Coping With Irrational Markets

One of the requirements for efficient capital markets involves the rapid dissemination of relevant information necessary to make investment decisions.  Superior information can provide a material edge for investors and has traditionally been viewed as a competitive advantage for those who have the necessary skill and work ethic.  The amount of information available to all investors today is greater than ever before but so is the noise — and the noise tends to become overwhelming and have negative implications for investor psychology.  This phenomenon is glaringly obvious so far this year as sentiment has turned decidedly negative.

Howard Marks recently released his latest memo, On the Couch, in which he provides commentary on recent market developments and current investor psychology.  Toward the end of the memo, Mr. Marks outlines his “prescription” for investors which is replicated below:

  • The first essential element in coping with markets’ irrationality is understanding.  The importance of psychology and its influence on markets must be recognized and dealt with.
  • The second key lies in controlling one’s emotions.  An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings.  Thus it is absolutely essential to keep optimism and fear in the appropriate balance.
  • Emotional self-control isn’t enough.  It’s also important to have control over one’s circumstances.  For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings.  Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance.  At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions.
  • And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool.  Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa.

It is likely that the majority of readers of the memo are professional investors who need to be particularly concerned with the third bullet point.  For a professional responsible for managing money on behalf of clients, having the right skill set and emotional temperament is not enough if the emotions of other people can result in fund outflows that force ruinous forced liquidations at just the wrong time.

Fortunately, individual investors have an edge when it comes to dealing with irrational markets.  By not being accountable to others, an individual investor only has to be accountable to himself.  Provided that the individual has made good decisions in the past, market volatility need not be a major concern except when contrarian actions can be taken to benefit from market irrationality.

Individual investors who take a passive approach and purchase low cost index funds are best served by ignoring short term market movements and not even looking at the market value of their portfolio more than once a month.  The perceived level of volatility of a portfolio is much lower if one examines market value once a month or once a quarter rather than daily or hourly.

Of course, many investors view themselves as enterprising investors.  Anyone reading this article is likely to be either a professional investor or an enterprising individual investor.  And who are we kidding?  Such individuals are going to be looking at market quotations on a daily basis at a very minimum.  When even Warren Buffett is known to keep CNBC on during the business day, albeit muted, how realistic is it to think that the rest of us can resist the urge to check quotations relatively often?

It is important to learn to view market gyrations as an opportunity rather than a curse so that we can act as contrarians.  Generally, this means having a certain amount of cash that can be deployed at opportune times.  One approach that can be helpful in down markets is to proactively place good-til-cancelled limit orders at low prices.  This can create a mindset of cheering for market declines rather than advances since those limit orders will get closer to executing as the market plummets.  Obviously, conviction is required to follow through on this approach and one must remain cognizant of intrinsic value changes that are actually warranted and adjust accordingly.

Oaktree has recently started posting videos of Howard Marks introducing the topic of each of his memos.  The introduction to “On the Couch” is available here.  Readers can also subscribe to receive notification of future memos.  Howard Marks is scheduled to be the keynote speaker at the 19th annual CSIMA Conference on January 29.  Mr. Marks previously appeared at the 2011 CSIMA Conference where he made a presentation touching on many similar topics.

Disclosures:  None

Berkshire’s Repurchase Level is not a “Floor”

“You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets.” –Warren Buffett on repurchases, 2011 annual report

After posting a 12.5 percent decline in 2015, Berkshire Hathaway’s common stock entered the new year only modestly above the company’s repurchase threshold of 120 percent of book value.  As a result, many commentators have been speculating on the possibility of repurchases in the near future.  Due to recent market volatility, many investors are seeking “safe havens” in the short run and have noticed that Berkshire has limited downside before reaching the repurchase threshold.  It is not uncommon to see references to a “floor” for Berkshire’s stock price roughly corresponding to 120 percent of book value.  Based on the last reported book value figure of $151,083 as of September 30, 2015, the repurchase threshold currently stands at $181,300 which is slightly more than 8 percent below Berkshire’s closing price on January 6.

The exhibit below displays Berkshire’s Class A share price and book value per share since 2000 along with Berkshire’s “buyback threshold” since Warren Buffett introduced the first such threshold in September 2011.  The threshold was originally set at 110 percent of book value and was subsequently raised to 120 percent of book value in December 2012.  It is unusual for a public company to telegraph its intentions in this manner.  However, Mr. Buffett feels strongly that if the company repurchases stock, departing shareholders should be fully aware of the possibility that the company may be buying and that management views the shares as undervalued.

