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Thomas Macpherson
Thomas Macpherson
Articles (191)  | Author's Website |

Underperformance and Value Investing

April 10, 2015

According to General Horatio C. King, a group of friends from Illinois called on Abraham Lincoln in the White House. Toward the end of the visit, one of the men asked Lincoln if he liked being president. Lincoln smiled and replied: "You have heard the story haven't you, about the man as he was ridden out of town on a rail, tarred and feathered, somebody asked him how he liked it, and his reply was if it was not for the honor of the thing, he would much rather walk[1]."

We’ve recently been feeling a little bit like the man who was ridden out of town. Over the past three (3) years Nintai has underperformed the S&P500 TR by 4.4% (on returns of 11.7% versus 16.1% respectively). This hasn't been easy for either Nintai or its investors. We have been blessed with investors who truly believe in our model and have been rewarded by our five (5) and ten (10) year returns.

We aren’t alone. Our good friend Science of Hitting discussed his underperformance in a frank – and refreshingly honest – way earlier this week. His article can be found here. Many other value investors have underperformed the broader markets over this period. A quick review shows since the Great Recession of 2008 it has been difficult for value investing. In particular value strategies significantly underperformed in 2008, 2009, 2011, 2013, and 2014.

Source: AXA

So what’s going on here? We were taught value investing is the only sure way to outperform in the long term. Obviously the operative words here are long term. Underperforming for three consecutive years or five out of the last seven is an extremely uncomfortable position for both investment managers and investors themselves. We recently wrote about patience being an essential tool for successful value investors and certainly this type of performance requires an extraordinary amount of that attribute.

All the great investors have had periods of underperformance. Ranging from the infamous Barron’s cover of December, 1999 asking, “What’s Wrong, Warren?” to Sequoia Fund’s 1970-1973 streak they are all too common. John Huber in his fantastic blog Base Hit Investing used Walter Schloss’ results as an example of this phenomenon[2].

Here’s an interesting fact I learned from doing that: despite Schloss trouncing the market by 10% per year (20% vs 10% S&P from 1955-2002), he had numerous 2-3+ year periods of underperformance. In fact, there was one period where Schloss actually underperformed for 10 years!

From 1989 to 1998, the S&P roughly doubled Schloss’ results. This means start to finish… there were years in that period he beat the S&P, but an investor who came in at the beginning of that period would still be behind an index fund 10 years later.

To outperform you have to underperform

Many people think outperformance is generated by a steady course of beating the general markets each year. Nothing could be further from the truth. Studies have shown the famous Super Investors of Graham and Doddsville underperformed the markets roughly one-third of their investing career. What’s particularly difficult to understand is that it takes times of underperformance to achieve long-term outperformance. This is for several reasons. First, if a value strategy beat the general markets every year, then it is likely far more investors would follow this path. It’s the underperformance that drives most of these investors from the value model. Simply put, most people don't have the temperament to hold on through the down times. Second, companies purchased by value investors are likely undervalued and perceived in a negative light. The markets will eventually recognize their value but we – and here’s the kicker – just don't know when. This can lead to significant periods of underperformance. Last, there are periods (such as seen in the past few years) where investors focus on lower quality, higher-risk stocks that generate high returns. Why buy a company that makes farm tools when you can purchase a cloud-based green network that has doubled in the past 12 weeks?

Why this is important

Value investors must have the patience and time to let the markets prove them right. But that isn’t the whole story. If it was that easy, then more people would simply buy a basket of stocks and retire rich. But clearly it isn’t. Successful value investors find a way to wait out times of underperformance and (hopefully) generate adequate long-term returns. We believe there are three specific habits and processes that help successful value investors ride out underperformance. These are:

A well-defined stock selection process

You will rarely beat the markets over time unless you have value-based investment process centered on company fundamentals, valuation, and a margin of safety. Rarely are value investors’ processes identical. Nintai focuses on allocation of capital, balance sheet, FCF and competitive positioning. Someone else’s might focus on PEG ratios, return on equity, and price over sales. No matter what the process is you must stick with it for an extended time as well as through any performance – both good and bad.

