Uncool, Imprudent & Deviant Investors

I've been reading the work of sociologist Howard Becker this past week, in which he makes an argument for reasoning from cases. By this, he means using detailed knowledge of one specific case to uncover more general ideas about how society works. Becker writes, "I want to avoid the fate of researchers who relied too heavily on a relatively few easily observed facts to do their explanatory work... that insistence doesn't fit well with much contemporary thinking about how social facts or events occur and develop, which instead works by measuring the connections between measured things rather than explaining how those connections produce the results we want to understand."

Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past. 

A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."

Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms. 

To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."

A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.

There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past." 

Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."

Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.

The Point Of A Bear Market

In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:

“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.

Babson continues reading the names of former stock market darlings.

Goodman tries to interject again:

“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.

Unrelenting, Babson continues to read names. Finally, Goodman cuts in:

“David,” I said, “you have passed the pain threshold of the audience.”

Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.

That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.

Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.

In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets. 

David Babson, I am sure, would never have made that mistake.