Berkshire's Price and BV History

Anyone looking at this chart might be forgiven for thinking that the repurchase threshold represents a “floor”.  Indeed, the stock has rarely traded below the prevailing repurchase level since it was first introduced in September 2011.  However, there are a number of reasons to be very cautious when thinking about the repurchase threshold.

Repurchases and Intrinsic Value

The main motivation for Berkshire to repurchase stock has nothing to do with maintaining a short term “floor” in the stock price.  It has everything to do with purchasing shares at a level that is clearly below intrinsic value, conservatively calculated.  Here is what Mr. Buffett had to say in the 2011 annual report regarding the newly introduced repurchase authorization.  (Note that the repurchase threshold was subsequently raised to 120 percent of book value in December 2012):

At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

It appears that many investors are focusing on part of Mr. Buffett’s statement rather than looking at it in full.  He clearly states that Berkshire will only repurchase shares well below intrinsic value and that he will likely repurchase aggressively if that opportunity arises.  However, it is also clear that repurchases will not occur simply to support the stock price and that Berkshire could very well pursue opportunities other than repurchases in particularly weak markets.

A Thought Experiment

We make no attempt to predict stock prices in the short run and have no particular opinion regarding the possibility of a major bear market in the near term.  However, it is worth pondering a scenario where stocks fall sharply in the near term and how that might impact Berkshire’s book value and propensity to repurchase shares.

If the equity markets enter a severe bear market in 2016, perhaps falling 30 to 40 percent, Berkshire’s large holdings in publicly traded securities will almost certainly participate in the decline as well which will have a negative impact on reported book value.  Additionally, Berkshire’s equity derivative investments will also show mark-to-market declines which will negatively impact book value in the short run.  Exerting a pull in the opposite direction, it is almost certain that Berkshire would still report substantial operating earnings which would increase book value.

Where will the dust settle?  It is certainly possible that a declining stock market could result in Berkshire’s book value falling in any given quarter or even in a full year despite the effect of substantial operating earnings.  Such a decline in book value would obviously reduce the repurchase threshold commensurately.  Therefore, even if the repurchase level could be considered a “floor”, that floor could be moving downward in the short run.

However, the situation is even more complex.  If equity markets decline severely, that will present major opportunities for Mr. Buffett to deploy Berkshire’s cash.  Not only will publicly traded equities be cheaper but the market for private businesses would probably soften as well.  If the market decline is also accompanied by real or perceived systemic risks to the overall financial system, as was the case in 2008-2009, Mr. Buffett’s phone will be ringing off the hook with offers for unusual investment opportunities at attractive terms because Berkshire will have cash and the “Buffett stamp of approval” is worth a great deal in crisis conditions.

Faced with a rich set of investment opportunities brought about by a market panic, there is no reason to believe that repurchasing Berkshire shares will be Mr. Buffett’s favored choice under such conditions.  

If Berkshire does indeed trade at or slightly below the threshold in a given quarter and it is revealed that Berkshire did not repurchase shares, or repurchased only a modest amount, all talk of a “floor” will likely disappear.  As Mr. Buffett said in the 2011 annual report, he has no interest in repurchasing shares simply to “support” Berkshire’s stock price.

Repurchase Threshold is a Long Term Buying Signal

Rather than viewing Berkshire’s repurchase threshold as a floor or as a short term buying signal, long term oriented investors should instead regard it as a long term buying signal.  This is not merely because of the fact that Mr. Buffett plainly regards purchases at such a level to be a bargain, but because Berkshire demonstrably provides more intrinsic value at such a price than one must pay in exchange for shares.

We last commented on Berkshire’s valuation in September 2014 when the shares were reaching record highs.  The shares continued to advance up to the end of 2014 and have declined since that time.  There are many methods that can be used to estimate Berkshire’s valuation but buying at a low price-to-book ratio has proven to be a reliable approach in the past.

Through year-end 2014, Berkshire delivered annualized book value growth over the preceding ten years of 10.1 percent.  This was a ten year period that included the tail end of a bull market, the most severe economic downturn since the Great Depression, and the subsequent recovery.  Even if we assume a somewhat lower rate of book value growth over the next decade, such as 9 percent, Berkshire’s book value will likely be close to $350,000 per share by 2026.

