This chapter brings together all the principles presented previously, to explain how a non-consensus, intrinsic value approach to investing can help to square the circle of generating returns and reducing risk via differentiated research and countercyclical investment behavior. The epic battle between active and passive investing is none other than being a contrarian. The more contrarian you are, the more active your portfolio.
By being correct, contrarian, and courageous, as well as holistic, prudent, and patient in your investment decisions, you can buy what you wanted to all along, on sale instead of paying full price, thereby improving the odds of making money instead of losing it.
Despite such desirable outcomes, few people practice non-consensus investing because going against the grain is very uncomfortable. There is no easy road to investment success, but there are some classic if counterintuitive precepts that can serve as your north star—that is what this chapter is about.
Non-Consensus Investing: A Research and Behavioral Framework to Generate Superior Risk-Adjusted Returns
Wall Street pundits and ivory tower academics have very little in common. But one thing they seem to agree on is that high returns and low risk are mutually exclusive and therefore it is impossible to accomplish both. I refuse to settle for this suboptimal choice. My non-consensus investment approach tries to square this circle by turning conventional investment norms on their head. Instead of being a dense database, it seeks to be a smart search engine. Instead of picking winners, it focuses on avoiding losers. Instead of letting our flaws become our failings, I believe we can use them as opportunities for learning and profit from them instead of suffering from them. This chapter brings all these precepts together so that a full picture emerges.
Non-consensus investing is about mastering certain intellectual and behavioral principles.
1. Being correct: understanding and not misunderstanding quality
2. Being contrarian: conducting differentiated research and investing countercyclically
3. Being prudent: avoiding losers and losses and prioritizing risk management over return management
4. Being holistic: understanding what can go right and wrong to figure out the upside potential as well as the downside risks
5. Being patient: waiting for opportunities to come your way rather than chasing them
6. Being courageous: standing resolute in the face of ridicule and backlash
Non-consensus investing is about buying what you always wanted to own but waiting for the right opportunity to present itself when others are ignoring it, misunderstanding it, or fearing it. Because you are buying on sale instead of paying full price, you improve the odds of making money instead of losing it. That is the essence of contrarian investing. It is about selling or patiently waiting on the sidelines when everyone is chasing the stock up on unrealistic expectations or unsustainable valuations; eschewing the crowded trade in favor of the lonely one and investing countercyclically instead of procyclically; waiting for clamor to give way to capitulation as sentiment waxes and wanes on different sectors, countries, or companies.
A non-consensus investor can find asymmetric risk/reward investment opportunities in many ways. Here are a few key ones:
1. Conducting differentiated research to identify what is misunderstood and therefore mispriced by the consensus.
2. Taking advantage of excessive pessimism that focuses unduly on negative developments in the near term while ignoring what can go right in the long term.
3. Investing countercyclically to other people’s investment appetite when the sentiment swings from greed to fear or reverence to repulsion.
4. Looking at pockets of the market suffering from sheer neglect.
5. Arbitraging differing time horizons, taking advantage of people’s inability or unwillingness to think long term.
Some of these attributes can exist simultaneously, as the following examples will demonstrate.
The Popularity of a Trade Is Often Inversely Correlated with Its Profitability
What is very popular rarely remains profitable, yet popular feels safe. Excessive popularity of a theme, geography, sector, or security is called a “crowded trade” in markets. This means that the crowd’s hot pursuit brings inflated stock prices, invariably making them overvalued. Markets penalize such price distortions with losses. This is why crowded trades are often doomed to failure. When too many people latch onto a trend, they bid it up to the point where valuations inflate like a balloon and are just a pin prick away from bursting.
This also explains why growth stocks tend to underperform in the long term. Their very popularity proves to be their undoing. When high expectations are built into the stock, it gets priced for perfection, and even minor setbacks cause major sell-offs. People expect that high growth to continue; if it slips—and it inevitably does—that can cause the stock to plunge. In the late 1990s, with the advent of the internet, networking-equipment stocks such as Cisco became crowded trades. They were attractive businesses with good prospects, but their high valuations provoked a meltdown. Between late 1997 and early 2001, Cisco stock went up tenfold, from $8 to $80, then crashed by 85 percent to $12 in under two years when growth disappointed. As of December 2018, Cisco stock has recovered to $43, but that still wiped out about half of net worth for those who had chased it at the start of the century.
