With Age Comes Wisdom…Before Senility
Investment Success Often Depends On Choosing The Right Investment Horizon
In an early philosophy course, to introduce the concept (and danger) of extrapolation, our professor used the example of an Englishman landing in France for the first time. Seeing two red-headed women on the dock, he immediately calls his friends in London to report that all French women are red heads. The title of a recent Casey Research paper, “Extrapolation Fever”, recently reminded me of this example and its title seemed particularly timely.
Extrapolation is the assumption that you can generalize from limited samples and/or that current trends will continue forever. Sadly, we all have a tendency to extrapolate and I have long believed that this is one of the worst biases of investing, responsible for the destruction of innumerable portfolios. This was the reason for my early adoption of a contrarian investment approach.
Possibly the second worst investment bias is our need to believe a good story. As a trend matures, its causes become obvious to the average investor. He or she comes to assume that this is the way the world always works, forgetting that by the time a story is obvious to a majority, it is already reflected in the price of a stock or of the market.
My view, and that of many contrarian investors, is that the world is cyclical. Economic indicators, for example, tend to fluctuate around either a long-term trend or a historical average, periodically “reverting to the mean”, as statisticians say. Financial markets, which are importantly influenced by the excesses of crowd psychology, do not only revert to the mean, but usually go through it, toward a more “exuberant” high or low.
In financial markets, the most common use of extrapolation is called momentum investing, which consists of buying what has been going up on the assumption that it will continue to go up. Numerous studies have documented that momentum investing works most of the time: stocks and markets tend to do as they have been recently doing. The only problem is that many studies also show that (almost by definition) momentum does not work when it counts most, i.e. at major market turning points. And as I have pointed out before, in investments it is not how often you are right that counts; it is how much money you make when you are right.
There is no need to revive an old argument about momentum vs. value. Let me just say that I personally don’t know any rich momentum investors – at least not any that made and kept a fortune in the stock market. I do know a few rich and successful value contrarian investors, however. There also are some that I have mentioned in the past, whom I do not know but enjoy watching and reading: besides Warren Buffet and Charlie Munger (Trades, Portfolio), they include Jeremy Grantham (Trades, Portfolio), at G.M.O.; Howard Marks (Trades, Portfolio) at Oaktree; and William Browne, of Tweedy, Browne. We not only have a commonality of views, but also similar experiences and career paths. All three gentlemen can also claim superior long-term investment records—and by long-term, I do not mean five year; I mean more than thirty years…
There is no lack of successful investors besides those I mentioned above, and my requirement for a thirty-year-plus record may seem self-serving, since only an older investor can have such a record. For example, 56-year-old Seth Klarman (Trades, Portfolio), founder of the Baupost Group, has a stellar 25-year record and writes highly stimulating shareholders’ letters, BUT... I will respond like famous Chinese leader Zhou Enlai who, when asked what he thought was the significance of the French Revolution of 1789, reportedly answered: “It is too soon to say”.
Today, there is one trend that has been in effect for a very long time and whose causes are well understood and routinely enunciated by even the financially less-literate: declining and low interest rates. A glance at the following chart will illustrate:
Interest rates approached 14% in 1984 and, although recently doubling, have remained under 3% since mid-2011. And, while interest rates declined by 80% almost without interruption for 30 years, the Standard & Poor’s 500 Index gained 1041%!
Interestingly, I am finding the investor consensus is now overwhelmingly anticipating that interest rates will eventually rise again. So, expecting them to do so is not exactly contrarian. But my concern goes beyond just the stock and bond markets.
Thirty years of “suppressed” interest rates, as economists say to describe the central banks’ aggressive role in reducing and almost eliminating financing costs in the economy, must have been addictive. All our instincts and economic reflexes are now unconsciously geared to this misleading environment and, for investors who have no experience pre-dating the early 1980s, it would take an exceptional imagination to picture what it was like to invest in an environment of high and rising inflation, high and rising interest rates.
Some of the successful “old guard” may provide some guidance:
We do think the market is going to go higher because the Fed hasn't ended its game, and it won't stop playing until we are in old-fashioned bubble territory and it bursts … But to invest our clients' money on the basis of speculation being driven by the Fed's misguided policies doesn't seem like the best thing to do with our clients' money… We invest our clients' money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns.
Howard Marks (Trades, Portfolio), in a lecture at Wharton (March 17, 2014), remembered his early career experiences, which taught him that with its Nifty 50 policy [early 1970s], Citibank had invested in the best companies in America and lost a lot of money; then it invested in the worst companies in America [junk bonds] and made a lot of money. He noted that “it shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.” An asset of high quality can be overpriced and be a bad investment; an asset of low quality can be bought cheaply and be a good investment. Then focusing on the present, he warned that the current low return on credit instruments, due to low interest rates, has spawned some risky behavior in the market. “If the market is pro-risk, then risky securities can be issued. We have to make sure that it’s not we who buy them.”
It would be hard to find a better conclusion than these two quotes, from investors who, over the years, have learned to let wisdom and prudence prevail over greed and short-term competition.