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Eliminating Inordinate Expectations

An expert from our 2019 Investor Letter II

Click here to read the full letter.


Global and domestic equity returns have left something to be desired since peaking in January and August/September of 2018, respectively. U.S. Large-Cap (S&P 500) produced a meager 0.86% one-year return through August, with mid-caps down 8%, small-caps down 14.1%, and micro-caps down 21.5%. At August end, most combinations of U.S. and global equities would’ve been down around 10% over one year and 5% since Jan-2018. Those who invested in December and January are mighty happy, while those who invested early last fall haven’t yet reaped much reward. The long-term differences will be negligible. We do not believe much judgement in either direction is useful right now. Time will be the arbiter of our performance. Steady is the effective allocator.

While we are confident in our ability to navigate markets, we are humbled by their intricacies and periodic foolishness. As I will explain, we’ve been in one of those odd market environments which occur from time to time where wacky beliefs become prevalent. The tide has begun to turn. What will make the difference is sticking to what we can understand, while staying far away from what we do not.


The S&P 500 generated an 18.5% total return through the first six months of the year. The largest hedge fund in the world (Bridgewater’s Pure Alpha) lost nearly 5%. For those counting at home, that is 23.5% behind the market. Many have used this result as further evidence indexing is superior. I have a very different view. The largest disparity between great investor returns and the market often happens at the point of peak madness.


We wrote in May that private equity was the hot commodity. One of the largest private equity investors has been SoftBank’s highly levered VisionFund. Noteworthy investments include Uber, WeWork, DoorDash, and Sprint. As recently as March, SoftBank reported a 45% IRR for its limited partners.[2] If most had assessed which was better to be invested in on July 1—SoftBank’s Vision Fund or Bridgewater’s Pure Alpha—SoftBank would have won out. What a difference a couple of months makes.


Uber’s poor IPO was a wakeup call that many lauded private valuations were nowhere near reasonable. The recent WeWork situation has only heightened those concerns. Before shelving their IPO, WeWork reportedly considered an IPO valuation of just $20 billion compared to a $47 billion valuation (on revenue of less than $1 billion), set by SoftBank in their most recent private funding round. Softbank has since pressured WeWork to cancel their IPO so they don’t have to acknowledge such a large loss on one of their largest investments. Unfortunately, cancelling an IPO does not change a firm’s present value. It only delays the inevitable. Eventually the music stops and most of the orchestra is exhausted.


Why hold cash? Cash is a free option to the long-term investor, providing the future ability to purchase better companies/securities at more attractive valuations. Often what is needed to generate higher quarterly returns is precisely what will destroy later returns. Short-term speculators can’t stand missing out today. The moment’s returns can be observed on paper or a computer screen. That’s comforting. Future consequences are not observed today. Notice I said future consequences are not, rather than cannot, be observed. Only to the blind are they unseen. Those with foresight plan for the foreseeable.

I. Thoughts on Investing

I have previously written volatility is the price one pays for performance. This statement deserves more explanation. It must be the right kind of volatility, not what leads to permanent losses. It is very hard or impossible for most investors to differentiate temporary mediocre returns and what is likely to end with permanent losses. There is a distinction. The latter occurs after buying at excessive valuations or into companies with negative cash flows and no durable competitive advantage. Participants are not investing. They’re speculating unintelligently—a dangerous game which ends poorly and typically with a bang. But it’s not a new phenomenon. Crowding into conventionally “safe” and accepted investments is a recurring pattern throughout history, wiping out many prominent people through each iteration. BBC’s popular show Downton Abbey, set in early 20th century England, shows a noble family losing their fortune in what was considered one of the safest investments of the time: railroad stocks.[1]


A fairly recent occurrence mostly forgotten by today’s investors was the “Nifty 50” of the 1970s. These were America’s most revered companies, widely considered the safest blue-chip stocks. Believing they could never go down, investment houses pushed valuations to unreasonable levels. Figure 1 shows subsequent returns from 1973-74 for a few of the most well-known names. One cannot separate expected future returns from current valuations.