On the other hand, an unpopular or lonely trade can be very profitable. When sellers abound but buyers don’t, stocks get marked down, throwing up bargains. A good example is the Japanese equity market in 2012. After a large and laborious market correction of 75 percent from January 1990 through December 2012, Japanese equities became so out of favor that Japan was disparagingly christened the “submerging” market, a little market humor meant to draw contrast with the high-growth “emerging” markets that were still the rage at the time. Ironically, just a decade prior, investors had craved Japanese equities as they soared 450 percent between January 1980 and 1990. Over the next twenty years, Japanese equities swung wildly from adulation to derision as the economy suffered from debt, deflation and successive downturns.
However, during those difficult years of decelerating growth and debilitating deflation, many companies swallowed the bitter pill of restructuring and deleveraging to become more competitive, profitable, and resilient. These efforts paid off. Leading companies such as Canon and Kao went from sprawling conglomerates to more streamlined businesses and from net debt to net cash. In addition, many younger companies such as Murata and Keyence leveraged their technological expertise in electronic and industrial components to become market leaders in their respective industries. Companies such as Daito Trust Construction developed new manufacturing techniques to reduce the need for manual labor in the housing-construction industry. Nomura Research Institute developed and offered infrastructure and software as a service, well before it became a buzzword in Silicon Valley. Last but not the least, corporate governance improved, with companies raising their dividends and/or share buybacks to return surplus cash to shareholders.
Ironically, these structural improvements did not attract much investor attention. Investors had experienced so many false starts in the country that they had become weary and wary (an example of the anchoring bias we learned about in chapter 9).
An unprecedented natural disaster in 2011, the costliest in Japanese history, coupled with a weak economy and strong yen were hurting near-term earnings, further sapping investor appetite. So, despite the substantive progress by the corporate sector, sentiment remained sour, and many blue-chip stocks were available at depressed values. This combination of high-quality businesses trading at large discounts to their intrinsic business worth created an attractive setup. Many Japanese equities were both underearning and undervalued, simultaneously offering low risk and high returns.
Around the same time, emerging markets had become a very crowded trade as investors were drawn to their high growth (while ignoring their high risks). While there were many attractive companies in emerging markets, my research revealed them to be overvalued relative to their business worth, so I avoided them. On the other hand, in true contrarian form, I scooped up many out-of-favor Japanese gems at bargain prices.
I was not surprised when the Japanese market, which was priced to submerge, stunned market participants by soaring 52 percent from 2012 to 2015, while the much-sought-after emerging markets declined 2 percent in dollar terms (figure 12.1). A $100 investment in the lonely trade (say an ETF mirroring the Nikkei 300) would have become $152, while going long the crowded trade (say an ETF mirroring the MSCI emerging market index) would have resulted in a decline to $98, a difference in performance of more than 50 percent.
There is a profound difference between a depressed market and a distressed asset. “Depressed” refers to a temporary dislocation driven by antipathy or indifference rather than permanent dysfunction. The short-term fundamentals diverge and disappoint, but the long-term prospects and capabilities remain intact. When neglect or pessimism becomes widespread, it is natural for multiple investment opportunities to emerge from a single thesis and for an entire sector or subset of the broader market, or even the market itself (Japan in our earlier example), to go out of favor. This is what I call a depressed market—earnings expectations and what investors want to pay for them are repressed.
“Distress,” on the other hand, refers to a real danger that could prove fatal. A distressed asset is typically a low-quality business that I would not own at any price, including a distressed one. You can take advantage of a depressed market by investing in it countercyclically. But a distressed asset, even if it is optically cheap, is more likely to take advantage of you.
The weak performance of derivative exchanges such as Deutsche Börse is a good example of a depressed market opportunity that emerged several years ago in 2012 in Europe. Exchanges thrive on transaction activity in various financial markets, such as equities, index futures, interest rate swaps, and the like. In the wake of quantitative easing, volatility decreased dramatically, reducing the need for hedging as markets moved in a singular direction. This hurt transaction activity and near-term earnings, which in turn caused their stocks to lag.
