I’ve started to notice a disturbing trend in the number of investors in my Twitter feed that share the same quality investing philosophy as myself. This was brought quite starkly to my attention recently by some light-hearted mocking and memes of ‘compounder bros’. Other than the mildly uncomfortable feeling that you are part of the group being mocked, the main reason this is disturbing is that it suggests the quality momentum trade may be becoming more crowded. The dot.com bubble and subsequent crash is a sobering example of what might be in store at some point. As I flagged in one of my recent posts, I’ve been thinking a bit harder about whether and how to adapt my strategy to this possibility.
Of course, my perceptions are likely to be distorted by the social media echo chamber. I’ve sought out connections with investors I think have interesting and well-founded perspectives. Naturally this makes the people in my Twitter feed more likely to share my investing philosophy. But I don’t think this explains everything.
As I pointed out last week, Cliff Asness of AQR suggested that it might be a rare time when over-weighting exposure towards value looks like it could be a good idea. This conclusion is driven by the empirical observation that the valuation ‘spread’ between the cheapest and most expensive stocks is at historically extreme levels. Other than the dot.com bubble we haven’t seen anything like this before. Some investors, like Neil Woodford and a few other value investors, have been banging on about this valuation spread for years, though according to Asness probably prematurely. The valuation spread has widened substantially over the last couple of years. Prior to that Asness believes it was largely justified by the fundamentals.
This interpretation seems fairly reasonable to me. My perspective is that it has taken a long time for the valuation spread to recover from the dot.com crash and grow sufficiently to fairly reflect the more certain growth prospects of high quality businesses. However, whether we have reached the point where the valuation spread is fair, or even gone beyond, is hard to say.
When judging this, you need to bear in mind that interest rates have fallen to historically low levels and are likely to remain so for the foreseeable future. The causes of this decline are largely structural. Interest rates are fundamentally driven by the supply of capital available to be lent and the demand to borrow it. Supply has been going up as our society has become older and less equal (rich people save more), while demand has gone down as our economy has become more digitalised and less capital-intensive. This has pushed interest rates down with little consequence for inflation. Historically low interest rates provide some justification for a historically wide valuation spread: in a world where the long term returns from lending money are so low and are likely to remain that way, compounded future profit growth is worth relatively more.
Whether this is a sufficient justification for the current valuation spread, or indeed an even wider one, is hard to say. We can’t predict the future with much accuracy so we don’t have clear, consistent benchmarks for what equity valuations should be. This exposes share prices to whimsical changes in sentiment.
Incidentally, my last two paragraphs describe the key ingredients necessary for a bubble. There is a well-founded narrative for why growth should be valued highly but no consistent benchmark to tell us how highly. This allows the narrative to become a self-reinforcing heuristic about how investing in growth ‘just works’. There is a good chance that the valuation spread would continue to expand for some time beyond the point merited by the fundamentals. Or, if sentiment changes, it could collapse again before this point is reached.
The upshot is that my strategy faces a lot of uncertainty. While it could continue to do very well, the risk that it may suffer some extended underperformance are increasing. I feel a bit exposed. I need to be clearer with myself on whether I plan to do anything about it and if so, what.
Stick to your guns vs adapt or die
My approach thus far has been to stick religiously to a single coherent long term strategy. It’s better to do one thing well than many things badly. I’m wary of the risks of making major adjustments based on bold macro calls.
There are plenty of examples of investors who have suffered from getting too cute with their market timing, rather than sticking to a long term strategy. An obvious recent example is Neil Woodford’s big sector bet on low quality UK cyclicals in response to his perception of the valuation spread. Timing is everything when making this kind of call. Unfortunately it is very hard to judge well. Instead of worrying about market timing and switching strategy, it may be more productive to just focus on executing really well.
The drawback of sticking to your guns is that you may sometimes need to be very patient. The evidence is pretty clear that the success experienced by most fund managers and strategies tends to come and go as there is reversion to the mean. Strategies can be out of favour for a very long time. For example, cheaper value stocks as a group have underperformed for over a decade now. Previously successful value investors like David Einhorn and even to some extent Warren Buffett have suffered from their focus on the wrong sectors. While some investors have suffered from choosing to mix things up at the wrong time, plenty of others seem to have suffered from failing to adapt.
