‘There is only one road to human greatness: Through the School of Hard Knocks’
School teaches us the 3 Rs; reading, (w)riting and (a)rithmetic.
Armed with these basics we head off into the fourth R — the real world.
The 4th R remains our lifelong tutor in all facets of our lives. Relationships, parenting, business, community, money, careers, health.
The school of hard knocks teaches us far more about success and failure then any formal education ever could.
One of my disappointments with the education system is that it pays scant regard to financial literacy.
While reading The Grapes of Wrath is fine, learning to read a balance sheet, prepare a budget, understand the traps of investing, and manage credit is, to me, just as important as literacy itself.
Without any formal education on financial literacy, where do most people learn how to manage money? Mostly from their parents. As cruel as this sounds, generally this will be a case of the blind leading the blind.
The other main source of financial literacy in the real world is the investment industry. With layers of conflicting interests, misinformation, commissions and lack of independence the investment industry hardly qualifies as the most reliable source for knowledge on long term wealth creation.
After nearly 30 years in the investment business, this is what I’ve learned about how to build and retain wealth. And the beauty of these lessons is that none of them is rocket science.
Buy low and sell high
Yes, I know this sounds so simple and hardly worth mentioning.
Yet the majority break this basic rule. The data of funds flow in and out investment products show the greatest inflow of funds occurs when a sector is red hot (over-valued) and the biggest outflows when an investment has tanked. While buying low and selling high sounds simple, very few people actually put it into practice.
Charlie Munger (Warren Buffett’s business partner) said the secret to successful investing is, ‘you need a margin of safety.’
The lower a share price is below its intrinsic value, the greater the margin of safety in the transaction. The same principle applies to property. Buying a property at a substantial discount to its replacement cost builds in a margin of safety.
When it comes to shares this is easier said than done. The average investor is clueless when it comes to the intrinsic value of a company. Which is why they tend to buy high…investing based on pure momentum and hype.
Fortunately there is an indicator that provides long term value investors with a guide to the intrinsic value of the US share market (the market that casts a shadow over the rest of global markets).
That indicator is known as Tobin Q.
The Q ratio, developed by Nobel Laureate James Tobin, is the total price of the market divided by the replacement cost of all its companies (data obtained from the quarterly Federal Reserve Z.1 Financial Accounts for the United States).
The current Tobin Q ratio is 1.09. This means companies are trading at a 9% premium to their replacement costs. In other words, overvalued.
The current reading is the second highest in the Q Ratio’s 115 year history. The only higher reading was prior to the dotcom implosion in 2000.
Just prior to the onset of The Great Depression, the Q Ratio registered 1.06 — lower than the current reading. That should be a warning signal in itself.
The lowest reading was 0.28 in 1982…companies were trading at a massive discount of 28% of their replacement cost. Now that’s what you call a margin of safety. This historic low reading was at the end of the 1968 to 1982 Secular Bear market and at the start of the greatest Secular Bull market in history. Perfect timing.
Buying low requires knowledge and nerve. Whereas buying high shows ignorance and impulse.
Being in the right asset class at the right time is 9/10ths of investment success
Roger Ibbotson( professor of finance at Yale School of Management) and Paul D Kaplan (director of Morningstar Centre for Quantitative Research) released an extensive study on the importance of asset allocation to investment success. The report concluded with:
‘…our analysis shows that asset allocation explains about 90 percent of the variability of a fund’s returns over time…’
The asset class — shares, property, fixed interest, precious metals — largely determines your outcome. For example, from 1982 to 2000 US shares returned 1400% whereas gold lost 65% in value. Being in the right asset class at the right time is crucial to long term wealth creation.
Which is why it is important to understand value. How much margin of safety is there in a particular asset class before you decide to commit your hard earned cash? Relying on your garden variety financial planner — who has a monthly sales target to meet — is unlikely to make you any the wiser on the level of downside in an asset class. You need to do your homework.
For instance, as an outsider looking in, the Sydney and Melbourne property markets appear to be very fully priced and have absolutely no margin of safety. In my opinion, these markets are a high risk/low return proposition. I suspect we’ll see a lot of pain in the next few years from those who borrowed too much to chase the price momentum in these property hotspots.
Passive versus active management
The funds management business is a multi-multibillion dollar industry. Managers with skill sets ranging from useless to exceptional are all looking to attract the investor’s dollar.
The more dollars under management, the greater the fees generated and the higher the capital value of the business.
All managers try to outperform the index relevant to their management style. Most fail…but they charge their investors handsomely for this failure.
The latest S&P Indices Versus Active Fund report (SPIVA) stated (emphasis mine):
‘As we lengthen the time horizon, underperformance strongly tends to increase. While 60 percent of large-cap active managers underperformed over the prior 12 months, 85 percent underperformed over the prior 36 months and 87 percent did so over the prior 60 months.’
Nearly 90% of active fund managers cannot beat the index over a five year period.
Then we look at the ‘masters of the investment universe’, hedge funds…an even more expensive fund management product.
According to the authors of The Investor’s Guide to Hedge Funds:
‘…attrition studies have shown about 30 percent of new hedge funds do not make it past three years, while yet another study found that 40 percent of hedge funds do not make it past 48 months.’
The latest Lyxor Research reports ‘Hedge Funds have underperformed over the last six years’. The point to note here is the report is based on the performance of those funds still in business…the survivors. Failure to account for the losses from the failed hedge funds, is known as ‘survivor bias’.
In other words, the data excludes the failures.
What happens if you add in the performance of those funds that have shut up shop?
According to The Investor’s Guide to Hedge Funds:
‘…studies have concluded that survivor bias in hedge fund data has a 2-3 percent impact on annualised performance…’
Deduct another 2–3% per annum from the reported hedge fund performance data and the truer picture is these so-called ‘masters of the investing universe’ have universally let their investors down.
With nearly 90% of active managers failing to beat the index and the majority of hedge funds struggling to add any value, investing in a low cost index fund is an obvious choice.
But the average investor — persuaded by the tied sales forces of the active managers — continue to overpay for underperformance.
If you boil it all down, the school of hard knocks has taught me to keep it simple.
Look for value. If it is not there, then wait.
Learn to ignore the hype.
My golden rule is that, the more hype about an investment (share, property, emus, tulips etc.), the more likely it’s over-priced and ripe for a fall.
When you do identify value, DO NOT invest in managed funds…you will pay for underperformance.
Invest in low cost Index exchange traded funds (ETFs).
The vast majority lack the literacy to read the signs the market is sending them.
When the next financial crisis hits, they’re going to react with primal instinct and panic. Without an established set of principles to guide them, they’re going to pay significant ‘school fees’ to learn some very painful financial literacy lessons.
The principles outlined above are the ones I am using to guide subscribers to The Gowdie Letter through the financial minefield that lies ahead. Knowing the principles is one thing. Knowing when and how to apply them will be the real key to our success.
Editor, The Gowdie Letter