However, I knew that such low activity levels were unlikely to last forever, and as they rose, so would their earnings and stock price. Six years later as of December 2018, the stock had doubled while the BE500 (European equivalent of the S&P 500) benchmark was almost flat. This is a good example of high returns without necessarily taking on high risk. It also demonstrates how active stock picking can generate returns, compared to investing passively in an index fund that mirrors a benchmark like the BE500 that has yielded practically no returns over the same timeframe.
Many international banks are examples of distressed assets, especially in Europe. While American banks have recapitalized in the aftermath of the 2008 financial crisis and now boast surplus capital, many of their European counterparts remain undercapitalized and should be viewed as distressed. I have avoided owning these international banks as their headline “cheap” valuations are a trap. Just because they are out of favor and nobody wants them does not mean you should chase them.
Another example of distressed assets is highly leveraged companies. Their bonds are typically rated below investment grade. Often, they sport a cheap multiple and appear to be a bargain, but do not fall for such optical illusions. Leveraged companies are highly risky, and equity investors should avoid them. Some would argue that the risk is accounted for in the cheapness of their valuations. I disagree. Risk is risk. Just because you are avoiding valuation risk does not give you a free pass to take on massive balance-sheet risk.
One word of caution with respect to owning depressed markets: It is not a license to go long on a wholesale basket of such stocks or sector or geography. Careful stock picking remains paramount, as the quality of business models and discounts to intrinsic worth vary even within the same sector or country. While taking advantage of a substantial portion of the market where value clusters, you must be careful not to cross the line from constructing a highly selective bottom-up portfolio to turning it into a thematic portfolio. Curation is critical to exploiting the power and payoff of non-consensus investing; what you leave out is as important as what you put in. A big loser in the basket can negate the gains from the winners.
Wait for the Sentiment to Swing—from Good to Bad, Greed to Fear, Clamor to Capitulation
For contrarians, bad news is good news because it gives you the opportunity to own something you always wanted to, except now you get to pick it up when you are being paid to take the risk of adverse developments. Crowds tend to buy stocks where good news is playing out and priced in, but no company or country or industry is immune from bad news. Wait patiently and let the investment opportunity come to you instead of chasing it.
For example, in Mexico in 2012, after the election of President Enrique Peña Nieto, which returned the Institutional Revolutionary Party to power after a twelve-year hiatus, the Mexican stock market became a favored investment destination, especially among investors focused on emerging markets. The regime change was expected to boost economic reforms and growth. This positive outlook contrasted dramatically with the economic and political disarray that investors expected in Brazil, where the unraveling of a corruption scandal led to the president’s impeachment and caused the economy to spiral down into a full-blown recession. Unsurprisingly, by late 2015, the Bolsa Mexicana index was trading close to its highs (up 40 percent from the lows it had reached in August 2011) while Brazil’s Bovespa index was on its knees (down 35 percent from the highs it had reached in March 2012). I avoided the popular and expensive Mexican stocks and instead bought inexpensive, out-of-favor Brazilian stocks such as Itaú bank.
A few years later, the tables had turned. Fresh elections in Brazil led to a more market-friendly president being voted in. On the other hand, an unexpected and protracted oil slump caused Mexican stocks to drop. In addition, over the prior few years, the Mexican peso had depreciated by more than 50 percent, reducing the probability of further falls (it is typical for a currency to stabilize after a large devaluation). This dramatically improved the risk/reward of the investment because both valuation risk and currency risk had diminished.
In the meantime, as prospects and sentiment recovered in Brazil, Itaú bank stock had gone up a lot. I took profits there, as investors had priced in the good news and were increasingly overvaluing the stock. Several months later, in early 2017, I used the proceeds to buy Walmart de Mexico, which had become a fallen angel as investors priced in bad news, making it undervalued. Over the next two years, Walmart de Mexico ADRs (American Depositary Receipts traded in the United States) went up 100 percent in dollar terms.
