In 1981, in front of a packed lecture hall in Rockford College, Illinois, Dean Williams presented what turned out to be a prophetic talk.
Unless you’ve lived under a rock for the past 20 years, you’ve undoubtably been exposed to one of the most liberating investment philosophies of the past half-century. Going back at least as far as the Dean of Wall Street himself, Benjamin Graham, investors have been told to dig deeply into a company’s financials, it’s operating history, and its record of corporate governance to assess whether a stock would prove to be a good purchase or not.
Investors who came after Graham widened the circle of study to include items such as competitive position, product quality, and the dreaded “scuttlebutt,” talking to suppliers and employees to get the inside scoop. The work needed to do a “proper” analysis on a company grew remarkably in size while individual investor returns didn’t.
A select group of investors have taken a different approach to their investment projects, however. Rather than plunge neck deep into analysis, they prefer to take a drastically simplified view of their investment choices. Rather than thorough qualitative research, they prefer to leverage statistical anomalies based on simple yet highly profitable financial ratios. These investors have come to be known as Quants.
When investment manager Dean Williams gave his talk, the legendary investor David Dreman was still in the infancy of his career. Only a handful of professions, such as John Templeton, Irving Kahn, or Walter Schloss, came close to falling into the quant category… and they were far from household names. Only as more investors adopted a quantitative strategy was it clear just how valuable Williams’ advice was.
Williams’ idea was decisively simple,
“We probably are trying to hard at what we do. More than that, no matter how hard we try, we may not be as important to the results as we’d like to think we are.”
The thought that an investor could actually try too hard to beat the market is still seen skeptically. Beating the market is hard. Every day we face a tsunami of competition from pros and private investors alike trying to beat us out in what is commonly seen as a zero-sum game. But Williams had good reason to take the position he did. It all started with Isaac Newton.
“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment. That was also the foundation of the security analysis, technical analysis, economic theory, and forecasting methods you and I learned about…”
But, as Williams explained, security analysis, like Newtonian physics, proved to be misguided.
“In the last fifty years a new physics came along. Quantum, or sub-atomic physics…….. events just didn’t seem subject to rational behavior or prediction……… What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There’s just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”
When added to Williams’ second observation, the combination proves devastating for modern investors.
“The second idea …is that most of us spend a lot of our time doing something that human beings just don’t do very well. Predicting things.
……where’s the evidence that it works? I’ve been looking for it. Really. Here are my conclusions: Confidence in a forecast rises with the amount of information that goes into it. But the accuracy of the forecast stays the same. And when it comes to forecasting — as opposed to doing something — a lot of expertise is no better than a little expertise.”
The idea that more information does not necessarily make for better predictions drives a stake through the heart of most investment analysis. Consider the modern day Buffetteers who are basing their investment strategies on discounted cash flow valuations or copper traders that use information from a wealth of different sources to form their purchase decisions. More information does not necessarily mean better judgements. But, investors shouldn’t be so pessimistic about this state of affairs, according to Williams. Instead, investors should see it as liberating.
“The consolation prize is pretty consoling, actually. It’s that you can be a successful investor without being a perpetual forecaster.”
So how, then, is an investor expected to profit in the stock market? Again, Williams’ thoughts are decidedly simple.
“If there is a reliable and helpful principle at work in our markets, my choice would be the one the statisticians call “regression to the mean”. The tendency toward average profitability is a fundamental, if now the fundamental principle of competitive markets. It’s an inevitable force, pushing those profits and their valuations back to the average. It can be a powerful investment tool. It can, almost by itself, select cheap portfolios and avoid expensive ones.”
But leveraging investment returns still involves an investment strategy, and an investment strategy still requires human interaction and judgement on some level. Humans, when it comes down to it, are the ones that ultimately still decide which stocks to buy and sell. How are we supposed to invest in Dean Williams’ world?
“Simple approaches. Albert Einstein said that “…most of the fundamental ideas of science are essentially simple and may, as a rule, be expressed in a language comprehensible to everyone”. ………as long as there are people out there who can beat us using dart boards, I urge us all to respect the virtues of a simple investment plan.”
