It’s said that to be a successful investor you need to possess two things: the right process and the right temperament. Let’s tackle temperament first. Fortitude, grit, impulse control, and the willingness to go against the herd, are all essential traits of successful investors. Though they may appear simple, in the clinch such as during a severe market correction or even an upheaval in one’s personal life, it’s easy to become reactive and afraid and focus on the short-term. We tend to do this even though all evidence points to the irrefutable fact that, over the long-term, markets go up. (Hard to believe when you’ve just taken a 50 per cent haircut on your net worth.)
“To be a successful investor you need the right process and the right temperament”
Now, let’s talk process. This is much less clear-cut. Investors tend to believe that their process is the right one. And, why wouldn’t they? To be successful, you need to commit. Trouble is, investment processes, or styles, go in-and-out of favour. One strategy works for a while and then another one takes leadership for a period of time. Unless an investor is willing to change her stripes at every inflection point, there will be periods—sometimes long periods—when her style underperforms another one, or the broader market itself. (This is where the right temperament comes in.)
Let’s put value investing in the spotlight as an example of an out-of-favour style. It has underperformed the S&P 500 index since 2008. Value investors eschew high-growth/high-valuation stocks like Netflix, Facebook, Amazon, and Google, as well as other high-tech darlings who have driven most of the stock market gains. This has left active value investors trailing plain-vanilla index funds for a decade.
Classic value investors who follow the orthodoxy of Ben Graham, the founder of “value investing” and one of Warren Buffett’s mentors, are in a real conundrum. If Graham were alive today, his evaluation methods for determining if a stock is buy or not, would have to be adapted to companies, like high-tech darlings, without the typical metrics that value investors consider, such as profits and tangible assets. As it is, hard-core value types tend to troll among legacy businesses in the bargain bin, searching for companies selling below their intrinsic value.
Recently, I had the chance to observe this fascinating and labour-intensive process during The Ben Graham Centre’s annual International Stock Picking Competition hosted by the Richard Ivey School of Business, University of Western Ontario. Student teams from Canada, Britain, U.S.A, as well as India, South Korea and Spain competed; the top-three team presented in Toronto. They had one week to evaluate a Canadian company: Westshore Terminals (WTE), a coal-loading enterprise based on the West Coast. A classic legacy business.
As it turned out, each of the three teams concluded that Westshore Terminals was not a buy at this time, although they lauded the company’s moat (high barrier to entry), a captive customer base, and annuity-like stream of payments. Ultimately, they felt there was too much business risk involved, given the global move to clean-coal technology as well as Westshore’s limited pricing power.
“Value investing process couldn’t be more different than momentum investing…”
The value investing process couldn’t be more different than momentum investing which targets stocks on the move and jumps on for the ride. For D.I.Y investors, or even for those who work with active wealth advisors, it’s important to remember that each investment style has its day. Whenever someone boasts the he or she has the secret to successful investing, it’s best to take a pause and wonder, how much is the process and how much is luck? Certainly, there are investors like Warren Buffett, who outperform the markets for long periods. But even Buffett underperforms from time-to-time.
A very important phenomenon to remember is “regression to the mean”. In a nutshell, this says that, after a period of over-performance (above the mean), there will be a period of underperformance (below the mean). Or, put even more simply, “what goes up must come down etc.” This applies to soufflés as well as to investment styles.
If you find that your investment style is currently out-of-favour, before you toss it in the bin, review your financial goals and your time horizon. More often than not, you’re still on-track and your patience will be rewarded.
As for the winners of the stock picking contest, congratulations to the students of Cass Business School in London, England who rated Westshore a “no-buy” with an intrinsic value of $19.80.