I tell you this story to illustrate how active management can win in the marketplace:
1. By actively redeploying capital from overvalued to undervalued stocks, it makes money for clients.
2. By contributing to fair-price discovery and reducing price distortion, it gives the market what it wants, which in turn rewards it for performing this double duty.
Long-Term Horizon: A Flower Is Far More Valuable Than a Seed
In investing, a difference in time horizons alone can yield payoffs, not just a difference in your research. Very often, perfectly sound investment ideas are left by the wayside because there is no immediate catalyst in sight to warrant an upward rerating. If a stock lacks near-term momentum, the investment community often shuns it, as it tends to be obsessed with instant gratification. Those who can tolerate delayed gratification can benefit from such shortsightedness. Instead of buying and selling seeds, you wait for the seed to blossom into a flower. A little patience creates a lot of value because a flower is far more valuable than a seed. Do not leave this money on the table. In a world filled with short-termism, a long-term horizon can be a reliable source of excess returns.1
Markets need to reward people for postponing consumption. The longer you give up your use of money by setting it aside, say in a time deposit instead of a checking account, the higher the interest rate you will earn for forgoing its immediate use. This is how patience puts more money in your pocket and why a long-term investment horizon is the only free lunch in investing.
Cultivating patience is especially important in non-consensus investing. Even if your thinking is correct, it takes time for non-consensus calls to become consensus. In the meantime, you must learn not to capitulate. Temporarily, it makes you look foolish, even though you are not. This takes character and courage, and it is one among the many reasons that investors do not practice non-consensus investing, even though in my view, the pros outweigh the cons.
No Good Deed Goes Unpunished
Besides patience being in short supply, there are several other reasons why investors fail to take advantage of contrarian investing despite their potential for delivering superior returns with lower risk.
Prime among them is that contrarians are guilty until proven innocent, and their proof statement comes much later. Investment theses take time to play out, and the more non-consensus your views are, the longer it takes. In the intervening period, you are often in solitary confinement. This is a tough pill to swallow. To add insult to injury, you are always the defendant, never the plaintiff. The burden of proof is on you, while the benefit of the doubt is given to the status quo.
Second, short-term pain precedes long-term gain, and few have the stamina for it. Even if contrarian managers are doing right by their clients by avoiding risky crowded trades, they are dropped like a hot potato when their performance fizzles while the benchmark sizzles.
Jean-Marie Eveillard of First Eagle Funds faced this in the late 1990s when he underperformed the benchmarks by refusing to invest in expensive and risky tech stocks. Legend has it that in less than two years, his investors redeemed in droves from the mutual fund he was managing, which went from over $6 billion in assets to just under $2 billion at the end of 2000. When a top executive at his parent company told him that if that continued, he would no longer have any money in his fund, he replied, “I’d rather lose half of my shareholders, which I did, than half of my shareholders’ money, which I did not.”
Those who stood by him reaped the benefits. His fund outperformed handsomely in the bear market that followed. In 2003, he went on to receive a Fund Manager Lifetime Achievement Award, created by Morningstar to recognize “mutual fund managers who throughout their careers have delivered outstanding long-term performance, aligned their interests with shareholders, demonstrated the courage to differ from consensus, and shown the ability to adapt to changes in the industry.”
Third, human beings are social creatures who crave company. In fact, we are genetically predisposed to seek strength in numbers because it protects us from predators in the physical world. Nature programmed us to stay with the pack, not stray from it. In the intellectual world of investing, this urge proves very counterproductive, to the point of being self-destructive. Contrarians, on the other hand, are typically iconoclasts, which also makes them outcasts. They do not fit in; they stand out. Most people find it hard to be contrarian; it goes against their very being.
Fourth, we humans prefer to take the path of least resistance, whereas non-consensus investing demands the path of most resistance. It is tough to buy when everyone is selling and sell when everyone is buying. Even Stanley Druckenmiller, a proven veteran investor (and my former boss at Soros Fund Management) who has the distinction of delivering 30 percent annualized returns per annum over a thirty-year career, confessed to this in a Bloomberg interview on December 18, 2018: “I have never made a buy at a low that I didn’t feel terrible about and was scared to death making. It is easy to sell at the bottom. You can go home that night and it relieves you of your nerves. But when you follow a process of investing based on reason and analysis rather than on emotion or by following the crowd, you will soon know and understand that you are on the right long-term path.”
