Vivek Kaul: Warren Buffett and the mediocrity of investing

Har shaks daudta hai yahan bheed ki taraf,

Phir ye bhi chahta hai usse raasta mille.

This basically means:

Every individual wants to run with the herd,
And then wants a right of way as well.

(I am not a professional translator, so the beauty of the original is bound to be lost in translation.)

Like all great poetry, the couplet summarizes what is perhaps a universal trait injust a few words. The beauty of the couplet is in its brevity—in what it does not tell us—in the question it does not answer: why do people like to run with the herd?

Dear reader, think of it in visual terms. Let’s say there is a herd of people approaching where you are standing. What will happen if you decide to go in the opposite direction? Well, if the number of people is huge, you are likely to be crushed by the sheer force of their movement. The point being, physically or otherwise, it’s just easier to go with the herd.

Why am I talking about this today? The 75th anniversary edition of The Intelligent Investor—The Definitive Book On Value Investing by Benjamin Graham was published a few weeks back. The book has an updated commentary by Jason Zweig, an investing columnist who works for The Wall Street Journal.

So, what is value investing? In simple terms, it involves buying the shares of a company that isn’t being properly valued by the stock market and holding it until the market starts valuing it properly. As Graham writes: “This value… is often determined chiefly by expected future earnings… Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.”

Given these reasons, a company’s share price may not adequately reflect its prospects and/or current earnings. At the same time, the share price could have been driven down way too much in comparison to the company’s current troubles. This difference between the current market price and the price that could have been achieved if the prospects were taken into account properly is huge. This creates an opportunity for substantial profit and is the dynamic at the heart of value investing.

The trouble is it is not as easy as it sounds.

1. Value investing involves going against the herd and investing in a stock that others are largely ignoring and avoiding.
2. It involves shutting out all the noise in the stock market at that point in time. Market professionals are always out there selling something because that’s how they make a living. And that something is usually not a value investing opportunity. The rise of social media and finfluencers has made this even more difficult than it used to be.
3. Value investing involves perhaps even looking stupid as an investor for a while—maybe a few months or even a few years. During this period, other stocks that are not really value stocks may keep gaining. This may even lead to a situation where the investors start questioning their investing decisions.
4. A value investor would not know when the situation is likely to turn in their favour because the direction of a company’s share price in the future cannot be predicted precisely. Indeed, for a value stock to start reflecting its right price, the herd of stock market investors that have been giving it a miss needs to start buying it. Investors are playing probabilities here and that is a difficult thing to do. As Zahaan Bharmal writes in The Art of Physics—Eight Elegant Ideas to Make Sense of Everything: “Anyone who says they know for sure what is coming… almost certainly does not… Probability can be assessed, but should not be taken as absolute. There is simply no way to know exactly what markets will do next, or what reaction will be to whatever they do.”
5. In order to identify investment opportunities, one needs to have a thorough understanding of different businesses—everything from their earnings prospects to how they fit into the overall economy—something that requires focused mental activity, which everyone can’t do, busy as they are with the vicissitudes of their everyday lives.
6. Little knowledge can be a dangerous thing when it comes to value investing. As Graham writes: “A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom. If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.”

All these reasons and more make value investing difficult to execute. To put it simply, going against the herd—the stories, propositions and theories that the finfluencers, experts, fund managers and everyone in the business of making money by investing other people’s money (OPM) are selling at a given point of time—isn’t easy.

Which is why Warren Buffett, the premier value investor of the last few decades, said this in 2013: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.” This is referred to as the 90/10 investment strategy, and is one of the ways of mediocre investing that can sustain itself for decades at end.

But it sounds so boring. There is no thrill in it. It doesn’t get the adrenaline going. It doesn’t leave investors with anything to talk and brag about when they meet others like them. In Mumbai terms, if you follow the 90/10 investment strategy, there isn’t much you are likely to have to say when someone asks you KLH, or kya lagta hai?

Plus, the OPM industry thrives on maintaining a constant buzz about investing. The key to their revenue lies in encouraging investors to stay perpetually active—frequently buying and selling stocks, regularly shifting asset allocations, and engaging in continuous portfolio adjustments. In essence, constant activity drives the OPM investment model.

(This leads me to a slightly different point. We live in an era where investors have turned those in the OPM business into mini-gods. But they forget to ask this: Did the OPM managers turn rich by making good investing calls? Or did they turn rich by getting investors to invest in their funds? These are two very different things. Also, what’s the track record of OPM managers across different phases of the market? Do they only do well when the market is doing well? Or have they done well in lean periods as well? Are they able to protect capital when markets are falling? Of course, this is not to say there are no successful OPM managers out there. Not at all. There are. But most of them aren’t. They are glib and confident talkers who are primarily in the business of selling. They are not in the investing business.)
 

A mediocre investment approach like the 90/10 strategy doesn’t really find much fandom amongst retail investors. It is more fun for them to chase performance. To constantly keep tinkering with investments. To constantly keep following what the OPM wallahs are saying.

An investment strategy as simple as 90/10, as easy as it sounds, is mentally difficult to adhere to over long periods. Ditto for asset allocation strategies where one may have a greater amount of money invested in fixed deposits, gold, etc., and a lesser proportion in stocks. Anyone who did not chase performance in the last few years has lost out. At least as of now.

When it comes to investing in stocks, it’s not the best businesses, the most well-run businesses, or the most profitable businesses that always give good returns over a period of time. Sometimes riffraff tends to do well. And avoiding that riffraff can come at a cost, at least for some time. The trouble is that no one knows how long that time will last. Which is why it’s just easier to go with the herd: Feel good when everyone else is. And feel bad when everyone else is.

In recent years, concentrated bets in what one may term riffraff stocks have delivered remarkable returns, making value investors who refrained from heavily investing in specific sectors or themes appear to have missed out on substantial potential gains.

But does that mean they were foolish in their investing approach? Not at all.

Diversification of investment is about preparing for a range of possibilities, prioritizing the return of capital over the return on capital. The absence of negative outcomes doesn’t invalidate diversification—it’s a safeguard. If adverse scenarios had unfolded, diversified investors would have been better positioned.

In his book Graham calls such investors defensive investors. “The defensive investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance and the need for making frequent decisions.”

However, this prudent approach often goes unappreciated in times of soaring stock prices. We are in an era where companies with stagnant sales have seen their stock prices surge, and firms with little chance of profitability ride the waves of social media buzz to command sky-high valuations. As long as this trend persists, diversification, value investing and defensive investors may seem outdated—until the tide inevitably turns.

It’s all about playing probabilities and being ready for different situations that can possibly pan out because no one really knows for sure. Those who say they know for sure are usually pretending, if not lying, or lying without knowing so.

In the end, it is worth remembering what Buffett said in 2013:

But as the old cliché attributed to the British economist John Maynard Keynes goes: “In the long run we are all dead.”