Someone who reads my articles sent me this email:
“What is your objective when investing? Are you a ROI investor? Is your goal to produce enough cash flow to live comfortably? Is it a game where money is just a score?”
My goal is a lot like Ben Graham’s goal. Graham ran what we’d call a hedge fund today. He didn’t try to have the most assets. He tried to have the best return on the assets he had. In that sense, he was a return on investment (ROI) investor.
However, he had another goal. And this is what makes his approach a lot like other hedge funds. He wanted an acceptable rate of return regardless of what the market was doing. If the market went sideways for 10 years, he still wanted to do better than bonds. He still wanted to deliver for his fund’s investors.
What’s an acceptable rate of return? For me, it’s 10%. If you tend to make 10% a year in stocks, you are compounding your wealth well. We can also aim a little bit higher. This is more a matter of relative returns. While folks will argue about what the market’s average rate of return will be in the future – I can tell you this, it’ll be less than 15%.
So if you can earn 15% a year over time, you will do better than the market. And 15% a year is obviously an acceptable return. So if your results are averaging out to 15% a year – you’re doing fine on both counts.
Other investors have other goals. Those are mine. I want to beat the S&P 500. I want to earn 10%. And I think I can – when I avoid dumb mistakes – make 15% a year. So you could say that’s my target. I want to make 15% a year over time.
How realistic is that? In today’s market – not very. I’m not exactly bullish on today’s stock prices. A return of 15% a year will likely be 2 to 3 times higher than what the S&P 500 does going forward. So it’s a very tall order right now.
Offsetting this is my small portfolio size. It’s much easier to earn 15% a year when you can buy micro caps in the U.S. and Japan and anywhere else you want. It’s much harder when you can only buy companies big enough to be in the S&P 500.
Still, I have to admit that outside circumstances – today’s stock prices – severely limit my chances of making 15% a year. And that’s a problem. You want your investing goal to be something you can control. Not something the outside world controls. So, while I’d like to earn 15% a year – I’m not sure that with today’s stock prices I can really say 15% a year is a goal. A goal should be a target you can aim for. Something you can control.
I invest my own money. I don’t invest for other people. So I don’t have to worry about year-to-year results. That is the big advantage individuals have over professionals. If you don’t believe me – just look at Fairholme. The investors in a fund can force the manager to make choices he’d rather not make. They can make the fund smaller right when it would prefer to get bigger.
Focusing on long-term results is a good idea. But it can also be an excuse. I read a lot of value investing blogs. And I have to admit that reviews of past performance are hard to judge. An investor should stick with a good idea that just hasn’t played out yet. But the belief that results only matter when they’re long term can be a way to avoid facing a bad scorecard.
I look at one-year results. I even look at quarterly results. I have a spreadsheet with my portfolio’s quarterly returns, the S&P 500’s quarterly returns, and the returns of some funds I think are pretty good. I compare them.
Over time, you do see patterns. For example, I’ve never thought of myself as an investor who cares about volatility. I’ve always thought I’d own the stocks I liked best regardless of whether I thought they’d fluctuate a lot or not.
Well, my portfolio’s quarterly results tell a different story. Even when I’ve done much better than the S&P 500, I’ve done it with less volatility. My results are always less volatile than the S&P 500. Down quarters are rarer. And in every period where the S&P 500 is down – I’ve tended to be down less. Or not at all.
In fact, looking back at my results – I have quarterly results for 2008, 2009, 2010, 2011 and 2012 (first three quarters) in front of me – my entire outperformance of the market is explainable purely in terms of beating the S&P 500 when the S&P 500 was down. I have zero advantage over the market if you only count quarters when the S&P 500 was up.
Why mention this?
Because it’s the reason to keep a record of your results. Just knowing whether you are beating the market or not isn’t very useful. In fact, it could be harmful. But knowing how – and when – you have beat the market or lost to the market can help you separate your view of yourself from the reality of how you really invest.
For example, I can see that I hold a lot of cash. And that I did not own – with two exceptions – either financials or materials stocks. If you look at a quarter-by-quarter breakdown of the S&P 500 by sector this explains a lot.
