Unconventional wisdom: Four lessons from a bear market
Learning from experience and history.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Four lessons from a bear market
“How did you go bankrupt? Two ways. Gradually, then suddenly.”
- Ernst Hemingway
I’m a big Hemingway fan. I’ve visited the six toed cats in Key West. I’ve seen his drunken scrawl on the wall of La Bodeguita del Medio in Havana. And I made my wife stop in Pamplona on a drive between Barcelona and San Sebastian.
The bulls weren’t running but I wanted to have a drink in Café Iruna in Plaza Del Castillo. This was the meeting spot of the characters in The Sun Also Rises. That novel put Hemingway on the map. And he began it with this epigraph:
“You are all a lost generation.”
—Gertrude Stein in conversation.
The lost generation is symbolic of the disillusionment of those that came of age amidst the horrors of the First World War. Fortunately, most generations are not subjected to that ordeal. But that doesn’t mean that each generation isn’t shaped by the events that occur during their formative years. That is just as true in investing as life.
For investors that have come of age after the global financial crisis the prevailing attitude is captured in an appropriate manner – a meme.
The saying ‘nothing ever happens’ is a product of strong share market returns and bear markets that end before anyone notices they’ve started. Over the long-term markets have always shown resilience. But never to this degree over the short-term.
Our experiences are always going to influence our behaviour to a greater degree than lessons from history. But that doesn’t mean we should ignore history. Jump in your DeLorean, accelerate to 88 miles per hour and take a trip with me back to the late 1960s and early 1970s.
The nifty fifty
In October 1969 Warren Buffett gave up on investing. Everything was too expensive. Instead he decided to run a struggling textile company named Berkshire Hathaway. Things worked out ok for him.
Buffett ended his investment partnership because he didn’t understand what was happening in markets. It was the nifty fifty era.
The nifty fifty were known as one decision shares. No thought was required. This was the anthesis of the Buffett ethos.
The nifty fifty was a list of 50 US growth shares. This was why Buffett struggled. At the time he was still an old-school value investor in the same vein as his mentor Ben Graham.
Graham seldom tried to gain a detailed understanding of a business. He just wanted to see the financial statements and to buy something for 50 cents that was worth a dollar.
For Graham valuing a business did not require an qualitative assessment of a company. He wanted the assets on the balance sheet to be worth more than the share price.
The nifty fifty didn’t fit this model. These were the bluest of blue-chips. They were nationally recognised brands that mostly sold consumer goods. They were established companies in good financial shape. They traded at lofty valuations.
They were representative of their time. We equate the 1960s with hippies on communes. But free love took free cash flow and the cultural revolution was a biproduct of rising living standards and increasing disposable income. This benefited consumer goods of all stripes.
People were eating out at McDonalds. They were drinking Coca-Cola and smoking Marlboro reds. They were taking pictures of the flowers in each other’s hair with Polaroid cameras.
This encouraged investors to push the valuation levels of the nifty fifty higher and higher. A one decision stock does not require a detailed valuation model.
This all came to a screeching halt in the 1973 / 1974 market crash. The crash was not caused by the valuation levels of the nifty fifty. Macro factors like the oil embargo, skyrocketing inflation and increasing interest rates were the initial culprit. But high valuation levels meant the market had a long way to fall. US markets dropped close to 52%. In the UK the loss was a staggering 73%.
The lessons from the nifty fifty for today’s market
Many commentators are comparing today’s market to the nifty fifty. On the surface this makes sense. The market leaders today resemble the nifty fifty. These are established companies that are in strong financial positions. In the US there is the magnificent seven technology companies. In Australia the poster child is CBA.
Nobody is worried about these companies collapsing. People are questioning the valuation levels. The conventional ‘lesson’ from the nifty fifty is that the valuations were unreasonable. Before applying that lesson to today’s market it is worth examining it in detail.
Lesson one: Not all narratives hold up to scrutiny
The author of Stocks for the Long Run, Professor Jeremy Siegel explored the nifty fifty. Siegel provides some useful stats that inject some reality into a good story.
The equal-weighted nifty fifty peaked in December 1972. The price to earnings (P/E) ratio of the 50 constituents was 41.9 in 1972. This was more than double the S&P 500 P/E of 18.9.
As a point of reference in late June the magnificent seven had a P/E of 44 while the S&P 500 was trading at 21 times earnings. You can see the resemblance.
Siegel’s paper has the benefit of hindsight. He looked at future performance and used that as a basis to determine if the nifty fifty shares in 1972 were overvalued, undervalued or fairly valued.
Siegel’s paper explores return data between December 1972 and August 1998. Based on these returns he determined that in aggregate the nifty fifty were overvalued by 3.20%. That isn’t much considering a valuation more than twice the market.
