Introduction
About two-thirds of money managers fail to beat their benchmark over the long run. In an industry filled with the brightest minds and armed with the best information, how can more fail than succeed? If a person were starting a firm from scratch, what could one learn from the winners and the losers? What do the winners have in common?
The two-thirds number is curious because it would seem that the winners and losers should be 50/50 over any meaningful period. We believe the underperformance is a result of the long-term drag from transaction costs, the least of which are commissions on trades. It is the myriad of other costs and intangible forces that contributes to the actual trading costs.
The Loser’s Game
One common trait of the outperformers is low portfolio turnover. This does not mean having low portfolio turnover will put you at the top. It simply means that high turnover greatly stacks the odds against you.
Many of the losers are playing the “loser’s game.” They are responding to the day-to-day news flow and acting upon it. To outperform one needs to either have better information or a better way to process that information. We believe that better information is generally not available. So the key to winning is a well constructed process.
Process versus Philosophy
One’s investment process must be driven by one’s investment philosophy; process without an underlying belief is worthless. Clients like to hear about your process because it is easy to grasp. It can be laid out in simple steps. When combined with good results, it tricks the mind into believing that it is a better mousetrap. Sometimes it is, but if there is no philosophy; it is destined for failure.
The philosophy is a description of the market anomaly that we as investors are seeking to exploit. The process is the plan of attack. Thus, the investment philosophy is what really defines an investment organization. It is the philosophy, not the process that defines the winners. It is not the quantity of people employed, the sophistication of the model or the quality of trading that separates the winners from the losers. It is the daily grind of correctly identifying anomalous security pricing and acting upon it (Making the donuts!).
The market is highly efficient. It incorporates all new information instantaneously. This is very different from saying that the market always prices securities correctly.
Running a Successful Investment Firm
To run a successful investment operation, a firm first must identify the anomaly and, importantly, stick with it in good times and in bad. But, in most cases, when a manager underperforms for a time, he will challenge and likely modify his process. Little by little, it will be changed until it is nothing like it was five years earlier. Worse yet, it will be indistinguishable from the competition; the firm then has taken its inevitable place in the loser’s game.
The anomaly has to be timeless, observable and intuitive. It is the mooring/safe harbor in difficult times. The process actually can be modified slightly over time as long as the philosophy never changes. For example, to use investment formulas such as “don’t buy Japanese stocks when the yen is over 120” may be successful for a period and may even appear obvious, but they are unlikely to be timeless. In contrast, buying low P/E stocks is an effective strategy and an underlying philosophy that meets all three criteria.
There will inevitably be periods when it is ineffective. In those periods, the winners have conviction to stay the course because they believe wholeheartedly in the philosophy and are unwavering under pressure.
Cornerstone’s Philosophy
The basis for Cornerstone’s philosophy is that investors overreact in the short run due to emotional stress or excessive optimism. As a result, the market constantly misprices securities relative to their long-term value.
The fundamentals of large companies rarely change as much as their market price changes would indicate, thereby affording an opportunity to buy large companies when the short-term news is bad and then to sell them when it is good. The reality of this strategy is that we never know when the short-term bad news will end. As a result, stocks can underperform for long periods after purchase; hence, we diversify and buy small amounts to start gradually building the position. Meanwhile, the balance of the portfolio is providing considerable upside that more than offsets the drag. Some new ideas can actually take off immediately, but we should never count on that occurring. In fact, it is prudent to assume the opposite.
Impossible to Time the Turnaround
Most large companies, even industry leaders, encounter financial and operational difficulties. Some have failed; however, the vast majority find ways to build a bridge to recovery. Outsized returns are available to the investor willing to buy when the quality and quantity of evidence of improvement is minimal. Generally, investors want to wait for prices to rise to confirm a recovery. Unfortunately, prices tend to move higher more rapidly than the “evidence of recovery” would support. Even when a turnaround is at hand, the investors on the sidelines are reluctant to jump in. Gradually more investors join in because the risk of being wrong appears worse than the risk of being in. However, the premium returns are no longer available in the stock at that point and are sometimes completely exhausted.
In Textbook Terminology
Investment textbooks describe the above investor behavior in terms of the Capital Asset Pricing Model (CAPM). The problem with CAPM is that Beta does not define risk well enough. But in principle, the model works for illustration. Investors require on any stock the Risk Free Rate plus an equity risk premium. The risk premium embodies market, industry and stock specific risk. When companies are struggling, the company-specific risk is disproportionate. In times like today, the industry risk can also be very high – Financials, for example, get a broad brush.
