Valuation-Informed Indexing #181
By Rob Bennett
After 10.1% Return In 2020, Mohnish Pabrai Changes Strategy [2020 Letter]
Mohnish Pabrai's flagship hedge fund, the Pabrai Investment Fund II, returned 29.6% in the second half of 2020. Following this performance, the fund returned 10.1% net for the year, underperforming the S&P 500 but outperforming the Dow Jones Industrial Average, which returned just 9.7%. According to a copy of the investment manager's year-end letter to Read More
Valuation-Informed Indexers takes valuations into consideration in every strategic consideration. We would never consider reporting a safe withdrawal rate that was calculated without taking into consideration the P/E10 level that applied on the day the retirement began. We would never give an investor advice on her stock allocation should be that did not take into consideration the P/E10 level that applied on the day the advice was being given. We would never make a blanket statement about how risky stock investing is without taking into consideration the P/E10 level at which the stock purchases were going to be made.
Buy-and-Holders give lip service to the idea that valuations matter. But they never consider the effect of valuations when giving investment advice. Their safe withdrawal rate studies contain no valuations adjustments. They recommend the same stock allocations at all price levels. They form judgments about how risky an investing class stocks are that suggest that stock investing risk is a stable thing rather than a variable thing (dependent on the valuation level).
2) Price Changes
Buy-and-Holders believe that price changes are caused by unforeseen economic and political developments. This is why Buy-and-Holders don’t believe that price changes can be predicted. If it is only unforeseen developments that affect prices, return cannot be known in advance. According to the Buy-and-Hold Model, prices should play out in a random walk.
Valuation-Informed Indexers believe that it is investor emotions that are the primary cause of stock price changes. Yes, it is economic and political developments that serves as catalysts for price changes. But the same development will have a very different effect in a market with a P/E10 value of 8 than it will in a market with a P/E10 value of 44. Since the market needs prices to be in the neighborhood of fair value to continue to function, the long-term pull is always in the direction of a P/E10 value of 15. Thus, the direction of long-term price changes is highly predictable.
3) Investor Emotions
Buy-and-Holders subscribe to the core principles of Rational Man Economics. Investors should pursue their self-interests. So Buy-and-Holders presume that they do. Buy-and-Hold is a mechanistic model. The idea is that emotions are yucky and unscientific and thus it is better to leave them out of any scientific analysis.
Valuation-Informed Indexers have taken note of the fact that most stock transactions are conducted by humans and that there is a wealth of literature in all fields other than investing showing that the humans possess emotions which cause them not to pursue their self-interests in many circumstances. We share the desire of the Buy-and-Holders to diminish the role played by investor emotions. But we see more promise in a strategy of recognizing the role of investor emotions and helping investors learn how to cope with their human weaknesses than we do in the idea of putting our heads in the sand re this factor.
4) Academic Research
Buy-and-Hold is marketed as a research-based strategy. It is not that today. Today, it is the opposite. Today there is 32 years of peer-reviewed academic research showing that valuations affect long-term returns. The Buy-and-Holders were able to get away with ignoring that research for so long as the bull market kept people happy. But we are now living through the long stretch of financial suffering that always follows a bull market. So people are starting to ask questions.
Valuation-Informed Indexing is the first true research-based strategy. Shiller’s research discredited the belief that price discipline is not required when buying stocks. So Buy-and-Hold never was a true research-based strategy. Valuation-Informed Indexing is the first. We incorporate all of the findings of the Buy-and-Hold Era that have stood the test of time, dropping only the One Big Mistake that caused the entire model to collapse and replacing the mistake claim (that timing doesn’t work) with the research-supported finding that short-term timing doesn’t work and that long-term timing always works and is required.
Buy-and-Holders view risk as a good thing. They argue that it is because stocks are so risky that they pay high returns. The implication is that investors should seek out risk because it is only by investing heavily in risky asset classes that they can have any realistic hope of financing their retirements.
Valuation-Informed Indexers view risk as a bad thing. The reason why they believe in taking valuations into consideration when setting their stocks allocations is that they want to keep their risk profiles roughly constant at all times and they understand that stocks are a far more risky asset class when prices are high than they are when prices are low. The research paper that I co-authored with Wade Pfau shows that investors can virtually eliminate stock investing risk by accepting the need to change their stock allocations in response to big valuation shifts.
6) Economic Events
When Buy-and-Hold produces poor returns, Buy-and-Holders blame it on that darn economy. It’s always something! Buy-and-Hold would work like a dream if only if weren’t for recessions and such!
Valuation-Informed Indexers blame Buy-and-Hold for the recessions! When stocks become overpriced by $12 trillion, as they did in 2000, the following years are going to see huge amounts of consumer spending dollars disappear as prices work their way back to fair value. The loss of spending power causes hundreds of thousands of businesses to fail and leaves millions of workers unemployed. To stabilize our economic system, we need to explain to investors the dangers of failing to employ price discipline when buying stocks.
7) Predictability of Returns
Buy-and-Holders reject the idea that stock returns can be effectively predicted as voodoo.
Valuation-Informed Indexers note that common sense tells us that long-term returns must be highly predictable. If they were not, stocks would offer the same long-term value proposition at all possible prices and that of course makes zero sense. We observe that there is now 32 years of peer-reviewed academic research showing that long-term predictions based on P/E10 values have been working for 140 years now without a hitch.
8) Where Things Are Headed
Buy-and-Hold is the model of the past. It remains popular only because the Buy-and-Holders have been successful for a time in suppressing challenges to it.
Valuation-Informed Indexing is the model of the future. We develop powerful new insights on almost a weekly basis, which I write up at this column. We don’t fear questioning and the learning never stops.
Rob Bennett has recorded a podcast titled Time Is Not a Four-Letter Word. His bio is here.