One of my personal heroes (not a major one, but estimable nevertheless) is a former classmate of mine.  A few years ago Yves, as I’ll call him, asked me to recommend a portfolio manager in France.  I suggested one with an apparently good investment record and a described investment discipline that appealed to my value-contrarian bent.
 
A couple of years later, however, Yves fired his portfolio manager.  His reason, I am told, was as follows:  “I have no complaint about the overall performance, which in fact has been excellent.  But it was achieved in ways that clearly are at odds with [the manager’s] stated investment discipline, and that makes me uncomfortable.”  Basically, it seems, the portfolio manager had been trading on short-term stock moves triggered by news developments rather than following his announced long-term, value-contrarian discipline.
 
Bravo to Yves!  Not only does it take strength of character to abandon a winning manager in the middle of a successful run; it also takes smarts to ask how a given investment result was achieved.
 

Warning!  Performance Depends upon the Measuring Period
 

In an earlier letter, I showed how the choice of a starting date affects the subsequent performance calculations (“The Rear Long(er) View” – 2/8/2011).  Of course, using a near-forty-year performance is one way to reduce the number of possible comparisons with competitors; and, if this is one of the few privileges of age, I plan to abuse it.  The main point, however, was that it makes a significant difference in published returns whether calculations were begun from a bottom or from a peak in the stock market.
 
In an even earlier letter (“Sophisticates Exposed” – 12/26/2008), I sampled some of the most successful long-term investors who had suffered significant dry spells during their careers.  Those included the likes of Warren Buffett, whose Berkshire Hathaway had seen its shares decline about 50 percent from top to bottom in 1999-2001, and again in 2007-2008.  Particularly during this last episode, other spectacular long-term records had been brutally interrupted, including those of such investment icons as Marty Whitman (down almost 60 percent in the year to November 2008) and Ron Muhlenkamp (down 65 percent between July 2007 and November 2008).  And the letter was written before the ultimate market low, in March 2009!
 
Another icon of the time was Bill Miller, whose Legg Mason Value Trust had outperformed the S&P 500 index in every one of the 15 years from 1991 to 2005.  Bill had previously pointed out, with admirable honesty, that part of his impressive record was due to the vagaries of the calendar.  Within calendar years, his portfolio had often underperformed, sometimes significantly.  Sadly, it also declined more than 70 percent between mid-2007 and November 2008, and its performance remained lackluster until Miller’s retirement at the end of 2011.
 
According to Chuck Jaffe of MarketWatch, despite this bad final stretch, a $10,000 investment in the Legg Mason Value Trust made when Bill Miller took over in April 1982 had grown to more than $235,000 in late 2011, for an annualized average return of 11.3 percent.  Over Bill’s full tenure, his fund still managed to edge out the S&P 500 and to beat a majority of mutual funds.  The problem is that, in typical fashion, many investors probably bought the fund only after several years of outperformance and sold it only after it underperformed for a few years. Those investors almost surely lost money.
 
The above stories about the “air pockets” suffered by investors in funds with some of the world’s best long-term investment records remind us that published performance often depends largely on the period over which one chooses to measure it.
 

There Is No Such Thing as a Short-Term Investment Discipline
 

Some traders may disagree with the title of this section, but in my observation, traders who have remained successful for a meaningful number of years (more than one or two market cycles) are so few that they qualify as exceptions to the rule.
 
Traders, by the very nature of their craft, must focus on short-term price movements and need to react to them very quickly.  It should be intuitive that this immediacy prevents any kind of long-term investment-selection discipline; instead, it fosters or at least aggravates market volatility.
 
But to an investor with a long-term horizon and discipline, volatility in stock prices is not risk, which would imply the possibility of a permanent destruction of value.  In fact, volatility may well create investment opportunities for the long-term-oriented, fundamental investor.
 
Over time, a company’s value tends to grow apace with fundamental characteristics such as sales, earnings, and assets.  Stock prices, on the other hand, are much more a function of the investing crowd’s bipolar psychology, constantly oscillating between extremes of optimism and pessimism.  This is why, as Benjamin Graham, the father of value investing, memorably summarized, “in the short run, the market is a voting machine, but in the long run it is a weighing machine.”
 
For credulous investors still in search of the elusive investment Holy Grail, the Bernie Madoff episode should serve as a reminder that seeking a superior performance without volatility can be dangerous to your wealth.
 