A number of valuation methods, such as the two-column approach, confirm that a price-to-book ratio of 150 percent is not unreasonable.  This would imply a stock price of around $525,000 ten years from now representing somewhat more than 10 percent annualized returns if buying at the current stock price.  This is quite attractive for a company with Berkshire’s overall risk profile and there is room for some upside beyond that.  (Note that if Berkshire starts to pay dividends at some point over the decade, which seems more likely than not, total returns would be somewhat lower due to less internal compounding and, for some shareholders, tax consequences).

The lesson is clear:  Use Berkshire’s repurchase threshold as a long term buying signal, not as a short term signal.  The threshold does not represent a short term floor and people buying the stock as a short term safe haven could very well be disappointed.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Assessing Investment Performance

“The performance of investors who add value is asymmetrical.  The percentage of the market’s gain they capture is higher than the percentage of loss they suffer …. Only skill can be counted on to add more in propitious environments than it costs in hostile ones.  This is the investment asymmetry we seek.” — Howard Marks

The end of a calendar year is typically a time for reflection and contemplation for most people, both on a personal and professional level.  If such reflection is to be more than a surface level passing thought, one must bring a certain amount of discipline and rigor to the process.  One year is plenty of time to assess the success or failure of a diet, exercise program, or quitting smoking but it is but a short blip of time in the world of business.  Since all intelligent investing puts the investor in the role of a businessperson, it follows that a single year is not a meaningful timeframe to evaluate investment performance either.

The vast majority of professional investors do not have the luxury of claiming that one year is an insufficient amount of time to evaluate performance.  The incentive structure and culture of most firms make annual performance paramount and the individuals and institutions entrusting funds to money managers often have even shorter frames of reference.  This is why closet indexing, window dressing, and other counterproductive actions are so prevalent.  Fortunately, individual investors do not face these institutionalized pressures.  An individual investor’s worst enemy is likely to be himself and therefore the struggle is internal and mostly a matter of temperament and personal discipline.  In this article, we ignore the pressures facing professional investors and focus on how to rationally assess performance in a way that can be implemented by individuals.

Annual Performance

One year is not a long enough period to assess performance but obviously longer periods are made up of shorter chunks of time.  As a matter of convention and convenience, it is natural for investors to look at performance annually.  This is not harmful as long as these annual periods are viewed in a longer term context.  Most investors probably look at annual performance but it is apparent from reading news articles and comments in venues such as Twitter that, in many cases, performance is not viewed correctly especially relative to benchmarks.

Investors who utilize brokers such as Vanguard or Fidelity can delegate the task of measuring their overall annual performance to the figures presented on annual account statements.  Those who prefer a more proactive approach can easily create a spreadsheet in Microsoft Excel that calculates the internal rate of return (IRR) of a portfolio based on transaction activity during the course of a year.  Such a spreadsheet must include the beginning account balance along with all additional purchases, sales, income received, commissions paid, and the ending account balance.  Depending on the complexity of an investor’s situation, it might be useful to calculate the IRR of sub-accounts such as taxable and tax-deferred accounts separately.  This is particularly useful for sub-accounts employing significantly different investment strategies.

Most United States based investors tend to use the S&P 500 as a benchmark but there isn’t really anything written in stone dictating the use of this benchmark.  Investors employing strategies focusing on very specific niches, such as small capitalization stocks, should probably pick a different benchmark.  It is critical to include dividends in the performance of the benchmark.  Most articles and tables in newspapers present only the price change of an index rather than total return.  This can be meaningful.  For example, in 2015, the S&P 500 had a slightly negative return based on price alone but a slightly positive return when dividends are considered.

Some investors prefer to use an investable benchmark such as the SPDR S&P 500 ETF (SPY).  The argument for doing so is that one cannot directly invest in the S&P 500 and must bear the small costs of an ETF or other index fund to implement a passive investment strategy.  In reality, whether one uses the S&P 500 or SPY is not likely to materially impact the question of whether an investor possesses sufficient skill to actively manage a portfolio.

Once a benchmark is chosen, it is important to not make changes to which benchmark is used except when clearly justified.  It is also intellectually suspect to switch to a different benchmark retroactively in an attempt to make performance look better.  Ultimately, all an individual is doing is fooling himself with such actions.  Benchmarks should only be changed if there is a clear change in strategy that fully justifies the change and benchmarks used in past years should not be retroactively changed.

Multi-Year Performance

If we refer to the quote by Howard Marks at the beginning of this article, it is apparent that skill must be measured over multi-year periods.  But how many years is sufficient to determine whether an investor has skill?

