Man in the mirror
June 30, 2014
Market Summary – 2nd Quarter, 2014
It is well documented that equities are the greatest wealth creation vehicle in modern history. Over the past 200 years, stocks have delivered almost twice the annualized return of bonds and almost 10 times the annualized return of gold1. The imperative for investors to earn the superior returns provided by stocks has never been greater. People are living longer, and cannot run the risk of running out of money in retirement. Real wage growth (adjusted for inflation) has been stagnant since the Great Recession, while the costs of the necessities of life continue to rise. Food and gas prices have both surged over 40% in the past five years2. Since March 2009, the S&P 500 Index has risen from 676 (its low point as the bear market ended) to 1,977, a 192% increase3! Sadly, and consistent with previous bull markets, most investors have only managed to capture a fraction of these gains. Over the past 20 years the average stock fund returned 8.7% annually, while the average stock fund investor earned only 5%. Worse, the investor who tried to parse the market by using “asset allocation” strategies (using a mix of both equity and fixed income investments) performed even more poorly, earning only 2.5% annually4. Based on their experience, many investors have come to believe that equities just aren’t living up to expectations. To them, the stock market can’t be trusted. But as Shakespeare wrote, “the fault, dear Brutus, is not in our stars, but in ourselves.”
Given the need for strong capital appreciation in the face of diminished purchasing power, why has the average investor been left behind?
Investors letting emotion dictate their investment decisions, on both individual holdings and investment managers, is a key reason that this calamity has occurred. Many continue to allow the primal emotions of fear and greed, rather than sound judgment, guide investment decisions. In the midst of a bull market (as is the case now) investors are often willing to overpay and take excessive risk in the pursuit of getting rich quickly or keeping up with the Joneses (or the Dow Jones, for that matter.)
It isn’t just fear and greed that are curtailing investor returns. A lack of patience is equally, if not more, culpable. Markets can be irrational – in both good times and in bad. Value investment managers, such as MPMG, avoid the overpriced and riskier investments whose momentum is strong. These investments drive the markets higher in the short-term, but inevitably these popular, momentum-driven investments correct and lead to great losses in the long-term. Value investors are a patient bunch who recognize that the greatest risk-adjusted investment opportunities take time to fully develop. This disciplined approach often leads to value investment managers’ tendency to under-perform in the short term during strong bull markets, but greatly outperform other investment strategies over extended periods of time. There is no greater way to sabotage investment returns than to prematurely lose patience with sound investment strategies and proven managers in order to chase the “shiny new thing” that currently appears to be working.
These self-destructive tendencies are not exclusively post-Great Recession behavior. It has consistently been replayed throughout history. Investors sacrificed close to half of their potential return since March 2009 because they were getting in and out of their investments at the wrong times. Understanding one’s emotional tendencies and following a disciplined, patient, unemotional approach is essential to successful investing.
Profit from conquering your emotions
Numerous analyses on the performance of top managers reveal an interesting phenomenon that is often overlooked. While the average investor is prone to become myopically fixated on what is currently working, they often fail to recognize that short-term performance is not a strong indicator of long-term success.
A recent study5 looked at the 10 year performance records of the very top performing managers6 and found that 85% of them had at least one three-year period in which they underperformed their benchmark. A separate study showed that for a group of value investors with excellent long-term track records, underperforming an index as much as 30 to 40% of the time was perfectly normal7.
Investors who appreciate that short-term underperformance is almost inevitable are best suited to realize not only the greatest long-term gains, but also to avoid the large losses that index investing produces during market corrections. Oftentimes, it is these periods of short-term underperformance that can set the stage for those future gains. Impatient investors ultimately sabotage their investment returns by constantly churning their investment managers and allocating funds to those who just delivered the
best short-term results with little consideration for their long-term record. This tactic – akin to buying high and selling low – is a proven way to underperform.
Successful investors judge their investment managers and strategies on their resiliency and ability to deliver sustained outperformance. Investors who appreciate the role of patience and a longer-term investment horizon are more likely to generate substantial gains in the market.
Flash Boys – a new threat?
Unlike emotional behavior that one can learn to control, there are new perceived risks that investors feel are out of their control, and are keeping them out of the market. These perceived risks are greater market volatility and lower confidence in the mechanics of the market brought about by high-frequency trading and technology.
