Fellow GuruFocus contributor Tom Macpherson recently wrote an article discussing his returns for the first quarter – and much like Nintai’s long term results, they were fantastic.
I was thinking about doing the same for readers but was having trouble coming up with a succinct way to describe my start to the year – then I found the right word: “ouch."
That adequately sums up how the last few months have felt from my perspective. While I’m focused on the long term, I still live one day at a time - and for better or for worse (almost certainly worse), I spend many of them in front of a computer screen with easy access to constantly changing stock prices. They haven’t been too kind lately - and it hasn't been much fun.
Going through my portfolio, it has started at the top; my words from my year-end review didn’t wait long to come back and bite me in the behind:
“The beauty of a concentrated portfolio becomes apparent when you find a handful of companies that are attractively valued and they perform as expected.”
Well, that works just as “beautifully” in the opposite direction: Berkshire Hathaway (BRK.B) and Microsoft (MSFT) fell 4% and 13% in the quarter, respectively. With those two companies accounting for nearly half of my investment portfolio, that’s a pretty big hole to start from.
In my opinion, there’s no real explanation in the operating results for Berkshire’s weak start to the year; considering we’re talking a few points, one really isn’t needed. On the other hand, Microsoft’s stumble out of the gates is largely attributable to a tough quarter in their Commercial business (grew 5% versus 10% in the prior year period) and an even tougher comparison coming in the next reporting period (especially for D&C). As I noted in early February, I think this is more of a timing issue than anything else, with the stacked comp still showing solid results in the Commercial business. Mr. Market seems worried that the last quarter was a change in trend for a business that has done quite well, averaged out, over the past five-plus years; I disagree.
My other sizable positions, PepsiCo (PEP) and Johnson & Johnson (JNJ), weren’t much help either, with the former treading water and the latter falling a few points. For all of the four names discussed here, what I said in my year-end review still stands today.
From there, Weight Watchers (WTW) grabbed the shovel and furiously started digging an even deeper hole. The company announced fourth quarter results near the end of February, with atrocious guidance for the coming year (more than 50% below what Wall Street analysts were hoping for). Personally, I thought a buck a share seemed like a reasonable expectation based on back of the envelope math; WTW came in well below my estimate too. The stock nosedived and hasn’t looked back since; since the start of the year, WTW has fallen more than 70%.
While I’m not going to rehash my arguments here (revisit my original thesis, here, if you’re interested), I think I should be transparent considering my previous discussions on Weight Watchers: I have not sold a single share. At the same time, I will not be adding to my position until I start to see some improvement on the trends in the North American business, as well as some change in thinking on certain strategies for driving consumer trial. In a scenario where I thought that was happening, I would add meaningfully to my position in WTW – and I would be willing to do so at prices well above where we stand currently. I add that last point because I assume the stock would move higher if we start seeing progress in the areas I’m watching.
Add in the other miscellaneous positions in my portfolio, none of which made much of a move, and you’re left with a pretty pitiful quarter. (The one exception was J.C. Penney (JCP), which was up 35% or so in the first quarter - but it’s a small position with a limited impact overall)
With all that said, I didn’t write this article to talk about my returns. What I’ve been thinking about is the impact short term underperformance can have on commitment to a (presumably) sound long term investment strategy. More specifically, here’s what I’m interested in discussing: as a long term investor, how do you determine whether your approach is sound?
If you’re a trader, you are likely buying and selling multiple names each week, leaving you with hundreds of “trials” at the end of each year; that’s a large enough sample to provide some tangible insight into whether or not the approach you’re taking is sound (likely to be successful).
Compare that to the investment approach that I, and many of the people that I’ve spoken with on GuruFocus, employ: long term, and largely concentrated to a handful of holdings. Our approach is closer to Warren’s twenty-hole punch card, with the outcome for any individual decision to be resolved in a period of years, not days. We don’t have the luxury of reviewing our performance over short periods of time; the answer given by Mr. Market over the next ninety days is not likely to have much meaning.
Even a few years of performance data can potentially be misleading: research from Davis Advisors shows that in the ten years through 2013, the vast majority (95%) of the top performing large cap managers (those that ultimately finished in the top quartile for the decade) spent at least one three year period in the bottom half of their peer group. Nearly three-quarters of those same managers spent at least one three year period in the bottom quartile of their peer group; that’s the kind of “long term” performance that results in large client outflows – even for the best managers. At the other end of the spectrum, there were undoubtedly managers who finished in the bottom quartile or decile of the peer group that spent a few years near the top.
If you’re not closet indexing, those years of underperformance can result in wide disparities between the index and your portfolio (as an example, look at the GoodHaven Fund over the past few quarters); inevitably, one starts to wonder whether they really know as much as they thought they did – and whether they should be confident in their abilities going forward.
