Upside Down Cakes and Other Surprises

April 4, 2007

Dear Investor:

We believe the chance of a recession has increased as the recent subprime shakeout points to more real estate pain ahead. As lenders tighten standards in the wake of defaults (classically closing the barn door after the horse has bolted), the virtuous cycle that formed the bubble for the past ten years has officially reversed: Credit tightening will lead to more defaults, which will lead to lower home prices, which will lead to more credit tightening and so on. If domestic GDP does decline somewhere in the next two or three quarters, international growth should still keep global GDP above 1%, which would be bullish for equities against a backdrop of low bond yields. We continue to favor large cap equities and think they are the only cheap asset class in the world.

The question often arises as to why we don’t just sell everything and sit in cash if we think that the economy looks shaky—in other words, why don’t we try to “time the market”—and then buy again after everything looks clear. This is an excellent question and one which we must periodically address. Aside from the negative tax consequences, transaction fees and other “hidden” costs of engaging in market timing, there are far more weighty and fundamental reasons why we don’t believe in this strategy:

1) “Market timing” strategies have very poor track records. Statistically, market-timing strategies are sub-par performers and very few, if any, have beaten their benchmarks over sustained periods of time. This is due to the fact that short-term market moves are inherently unknowable. There is no one who can tell you which way the market is headed tomorrow and if someone claims to, I’ll show you a charlatan. Our strategy is one of investment, not trading, and true investors are agnostic to short-term market moves.

2) There is no short term link between stock market moves and economic conditions. Because the stock market is what’s known in finance as a “discounting mechanism,” it’s often reacting to perceived risks that are many months hence and discounting those future events to the present. For example, Coca-Cola stock is often zigging or zagging on any given day based on what market participants estimate Coke’s cash flows will be a year or two down the road. What is already known is not interesting to markets. The market only cares about uncertainty (i.e. the constantly fluctuating and myriad possibilities of the future). Sometimes this is a difficult concept for investors to understand, especially when they see the market react in immediate fashion to instant news, such as a terrorist bombing or a change in bond yields. It follows, they think, that economic conditions would cause the market to track it in perfect lockstep, but this couldn’t be further from the case. The market only prices in perceptions, and perceptions are constantly fluctuating. This leads to real-time market moves that have nothing to do with current conditions. A perfect, common example of this phenomenon is what we’ve named the “upside-down cake.” This occurs when a company announces a positive earnings “surprise,” but the stock goes down once the news is announced. This occurs because the positive earnings growth was not really a surprise after all. It had actually been discounted by the market long ago, causing the stock to have risen prior to the announcement. Once the news becomes reality, the stock sells off because the surprise is now gone (note that we are not talking about insider trading here, but rather just the market moves that come with justified and completely legal apprehension of future events).

3) The stock market often sways to irrational extremes, of both panic and exuberance. Thus, market prices are often the result of irrational emotionalism, not fundamental reality. The school of thought that examines this phenomenon is known as behavioral finance, which directly refutes the “efficient market hypothesis,” a theory that was solidly debunked in the wake of the Internet stock collapse. Behavioral finance tells us that stocks and fundamentals get out of whack over the short term but track each other pretty well over the long term. Nearly every legendary value investor from Charlie Munger to Warren Buffett to Bill Miller believes in some version of behavioral finance; otherwise, they would never believe they could buy a stock at a discount to intrinsic value. It bears repeating that nearly every legitimate study has shown value investing to be the most successful technique over the long-term, with returns that exponentially eclipse market-timing. We believe this is so because value investing counteracts human nature instead of conforming to it—something which is psychologically impossible for most market participants. Thus, value investors believe that often the best time to buy stocks is when people are overly fearful and sell when people are overly confident.

4) In markets, it’s much harder to know when something will happen than to know what will happen. For example, we have written for some time that real estate would implode. We just didn’t know when. As a result, we were more than two years early with this prediction. Of course, as the old saying goes, even a stopped clock is right twice a day. In other words, if you’re too far off about the timing of the event, it’s the same as being wrong. This is true. But as an investor, you can be off on timing by two or three years and still generate very good investment returns through your hypothesis.

This is exactly why buying options is such a dangerous strategy: it requires not just a knowledge of what, but when—and not just when, but precisely when. The trader must time it perfectly, especially if betting on a return to rational pricing. If not, disaster ensues. As the old trader’s saw goes: “Markets can remain irrational longer than you can remain solvent.”

An investor, however, has the luxury of being off on timing and still making money. Here’s an example: If we determine stock XYZ to be 20% undervalued, and we believe XYZ will grow its earnings at 6% annually for five years with a 2% dividend yield, we can do an approximate job of calculating its five year return. Assuming the economy runs on an even keel, the 6% earnings growth and 2% dividend are reasonably predictable, especially if company XYZ is in a stable industry like consumer staples. The big wild card is the discount to its intrinsic value. Even if we’re certain the stock is undervalued, we have no idea when the value gap will close. Since stocks and fair value eventually track each other over the long term, we can assume the gap will close. Whether it takes two years, three years, five years or ten depends on investor psychology—something even less predictable than the economy. If the value gap on stock XYZ closes in two years, the annualized return in our example would be approximately 20% (6% earnings growth + 2% dividend yield + 12% annual compounded increase attributable to reaching intrinsic value). If the fair value on stock XYZ closes in three years, the annualized return would be 16%. Five years would be 13%, while ten years would be just over 10%. This shows how the value investor can know what will happen (the stock reverts to its intrinsic value), but not when (the precise point in time when the stock reverts). The amount of the return will be inversely proportional to the amount of time it takes. But the value investor will still do reasonably well, even if off by a decade.

We follow the above strategy. Instead of timing the market, we prefer to rotate money from overvalued sectors and stocks to undervalued sectors and stocks in a process known as “tactical rebalancing.” This strategy is largely agnostic to when something will happen, but is very focused on what will happen. By rotating from overvalued to undervalued, we try to capture the reversion to value that boosts returns in our XYZ illustration (and conversely avoid the reversion to value by overvalued assets that would damage returns). An example is our ongoing rotation from the expensive small-caps to the forsaken large-caps. Even if this gambit’s timing is off by a couple of years, we still can do well.