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Articles (361) 

Don't Blame the Market

Disguised market timing is no excuse for poor performance

June 20, 2017

Over the past decade, a number of renowned value funds have significantly underperformed the market.

Fascinated by this fact, I read the most recent 10 years investor letters of most of the underperforming gurus. As I covered in my last article, theres a variety of excuses, some legitimate and some dubious at best. All concluded that the strategies will work in the future because they have worked in the past; before the underperformance began, none suggested a change was needed. What I found disturbing is not necessarily the excuses but the inconsistency between what they say versus what they have done. But perhaps thats ubiquitous so Ill leave that out of todays discussion.

The readings led me to two quotes from Warren Buffett:

  1. You can learn a lot just by observing.
  2. You should learn as much as possible from others mistakes.

They also remind me of the combination of a few investment adages that are frequently cited by the great Howard Marks (Trades, Portfolio). I find them relevant in todays markets, as they have always been.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.

It's important to remember that overpriced is far different from going down tomorrow.

Sometimes being too early is indistinguishable from being wrong.

Should happen is different from will happen. The most probable outcomes fail to happen all the time and even if they happen, they fail to happen on time.

Improbable outcomes happen all the time.

Let me review an excuse I take most issue with:

Calling the market expensive and holding a large percentage in cash every year since 2012-2013

A few gurus have been calling the market expensive since 2012-2013 as the price-earnings (P/E) ratio (especially the Shiller P/E ratio) has suggested so since then (see chart below).

As a result, they have been holding more cash and less equities in the portfolio. Recently a few of them have been using an extended period of large percentage of cash holdings as an excuse for underperformance. I personally reject the notion that one should only look at equity returns as opposed to the total portfolio returns when evaluating performance.

First of all, cash is an investable asset class with an expected normal return of 0%. Holding a large percentage of portfolio in cash implicitly implies that one thinks that the opportunity cost of holding cash namely holding other assets such as stocks is justified. Assuming a holding period of three to five years, one must assume the prospective return of cash is superior to the prospective return of other assets in the next three to five years, which implies a negative three- to five-year prospective return for other assets such as stocks and only in obvious bubble territories such as the nifty 50 bubble, the tech bubble and the housing bubble years had the prospective return of stocks been obviously negative.

On the other hand, I can also relate to the notion that we should always keep some cash in the portfolio as preparation for the no-brainers that happen infrequently and transiently. But the trick is, you have to bet heavily when such opportunities present themselves. When this happens, cash level goes down and a large equity position emerges.

Now lets see how the aforementioned adages apply here:

It's important to remember that overpriced is far different from going down tomorrow.

  • You may have come to the conclusion that the market was overvalued in 2013 but that doesnt mean the market will go down in 2014 immediately.

Sometimes being too early is indistinguishable from being wrong.

  • If you call the top in 2013 based on the Shiller P/E and have stayed out of the market or have a lot of cash in the portfolio, you borderline being wrong.

Should happen is different from will happen. The most probable outcomes fail to happen all the time and even if they happen, they fail to happen on time.

  • You can say that the market is overvalued and should go down in 2013, 2014, 2015, 2016 and today. But even if you are right about the valuation, in a mildly to moderately overvalued market, you still have to make allowance for the fact that the most probable outcomes fail to happen all the time.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.

  • We know for sure that the Shiller P/E has been high for a few years. But that doesnt mean we know for sure that the market will go down once, say, the Shiller P/E hits 25, or that the Shiller P/E will revert back to the historical average, which is a lot lower. Inflation, interest rate, macro factors, business fundamentals and a lot of other factors affect the market valuation. In other words, the predictive utility of the Shiller P/E is not a sure thing, but if you act upon it based on the assumption it is a sure thing, then you get in trouble.
  • Before the election, everybody thought if Donald Trump won, the market would tank. After the election, the market marched on even though the uncertainty level keeps going up and the market is supposed to abhor uncertainty. Again, if you think you know for sure that Hillary Clinton would have won, or if you think that you know for sure that if Trump won, the market would have collapsed, it has been proven it just aint so. And if you think you know for sure that Trumps unpredictability will create market turmoil in the early days of his presidency, youve been proven wrong. It just aint so.
  • On the other hand, we can acknowledge that we dont know what the market will do in the next year or the next two years but still make intelligent decisions nevertheless. There were plenty of fat pitches during the past five years in an elevated market.

