GuruFocus has its own methods for deciding who is and isn’t a guru. I’m not going to talk about that. I’m just going to talk about what is and isn’t a great investment performance.
And hopefully lower some expectations.
Someone sent me this email:
I want to know how you gauge an acceptable level of return in stocks.
On the guru scoreboard, there are many guys who are making less than 10% over their 5, 10 and lifetime track records. (which by the way I find confusing: if it were me selecting gurus, I would not endow a money manager with guru status until he/she achieved at least 10% over an appropriately long amount of time)
Seen another way, returns are relative to what? Bank interest? Inflation? Govt. or corporate bonds? The way I see it, beating bank interest with my stock holdings is a good start. Even better would be to beat the rate of inflation. To achieve a 10% per year for the next 30 years would be excellent no?
First of all, yes. Earning 10% a year over 30 years will allow you – and any other saver – to achieve all your financial objectives. Over 30 years, one dollar compounding at 10% a year become $17. Nobody needs to reach for more than 10% a year in the long run. Nobody “needs” more than that.
Second, let’s tackle the guru issue.
We know 10% a year earned over the long run is definitely enough for the average investor. But is it enough to be considered a guru?
It depends on the environment. An investor’s returns will be the result of the asset type they invest in plus their skill in picking which specific assets in that group to own.
Let’s start with an obvious example. What if you are a bond investor today? What kind of returns should we demand to prove you have skill? To prove you are a “guru”?
Right now, not much. Today, the Moody’s 30-year BAA corporate bond yield is 4.7%. BAA is not the highest credit rating a company can have. It’s far from AAA. And 30 years is about as long dated a bond as anyone is going to buy. So, while it’s true you can take more or less credit risk – you can buy AAA bonds and you can buy junk bonds – and you could certainly own shorter maturities (most every bond investor will) you can’t escape the fact that the investment return in bonds is less than 5%.
I like to think of both investors and investments as earning investment returns and speculative returns. If you buy a bond that yields 6% you are getting a 6% investment return. If you hold that bond while interest rates fall to 3%, you can earn a huge speculative return (because the price of the bond will double to bring that yield down). But that really doesn’t change the investment return. It would be silly to think the interest you were paid for holding that bond and the capital gain you achieved because it became harder to get such interest elsewhere are the same thing. The interest is a recurring source of underlying value. The capital gain is a one-time trading profit.
Investing in stocks works the same way. I’ll use Value Line as a good gauge of how cheap or expensive U.S. stocks are. Value Line covers 1,700 stocks. Today, the median P/E ratio of all Value Line stocks is 16.1. Back at the market low (March 2009) it was 10.3. And at the old market high – July 2007 – it was 19.7.
We can – and should – flip the median P/E ratio to get some idea of the investment return available in stocks. At the market low it was 9.7% (1/10.3 = 9.7%). At the market high, it was 5.1% (1/19.7 = 5.1%). And today it is 6.2% (1/16.1 = 6.2%).
That is an overly simple way of looking at things. Because it also matters whether we think earnings are especially high or low relative to book value and sales. In other words – are corporate profits higher than normal because return on equity and profit margins are higher than normal?
I would say yes. Others may so no. So I think today’s P/E ratio of about 16 on stocks is actually understating how expensive stocks are. Again, others may disagree. It’s a matter of opinion – of personal speculation. So let’s put that aside.
The next issue we face is interest rates. As Warren Buffett says: “Interest rates are like gravity.” They influence all asset prices. While interest rates are a weak force in determining the value of any one asset – they are a universal force. They are always acting on all asset prices.
Right now, there is much more money around than needed.
Strong banks have more deposits than loans. Banks where the CEO will tell you he wants to lend over 90 cents of every $1 they have in deposits are instead lending 80 cents or less. While the numbers vary from bank to bank – the direction of this difference remains the same. Banks are making fewer loans than they would like given the amount of deposits they have.
Strong companies have more cash than opportunities. Anyone who reads the 10-Ks of American public companies and then listens to the conference calls of those same companies will notice this fact.
Returns on equity are high. In some cases, very high. Yet companies with an ROE of 20% are lowering their net debt (paying down debt, piling up cash, etc.) and buying back stock. They are not spending heavily on expanding the business.
Think about that. If you are averaging a more than 20% return on the equity you now have – shouldn’t you increase the amount of equity in your business?
