We are holding a high amount of cash (60%) in our three portfolios at this time; we are not adding any new stocks again this week, and we have tight stops on each of our existing positions. This is at a time when the overall market (represented by the S&P 500) is hitting fresh all-time highs. So what’s the problem? Why aren’t we taking advantage of this bull market?
In the past, many IntelligentValue subscribers would choose to leave us about now, ostensibly because they felt that their subscription was payment for the regular disclosure of good stock picks. If we didn’t have those undervalued stock picks listed each week consistently, apparently some felt they were shortchanged and subsequently cancelled their subscription.
This pattern of behavior is unfortunate, because the advice to hold cash in a portfolio (either partially or completely) is just as valuable as a recommendation to purchase particular individual stocks. Because of the high cash condition of our portfolios again this week, I’m going to elaborate briefly on why this is true. To some, this discussion may be blatantly obvious, but to others it’s not so clear why cash is an advantage. If you’re in the former group, please consider this a brief refresher article. If you’re in the latter group, please pull up a chair.
“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.”
– Mark Twain
THE TEMPTATION OF THE QUICK BUCK
The majority of market participants follow approaches that provide no real hope of long-term gain. In fact, most pursue avenues that hold the chance of considerable financial loss and resemble outright gambling more than they do investments. It’s easy for the undisciplined individual to fall prey to investment schemes that promise quick and easy gains.
The temptation of making a quick buck is high, and the majority of investors are unable to fight the influence of the crowd. This activity is invariably focussed on stock prices and speculation of where those prices might go next, rather than a clear and thorough analysis of a business’s fundamentals.
After all, fundamental analysis is difficult, and surely anyone can easily see that the latest hot technology stock will quickly grow into its 175 PE ratio! “There’s no analysis needed to anticipate that gain,” they reason. Plus, “Everyone on TV is talking about that stock and how could everyone be wrong?” This kind of flawed logic is rife in the investment world, both with individual investors and professionals.
THE SOURCE OF THE INTELLECTUAL CORRUPTION
In many ways, Wall Street functions as a giant casino where the collection of commissions and fees easily trumps any fiduciary responsibility a firm may have to their clients. Wall Street is clearly more concerned with the volume of trading than it is with their client’s financial success. This can be attributed to up-front fees being charged on every transaction, which provides the entire structure of the Wall Street machine with an incentive to promote the volume of trading over successful investing.
In this atmosphere, Wall Street’s drive for commissions coerces the entire system into a short-term trading mentality. The concept of investing in America has developed into a speculative gambling enterprise, with the ‘house’ consistently winning. Stocks become less a document of partial ownership in a business and more a digital ‘chip’ that is traded endlessly back and forth.
The speculative churning of stocks seeps into every nook and cranny of the investment world. Institutional money managers face pressures that force them to join a short-term relative performance derby. In this race, the risk of portfolio losses on their job security is great. In an effort to avoid losses, many engage in indexing, which is a sure-fire recipe for mediocrity. This base of holdings is then supplemented by short-term investment fads and the latest, most popular stocks as a way to stay ahead of the ever-present S&P 500 benchmark.
These money managers can rest assured that their quarterly reports to their clients are greeted with gusto when the most popular names comprise the investment list. However, historically only 3% of money managers beat the S&P and the majority actually lose money over any given 10-year period, so this approach is most assuredly not working out well for the clients.
For individual investors, the frenzied atmosphere of the market, which includes breaking headlines continuously fed to their inbox and TV channels with one ‘expert’ after another, supplemented by regular features about ‘fast money,’ leads many to become enmeshed in the short-term chase for returns. In this environment, stocks are more like commodities than certificates of ownership in a business.
THE GUESSING GAME POSING AS INFORMED ADVICE
As the daily parade of experts on TV give their opinions about what to expect next, you constantly hear phrases such as “I think,” “I believe,” and “we expect.” In essence, these gurus and experts are just giving their opinions, which are merely guesses. As soon as the opinion is projected out in airwaves across the world, it is quickly forgotten by the speaker because we find them back on the show a week later giving an entirely different forecast, oblivious to the fact that their previous guess turned out to be 100% incorrect.
The stock-market community is obsessed with something that is diametrically opposed to a rational approach to investing, i.e., forecasting the future. Value-investing great Seth Klarman said it well:
“Speculators are obsessed with predicting—guessing—the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron’s, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.”
