Through Thick And Thin – Or Dealing With Downturns

17th Dec '15 by Tom Firth

8 comments 10049 reads

We all know it’s easy to conceptualise a strategy over a long period but that it’s another thing all together to see it through in reality. We investors tend to turn tail at the first sign of trouble and count ourselves lucky to escape with just our capital. It’s only looking back later we realise the gains that may have been had we stuck to the plan. Markets, after all, are said to transfer wealth from the impatient to the patient…so what can we do to help ourselves get on the right side of that old adage?

Patience and investing…

Joel Greenblatt, when asked why value investing works, famously once responded as follows:

Value investing works.
Value investing doesn’t always work.
Point 2 is part of the reason why point 1 is true.

He means that, in the long run, a true value strategy is more or less certain to make you money. Buying dollars for 50 cents simply makes sense as a way to profit and if you are truly diligent in doing this, you can’t help but win…eventually. Yet there are times when the madness of markets overpowers rationality and, despite your efforts to uncover discounted dollars, other investors just won’t pay up to take them off your hands.

These are the times when value investing doesn’t work, when people give in to consensus and take a hit just to get out of the game. However, it is this very action that leaves those discounted dollars even cheaper than before, providing opportunity for the truly patient to make their profits. And so the cycle continues.

Just how hard is it do this though? It’s one thing to look at a chart in retrospect and think ‘ah, if I had spotted this stock 10 years ago, and held on through thick and thin, I’d have made 10 times my money!’ It is something else to recognise the opportunity in the first place, and something further still to recognise a continuing opportunity through the turbulent ride that any given decade brings in the markets.

An example…

How about an example to demonstrate this? I have chosen A class Berkshire Hathaway shares as they have often been a classic buy-and-hold value/quality investors stock with a wonderful cumulative return chart looking like this:

One look at this and good old hindsight bias kicks in – ‘All I had to do was buy the stock in…

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Novice Investor

17th Dec '15

I see lots of articles, and often end up with the view that it wasn't of any specific use to me as an investor.

Of course the King of these is/was Chris Dillow in the IC, who always finished with a paragraph telling you why something would would happen, but might not. As useful as a chocolate fire guard.

If I was a beginner, what exactly am I to take from this article?

Tom Firth

18th Dec '15

To be honest, I suppose the article is a documentation of some aspects of my own thinking around planning my investing career ahead of me. As I mention in the piece I've quite some way to go and so it's important to think about what is going to work for me, given that I am doing this over 40+ years and not just for a few.

So I might hope that a beginner (I'm not at all far off one myself!), especially one in the mid 20's age bracket like me, might read it and just give a little more thought to their long term plan than usual. For some people this may be second nature already but my experience of talking to younger investors is that they often don't quite recognise the scale of what they may be trying to do.

A tired but fitting analogy might be an Antarctic expedition. If I were to just set out and try to tackle each leg head on with no preparation I would likely not do so well, given the size and difficulty of the task. By planning ahead and trying to foresee potential problems I have a better chance of overcoming them...etc.

It's nothing more than that really. When I think about trying to execute a long term, fundamentals research based approach over my investing life, these are some problems I envisage - and I think I might be able to solve them to some degree through systematising my process. I do of course caveat that because whatever you do, getting to the Antarctic is hard and I don't think there's any benefit in kidding myself it's going to be easy...

Tom

Thanks for the reasoned reply Tom; much appreciated.

NI

Howard Adams

Tom

I nicely argued piece, and response to NI (above). I look forward to forthcoming pieces.