Maybe. Maybe not. What matters is the return on the equity you add. With debt often available around 5%, many companies are not borrowing. Nor are they reinvesting all of their earnings. Some are piling up cash (often overseas). Others are buying back stock.
There’s a huge spread between the rate they can borrow at and their current returns on capital. But those are average returns. So this is a sign that returns on added capital are expected to be much lower than returns on capital already in the business.
Again, this just points to the idea that there is more money than needed.
The clearest sign of this phenomenon is interest rates. They are low. In fact, the yields on certain bonds look about as low as they’ve been at any time since World War 2.
What influence do low interest rates have on the price of assets like stocks?
Low interest rates encourage high asset prices. If interest rates get lower in the future, that will encourage – though not guarantee – higher stock prices. And if interest rates get higher in the future, that will encourage – though not guarantee – lower stock prices.
This is the speculative part of an investor’s returns. If an investor speculates right about interest rates – or short-term asset price moves of any kind – he can make more owning an asset than the underlying investment return in that asset.
This is very obvious if we look at stocks since the 2008 crash. The annual returns don’t line up with increases in earning power at all. These aren’t investment returns. They are speculative returns. There has been a big – justified, but still big – one time capital gain caused by multiple expansion. Stocks were cheap at the start of 2009. And they are expensive today. That’s a one-time gain.
Here are the returns of my portfolio and the S&P 500 since the start of 2009:
2009: 41% vs. 26%
2010: 34% vs. 15%
2011: 20% vs. 2%
2012: 6% vs. 16%
Based on those returns – 41% in 2009, 34% in 2010, 20% in 2011, and 6% in 2012 – would you say I am a good or bad investor?
It’s actually very hard to tell. I didn’t give you my returns for 2008 – which were hugely negative. I only showed you four years of results. And – with the exception of 2011 – they were all years in which U.S. stocks generally shot through the roof.
These were great years for stocks. In great years for stocks, it is almost impossible to tell whether or not someone is a great stock investor. For instance, my four-year record tells you nothing.
The most telling year in that group is 2011. In fact, I would say that an investor’s performance in 2009 and 2010 tells you almost nothing about them as an investor. Their performance in 2011 tells you a lot more. And my performance – because it was so bad – in 2012 also tells you something.
You’ll notice the S&P 500 had almost identical returns in 2010 and 2012. Yet I had very different returns (34% vs. 6%). Why?
In 2010, I thought stocks were cheap. And I found some worth owning. In 2012, I though stocks were expensive. And could only find one worth owning. As a result, I was 75% in cash for most of 2012. While I was 100% in stocks in 2010.
On a speculative basis – I was clearly wrong. The year 2012 turned out to be just as good as the year 2010.
What does this tell you about me as an investor?
I was wrong. I am a bad market timer.
So the next question you want to ask is whether you are looking for someone to time markets, make the right speculations, etc.
If the answer is yes – you should not pick a guru with a record like mine. Because that’s not a good speculative record there. In fact, I was more fully invested in stocks in 2011 (a bad year for stocks) than I was in 2012 (a great year for stocks). So I had the timing exactly backwards.
But, as it turned out – I was able to turn a bad year for stocks (up 2% in 2011) into a good year for me (up 20% in 2011) through stock picking. I didn’t own any U.S. big caps. I did own Japanese net-nets.
So if you are looking for someone to make odd decisions like that about WHICH stocks to own – you should go with a guru who has a record like that. Go with a guru who gets a good return in a bad year for stocks.
Why not just look at a guru’s long-term record?
Because it’s incredibly influenced by the starting and ending points you pick. Always look at a guru’s 3-year, 5-year, 10-year and 15-year records. That at least takes care of the starting point problem.
But it doesn’t take care of the end point problem. Which is a huge one. Bruce Berkowtiz’s Fairholme Fund dropped 32% in 2011. If you looked at his long-term performance at the start of 2012, you’d say it wasn’t good. It wasn’t good over 3 years, 5 years, 10 years, etc. It just wasn’t that amazing anymore.
Now imagine Fairholme bounced back and made up that lost ground. It would need to rise 47% to do that. And – as I write this – I believe it’s made up about 43%. Basically, it’s almost back to where it was before that huge drop.