Clearly articulated expectations

At Nintai we tell our investors our focus is on outperforming the general markets from a five- and 10-year perspective. We will openly admit we have little idea of how we will perform during any three-year cycle. When interviewing potential investors or simply investing on your own, you must have a clear idea of what your expectations are and then measure against these over time. We have seen many individuals and money managers come to grief because they simply didn't prepare their investors with certain expectations.

Data-driven decision making

A famous investor once said, “The best investing is unemotional, data driven investing.” I completely agree. We know humans feel loss roughly double their gains – better known as loss aversion. We have created a mechanical and data driven process that offsets these emotions. Much as we discussed in our “Patience Is A Virtue” article, mastering the seven emotions takes both moral courage as well as a system that assists you in that endeavor.


None of our investors or our investment team enjoy underperforming. Some years can seem like daily water torture as you see every stock but yours rocket upwards. The way to ride this out is setting expectations, picking great companies, and with great patience wait until the markets buy into your thesis. This is perhaps the most difficult part of value investing. But with these arrows in your quiver you can likely avoid being run out of town and keep your honor. And that’s something Mr. Lincoln – and your investors – will applaud.

As always we look forward to your thoughts and comments.

[1] P. M. Zall, “Abe Lincoln Laughing: Humorous Anecdotes from original Sources by and about Abraham Lincoln” Berkeley: University of California Press, 1982 page 143.

[2] Base Hit Investing, “Value Investing: Luck vs Skill Part 1”, John Huber, October 23, 2013. (http://basehitinvesting.com/value-investing-luck-vs-skill-part-1/)

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website

Rating: 4.3/5 (14 votes)



The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

Tom: Great article as always - and thanks for the shout out! Quick question: you said the following in the article - "At Nintai we tell our investors our focus is on outperforming the general markets from a five- and 10-year perspective." As you look at companies, how do you build that into your valuation? Do you actually look at the market and say "we think it's priced for 4-7% a year, so we'll be happy with 10% or more", or do you simply have a hurdle that's set in stone (12% or more, which beats the long term average)? Would be interested in hearing your thoughts on this - thanks!

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Science: thanks for your comment. There are several ways we look at this. First, we have absolutely no idea what the markets will do in 5-10 years. That being said we are constantly analyzing the portfolio on Abacus to make sure of two things - first that the portfolio is trading below the average PE of the S&P 500. Second is the portfolio projected earnings over the next 5 years is substantially higher than the S&P500. Along with several other factors (such as ROE, ROC, and ROA) we believe this shows us we will likely outperform over the next 5-10 years. Note that this process means we're are agnostic to where the markets are going - just that we can beat them relative to their returns. It also means we don't have a number or hurdle for returns to meet in our head (our compensation is based on a hurdle but that's a seperate issue). Hope this helps. Thanks again for your questions. Best. - Tom

Jonathan Poland
Jonathan Poland - 5 years ago    Report SPAM

Do you use leverage at all in your investing operation? If you read back letters of Buffett's annual letter, leverage was instrumental in boosting his performance and even making up the lion's share.

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Hi Jonathan. Thanks for your question. We do not use leverage. Best - Tom

Vgm - 5 years ago    Report SPAM
Thanks Tom. Enjoyed it. It's healthy to be able to talk about underperformace.

Bill Nygren (Trades, Portfolio) recently touched on related material:


Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Thanks VGM for your comment. I actually feel better talking about both successes and failures. We have learned a lot from our underperformance over the past three years. Perhaps not the easiest method of teaching but valuable nonetheless. Thanks again for your comment. Best - Tom

Doug Morse
Doug Morse - 5 years ago    Report SPAM

Thank you for another informative article. I would appreciate your thoughts: if even actively managed, value-focused investors must expect periods of underperformance and require a 5-10 year horizon, why not simply purchase low cost mutual funds and hold them over the same time period? Why go to the trouble or expense of active fund management if in fact it is this difficult to beat market returns? Please note I ask this question in the spirit of discussion, not to offend anyone. Any commentary is appreciated.

