Value Investing & The Stock Market: A Look At 1814-2014 by John Huber, Base Hit Investing
I spend virtually zero energy thinking about the overall stock market. I’m always aware of what the indices are doing, but I really don’t pay attention to where I think they are headed or where they’ve been recently. As Munger has said, sometimes the tide will be with us and sometimes it will be against us, but the best thing to do is to just continue to focus on swimming forward.
I think this has been going on for well over a year now, but lately I’ve been hearing about many people who are worried about the stock market. This is a natural enough concern after a 5 year period from 2009-2013 that saw the S&P 500 advance 15.4% per year before factoring in dividends. I would agree that it is a virtual certainty that the next 5 years will not equal or exceed the returns we’ve seen in the last 5 years from the S&P. But it’s interesting to note the level of fear that exists in the market, even as the S&P continues to reach new highs. Many talk about the next “crash” as if another 2008 is right around the corner (maybe it is, maybe it isn’t–I don’t participate in that game, but as I’ll demonstrate below, the odds are against that type of a market event in the near future).
Read About Businesses, not Stock Market Predictions
In any event, this type of observation on the general state of the stock market doesn’t affect the way I conduct my work. It means nothing to me. I’m trying to find good operating businesses at cheap prices, and my energy is firmly focused on evaluating those situations, one at a time. If I find a business that I determine will compound intrinsic value at 10-12% per year and I can buy that business at a material discount to its current intrinsic value, why would I care what the S&P 500 does in 2014, not to mention trying to anticipate the Fed’s next moves, where interest rates are headed, European problems, etc… The macro things are important, as Buffett says, but not knowable (or predictable). So I like focusing on good solid “block and tackle” style investing. Find good businesses at cheap prices. Spend time reading and evaluating these things. Read more 10-K’s and fewer Section A’s of the Wall Street Journal, etc…
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Stock Prices Over the Past 200 Years
Having stated the above disclaimer, I will proceed forward with some interesting general market data to share. I’m a glutton for historical numbers, especially pertaining to stocks. A while back I came across a post that had a histogram of the overall stock market returns since 1825. More on the numbers shortly…
Prior to reading that post, I was already aware that from the end of 1814 to the end of 1925, the US stock market experienced compound annual growth of about 5.8% per year. This is based on data put together by Robert Shiller, and this measure used a price weighted index, which has many flaws, but is the way that most of the indices are measured today.
To use a different time period and a different yardstick, Buffett once mentioned that the Dow went from 66 to 11,219 during the 100 year period during the 20th century, which is a 5.3% CAGR. Add dividends to that figure, and shareholders might have realized 7-8% annually or so.
To use a third historical time period, I noticed in Buffett’s annual shareholder letter that the S&P 500 has averaged 9.8% annually over the last 49 years (since he took over at Berkshire).
I think the last 200 years provides pretty good evidence that over the very long term, I feel comfortable expecting the market to average somewhere between 6% and 9% annually including dividends (if I had to guess, I’d be closer to 6 than 9).
As we all know, these averages tend to hold up over time, but any individual year can result a widely varying result–the type of year that is hugely positive or terribly negative, right? Yes, this is certainly true. But I think that the probabilities of these outlier years are much lower (especially the negative outlier years) than many people might realize.
Take a look at the last 189 years of general stock prices:
Some anecdotes I find interesting by observing the results 189 years between 1825 and 2013:
- The market had 134 positive years and 55 negative years (the market was up 71% of the time)
- 44% of the time the market finished the year between 0% and +20%
- 60% of the time the market finished the year between -10% and +20%
- Only 14% of the time (26 out of 189 years) did the market finish worse than -10%
- Only a mere 4.8% of the time (fewer than 1 in 20 years) did the market finish worse than -20%
So to put it another way (using the 189 years between 1825 and 2013 as our sample space), there is an 86% chance that the market finishes the year better than -10%. There is a 95% chance the market ends higher than -20%. And as I mentioned above, there is a 71% chance that the market ends any given year in positive territory.
One last observation: the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!
Now, lest my readers suspect me of predicting further gains… let me make it clear that I’m not trying to make a case that I think the market won’t or can’t go down, or even go down a lot. On the contrary, after 5 years in a row of not just positive years, but exceedingly above average gains, we are certainly “due” for a down year. After all, the market finished the year down 29% of the time over the past 189 years, or about once every 3 or 4 years.
