“But I don’t want to go among mad people,” Alice remarked.
“Oh, you can’t help that,” said the Cat: “we’re all mad here. I’m mad. You’re mad.”
“How do you know I’m mad?” said Alice.
“You must be,” said the Cat, “or you wouldn’t have come here.”
— Lewis Carroll, Alice’s Adventures in Wonderland
Allow me to introduce myself. My name is David Shafer and among the things I do is to run a financial service business that educates folks about finance and sells a limited array of financial products. There are four main adjectives, invectives if you may, that people throw at me: intense, lazy, anti-authoritarian, and arrogant. They are all true, but not in the way most people think of them. Somehow, I succeeded in the academic world as a student and ended up with a couple of degrees [B.S. Finance, Ph.D. Social Psychology].
But the real story of my investment education started about 10 years ago. You see, 10 years ago I was a busy Visiting Professor, who did what the mainstream financial experts suggested, invest in mutual funds in a buy and hold strategy. But, even though the mutual funds were doing great, there was something in the back of my head that told me there is something wrong. So I started to listen to that voice in the back of my head and started a research protocol to learn about investing. Unfortunately, it was aimed in the wrong direction. It was aimed at understanding the basic personal finance theories, like efficient market theory [EMT] and capital asset pricing model [CAPM].
I sold some of my mutual funds and started to invest for my self when an opportunity came to invest in an IPO of a friend’s company. I bought $5,000 of stock in her company and also bought 2 shares of Berkshire Hathaway B for around $3,200. I simply forgot about the Berkshire Hathaway for a couple of years with my excitement over trading stock. That $5,000 investment went to $10,000 in a matter of months. So I sold and bought shares in another couple of technology companies. A year after that my investment was at $15,000. Wow, I was an investing genius! So I sold those shares and bought 1000 shares of a company called FINET.COM at $11/share. The company had a strategy to use the internet to sell mortgages. Great idea I thought. I bought 300 more shares at $8 and 200 more at $5. I sold all the shares at $1.50. I had lost over half the original investment! My wife and my ego were very upset!
So I decided to use my old graduate school trick. Whenever I had to read theoretical treatises I simply wrote down, “where’s the evidence,” and asked my peers who were attracted to these theories [post-modernism was quite the rage at the time] to provide me with real world evidence to back up the theories. Drove my peers crazy, but was very effective! So this time my research started at the opposite end, the evidence on who has made money in the market and who hasn’t.
As you can probably guess, I started with a familiar name, Warren Buffett, whom I still owned those two shares of his company. From Buffett I went to Buffett’s mentor, Benjamin Graham, and then to Graham’s other students. This led me to Peter Lynch and other value investors. Later I discovered Richard Dennis and the “Trend Followers.” My requirement was each person that I looked deeply into their strategies had to have a public record of beating the market significantly over an excess of 15 years.
Although the methods varied widely between the value investors and the trend followers there were a couple of consistent points. First and foremost was that price mattered. Now the trend followers insisted that price was the only thing that mattered and all the rest was inconsequential. While the value investors thought that fundamental business metrics were of critical importance to evaluate price. But they all agreed that price mattered greatly.
The other area of agreement was that emotions ruled the market and created buying opportunities. In other words the market was not efficient but emotional and this fact created opportunities when the odds favored you.
Ben Graham, who outpaced the stock market by 25% for 20 years, writing 50 years ago in The Intelligent Investor, wrote:
“Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market-to buy and hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.”
Warren Buffett, who has doubled the return of the stock market for 45 years, says the same thing more succinctly:
“Be fearful when others are greedy and greedy only when others are fearful.”
In other words, buy when stocks are cheap, but not when stocks are expensive.
Ben Graham suggests a formula that should be recognizable to readers of this blog. He suggests a general 50-50 split between stocks and bonds. But he suggests dropping the percentage down to 25% stock ownership when stocks are expensive and increasing their percentage to 75% when they are cheap.
That of course leaves the question of how to tell if stocks are cheap, fairly valued, or expensive. Graham suggests averaging out earnings for the previous 7-10 years to get a mean figure without the ups and downs of the business cycle [something that also should be familiar to readers].
Buffett invests a little differently. In real estate investing there is a refrain, “you don’t make your money when you sell the property, you make it when you buy the property.” If you have paid a fair value price or better yet, a below value price, then you will find you have made a successful investment when you sell. If you overpaid, you either have to find “a greater fool” to buy the asset from you or deal with a poor outcome. Buffett places great value on purchase price. Sometimes he goes years without finding an extraordinary business [Buffett’s other requirement] that is undervalued or even fairly valued. During these times Buffett relies on other means [buying the entire business or other asset classes that are under priced, etc.] to put his capital to work. Buffett also updates Graham’s valuation process insisting it is return on equity that is of prime importance not earnings per share. But he agrees with Graham that you need to look back 7-10 years no matter what metric you use.
In closing our ramblings on the importance of price we turn to another Buffett quote:
“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Academics, with no history of investment success, came up with a theory, a way of viewing the stock marketplace, which is totally opposite from the way successful investors view the market. I don’t know why or what the boardrooms of Wall Street firms were thinking when they decided to take those academic theories and turn them into financial propaganda for the masses. I doubt they imagined the success their propaganda would engender for themselves. Somewhere along the way, financial advisors, in mass, deluded themselves as to successful stock investment theories. They forgot to ask that question I used to confound my graduate school peers, “where is the evidence?” The evidence has clearly defined that price matters greatly. In fact, it matters more than any other factor. Buy-and-hold mutual funds [whether index funds or not] is a failed strategy based on a theory that never made sense to anyone who had actually found success investing!
Now, I personally follow Warren Buffett’s strategies, investing in concentrated ways, in-depth analysis of individual companies, and buying when the price is right. It has done well by me, enabling me to have moderate positive returns throughout this bear decade. And I also follow Graham’s and others advice building up an income oriented section of my portfolio with the same strategies in mind. Mainly, buy when the price is down and the dividend yield is up. But I see nothing inherently wrong with using index funds [and their diversification] to control the range of returns as long as you pay attention to price. The Dalbar, Inc. series of studies demonstrates the folly of not attending to price or of buying high and selling low. That is what most people, whether they have a financial advisor or not, tend to do for reasons that we will not discuss here. The latest data from Dalbar tells us that over the last 20 years the average equity mutual fund investor’s return was 1.87% versus the S&P 500 return of 8.3%. Surely, mutual fund investors can benefit from a better strategy, a strategy that includes price as a consideration.