The 2022 Nobel Prize for Economic Sciences was, a month or two back, shared equally between three American economists – Ben Bernanke, Douglas Diamond and Philip Dybvig – for their research on banks and financial crises. Announcing the trio of winners, the prize’s committee noted their insights had “improved our ability to avoid both serious crises and expensive bailouts”.
Here on The Value Perspective, we naturally hope that statement turns out to prove well-founded – although we confess we found our attention caught more by another major gong that was awarded around the same time, albeit in a very different field. This was the 2022 Booker Prize, which was won by Sri Lankan author Shehan Karunatilaka for his novel The Seven Moons of Maali – from which the above quote is taken.
For much of the period since the 2008/09 financial crisis – to which Bernanke, as the then chairman of the US Federal Reserve, had something of a ringside seat – value investing has had a tough time. As a result, some people might be wondering, reasonably enough, why they should adopt the discipline – at which point, we would direct their attention to the following chart, which is, in essence, the ‘North Star’ of value investing.
Using data going back to the late 1800s, this shows the 10-year annualised returns of US equities, grouped by valuation, and as such is the visual embodiment of the basic principle of value investing – that if you buy cheap companies then, on average and over the longer term, you will make money and, if you buy expensive companies then, on average and over the longer term, you will not.
The thing that is so enduring and powerful about this chart is that it talks about nothing other than the price you pay – no macroeconomics, thematics, politics, profits or anything else. That is an important lesson but one that so many people manage to look past – possibly because the more problematic aspect of the chart is that, while it makes it very clear where you ought to invest, that is far, far easier said than done.
In fact, humans are pretty much hardwired to do the opposite of what the chart advises because the companies that live on the right-hand side seem exciting and attractive while those on the left look dull and scary. In Lord of the Rings terms, it is akin to choosing between staying in The Shire or taking a trip to Mordor – most would pick The Shire but, of course, if Frodo had stayed home, the story would have had an unhappy ending.
One single constant
Ultimately, here on The Value Perspective, the way we make money is not by looking to forecast any of the factors that matter so much to other investors – those macroeconomics, thematics, politics, profits and so on. No, it is by counting on the one thing we believe will not change over time – the only aspect of investing that we can see has remained consistent over the last 150 or so years. And that is human behaviour.
We may like to think we are more sophisticated than we were 150 years ago but the evidence would suggest otherwise – that, in effect, in the short term, we learn a lot; in the medium term, we learn a bit; and, in the long term, we learn almost nothing. The reality is, most investors behave in a very consistent pattern – a predictable cycle of emotional responses, any of which can witness on an almost daily basis.
Let’s start with ‘euphoria. Say, you already own a stock that you are convinced is a great business. The technicals are amazing, the model is fantastic, the company management are illustrious and, when it comes to potential new competitors, it has a metaphorical ‘moat’ you could park a metaphorical superyacht in. It is wonderful. The valuation? Well, it will grow into the valuation but as things stand …
- Euphoria: That is the place you are in – and it is a great place to be – but then something goes wrong. It is only a little something – a profit warning of some sort, perhaps – and you will initially grow a little anxious. But then you will remember, ‘No, no – I have done the analysis. This is a quality business and, actually, this is a buying opportunity. Back the truck up. Buy more for the portfolio. Mr Market, I reject your concerns …’
- Denial: So you conclude this is a buying opportunity … only … what if it isn’t? ‘Why is the stock still going down? What don’t I know that everyone else in the market apparently does? Why is the company’s share price still falling? I really do not understand this. Hang on … now I’m actually getting a bit nervous. Maybe I have got it wrong after all…’
- Fear: ‘What if …? Oh no. I’ve just bought more of this – in fact, I’ve just doubled my position. People will be calling to ask why I’m the biggest holder of this stock. I’m the biggest holder of this stock! And it’s falling …’ That is when the wheels typically come off. The business may have had this wonderful moat but that superyacht is now looking a lot more like a dinghy – and, what is more, a dinghy that is starting to sink …
- Despair: And this is when you start to give into despair. You become very concerned about the world and suddenly realise, ‘Oh no, I’ve made a terrible mistake. But OK … look – it could happen to anyone, right? It’s not really my fault. And this is a portfolio – things can and do go wrong. It’s OK. I’m just going to get out but I will do it quietly. Shhh – nobody will notice. This never happened …’
- Capitulation: So you cut the stock from the portfolio. ‘Let’s never mention it again. I do not want to know what’s going on with it. Why? What’s going on with it? Nothing? Good. Don’t. Want. To. Know. But it does seem to be doing a little better. Why? I know the business could never have fixed all its problems in the time the shares have been recovering. So you know what? I’m going to ignore it – people are getting spoofed …’
- Disinterest: ‘No. This is not happening. Nothing to see here. Although …now I look at it again … and markets do seem to be improving … and the management do appear to be back into their stride … they really are talking a compelling game. And, actually, they do seem to have fixed a lot of things with that massive acquisition they did in Indonesia that everyone liked. So maybe I have got this wrong …’
- Acceptance: ‘Maybe this is a really good business after all. You know what? I should have stuck to my guns and, while we’re on that sort of subject, I need to bite the bullet. I need to toughen up, get back on the horse and dive right back in and I need to do all that right now.’ So you do and the stock continues to tick back up and, before you know it, we are right back to …
- Excitement: ‘Happy times are here again. I’m going to make all those losses back. This is a great place to be and this is a great company. The technicals are amazing, the business model is fantastic, the company management are illustrious and when it comes to potential new competitors, I have never seen a metaphorical moat like it. It is all just wonderful. The valuation? Well, it will grow into the valuation … won’t it?’
That cycle is very typical of humans and, while that again may sound depressing, it is also something value investors can trade off. Amid all the change of the last century and more, one thing has stayed the same. Us. Human beings are the constant – markets are cheap when we are fearful; and they are expensive when we are greedy. As Shehan Karunatilaka also has one of his characters reflect in The Seven Moons of Maali Almeida, we are what is underpinning value’s ‘North Star’ chart and we are systematically exploitable. And value investing is the system.