Regards
Howard

TangoDoc

21st Dec '15

I think what I've taken from this article is one more welcome reassurance that I'm not crazy to keep holding onto shares that I feel no reason to sell, in a drawdown. Because we are gambling in the hope of better returns than placing our free cash anywhere else we have to absorb the potential stress of the inherent risk. If we wanted certainty, we'd not be here. i have a friend who has given himself sleepless nights trying to second guess the wilder swings of sentiment and, for a while, his entire investing philosophy centred on looking for companies whose prices fluctuated wildly. He didn't even care what the company did to make money; he was playing a constant game of "whack-a-mole" and it made him sick and, in the end, he lost money and quit investing.
When thinking about differing philosophies of investors, Henry Ford apparently said, when asked what to invest in, "Land, they're not making any more of it"! I believe that its that sort of philosophy that keeps me happy to hold oil, gas and even the miners for the long term and ignore the current drawdown. Indeed, I am most comfortable holding onto shares in what I think of as "tangibles" whatever Mr Market thinks, day to day. If only the recent talk of doom, gloom and climate change would make a difference to our descendants' future! I'm pretty sure nothing serious will happen while self-interest powers all governments. We will continue to waste fossil fuels, jetting about the world, floodlighting our streets and, apparently the human race is addicted to warfare, especially close to oil wells. Greed and neurosis has made it impossible for us to solve our energy problems by nuclear energy or renewables. Ultimately, he who owns the land, the fuel, the minerals and the water becomes the king. I can wait.

WarrantStar

Hi Tom. Nice article. Would it be fair to summarise it as follows:
If there is a significant and widespread market drop, but no bad news relating to my particular shares, and I do not have any pressing need for cash, then I should sit tight and continue to hold everything?
If that is what you suggest, then is there any evidence that this is indeed the most profitable approach in the long term? (The alternative being that I sell some or all of my holdings so as to avoid further losses)

22nd Dec '15

I definitely agree with you that it's important to keep a level head during downturns if you own quality assets or have a good system and your example of land is interesting. The logic is that land will always be valuable and, assuming population growth, should become more valuable over time so a blind buy-and-hold is probably going to be a good strategy over an individual's investing career...makes sense.

I think the game changes a little when we start to talk about companies though. There is a lot more going on with companies than just the business they are in and so they become a little less predictable! Land may be a good bet for 50 years but an investment in a property company can still go to 0 over the same period.

You make the point in your first sentence that "I think what I've taken from this article is one more welcome reassurance that I'm not crazy to keep holding onto shares that I feel no reason to sell." I think those last few words get at the point I'm really thinking about - what process are using to determine if you feel no reasons to sell that company?

If you rely on a manual research process then either you have to do substantial work to accurately answer this question, or trust your initial analysis was correct. If you just leave it to fate, then you will eventually miss a changing situation. Not all companies rebound out of drawdowns after all - just take a look at any number of financials after 2007!

My solution instead is to find a robust system and to then simply stick with that through the down turns. Sure you will still have periods of poor performance, but the system will pick up on deteriorating fundamentals that the buy-and-forget investor will miss and involves much less judgement than the research process. It is hard enough just to stick with a plan but when you are forced to make frequent subjective calls then the chance of major errors increases and with it the chance of permanent losses.

Tom

Hi Warranstar, thanks for the feedback!

To be honest with you, that's not quite what I was getting at although I do think that there is some evidence to suggest blind buy-and-hold works. There was this story from Fidelity for example that was mentioned on the forums here a while ago:

http://www.businessinsider.com/forgetful-investors-performed-best-2014-9?IR=T

In short, Fidelity found their best performing retail accounts belonged to those who forgot they had Fidelity accounts! For most people, the endless cycling in and out of positions just led them to buy high and sell low, incurring a whole load of transaction costs along the way. I've not got any more serious reviews of that hypothesis to hand I'm afraid but will have a look at some point.

The strategy I was arguing for was a much more systematic approach that removed, as far as possible, room for biases and bad thinking in the decision making process, i.e. the StockRanks.

My reasoning is not that it's impossible to accurately identify and hold great stocks like Berkshire for many decades (which has been done and we know is very profitable), just that it is exceptionally hard to do so. Even to get it right on one stock requires near constant research and judgement, leaving you with many opportunities to get it wrong over the lifetime of the investment.

Instead, by using a simple systematic decision making process, we reduce enormously the number of judgements we have to make and it is this that I think increases our chance of success.

Tom

Through Thick and Thin – or Dealing with Downturns

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Tom Firth

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