One of the many seductions of dabbling in the stock market is the potential for lottery winners. Look at the returns these stocks have generated since going public:
At the recent CFA Institute Equity Research and Valuation Conference in Philadelphia, Myers credited much of his success to the influences of legendary investors like Warren Buffett, Benjamin Graham, and Seth Klarman, as well as to genetics. As Myers explained, appreciating the wisdom found in Buffett’s shareholder letters, Graham’s The Intelligent Investor, and Klarman’s Margin of Safety is “either in your DNA or it isn’t.” In practice, Myers has applied the collective work of his investing forebears to his search for those rare standout stocks that he refers to as “six-foot-tall second graders.”
Myers drew on his experiences as a value investor and shared some of the lessons he learned along the way that have come to shape his investing philosophy. These lessons are summarized below and are well worth heeding.
The long view of possibilities.
As we near the end of the year and are evaluating the performance of the stock and bond markets, it has clearly been a difficult year. Even the U.S. market, which has performed strongly the last few years is barely at breakeven for the year. The reasons for the poor performance ranges from a slowing economy in China, to the rout in commodities, and the fear of a slowdown in the US economy.
Liquidity is a coward – It’s never there when you want it.
Recently I was listening to an interview with Jeff Gundlach, the CEO and CIO of Doubleline Capital, where he was talking about the liquidity of commercial mortgage backed securities (a type of bond that is backed by mortgages on commercial buildings) and he used that phrase to describe the market in those securities. Until you have actually been in a position that you can’t get out of at a reasonable price you would never understand how true that statement is. Unfortunately in the last week, many high yield bond investors and managers at Third Avenue Focused Credit Fund are finding out how price and liquidity can disappear just when you need it most. (Third Avenue Blocks Redemptions From Credit Fund Amid Losses)
I love clichés. The thing about clichés is that they wouldn’t be around and so heavily used if they weren’t true. In this case, there is a hard lesson to learn. One that can go without notice until you are right smack in the middle of it and wishing there was a way out.
Academics have long argued that investors should rationally expect to be compensated for the risk of owning stocks. The higher a company’s perceived risk, the higher a rate of return investors expect. In demanding higher returns, investors pay lower prices for a company’s stock, relative to its earnings, cash flow, or other fundamental measure. Paying lower prices, the theory goes, paves the way for higher future returns.
Historically, evidence supports this theory. Since 1927, large-cap value stocks in the United States have returned 11.1% per year, while large-cap growth stocks have delivered 9.4%. Among small caps, the performance advantage of value has been even greater. Small-cap value stocks have returned 14% per year while their growth counterparts have returned 9.2%.1
Source: O Value, Where Art Thou
European Central Bank policy is having unforeseen consequences and this one is a real head scratcher, getting paid by the bank to borrow money. How long do you think this can last?
But it isn’t all bad. Some Danes with floating-rate mortgages are discovering that their banks are paying them every month to borrow, instead of charging interest on their home loans.
To be sure, bonds (fixed-income products) play an important role in any investment strategy, providing specific characteristics, such as predictable coupon/interest payments (usually fixed), fixed maturities and return of principal. These factors, in combination, are essential for effective financial planning and overall asset allocation. Additionally, and perhaps most importantly, bonds provide a necessary counterbalance, acting as a low-correlation asset to the higher-volatility equity portion of a portfolio.
Investors have been looking for income from alternatives to low yielding bonds since the Federal Reserve lowered the interest rates to zero after the 2008 financial crisis. This search for income in a low interest rate environment has led to a huge inflow of investment into master limited partnerships and high yield bonds over the last few years. According to the Wall Street Journal, from 2010 to 2014 a net $44 billion flowed into MLP mutual funds and exchange-traded funds. Lured by yields of 6% plus at a time where the 10 year treasury bond yields 2 percent, investors have been forced into assets that carry far more risk.
Active investors still rule the market by a wide margin. Some would like to assume they’re just throwing darts in the dark, but in reality active investors are only getting smarter and better over time as more competition enters and technology progresses. As Michael Mauboussin has postulated in his work, the paradox of skill means that as more sophisticated investors have entered the marketplace the level of outperformance will continue to narrower over time. And as skill improves, luck becomes a much bigger factor in separating the winners from the losers.