– Seth Klarman
This speculation of what will happen in the future is a fool’s game. However, it’s the same game that has been played over centuries using crystal balls, tarot cards, and tea leaves. It’s disappointing that with so much fundamental business information now available at their fingertips, the majority still depend on the predictions of investment soothsayers to tell them what will happen tomorrow or next week.
Most so-called ‘investment professionals’ that appear in the media are really ‘speculation professionals,’ because they are advocating short-term bets based on predictions of market fluctuations rather than making intelligent long-term investment decisions based on business fundamentals.
The majority of market participants are caught up in the comfortable atmosphere of speculative consensus, a world where the emotional responses of greed and fear dictate short-term decision-making. However, as addictive as it is, the excitement of hitting the ‘buy’ and ‘sell’ buttons with an online broker and taking a ‘flyer’ on the latest hot stock is truly asinine behavior. It is the definition of ‘speculation,’ which is another word for gambling.
There’s one critical difference between investors and speculators that should be important to you: investors have a good chance of achieving long-term gains, while speculators are likely to lose money over time.
WHY QUANTITATIVE VALUE INVESTING WORKS
Quantitative value investing is the antithesis of the speculative activities that dominate the stock market today. There are several crucial ways in which value investing differs from all other styles of investing.
First of all, it is based upon the quantitative analysis of a company’s fundamentals, i.e., its book value, its cash flow, its capital expenditures, its return on equity, etc. Based on these fundamental aspects of the business, we can assign a reasonable value. Purchasing at a substantial discount to this value is the key to unlocking the world of investment gains (more on this in a moment).
Secondly, there is little or no forecasting of the future involved in quantitative value investing (at least the way IntelligentValue practices the art). Any discipline that depends upon forecasts of the future is risky, vulnerable to error every step of the way. We base our value analysis strictly on conditions as they exist today, not extrapolations or predictions of the future.
The typical speculative approach to stocks includes the daunting task of predicting the unpredictable, whether it is oil production next year, next quarter’s GDP figure or a particular company’s net earnings next year. You also have to accomplish this mission faster and more efficiently than thousands of other very smart individuals. Is an impossible game you would be wise to avoid.
Thirdly, quantitative value investing is a risk-averse approach. We are looking to purchase at a discount to the company’s intrinsic value. In the words of Warren Buffett, it’s the concept of purchasing a dollar bill for forty cents. We seek to find a margin of safety in our investments to protect us from loss of capital. On the other hand, speculative investing is a greater-fools game. You’re hoping someone else will pay a higher price for an asset when the price may be entirely unrelated to the asset’s value.
Consider Amazon, currently with a shockingly high PE of 871. Will someone pay a higher price than that? Perhaps. Perhaps not. But Amazon investors are hoping someone will buy their shares at a higher price based wholly on speculation that it will someday make a reasonable profit.
In value investing, we have a good idea of what an asset is worth and are paying for the stock at a safe margin below that value. Amazon’s stock could shoot higher, or the bottom could fall out based upon the next company-related headline, either positive or negative.
And a fourth difference is that value investors maintain cash balances at times. We maintain a cash balance when we are unable to find attractive, undervalued opportunities, and put that cash to work when those opportunities become available. We’re not afraid at all to hold a significant amount or even 100% cash in our portfolio if we are unable to find stock ideas that meet our margin of safety requirements.
The result of our quantitative value-investing approach is apparent: returns greater than 100% annually and never a losing year (even in the 2008 market collapse we made a solid return). On the other hand, the speculative approach that dominates the market, while potentially exciting, is a losing game.
WAIT FOR THE OPPORTUNITY
Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. The rampant speculation that rules the market is an edge that value investors can exploit to their financial advantage. Currently, we are finding few stocks that meet our quantitative standards for selection. The most likely reason for this is that stocks are somewhat overvalued.
At times like these, it pays a value investor to maintain their discipline and hold cash even if the overall market is setting new highs. Turn off CNBC, Bloomberg, and Fox Business, cancel your subscription to the Wall Street Journal, and put aside Forbes. Those are all media that thrive on the Wall Street volume-at-any-cost machine and cause unnecessary distractions for value investors.
For years, investors have been given the message by the ‘machine’ that they need to stay totally informed about conditions of the market in order to anticipate changes, get ideas, and speculate on the future.
You will be better-served by ignoring the media and instead following our value-based stock selections, which means holding cash at times until our quantitative systems reveal fresh undervalued opportunities. There’s a substantial reason our portfolios are mostly in cash at this time, and we believe our systematic approach will be proven correct again.
Stick with the program! Our 100%+ annual returns have proven the case for this admonition year after profitable year since our launch in 2004.