The S&P 500 has been more volatile than my portfolio because the S&P 500 doesn’t hold cash (obviously), is all U.S. stocks (I was 50% in Japanese net-nets at one point), and includes financial stocks and materials stocks.
Even though I talk as if I never buy financial stocks – I did buy two financial stocks over the last 5 years. I owned a micro cap insurer (now private) called Bancinsurance. And I owned Berkshire Hathaway (BRK.B).
How should I judge my performance? This is the hard part for all of us. In a sense, any year when I beat the S&P 500 is a good year. By that measure, 2008 (in which my portfolio and the market were equally decimated) and 2012 – in which I’m badly underperforming the S&P 500 with just a 5% return – are bad years. I would agree with that. I did a bad job investing in 2008 and 2012. For different reasons. I owned too many borderline ideas in 2008 when I should’ve just held cash. And then I failed to find good ideas in 2012 – and have been 75% in cash for much of this year.
If we look at a purely relative scorecard the good years – which were only 60% of the time – were 2009, 2010, and 2011. My best absolute performance was in 2009. And it has been downhill every year since.
Should that worry me?
I think this is a key question. After the crash, I – like just about everybody else – had a terrific 2009. Then a slightly less good 2010. Then – unlike some investors – I had a perfectly fine 2011 (up 20%). And finally – unlike plenty of people – I’ve had a downright dull 2012. The year is almost done. And I’m looking at a 5% return. At that rate – I might as well own bonds.
The trend is ugly. But I doubt it has anything to do with my investing abilities. A rising tide lifts all boats. And almost all I see in the trend of my results from 2008, 2009, 2010, 2011 and 2012 is the tide. Most of the trend is explainable by what happened to the market – not what happened to my stock picking.
That’s why you need to be careful about drawing conclusions year by year. It’s easy to pat yourself on the back when you don’t deserve it. I didn’t do anything impressive in 2009. I also didn’t do anything stupid. I did one smart thing. I made sure I was 100% invested 100% of the time. The result was a 41% return that year.
That sounds impressive. It’s really not. I’ve done plenty of net-net buying in the past. And plenty of micro cap buying too. Micro caps and net-nets did well in 2009. And the truth is that I probably did worse buying big stocks – like IMS Health, Omnicom (OMC), and Berkshire Hathaway (BRK.A)(BRK.B) – than I would’ve done in the kinds of net-nets specifically and micro caps generally that I’ve favored in the past. In fact, that’s exactly what back tests show. Those tiny stocks soared in 2009.
So no points for stock picking in that year. I only did one good thing in terms of stock selection. I bought a stock that was taken private.
Personally – and some folks may disagree with this – I think you should value the feedback from such buyouts more than you should the feedback from stocks you simply flipped. I think having somebody come in and pay almost twice what you did for your shares of the company is a good sign. I think a control buyer is often a better sign than a temporary uptick in the market.
If you own a stock for a year, it’s hard to judge how well you chose that stock. I think a buyout is a good sign you chose well. When we look at stocks you held for more than a few years – I think earnings become more important.
I’ll use George Risk (RSKIA) as an example. This is a stock I bought in 2010. It’s been a good – not great – investment for the two years I’ve owned it. But the business performance has been solid. And to me that supports the idea I chose that stock well. Of course, it also supports the criticism that there was no catalyst.
How about a stock I did not choose well?
Here, again I think it’s key to look past the numbers. Just like my absolute best year (2009) was nowhere near my best year in terms of stock picking – my biggest mistake was not a big loss in terms of what I actually realized. It was a huge loss in terms of the risks I ended up taking.
That big mistake was buying Barnes & Noble (BKS). I bought this stock in 2010. Before the proxy vote between Burkle and Riggio. I didn’t know if Riggio or Burkle would win the proxy vote. That wasn’t my mistake – although Burkle did lose. My mistake was misjudging the risk of catastrophic loss in the stock.
The e-book market developed fast. And Barnes & Noble bet big on the Nook faster than I expected they would. This resulted in a much worse financial situation than I normally invest in. Later, there were two deals – with John Malone and Microsoft (MSFT) – that changed that situation a bit. But there was a period after Burkle lost the proxy fight where I owned a stock – in fact, a retailer facing a societal shift – that was super risky compared to what I normally invest in. This was a big mistake.
