The S&P500 pushed higher 2.4% last week on light volume and ever growing complacency–the volatility index has dropped to multi-year lows. While economic numbers actually deteriorated last week, and while retail money flows showed that the average investor pulled money OUT of the stock market last week, prices continued grinding higher on hopes for continued central bank money printing and simple momentum: to many professional investors, the logic is “prices are grinding higher, so why not stay with it”.
Beneath the surface, things aren’t so rosy. The breadth of the rise is narrowing, meaning that fewer and fewer “hot stocks” (think Apple) are leading the indices higher, while many less known stocks are lagging. If indices were already overbought, and overly bullish before last week, they have now become even more so.
The disappointing macro data came in several forms. Retail sales rose slightly less than predicted. Import prices were higher than expected; export prices were lower. Both will squeeze corporate profit margins. While inflation, as measured by the government’s PPI and the CPI was tame, inflation as measured by the credit markets (the 10 year breakeven rate) rose to a one year high: 2.41%. The big surprise disappointments of the week came on Friday. Industrial production growth collapsed; instead of rising 0.5%, it was flat. And finally, consumer sentiment was expected to rise to 76.0; instead, it fell to 74.3. And both industrial production and consumer sentiment are leading indicators.
Last month, an investment manager named Walter Schloss passed away at the age of 95. The Economist magazine paid a tribute to a man who had a remarkable investment career.
Most folks, even professional money managers, had never heard of Mr. Schloss. He never appeared on CNBC or Bloomberg to tout his “stock picks” or to peddle his services to prospective clients and other sources of asset management fees. As The Economist notes, Mr. Schloss never had more than 100 clients.
But Mr. Schloss was a disciple of Ben Graham, who also happened to be the mentor of Warren Buffett.
So why was Walter Schloss remarkable? Because over a 40+ year span of managing money, he beat the market by 60% on average, annually.
How did he do it? By doing the exact same thing that Howard Marks (profiled here a few months ago) espoused–by finding and buying stocks that were worth far more than the prices markets temporarily priced them at. These stocks were out of favor “cigar butt” stocks that “weren’t worth much, but sold for far less.”
So in time, as the markets recognized the price vs. value discrepancy, prices rose to meet the higher values. And that is a recipe for beating the market.
But there’s another set of key lessons here. First, a recipe for success can only be declared as such—as success—only when it’s assessed over a very long time period. And 40+ years qualifies as a very long time period. Why is this important? Because statistically, it’s very possible that any particular manager could have a lucky streak that lasts 2, 5, and sometimes 10 years. While the news media and the investing public falls in love with such a manager, the absence of a truly successful formula will ultimately lead to disaster. Bill Miller of Legg Mason, one such example, was a “rock star” manager for over a decade; he was fired last year after incurring several years of massive losses.
Second, how could Mr. Schloss do something so simple—and something so easily capable of being copied—while almost no other investors or investment firms did too? Because he did not manage for the short-term and he did not work with investors who expected short-term out-performance; both would work AGAINST his successful long-term strategy.
What does the rest of the investment world do? Most retail investors and even most professional and institutional investors cannot or will not manage for the long-term. Either they haven’t done the analysis to convince themselves that their bargain purchases will work in the long-term, OR they don’t have the emotional patience to wait until the prices of their investments rise to meet the higher intrinsic values. And professional managers who may even understand this process, may have no choice but to abandon good investments because their investor clients lose patience and choose instead to chase short-term performance goals instead (again, think Apple).
What’s an example (and only an example, NOT an investment recommendation) of an out of favor stock that’s very likely priced today for less than it’s actually worth? Hewlett-Packard. Sexy? In favor? Sure to go up from here? No. No, and no.
But unlike Apple, essentially a two product company, that’s dominating the headlines today, Hewlett-Packard is under-priced, un-loved and under-owned. And by owning a portfolio of such firms and by holding on to them for many years, as Walter Schloss has proven, one can earn a healthy rate of return, a return that utterly blows away the market.