Credit: Shutterstock photoOver the past five months, I have profiled some 40 gurus listed on the GuruFocus Scoreboard - and become aware of a problem.
Altogether, the Scoreboard is populated by 73 gurus with results for at least 10 years; they are mutual fund, hedge fund and investment managers who rank as the best of the best, based on some current or previous investing achievement.
But of the 73, only 28 have 10-year track records that beat the Standard & Poor's 500 (based on publicly traded funds, before dividends and distributions). In many cases, that underperformance is the result of big losses during the 2008 financial crisis or the pullback in 2015.
While most gurus speak of using risk management - through margins of safety - many appear to have failed to use it effectively.
All of which raises the question: "Is margin of safety enough to protect us against financial storms?"
A loss and recovery visualization
Behind that failed risk management lies some real pain: Getting back to even requires returns that are greater than the amounts lost. For example, a loss of 20% requires a return of 25% to get to break-even again. A loss of 30% requires a return of 43% to return to break-even.
Gerbrandt Kruger, writing for BizNews, provides the following table to show the returns needed for several levels of losses:
Suppose you have a $100 investment and it declines to $90. To get back to break-even, you must earn $10 on the $90 you have left (not the original $100). To calculate, use this simple arithmetic: Divide the amount lost by the amount remaining. For example, dividing $10 by $90 equals 11%. A return of 11% is needed to overcome a 10% loss. But then the math gets harder, so to speak.
Let's do the same calculation for a 40% loss (which many investors suffered in 2008): After a loss of 40%, or $40, on a $100 investment, an investor has $60 remaining. The calculation is the same as before: $40 divided by $60 = 67%. In other words, the investor who lost 40% needs a positive 67% return to get to break-even, and that's a challenge.
Notice on the chart above how the losses (in blue) make a straight line as they increase while the recovery values form a curved line as they go up. The recovery line shows exponential increases, not linear. Or, the more you lose, the harder it becomes to get back to break-even.
What's more, these are amounts investors need to recover before they can get back to building their capital.
For a contrarian view on recovery from losses, see this article by David John Marotta; he argues that recovery is not necessarily as difficult as most pundits (including me) suggest. Still, it must be asked, "Why were there losses in the first place among gurus who promised robust risk management?"
Think of the recovery curve as reverse compounding. When you have positive compounding, you begin to have interest earning interest, a positive leapfrogging process. But when compounding reverses, losses behave like bad credit card debt, to use a different metaphor.
What about margin of safety?
Most of the gurus I profiled promised risk management, primarily by buying stocks with a margin of safety. So why did they lose so much in 2008, and to a lesser extent in 2015?
Evidently, their margins of safety were not robust enough. They appear to have been unprepared, despite the fact some of them made their reputations with huge gains during and after the dot-com bubble. Even those who did not would have been aware of what happened between 1999 and 2002.
Warren Buffett ( Trades , Portfolio ) has been called one of the most prominent advocates of margin of safety, and he's famous for his first two rules of investing: "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." How do we reconcile these two facets of Buffett's extraordinary investing career?
In a GuruFocus article, Geoff Gannon explained that intrinsic valuation (and by extension, margin of safety) matters a great deal when investors buy for one to five years, or even 10 years. However, he points out that Buffett's holding periods have grown "very, very long," which means shifting focus to returns on investment, returns on retained earnings, etc. This explanation allows us to square Buffett's early endorsement of margin of safety and the dictum not to lose money. A note: While Buffett lost 9.6% in 2008, he has gone on to beat the benchmark over the past 10 years.
From a different perspective, Thomas Macpherson wrote, in a GuruFocus article, "My outperformance over the 10-year period 2006 to 2015 occurred in large part because I lost far less than the Standard & Poor's 500 during the market swoon in 2008-2009. I achieved this by holding far more cash than others."
And in his book, "Seeking Wisdom: Thoughts on Value Investing," Macpherson outlined a more robust risk management strategy he uses in his professional capacity as an investment manager. Called "Getting to Zero," it involves stress testing five critical components of a company's business: revenue collapses, loss of access to credit markets, bad capital allocations by management, losing a competitive moat and regulatory intrusion by government.
