You’ll Be Stunned: Poor Philosophy and Bad Processes Make for Poor Investment Results

You’ll Be Stunned: Poor Philosophy and Bad Processes Make for Poor Investment Results

Chris Mayer’s article, Useless Investing Variables: We Are Our Own Worst Enemy, which was recently published by The Daily Reckoning, provides support for the view that the toolkit of successful investors includes an acceptance that to build portfolios that deliver results, it is necessary to be contrarian. In turn, this means that it is impossible to be right all the time – underperformance is part of the journey to achieving great results.

Successful investors, then, are far sighted. Also, whilst investing is often paraded as a complex, intricate and highly sophisticated practice, the best decisions tend to be those that are based on simple principles, a point that Warren Buffett puts well in noting “investing is simple, but not easy”.

To develop these arguments, Mayer goes to the data, and draws on the experience that investors have had in Ken Heebner’s Focus Fund which is a thirteen-year old, non-diversified, US fund that invests in companies regardless of their size or market capitalisation.

Below is Mayer’s argument which happens to draw heavily on the recent work of James Montier, who is part of GMO's asset allocation team. Followers of Gone to the Dogs will know that I consider James to be one of the sharpest thinkers in the world of investment philosophy and strategy.

Useless Investing Variables: We Are Our Own Worst Enemy

Ken Heebner’s CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen?

It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years – and still managed to lose money.

Psychologically, it’s hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We’re hard-wired to do the opposite.

I recently read James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. It’s a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy.

One of my favorite chapters is called “Confused Contrarians and Dark Days for Deep Value.” Put simply, the main idea is that you can’t expect to outperform as an investor all the time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time!

It seems strange. Great chefs don’t cook bad meals, but the best investors routinely make a hash of things. Shocking as it may seem at first, it makes sense in the context of markets. “If everyone else is dashing around trying to guess next quarter’s earnings numbers,” Montier writes, “and you are exploiting a long-term time frame, then you may well find yourself staring at the wrong end of a bout of underperformance.”

The point being you can’t worry too much about short-term performance. Investing is a game won by determined turtles, not hares. That means you have to stick with solid ideas, instead of trying to catch what the hottest thing is.

Another chapter I like is “Keep It Simple, Stupid.” It illustrates another key point about the nature of investing: It pays to focus on a handful of essential details and ignore the rest. Montier shows us experiments in which people made worse decisions when given more information. For example, in one instance, researchers asked people to choose the best of four cars given only four pieces of information on each car. (In the examples, one car is noticeably and objectively better than the others.) People picked the best car 75% of the time. When given 12 pieces of information, their accuracy dropped to only 25%. The added information was more than just extraneous; it made their choices worse.

In the context of investing in stocks, it’s better to focus in on key variables that clearly matter and ignore the rest. My investment process aims to do that by boiling down the many details of investing in a company into four major areas. Too many details spoil the broth, but most investors haven’t learned this. “Our industry is obsessed with the minutia of detail,” Montier writes.

I certainly would agree. I read quite a bit of investment research in any given year and I am always amused at the detailed modeling (and forecasting) that goes on. If an idea depends on such finely tuned analysis, then odds are it is not such a great deal.

Throughout the book, Montier reveals and validates many ideas essential to smart investing. He also quotes liberally from scores of investing luminaries from Benjamin Graham to Sir John Templeton. There is a lot of wisdom here. Though repetitive at times, digesting these ideas is like eating your vegetables. They keep your portfolio healthy.

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Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris is the editor of Capital and Crisis and Mayer’s Special Situations , a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks.

Selling His Soul To Golden Slacks

An unfortunate reality of the investment industry is that even the greatest managers make mistakes. And, as the story behind Goldman Sachs unravels, it increasingly appears that Warren Buffett, arguably one of the world's smartest investors, has been duped by what is perhaps the world's craftiest investment bank.

The story told below by Alice Schroeder, who is the author of The Oracle of Omaha's biography, Snowball, is a tale that lays bare one of Buffett's greater mistakes: selling his soul to "Golden Slacks".

The great vampire squid wrapped around the face of humanity appears to have taken another victim.

Buffett Rented Good Name to Goldman Sachs Too Cheap

At the height of the financial crisis, Goldman Sachs sold Warren Buffett’s Berkshire Hathaway $5 billion of perpetual preferred stock with a 10 percent dividend and warrants on $5 billion worth of common stock at a strike price of $115 a share.

