Justin's note: Today, I’m sharing another important essay from my good friend and colleague Chris Mayer. Chris is one of the best value investors on the planet. For 10 years straight, he outperformed not only the S&P 500, but also legendary investors like Warren Buffett and Carl Icahn.
On Tuesday, Chris revealed the three traits all 100-baggers (stocks that return 100-to-1) have in common. Today, he shares a key thing to watch out for in your quest to find them…
By Chris Mayer, editor, Chris Mayer’s Focus
Now for some timeless investing principles you’ll need in your hunt for 100-baggers. Let’s begin with a startling statistic…
It comes from a 2011 study by investment firm Davis Advisors. They looked at a universe of 190 mutual fund managers whose 10-year performances put them in the top 25 for the decade ending December 31, 2011.
Davis Advisors then posed an interesting question: What percentage of these top performers had at least one rolling three-year period during which they put up lousy numbers?
More specifically, what percentage of these top managers put up numbers in a three-year period where they were at the bottom 25%?
The answer may shock you: 96%.
In other words, almost all of them. Moreover, a third of them spent at least one three-year period where they were in the bottom 10%. Meaning 90% of their peers beat these top dogs for at least a three-year period.
From this, we can deduce one portfolio strategy you never want to adopt: Never buy a manager because he’s hot. (And on the flip side, don’t leave him when he’s not.)
Bloodless statistics may not do this story justice. So here is a story you won’t forget…
Bill Miller was a star investor for many years at the helm of the Legg Mason Value Trust Fund. His fund beat the S&P 500 for 15 years straight – from 1991 to 2005.
The press gushed about this streak and made Miller into a celebrity. But Miller himself was more circumspect about his record.
In his fourth-quarter 2005 letter to shareholders, he wrote what I consider to be one of the more remarkable and eerily timed passages in the annals of finance:
You are probably aware that the Legg Mason Value Trust has outperformed the S&P 500 index for each of the past 15 calendar years. That may be the reason you decided to purchase the fund. If so, we are flattered, but believe you are setting yourself up for disappointment. While we are pleased to have performed as we have, our so-called "streak" is a fortunate accident of the calendar. Over the past 15 years, the December-to-December time frame is the only one of the twelve-month periods where our results have always outpaced those of the index. If your expectation is that we will outperform the market every year, you can expect to be disappointed.
He’s telling you the streak is arbitrary and meaningless. In fact, there were 22 funds that did better than Miller over the 15-year period but didn’t happen to beat the S&P 500 for 15 straight calendar years. And yet they worked in relative obscurity while Miller shined as the celebrity investor.
Besides the frank takedown of his own streak, the timing of Miller’s warning about being disappointed was eerie; 2005 was the last year of the streak. In the next three years, Miller’s performance fell to the bottom 1%. Not long after that, Legg Mason removed him from his post.
Think about it: Here we have a guy who was on top of the world for 15 years and then was at the bottom for three.
And since? He’s on his own now, running the Miller Opportunity Fund. In 2012, he was up 39% versus 16% for the S&P 500. In 2013, he was up 67% versus 32% for the market, then he trailed badly for two years. He’s No. 1 again this year with a 19% return versus 9% for the market. Over the last five years, he’s delivered 22% annually versus 15% for the market.
You can draw many different lessons from Miller’s saga. But the one point I’d like to sear in your mind is the simplest. I repeat: Never buy a manager just because he’s hot. (And on the flip side, don’t leave him when he’s not.)
Simple Wealth, Inevitable Wealth
I read about the Davis Advisors study and Miller’s Q4 letter in Nick Murray’s book Simple Wealth, Inevitable Wealth. Murray is a longtime investment advisor and author. In his book, he shares what he calls the “simple truths” of investing:
If one labors diligently and lovingly at this profession well into five decades – as I’ve tried my best to do – one learns an awful lot about how markets and investments really work.
Indeed. His book is a short and easy read, but Murray has packed timeless good advice inside.
To start, he has an apt analogy for investing: It’s like planting a tree.
You don’t dig it up every ninety days to check on its progress. (Nothing much will have changed in that brief time, and you might harm the tree). You don’t uproot the tree and store it in your garage over the winter, to protect it from what you regard as “bad weather.”