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Hi SeekingProfit. No offense taken! It's a great question. I think the data would tell you that your proposed action is right in the vast majority of cases. Most funds don't beat the markets in the long term and that's part of the reason we saw Vanguard take in so many new assets and actively managed stock funds continued to decrease in AUM. There are funds out there however that DO actually outperform the markets. These are few and far between. Unless your fund has a history of long term outperformance, sets realistic expectations, and charges relatively low fees, I believe you are better off going with the index fund. It will be interesting to hear other answers to the question. Thanks again for your question. Best - Tom

Zejia - 5 years ago    Report SPAM

Hi SeekingProfit&Tom,

I think if the fund underperformed the market for 10 years, I really think the fund manager needs to recheck his holdings, whether the reasons for buying was valid or whether he bought them at a wrong time.The case Schloss underperformed for ten years is vary rare, I guess.

Great article, Tom. Thank you.

Batbeer2 premium member - 5 years ago

>> Why go to the trouble or expense of active fund management if in fact it is this difficult to beat market returns?

That is a good question.

FWIW I think there are two reasons:

1) The person doing the work enjoys the proces (Buffett/Chou) or

2) They need the ego boost (Trump/Ackman)

In other words, anyone who thinks value investing is in any way easy is wrong. It's probably not worth the trouble. Unless you get a kick from doing the analysis.

Just some thoughts.

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Zejia and Batbeer: thanks for your comments. After writing this - and reading several other articles - we began asking ourselves "how long is too long to underperform?". That will be the subject of this week's article. Zejia - we agree. Ten years seems a long time. But if you underperform for so long are you another Schloss or just an incompetent investor? Hard to know. Batbeer - another question to ask is why would anyone invest in such a performance? Thanks again for your comments. Best. - Tom

Batbeer2 premium member - 5 years ago

@ Thomas

You say:

>> would anyone invest in such a performance?

I'd say yes, but not many. To let someone manage your money you need to know:

1) They can de trusted

2) They can de trusted

3) They have some talent.

In that order.

Interestingly, many people will look for funds that outperform the market to see if the manager is talented and then try to figure out if they can be trusted and/or depend on regulators to deal with that problem. The trouble is that almost all the funds reporting excess returns are managed by people who simply can't be trusted with your money. I'm not kidding.

It is soooo easy for a manager/firm to create dozens of funds with audited returns that beat the market.... IMHO there's no hope for anyone who thinks they can select a manager/fund by looking at (out)performance first. People doing that don't realise just how terribly the odds are stacked against them.

If I were looking for someone to manage my money I would be so happy to have found a manager I can trust (white elephant) that I wouldn't bother to check if the guy/gal was beating the market. I can think of exactly one. Francis Chou (Trades, Portfolio).

So to answer your question: Anyone investing in performance like that will be doing it because:

0) They want someone to manage their money for them

1) They have good reason to trust that particular manager and

2) They are smart enough to know hardly anyone else in this business can be trusted.

If that is a small subset of clients then that's just too bad. IMHO, a fund manager going after the much larger group of clients who look at performance first can only beat the likes of Legg Mason by cheating.

Batbeer2 premium member - 5 years ago

>> if even actively managed, value-focused investors must expect periods of underperformance and require a 5-10 year horizon, why not simply purchase low cost mutual funds and hold them over the same time period?

Not everyone cares about outperformance. The people I know that are much richer than myself didn't do it by giving much thought to the performance of the S&P500 or any other benchmark. Many have become rich without beating the index. Meanwhile many millions of investors have lost their life savings trying to beat the S&P500.

So yes, I think it is a very good idea to work hard, underspend your income and sink your excess cash in a low-cost index fund. That is so much easier than picking stocks or fund managers.

Of course if, like Buffett, you are not very good at much else except throwing newspapers and reading, then maybe your best bet is to spend your days picking stocks.

Snowballbuilder - 5 years ago    Report SPAM

I think many people have gotten rich without beating the index. Meanwhile many millions of investors have lost their life savings trying to beat the S&P500.


I think the objective of many succesfull investors is to achive strong absolute return with low risk of permanent loss of capital.

i ve never listened Mr del vecchio talking about beating the index and for what i know He has virtually all his capital in just four investments ... Luxottica, generali , unicredit and foncieres des region .

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Batbeer and Snow: thanks for your comments. You remind of the story told about the guy was being asked if his funds had beaten the market and he said, "hell....what do I care? All I know is I made enough to live in Florida and fish all day". Thanks for both pointing out performance is always relative to your goals. Best. - Tom

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