You Don’t Have To Be a Pro To Understand What Is Important
 

In investments, a little knowledge can be dangerous, which is why inheritors who rush to take stock-market courses make me very nervous.  This is not necessarily because such courses will teach the wrong things; it is because the illusion of knowledge they create can tempt one to try desperately to “understand” complex techniques or products that common sense should have eliminated in the first place.  Mark Twain’s life advice applies to investments quite well:  “What gets us into trouble is not what we don't know.  It's what we know for sure that just ain't so.”
 
When I was speaking publicly, which is of course a long time ago, I often urged my audiences to try to forget everything they “knew” and, instead, to mobilize all the common sense they had inherited.  You become incredibly clear-minded when you don’t feel in a position of inferiority just because the person who addresses you knows more than you do.  In contrast, it is amazing how many highly educated financial analysts sheepishly fell in line behind Enron simply because the company’s senior management treated them as ignorant and stupid.
 
There are no stupid or irrelevant questions when discussing investments.  If you don’t understand something, someone has not explained it well.  If you still don’t understand on the second explanation, don’t buy the investment or don’t follow the adviser.
 

A Compatible Discipline: What’s Your Sign?
 

When choosing a money manager, you should first try to understand his or her investment discipline and make sure that 1) it makes (common) sense to you; and 2) the volatility implications and the patience requirements of that discipline fit your emotional personality.  This is important because even the best managers will have periods when they will be swimming against the tide.  When this happens, you should be prepared to recognize whether any counter-performance is consistent with the discipline you have approved and, if it is, to have the patience and strength to ride it out.  Like my friend Yves, you should also have the strength of character to ditch a successful manager who does not follow his or her announced discipline.
 
For space’s sake, I will only mention as examples two major schools of investment in stocks. This arbitrarily leaves out the fixed-income area (bonds, etc.).  While bonds may well have a place in your portfolio, as a long-term investor I believe it is equities (stocks) that will eventually make the difference:  They ultimately reflect the fate of business enterprises, which is where a nation’s wealth is created.  As such, the growth of your patrimony and protection against inflation’s erosion of your spending power will more likely come from stocks.
 
I will also leave aside trading approaches (charts, momentum-following techniques, etc.) and the numerous and growing mathematical concoctions that aim to improve returns while lowering volatility.  This is an area, as I mentioned earlier, where the wisdom borne of common sense should reign over a little knowledge.
 
As far as equities are concerned, and at the risk of over-simplification, there are two broad types of disciplines: value and growth.
 
Value investors tend to espouse the attitude of the savvy shopper.  They know the product well; and the cheaper it gets, during occasional sales for example, the happier and the more inclined to buy they are.  In investment terms, they believe that “what you see is what you get,” which means paying attention to the past (earnings over the years) and the present (assets and liabilities on the balance sheet), rather than betting on the future.
 
Growth investors believe that you can make more money by buying into companies that have exceptional characteristics, be they unique products or outstanding management, as evidenced by good returns on equity or assets, good cash flow margins, etc.  Such characteristics, which should allow these companies to grow at superior rates for the foreseeable future, make the current purchase price of the stock less of a consideration because, if you overpay now but are correct about the company’s fundamentals, profit growth should eventually bail you out – and more.
 

Choose Your Volatility and Your Kicks
 

Being with a value-oriented manager is unlikely to give you any thrills.  The companies in a value portfolio are likely to seem dull, with few surprises to be expected either way.  They may even be a little more cyclical than newer, faster-growing companies.  One reason they are relatively cheap is that they are overlooked:  Few financial analysts still find it worthwhile to follow companies where there is no “story” to tell, and thus few opportunities to be quoted in the media.  There may even be an occasional article arguing that one of your companies has become obsolete because of new technologies or changing demographics.
 
You are also unlikely to own the next Microsoft or Apple, although you might own today’s Microsoft or Apple – at more friendly valuations than in their earlier years, but arguably with less spectacular growth in store.  Basically, you hope to make money through moderate growth in earnings over time; some price/earnings ratio appreciation as the shares go from grossly overlooked to fairly appraised; and, often, a helpful dividend yield.
 
Being with a growth manager should give you more palpable pleasures along the way: good corporate news in the media, endorsement on TV programs by analysts at prestigious brokerage houses, a pattern of beating the estimates whispered to the analyst community by corporate CEOs, and “stories” (a regular flow of new products or corporate initiatives).  The problem is that when everything is promising at a company, this is reflected in its share price.  And, since undiscovered growth stories are rare, growth investors usually pay a high price for the shares of superior companies.
 