And when you find a big mistake like that in your past performance – you need to charge yourself for the full mistake. I lost a tiny amount (like 3%) on my investment in Barnes & Noble. But I exposed myself to a much, much bigger risk. It’s important to fess up to those mistakes – even when the historical record would let you ignore them because of where the market happened to let you get out of the stock.
It’s also important to look at how you failed to meet your investment goals in ways other than price performance. A good example of this for me is turnover. My turnover has been way too high over the last five years.
Why should I care?
My goal is to both beat the S&P 500 and earn an acceptable return at all times. Now, I would say “all times” should be defined as a period of say three-year returns or five-year returns – not one-year returns.
So, let’s look at a stock I bought and sold – but could’ve just held. Let’s talk about Omnicom. I bought Omnicom at just under $28 a share back in 2009. The stock is now at $47 a share. So it’s hardly been a home run relative to the stock market. I did well in the stock only because I sold it after a short holding period (a little over one year).
I did well. So why was selling Omnicom a mistake?
You have to think about opportunity costs. And you have to think about your goal as an investor.
My goal is to do well enough all the time – even when the S&P 500 doesn’t. After selling Omnicom, I would – in the next two years – go on to own Barnes & Noble and hold up to 75% of my portfolio in cash.
Obviously, that means there would’ve been no harm in holding a stock like Omnicom – that went sideways for two years – instead.
Yes, my average performance was better than what Omnicom would’ve done if I kept holding it. But my marginal performance was not. The things I replaced Omnicom with in later years – basically, Barnes & Noble first and cash later – didn’t do any better than Omnicom. And Barnes & Noble was riskier.
So I created turnover for no reason. Omnicom is cheap today. If I had held it through 2010 and 2011 – I’m sure I would’ve held it right up to now. That would’ve meant lower turnover. And sticking for four years in a business I liked.
Selling Omnicom was a process error. It doesn’t show up in my returns because the whims of the market rewarded me. I lucked out. I didn’t actually lose much in Barnes & Noble – though I sure could’ve – and Omnicom went nowhere for two years. But it’s cheap now. So we shouldn’t confuse my good luck in having the multiple of the stock I sold contract with my skill in selling a stock that was overpriced or selling a stock where the business was getting worse. Omnicom wasn’t overpriced. And the business got better, not worse.
That’s why I want to warn you against reading too much into your results. A goal is a good thing. A process is a great thing. Past performance is a reality check. But the reality you care about is a subtle reality. The mistakes that matter and the mistakes that get measured aren’t always the same.
I had some stock picking victories that I think both mattered and got measured – Bancinsurance and IMS Health. But I also had a big stock picking defeat – a huge error – that didn’t get measured but definitely did matter. Investments like Barnes & Noble pose a risk to my process. And my long-term goals. This is especially true for me because I bet so big on each stock. Barnes & Noble was 25% of my portfolio.
It’s a good idea to break your big goal into little goals. Performance is complex. I underperformed this year. But I’m not beating myself up about it. I didn’t see a lot of stuff worth doing at the time. And looking back, I still don’t. I’m still beating myself up about Barnes & Noble – and other things – I did in the second half of 2010. And that was actually a great year going by the numbers alone.
So don’t just look at your headline results. Look at numbers inside the numbers. For me, the thing that stands out is turnover. My turnover is too high. And the more I look at when I sold stocks – the less I see a benefit to that selling. Even when I outperformed, it was not because I was smart enough to sell one stock and buy another. There is zero evidence of that in my past. So I should raise the bar even higher before selling in the future.
That’s the kind of tweaking of your goals you can do. Looking at my past, I can try to change my future. For me, that change is about selling less often. Holding on to a stock longer even when I think I have a better idea. I haven’t been a good judge of when a new idea is better than a stock I already own. So I should raise the burden of proof. I should make my process one where selling is something that’s very hard to do.
That fits my goals. It wouldn’t fit a pure relative return investor. If your only goal is to beat the S&P 500 – then selling less may not make sense. But if your goal is to make sure you do fine even when the market doesn’t – then selling less might make sense.
It does for me. So my turnover is a number I’ll be tracking carefully over the next five years.
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