Give the tree enough room, enough light, and enough time. Then leave it pretty much alone…
That’s what investing is like – if you let it be.
Try to remember the tree analogy when you are tempted to cut one of your investments short or feel impatient when nothing’s happened after six months or a year.
Stocks work best when they are held a long time and you let the power of compounding turn a little into a lot. And not selling means no capital gains taxes to drag down your returns. Keep in mind the basic 100-bagger math: A 20% return will turn $1 into $100 after about 25 years.
Returns like 100-to-1 can fund a retirement, pay off a mortgage, and create lasting wealth. But to get there, you must hold on.
One motif runs through Murray’s book: Returns are more a function of how you behave than what you invest in.
For example, you may own a good stock. But then the market falls and you get scared and sell. As Murray says, “The ability to distinguish between volatility and loss is the first casualty of a bear market.”
People make the mistake of thinking a fall in a stock’s price means they’ve lost money. But the underlying value of the business may not have changed or may even have increased. The decline in share price may just be temporary, part of the normal ebb and flow of market prices.
Yet people turn these temporary declines into permanent losses – by selling.
Let’s use an example to illustrate this a little better…
Say there’s a big storm that rips through your neighborhood. It blows down trees, rips up sidewalks, floods streets, tears holes in roofs. That’s going to temporarily lower the price of your home if you sold it then.
The benefits of owning your home remain the same. You still have a spacious two-car garage. You still like your neighbors. The local schools are still good.
So would you sell your home just because the price tag on some realtor’s computer screen is lower than it was a week ago? Of course not. If you did sell, you’d be turning a temporary decline into a permanent loss.
Instead, you’ll wait for the city to plant new trees and fix the sidewalks. Wait for the flood waters to recede. And wait for the insurance companies to pay for everyone’s new roofs. And after all is said and done, home values will be right back where they were before – if not even higher because of the new improvements.
It’s the same with stocks.
As I like to say, the idea is not to own a stock that doesn’t go down because any stock can trade for any price at any time. The idea is to not own a stock that goes down and stays down.
Murray also addresses the idea of “sitting it out” because current events make it seem like a bad time to invest. He says many people fall into the trap of “current events driven” thinking. But such thinking could keep you from ever investing in stocks.
As Murray points out, let’s say it’s 1979. You could’ve stayed out of stocks because of high inflation (1979–80). Then there was a bad recession in 1982. Sit that out, you think. In 1987, stocks crash. Then the Japanese were going to take over the world (1988). Don’t forget the Gulf War (1990). Another recession in 1991. Emerging markets melted down in the Asian financial crisis of 1997–98. Stay out. Then there was 9/11 in 2001. Another Gulf War (2007). You’re still out. The global banking crisis in 2007–08. The Greek default in 2010. The debt ceiling in 2011. And the fiscal cliff in 2012…
He stops there because the book came out in 2011 (5th edition). But we could continue the list with more current events-driven fears to keep you from investing. (And we could easily fill in a lot more worries than Murray listed from 1979 to 2011!) There’s no end to it. The point is you can always find one reason or another to "justify" not owning any stocks at all.
Meanwhile, you could’ve ignored the headlines and invested. Even if you just dropped your money in an S&P 500 fund and reinvested the dividends, you’d have earned almost 12% annually through 2016.
I’ve been in the letter-writing business a long time. I always seem to get a steady stream of readers who say something like: “Well, so and so says the market is going to crash, and there is that thing in the news that could be bad. So why not wait and buy your stocks after the market tanks?”
I’ll let Murray answer it:
Let me be mercifully brief; this will only hurt for a moment. It can’t be done. No one has ever been, and no one will ever be, able to consistently time market tops and bottoms.
Three Things You Should Never Expect
I should laminate what Murray writes next and send it to readers to post on their wall:
An adviser cannot, with any consistency or precision, forecast the economy. No one can.
He cannot, with any consistency or precision, forecast the markets, much less time them. No one can.
He cannot, based on their past relative performance, forecast the future relative performance of similar mutual funds or other equity portfolios. No one can.
Be very skeptical of any adviser who claims he can do any of these things. No one can.
What to do then? Invest through the cycles. Murray has a great example where he shows how you can buy a fund that goes nowhere and still make money. In his example, you put $1,000 in the fund at $20 per share in the first month. And you add $1,000 every month for the next 24 months.
