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.
Conclusions
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/)