This is exactly the approach that I’ve taken to invest my own savings. Ultimately, selecting high quality net net stocks is not rocket science. It comes down to selecting stocks that show simple, yet promising, characteristics. Finding these companies does not require hours of time spent talking to suppliers or reading industry profiles. It really comes down to basing your investment decisions off of a few simple balance sheet and income statement calculations.
But, while simplicity is a virtue, it’s not enough to guarantee great returns. Another key characteristic comes into play when building a great track. Williams continues,
“Consistent approaches. Look at the best funds for the past ten years or more. …What did they have in common? ………it was that whatever their investment plans were, they had the discipline and good sense to carry them out consistently.”
In my experience, nothing destroys an investor’s best chance for outstanding returns over the course of his life like the inability to commit. It’s the failure to stick to a promising strategy due to the inability to stomach short term variance or just the tendency to drift between styles that really sabotages an investor. As I’ve written to those who’ve requested free high quality net net stock picks, sticking with a great strategy is far more important than being the most knowledgable investor.
According to Williams, all of this suggests that investors should be approaching their work from a different orientation.
“How are most of us organized? To gather information and use it to make predictions. ……..For all of this to make any sense, we all have to believe we can generate information which is unknown to the market as a whole.
There’s an approach which is simpler and probably stands a better chance of working. Spend your time measuring value instead of generating information. Don’t forecast. Buy what’s cheap today.”
Talk about liberating! Williams wasn’t kidding. In fact, this has been my approach since adopting Graham’s famous net net stocks strategy. Picking high quality international net nets and leveraging the great statistical returns associated with them has proven to be a much more profitable, and much less strenuous, approach to investing.
But there’s another aspect of this type of investing that I didn’t grasp at first. The longer I invested in net nets, however, the more clearly this came into focus. Williams explains,
“Like those who study quantum physics, we should be more content with probabilities and admit that we really know very little.”
So, how can we leverage these probabilities to earn good returns? He continues,
“…if you’re going to manage money mechanically, a good rule is: Buy the stocks with the lowest multiples. Imagine two portfolios. One has stocks we all agree are the “best” companies, with the best prospects for growth. And they’re priced that way. To justify those prices they all have to meet our expectations. But we know that some of them won’t. They’ll disappoint us. The other portfolio has all the companies we don’t like or don’t care about. They’re priced on low expectations. But we know that some of them will surprise us and do well. And since we haven’t paid for the expectation that any will do well, that’s the portfolio with the odds in its favor.”
Admitting how little we actually know about the future is a fundamental aspect of good investing. Rather than destroying our chances of earning great returns, admitting our own fallibility sets us up for a different sort of investing — buying a diversified list of stocks with the odds of good returns, as a group, in our favour.
Arriving at that group of stocks involves ignoring market, industry, or company forecasts and basing our decisions on hard facts. Those hard facts come down to assessing the firm’s financial position, its current valuation, and the returns on offer from a proven investment strategy. This is essentially the approach I’ve taken for my own portfolio.
Proper investing involves getting ‘Meta’. Why would you be content to drift between styles, at worst embracing a haphazard approach to investing or at best using a strategy that’s not optimal for your time, effort, and finances? You really have to take a step back from looking at stocks to assess what it is you’re actually doing as an investor. For me, that amounted to researching many different investing styles before arriving at Graham’s net nets.
Probabilities are an interesting thing. You can be right on each one of your picks without all of them working out. After all, you’re not right in the stock market merely because your stock has gone up; and, you’re not necessarily wrong if it hasn’t. Leveraging probabilities means putting together a portfolio of stocks that, as a group, has a better chance than not of working out. It also means recognizing that that some of your stocks will disappoint and your portfolio won’t work out each and every year.
“The last of the mental qualities we talked about was consistency …and how it seemed to be present in nearly all outstanding investment records. You’re familiar with the periodic rankings of past investment results published in Pensions & Investment Age. You may have missed the news that for the last 10 years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri. Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welch, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it,” the reporter wanted to know. Mr. Welch showed the reporter his copy of Value Line and said he brought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision — not your own impulse.” The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” Exactly. That’s what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.”
And that’s really what it comes down to. Unlike those who have fallen into the Warren Buffett trap, spend time finding a proven strategy that’s simple to use in practice and then stick to it. Doing so will mean shifting your chance of earning great investment returns over the course of your life so that the odds are in your favour.
So really, are you trying too hard?
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