It is likely that the proliferation of high frequency trading has heightened trading volume and volatility in the market. Consider that price fluctuations within a trading day were 40% higher between 2010 and 2013 than occurred during an earlier bull market period from 2004 to 20068. The most noticeable scar of high-frequency trading on the average investor was the “Flash Crash” of May 6, 2010. It was on this day that in a matter of minutes and for no apparent reason that the Dow Jones Industrial Average lost more than 1,000 points, only to recover those losses within a few minutes.
While the recovery from the Flash Crash was quick, the damage done to the average investor has been – and remains – significant. Many rattled investors in 2010 succumbed to their emotional tendencies by exiting the equity market. Many have remained either out of or under-invested in equities – only to see the S&P 500 Index rise by over 70% during that time9. Michael Lewis, author of the celebrated New York Times bestseller Flash Boys, captured this unfortunate event by stating that “the fantastic post-crisis bull market was noteworthy for how many Americans elected not to participate in it.” Consider that prior to the Flash Crash 67% of U.S. households owned stocks; by the end of 2013, only 52% did.
We at MPMG maintain that the risk created by high frequency traders is a risk to the short-term trader, not to the long-term investor. We look forward to introducing Michael Lewis as the featured speaker at our annual Speaker Series event to be held this summer. At that time Mr. Lewis will elaborate on his findings in Flash Boys, and address questions on this issue.
History foretells a fruitful future for investors
There is evidence to suggest that it is not too late for investors that have been scared to the sidelines. Much of the media attention has been on the major stock indices touching all-time highs. Consequently, many investors are wondering if stocks are overvalued. What many investors fail to appreciate is that earnings and margins are also breaking through to record levels, and that opportunities remain robust within specific companies.
Further, investors view the recent improvement in the stock market with too narrow of a prism. When viewed in a historical context, stock returns for a 10 year period ended in 2011 were less than 3% per year. History has demonstrated that long-term periods of low returns in the market have been followed by periods of higher returns.
It is not possible to forecast what the next 10 years have in store for investors. However, history suggests that it could be significantly better than the past 10 years. Lower prices for stocks provide the foundation for higher future returns – but only for those that manage to remain invested in the market.
The case for value investing
Recognizing (i) that equities are the greatest wealth creation vehicle in modern recorded history; (ii) the importance of overcoming emotional investing and exhibiting patience; and, (iii) that history suggests that the robust beginning to the 10 year period beginning in 2012 may very well be a precursor to a decade long period of strong performance, the next logical question would be “how can I maximize my wealth in the stock market?”
During bull markets, growth-style investment managers garner most of the publicity. As markets reach new highs people become excited and want to chase this momentum. Yet one of the enduring paradoxes of investing is that over extended periods of time these growth-style investments underperform value-style investments by a significant amount.
Consider that $1 million invested in the Standard & Poor’s 500-stock index in 1968 would have grown to $79 million by the end of 2013. However, a $1 million investment in the 20 percent of the S&P 500 with the lowest price-to-earnings ratios would have been worth $578 million, or more than seven times the return of the broader market10.
Value stocks fail to generate the headlines or excitement of the “latest and greatest” investment styles because they generate more consistent, if not world-beating, annual returns. Examining the top-performing market segments each year from 1985 to 2004, value stocks of large cap companies had the highest annualized rates of return (14.5%). Despite their leading long-term results, these value stocks were only the top-performing asset class in two of those 19 individual years. Perhaps more profound, however, is that they were never the worst-performing class in any individual year10.
The value investing approach is similar to that of the tortoise in Aesop’s fable, “The Tortoise and the Hare”. As the story goes, the flashy and swift hare was fast out of the gate in its race against the unexciting and methodical tortoise. As the long race progressed the hare became tired and distracted, and it stopped to take a nap. Meanwhile the slow and steady tortoise kept pushing forward, and ultimately won the race.
The moral of this tale has resonated with us since our inception almost 20 years ago and is the reason that we chose the tortoise as our firm’s logo. Building wealth in the markets is a process devoid of shortcuts and “get rich quick” schemes. It requires a disciplined, patient, and unemotional approach. The lesson to be gleaned from these facts and studies is this: if you can avoid the excesses of the day and focus on buying good businesses at the right price, you will ultimately be rewarded.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.