“One of the most demanding times is when you underperform. Whether it’s an individual stock that drops by 30% in one day or the entire portfolio grinding down month after month, stress can reach an intolerable level. Nobody said this would be easy. I always think these are times to really review your process. Is there something you are missing? Are there inputs that might give slightly different or better insights? I also see this time as a teaching moment for my clients. Do they understand why I am underperforming? Am I explaining it well enough. Most importantly, do I understand why I’m underperforming?
- Ted Regina, Ph.D.
One of the most overlooked sections in great value investing writing is chapter two in Benjamin Graham and David Dodd’s classic “Security Analysis." [1] Entitled “Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors,” the chapter is filled with insights on both an investor’s approach and views on data and information about possible investments. I think many investors prefer Graham’s “Intelligent Investor” because of its length (575 vs. 733 pages) and Warren Buffett (Trades, Portfolio)’s very vocal support of chapters eight (“The Investor and Market Fluctuations”) and 20 (“Margin of Safety as the Central Concept of Investment”).
During times of underperformance, I generally turn to the investment classics to clear my head of the worries, doubts and emotions that come with it. Boy, have I been reading a lot over the past quarter. Nintai and Dorfman Value holdings Novo Nordisk (NVO, Financial) is down -36.4% year to date, Hargreaves Lansdown (HRGLF, Financial) is down -38.4% year to date, Manhattan Associates (MANH, Financial) is down -24.5% year to date and T. Rowe Price (TROW, Financial) is down -11.6% year to date. Just a solid wall of red across the board.
Returns like this can make you question your investment process[2]. The pressure can get immense to tweak the system or make hasty changes to try to stop the losses. I know I have spent many days listening to quarterly earnings calls, reading through 10-Qs and talking to customers of our holdings. But I think one of the more important things is to go back to chapter two in "Security Analysis" and reread it after taking a deep breath (and maybe pouring yourself a wee dram if that kind of thing works for you).
In this chapter, Graham and Dodd start out by discussing four fundamental elements necessary to answering this question: should security (S) be bought, sold or held at this price (P) at this time (T) and by this individual (I)?
(S) The security
Here Graham and Dodd look to answer three questions. First is defining the business. Do we understand how it makes its profits? Second, what is the price of the security? Are the terms offered going to provide us with an adequate return? Last, define the security itself. Where do we stand as shareholders or debt holders? I would add one additional item – corporate financial statements. Investors should know these to an in-depth degree for each of their holdings.
(P) Price
Price is what you pay, value is what you get. How many times have we heard this phrase (far too many times in my view)? Graham and Dodd point out the danger of paying the wrong price is equal to buying the wrong issue. They end this section by saying, “…the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences.” I could not agree more, which is what makes such significant price drops in my holdings so painful.
(T) Time[3]
Graham and Dodd point out that an investment can look vastly different depending on the time. Tech stocks certainly looked different in March of 1999 versus March of 2002. It is important that your models work in most settings – such as 1999 or 2002 - and can adapt to new information. The authors state, “security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times – or, at least, under all ordinary conditions.” Being able to adapt with the times is essential.
(I) The individual
Before any investment is made, it should be assured it meets the investment criteria of the potential holder. I have been remarkably fortunate in having investment partners that have extremely long time horizons (such as the Nintai Charitable Trust) or individual investors with great patience. It is during periods like right now – when underperformance is a very real concern – that you find whether your investors’ needs are aligned with your investment approach.
Breath in patience, breath out...profanity?
I am not a real proponent of checklists. I understand their value to some – just ask any airline passenger flying with a captain who has not done his pre-flight checklist. In general, I have found that a structured process is better for me than the list. With the latter, too many times I became focused on one particular item at the expense of several others. Process looks at things more holistically, while the checklist is driven by data. I generally look for a process that keeps emotions in check, allowing for a more integrated and objective look at the data. An old friend of mine said that problems begin when you do no let the profanity out. This is what makes the second chapter of "Security Analysis" so vital. In its own way, it allows investors to expunge the fear and terror as they watch their investments drop in price (along with a steady stream of epithets).
Conclusions
Every investor will go through a dramatic period of underperformance in his or her career. It is just a question of whose turn it is to be – as John Dorfman and I say – “in the barrel.” It is safe to say the past 30 days has been this humbled writer’s turn to go over the falls. It is not very pleasant for me as an investment advisor and even less fun for my investors. The key is to avoid making any hasty decisions that assure locking in bad decisions through uncontrolled emotions. Each time I read chapter two, it allows me to reel these in and get back to basics. By answering Graham and Dodd’s question, I can feel comfortable knowing the smartest move might be to do nothing at all.
As always, I look forward to your thoughts and comments.
Disclosure: Nintai Charitable Trust is long NVO, HRGLF, MANH and TROW, as are some individual accounts at Dorfman Value Investments.
[1] “Security Analysis”, Sixth Edition, Benjamin Graham and David L. Dodd, McGraw Hill, 2009
[2] We can take heart in the fact 60% of all funds that outperformed their bogey over a 15-year period (1998-2013) underperformed in 7 of those years. See here for more information.
[3] Graham and Dodd are addressing more “timing” than “time”. Utilizing time as risk mitigation is an entirely separate concept deserving it’s own article.
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