We are mainly focused on the stock specific risk, because we are a bottom-up manager. When a large company is selling at a significant discount to what is justified by its long- term historical record, it has a high level of stock specific risk in its risk premium. Considered another way, the expected return is very high. As the company rights itself, the risk premium contracts first to the level of industry risk premium and then to a market premium. The last move occurs when most of the market participants have already taken a position, and the majority of investors are left with market returns less transactions costs.
Can We Improve on the Basic Philosophy?
Given the past above-average returns achieved by following the basic Cornerstone philosophy, is it possible to improve performance by using short-term metrics, trend forecasts, management projections and such other information as insider buying, analyst estimate changes or earnings surprise. The answer is that we can, as long as the philosophy remains intact. The problem is that it is sometimes difficult to tell if that is the case.
Consumer Cyclicals Example
In the example of Consumer Cyclicals, this challenge is evident. The macro trends for Cyclicals are clearly negative. The consensus view is that the economy is weakening, possibly worldwide, and that any company that relies on consumer spending will have a difficult time outperforming. This is partly due to the fact that analysts will lower estimates continually until the bottom is reached; this could take months or years. Why not wait until the revisions bottom out and buy at that point? Better yet, why not wait for company insiders to buy.
The compelling reason why one need not wait until a consensus expectation of recession is reached is simply that such agreement would already be reflected in low stock prices. Unfortunately, prices do not go up just because they are cheap – they can get cheaper. Thus, timing a purchase is nearly impossible and a fruitless exercise.
Another way to state the problem is in terms of mean reversion versus trend-following; both are powerful forces. In our view, mean reversion wins out over trend-following when it comes to stock prices.
Trend-following is enticing because in life, it’s a useful tool. The Falcons are more likely to keep losing than winning. Three hot days in the summer are not likely to be followed by a cold one. The difference in the financial markets is that price embodies the expected scenario. So the trend of weak sales at Wal-Mart may continue, but the price may revert toward the stock’s central value. As time passes and as WMT continues to divert from its value, the tension for mean reversion increases.
The Daily Investment Meeting
Our daily meetings are designed to accomplish two objectives:
1) Verify the model’s data
2) Validate the investment thesis
The key to our valuation methodology is the data used in the model. Again, we are looking for stocks where the price differs from the value. In an overly simplistic view, the fundamental analysis is merely a check of the data inputs in the model.
The Model and Fundamental Analysis
A financial asset’s value is the present value of its future cash flows discounted at an appropriate rate. The Fair Value Model™ simply makes this calculation, but it is not easy to see without close examination.
In the Fair Value Model™ the discount rate is the risk-free rate (k below); the standard risk premium factors of Operating Leverage, Financial Leverage, and Liquidity are embedded in the model calculation.
With no ambiguity over the discount rate calculation, the cash flows are the important point for debate. We use earnings as our proxy for cash flows and use the reinvestment rate of cash to calculate the company’s sustainable growth rate (g below).
Armed with the growth rate and the discount rate, we are using the basic formula for value to appraise a stock’s worth. In this case it can be derived from the formula:
P = D1/k – g
Or, P/E = Dividend Payout ratio/(k – g)
The growth rate is the most important factor that needs to be verified, justified and challenged. In simple terms, we use the lesser of the sustainable growth rate or the actual earnings growth rate, thereby, tempering valuation of high return companies that are no longer able to grow at past rates and those that are currently growing at unsustainably high rates.
The Razor
The Razor, which incorporates the last twelve months earnings, may be a better measure of value, particularly for rapidly changing companies like Apple, Newel and Honeywell (all in our portfolio) and for those companies like large Pharma, that are not currently experiencing the level of past successes.
The Forecast Razor, a valuation using the next twelve months earnings, is helpful to identify value traps such housing stocks and the financials over the last 6 to 9 months; Materials may be a similar trap going forward.
In the end our Normalized value is preferred as it uses the company’s long-term financial history. While we can easily observe short-term data and determine that the historical record is not relevant to the future, we should be aware that this is not usually the case.
Art versus Science
So which value is most appropriate?