As you might expect the returns of the nifty fifty were close to the overall market return. Between 1972 and 1998 the nifty fifty returned 12.20% per year if the portfolio was never rebalanced and 12.50% if it was rebalanced annually. The S&P 500 returned 12.70% a year.
The nifty fifty was not wildly overvalued.
Lesson two: Things do happen
The summarised and simplified message from Siegel is that long-term investors should load up on shares. And I am a big believer in Jeremy Siegel’s work. His look at the nifty fifty firmly falls into his worldview.
The problem is that not everybody has enough time to ride out the twenty-six year period that Siegel explored. And this is an important message to the crowd advocating for a ‘nothing ever happens’ view of markets.
The crash of 1973 / 1974 was an example of many bad things happening. Not only did these bad things happen but they had a profound impact on share market returns and the lives of investors.
The market in the US didn’t recover to the 1972 pre-bear market levels for nine years. In the UK the recovery didn’t happen until 1987 - just in time for the 1987 Black Monday crash. If we include the impact of inflation the US market didn’t recover for over twenty years until 1993.
The maths behind investing is simple. The best time to get high returns is later in your career. The worst time to get low returns is when you retire. People who retired during the mid-to-late 1970s would not share the view of the ‘nothing ever happens’ crowd.
Lesson three: Pay for quality – just not too much
Buffett first met Charlie Munger at a dinner party in 1959. They instantly became friends but it took a while for Munger’s influence to take hold. Eventually Munger helped Buffett evolve his investment style.
Evolve is the key word here. Buffett didn’t turn his back on finding undervalued shares. He just changed his definition of undervalued from Graham’s financial statement approach to a more holistic view of value.
This is what Siegel’s research showed. Relative valuations like the price to earnings ratio don’t tell the whole story. You should pay more for growth shares and blue-chip companies. Quality matters.
The nifty fifty were better companies. They grew earnings at 11% a year between 1972 and 1998. The overall S&P 500 grew earnings at 8%.
Paying more does not mean you should pay any price. I divided the nifty fifty into three groups based on their performance between 1972 and 1998 - the 15 best performing shares, the middle 20 shares and the 15 worst performing shares.
Top performing shares
Middle shares
Lowest performing shares
The 15 worst performing shares have the highest average P/E and the lowest earnings growth. The obvious lesson is you shouldn’t buy very expensive companies that don’t grow earnings.
Comparing the top and middle group is more interesting. The top performing group was the cheapest of the nifty fifty and had the highest earnings growth. This is a great combination. But the shares were not cheap. They were trading at a much higher valuation than the overall market. These were the types of shares Munger encouraged Buffett not to ignore.
Siegel has calculated a measure he calls ‘warranted PE’. That is the P/E of each share that would provide a market matching return.
You can see the big difference between the cheaper quality shares in the top performing group and the more expensive ones in the middle group. That is the lesson. You should pay for growth and quality – just not too much. Valuation always matters.
Lesson four: This is hard
Perhaps the lesson you’ve taken away from this exploration of the nifty fifty is that it all seems hard.
The lessons I’ve offered require the fortitude to resist conventional wisdom. The strategic nuance to consider the ramifications of an extended downturn while taking enough risk to achieve your goals. The ability to walk the tightrope of paying more for quality…without paying too much.
Maybe the best lesson is that the market won in Siegel’s exercise. It was close. But the market still came out on top. It is hard to pick winners.
The good news is that investors today have an advantage over investors in 1972. We can just buy a cheap index fund. If it all seems too hard that is a great option.
Final thoughts
We all create narratives that bring a sense of order to our lives. Generational narratives can have a long-lasting influence over our actions. But they can breakdown.
In the western democracies the lost generation opted for isolationism and appeasement. But eventually it turned to resolve when left with no other choice.
Confidence the post-war boom wouldn’t end inflated the nifty fifty. Then the market wilted in the face inflation, economic warfare and the breakdown of Bretton Woods.
It is inevitable that the confidence in swift rebounds that ‘nothing ever happens’ represents won’t last. That will be the real test for investors.
Comments? Email me at [email protected]
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What i’ve been eating
I’m going to turn from Hemingway to John Steinbeck. Steinbeck’s masterpiece was the Grapes of Wrath which told the story of the destitute Joad family traveling from Oklahoma to California during the great depression. For people more into music than literature Springsteen’s album Ghost of Tom Joad was inspired by the novel. What drove the Joad family west was the severe drought and dust storms that ravaged Oklahoma in the 1930s. Known as the dust bowl they ruined harvests and exacerbated the impacts of the depression. During these challenging times the Oklahoma burger was born. Onions were added to beef mince as a cheap filler and they were smashed together on the griddle. This is the type of burger served at Eat at ROBs in the Sydney suburb Rozelle. Our colleague Joseph won’t shut up about the burgers so we took a team outing. The burgers were great. The hot chips were average – which didn’t stop me from eating every last one.