As a company matures, however, its earnings growth rate is likely to slow, which in turn should command a lower price/earnings ratio for its shares.  The challenge of the growth investor is to assess whether the growth rate of earnings will remain high enough, long enough, to more than offset the decline of the price/earnings ratio.  Also, when a company’s share price reflects good current business and high expectations, even a temporary slowdown can have a disproportionate effect on its shares.
 
So, while value stocks may become volatile due to economic fluctuations, growth stocks are subject to volatility induced by investor psychology.
 
My personal bias towards value and contrarian investing has probably become evident, but I do believe that, properly designed and followed, a discipline of investing in growth companies can also produce superior results over time.  In fact, I met the living proof of this in the 1980s when Philip Fisher, the pope of growth-stock investing and, according to Morningstar, one the great investors of all times, invited me to spend a whole day with him in answer to one of my articles.  It is hard to remain totally unchanged after contact with someone possessing so much savvy and experience.
 
Of course, there are a number of different flavors and colors within the value and growth disciplines as well as in between, as with the attractively named GARP (Growth At a Reasonable Price).  Other subjects also deserve to be discussed, such as the appropriate amount of diversification among investments, or what really constitutes long-term investing.  I’ll try to address these subjects in future letters.  But now, I would like to end on an intriguing question.
 

Discipline vs. Genius
 

In November 1993 I wrote about a research paper from the National Bureau of Economic Research (“Contrarian Investment, Extrapolation, and Risk” – May 1993), which essentially confirmed findings by other researchers that fairly simplistic strategies of buying out-of-favor stocks with low ratios of price to book value, earnings, or cash flow produce consistent, superior investment performance when compared with “glamour” stocks with typically higher ratios.  The authors attributed these results to various factors, including investors’ herd instinct, their tendency to extrapolate past corporate results too far into the future, and the erroneous belief that a good company equates with a good stock regardless of price.  So far, no great surprise for the value investor that I am.
 
But the most intriguing chart in the study was one showing that, on average, the stocks of companies that have had the poorest sales growth over a five-year period subsequently outperform, by a wide margin, the stocks of companies with the best historical sales growth.
 
This not only reaffirmed my conviction about the overwhelming importance of following a discipline, even a somewhat quirky one, but it also raised a doubt in my mind about the value added by a thorough analysis of a company’s fundamental strengths and weaknesses.  After all, it hardly requires outstanding analytical skills to select the 10 percent of companies in a sample that have had the poorest sales growth over five years!
 
I discussed this with a friend who was a hall-of-fame fund manager and a value investor with a great long-term record.  Typically, his portfolio contained well upwards of 200 names, as opposed to 30-40 stocks for mine.  I asked if he thought the discipline effect on such a large sample had a greater impact on his superior performance than his team’s stock-picking skills.  He did not think so, but my doubt persists.
 
Be this as it may, replicating in practice the results of the NBER study would not be very practical.  To reap the beneficial effect of the discipline without risking that a small number of misses distorts the results, a portfolio would have to hold a large number of stocks.  Moreover, this type of selection often works best on smaller, less-followed companies.  To include large, medium-sized, and smaller companies would require starting with a population of maybe 3,000 stocks, and selecting the 10 percent with the most favorable characteristics would necessitate buying 300 stocks.  Few clients would bear seeing monthly statements with several hundred names, most of which they’ve never heard of.
 
In addition, there usually is some reason for companies to have the lowest valuation ratios or the lowest sales growth in a sample:  Some of them are truly troubled companies, and a number likely will fail.  However, those that don’t will likely experience huge stock-market recoveries from their current, very depressed valuations; those are the ones that will contribute most of the discipline’s over-performance.  But many investors might find it difficult to maintain their confidence in a discipline that produces bankruptcies every year, even with good overall results.
 

Conclusion
 

Choosing a manager with a discipline that you understand and can relate to is of paramount importance.  This is not necessarily because you will always choose the best discipline, but because having one as a reference will give you the strength to resist ill-advised or simply unnecessary decisions.  Just the same, when interviewing and monitoring portfolio managers, ask them to comment about periods when they underperformed and try to assess if it was their discipline that temporarily was at odds with the market trend, or if they strayed from that discipline.  Asking such questions is just common sense.
 
François Sicart (In Mexico)
January 22, 2012
 
This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.