I've begun to receive a number of emails recently with the market at all time highs questioning the wisdom of keeping money invested at these levels. As the market races higher it's natural to start to think about when the next downdraft might occur and what it might look like. The most important point in this post isn't thinking about the future, it's what to do right now, when opportunities appear scarce.
There's a common cliche that value investors are to ignore the macro noise and only look at companies from the bottom up. I'm not sure where this meme started, but it doesn't seem right. It seems we should always be aware of the environment we are investing in, but we shouldn't let that awareness dictate our decisions.
The problem with macro focused investing is that one needs to get the forecast correct, but also the timing of the forecast correct. I remember one story in the Snowball where Buffett's uncle was so worried about the government defaulting it prohibited him from making sound decisions. I believe he convinced Buffett to purchase a farm just in case something bad happened. Of course Buffett continued to invest in the face of the fear, and if his uncle would have invested with him he would have been rich, instead he was poor and worried.
With the most recent financial crisis the focus seems to have shifted to investors who had the uncanny ability to predict the future and earn outsized profits. Guys like Michael Burry, who foresaw a housing crash, and were able to profit from it. In hindsight everyone "knew" there was a housing bubble. The human ability to re-write memory is amazing, I can't remember talking to anyone post 2008 who has said "I never saw this coming, I thought we were going to have a soft landing." Right now in Canada where there appears to be a housing bubble, a familiar pattern emerges. A few people are predicting a crash, most people are ignoring it, and some cable TV stations have decided to flood viewers with Canadian real estate shows. Even if housing prices are high, the question is one of timing, when will the market finally pop?
How I think of macro elements as they relate to how I invest might best be described by an analogy. My house needs a new roof, it's undeniable to anyone who looks at it. Some of the shingles have lost their grit, and in sunny spots the ends are turned up. It's been like this for a while, and we haven't had any leaks so far. I had a roof guy inspect it who said it might last two years, or seven or eight years. I don't know if it will last five years worth of storms, or two weeks worth of storms. But since I'm the thrifty type I'd rather ride this roof out until I see signs of failure. Why upgrade when I don't need to? In the meantime I'm not putting any housework on hold because of the imminent roof replacement. We have made changes to rooms directly underneath the roof, it's possible we might get a leak and need to repair it, but it hasn't stopped us. At some point I will have to fork out a LOT of money for a roof, or get up there and do it myself.
How does my story relate to investing? I think investors always need to be aware of their surroundings, but don't let the cart drive the horse. At times things might look dire, and maybe it really is worth selling everything and going cash. But my experience has been that the turning point is usually unexpected and sudden, and impossible to time. There are a lot of macro related things that are a mathematical certainty. There is too much debt and not enough money to pay it off, at some point it will need to be reconciled. At some point Japan will have to face its debt problems. At some point the US will have to face its debt/pension problems, and at some point Europe will have to decide how to handle their debt problems. These aren't opinion page ideas, by the math these things will need to be reconciled at some point, either through defaults, inflation, higher taxes, all, none, or something innovative no one has thought of yet.
When the easy opportunities start to dry up my radar goes up with regards to the level of the market. Right now the selection of net-nets in the US is poor at best. Outside of some unlisted net-nets the pickings are very slim. This isn't some sort of timing indicator, but it's just a general acknowledgement of the environment we're in. Instead of going to cash I continue to look for opportunities in offbeat places. Right now there are plenty of banks that are cheap, as well as plenty of unlisted and foreign stocks.
My only caution in the current environment is to ensure that what appears to be a margin of safety is a true margin of safety. A lot of value investors were wiped out in financials in 2008. They thought they had a margin of safety but didn't forecast what would happen. A good gut check is to ask what would need to happen to put a potential investment out of business. I have some companies with so much cash they could operate for more than a decade at current levels with zero revenue. Debt is a margin of safety killer, beware of it, it's not always bad, but it can be worse than it initially appears on a balance sheet.
When I first started to get interested in investing a common theme that re-appeared in books was that investors needed patience. Patience to purchase stocks and hold them through thick and thin for the long term. Growth investors are always being stereotyped into being short term focused watching for the latest earnings beat or surprise news. Value investors are no different, we've been hooked on the notion of a catalyst. A catalyst is a substitute for patience. When we don't have patience to actually hold a company for years we look for one with a catalyst that will hopefully shorten the holding period.
Investors need more patience, patience to wait for value to be realized, and patience to wait for more opportunities. I think a market like the current one is a great test of patience. It's hard to hold cash and wait for better opportunities in a rising market. It's also hard to hold flat or declining stocks when seemingly everything is heading higher.
Use the rising market as a gut check, assess each company in the portfolio and re-evaluate their margin of safety. If it doesn't exist anymore, or the company is fairly valued then sell into the rising market and move on. If the daily new highs are worrisome, or if macro fears are causing panic I would recommend closing down the computer and taking a walk outside. The weather has turned and it's a beautiful time of the year to get outside and relax. After-all, if your portfolio is full of safe and cheap stocks watching the market minute by minute won't change a thing, except to raise your blood pressure.
One final note, as things like this always go I'm sure the market will probably crash in a few weeks or Japan will default, or in the US rates will spike and someone will email me "I told you so!" Maybe that will happen, or maybe nothing will happen for another three years as we drift higher. I don't know, and anyone who claims to know is lying.
Talk to Nate
Looking for value in the overlooked margins of the market.
I'd be curious to see a historical plot of the percentage of listed stocks that are net-nets.
ReplyDeleteI don't have the tools to do it, but if someone has a stockscreener123 account they could run a historical backtest for net-nets plotted yearly. I'm guessing anyone with a Bloomberg could do the same.
DeleteMy recollection from what I've seen, completely anecdotal is that in periods like 2003 and 2009 there were a lot, and in 2001 and 2007 almost nothing.