Finally, when you march to your own tune, nobody except you can hear the music. Everyone else is dancing to a different song, and you will look awkward and out of sync while everyone else will appear graceful. When your portfolio is positioned differently and your views are not yet playing out, your performance will struggle and make you look out of step. Few can tolerate this kind of discomfort; most find it easier to simply march to the same drumbeat by following the crowd.
Sometimes, this profession can be cruel and gut-wrenching. If you have selected non-consensus money managers to handle your investments, support them with patience and approval—and maybe some brownies from time to time! Being a contrarian can be hard and lonely. Support groups have proven their worth for people going through tough times, and investing is no different. It is important to connect with like-minded investors to help you stay the course. Feel free to visit my website, www.nonconsensusinvesting.com, to swap notes. I may also post some exclusive content, investment puzzles, inside scoops about the book or what I am up to—so check in from time to time.
Get Performance, Not Fashion Statements, with Your Portfolios
Herding, crowded trades, and momentum employ a common ruse: they offer the seduction of a chase that gets even more alluring when more join in. Mob psychology takes over in crowded trades. An auction-like frenzy develops, where the thrill and adrenaline of outbidding overtake the dispassionate evaluation of what something is worth. The non-consensus investor treats markets as a shopping mall where things periodically go on sale as opposed to an auction house where you must bid the highest price to get what you want. By waiting patiently for your desired items to be discounted, you can get what you want and not pay up for it.
“The non-consensus investor treats markets as a shopping mall where things periodically go on sale as opposed to an auction house where you must bid the highest price to get what you want.”
In investing, you should cast your net wide in any pocket of the market or part of the world that is suffering from neglect, pessimism, or misguided fears. These tend to be fertile grounds for generating high returns with low risk, provided they meet the tests of high quality. You can always count on something to go wrong somewhere and provide contrarian opportunities. Your job is to figure out whether what has gone awry is temporary or permanent.
Whenever investors pursue a fad or a fetish, there is usually money to be made by looking at the opposite end of the spectrum. Often when investors favor U.S. markets, opportunities surface in neglected international markets. When some sectors are in vogue, it pays to direct your attention to sectors that are being ignored. If small caps are in much demand, moneymaking opportunities may lurk in mega caps.
If these examples sound too obvious, try this: Look at companies you are researching with a different lens or barometer. The recent craze to own companies with hyper growth may have left the door wide open for contrarians to invest in companies with sturdy growth. For instance, over the last few years while investors were chasing heady growth and bidding up the FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks, they were in my estimation overlooking and mispricing the MAANG (Michelin, American Express, Amdocs, Nippon Telephone, and Gilead)—companies with steady growth but not in as much vogue.
Another obsession afflicting the market is the fixation toward passive and away from active. Such a polarized crowded trade, in my view, sets the stage for a strong comeback of truly active money managers. I believe the pendulum is likely to swing away from passive strategies when investors realize they cannot rely on beta (broad equity market exposure) alone to generate compelling absolute returns. They will have no choice but to seek performance from alpha (idiosyncratic returns that can be derived from superior stock picking). In financial speak, beta is systematic risk that is reflected in the benchmark’s returns; alpha is the extra (risk-adjusted) return generated compared to a passive benchmark. Only active managers have the potential to generate alpha because the benchmark cannot, by definition, exceed its own returns. As I point out later in this chapter, benchmark returns are likely to be low or negative in the coming years as rich valuations and weak balance sheets cap the upside. If you do not want to resign yourself to such unattractive returns, you owe it to yourself to explore active investing.
However, even the few who are brave enough to invest actively are falling for another herding trap: favoring quantitative (quant) approaches over qualitative ones. Quants have driven a wedge between passive and active by occupying the middle ground. Note that passive is itself a quant approach that replicates “dumb” beta, while quant or factor-based investing tries to offer “smart” beta to generate alpha. By being different from the benchmark, quant can call itself active.
