A Possible Investment Scenario You Must Not Ignore

January 13, 2014

Food-for-thought-table

Source: Warren Buffett from the book “Tap Dancing to Work” by Carol Loomis

As you have noticed, the Dow did nothing for 17 years (1964-1981) despite a 373% GNP growth. Then, the Dow grew about 10 times in the next 17 years with only a 177% GNP growth.

Why you ask? When treasury interest rates go up, company intrinsic values* go down. Conversely, when risk free interest rates go down, companies are worth more. Company valuations are tied to interest rates, because investors compare risk-free investments with those that have risk (i.e. stocks, real estate, etc.). If you would like a detailed explanation of why this is so, please ask me during your annual review.

*Intrinsic value definition (what companies are worth, not stock prices….remember stock prices are based on emotion and do not reflect the company’s true value at all times)

Another reason why the Dow went up during 1981-1998 is that corporate profits margins increased (actual figures unavailable). When companies are more efficient and profitable, their values should increase as well.

Current market situation

Dow Jones Industrial Average Dec. 31 2013: 16,576.66

30 year Treasury yield Dec. 31 2013: 3.97%

Today, The Dow is at an all-time high, corporate profit margins are close to all-time highs (due to temporarily low borrowing and labor costs), and treasury interest rates are still considered to be close to all-time lows (despite a recent rise recently). History has proven that economic factors tend to revert back to their long term averages. That means we should expect interest rates to move up and corporate profit to move down back to their long term averages at some point in time. When this happens, stock prices in general may be stagnant or even go down temporarily.

This is only one possibility out of many scenarios, but still a possibility must not be ignored.

Plan of action if this scenario plays out

I don’t know when the market may start to correct or become stagnant, but I do know that the only way you can make money in a period of stagnation or any difficult environment is to:

  1. Maintain the discipline of investing in high quality companies that have sustainable competitive advantages, and the power to pass on inflation to their customers. The key to this simple concept is being able to value what the companies are worth in multiple future scenarios, and having the discipline to invest heavily only when the price gives you an appropriate margin of safety. Although superior investing concepts are simple, implementing it is not. If generating superior investment results were easy, then the average investor would be rich. According to Charlie Munger, “everyone who thinks this is easy is stupid.”
  2. Compare as many investment alternatives as possible, and invest in the ones that make the most sense. Only inexperienced investors focus on their stock holdings and don’t compare it with other options.

 

In seeking out the best risk adjusted returns possible, I actively maintain a watch list of around 75 stocks (and other types of investments such as bonds, real estate, derivatives, private equity, etc.). Based on my research, this list constantly changes as I take out companies which become less attractive, and add companies where I could see ourselves investing in. I dig through so many sources to make sure that the watch list (our bullpen) is as fresh as possible. I scout hundreds of stocks each year.

Result

People who are getting high returns during these few years where prices are driven by greed and illogical enthusiasm will be sorely disappointed. Just like the traders in the late 90s (internet bubble), it is easy for the average investor to mistake their luck for skill. This is called the overconfidence bias, and history has shown that when the tide turns, the market has never been merciful to those who do not know what they are doing. It’s not what you know that gets you in trouble. It’s what you think you know but actually don’t that does get you in trouble.

 

Another more funny way to say this is “In a tornado, even turkeys fly.”

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