In a way there is no clear cut answer to this dilemma. It requires judgment and experience. On the one hand, we find that good companies like Pfizer, IBM, Nokia, and Wal-Mart are more likely than not to continue their historical record. Going back twenty years we would find much less fluctuation in their ROE history than in the price. Over that period there were probably countless times when smart investors forecasted that the next year would be much worse than actually occurred. On the other hand, the opposite can also be true – but less likely.
To say that it is different this time is a bet against the odds. The macro evidence is always compelling and seems obvious. As a result, long-term investors are constantly offered opportunities to buy good companies at discount prices. A risk remains that the consensus view will materialize or be worse than expected. In that case a manager needs to be patient to realize value, and it could take a few years.
Stock Examples
With any stock one must ask whether the market is right or the price of the stock does not yet embody well-publicized evidence. This is possible, but unlikely. More importantly, it is not a necessary condition for us to outperform. For illustration, cyclical stocks were major winners for us in 2006, against consensus view. In 2007, Nokia offset some of the underperforming Financials. Nobody could have predicted that Nokia would rise 100% last year. For all intents and purposes, Nokia is no different today than last year or the year before. The 2007 move was simply the price reverting to the value. Because it was impossible to see, the rewards were huge. This year Eli Lilly could be another such performer. We cannot predict it; we are merely stacking the odds in our favor.
Measuring Success in Stock Picking
Another challenge with this investment approach is determining which stock decisions were good and which were bad. In life it is a simple exercise of whether the plan did or did not work. With stocks it is much more complex. A good decision can have a bad result and vice versa.
Our odds of being right in any three month or one year period are, at best, only slightly better than 50%. A stock that goes down may have had a better chance of going up. This does not make buying it a bad decision. This is important, because our strategy requires the gradual building of the position. If buying the stock were viewed as a bad decision it would be harder to add precisely at the time when adding is the right thing to do. That is, the expected return is actually higher than at the initial purchase.
The important factor is whether or not the decision was consistent with the philosophy and driven by the process. Constant application of the process will ultimately produce superior returns. The biggest risk is deviating from the philosophy by allowing short- term events to distract from the proper long term approach. Cornerstone has low turnover of companies in the portfolio, so this risk comes into play if we are hesitant to trim winners that are reaching intrinsic value and fail to add to losers that are increasing their upside return potential.
Measuring Success
The best way to measure success is to consider the entire portfolio as one equity asset and compare it to some relevant benchmark. Much has been written on this subject and is beyond the scope of this discussion. In short, a blend of some index and some peer group offers the best measurement. For Cornerstone that blend is the S&P 500 and a peer group consisting of similar managers. The latter should be comprised of managers with similar styles and characteristics. The closest group is Core Managers, although a case could be made that Cornerstone’s value bias should be considered.
For these two measures, Cornerstone’s results have been extraordinary. Versus the S&P 500, Cornerstone has never lost in any calendar year and has an outstanding quarterly batting average since inception. Versus peers, Cornerstone is in the top 5% of all Core, Value and Growth managers for the trailing five years through March 31, 2008 (statistics attributed to the LCG Monthly Investment Manager Universe database). An attribution analysis would illustrate that most of the outperformance has come taking less risk and is largely attributable to stock selection.
Our Conviction
Cornerstone is among a minority of managers now that are beating their benchmark; should we now try to improve performance upon that? History suggests that mean reversion in performance is very powerful. That is, the bottom quartile mangers for the last five years are more likely to be in the top quartile going forward and vice versa. However, we would argue that the reversion is not purely statistical and is actually driven by changes in the methodology. Both underperformers and outperformers tend to tweak their methodology with the hope to make it better. While it may be possible to improve, it may not be worthwhile to try to do so at the risk of undermining the very process that created the success.
From a firm standpoint, clients are attracted to philosophies that are theoretically sound and empirically proven. Cornerstone’s meets both of those criteria. Further, when the inevitable underperformance occurs, our only safe harbor will be our philosophy. If we can ride through those times by assuring clients that our approach will work, we can continue to employ it long enough for it to begin working again. If we doubt ourselves, our clients will sense our hesitance and leave. If we begin to lose clients, we will feel more pressure to change. When we change we will join the other two-thirds of the competition destined to fail.
John Campbell, CFA
Chief Investment Officer
Cornerstone Investment Partners
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