Yes, i do remember. Buffett’s bet was against a fund of hedge funds (i.e a fund that invest in other funds) , which is an abomination from a fee structure perspective: you pay 2% management fees and 20% performance fees in the inner fund, and then again 2% and 20% in the outer fund.
That is enough to transform even a 20% annual performance in a 8% annual performance. No wonder the funds lost so badly.
But again, Buffett and Greenblatt say we should index, but they never did it themselves (and their investors thank them for that).
I agree with that. I tend to run away as soon as i hear the words market-timing. What I would note however is that:
- I did not see a lot of bashing when the Corona thread evolved into a “who bought VT at the lowest point” contest (which is completely market timing and goes to the antipodes of passive investing paradigm)
- This whole discussion was started after we talked about Fundsmith, which as a company is adamant about not timing the market, but buying (hopefully for life) wonderful businesses. No market timing there
But in general I agree with you: those giving market-timing “advice” should be able to back it up with sufficient proof.
And you still did not read the article i asked you to read, otherwise you would have found the answer to your question. Had you read it you would have indeed found that you don’t judge future outperformance by past performance, but by looking at the investment tenets and philosophy. That’s the same as confusing symptoms for rootcause.
Anyway, I won’t dodge the task, so let me explain why I personally think that, let’s say, Terry Smith and Mohnish Pabrai will continue to outperform (both in distinctive styles).
Terry Smith:
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Fundsmith only invests in good businesses, which means:
- these businesses have a high returns on capital employed (on average 27%): for every frank invested in the business, it returns every year 27 rappen.
- with sufficient runway to reinvest around half of these returns in the business at the same high rate of return (they usually grow around 15% per year thanks to reinvested earnings, not additional external capital)
- have a high pricing power (on average 65% gross margin): that means that if the business build something that cost 3.5 CHF, it will manage to sell it for 10 CHF. It shows that there is absolutely no competition able to grind their margins.
- these businesses have been there on average for more than 50 years: it shows that competing with them is not easy.
- they are extremely cash generative: the earnings are real cash flows, not accounting accrued earnings.
- they usually on small, recurring everyday tickets, which makes them strong in times of crisis: people still brush their teeth and feed their dogs during the corona lockdown.
- to sum up, those businesses are compounding machines which should continue to compound their cash flows at a high rate.
- These businesses are quite rare: out of the dozen of thousands listed companies in the whole world, Fundsmith maintains a list of only around 75 companies filling those criteria, of which it invests only in 25-30.
- which leads me to my next point: Fundsmith does not diversify, and contrary to index funds, is not willing to mix good businesses with mediocre ones.
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Now comes the question of valuation:
- Fundsmith just states that it tries not to overpay for a business (stating that they usually buy around 4% free cash flow yield), but this is where i did most of my research to understand why it works
- the first thought that usually comes to mind is that since those businesses are so good, everybody should know that, and thus investors should have bid up the price so much that these businesses do not offer any excess returns compared to other investment opportunities, right?
- however, this is simply not the case. There are countless examples of good and famous businesses that everybody knows and that continued to outperform. For instance, Pepsi was already a famous, outstanding and predictable business in the nineties, and still it managed to outperform the market during the following 30 years. Everybody knew about it, and yet it was still mispriced for 30 years. How come?
- my personal explanation is following:
- recall that the fair value of any asset is the present value of its future cash flows discounted at your opportunity cost
- if the price is too low compared to fair value it is either that the market uses a discount rate that is too high, or that the cash flows are under-estimated
- high discounting rate does not make sense: this would be equivalent to saying “the better the business, the higher the margin of safety i am asking and the worse the value of future cash flows”
- the likely reason is that as human being we under-evaluate the effect of compounding at a high rate, and so the human brain just underestimate the value of future cash flows.
- an example of this: would you rather have : a) 700’000 CHF now, or b) 1 rappen doubled every day for 30 days? The answer is b) because 0.01 *2^30 equals roughly 10’000’000 CHF. But the way the question is presented, our brain is not even able to grasp that proposition b) is worth more than ten times more proposition a)
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Finally, once a business is bought, Terry Smith does nothing: he just rides the compounding machine as long as possible. It is not market timing, but time in the market. I would not be surprised if his turnover is even lower than passive ETFs.
Doing this allowed Fundsmith to compound investor’s money at around 15% per year, while enduring less volatility (i.e the risk as usually defined by volatility was much lower). On a risk-adjusted basis, the performance is phenomenal, and both Sharpe and Sortino ratio are there to testify it.
Mohnish Pabrai:
Although Pabrai also likes to buy outstanding businesses for life (Moody’s, Mastercard…), he invests more in what I’d call “high uncertainty, low risk” situations:
- high uncertainty = you have no idea what’s going to happen
- low risk: whatever happens, you won’t lose much money
- markets usually detest uncertainty, and punish companies who suffer from uncertainty, which means that often you can find quite interesting situations:
- For instance, he invested in Ipsco in the following situation (the number are from my memory, so they might not be absolutely exact, but you get the general idea):
- Ipsco was a steel maker, earning around 30$/share a year
- it had around 45$ of net cash on the balance sheet (that is, after paying debt)
- but it had absolutely no visibility on how the few next years were going to be. No visibility at all. As a result, the market had punished the stock to 45$ a year (brrrrrrr… uncertainty!)
- whatever happens, buying at 45$ was low risk because of the ample cash available in the balance sheet (limited downside)
- Pabrai said “you know what? why don’t i buy the stock and see what happens in the following few years?” He did that. After a year, Ipsco posted yet another 30$ returns (Pabrai had bought in fact at a P/E = 1.5), and went on to do the same afterward. Once the market understood that after more than 6 months, the stock went back past 150$ and Pabrai sold.
- This should not be confused with gambling. In gambling, you usually have fairly equivalent downsides and upsides. here, it is more like “Tail I win, Heads i don’t lose much”. That’s why this guy has been compounding at 26% since 1995 and why i think he will continue.
That was my thesis why those two managers (among my list) will continue to outperform for years ahead.
But since reading an article seems so difficult in your case, i reckon that doing the analysis above is many orders of magnitudes more difficult. Therefore i confirm : Cortana you should stick to indexing.