How Long Are You Willing to Look Stupid?

The conference was private, and so I can’t quote people directly. But the same issue came up repeatedly across panels and participants. For example, if you were a traditional factor investor, especially in value and small capitalization stocks, you were feeling the heat. Lots of other strategies and styles were almost as disappointing. The math of markets is such that you will occasionally look stupid when your preferred approach is out of favor. This happens quite often; it is an enduring aspect of markets, not an anomaly.

“Stupid” manifests itself in many ways. How comfortable are you holding a position that isn’t working, and hasn’t worked for several years or even longer? In order to do so, you must have a belief rooted in evidence that the investment thesis isn’t merely a temporary source of alpha (above-market performance) soon to be arbitraged away. Consider trend-followers: they have been underperforming long enough that the question is whether that model has been broken, i.e., what seemed like an inherent feature of markets was actually a temporary, random aberration that will never work again.

This brings up our second question: What degree of confidence do you have in the process you use? The answer comes to us via the CFA Institute’s annual Graham & Dodd awards. This year’s winning research paper is “Buffett’s Alpha,” which looked at where Berkshire Hathaway Inc.’s market outperformance came from. The conclusion: Berkshire’s “returns appear to be neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks.”

If that sounds simple and boring, well it is — except for long periods when this sort of investing style is out of favor. There have been decades at a time when it looked like Berkshire’s winning streak had ended, and Buffett was a mere mortal who had lost his touch. Recall the late 1990s, when Buffett eschewed pricey technology and dot-com stocks? This may have been satisfying to some, but what they didn’t know was that Berkshire was on the cusp of that period when value was about to begin a 15-year run of outperformance. Buffett understands the pitfalls of his approach, and has total, justified confidence in his process. So what if leveraging cheap, safe, high-quality stocks makes the greatest investor ever look stupid for years at a time?

Speaking of Buffett and looking smart: Some of these same themes were touched upon by Buffett in his annual letter to Berkshire shareholders this past weekend, whether he was discussing the recent disaster of Kraft Heinz Co. or the underwater position in JPMorgan Chase & Co. Perhaps no Berkshire holding better illustrates this than the company’s huge stockpile of $132 billion in cash and liquid securities, which make up about a quarter of Berkshire’s market capitalization.  If the company were a true mutual fund, this would be an enormous drag on performance over time.

But Buffett watchers have learned that he doesn’t think in terms of quarters or even years but instead contemplates investing over decades.

The success of Berkshire teaches us a couple of lessons: First, you must have a process for deploying capital in which you have a high degree of justified confidence; and second, you must be comfortable holding onto a position that isn’t working and possibly looking stupid, perhaps for years, as you wait for the cycle to turn.

That’s enough to humble any mere mortal.