Over the years we have observed many investors fall hard after reaching the peaks of their careers. A few come in mind. Bill Miller of Legg Mason Value Trust, beating the S&P 500 for 15 consecutive years until 2005, was killed by the market in the years that followed. Ken Heebner of CGM Focus Fund, who gained 80% in 2007 by shorting mortgage banks, gave up all his gain in 2008, and then some. John Paulson, the hedge fund giant, made a great deal of money and fame shorting financials in 2008, then lost the money and more in 2011.
Why did all of this happen?
The answer is actually very simple: RISK, which made them, then broke them. These investors took excessive risks with their investments. They were right initially, then wrong and the bottom fell out.
During the interview with Don Yacktman last week, which we will publish soon, GuruFocus discussed this with him after we talked about how he defines a high quality business. We asked him how he beat the market going both ways, down and up. How he made the decision of selling stable companies like Procter & Gamble (PG) and bought into a seemingly risky car loan company, AmeriCredit. Then we found his secret – Risk Adjusted Potential Returns. He said:
“… what happens is in a period this disruptive (in 2008 and the beginning of 2009), when the other people are like deer in the headlights, you can be objective and say, wow, I’ve used up all my cash and they’ve all hit my hurdle rates, and there are really good opportunities out here. But now all of a sudden, I’m faced with an interesting problem. I’m starting to see things that potentially can earn me 20, 25, 30% compounded returns. Should I give up something that has 10 and I’m very comfortable with? Well yeah, if you can justify the risk. And particularly when you’re not dramatically increasing your risk.”
“With Americredit (ACF), News Corp (NWS), Viacom (VIA), all of them had some risk to them, but man were they just breathtaking returns. So we sold of Proctor & Gamble totally, and just like the military holding some in reserve, we still had Coke there, we still had some other things held back, that if the market had continued to go down, we would have been more and more and more away from the great stuff, into these things that had more cyclicality to them.”
AmeriCredit fell to less than $3 and Yacktman bought a large chunk of it. It was then bought out by GM at $24 in 2010. The Yacktman Fund outperformed the S&P 500 by 11% when the market was down 37%, and outperformed 32.8% when the market was up 26.5% in 2009.
Like Warren Buffett, great investors achieve their outperformance mostly in down years. If you are investing your own money, it is not important at all if you outperform or underperform the market by a percentage or two in good years. The key is to do well in down years, grab the great bargains in market fear, and profit afterwards.
Therefore, when you think about your potential returns, always think of them in terms of “risk adjusted returns.” Is the return worth the risk? Is the risk you take justified by the potential return in this investment? What if you are wrong?
Don’t bet. Invest!
This was what Don Yacktman did. It has served him well.