Jae Jun, in an Old School Value blog post, says valuation is important in assessing the margin of safety. But every valuation method has its own assumptions, so he uses as many as seven methods: They are (1) DCF, (2) reverse DCF, (3) the Graham formula, (4) EBIT multiples, (5) absolute P/E, (6) earning power value, (7) a net net calculation.
Finally, note that gurus run large to very large funds, from tens of thousands of shares to millions of shares in each holding. This makes it difficult to move in and out of positions nimbly. For example, retail investors would never move the market by selling a few hundred or thousand shares. But mutual fund managers cannot. They can't exit a full position easily; they need to feed a relatively small (in the context of their portfolios) number of shares into the market over time. If they're selling, they need to avoid pushing the market price down and reducing the price on subsequent tranches. If they're buying, they need to move slowly to avoid pushing the market price up. Many investors watch institutional investors (like mutual funds) closely for signs they are buying or selling.
Not all gurus are created equal
Of the 28 gurus who beat the S&P 500 over the past 10 years, only three did not lose money in calendar 2008:
- Prem Watsa (Trades, Portfolio): The man known as the Canadian Warren Buffett outdid the original Buffett in 2008. He ended the year 21% richer, so to speak, while Buffett ended the year with a 9.6% loss. Watsa is also known as a fanatic hedger. In a 2011 article at ValueWalk, Jacob Wolinsky wrote Watsa is a believer in black swans - once-in-a-lifetime events (such as the 2008 financial bust). As a result, he hedges a lot, or at least he did until the hedges became a significant drag on performance in the past five years. Going into 2008, though, it was a brilliant move. Watsa scored a big gain for the year by purchasing very cheap Credit Default Swaps (CDS) on bonds. Those bonds shot up in value as subprime crisis rolled out.
- John Paulson (Trades, Portfolio) is the second guru to consider, with a gain of 6.3% in calendar 2008. But times have been harder lately, with the New York Times reporting he suffered double-digit losses in 2014, 2015 and 2016. According to Newsweek, he began feeling nervous about the housing market in 2005. He first considered put options but found them too expensive. So Paulson turned to Credit Default Swaps, a bet against the housing market and the broader economy. He also shorted Bear Stearns after listening to a corporate, reassuring presentation that he did not believe. Both bets were highly profitable for Paulson.
- Bill Ackman is the third and final outperforming guru to post a gain in calendar 2008. Again, we see Credit Default Swaps but used this time in a more complex way. Without getting into much detail, Ackman had taken an activist position against MBIA Inc. ( MBI ), the Municipal Bond Insurance Association, set up by several major insurance companies to diversify their municipal bond holdings). MBIA had sold CDS, and Ackman bought CDS against MBIA's debt. In 2008, MBIA crashed, and Ackman made a small fortune selling those CDS.
Obviously these three gurus have Credit Default Swaps in common. But perhaps more importantly, all three had done an excellent job of reading the market and correctly assessing its susceptibility to flaming out.
Conclusion
Margin of safety was one of the key ideas articulated by Benjamin Graham, the father of modern value investing. Almost all GuruFocus gurus have also put it to the fore in describing their investing styles.
Theoretically, buying low, holding for a few years and then selling should produce high average annual returns. Yet, as we have seen, few gurus can beat the S&P 500 benchmark, despite adhering to their self-imposed margins of safety.
Does this mean margins of safety are not enough to protect stocks and portfolios? Perhaps.
Perhaps a holding period of two, three, five and even 10 years is not long enough for margins of safety to work effectively. As we saw in the article about Buffett's extended holding periods (now often more than 20 years) may be the difference. Over lengthy periods of 15, 20 years or more, compounding may have enough power to overcome limitations to the margins of safety.
It's also worth noting that the three outperforming gurus who made it through 2008 without a loss were asking the right questions. Instead of focusing on a big pullback as a means to buy new stock at a discount, they were seeing the bigger picture, and asking, "How do we preserve our capital so we can afford to buy liberally when the next big decline hits?"
No doubt the debate about effective methods of risk management will continue, but for now, it seems safe to say that margins of safety, on their own, are not enough to protect against the next big slump.
Disclosure: I do not own stock in any of the stocks listed in this article and do not expect to buy any in the next 72 hours.
This article first appeared on GuruFocus .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