Hi Nate,
ReplyDeletegreat thoughts, very similar to mine. Patience is in my opinion one of the biggest "edges" an investor can contribute to a investment portfolio, however also one of the most difficult ones as well.
At the moment, I see some "passive" market timing in my own portfolio. I sell share because they are not cheap anymore, but i struggle to find new ones.
So cash is steadily increasing without actively doing so.
MMI
Patience is a great edge, I think many if not most investors lack patience. The ability to wait and ride out the waves is almost always successful when something is purchased cheap enough (and won't go under) or when the company is of reasonable quality.
DeleteWhile this is likely obvious to most, it's important not to confuse patience with failure to recognize opportunity cost. Catalyst driven investments can compound quickly.
Delete... and thanks for writing the best "sell in May" piece yet!
The best sell in May piece, I appreciate the compliment, I figure this post would mark a top..
DeleteI somewhat agree on catalyst driven investments. If there is a hard catalyst and value will truly be recognized in a timeboxed period then yes, they do compound quickly. My general feeling is everyone is reaching for a "catalyst" these days whatever they may be, and at times are even passing over great investments because one doesn't exist.
I've recently been thinking about the macro as well. I have a few positions that I would say are at the 'top end' of my range of valuations. I dont mind holding these long term, but part of me is toying with the idea of cashing these in just in case the market has a down period.
ReplyDeleteTheres no easy answer really, most important thing is dont lower your standards for investment just because it takes far longer to find something decent.
I think you summed up this post well in one line, don't lower your standards when bargains are hard to find.
DeleteI find in this market I'm naturally cash heavy. I've been selling things as they reach IV and haven't found as many new investments, so cash is building up.
In terms of holding for a long time I had similar thoughts. I looked at some of these companies and thought would I mind holding through another recession? Some that are fairly valued I don't mind at all, others I thought I that I should be glad I've been given the price offered, so I sold.
Hey Nate -- on the small community banks topic, my mind is slipping me on a great quote about what one should look for in the Management of one of these small banks.
ReplyDeleteSomething involving "golf courses by 3pm"?
Does that ring a bell? I vaguely remember reading that quote here, and thought it was hilarious and true.... Rapid asset growth is the last thing you want with a small bank or insurer.
Yes, it's the 3/6/3 rule:
DeleteTake deposits and pay 3%, make loans at 6% and be on the golf course by 3pm..
Rapid asset growth would be a red flag for me at a small institution. A lot of management isn't experience in that sort of environment. With that said there are some roll-up CEO's who have come into small community banks and are looking to use the bank as a platform for acquisitions, I would say these are the exceptions.
I think there is a Buffett quote that relates to this:
ReplyDelete"We try to price, rather than time, purchases. In our view, it
is folly to forego buying shares in an outstanding business whose
long-term future is predictable, because of short-term worries
about an economy or a stock market that we know to be
unpredictable. Why scrap an informed decision because of an
uninformed guess?" - Chairmans Letter 1994
This is one of my favorite quotes form his letters. I think it really helps to frame your decisions in terms of your confidence and speaks to your point about examining the businesses you own.
If you own a great company and its fairly to undervalued, why would you sell it because you think there MIGHT BE a correction in the market?
In essence, don't substitute a sure thing for a maybe.
Haha, that's it! Perfect, thanks so much Nate.
ReplyDeleteBtw, you know what this market feels like to me? 1993-1996. Wall Street climbing a wall of worry.
One of the things I most enjoy doing is reading old letters / thoughts from value investors about the market environment, then lining them up with how the market actually performed.
You'll see certain value investors wringing their hands about the values of yore, not a short 3 years prior. Read Klarman's investor letters from that period -- it's the exact same talk that pervades today.
The time you want to feel most cautious about is when investors STOP wringing their hands and you can identify a clear pain point, usually relating to systemic leverage in the financial arena (margin lending within investment trusts and insurance companies/brokers in 1930-32, S&L crises in late 1980s, portfolio insurance in 1987, AAA rated synthetic CDOs that were linked to BBB- subprime collateral that only needed 10% loss rates before being worth zero, etc. The one exception is the OPEC crises in 1973-74, which I haven't quite figured out).
The problem I have with so many market prognosticators is that they don't have the financial acumen to understand *why* the last crises happened. They nearly ALL had to do with "hidden" leverage. And so while I see a ton of people talking about the problems in EU banking /sovereign systems and US pension/pension-like systems such as SSA, Medicare, etc. -- NONE of it is remotely hidden.
I believe many value investors learned the wrong lesson from 2008-09. To me, the big blind spot in most value investors' "circle of competency" is capital structures/debt, NOT macroeconomics. 2008 burned so many value investors not because they ignored the macro, but because they ignored financial leverage and asset/liability mismatches. Those that did understand suffered zero impairment of capital.
Value investors raising caution is a bit like God telling the Hebrews in the Old Testament not to eat swine because it's "unclean." The logic was right, but for the wrong reason -- in those times, it was impossible to tell a pig that had tapeworm (and other diseases) from the ones that didn't. When modern science came about that showed that it was the tapeworm that caused the disease and not the "unclean" pig... eureka!
Nate, I can see you understand the "modern science" by the analyses you do of individual securities. But most market prognosticators are just looking at charts and saying, "Too high!"
Anyways, my point is investors need more science and less theological chart reading to make good investment decisions. Warren understands this.
Do you happen to know where we could find Klarman's letters?
DeleteCheck out EDGAR for "Baupost" filings -- you have to noodle around a bit to find them, but they're there.
DeleteIf you're feeling less adventurous, I know someone had consolidated them, formatted it, and put it up in Scribd.
Problem is I believe Scribd has turned itself into a paywall site, so it may be impossible to access without paying.