The correct attitude in the past five years is exemplified by Oaktree: Invest but with caution. You can be defensive most of the time and shifted toward offense in August 2015 or early 2016. You can lower the portfolio turnover and bet bigger but less frequently. You can make more special situation investments. Or you can invest globally where the market is cheaper. Theres always something to do. Holding a lot of cash for an extended period of time because a money manager claims that the market is expensive is not the most prudent behavior.

I also want to clarify that I only take issue with holding a large percentage of portfolio in cash for an extended period of time and not acting on opportunities, and using this as an excuse for underperformance. I have no problem with temporarily holding a lot of cash. And I certainly have no problem with an investor who holds a lot of cash because he or she truly cant find bargains due to various limitations such as circle of competency and time constraints.

About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (9 votes)



Fung9815 - 3 years ago    Report SPAM

Actually, I am often puzzled with many renowned value investors paying much attention to the "market" valuation. Isn't value investor a bottom-up securities selector?

True, many value-investing fund managers are mandated to beat the market (as oppose to some who are mandated to achieve absolute returns), hence basing the index as opportunity cost is essential, but other than deciding your discount rate/opportunity cost, market valuation should not play a huge role in securities selection or portfolio management. Saying stuffs like "I think this stock is truly undervalued but I wouldn't buy it because the market is high" is nonsensical.

I've seen a "value-investing" fund manager who has done nothing at all since 2012, claiming that the market is too high, and enormously underperformed the market for years. Underperforming temporarily for 1-2 years is acceptable in investing, but doing so for half a decade, especially because of not trying at all, is utterly unacceptable.

Bargains can be found even in a high market; keeping cash is a reasonable strategy at all times; selecting securities one at a time, not judging the market level, is the only way to go.

Jtdaniel premium member - 3 years ago

Hi Grahamites,

I really appreciated your two "no excuse" articles. There have certainly been some reasonable investment opportunities since 2013, but I can't recall many real hanging curve balls. One reality that many 401(K) investors face is a very limited number of available options -- usually stock or bond index funds and a money market or stable value fund. If the general stock and bond markets look unattractive, parking these hard-earned savings in a safer option seems to be in keeping with the philosophy of value investing.

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Hey Grahamites. Great article. I will be putting out something later this week on some thoughts about value investing in these heady markets. I am a bottom up investor and currently about 10-15% in cash. I'm not finding many opportunities (note I didn't say "any") so I've been slowly building cash for the past 24 - 36 months. For those who are making excuses for their underperformance, I would remind investors they must underperform sometimes if they are going to outperform in the long term. Is it fun? It sure as hell isn't, but that's how we earn our pay. To beat the markets you have to be different than the markets. The challenge is beating them in more years than you underperform. Thanks again for a great article. - Tom

Grahamites - 3 years ago    Report SPAM
Fung9815 - Thanks for your insightful comments. I agree underperforming for half a decade, or a full decade, is absolutely unacceptable. Totally agree bottom up is the correct approach. But as Howard Marks (Trades, Portfolio) said, we also have to incorporate some macro economic analysis in the process and how that works is very arbitrary. Also, having a sense of where we are in the cycle is also important in terms of deciding whether we should act defensive or aggressive, another Howard Marks (Trades, Portfolio) classic. All considered, bottom up hard core fundamental analysis and one company at one time is still the key.

Grahamites - 3 years ago    Report SPAM

Jtdaniel - Great points. Thanks for commenting. Like you said, there weren't many no-brainers since 2013 but during August of 2015 and Jan and Feb of 15 we had two brief period where some securities got very attractive for a short period of time. There are also a few occations when earnings or guidance miss led to irrational price reactions. Non-professoinal investors who only have time to follow a limited amount of companies closely may be constrained but for professional investors, and especially those who have a niche (either in a sector or in special situation), I can say with confidence that they should find plenty of opportunities during the past 3-4 years. The question is did they have the conviction to act big on them. (Wells Fargo being an obvious example). Now for the non-professional investors, it's a different story and specifically as to the point you raised, which is parking your hard earned savings in safer options, I think it's a prudent strategy. I remember you also have a strategy of putting a % of savings in the market every year regardless of market level? Think Mr.Buffett also suggested something like that.

Grahamites - 3 years ago    Report SPAM

Tom - Thanks for great comments. Yes, sometimes investors have to underperform in the short term in order to outperform in the long run. But to underperform for a decade and then making excuses (especially about cash levels and market valuation) is not acceptable. It's sort of a touchy topic in the professional community. How much cash is too much? How many years of underperformance is acceptable? It is not easy to outperform and it may have just gotten harder. From what I read, you certainly have a very sound strategy that will most likely lead to long term outperformance:) I look forward to your future articles Tom!

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