By Jim Fink
A couple of years ago I introduced you to James Montier, an investment practitioner who is well known for his study of behavioral finance, which analyzes the role human emotions play in people’s investment decisions. These emotions (e.g. fear and greed) are almost always detrimental to investment performance, so it’s best to eliminate most of them from your investment process. One emotion that isn’t detrimental to investing is happiness, which Montier wrote about back in 2004. Happy people are less likely to succumb to fear or greed because these detrimental emotions are often symptoms of an inadequacy in a person’s life that is filled by an unhealthy obsession with money.
Okay, so let’s say you’re happy and consequently avoid the greed/fear syndrome associated with unhappiness. Are you therefore automatically a great investor? No. Happiness helps, but it is not sufficient. Even happy people make investment mistakes that can minimized with experience and the proper education. I took a stab at offering some investment rules of thumb in an article last year entitled Letter to an Investor as a Young Man. I think it’s worth re-reading but I could be biased. For a fresh and unbiased perspective on the pitfalls of investing, re-enter James Montier who in March 2011 wrote The Seven Immutable Laws of Investing, which focuses on eliminating behavioral biases that can impede the accumulation of wealth. I’ll summarize his seven laws and provide a critique.
1. ALWAYS INSIST ON A MARGIN OF SAFETY
This piece of advice is excellent but is not original to Mr. Montier. As I wrote in So, You Want to Be a Value Investor?, superstar value investor Seth Klarman has written a book entitled Margin of Safety on the importance of investment humility. Anyone can conduct a discounted cash flow (DCF) analysis on a stock and come up with a valuation, but all too often analysts see the number that pops out from such DCF spreadsheets as the gospel, rather than an estimate. Estimates can be WRONG, either through human error or simple bad luck. Consequently, the prudent thing to do is to discount your value estimate by a substantial amount (e.g., 15% to 20%) so that even if your initial estimate is wrong, the price you pay for the stock is so cheap that the investment still can turn out to be profitable.
Montier applied this first investment maxim to the stock market and argued that there is no margin of safety for any asset class: “Today it appears that no asset class offers a margin of safety.” In fact, Montier goes even further and says that all asset classes are overvalued. With regard to stocks, Grantham, Mayo, Van Otterloo’s (GMO) most current asset allocation model (April 2013) demonstrates that no equity style is projected to match the stock market’s long-term average annual real rate of return of 6.5% over the next seven years! The best of the worst are emerging-market stocks at 6.2% and “high quality” U.S. stocks at 3.4%. The term “high quality” refers to companies with stable and predictable cash flows and low debt levels, similar to Lubrizol — a Warren Buffett acquisition in 2011 — and most of the large-cap stocks in theVanguard Dividend Appreciation ETF.
With regard to bonds, Montier was even more pessimistic. He estimated that the ten-year U.S. Treasury “should” be yielding 4.5% to 5.0% based on a real rate of return of 1.5%, a 2.5% inflation forecast, and a 0.5% to 1.0% “fudge factor” in case inflation is higher than expected. In contrast to this fair-value yield, the actual yield on 10-Year U.S. Treasuries (Chicago Options: ^TNX) is currently only 2.08%, less than half as much. Montier’s bearish bond assessment still rings true today, with Warren Buffett recently stating that long-term U.S. government bonds are a “terrible investment” and PIMCO’s Bill Gross similarly calling the 31-year bull market in bonds “dead.”
Montier hated the argument that investors should buy stocks because bonds are relatively more expensive. Investment returns are based on absolute valuation, not relative valuation, and both stocks and bonds can perform poorly when they are both expensive:
One of the “arguments” for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I’ve described this as the ugly stepsisters’ problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I’d rather wait for Cinderella to come along.
In fact, Montier recommended increasing cash levels:
This dearth of assets offering a margin of safety raises a conundrum for the asset allocation professional: what does one do in a world where nothing is cheap? Personally, I’d seek to raise cash. This is obvious not for its thoroughly uninspiring near-zero yield, but because it acts as dry powder – a store of value to deploy when the opportunity set offered by Mr. Market once again becomes more appealing.
This is an important point about cash. Cash may be trash in today’s low interest-rate environment, but it still deserves a place in your portfolio for rebalancing purposes.