Prudent investing is a process of selecting assets which (a) are likely undervalued relative to what their true value will be in coming years, and (b) hold very little or no chance of permanent loss. Even so, mediocre relative performance and drawdowns are to be expected.

Figure 1

Eliminating Inordinate Expectations

The bulk of market participants cannot overcome the appearance of subpar returns. This takes on two forms: (1) underperforming a benchmark, usually the S&P 500, and (2) periodic negative returns. Whereas the speculative bubble often provides astonishing returns before ending abruptly and with little apparent warning, the two forms of mediocre returns create a sense of discomfort and unease which slowly erode one’s resolve. Recent returns are extrapolated into the future as if what has happened must obviously continue. What is forgotten in this mental emotional process is that you can’t have the good without at least some pain, even if that pain is 100% nominal and temporal. Nick Saban should not be expected to win the national title every year. Yet some were calling for his firing after last season’s national championship game. Many American football programs have fired a good coach after a mediocre season only to spend years toiling to merely return to where they’d been under the disgraced coach. I think there are many similarities between managing investments and today’s college football coaches. There’s lots of money involved. It’s a winner take all type of business. The best do very well; the rest don’t. There’s a delicate balance between pleasing fans today and acting intelligently and with patience. Without fans there is no program. But most fans act emotionally and do not have the skillset or discipline to make the best long-term decisions for the team. Similar is the dynamic between investment managers and most investors.


Hanging on to indisputably fatal flaws in investment thinking is an immovable roadblock. Inordinate and naïve expectations unintentionally lead to a dangerously short-sighted way of thinking. It is wrong though to blame or condemn investors. These erroneous beliefs and emotions are perfectly useful in many other areas of life where what has worked is likely to continue working. What must be condemned is the belief that many can become good investors without years of study and experience. A stock trading course won’t do the trick. Still, investors unable to eliminate unreasonable expectations have no hope of performing well. To reiterate what I wrote earlier this year, “As long as human beings possess an innately irresistible pull towards what has recently performed best and away from what hasn’t, opportunity will exist.”


Most would not have reaped the rewards of investing with the greatest managers because they would not have been able to take the periodic 30-50% drawdowns. As one fund manager I follow says, “Drawdowns are a feature not a bug... [price declines] are nothing to fear though. Periodic disconnects between economic reality and share prices are the rationale behind investing [selectively].”[3] What really matters is some combination of adequate long-term returns and absolute returns. Somewhere between what a family or institution needs and what is reasonable (assuming what is needed is less than what’s reasonable).


Outperformance requires periodic underperformance for without it there could be no outperformance. If this were not true, then either:

a) everyone would outperform, so no one would outperform; or
b) the constant outperformer would in short order close to outside investors.

In the first case (a), if everything were easy, we wouldn’t know difficulty or pain. We wouldn’t need patience or prudence. There would be no easy or hard. By historical standards (and current global standards), virtually all Americans are very rich. Yet they don’t feel that way. If everyone is rich, no one is.


Closing to the outside (b) does occur. Many of the greatest allocators do so, not because they’ve outperformed every year, but because they’ve done so in the absolute. Everyone looks at returns in the absolute after the fact. The hard part seeing the big picture daily—to think in absolute terms rather than transitory relative terms. None of the great investors built their wealth in a day and few had the patience stay the course along the way. Opportunity exists because things fall out of favor. Mispricing occurs because so many make purely price-oriented decisions while so few many fundamentally oriented decisions.


Do you agree? If not, what are the alternatives? It is somewhat gut-wrenching to see so many in all walks of life believe there is a path to investment success devoid of fundamental analysis, discipline, and perseverance. Easy money fashions of each period fade with the wealth of its enthusiasts. There is no place one can simply throw dollars and expect outsized long-term returns without some awareness and ability. One must have the capacity to succeed—and the first step is patience. The second is some proficiency in the underlying drivers of value. Otherwise one is doomed to repeat the same historical mistakes of the railroad craze (turn of the 20th century), the nifty-fifty (1970s), and the dot com bubble (1990s), just to name a few. I fear today’s fashion is too readily accepted by too many smart people who aren’t paying much attention to valuation: the S&P 500.

Click here to read the full letter.