Times that try stock picker’s soul

Drew Dickson points out that there is one way to generate excess stock market returns over the long term, and it isn’t to “own winners at any price.” Sure, in hindsight it was, but that is very convenient. It’s very convenient to now ignore the stocks we thought were winners but weren’t. It’s also very convenient to draw parallels between past winners and newer companies as if it is a foregone conclusion they too will win in a similar fashion. Nor do excess returns come from “owning good companies at any price” or “owning high-quality companies at any price.” The “one way” to outperform is to buy a concentrated portfolio of securities that Mr Market doesn’t own; names which are shunned because Mr Market has become overly pessimistic about the fundamental prospects for businesses that are better than he believes or realizes. That’s it. That’s the formula.

This often isn’t sexy, it often isn’t fashionable, and it often isn’t fun. However, a successful investor outperforming Mr Market over the long term owns companies that, by definition, Mr Market believes are pretty stupid to own. 

Instead, Mr. Market often thinks growing, glamorous, names are much smarter to own. They definitely are smarter looking. And it is surely more entertaining to own these stocks. It’s also easier to sleep at night. They are obviously more dynamic companies and, in many cases, they indeed are better companies. And there are periods where these growing, good and glamorous names do tremendously, well. During these episodes, it downright sucks to be a fundamentally-driven value investor. Equity markets had one of those periods in 1998-1999, and – in Dickson’s view – they may be having another one of them now. Paraphrasing Thomas Paine, these are the times that try stock-pickers’ souls.

The stock market, at least at the moment, seems most sensitive to whether or not a company is classified as a “good” or “bad” business. And “good” means your stock has already appreciated, is already expensive, and is showing even the slightest degree of business momentum. And no price is high enough for “good”. Because good is good, so why wouldn’t you own it? “Bad” is the opposite. Bad is an already-inexpensive stock that has already sold off, and one that has already exhibited fundamental weakness, even if it’s likely a short-term phenomenon. And no price is low enough for “bad”. Because bad is bad, so why would you own it? As maddening as this behaviour is, it is typical of investor psychology at peaks and troughs; and consequently, the “price” of growth is higher than it has ever been.

Dickson asserts that there is no new era. Stocks are still worth the present value of their future cash flows. While narratives can dominate in the short term, and while the short term is sometimes longer than we like, the fundamentals eventually matter. They have to. We are buying fractions of the equity value of large, liquid, listed, enterprises. The fundamentals “have to matter” because these fractions of equity, these shares, are worth the present value of all future cash flows to that fraction of ownership. We have no idea when “eventually” is going to arrive. Whether or not we are three days or three years away from this growth bubble popping, he doesn’t know. But he is tremendously confident that it isn’t “different this time.”