January 5, 2016

Dear Investor:

2015 was the year nothing worked, as recently reported in Bloomberg.com. Most bonds and stocks delivered negative returns. The relative winner, cash, went nowhere fast. Overseas indices were big losers compared to their domestic cousins, down anywhere from single digits to 33%. Our investments in energy, steel and emerging markets did poorly, underperforming most major indices.

A young 2016 has provided little encouragement, greeting markets with a 270 point Dow drop.

An understandable question we get from clients is this: if what you owned last year underperformed, why not get out of those stocks and into the ones that did well?

The very simple (but not easy) answer: that’s the least likely strategy to work. A quandary of markets is that what did well in prior years is less likely to do well in future years, due to reversion to the mean. And what did poorly is paradoxically likely to do very well. More important, for quality assets (we try not to buy any other kind), expected returns go up as prior returns go down. All stocks have an expected return based on the sum of (1) their dividend (or interest yield) plus (2) the earnings growth rate plus (3) their degree of undervaluation. As something becomes more expensive relative to its cash flows, its expected return drops; if it becomes cheaper, its expected return rises. That’s why people get into trouble chasing past performance. Because of the cognitive flaw that psychologists call “recency” we all tend to extrapolate recent occurrences to the future. This leads some to believe that what did well over the past few years is likely to do well again in the future—when the opposite is more likely to be true.

If investors swap out of underperforming assets into ones that did well, they tend to suffer the most ignominious fate of all: they get “whipsawed.” What did well does poorly just after they swap into it, thus compounding their losses.

Instead the value investor buys more of the asset that just did poorly, so long as it’s still undervalued. The trick is to do the homework on the underlying cash flow numbers to be sure those flows still support the price. If not, then you have to admit the mistake and sell, even at a loss. But if yes, then you’d be foolish not to buy more.

Just as a nice, valuable house is only a better purchase if it declines in price, so too the shares in a good company. There’s no difference in the analysis. But because stocks are abstract and few understand what they truly are—the legal claims on the cash flows of an underlying business—few look at it the same way. When stocks, even valuable ones, go down in price, people tend to panic. They sell when they should do exactly the opposite. As legendary value investor Chris Davis always says: price is what you pay, value is what you get.

In the past quarter, we exhaustively double-checked all underlying free cash flows for the major holdings of our energy, steel and emerging market ETFs. The results are encouraging: these are the cheapest prices relative to underlying cash flows since 2009. In retrospect, 2009 was a time for optimism, not pessimism. 2016 is similar, though it hardly appears so. And just as in 2009, the bleak macro picture (including stalling Chinese growth) has already been anticipated and thus well priced into stock prices, leaving assets trading at bargain levels.

In the wake of movies like The Big Short, which glamorizes the huge, enormously successful short bet of the swashbuckling hedge fund managers who invested alonside John Paulson, some will reach the conclusion that trading or engaging in speculative strategies like short-selling are good ideas. They are not. For every hedge fund that attempts it, hundreds more go bust by having the timing just slightly wrong.

When you short a stock, you must have the timing exactly right; if not, you can get wiped out. The mechanism of shorting a stock—whereby you borrow it and then sell it, hoping to buy it back when (if) the price declines—is enormously perilous. Most stocks, even bad ones, go up over time. Stocks in general rise two thirds of the time, so by shorting you are playing in a casino where the odds are always stacked dramatically against you. And your downside is limitless: if the stock goes up, theoretically to infinity, you are on the hook for the full price. When you’re long stocks (meaning you own them as an investor), time is on your side; when you’re short stocks, time is against you.

Short-sellers try to manage such risks by buying put options (bets by a certain date that a stock will decline in price), but such options are “time-wasting” assets, meaning that they expire valueless if they don’t pay off in time. It’s hard enough knowing what will happen without knowing exactly when it will happen. Buying an option requires both. Just ask the countless hedge funds who went bust trying to execute the same strategy as Paulson before the financial crisis and many more after.

The best strategy will always be to invest, that is, to buy quality assets trading at a discount to their intrinsic value and hold them until they are overvalued. That’s why all the most successful money managers like Warren Buffett, Charlie Munger, Charles Brandes and Howard Marks are value investors (yes, even more successful and with better long-term records than the uber-successful protagonists in The Big Short).

The huge disadvantage of investing (as opposed to trading) is that it requires time and, therefore, patience. No one can expect equity investments to pay off in less than 3-5 years. Anyone who does should not be in stocks at all.

Today is more like 2009 than 2007, with assets once again trading at huge discounts to intrinsic value. Our holdings in energy, steel and emerging markets are tremendously undervalued and are likely to do extremely well over the coming years, even if they do still worse over the coming months. No one can time these things with any precision. And there are, of course, no guarantees in the investment business. But I have never seen such good values since March of 2009 as I do today in steel, energy and emerging markets.