And – you know what – I don’t think much has changed. The names in Fairholme’s portfolio haven’t changed much. The competitive position of those companies hasn’t changed much. And their long-term “normal” earning power hasn’t changed much either.
What has changed?
Market sentiment toward financial stocks. That’s it. Berkowitz stuck with his same view for a couple years. Everybody else in the market changed theirs.
But if you look at 3-year, 5-year, 10-year and 15-year performance numbers – at a single point in time – you’ll miss that.
You need to look at rolling results. What would the 10-year record have been at the end of 2005, 2006, 2007, 2008 and 2009? Never look just at performance ending in one year. Look at performance on a rolling basis.
This is very important. If you fail to do this – you’ll tend to be most negative on a guru at the exact moment when they are at their most contrarian. In other words, you’ll see the fund as being a limp rubber band when it is actually at the moment of greatest tension.
You will equate past results with future potential. However, the degree to which a guru’s “style” is out of favor actually determines future potential. When the market is most in agreement with a guru – that guru has the lowest future potential. And when the market is least in agreement with a guru – that guru has the greatest future potential.
So keep those two ideas in mind. One, any investor – including a guru – is limited by the underlying investment returns available in their chosen asset class. And two, performance measures always overstate the recent past because they have a fixed end point. Use rolling returns – with at least five different end points – to help solve this problem.
How do we adjust for environment?
This is a tough one. Many great value investors got their snowball rolling in the 1940s or 1970s. This is not an accident. By my calculation – everybody has a different favorite valuation metric – stocks looked priced to offer the best long-term returns in 1942 and 1982. They looked priced to offer their worst returns in 1929, 1965 and 1999.
Right now, if you are going back to a guru’s results starting around 1999 – you’re being incredibly unfair to that guru. There have only been a few brief moments since 1996 when stocks overall have been clearly cheap. For most of the 1970s and 1980s stocks were clearly cheap. Bonds may also have been cheap at times. So you could dispute relative valuations. But absolute values were clearly present in stocks. That’s rarely been true since the Internet boom started.
This isn’t unique in history. It’s been very hard for even the best investors to make money in Japan. Some would say there are macroeconomic reasons for that. There are. But by far the biggest reason it’s been hard to make money in Japanese stocks is that they were clearly overpriced for decades.
Over the last 15 years, the S&P 500 has returned 5% a year. Should you expect 10% over the next 15 years?
How about another 5% a year for the next 15 years?
Maybe. If I had to pick either 10% returns or 5% returns as my prediction for the next 15 years – I’d definitely pick 5% returns. My actual estimate would be somewhere in between.
I would say a guru is someone who – over long period of time, and on a rolling basis – can often beat the S&P 500 by about 5 percentage points a year. Looking over the last 15 years,that would mean a guru is someone who can return about 10% a year (actually, a smidge less). And over the next 15 years, I’d expect the numbers to be pretty similar.
I would not eliminate someone from guru contention just because he earned 8% or 9% a year over some long-term performance period.
Finally, I want to illustrate the problem of using a compound annual return cut-off without taking into account the market environment. This helps prove my point about the need to use rolling returns – never just one set of point to point compound returns.
I showed you my personal investment results for 2009, 2010, 2011, and 2012. If you tally them up you’ll see my compound return was 24% a year over those four years.
Okay, let’s dial it back one full year. Let’s take January of 2008 as our start point.
In that case, my compound annual return goes from 24% over the last four years to 9% a year over the last five years.
To most people, 24% a year sounds like a definitely guru level performance. And 9% a year sounds like a definitely not guru level performance.
You can’t just ask whether someone returned 24% a year or 9% a year. You need to know what environment they were operating in.
It was easy to earn more than 20% a year in stocks from 2009 through 2012. And it was hard not to lose more than 30% in 2008.
The 2000s have been a tough time to make money in stocks. You can’t compare today’s gurus with gurus from the 1980s. The guys who started 30 years ago, had it much easier. Stocks were much cheaper. And that’s what matters most.
What you want to look for isn’t just a good long-term performance. You want to look for skill. And that especially means skill in handling the stock prices you were dealt.
Since the late 1990s, earning 8% or 9% a year in stocks has actually been an excellent performance. And I can safely predict that most people reading this article will not earn more than 8% or 9% a year over the next 15 years.
They’ll earn less.
So, if you can find an investor who will do better than 8% or 9% a year over the next 15 years – I’d call that person a guru.
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