“There remains an illusion among investors, especially professional money managers and analysts, that with enough digging and number-crunching, uncertainty can be conquered.” Unfortunately, it can’t.
That’s the thrust of one of the best essays on investing I have ever read. The essay is the October letter to clients from Sam Mitchell, managing director of Marshfield Associates, a Washington money-management firm that has produced one of the best records in the nation in recent years.
Marshfield’s stock accounts returned an annual average of 7 percent for the 36 months ended Sept. 30. That compares with an annual loss of 13 percent for the benchmark Standard & Poor’s 500-stock index. An investment of $10,000 in 1992 rose to $52,000 (before relatively modest fees) this year, compared with just $24,000 for the S&P. Marshfield is generally considered a value-stock shop, though that term (which connotes a bargain-hunting bent) is far too simplistic for the philosophy the firm espouses. And, indeed, Marshfield has clobbered the Russell 3000 value index in recent years as well.
Mitchell’s October letter is brutally honest, accurate and very disturbing. But, for investors with discipline and common sense, it offers hope at a daunting time.
The argument is that investing is fraught with uncertainty, with real risks. The world of business is complicated and unpredictable, and, as Mitchell writes, “the attempt to develop accurate forecasts of earnings or market prices is a fool’s errand.” Successful investors figure out strategies, not to overcome risk, but to live with it.
Still, Wall Street and Main Street abound with people who think the key to picking winners is to scrutinize income statements more carefully or to build better financial models. But, “no matter how strenuous and ingenious, efforts to slay the uncertainty dragon have always resulted in disappointment, anger, sub-par returns and occasionally criminal behavior.”
This is the essential nature of stock investing: It’s a dark and risky place. But, as Mitchell puts it, “if investors are to earn a return above the risk-free rate, they have no choice but to invest in securities whose returns are not guaranteed.” In fact, stocks have, for the past 76 years, earned a return that, in the average year, is 5 or 6 percentage points higher than the risk-free rate. You don’t get returns like that without taking risk.
Stock investors, especially since the early 1990s, have seen high returns as an entitlement. And politicians – as well as some journalists – play into these false expectations, promoting the notion that the only reason people lose out in the market is that someone is cheating them, or not telling them enough about the inner workings of companies. But such concerns are really a distraction. The nature of business is deep uncertainty.
Mitchell is not merely saying that stocks lack a money-back guarantee. He is saying that, when it comes to specifics on how a company will perform, hardly anyone knows anything.
“Managements themselves can tell only in rough terms what their profits are going to be from quarter to quarter,” he writes. “As for what their numbers are going to be in a year, they are only slightly less clueless than the rest of us.”
So what should stock investors do in the face of such uncertainty?
First, understand what you can know. Good managers, writes Mitchell, can tell investors “what they are doing to create and capture enough value to earn high cash returns for a long time, but it is unrealistic to expect them to know the precise timing, magnitude and results of their efforts.” With these basics, it’s possible to construct a reasonable range of earnings and cash flow over time – and, thus, come up with a range of values for a stock.
Second, realize that psychology plays a big role in the price that a stock carries in the short term. “We are always amazed,” Mitchell writes, “at how fast and how much investor attitudes toward a company can change. Like schools of sardines, investors seem to change their perceptions all at once.”
Warren Buffett’s mentor, Benjamin Graham, observed this phenomenon long ago and developed a useful metaphor: Mister Market, a manic-depressive who sometimes gets so giddy he will buy your stock at a ridiculously high price and sometimes gets so depressed that he will sell you his own stock at a ridiculously low one.
“While prices tend to gravitate over the long run around a reasonable range of economic value, they can fluctuate much further above or below this range than a rational observer would anticipate,” writes Mitchell.
So here are five Marshfield aphorisms to cut out and stick on your refrigerator door:
“1. Attempts at precision are futile (this means that 90 percent of what Wall Street tries to do is a waste of time).
“2. Buying a stock when investors are optimistic increases the probability of failure (and vice versa).
“3. There is no way investors can avoid the possibility that the value of their investment will plummet shortly after purchase, no matter how careful they have been.”
“4. Success or failure is random in the short run (a couple of years, minimum), and lack of patience is a recipe for failure.”
“5. Fear is just as deleterious to wealth building as greed.”
Fear, I don’t have to remind you, is rampant today. So what has Marshfield been buying lately for its clients? Here are three stocks that “share the same characteristics: quality, owner-oriented managements, cheap price relative to our estimate of value, strong industry position, solid long-term fundamentals and a cloudy-to-terrible short-term outlook.”
