The party on Wall Street didn’t end on New Year’s Eve. The gala continued
right into 2018 as January’s total return marked the best start to a year
since 1997. Indeed, since Trump was elected President, the U.S. markets
have largely shrugged off the political sideshow and chaos of the White
House as the S&P500 put together an uninterrupted 15-month rally with
no losing months on a total return basis. That period was the longest
streak in the history of S&P500, beating the previous record of 10
months, set back in 1995, by a comfortable margin.
The recent mini-streak ended in early February 2018. The CBOE Volatility
Index (VIX), or “the fear index,” which is considered by many to be the
world’s premier barometer of investor sentiment and market volatility,
skyrocketed by 116% on Feb. 5. That was the largest one-day increase ever . On the same day, the S&P 500 fell by 4.1%. Investors were
provided with a quick lesson on the dangers of short-term speculation and
trend extrapolation as leveraged bets on low volatility imploded.
During the S&P500’s hot streak, the price index jumped 33% over 15
months. The index outperformed the underlying corporate fundamentals, which
pushed the S&P500 index even deeper into overvalued territory. By the
end of the month, investors had something new to worry about – heightened
risk that the Federal Reserve might hike interest rates faster than
expected following growing signs of inflation.
Don’t get your teeth kicked in
“The most dangerous people in the world are very smart traders who have
never gotten their teeth kicked in.” – F. Helmut Weymar
At Pender, we sometimes say that there are only two kinds of companies:
Companies that are having problems and those that are going to have problems. The same is also true for the broader
indices – it’s just a question of when a major correction will occur as
extended periods of tranquility are often followed by not-so-tranquil
times. The S&P500 is currently in the midst of the second greatest bull
market in length and magnitude in history. It is less than a year
away from becoming the longest bull run ever. It has been so long since
there has been a major correction that the institutionalized memory of the
gut-wrenching selloffs that occur periodically in the markets is in danger
Increasingly, the investors and fund managers who are making important
investment decisions have never had their proverbial teeth kicked in. A survey of more than 4,800 fund managers in
London, New York, and Paris conducted last year showed that half of
respondents had nine years of experience or less. That means there are
thousands of fund managers who didn’t experience the 2008 collapse and its
run up, let alone the dot-com bubble that burst in the early 2000s, the
1997-1998 Asian financial crisis, or the more distant 1987 and 1973-74
Unfortunately, what we learn from history is that we don’t learn from
history. In any case, we keep in mind Buffett’s simple guideline,
“The less the prudence with which others conduct their affairs, the
greater the prudence with which we must conduct our own.”
Secret Rule #2 and patiently onward
“In a rising market, enough of your bad ideas will pay off so that
you’ll never learn that you should have fewer ideas.” – Daniel Kahneman
Warren Buffett’s #1 rule of investing is “never lose money,” followed
quickly by his second rule — “never forget #1.” While we remain admirers of
the Oracle of Omaha, there is a clear flaw with Rule #2. Taken literally,
one could put money in a GIC or a T-bill and meet both rules. But after
taking into consideration inflation and taxes, investors would be going
backwards, never mind have any realistic chance of growing their wealth
over time. Rather, we believe Rule #2 should reflect what Buffett actually did to accumulate his capital.
The real secret Rule #2 is to be patient and to appreciate that investing
is an endeavour where magnitude is more important than frequency. In other
words, how big your wins are matters more than how often you win. Like many
aspects of life, it turns out that capitalism is also beholden to the
“80/20 rule” – that is, a minority of individual stocks account for most of
the stock market’s total returns over time, because only a handful of
companies create real long-term wealth.
The key, in our opinion, is to be patient with such compounders, so one can
benefit from magnitude in capitalism. This also explains in large part why
portfolio turnover and returns tend to be inversely correlated. It’s hard
to keep up when you sell the Starbucks, Amazons, and Berkshire Hathaways of
the world early-to-midway through in their respective lifecycles.
We believe it is important to see the world as it really is in order to
stack the odds in one’s favour. It turns out that successful long-term
investment strategies are also behold to the “80/20” rule. The greatest
flaw in short-term investing is the belief that great business performance
is always linear. Time tends to push out those of weak conviction and
creates opportunities for those with a long-term perspective.
An idiosyncratic and patient approach to portfolio management is not
practiced by many, but it tends to work over the long haul because it is
aligned with how the world really works. Don’t just take our word for it.
research concludes that among high Active Share portfolios – whose holdings differ
substantially from their benchmark – only those with patient investment strategies on average outperform. This
successful group represents a very small percentage of all active
investors. In large part, incentives driven by short-term relative
performance and benchmarking prevents most managers from implementing the
secret Rule #2 in their investment strategies. Yet these real-world
findings have clear implications for today’s active vs passive debate.
Read more on how long-term considerations impact our investment strategies
as they relate to interest rates, disruptive business models and cycles
(including comments on individual holdings) in this
Please do not hesitate to contact me, should you have questions or comments
you wish to share with us.
Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management.
He works alongside David Barr, Pender’s President, in setting the
direction of Pender’s overall investment strategy. This article first
appeared in the
Pender Investment Insights blog. Used with permission.
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