How to invest in an ignorant world

Step back. Look at the big picture.

Stocks are near record highs. Investor sentiment has never been more bullish. The Vix, which measures nervousness in the marketplace, is near record lows.

Stock prices are ‘above the line’. That is, they are above 20 times earnings. They could go much higher. But our simple approach tells us that the safe gains are behind us. It is better to be out than in.

Yesterday, we imagined a man who had lived, and invested, throughout the entire 20th century. Today, we meet a man, in the flesh, who almost did that… a man 42 years older than we are. He makes 66 seem like childhood.

Mr Irving Kahn is 108, to be exact. Born in 1906, he began investing before the Crash of ’29. He spotted the anomaly… and decided to take advantage of it. He sold stocks short.

“I borrowed money from an in-law who was certain I would lose it but was still kind enough to lend it. He said only a fool would bet against the bull market.”

In the event, he doubled his money. But Mr Kahn gave up speculation in favour of long-term value investing. In fact, he practically invented it. He was Ben Graham’s teaching assistant at Columbia; a midwesterner named Warren was a student:

“In the Thirties Ben Graham and others developed security analysis and the concept of value investing, which has been the focus of my life ever since. Value investing was the blueprint for analytical investing, as opposed to speculation.”

“During the Great Depression, I could find stocks trading at tremendous discounts. I learnt from Ben Graham that one could study financial statements to find stocks that were a ‘dollar selling for 50 cents’. He called this the ‘margin of safety’ and it’s still the most important concept related to risk.”

“Indeed, he uses the same approach today. “During the recent crash and in other sell-offs, Tom and I looked for good companies selling at a discount, which do surface if you’re patient. If the market is overpriced, an investor must be willing to wait.”

That, of course, is the price you pay if you’re going to profit from our STS (simplified timing system).

You will wait a long time for prices to fall below ten times earnings, and a long time for them to clear 20 times earnings. Then, like now, you won’t want to sell. Because they are still going up! And if you do have the discipline to sell, you may regret it for years, as prices continue to rise and you are regarded as a numbskull by everyone, including yourself.

Mr Kahn does not believe in market timing. Instead, he just looks for under-priced stocks. As the market rises, he finds fewer and fewer. At the extremes, he is forced out of the market entirely by a lack of good value.

That’s what happened to Buffett in 1968, when prices had gotten so high that he couldn’t find any way to use the money he had under management. What could he do? He sent the money back to its owners.

STS is for people who are not going to do the difficult work of studying company filings to figure out where the value is. We’re just going to get in and out according to a very rough measure of value – price/earnings ratios – with no consideration of discounted income streams, debt levels, taxes or anything else. As we saw yesterday, that this approach would have it would have greatly outperformed ‘buy and hold’ over the last 114 years.

But we still have an open question: how is it possible that this sort of opportunity exists – even for someone who doesn’t do the hard research? How come there are still dollars lying on the ground, when there are so many smart people who should have picked them up?

Couldn’t Goldman Sachs simply hire a few mathematicians, program a few computers, and arbitrage away these gains?

We put the question to Porter Stansberry:

So, the question is, what is the market inefficient, given all of the computers and all of the brains on Wall Street? How is it possible that little guys like us are still capable of outsmarting the big guns at Goldman?

Three explanations:

1. They are conflicted

Take my prediction that GM would go bankrupt.

Here was a car company that hadn’t made a real profit in 20 years, was sitting on $400bn in debt, and had more retirees on the payroll than workers. Seemed like a pretty simple bet to me. However, Wall Street was making a lot of money selling GM bonds. There were huge incentives not to rock the boat.

Likewise with my prediction about Fannie and Freddie going bust. Everyone on Wall Street was selling those clowns paper that was worth $0.20 for a full $1.00. Going along with the lie was more profitable than shorting the stocks could have ever been.

2. There is far too much opportunity cost

Trying to arbitrage every minor discrepancy in value would take far too much capital. Firms that have tried to do this (Long Term Capital Management) end up using far more capital than they can afford to borrow.

There are just too many financial instruments to handicap. Likewise, there’s too much knowledge to manage to do so accurately and in a timely fashion.

3. There is far too much risk

Even when investors possess superior knowledge, getting the timing right and managing all of the other variables is impossible.

Take my short sell of Netscape, for example. Back in 1999 I was shorting Netscape, which produced the first web browser. Microsoft began ‘bundling’ web browsers inside its operating system, so nobody needed Netscape – which had given its software away and had no revenue model. The stock was a zero. I was shorting it (personally, with real money) as it sank from $25 per share all the way down to $15.

Then, I come into work one day with the news that AOL bought it, using stock, for $90 per share. I got wiped out. And it wasn’t until about a year later that AOL’s stock collapsed, in large measure because it had been fudging all of its accounting (they were budgeting marketing expenses on the capital account). 

I’m sure we’ll find that the market is least efficient (and we have the best opportunity to make outsized returns) when:

1. We’re dealing in securities that have little or no following on Wall Street.

2. We’re dealing with stocks that have been heavily promoted by Wall Street.

3. We’re dealing with securities where we have an abundance of first-hand knowledge and experience.

4. We’re dealing in industries where unusual amounts of expertise are required to follow it – insurance or biotech – for example.

5. We focus our portfolios into only a few themes (fox holes) where we have an edge.

Does that answer our question? Well, it’s as good an answer as we’re going to get.

But it doesn’t settle the question, either.

If there is a dollar lying in the street, there may be a reason – a reason you don’t see – why no one has picked it up. Maybe no one is looking. Maybe ‘The Street’ wants you to believe it isn’t there… maybe it’s too hard to see… or too hard to pick up.

But maybe it isn’t really there!

More to come, tomorrow, as we wrap up our series on how to invest in an ignorant world.