I just think that it’s difficult to predict when the down year–and certainly when the next big crash will come. Make no mistake, the market will crash from time to time. The economy will suffer another banking crisis. It’s just difficult to know when. The stock market certainly will go through another 10% correction in the near future. It will likely go through a 20% correction in the near future. There have been 12 of those corrections since the mid-50?s when the S&P 500 index was instituted, or about one every 5 years. We haven’t had one since early 2009, so we’re due for one of those as well.
Some Businesses Create Value During General Stock Price Declines
But I think it’s important to remember that it’s incredibly difficult to precisely predict the timing of such a correction. And even when such a correction occurs, the business you own might actually be more valuable intrinsically after the correction than it was before it. It doesn’t mean the price will be higher, but often times quality businesses create value during these types of market events. Think about all of the enormous value Berkshire Hathaway created for shareholders during the last crisis in 2008-2009.
There are many businesses that can use their resources to actually take advantage of stock price corrections/crashes, either in the form of buying back their own stock at low prices, making acquisitions, or sometimes just gaining market share as competitors struggle. A study of Henry Singleton at Teledyne is very worthwhile when considering the value that can be created for shareholders during bear markets.
So to me, it is not worth the risk trying to sell a quality asset that is compounding intrinsic value just to try and outsmart other speculators in the near term. It’s a much more achievable task to locate a group of well selected quality businesses that happen to be undervalued relative to their true earning power, and patiently let them compound value for you through low and high tides.
Crashes Are Rare
Although certain to happen again, crashes are rare. The 2008 type scenarios, are extremely rare. Only 3 times since 1825 did the market finish a calendar year down 30% or worse. That’s about once every 63 years. People tend to overestimate the probability of a market crash when one recently occurred. The storm clouds of 2008 are in the rear view mirror, but they are still visible, and the effects of the storm still evident. This phenomenon works in the opposite direction also, as Buffett pointed out in his 2001 letter to shareholders:
“Last year, we commented on the exuberance — and, yes, it was irrational — that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19 percent.”
19% for the next decade?! That prediction turned out to be about 20% per year too high. But remember, in December 1999 the market was about to put a ribbon on 5 consecutive years of 20% or greater gains, a feat that never had happened before and likely will not happen again. Irrational exuberance to be sure.
As an aside however, I think it’s interesting to look at how various value investors did during the 2000 to 2002 market crash. Joel Greenblatt once told his students at Columbia that he had two of his worst years of his career in 1998 and 1999, only to gain over 100% in 2000. The 2008 credit crisis was obviously a much different, much more serious, and much more systemic crash, and there was virtually no place to hide. But even those types of events, as rare as they are (roughly once every couple generations) can’t permanently destroy an investor who owns quality assets at prices well below their aggregate intrinsic values. There is one thing I once heard from the great investor Glenn Greenberg that had a profound impact on the way I think about my investments. Greenberg basically said that he wanted to construct his portfolio in such a way that a 1987 type crash (down 25% in one day) would not worry him because the quality of the companies in his portfolio gave him confidence that despite their lower quotational values, their intrinsic values would increase over time, thus providing him with a margin of safety (time was his friend).
Value Investing Requires Patience and Logic, Not Crystal Balls
It doesn’t mean that value investors are immune to market corrections/crashes. On the contrary, the immense discipline and patience that is required of value investors is one reason that the strategy continues to work despite its well known formula, obvious logic, and proven merit. Sometimes the hardest thing to do is the right thing, and human behavior ensures that value investors will always be able to eat.
They key thing to remember is that when you own a stock, you own a piece of a business. Graham’s logic is as simple as it is timeless. It really helps to remember that you don’t own numbers that bounce around on a screen, you own a business that has assets, cash flows, employees, products, customers, etc… Just like the owner of a stable, cash producing duplex located in a quality part of town isn’t frantically checking economic numbers or general stock index prices on a daily or weekly basis, nor should the owner of a durable business that produces predictable cash flow–purchased at an attractive price–be concerned about the day to day fluctuations in the quoted price of his share of the company.
But as Munger said, sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it’s best to focus on swimming as opposed to anticipating the changes in the tides.