Over the next few weeks, I will be sharing excerpts from the winter letter I wrote to IMA clients. In the past, I would sanitize them and turn them into articles. I think the relationship with my readers has evolved to the point that I don’t need to do that.
Herr Schadenfreude Is Not a Friend of Ours
Everybody needs to have his or her why.
Why gives us meaning in life. This is what pulls us forward, what makes us grow as individuals, what gives us purpose in life. It’s the reason we get up in the morning. We usually have multiple whys. For instance, my why as a parent is to raise kids who are good human beings that can thrive in this world. My why as a writer is to help and inspire people. My why as an investor, which perfectly aligns with IMA’s why (being CEO and IMA’s locomotive is helpful here), is to produce uninterrupted compounding for the IMA Tribe.
For years, the “uninterrupted” part of IMA’s why did not matter. The music was blasting loudly, the punch bowl was continuously refilled with the cheap liquor of low interest rates, and everyone was dancing and making money. The less common sense you had, and the richer your imagination was, the more money you made. Sure, risks were everywhere. Everybody knew about them. But for a long time, the more risk you took, the more you easily and quickly became more and more “wealthy”. Profits, cash flows, valuations and margin of safety were not the words that were popular at that party.
And then… interest rates went up, the music stopped, the punch bowl was taken away and, predictably, the speculative bubble burst.
Warren Buffett said: “Over the years, a number of very smart people have learned the hard way that a long stream of impressive numbers multiplied by a single zero always equals zero.”
Over the last year, I observed many smart people who had shown incredible, mouthwatering returns for the last 5-10 years, only to have them multiplied by a negative 70-90%. It is difficult to continue compounding one’s capital when you are down this much on a portfolio level; at this point, volatility becomes a permanent loss of capital. You might as well multiply them by Buffett’s proverbial zero. This is how compounding gets permanently interrupted. Their portfolios profited from the bubble, and then perished because of the bubble. Of course, most of their clients came to them at the top, chasing high returns.
It is only natural for us to entertain a visit from our German friend Schadenfreude; after all, anyone who was not dancing but rather was concerned about what would happen to their clients’ capital when the music stopped looked inadequate – not quite a failure, but not as smart or enlightened as the ones dancing at the party. But now the tables have turned.
Being a value investor became an incredibly lonely and painful place to be over the last five years. If you ran a value investment firm, attracting clients was very difficult. I’ve read about mutual funds closing value investment strategies and consultants removing the “value” boxes from their “value-core-growth” portfolio construction framework.
IMA was a rare exception; we have grown significantly in a shrinking universe. I think this is because we are attracting “misfits” like you, who are drawn by our common sense and are fine with getting rich slowly and not having to worry about the music stopping one day. Or, if you’d like me to go Disney on you, the clock strikes midnight and their shiny carriage turns into a pumpkin.
From the bottom of my heart, thank you for your trust!
Though we achieved very reasonable returns that I am proud of over the last decade, I have to admit that I have personally had unpleasant experiences when prospective clients almost laughed at me when our returns did not measure up to the out-of-this-world returns they received from their “growth” money managers whose portfolios were drowning in bubbly stocks.
I am embarrassed to say that in recent months we did on occasion consort with Herr Schadenfreude, but we quickly sent him away. Deriving pleasure from someone else’s misfortune just doesn’t seem like the right thing to do. Also, for me it’s personal.
I have some value investment friends who have had their investment principles slowly eroded by the seemingly never-popping bubble. You don’t lose your principles overnight; it’s a slow, painfully incremental process. (This applies not only to investing but to other parts of life as well.) One compromise led to another, and, God forbid, they produced returns, and did so for quite a long time. Today, these friends are hurting; they are good, smart, even brilliant people. I talk to them all the time and value them as human beings; I treasure their friendships.
Pain destroys any arrogance that has infiltrated our thinking. It occupies our subconscious mind, effectively trapping us in a loop of self-reflection where nothing else matters. It serves as an effective reminder of our mistakes, allowing us to reexamine and refine every aspect of our investment process. It is the best teacher, helping us to ensure that we learn from our mistakes and never make them again. It is an invaluable tool that can help us grow.
Ben Graham, the father of value investing, developed his investing framework after he suffered significant losses during the Great Depression. I’ve benefited tremendously from pain, too – I wrote about my painful travails from 2015 in Soul in the Game, in the chapter called “Pain, Opera, and Investing.”
If I did not have all my investable assets managed by IMA (which is the right thing to do for a money manager), I might have let some of these friends manage my family’s money.
That is just one of many reasons Herr Schadenfreude is not welcome at IMA.
Of course, there are a lot of people who lost their money, whose lives have been ruined by the bubble burst. Unfortunately, a Jeremy Grantham quote comes to mind as I type this: “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.” Most people (not all) who lost their money will learn a lot from this bubble. But society as a whole, especially its future iteration, will learn very little. We’ll have other bubbles, likely with different actors, in our future.
Our why – uninterrupted compounding – is our North Star. This doesn’t mean that we are not going to have down years – volatility is an inescapable part of the stock market journey. But we are going to continue building and improving our all-terrain portfolio. We are prepared to be a responsible adult at future parties filled with drunken teenagers.
Until you show your long term results against an appropriate value index one year of outperformance versus an S&P index means nothing.
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds – Warren Buffett