Be Conservative, Not Conventional
Do we extend the rally off of the February 4th and 5th "hammer lows," or do we base for awhile?
Here's the paradox: The odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return -- and sleep better en route. Folks who seek a killing usually get killed. Gunslingers get shot, and often in the foot, with their own guns.
While there is always some guy around on a red-hot streak, his main function is to tempt the rest of us into becoming fools and paupers. A return of 15% to 20% annually is a lot more than most folks realize, or need.
If a 30-year-old with $10,000 in an IRA gets 15% annually, he'll be a millionaire before normal retirement. That's the power of compound interest. If that same 30-year-old were to sock away another $2,000 per year at 15%, he would end up as a 65-year-old $3 million fat cat. At 20%, it's an incredible $13 million. That's a lot, but it's not too much to ask.
The two most definitive studies ever on long-term returns, the Ibbotson/Sinquefield and Fisher/Lorie studies, both point to average annual returns for stocks of 9% plus per year going back to the mid-1920s. So 15% to 20% per year is really 66% to 100% better than the market as a whole. That's tough but doable.
Consistency is the key. It is close to impossible to get a good, long-term rate of return if you suffer serious negative numbers en route. It's the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.
-- Ken Fisher, Forbes, 1989
I was reminded of Ken Fisher's cogent comments from his 1989 Forbes article as I perused Berkshire Hathaway's (BRK.A) annual shareholders' letter over the weekend. The "memory jog" came while examining Berkshire's stock market performance. Sure enough, since 1965 the S&P 500's compounded annual gain (including dividends) was about 9.3% for a compounded return of 5,430%. Over that same time frame Berkshire's annual compounded return was 20.3%, or 434,057%.
Consistency was the key to Berkshire's outperformance for over the course of those 44 years the S&P 500 suffered 11 down years, six of which were double-digit declines. Berkshire, however, had only two negative years, neither of which were in the double digits.
Such risk-adjusted investing has always characterized Warren Buffet, for he maintains it isn't his best ideas that gave him his tremendous track record, but it was having a smaller number of bad ideas that resulted in a permanent loss of capital. "We haven't taken two steps forward and one step back. We've taken two steps forward and a fraction of a step back. Avoiding the catastrophes is really important."
As usual, Buffet peppers this year's letter with witticisms that offer useful gleanings to investors. I particularly liked the section titled "What We Don't Do." The first bullet point reads:
Charlie and I avoid businesses whose futures we can't evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930), and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.
I revisit Buffet's and Fisher's comments this morning because at my firm we think 2010 is a transitional year where being "conservative not conventional" is the preferred investment strategy. Accordingly, we like high-quality "growth" over "value" and are avoiding companies with highly leveraged balance sheets. We are also looking for companies whose earnings forecasts are being revised upward, as well as companies with dividend yields. We prefer large capitalization stocks because the drag on relative performance from narrowing credit spreads is waning. Moreover, the current economic, and credit, environments are worse for small/mid-caps; and large-caps tend to outperform when the economic momentum peaks like it appears to be doing. Further, large capitalization companies' P/E multiples are 20% below those of the small/mid-cap complexes. That said, we are always interested in special situations, no matter what their capitalization flavor.
If indeed this turns out to be a transitional year, we think investors should employ a more dynamic strategy in part of their portfolios. This doesn't mean we favor the "rapid fire" strategy of trying to day-trade, or even trade on a week-to-week basis. Rather, we favor waiting until the risk/reward ratio is tipped so far in our favor that if we're wrong, we'll be wrong quickly with a de minimis loss of capital.
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