Absolute Return Partners letter for the month of May 2017, titled, “Investment Rules.”

The stock market is filled with individuals who know the price of everything, but the value of nothing. – Phillip Fisher

Back in 2013, Harriman House published a book called Professional Investor Rules, which covered … guess what … self-imposed investment rules set by a selected number of professional investors (exhibit 1). Cutting a long story short, back in February, one of the editors of Harriman House suddenly called and asked me if I would be interested in writing a chapter for the follow-up to Professional Investor Rules that they are planning to publish later this year.

The very first thing I did was to check who contributed to the first book. When realising that investment midgets like Marc Faber, Bill Gross and Niall Ferguson (plus more than 20 other highly esteemed professional investors) had contributed, I said to myself: “Well, if they can do it, so can I.”

Investment Rules

Exhibit 1: Professional Investor Rules by Jonathan Davis

Source: Harriman House, 2013

Investment Rules

The following is, with only a handful of adjustments, my contribution to the second rule book. It is admittedly a little different from the typical Absolute Return Letter, but I enjoy not always writing about the same topics, and I hope you’ll find it equally enjoyable to read. I will let you know when the book is published. All I know at this stage is that it should come out later this year.

Rules about Rules

Investment rules shouldn’t be static. Investors should adapt their rules per the environment they are in. From experience, I can confirm that those who don’t adapt usually get into trouble sooner or later. My first and most important rule when investing is therefore a rule that defines the rules I should adhere to.

What exactly do I mean by that? How can I possibly have a rule about rules? Allow me to explain. As I see things, there are rules and then there are rules. The most important ones always apply; those are my first frontier rules. There are not many of them, but they are all critically important.

The second layer of rules – the second frontier – are strictly speaking not rules but principles. I treat them as rules, though, because I follow them almost whatever happens.

Warren Buffett once uttered the now famous words: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” From my 30+ years of investment experience, I can confidently say that those who lose their shirt on investments are almost always those who don’t stick to their principles; those who get carried away when an opportunity presents itself.

I have a less than outstanding short term track record (as most investors do) but, over the years, I have found that my track record over the long term is better than just good, so I stick to the long term – just like Warren Buffett does. The four rules that I will present to you today have worked very well for me over the years, but don’t expect them to work particularly well if your time horizon is only until next week. Now to the first of my rules.

#1:   Adapt the investment principles you follow to the environment you are in

Let me give you a very simple example why my investment principles change subject to the environment we are in.

Many investors are in love with growth stocks, and it is not difficult to understand why. Growth stocks have outperformed value stocks for many years but, if you do your homework properly, you find a close link between bond yields and the relative performance between growth and value stocks.

When bond yields decline, growth stocks outperform value stocks, and vice versa when bond yields rise. With declining bond yields for most of the last 35 years, it is easy to understand why many investors are infatuated with growth stocks. An entire generation of investors have never seen value stocks outperform growth stocks, and those who have hardly remember because it is more than 35 years ago.

Now, assuming we stand in front of a multi-year rise in interest rates, even if it is of modest proportions (as I think it will be), all that could be about to change. Investors who are wedded to their growth stock rule may be disappointed, while those who are prepared to adapt to the changing regime are more likely to outperform.

Another example is the wider performance of equity markets. At the very highest level, I divide equity markets into secular bull and secular bear markets. Over the last 150 years or so, the US has enjoyed six secular bull markets and only five secular bear markets (exhibit 2).

A secular bull market is characterised by rising earnings multiples, whereas earnings multiples decline in secular bear markets. Falling earnings multiples lead to the sharply lower returns that characterise secular bear markets. As you can see, the difference in total returns between secular bull and bear markets is quite dramatic.

Investment Rules

Exhibit 2: Secular US equity bull and bear markets since 1877

Source: Jill Mislinski, Advisor Perspectives, March 2017, www.advisorperspectives.com

There are no rules as to how long a secular bull or bear market should last for, but history provides some guidelines. Only one has run for more than 20 years, and both bull and bear markets tend to stay in a relatively predictable channel – at least they have done so for the past 150 years (exhibit 3).

Investment Rules

Exhibit 3: S&P Composite – 1877 to present (inflation-adjusted regression channel)

Source: Jill Mislinski, Advisor Perspectives, March 2017, www.advisorperspectives.com

As is also apparent from exhibit 3, the secular bull market we have been in since 2009 is (at the time of writing) 98% above the long-term trend line but, when secular bear markets take charge, equity markets rarely ‘just’ go back to the trend line. Most of them go all the way back to the bottom of the channel.

This leads me to conclude that equities in general, and US equities in particular, are priced for problems in the years to come; hence I would allocate only a limited amount to this asset class at present.

Having done my very best to dampen your expectations, let’s kill another sacred cow. There appears to be a firmly entrenched view amongst investors – probably driven by the so-called Fed Put (aka the Greenspan Put) – that, whenever the going gets tough, the Fed will bail you out, and it won’t take long before equities are back on track.

For that very reason, many investors have chosen to sit out most storms in recent years. If you subscribe to that philosophy, let me remind you that equities sometimes spend decades under water before they finally come back with a vengeance (exhibit 4).

Investment Rules

Exhibit 4: Longest runs of negative real equity returns since 1900

Source: Dimson, Marsh and Staunton, London Business

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