“A man always has two reasons for doing anything: a good reason and the real reason.” - J.P. Morgan
"I asked the investor why he was withdrawing from the fund and he said he thought we were stupid. When I pointed out that our long term-term track record was superb, he said ‘I can take you lookin’ smart for years, but when you look stupid, that don’t look or feel good no matter how smart you might be.’” - An Anonymous Fund Manager
Over the course of my investment career, I’ve often run my portfolios slightly different than the rest of the financial services industry. With the blessings, investors in my old firm did well over time (though I must, by conscience and law, state that past returns do not guarantee future results). It wasn’t all peaches and cream, though. There were times my corporate investors and employees questioned not only my intelligence, but even my sanity. It’s easy to look stupid in the investment world. That being said, I would argue there is a distinct line between looking stupid and acting stupid, but they can look awfully similar at times.
Most Wall Street fund managers prefer not to look stupid in their own right. Given the choice, billions of dollars will be allowed to run like lemmings right off a cliff without a whiff of remorse – as long as they go as a crowd. It isn’t just publicly traded companies and their investment management owners. Private equity acts in a similar fashion. One year all the rage will be dental supply companies, then lab testing facilities, followed by auto supply parts dealers. Like the thundering herds of buffalo of old, investment money and its managers can rarely be blamed for moving in such an enormous mass.
This herd mentality combined with the growth of index or passive investing through exchange-traded funds had led to an enormous amount of closet indexing. This means an investment manager might have a portfolio with a 97% match to some index such as the S&P 500 or Russell 2000 guaranteeing they never lose (or gain) more than the 3% of the index, yet charge 1.25% for the privilege of doing so. It has a very poor track record of making investors rich, but making money managers quite wealthy in their own right. Where are the customers' yachts indeed?
In 2007, my portfolio at Nintai Partners had become vastly different in make-up than most anything else on Wall Street. Roughly 35% of my total assets were in cash. Not short-term bond funds. Not even short-term U.S. Treasuries, but cold hard cash sitting in our corporate checking and savings accounts (My current portfolios at Nintai Investments LLC aren’t much different as of March 2018, ranging from 20-30% in cash as a percent of assets under management.). At the time, many people – including active money managers, corporate directors and my fellow employees thought I was looking quite silly for arguing there were simply no places to safely employ our capital. The economy seemed to be moving from strength to strength, the VIX was at all-time lows and we seemed to have put the technology bubble well and far behind us.
Unfortunately, the line between looking stupid and acting stupid can be crossed without ever recognizing what happened along the way. A rather unfortunate example of this has been Bruce Berkowitz (Trades, Portfolio)’s Fairholme Fund (Trades, Portfolio) (FAIRX). I should be up front that this look at Berkowitz isn’t an attack or judgment on his process. He’s proven many times over that fortune favors the bold. I tip my hat to Fairholme and Berkowitz for not giving up on a process that has worked 30 years. Indeed, in 2010 Berkowitz was awarded Morningstar’s Manager of the Decade 2000-2010.
All that said, the Fairholme Fund has absolutely devastated its long-term return history over the past decade with huge bets in Sears Holding (SHLDQ, Financial) (filed for Chapter 11 bankruptcy protection in October 2018), St. Joe Co. (JOE, Financial) (Berkowitz serves as chairman of the board and the stock has returned -8.2% annually for the past 10 years) and Imperial Metals (TSX:III, Financial) (-35.7% annualized return since 2013). These returns have produced an underperformance of the S&P 500 by -7.8% over the last 10 years and -14.6% over the past five years. During his successful run, many claimed Berkowitz looked stupid (but nobody laughed from 2000 to 2010), but many more feel today he has acted stupidly. The answer? Who knows. Stupidity – much like beauty – is in the eyes of the beholder.
Why this matters
The concept of looking stupid can play a huge role in an individual or institutional investor’s thinking and application of their investment process. For someone like Berkowitz, it means very little – his confidence in his process has been honed over 30 years – and allows him to continue to choose and hold investments regardless of how others perceive his abilities. (It should be noted he’s had significant redemptions combined with the aforementioned losses.)
Looking stupid versus acting stupid: Internal vs. external thinking
One of the distinctions I think exists between looking and acting stupid are based on internal versus external perceptions. For instance, the act of looking stupid is generated nearly entirely by outside views of your actions – meaning your investors (if you are a money manager) and other investors think you are stupid. I find it rare when individuals themselves think they are stupid. The assumption is most investors who think that way about themselves would find a new line of work or suddenly become tremendously excited about index funds.
Looking stupid versus acting stupid: System 1 vs. System 2 thinking
I have found that most of the time acting stupid is generated internally by bad thinking – generally letting what Danny Kahneman calls System 1 thinking override the individual’s System 2 thinking. A classic example would be selling a stock simply because it dropped 30% (System 1 thinking) versus ascertaining why it dropped and what its current worth is at the time (System 2 thinking). This type of behavior could be classified as acting stupid, not looking stupid (though it may be both).
So what’s an investor to do? How do you know you are simply looking stupid and not acting stupid? I might suggest there are several things to implement in your investment process to help discern between the two.
- Develop and stick with your process: Much like many other professions, if you have a process that has achieved success, then stick with it. As the saying goes, dance with the one that brought you. Over 25 to 30 years, most investors have gone through several business cycles that test whether their investment process is viable. Having others call you stupid is one thing, but feeling that you are acting stupid means you’ve lost confidence in your process. This rarely leads to positive outcomes.
- Patience, patience, patience: Every investment process – growth versus value, small-cap versus large-cap, will have its good and bad years. The key is avoiding emotional decision-making or being placed in situations where your decision-making is forced outside of your process. If you’ve been previously successful, have the confidence to wait out the markets and let your process work for you.
- Be your own palm tree; strong but flexible: If you are relatively new to the investment world, I always suggest investors develop their own process (or mimic one), but be flexible enough to learn from their mistakes and tweak the system as they go along. Think of this as a precursor to the first two recommendations, but don’t mistake: no investment dog is too old to learn new tricks.
Conclusions
On March 11 – after four months of in-depth research, including reviewing financials, talking to management, customers, thought-leaders and competitors – I decided to purchase F5 Networks (FFIV, Financial) back into my individually managed portfolios. I had sold it over a year ago after its price reached over 155% of my estimated intrinsic value at the time. A drop in price combined with a substantial increase in my estimated valuation brought the stock back into buy territory. All of this followed my process that has worked for me over 20 years. On Tuesday, March 12 – the day after purchasing shares – the stock dropped 12%. I can’t think of a better example of looking stupid. But did I act stupid? Time will tell, but certainly the drop in price (and its associated news) – had zero impact on my estimated intrinsic value. By sticking with my process and being patient, I feel confident I will avoid acting stupid.
As always, I look forward to your thoughts and comments.
Disclosure: I hold F5 Networks (FFIV, Financial) in several investment accounts I personally manage.