Quants have curried favor with investors by highlighting the scientific and algorithmic modeling that underpins their investment decisions compared to the more eclectic and artistic approaches of stock pickers. This preference for precision has all the makings of yet another crowded trade. It offers the illusion of proof via back testing; stock picking, in contrast, cannot explain itself as a neat formula or set of rules. While I appreciate the difficulty of comprehending the art of stock picking, that does not mean it is an inferior approach, just a different one.
Think of stock pickers as jazz musicians and quants as musicians who play classical compositions. Classical musicians faithfully follow notations in sheet music, but jazz musicians follow their finely honed instincts. Jazz is not about reproducing someone else’s musical score but composing one’s own tune. It is constantly adapting and improvising, not scripted or formulaic. Yet despite that, it never descends into cacophony, always rendering a soulful melody. Non-consensus investing is akin to playing jazz. It is not a regurgitation of the consensus view or readily available information but a quest for originality to develop differentiated insights. It is opportunistic yet disciplined. It constantly adapts and iterates to find overlooked or misunderstood investment opportunities to generate superior risk-adjusted returns.
While quants use computers to decipher relative value, non-consensus investors use judgment to figure out intrinsic value. To think of one as superior or inferior is to miss the point. The two are simply different approaches, and if they stay true to themselves, each can render a good performance (although as I pointed out in chapter 10, I would caution against thinking of relative value as value investing).
I think it is no coincidence that jazz is an American invention. American ingenuity and entrepreneurship are the envy of the world because, like jazz musicians, we dare to improvise. Creativity has been the foundation of our economic success and is the key to our investment success as well. Of course, like entrepreneurship, stock picking is hard. It is neither error-proof nor stress-free. Failure is a by-product of greatness, and just as many entrepreneurs fail, so do many active managers. However, just as a society in which everyone wants to be an employee and nobody aspires to be an entrepreneur would become stagnant instead of vibrant, a market where everyone invests passively and avoids taking any active risk becomes static, not dynamic.
The prevailing negative view of active investing reminds me of the premature and incorrect verdict passed on American capitalism after the great financial crisis of 2008. Not only has the American economy recovered, it has prospered, thanks to the very capitalism it was criticized for. From shale fracking to gene-splicing, American enterprise continues to push the boundaries of innovation to develop an original symphony like no other. Stock picking (aka truly active investing) is no less an expression of individual creativity and ingenuity than jazz or entrepreneurship—and in my opinion, destined to be just as successful.
Active Investing Is Dead: Long Live Truly Active Managers
As of February 2019, the S&P 500 index traded at 2800, more than tripling in value from the market lows of March 2009. A disproportionate amount of this increase has come from valuations going up rather than earnings or free cash flows going up. As a result, equity markets are richly valued on a variety of methodologies, such as those used by Nobel Prize–winning economists Robert Shiller and James Tobin, investment gurus like Warren Buffett, or independent analysts such as Stephen Jones. All of them point in the same dismal direction: future expected annualized equity-market real returns in the United States are likely to range between +2.5 and −4 percent as shown in figure 12.2.2
FIGURE 12.2 Ten-year projected S&P 500 real total return as of December 2018, using widely respected methodologies
With the U.S. ten-year government bond yielding close to 3 percent as of December 2018, equity indices will have a tough time competing against fixed income—not to mention, who wants negative returns? Investing passively in equities means you lock in such potentially low or negative returns. This is a potentially dire outcome for many pension plans and retirees who have expected and assumed far higher returns (about 6 to 8 percent) on their equity portfolios. Before you despair, remember there is an alternative—active investing.
Not only has truly active investing delivered outperformance in the past,3 it is likely to continue to do so in the future because the opportunity set is larger. The excessive popularity of passive and the diminishing proportion of active have made markets less efficient, creating more moneymaking opportunities for truly active managers.
“The excessive popularity of passive and the diminishing proportion of active, have made markets less efficient, creating more money-making opportunities for truly active managers.”
