How can an investor outperform markets over long periods of time? The best way to answer this question is to invert the questions: What causes investors to systematically underperform the markets over long periods of time? Professional money managers are a good sample group to examine for reasons on why investors underperform, because money managers consistently underperform. According to John Bogle’s research, only 35% of money managers beat the market in any given year. This number drops to 25% over 10-year periods, 10% for 25 years, and 5% over 50 year periods. A young investor has a lifetime to put their capital work; however they only have a one in twenty chance of beating the passive market indices over their lifetime.
There are multiple components that cause money managers to underperform, but we will focus on one. According to John Bogle’s research, managed funds average turnover rate is 110% a year versus a zero turnover from a passively owned index fund. Multiple studies have been done with results showing that low turnover investment strategies perform significantly better over time. Why? The most obvious factors contributing to this outperformance is that one pays lower taxes and commissions. The hidden factor of why low turnover investing is superior is switching costs.
Visiting the GuruFocus website on a regular basis will give an investor a plethora of ideas from other successful fund managers to build their own portfolio. However, if one has a portfolio of twenty securities, and it is constantly churned for new ideas, they may not give their ideas enough time to be reappraised in the market place to reflect the true intrinsic values of their companies. If one constantly rearranges their portfolio for the next new idea they will miss the capital appreciation of a good portion of ideas as their holding period will not be in the two to five year time period where most of an investments value is realized.
Investors tend to look at businesses as though they are stagnant. Investors are enamored with day to day fluctuations of stock prices in the market. Also, investors systematically overweight company’s recent bad news which is predominantly already priced into a stock. One of the most important concepts Benjamin Graham taught is that an investor is a fractional business owner, and they are therefore buying a piece of a business. When looking at a company’s financial statements an investor needs to remember they are looking at a snapshot from a short period of a company’s lifetime.
“They just let the portfolio evolve over time. And because the world is largely unpredictable, a diversified portfolio that's well representative of the U.S. economy (or the global economy for that matter), which is just allowed to evolve, is likely to do better than the average professional.” - Bill Miller, Money Magazine
Investor sentiment takes time to change. McDonald’s and Altria have provided extremely successful returns over the past five years, but were hated at the beginning of the decade. The internet bubble still leaves bad thoughts in the minds of investors. Does anyone think investors will be buying subprime mortgages and CDO’s over the next few years? It can take several years to begin seeing investors’ sentiment change, therefore investors need to let their businesses evolve and the stock price will follow the operating results, for better or worse over an investors holding period.
Warren Buffett states that his “favorite holding period is forever.” That works for Mr. Buffett because he is able to buy whole businesses and redeploy the cash flows from these businesses into areas which have higher returns on capital. Also Mr. Buffett has a large anchor of size. Mr. Buffett has over $40 billion in cash, why would he sell his portfolio of securities which would generate large tax liabilities and he would still be unable to redeploy the capital into better situations. Most investors do not have the luxury of having too much money to invest. If an investor finds an investment that sells at twenty percent of intrinsic value they should obviously swap out an investment in their portfolio that sells for seventy percent of intrinsic value assuming everything else is equal. Investors do not need to buy and hold forever, but do need to maintain a long-term business oriented outlook, which leads to a low turnover ratio.
Mohnish Pabrai has been very successful in implementing a rule to avoid switching costs. He talks about it in Chapter 15 of his book The Dhando Investor. His rule states: “ Any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.” Therefore, Mr. Pabrai has held stocks through significant periods of volatility; only selling before two years if he is certain intrinsic value is below the current stock price. If he is unable to assess the intrinsic value with any certainty he simply hangs on until he has a clear view of intrinsic value. His rule help him lower commissions, taxes, and most importantly they help him avoid switching out of businesses before the intrinsic value is recognized in the marketplace.
“All man’s miseries derive from not being able to sit quietly in a room alone.” – Blaise Pascal
Remaining inactive in the stock market is one of the keys to success in investing. Mohnish Pabrai refers to himself as a “man of leisure,” spending his days reading and waiting for an idea to leap out at him. Being able to spend one’s time learning businesses, and prepare for falling prices is much more effective than actively looking for value by the minute. There is an increased probability of error when looking at stocks when stocks are setting new highs. Mr. Pabrai wrote an excellent article entitled “Buffett Succeeds at Nothing”, explaining how Mr. Buffett plays bridge, and Mr. Munger works on his mental models to fill the time periods of lofty security valuations. One should challenge themselves to delay decisions at least one day, as this is an effective tool to help an investor make sound decision. As Mr. Buffett states “ It is better to do nothing at all than to do something stupid.”
How often should investors review their investment positions then? Mohnish Pabrai updates his investment ideas once a quarter or whenever there is meaningful news. There are a small minority of investments that require daily monitoring, such as Mr. Pabrai’s investment in the shipping company Frontline where he monitored their daily rates. Three month’s out of every year he looks “at any additional pertinent developments that may impact intrinsic value.” The rest of the time Mr. Pabrai lets the company’s story evolve. One can only learn so much about a company as an outsider looking in and they must be able to appraise businesses and let their investment thesis play out. The irony is most investors cannot possibly only check up on their companies every three months. This seems so infrequent in an age where data flows quickly through the internet. However, behavioral finance suggests that thirteen months is the optimal time frame to reassess one’s portfolio. Investors should control their information flow. Mr. Buffett operates without a computer and prefers not to know the price of a security when valuing a company. Joel Greenblatt’s magic formula suggests adjusting each company every 365 days plus or minus a day for tax purposes. All of these different rules provide buffers to make sure investors avoid hyperactivity and missing the capital appreciation of an undervalued investment.
A low turnover approach will not yield good results if you systematically overpay for companies. An investor still must purchase companies at a discount to intrinsic value. Investors should be able to appraise businesses properly so that they are able trust to their investment thesis through thick and thin. Then time must pass while they wait for their businesses to evolve as opposed to treating their investments like playing cards in a game of gin rummy.