It is not a good idea to refer to a fixed number of years as a sufficient amount of time to measure skill.  Instead, it is important to consider the overall market environment and pick a timeframe that includes both a major bull and bear market.  Why is this the case?  It is very possible, and indeed likely, that an investor with a proclivity for taking huge risks will dramatically outperform a benchmark over the course of a strong bull market.  It is difficult to know whether the investor took these risks intelligently or not without observing performance during bear markets.  It is also possible, and very likely, that an exceedingly risk averse investor will dramatically outperform a benchmark during a severe bear market, but it is difficult to know whether such an investor was uncommonly wise or just inherently incapable of taking intelligent risks without observing performance during a subsequent bull market.

In general, stocks tend to rise over long periods of time.  In the sixteen years since the turn of the century, the S&P 500 had a positive total return in twelve years.  The last year in which the S&P 500 had a negative total return was in 2008.  With the exception of 2011 and 2015, which featured low single digit returns, the S&P 500 has posted very strong double digit positive returns over the past seven years.

Based on the performance of the overall market in recent years, it is difficult to be confident that an investor possesses real skill without looking at a record that spans at least a full decade. 

If we have access to an investor’s record from January 1, 2006 to December 31, 2015, we would be able to observe performance during the tail end of a bull market, through one of the worst bear markets in generations, as well as during the subsequent bull market that is still underway.  An investor who took imprudent risks in 2006 and 2007 would likely have faced ruin in 2008 that more than fully offset the gains of the good years, and reduced the capital base to the point where significant outperformance during the last seven years would be required just to match the benchmark.  An extremely risk averse investor incapable of taking intelligent risks would have been saved from much of the agony of 2008 but would likely have not participated in the current bull market.

This Presents a Dilemma …

Active investing is not without costs in terms of time, effort, transaction costs, and the very real possibility that performance will fail to match totally passive alternatives.  At least in recent history, it is difficult to know whether an investor has any skill without a track record of a full decade.  How can investors with less experience or an investor just starting out begin to determine whether the effort is worthwhile?

For new investors, one of the most important factors to consider is whether the process itself is rewarding and fulfilling.  If reading 10K reports and similar documents is not your idea of a good time, it is exceedingly unlikely that active portfolio management makes any sense.  Investors who outperform must have a passion for the process.  They must find it intellectually rewarding in and of itself without considering the superior returns that might be achieved.  When a passive approach is available at very low cost, why even bother to find out if real investing skill is there if the process itself is not enjoyable?  This is particularly true when anyone earning the median income in the United States can almost certainly achieve financial security with a 10-15 percent savings rate over a long career.  For high income earners in fields outside investing, a passive approach coupled with a healthy savings rate is more than enough to guarantee financial security.

This leaves the question of how to evaluate the performance of an investor who has only been operating during the course of the current bull market.  Many investors with significant skill could very well not outperform during a bull market with this prudence more than amply rewarded during a subsequent bear market.  As a result, simply looking at raw performance numbers over the past few years is not sufficient to make an informed judgment.  If an investor has significantly outperformed in recent years, that isn’t necessarily proof of superior skill either.  It could be the result of luck and blind risk seeking behavior.  The only way to judge performance without a longer track record is to examine individual decisions and try to determine if they were intelligent and well thought out.  This requires that the investor has prepared an investment thesis, or at least an informal note, documenting each decision that was made.  Unfortunately, self evaluation is difficult and some type of peer review may be necessary to retain intellectual honesty.  An investor in this situation might, at least at an intellectual level, hope for a bear market in the near term as it would likely demonstrate whether their skill exists or not.

One Supplemental Measure

The use of a benchmark to measure performance is important but perhaps a more interesting metric is to attempt to learn if you are your own worst enemy when it comes to trading.  A very simple way to do this on an annual basis is to track the performance of your portfolio as if you had made no changes throughout the year.  Measure this figure against the actual performance of the portfolio.  Although a year is not really sufficient to judge the success or failure of a trade, if one finds that trading is consistently detracting from results, it is an important sign that a different perspective could be useful.  Some of the best investors are extremely inactive.  Charlie Munger’s investment portfolio at The Daily Journal has been unchanged for years after he chose to deploy cash very close to the bottom of the market in early 2009.  As Mr. Munger says, “Investing is where you find a few great companies and then sit on your ass.”

Disclosures:  None