Your goal, therefore, should not be to give up on achieving higher returns than the benchmarks, but to pick those money managers who are truly active (recall the distinction in performance of faux active managers versus truly active managers from chapter 4). Yet investors continue to choose passive because of their singular focus on lower fees. This is a case of the tail wagging the dog. The goal of investing is to generate the highest returns with lowest risk, not to incur the lowest fees. Most pension funds and retirement nest eggs remain underfunded and will need higher returns than passive investing can potentially deliver in the decade ahead, if the expert forecasts of low to negative real returns in the S&P500 are right. Those managers and investors would be wise to follow the example of the man I consider the dean of active investing, David Swenson, who oversees Yale University’s $29 billion endowment, which has generated outstanding results by astute asset allocation supplemented by use of talented active managers. According to their website, over the past thirty years ended June 30, 2018, Yale’s investments have returned an unparalleled 13.0 percent per annum, adding $31.6 billion in value relative to the Cambridge mean. Relative to the median endowment, Yale’s superior active manager selection contributed an additional 2.4 percent of outperformance per annum. Incidentally, this 2.4 percent outperformance corresponds very well to the findings of the studies done by Professors Cremers and Petajisto referenced in chapter 4.
Passive: Penny Wise, Pound Foolish?
As I have said before, I am not against passive per se. I think John Bogle, the pioneer of low-cost passive investing, rightly called the bluff of money managers who pretended to be active but were not (such as the closet indexers or low active share managers referenced in chapter 4). Markets need healthy competition, and consumers should have choices. My concern is that the pitch on passive has become so one-sided (everything else is inferior) and one-dimensional (low costs) that investors do not see the full picture. Investing your own savings or overseeing someone else’s is too important to not hear all sides, especially the dark side of passive investing.
Investors see the active-versus-passive debate primarily through the lens of cost, but it should also be viewed through the lens of risk. To refresh your memory on the litany of risks I outlined in chapter 2, here is a recap:
1. Crowded-trade risk
2. Valuation risk
3. Redemption risk
4. Liquidity risk
5. Front-running risk
6. Permanent-impairment-of-capital risk
7. Behavioral risk
8. Momentum risk
9. Reflexivity risk
10. Market-inefficiency risk
Popular Wisdom Is Often a Contrary Indicator
It is worth recalling the pronouncement on the cover of Business Week magazine in October 1983: “The Death of Equities.” This popular view not only proved ill-timed, it proved dead wrong. Equities went on to deliver their best returns in the decades ahead. I believe that the October 2016 Wall Street Journal headline “The Dying Art of Picking Stocks” will prove equally ill-timed and incorrect.
Passive is typically a bull-market phenomenon, when equity markets are delivering high absolute returns as they have done in the past decade. Active tends to do better in bear or choppy markets, which is where I believe we are headed. The contrarian in me would argue that you should consider seeking the other side of the trade when others are unwilling or unable to step up to the plate. In figure 12.3, notice how the pendulum swings over the decades—historically when the majority of active funds underperform passive over a five-year rolling period, it tends to mark a bottom, which then sets itself up for a dramatic reversal.
FIGURE 12.3 Percentage of funds (and fund assets) outperforming S&P 500 on a five-year basis Note: The figure shows the percentage of U.S. active equity mutual funds (black line) and fund assets (gray line) outperforming the total return of S&P 500 based on trailing five-year performance, after fees. Funds are those in existence for five years or more and include U.S. growth, growth and income, and income funds (based on CRSP fund-objective code). For percentage of fund outperformance, only funds with more than $100 million in total net assets are considered. Percentage of fund-assets outperformance is calculated as the ratio of total net assets of U.S. active equity funds outperforming the S&P 500 over total net assets of all U.S. active equity funds. Period of analysis is from January 1970 through December 2018. Source: CRSP, Bloomberg, Robert Shiller data, Nomura—Instinet, Joseph Mezrich.
Keep in mind that investors need to put trillions of dollars to work in equity markets. The capacity of any active manager to manage assets is in the billions if not millions. Just as any popular sporting event or concert with limited seating capacity sells out quickly, active capacity is equally limited and could fill up quickly. Better to dig your well before you are thirsty and get those soon-to-be-coveted truly active money managers before they are full up and close their doors to new clients.