This package gave Berkshire a return of more than 15 percent in exchange for its money and Buffett’s endorsement, which Goldman desperately needed to raise funds to survive the panic.

At first it seemed that Berkshire had gotten a rich price for Buffett’s one-time imprimatur to help Goldman avert failure in a liquidity crunch. Since then, Buffett has been sitting in Omaha, Nebraska, cashing checks for $500 million a year. The preferred is an extremely expensive form of capital that is redeemable at Goldman’s option. It is costing Goldman $100 million to $200 million a year in extra dividends compared with the cost if it refinanced. Goldman can afford it, so why has it not paid this money back?

Meanwhile, instead of regaining its luster since the financial crisis, Goldman has produced a nonstop soap opera of indignities unbefitting a blue-chip bank. Keeping the preferred makes no sense -- unless Goldman values having Buffett’s reputation on call even more, as insurance.

Opposed Interests

Deals like the preferred-stock investment do present moral hazard. The parties’ interests aren’t only opposed, but Goldman knows far more about its internal problems and risks than Buffett, and has more control over the course of events. Buffett had already been spattered with his share of mud associated with Goldman even before the Securities and Exchange Commission filed civil fraud accusations against it last week for allegedly creating and marketing a collateralized debt obligation that was designed to lose money. (The bank calls the allegations “completely unfounded.”)

Last week, one of Berkshire’s directors, Ron Olson, speaking on Bloomberg Television ahead of Berkshire’s annual meeting, defended Goldman, saying that Buffett invested out of belief in “not just the strength of Goldman but its integrity.” With horrible timing for Buffett, the SEC filed its suit three days later.

Goldman had gotten a Wells notice in July 2009 informing it that the SEC might file civil fraud accusations. It didn’t disclose that to investors. While this disclosure isn’t required, most companies do it. You have to wonder whether Buffett knew.

Tell More

What else might Goldman Chief Executive Officer Lloyd Blankfein have not told Buffett while Buffett was defending Blankfein as the best person to run the bank? When Buffett struck the deal with Goldman he had never met Blankfein. Some thought Buffett was really investing in his trusted Goldman banker, Byron Trott, who was sometimes mentioned as a possible successor to Blankfein. But Trott left Goldman six months after Buffett made the investment to start his own private-equity fund.

Buffett made a similar deal once before when he invested $700 million of Berkshire’s money in Salomon Brothers in the 1980s on little but faith in its management. The parallels between the two investments are striking enough that it raises the question: What could Buffett have been thinking by investing in Goldman? He was again buying into a business that he once professed to despise. He was again renting out his reputation in a way that subjected him to moral hazard.

Cover Up

Salomon had covered up employee misconduct, held back information from its directors, including Buffett, and almost went bankrupt after defrauding the government in Treasury bond auctions.

The Salomon experience, though, may shed some light on why Buffett did it, because it taught him a lesson: that renting his reputation could actually enhance it if the disgraced company recovers. Buffett told Congress he would be ruthless with anyone who lost “a shred of reputation” for Salomon. It survived, and Buffett was credited as the hero.

It seemed then as if he could cure a company’s ills simply by associating with it. And so, when Buffett says he invested in Goldman Sachs because of its management’s “integrity,” he may really be saying that Goldman must have integrity because he invested in it.

Buffett’s Miscalculation

This, I believe, is where Buffett miscalculated. Years ago he became too much of a corporate insider to be truly independent, but for a long time it didn’t seem to matter. This latest metamorphosis is embarrassing. The commercial nature of the transaction is so transparent that it can’t be disguised with talk of integrity.

Buffett swapped his reputation at a cheap price. Goldman is holding him to the deal, hanging onto the preferred stock while Buffett’s reputation is still useful. It is painful to watch Buffett behaving like a hostage to Wall Street, damaging himself by defending investment banks and saying flattering things about Goldman in a way that contradicts any principled view of the securities business.

When Goldman’s fortunes eventually reverse, it won’t change anything. Goldman will doubtless be perceived as the blue chip of Wall Street again.

The list of problems that occurred after the 2008 financial crisis are nonetheless indelible and will stand alongside the firm’s marketing of closed-end investment trusts before the stock market crash of 1929 as one of the two great black marks in the firm’s history. Berkshire will exercise its warrants, and will pocket its financial gains, which are the price of being associated with Goldman in this episode. The money wasn’t enough. Goldman outsmarted Buffett in this deal.

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Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life” and a former managing director at Morgan Stanley, is a Bloomberg News columnist.