My takeaway is this: no matter your current results, investing must be a process of continual learning and evolution. While returns are what count at the end of the day, it’s always important to differentiate between the process and the outcome; dumb luck won’t last over time – and can be worse than failure when it leads to a false sense of confidence in one’s ability. One thing can be stated definitively: in the long run, a superior process will result in a superior outcome.
This is what I’ve been thinking about during this period of poor performance: is it indicative of an inferior / flawed process? And it has brought me to a question I’ve asked myself many times previously: like any great company, what is my sustainable competitive advantage over time?
What leads me to believe that my process is superior to the average market participant? For one, I think I can be smarter in spots by focusing exclusively on a handful of companies that are likely to do well over time. If I read a decade of annual reports, track competitors, spend time studying an industry, and come away with a clear understanding of the key factors that will determine individual companies long term success, that is likely to be valuable information known by few others; mixed with a fair bit of patience, I believe I can find opportunities where better than average returns (based on what the market has historically produced) can be expected with a high degree of confidence over time. That last qualifier – “over time” – is the second reason why I think my process can be superior: I’m willing and capable of waiting years for events to play out, while many other market participants are constrained by the need for immediate results.
More than anything else, I think those two factors – concentration and patience – are the basis for a superior process. If I’m correct in my assessment, and stay within the constraints that I've set for myself, superior outcomes will come with time.
I’ll close with a story from Paul DePodesta, a gentleman who was instrumental in the use of sabermetrics in baseball (he’s currently VP of Player Development & Scouting for the Mets); I think this is relevant to this discussion:
“Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.
On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: 'Dealer, I want a hit!' She paused, almost feeling sorry for him, and said, 'Sir, are you sure?' He said yes, and the dealer dealt the card. Sure enough, it was a four.
The place went crazy, high fives all around, everybody hootin' and hollerin', and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: 'Nice hit.' I thought, 'Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn't justified just because it worked.'
Well, I spent the rest of that weekend wandering around the casino, largely because I had lost all of my money playing blackjack, thinking about all of these different games and how they work. The fact of the matter is that all casino games have a winning process - the odds are stacked in the favor of the house. That doesn't mean they win every single hand or every roll of the dice, but they do win more often than not. Don't misunderstand me - the casino is absolutely concerned about outcomes. However, their approach to securing a good outcome is a laser-like focus on process... right down to the ruthless pit boss.
We can view baseball through the same lens. Baseball is certainly an outcome-driven business, as we get charged with a win or a loss 162 times a year (or 163 times every once in a while). Furthermore, we know we cannot possibly win every single time. In fact, winning just 60% of the time is a great season, a percentage that far exceeds house odds in most games. Like a casino, it appears as though baseball is all about outcomes, but just think about all of the processes that are in play during the course of just one game or even just one at-bat.
In having this discussion years ago with Michael Mauboussin, who wrote "More Than You Know," he showed me a very simple matrix by Russo and Schoemaker in "Winning Decisions" that explains this concept:
| Good Outcome | Bad Outcome | |
| Good Process | Deserved Success | Bad Break |
| Bad Process | Dumb Luck | Poetic Justice |
We all want to be in the upper left box - deserved success resulting from a good process. This is generally where the casino lives. I'd like to think that this is where the Oakland A's and San Diego Padres have been during the regular seasons. The box in the upper right, however, is the tough reality we all face in industries that are dominated by uncertainty. A good process can lead to a bad outcome in the real world. In fact, it happens all the time. This is what happened to the casino when a player hit on 17 and won…
As tough as a good process / bad outcome combination is, nothing compares to the bottom left: bad process / good outcome. This is the wolf in sheep's clothing that allows for one-time success but almost always cripples any chance of sustained success - the player hitting on 17 and getting a four. Here's the rub: It's incredibly difficult to look in the mirror after a victory, any victory, and admit that you were lucky. If you fail to make that admission, however, the bad process will continue and the good outcome that occurred once will elude you in the future…
At the Padres, we want to win every game we play at every level and we want to be right on every single player decision we make. We know it's not going to happen, because there is too much uncertainty... too much we cannot control. That said, we can control the process.
Championship teams will occasionally have a bad process and a good outcome. Championship organizations, however, reside exclusively in the upper half of the matrix. Some years it may be on the right-hand side, most years should be on the left. The upper left is where the Atlanta Braves lived for 14 years - possibly the most underappreciated accomplishment by a professional sports organization in our lifetimes. In short, we want to be a Championship organization that results in many Championship teams.
I'll touch on our draft in greater detail in the next day or so, but I will say that we are proud of our process and it was carried out with discipline. Will it lead to a good outcome? We don't know for sure, but we have confidence in the group of picks that were made. I do know, however, that our process gets better every single year, and we expect it to be better again next year.”
