aspects is to avoid basing your choice on where you think the market will go up or down in the short term. You need to have a baseline plan for all markets to avoid scenarios where you panic. It’s easy to panic when you don’t have a plan in place. If your risk profile is wrong, you will likely underperform. Taking too much risk can cause quick painful losses. If you switch to a more conservative approach after you lost money, it will be difficult to make the money back.
Stay Disciplined
No matter how much you plan or how closely your portfolio matches your risk profile, if you want to go against your plan on a whim of a decision, it’s possible. There can be some circumstances where you need to wait a defined period before you can get your money back, but eventually, you will be able to. You can override your personal financial advisor if you have one and you can take your money out of passive funds at inopportune times if you are making emotionally charged investing decisions. These are all mistakes you can make if you don’t follow through on your discipline. Recognizing you have the freedom to mess up your finances is daunting for some people who aren’t experienced. The key for inexperienced and even experienced investors is to take a methodical approach rather than being reactionary.
One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Bill Miller.
Miller served as the Chairman and Chief Investment Officer of Legg Mason Capital Management and is remembered for beating the S&P 500 Index for 15 straight years when he ran the Legg Mason Value Trust.
One of the best resources for investors is the Legg Mason Shareholder Letters. One of the best letters ever written by Miller was his Q4 2006 letter in which he discussed the end of his 15 year ‘winning streak’ and how too many investors miss the most important aspect of investing by focusing on value or growth. Miller writes, “The question is not growth or value, but where is the best value?” It’s a must-read for all investors.
Here’s an excerpt from that letter:
Calendar year 2006 was the first year since I took over sole management of the Legg Mason Value Trust in the late fall of 1990 that the Fund trailed the return of the S&P 500. Those 15 consecutive years of outperformance led to a lot of publicity, commentary, and questions about “the streak,” with comparisons being made to Cal Ripken’s consecutive games played streak, or Joe DiMaggio’s hitting streak, or Greg Maddux’s 17 consecutive years with 15 or more wins, among others. Now that it is over, I thought shareholders might be interested in a few reflections on it, and on what significance, if any, it has.
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.
This is an oldie but goodie – Peter Lynch on how to pick stocks. By chance, we were also doing the Lynch book list and ran into some confusion if anyone knows please let us know
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.
When we find an attractive stock to invest in, we outlay money, aka invest, to earn an attractive return and the investment will involve a degree of risk.
One of the most dangerous, commonly accepted and ill thought out concepts in investing is the risk / return trade off.
That is: high returns equals high risk.
Unfortunately, Investopedia continues to spread this type dogma, as you can see by the graph below.
Volatility (standard deviation) is not risk!
The appropriate definition of risk is from the Oxford dictionary (or any other branded non-financial dictionary) as: Exposure (someone or something valued) to danger, harm, or loss.
“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.