The share price of the fund starts at $20… and ends at $20. Total return: 0%. But our investor who invested monthly earned a 17.5% annualized return. How?
Because the price of the fund went from $20 in the first month to $19.50 in the second to $19 in the third… all the way down to $14 in the 13th month. That’s a drop of 30% in about a year. Then it starts to recover. By the 24th month, it’s back to $20.
But the investor, because he bought every month, accumulates lots of shares at lower prices. So, overall, he did very well over 24 months even though the price of the fund went nowhere.
You can see where this is applicable to the broader market. Murray chose his example wisely: A 30% drop in about a year is roughly equal to the average post-WWII bear market. Nothing to say the future will work out just that way, but the point stands.
(The first edition of Murray’s book came out in 1999, near the top of a major bull market. It took 13 years for the market to get back to even. But as Murray notes, his principles and advice never changed in subsequent editions. And if you kept investing regularly, as Murray advises, you’d have done well even if you started in 1999 – much like his example.)
So when do you invest?
[To build wealth] you have to buy and hold equities. Buy them, even when every talking head on TV is blathering that the market is “too high,” whatever that means. (If you think the market’s “too high” now, wait ’til you see it twenty years from now)… Buy them, at the only right time to buy them: when you have the money to invest.
Bold. And yet I think his advice is good for most people. “Money to invest” means money you don’t need to pay groceries. It’s money you can afford to leave alone for at least a few years, preferably longer.
Ever since I started in the market back in 1994, I’ve owned stocks. I never say “I’m going to sell all my stocks because the market is expensive.” That’s crazy talk to me. There is always something interesting to own out of thousands of possible stocks.
I’m always careful, selective, and patient. I leave room to buy more and keep good cash reserves for new opportunities. I’m not risking money I need anytime soon. I have no debts. Not even a mortgage. And I have a rainy day fund. So I continue to invest. When the next bear market comes, I’ll keep investing.
I’m not as optimistic as Murray. (He writes, “The fuel on which all successful wealth-building in equities runs is optimism. And optimism is the only realism.”) I think lots of bad things can happen (and have happened). I think it’s wise to prepare for rainy days and nights.
But I also believe in the power of compounding. One of the best ways ordinary people can harness that power is to own shares in good businesses and hold on to them for years.
Editor, Chris Mayer’s Focus
P.S. Some of the world’s best investors email me ideas… But until now, I haven’t been able to share them with you.
Now, for the first time, I’m preparing to share three of these ideas from my private network… And I’m so convinced they’ll pay off for you, I’m putting $5 million on the line to prove it. Click here to learn more…
In today’s Mailbag, some praise for our interview with Doug on Catalonia’s independence…
It was interesting to read about Doug Casey's view on Catalonia's independence and independence in general. I (and probably many of Doug's readers) may be interested in Doug's views on the independence of the various regions of the USA.
Also, a reader has a question regarding our recent essay on the great marijuana bull market.
The Horizons Marijuana ETF is not listed, either as HMMJ.TO or its OTC.TSX, by my brokerage (Schwab). Not sure if it’s a moral thing because they had the TSX symbol up earlier but when I called they said that was not marketed by them and now that symbol has disappeared. May be a problem other brokerages will have also. If you have one that will do business, let us all know.
Justin’s note: Thanks for writing in, Richard. While Schwab does not offer the fund, there are a few brokerages that do.
E-Trade, Fidelity, and Merrill Edge have it listed as Horizons Marijuana Life Sciences Index ETF under the ticker HMLSF. Hope this helps.
[Have you invested in pot stocks yet? If so, let us know how it’s going right here.]
Another reader enjoyed our recent essay on the opportunity shaping up in Russian stocks and is wondering if there are other ways to play it…
Thanks for your Russia comments, Justin. I always enjoy your views. If you haven’t already, read Bill Browder’s Red Notice for context. I would prefer individual stocks to an ETF. Got any suggestions?
Justin’s note: Russian stocks present a major moneymaking opportunity today. But as I said in the essay, they’re highly speculative. The easiest and safest way to bet on them today is to spread your risk around through a fund like the VanEck Vectors Russia ETF (RSX).
I don’t recommend buying individual stocks at this time. However, my team and I are hard at work researching the sector and I’ll write in the Dispatch if that changes.