Bad Markets, Good Investing

Chris Mayer - Thu 05 Jul, 2007

Some of what makes a great investor is baked-in natural talent, beyond imitation in the same way countless hours of golf practice won't turn you into Tiger Woods. But some things you can copy. In fact, a few things are very easy to copy. Three of them include: discipline in the price you pay for an investment, keeping your turnover low (sticking with your investments longer) and focusing on your best ideas. Research supports the idea that the best-performing investors concentrate on their best ideas.

Some of what makes a great investor is baked-in natural talent, beyond imitation in the same way countless hours of golf practice won't turn you into Tiger Woods. But some things you can copy. In fact, a few things are very easy to copy. Three of them include: discipline in the price you pay for an investment, keeping your turnover low (sticking with your investments longer) and focusing on your best ideas. 

What follows is some shoptalk gathered at a recent investment conference in Hollywood, CA, that reinforces these three principles. Let's start with lessons from the Great Depression... 

The Great Depression was a terrible time to own stocks. During the entire span from 1929 to 1939, stocks delivered a negative return. Small-cap stocks were hit the hardest, losing more than 5% a year on average. Bonds were the only place to hide, scratching out a relatively robust 4.7% per year.
Or maybe not. 

Two great investors, Robert Rodriguez and Steve Romick, both money managers at First Pacific Advisors (FPA), show that a little discipline - a little attention to prices paid - would have given you good returns, even in the Great Depression.
They show that waiting just two years - until 1931, instead of 1929 - turns negative returns to positive ones. Suddenly, small caps beat out the alternatives:
Between the market lows of 1931 and 1939, small cap stocks outpaced bonds. And if you factor in the de flation that occurred during the 1930s (as opposed to the inflation that we all know), small caps delivered an even more impressive result. Because the 1930s were a deflationary time, a dollar in 1939 bought more than a dollar in 1929. If you factor that in, the real return on small-cap stocks was 9.2% annually during the Great Depression. 

Rodriguez and Romick are not market-timers. They are stock-pickers. They buy stocks when they are cheap. They hold onto them. So their basic message is simply this: Stick with buying cheap stocks. You can still earn good returns even in a lousy market. If you could buy all small-cap stocks and get a 9% annual real return during the Great Depression, think what a stock-picker could have done by just sticking with the cheapest stocks in a friendlier investment environment.
Stock-pickers are a minority these days. As James Montier, a researcher at Dresdner Kleinwort, recently observed, "Stock-picking has become a minority occupation. But if no one else wants to be a stock picker, then this is, most likely, where the opportunity lies." 

The second part of Rodriquez and Romick's presentation had to do with patience. Investors, as a group, are not patient. They flip stocks too often. They sell when prices fall and buy when prices rise. The fund flows into (and out of) Rodriguez's own fund offers a classic example of how most investors behave.
The FPA Capital Fund, run by Rodriguez, has been one of the best mutual funds in the business for about two decades. Through 2005, in fact, it was the best-performing mutual fund over the past 20 years, beating the market by a sizable margin. 

In 2006, the fund slipped a bit and lagged the market. Despite Rodriguez's two-decade-long performance history, some investors actually pulled money out of the fund. The fund lost 8.6% of its money under management to redemptions in the first quarter of 2007 alone. This has happened before. When the fund lagged the market in 1999 the fund lost 15% of its assets due to redemptions. In the following year, it lost a whopping 25% of its assets from redemptions. The Fund subsequently beat the market by 35 points in 2001. 

The FPA Capital Fund's experience illustrates a classic case of investor impatience. There are several studies out there that show the average investor actually earns returns less than what mutual funds report. Why? Because the average investor tends to take his money out at bottoms and invest it near tops.
The typical investor trades too much. Again, Montier, commenting on empirical research exploring the link between turnover and performance, wrote: "Unsurprisingly, those funds with the highest turnover deliver the worst performance, while those funds with the lowest turnover do the least damage to net risk-adjusted returns." 

So the lessons to take from Rodriguez and Romick's presentation are twofold: First, pay attention to the price you pay and you can make good returns, even in a bad market. Second, don't chase past returns. Instead, be patient with your investments and give them time to bear fruit. 

Lastly, focus on Your Best Ideas 

Zeke Ashton is on nobody's list of great investors - at least not yet. But he is a rising young star. His presentation brought home another trait that successful investors have: They tend to focus their money on their best ideas.
 
Again, research supports the idea that the best-performing investors concentrate on their best ideas. The average mutual fund owns 128 stocks. Among the top 25% of all funds, the average is only 63 stocks. The bottom 75% own over 140 stocks. In short, the best investors own fewer stocks. As Ashton said, "The goal for all investors should be to get the most value out of your best ideas without risking significant capital loss if you are wrong." 

What makes a great investor is endlessly fascinating to me. I love to study how great investors play the game. Doing so also helps reinforce good investing habits. Sometimes, these habits are relatively easy to copy: pay attention to price, trade less and focus on your best ideas. 

Regards

Chris Mayer
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