In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at the European debt crisis and its impact on long-term strategy.
Excerpted from the June 8, 2012 issue of the Validea Hot List newsletter
For the past several weeks, investors — who already had Europe’s debt woes on their minds — have become fixated on the continent. The headlines are dominated by the latest news about Greece’s debt crisis, its political turmoil, and, of course, the question of whether it will exit the Euro — and what that means for the global economy and financial markets. Signs of trouble on the Greece front trigger significant, broad-based sell-offs; signs that a resolution won’t be too chaotic trigger broad-based rallies. All in all, the news has been mostly negative, so the market has flirted with “correction” territory (i.e., a 10% decline from previous highs) in recent days.
When I listened to interviews with Donald Yacktman and Whitney Tilson — two strategists with strong track records who I respect quite a bit — this week, however, they weren’t fixated on Greece. And in discussing their strategies and outlooks, day-to-day news coming out of Europe seemed to play little role.
In fact, Yacktman, whose flagship fund ranks in the top percentile in its category over the past five and ten years according to Morningstar (and the second percentile over the past 15 years), stressed the importance of not getting hung up on the short term. Asked by WealthTrack’s Consuelo Mack what had made his fund so successful, he said, “I think more than anything it’s a combination of objectivity and horizon time. We’re very patient. We’re very long-term investors. Horizon time is a huge part of that. I know there are a lot of people who would like to buy certain investments that they look [at] as good value for their clients, but they’re worried that they won’t look good for the next quarter or the next year and that they might get fired because of that. And so this longer horizon time, we’re just willing to stay there, because we know that [the investing approach] will stand the test of time.”
Yacktman said his value-focused approach is like “buying beach balls being pushed underwater and the water level is rising”. Logic dictates that at some point, the external pressure won’t be enough to keep the ball down, and it will shoot back out of the rising water — and the longer it takes and the farther down it goes, the bigger the bounce will be, he says. I’d add that exactly when the bounce will occur is never really certain (nor is it guaranteed), but Yacktman seems to be saying that if you are confident in the ball’s buoyancy — or a stock’s fundamentals — you can wait for the bounce and reap the benefits. With stocks, however, many investors don’t have the patience, and they end up selling while their picks are “underwater”.
Tilson is another investor who does have the patience to wait for the ball to bounce, and it’s no doubt a part of why he’s been so successful. Asked in a CNBC interview when he cuts his losses on holdings that fall in the short term, he responded, “We don’t. If we still have conviction in the stocks we hold, we selectively add to them, and that’s what we’ve been doing. (Incidentally, that’s essentially what the Hot List does. In addition to revamping its holdings at each rebalancing, our system also brings the existing holdings back to or near an equal weighting. So if a particular holding falls, but its fundamentals and financials remain strong enough for it to stay in the portfolio, the Hot List will buy more shares of it on the rebalancing date to bring it back around that 10% weighting.)
Tilson says short-term volatility isn’t something to fear, but something to take advantage of. “We’ve sort of got a strong stomach for volatility,” he said. “We deliberately — we think as other investors flee volatility, that’s the time we’re willing to wade into the most out-of-favor stocks because that’s where the bargains are.”
What Yacktman and Tilson both possess — and what so many investors lack — is perspective. It’s harder and harder to have a sense of it in today’s world of high-speed Internet and smartphones and 24-hour financial television, but that makes it all the more critical. If you think you can stay ahead of the high-frequency traders and other pros when it comes to short-term market movements, I wish you luck. I think it’s far more likely that it will lead to a continual cycle of buying high and selling low.
Right now, those who are focused on the short term are consumed with the incessant day-to-day speculation about whether growth will continue or recession will hit, and whether a new bear market has arrived the bull market will continue. Amid all that, nearly four years after the 2008 market meltdown and global financial crisis, it still at times seems as though the financial world is balanced on the edge of a knife. Every day without resolution leads to a growing sense of fear; every downturn is seen as a possible “beginning of the end”.
But when you step back and consider the bigger picture, you see that what’s going on — lengthy economic turmoil — is not unusual if you understand the historical context. Consider the work of Kenneth Rogoff and Carmen Reinhart, who have done perhaps the most extensive research on past financial crises. In examining about 15 pre-2007 financial crises across the globe, Reinhart and Rogoff said in a 2008 paper that on average real house prices fell for six years before rebounding. In very few cases did the declines last less than five years. Unemployment, meanwhile, increased on average for nearly five years by an average of 7 percentage points. Real public debt jumped 86% on average in the three years after the crises.
In other words, it takes time — for most investors, an uncomfortable amount of time — to recover from a financial crisis. While the 2008 crisis seemed to explode in a furious instant when Lehman Brothers collapsed, the conditions that led to it were a long time in the making. Credit and housing bubbles inflated over years and years, spurred by low interest rates, before they popped. Recovering from such periods thus also takes several years. There is no magic pill that the Federal Reserve or anyone else can administer to change that. And during these years of recovery there will be (and obviously have been) major ups and downs. It’s a bit like an earthquake; after a big one hits, aftershocks inevitably follow as the tectonic plates work to slide into their new alignment. The aftershocks themselves can be quite large and fear-inducing. (While Europe’s crisis is very different in nature from the U.S.’s 2008 crisis, it is in many ways related, born of an atmosphere of reckless spending and easy money that pervaded much of the developed world. You could thus say that, while different, it is indeed an aftershock from the 2008 crisis.) But eventually, the plates will find their new equilibrium, and order is restored. Unfortunately, in a financial crisis, this process takes place over a period of several years.
If you realize and accept that, you can deal with those ups and downs in a more constructive way. Others will get stuck in the cycle of bailing on stocks every time the lingering debt worries at home or abroad flare up, and then jumping back in along with everyone else when the hopeful signs emerge. But you — like Yacktman and Tilson — can focus on what really matters over the long run: value and fundamentals. You can buy good stocks that others have dumped too hastily, and you can avoid the overpriced safe-havens that investors flock to in fear-filled times.
That’s easier said than done, of course. But it’s what just about every one of the highly successful investment gurus I follow has done. From Benjamin Graham to Peter Lynch to Warren Buffett to Joel Greenblatt, they almost universally stress the need to focus on the long term, stay disciplined, and make rational, value-based decisions. With its quantitative strategies and methodical rebalancing process, I’ve designed the Hot List to do all of those things. Whatever strategy you use, you should be sure that it incorporates those tenets. In the short term, it will be difficult and at times painful. But in the long run, it will tilt the odds of success well in your favor, and that’s what really matters.
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