The Victors Write the History Books, Even in Finance [ANALYSIS]

The Victors Write the History Books, Even in Finance by David Merkel, CFA of The Aleph Blog

“It ain’t what you don’t know that hurts you, it’s what you know that ain’t so.”

(Attributed to Mark Twain, Will Rogers, Satchel Paige, Charles Farrar Browne, Josh Billings, and a number of others)

Warren Buffett’s 2018 Activist Investment

Berkshire Hathaway Warren BuffettMost investors are aware of Warren Buffett's most high profile long-term investments. However, there is one long term investment that is often overlooked. Q2 2020 hedge fund letters, conferences and more This is building materials maker USG, which was owned by Berkshire Hathaway for more than 17 years before it was acquired in 2018. If Read More


A lot of what passes for investment knowledge is history-dependent, and may not serve us well in the future.  Further, a certain amount of it is misinterpreted, or, those writing about it, even really bright people, don’t understand the hidden assumptions that they are making.  I’m going to clarify this by commenting on three graphs that I have seen recently — two that I think deceive, and one that I think is accurate.  Let’s start with one of the two, which come from this article at AAII, interviewing Jeremy Siegel:

Finance History Books

Leaving aside the difficulties with the data from 1802-1871, there is an implicit assumption of buying and holding that undergirds these statistics.  Though the lines look really smooth now in hindsight, for those investing at the time they were often scared to death in bear markets, selling out at the worst possible time, and in bull markets, getting greedy at the worst possible time.

Now one might say to me, “But David, forget what happened to individuals.  As a group, people must made returns like this, because every buyer has a seller — even if some panicked or got greedy, someone had to take the other side of the trade and benefit.”  True enough, though I am suggesting that average people can’t live with that much volatility.  Even if you cut 1929-32 in half by being 50/50 Stocks/Treasury Notes, how many people could live with a 40% downdraft without selling out?

But there is another problem: when does cash enter and exit the stock market?  Hint: it doesn’t happen via secondary trading.

Cash Enters the Stock Market

  • An Initial Public Offering [IPO], secondary IPO, or rights offering leads people to give money to a corporation in exchange for new shares.
  • Employees forgo pay to receive company stock.
  • Shares get issued to suppliers in lieu of cash (common with scammy promoted stocks)
  • Warrants get exercised, and new shares are issued for the price of cash plus warrants.

Cash Exits the Stock Market

  • Cash dividends get paid, and not reinvested in new shares
  • Stock gets bought back for cash
  • Companies get bought out either entirely or partially for cash.

I’m sure there are other ways that cash enters and exits the stock market, but you get the idea.  It means that cash is exchanged with the company for shares, and vice versa, not the trading that goes on every day.  Now, here’s the critical question: when do these things happen?  Is it random?

Well, no.  Like any other thing in investing, n one is out to do you a favor.  New stock tends to be offered at a time when valuations are high, and companies tend to be taken private when valuations are low.  Thus back in the tech bubble, 1998-2000, a lot of cash got soaked up into companies with dubious valuations and business models.  With a few exceptions, most lost over 90%+.  Now consider October 2002.  How many companies IPO’ed then?  Very few, but I remember one, Safety Insurance, that came public at the worst possible moment because it had no other choice.  Why else would the IPO price be below liquidation value?  Great opportunity for those who had liquidity at a bad time.

The upshot is that because stock is issued at times that do not favor new investors, and stock is retired at times that do not favor existing investors, the dollar-weighted returns for stocks in the above graph are overestimated by 1-2%/year.  Stocks still beat bonds, but not by as much as one would think.

But here’s a counterexample, taken from Alhambra Investment Partners’ blog:

Finance History Books

Note that buybacks don’t follow that pattern.  Corporate managements often exist to justify themselves, and so a great number of them do not behave like value investors when they buy back stock.  Part of this is that capital seems cheap during the boom phase of the market, and so they lever the company up, issuing debt to buy back stock at high prices.  It increases earnings in the short-run, but when the bear market comes, the debt hangs  around, and intensifies the fall in the stock price.

This is why I favor companies that shut off their buybacks at a certain valuation level.  If they have to dispose of excess cash to avoid takeovers, pay out special dividends… leave the reinvestment issues to shareholders.  If they buy back stock at levels that are too high, it does not increase the intrinsic value of the firm, though it might keep the price higher for a little while.

Here’s the other graph  from this article at AAII, interviewing Jeremy Siegel:

Finance History Books

What this graph is trying to say is that if you just buy and hold on long enough, results get really, really certain, and investing a lot in stocks reduces your risks, it does not raise your risks.

I’m here to tell you that is an amplification of the past, and maybe not even the best amplification of the past.  This is where the victors write the history books.  Your nation is blessed if:

  • You haven’t had war on your home soil.
  • There are no plagues or famines
  • Socialism is kept in check; expropriation is not a risk (note the many countries grabbing pension assets today)
  • Hyperinflation is avoided (we can handle the ordinary inflation)

Any of those, if bad enough, can really dent a portfolio.  We can have fancy statistics, and draw smooth curves, but that only says that the future will be like the past, only more so. ;)  I try to avoid the idea that mankind will avoid the worst outcomes out of self-interest.  There have been enough cases in history where that has not proven true, and envy and revenge dominate over shared prosperity.

I’ve already made the comment on how many can’t bear with short-run volatility.  There is another factor: when you look at the above graph, it represents the average valuation level, yield curve shape, etc.  If you are applying this model to today, where credit spreads are low, cash earns nothing, the yield curve is wide, equity valuations are medium-high, you would have to adjust the expected returns to reflect what the likely outcomes are, and the graph would not look as favorable.  Volatility looks low today, but realized volatility is likely to be higher, and will not likely follow a normal distribution.

Closing

My main point here is to beware of history sneaking in and telling you that stocks are magic.  Don’t get me wrong, they are very good, but:

  • they rely on a healthy nation standing behind them
  • their past results are overstated on a dollar-weighted basis, and
  • their past results come from a prosperous time which may not repeat to the same degree in the future
  • you may not have the internal fortitude to buy and hold during hard times.

Previous articleGovt Actions In Fannie, Freddie Case Provide Defense To Others
Next articleBlackBerry L Concept Redefines Slider Phones
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.