2. THIS TIME IS NEVER DIFFERENT
Montier argues that overvalued assets will never perform well, despite rationalizations investors make concerning a “new era” that justifies higher valuations.
New eras were declared in the prosperous 1920s right before the Great Depression, in the “synergy” conglomerate craze of the late 1960s right before the stagflation of early 1970s, in the Keiretsu-hyped economic miracle of Japan of the late 1980s right before that country’s 20-year bear market, in the U.S. Internet bubble of the late 1990s right before the 2000-2002 stock market crash, and in the derivatives-fueled housing bubble of 2005-2007 right before the 2008 financial meltdown.
Montier is making a good point, but I would phrase it differently by simply saying valuation matters! It may not matter right away, but eventually those who ignore overvaluation will get hurt badly. I don’t like his title “This Time is Never Different” because it could be mistakenly construed as applying to downside scenarios as well as upside scenarios. Montier meant it as a cautionary lesson against expecting unrealistic upside scenarios, but that does not mean that investors should not guard against unprecedented but possible disasters.
I wrote about black swans in BP Oil Spill and Black Swans and the point is that just because a disaster has never happened before doesn’t mean it won’t in the future. A case in point is Japan’s nuclear crisis in March 2011. Seismologists were expecting a large earthquake but in a completely different part of Japan than where it actually hit. You need to protect your investments against the unexpected.
3. BE PATIENT AND WAIT FOR THE FAT PITCH
This is another great piece of advice, but again it is not a Montier original. Warren Buffett has been preaching investment patience forever, famously stating in 1974 that:
I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.
Buffett said the same thing ten years later in 1984 and again 13 years later in Berkshire Hathaway’s 1997 shareholder letter. When Buffett repeats something over and over again, it’s worth taking seriously.
4. BE CONTRARIAN
I’m starting to think that Mr. Montier is a Warren Buffett devotee because this is another investment maxim borrowed from the oracle of Omaha. In Berkshire Hathaway’s 1986 shareholder letter, Buffett wrote:
Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
The thinking behind this investment rule is simple. If everyone is bullish, they have all bought the stock and bid up its price to overvalued levels. By contrast, if everyone is bearish, they have all sold the stock and its price has been pummeled to an undervalued level. Investor emotion overshoots on the upside and the downside. One caveat: as I wrote in my article about the Volatility Index (VIX), contrarianism only works at extremes. Trends should be respected until such time as you are confident that absolutely everyone is on one side of a trade (other than you, of course).
5. RISK IS THE PERMANENT LOSS OF CAPITAL, NEVER A NUMBER
What Montier is trying to say here is that there are many sources of risk and one should take them all into account. It is impossible to reduce risk to a single number. He sees three separate sources of risk that must be measured separately: (1) overvaluation where the price paid is too high given the underlying cash flows, which are assumed to be accurate; (2) probability that the underlying cash flow estimates are not accurate; and (3) risk that borrowed money used for investments can be taken away from you and force you to sell at the worst possible time (i.e., margin call risk).
6. BE LEERY OF LEVERAGE
This is partially a repeat of Rule No. 5, but it is worth repeating. Anyone who has read the story of the collapse of Long-Term Capital Management or the blow up of Victor Niederhoffer understands that leverage can be deadly. Both sets of investors claim that there investments would have turned out profitable if they had been given time to recover. The problem is that lenders of money don’t want to wait and can demand their money back at any time.
One exception to this rule against leverage involves the use of options. Buying options provide an investor with leverage without exposing you to margin call risk. An investor’s risk is limited to the price paid for the option, so no lender can pressure you to sell. Consequently, I would change the rule so it refers to “borrowed money” rather than “leverage.”
7. NEVER INVEST IN SOMETHING YOU DON’T UNDERSTAND
This is a Peter Lynch favorite! In his 1994 book Beating the Street, Lynch wrote: “never invest in anything that you can’t illustrate with a crayon.” I wholeheartedly agree with this one, as does Warren Buffett. In Berkshire Hathaway’s 1999 shareholder letter, Buffett wrote:
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries — and seem to have their claims validated by the behavior of the stock market — we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.
All too often, charlatans try to part you from your money by promising you big returns based on business models that are frauds masquerading as complex genius. Examples: (1) Bernie Madoff; and (2) Long-Term Capital Management.
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