For Every Boglehead, There Needs to Be a Contrarianhead
In my view the epic battle between active and passive is none other than that of being a contrarian. The definition of passive is to toe the benchmark, while active is about being different from it. The higher the active share, the greater the disagreement with the benchmark of what is mispriced (undervalued or overvalued) and needs to be arbitraged to its fair price, thereby restoring efficiency to markets.
While this book seeks to pay homage to equities as an asset class and to truly active investing as an investment approach, it does not guarantee that they will always beat the competition for all time to come. From time to time, when the sentiment swings too far in one direction, it may be appropriate to take the other side of the trade. When I was putting the final touches on my manuscript in early 2019, fixed-income and passive approaches dominated investment preferences if not allocations; equities and active investment approaches were still viewed with skepticism. By the time you read this book, that trend may have abated or even reversed. My core message is on the power and payoff of non-consensus investing and how it can help to improve the risk and return profile of an investment decision. It is one among many ways to approach investing. The decision of what makes sense in your circumstance is ultimately yours. I am merely presenting a choice, hopefully a compelling one.
I did not write this book to champion one asset class or investment approach at the expense of the other, but to ensure that all sides are heard. It is true that not all active managers can outperform the market; after deducting fees and expenses, it is mathematically impossible. And by definition the sum of all active is passive, which is the market itself. However, this notion has been taken too far that no active manager can outperform markets. Everyone can’t be above average, but that does not mean nobody is.
I hear so many investors talking up the virtues of passive and the vices of active but failing to consider the other side. Passive is increasingly perceived and pitched as the default choice, which is a short distance from becoming the only choice. When you take away choice, you take away freedom. Without the freedom to choose, democracies turn into dictatorships and markets become pawns of flows rather than fundamentals. This is not good for markets or society. We owe it to ourselves to consider all points of views—especially the non-consensus and counterintuitive ones—before passing verdicts of right or wrong, good or bad. Passive is a prisoner’s dilemma; if everyone chooses it, everyone is likely to be worse off. Just as democracies need plurality to prosper, markets need diversity (of views) to flourish. In my view, for every “Boglehead”, there is a role and room for a “Contrarianhead”.
Top Takeaways
Investment opportunities abound if you know how to look for them. This book describes a road map that has proven useful to me in different types of market environments—bull or bear, developed or emerging, domestic or international, new or old economy led as well as in small to mega caps. I have shared my practitioner’s perspectives and insights on how to spot opportunities and improve the odds of making money instead of losing it. No insight in and of itself is a silver bullet, but together they can pack a powerful punch. Here is a recap of the top ten precepts underpinning the practice and payoff of non-consensus investing which are explained throughout the book:
1. Counterintuitive thinking can help to crack the code of delivering the “and” proposition in investing,
2. Conduct differentiated research that is correct and proves the consensus wrong
3. Get the biggest bang for one’s research buck by scoring upset victories
4. Avoiding losers and losses is more important than picking winners
5. Misunderstanding quality could be the mother of all mistakes as well as the mother lode of all opportunities
6. Connect the dots that others have not and buy quality on sale
7. Avoid behavioral biases and emerge a victor instead of a victim
8. Know what you are getting, not what you are paying
9. Lose the battle and win the war
10. Non-consensus investing can serve as your north star as you walk down “the road not taken.”4
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1. A long-term horizon benefits from a statistical concept known as the square-root-of-time rule, sometimes used in conjunction with the term “time diversification.” The latter suggests that, on a relative basis, more volatile assets become relatively less risky over time. The square-root-of-time rule dictates that while drift (expected return) grows linearly with time, standard deviation grows more slowly at the square root of time. In other words, volatility dominates the return-generating process over short periods of time, but in the long run drift eventually emerges as the more dominant factor as noise washes out.
3. Recall the study referenced in chapter 4 that showed that truly active managers beat passive by more than 2 percent per annum on a gross basis.
4. “The Road Not Taken” is a poem by Robert Frost, published in 1916. Although there are many interpretations, to me it champions the notion of following your own path, especially one that few would have dared to choose, and how game-changing that can prove to be. The poem begins like this: “Two roads diverged in a wood, and I took the one less traveled by, and that has made all the difference.”