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Peter Cundill & Black Monday - A Lesson in Patience

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The Science of Hitting
Oct 23, 2013
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“Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.”

– Charlie Munger

In 1987, the Dow started the year at less than 2000; by August, the index had crossed 2600, for a year to date return of 30%. Much like today, this isn’t the type of environment that generally leaves the value investors feeling comfortable; we’re often alone in our distrust of rising markets.

Peter Cundill was in that camp back in 1987. As the year went by, securities in his portfolio continued moving higher and in excess of book value. For him, this qualified the investment as an automatic sell, unless there were overriding reasons to hold steady. As it turns out, Peter must not have found many situations where he decided to hold on: by the time October rolled around, the portfolio was more than 40% in short term money market instruments. As Peter wrote in his journal at the time, the likelihood of a “possibly violent stock market collapse” seemed higher:

“I have an unpleasant feeling that a tidal wave is preparing to overwhelm the financial system, so in the midst of the euphoria around I’m just planning for survival.”

Consider for a second those last three words – "planning for survival." Sitting with 40% of his client’s funds in cash, presumably underperforming by a wide margin as the market kept adding to its year to date gains, Cundill’s concern was that he had too much on the table. Ironically, most fund managers (and individual investors) approach investment decisions from the exact opposite viewpoint: they give themselves a few weeks or months (if that) to be proven right on their few real deviations from closet indexing, and then throw in the towel if the market moves against them – as the validity for their position is being strengthened, all else equal – to save face and avoid anymore “tracking error” (nothing seems to drive behavior much like career risk). Many people who have spent 2013 underinvested apparently feel this sense of urgency: As stocks have got much more expensive over the past ten months, their interest in equities has only increased.

Of course, the story doesn’t end with Mr. Cundill building up his cash balances. On Wednesday, Oct. 14, 1987, the Dow fell by 4.5%; it fell by another 3% on Thursday, and another 6% on Friday. At this point, Cundill noted a change in his fellow market participants – “traders and investors alike began to lose their nerve” – and if the markets fell 13% the remainder of this week, the traders and investors of 2013 wouldn’t respond any differently. In that day’s journal entry, Cundill quoted the famous line from Horace’s "Ars Poetica," as often cited by Ben Graham:

“Many shall be restored that now are fallen, and many shall fall that now are honored.”

Monday, Oct. 19, is the day that lives in infamy; by the time the clock struck four, the Dow had fallen more than 500 points – with the 22.6% decline still holding the record as the largest drop in the Dow’s history. In the preceding four trading days, $1,000 invested in the Dow had dropped to a value of $674 – good for a decline of nearly one-third.

The next time you get concerned that you’ll miss a bull market because the market has increased 2% to 3% in a week, ask yourself a few simple questions: Do you have an intimate understanding of the business that you are investing in? Does the current valuation provide a margin of safety and imply “glass half empty” assumptions, as compared to reasonable future expectations? Finally, how would you react in your investment declined in value by one-third seemingly overnight – would you happily buy more?

Of course, most people were not asking themselves these questions in 1987 prior to the crash, and they are almost certainly not asking them today. As Mr. Risso-Gill notes in the book, they didn’t walk away from the 33% drop ecstatic to buy now (seemingly) discounted securities – they were “shell shocked and terrified.” Many of the people who are loading up on PepsiCo (PEP) and Procter & Gamble (PG) at $80 per share would sell immediately if they fell back to the mid-$50s.

Cundill’s value slant paid off nicely in 1987 (and throughout his career): By the end of the year, the Dow finished the year down 12% – a relatively small decline considering what had transpired in October. Cundill’s fund ended the year up 13%, beating the indices and his peers by a wide margin.

What’s the takeaway? First off, let me be clear about something: I’m not trying to draw any corollary between 1987 and 2013 beyond the simple fact that equity markets have moved considerably higher this year. I have no idea what the market will do next week or next year.

My point is much broader, and comes back to Charlie Munger’s quote from above: If you’re like me, the sea of opportunity that was available a few short years ago has essentially disappeared. I’m happy with my current holdings, but will start moving them to cash if they go too much higher from here (I mean double digits, not 1% or 2%). As dividends and new funds find their way into my portfolio, they will be left untouched, as cash or short-term fixed-income instruments. I’m continuously searching; right now, the major opportunities, clearly recognizable as such, are nowhere to be found. Until I can start finding them, I will not act – it’s that simple.

Many readers will likely agree with that statement; this article is a simple plea to staying true to those principles (maybe I’m pleading with myself more than the reader). Higher prices are a reason for caution, not chasing. If you missed buying something when it was lower and it has since done well, that doesn’t justify buying it today at fair value. If markets continue higher, cash will continue to be a headwind. And while it may seem like an increasing burden at that time, its value as a call option with no expiration date or strike price is increasing; recognize it as such.

Continue looking – and when you find something worth keeping an eye on, set buy prices that might seem ridiculous compared to current market values. As we learned in October 1987, the tide can turn quickly in the stock market. There will be a time again when the “shell shocked and terrified” will be left licking their wounds – prudence and opportunity will again go hand in hand.
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