One of the constants in investing is that investment theories are disbelieved, prosper, bloom, overshoot, die, and repeat. So is the only constant change? That’s not my view.
There are valid theories on investing, and they work on average. If you pursue them consistently, you will do well. If you pursue them after failure, you can do better still.
How many times have you seen articles on investing entitled “The Death of ____.” (fill in the blank) Strategies trend. There is an underlying kernel of validity; it makes economic sense, and has worked in the past. But any strategy can be overplayed, even my favorite strategy, value investing. My style of valueinvesting tries to adjust for that, but it is not perfect there. (And to tell the truth, September has been a bad month for me, though 2013 has been a very good year.)
In his first-quarter letter to investors of Greenlight Capital, David Einhorn lashed out at regulators. He claimed that the market is "fractured and possibly in the process of breaking completely." Q1 2021 hedge fund letters, conferences and more Einhorn claimed that many market participants and policymakers have effectively succeeded in "defunding the regulators." He pointed Read More
So what are valid strategies?
- Price Momentum
- Long-term mean reversion
- Insider Buying
- Neglect (Low volume relative to market cap)
- Accounting Quality (Net Operating Accruals)
- Low Equity Price Volatility (which isn’t working now, because it became too popular)
- Shrinking Assets
- Shrinking Shares (Buybacks)
- High Gross Margins as a Fraction of Assets (“Quality,” a quantitative measure of moats.)
This list is not exhaustive, but it is what I use. The main idea here is to be aware of what is out of fashion, and to be ready to invest when that which drives a strategy to be out of fashion stops getting worse.
So, don’t lose confidence in winning strategies. Rather, trade out of winning strategies when they are too good, and revisit them when you see the “The Death of ____” articles, or things like them. This can apply to sectors and industries as well. Be willing to pick over industries that have underperformed, and buy strong companies that can survive the downturn. As I have said before, failures occur in weak industries, and after they do, the remaining companies gain pricing power, and thus you invest in survivors.
Value investing is emotionally hard. You have to be willing to take short-term pain in the interests of long-term gain, if there is a sufficient margin of safety. No strategy works every month or year. Returns from valid strategies are most often lumpy. The markets are almost always lumpy.
Prepare yourself for volatility. It is the norm of the market. Focus on what you can control — margin of safety. By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.
Finally, don’t give up. Most people who give up do so at a time where stock investments are about to turn. It’s one of those informal indicators to me, when I hear people giving up on an asset class. It makes me want to look at the despised asset class, and see what bargains might be available.
Remember, valid strategies work on average, but they don’t work every month or year. Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.
By David Merkel, CFA of Aleph Blog