I think you can still be successful over the long term by sticking to a well-founded strategy with a genuinely long term edge, though at points you may need Buffett-like resilience to sit through the inevitable extended periods of underperformance. This requires a lot of conviction. With insufficient conviction you are liable to lose faith at the wrong time.
The alternative is to have flexibility built in to your strategy, in a way that allows it to adapt well to varying market conditions. Many famous and successful investors have achieved this flexibility in various ways:
- The most direct way to adapt to changing market conditions is to focus directly on the forces that drive markets as a whole. George Soros was successful in flexibly employing varied strategies to take big bets based on macroeconomic calls.
- At the opposite extreme, you can focus on exploiting very short term patterns in price behaviour, caused by investor biases. These can occur whatever the market is doing as a whole and you can take advantage by going long or short using any kind of tradable asset. If you can get good at this the returns could be very large indeed, as demonstrated by Jim Simons of Renaissance Technologies.
- Another approach is to ‘protect your downside’ by systematically going to cash when market conditions are not in your favour. Momentum trading strategies, like those employed by Mark Minervini, can do this well by using stop losses to raise cash and leaving you the discretion over when to put it back to work.
- Diversifying across different kinds of investment opportunity can give you more flexibility in responding to market conditions. Peter Lynch invested across several different categories of investment opportunity, including fast growers, stalwarts, cyclicals, turnarounds and asset plays, using a different approach for each. This flexibility, employed within a structured framework, was probably a key ingredient of his consistent success.
While sticking to a coherent strategy over the long term certainly seems more straightforward, there should be benefits to building in some flexibility if you can do it right.
Flexing my strategy
Is there anything I can take from these examples that will allow me to make my own strategy more flexible in adapting to market conditions? I would like to, but the issue I face is practical. How do I do so without sacrificing the discipline and focus that comes with following a simple coherent strategy?
Plenty of investing greats have said that discipline is the most important attribute you need for success. I have no doubt this is true. While some may not have qualms at haphazardly mixing up different styles from investment to investment, for me having a coherent overall plan is key. Too much is counterintuitive in investing to allow yourself to be ruled by your gut.
I need some rules but at the same time don’t want things to become too rigid or complicated. It’s a difficult balance to get right. Below are some of the options I’ve thought of, each with their advantages and flaws.
Big bang switching
One option is to allow yourself the flexibility make a ‘big bang’ switch when certain rare situations are triggered. At the extreme this could mean selling everything and embarking on a wholesale shift in strategy all at once. For example, you might decide one day that enough is enough: the evidence is now overwhelming that fashionable technology stocks are in a bubble so now is the time to start focusing on beaten up cyclicals and asset plays instead.
This has the considerable advantage of clarity and decisiveness. As long as you are clear about the change you are making, this avoids you needing to juggle multiple strategies over time. The clarity should help you execute well.
The downside is that it’s easy to get the timing very wrong. It’s common for investors to start calling inflection points (e.g. market tops or bottoms) either far too early or too late. You don’t need perfect timing to not end up in a mess, but you do need to be roughly correct and have sufficient conviction. This makes major switches a risky and psychologically challenging thing to do.
That said, I have made a mental note to look out for certain situations when I think a major switch may be appropriate:
- Is a bubble developing? Then start raising cash or switch to some value plays.
- Is the economy highly likely to crash the market (e.g. a la Financial Crisis)? If you are confident enough that the market is likely to fall by at least another 20-25% then it makes sense to sell everything. But you also need to be prepared to buy back when it does, even if things still look grim. Otherwise you miss the bounce and there is little benefit.
- Has the market already crashed? Then switch to value-hunting.
With the possible exception of the last one, identifying when these situations apply is easier said than done. I’d be very cautious about making any of these switches in practice and they should happen very rarely, but I think it helps to be mentally prepared for the possibility.
A less dramatic option is to run multiple strategies simultaneously. For example, imagine yourself as two fund managers, one who specialises in high growth businesses and the other in value e.g. cyclicals, turnarounds and asset plays.
In principle, I think this approach has a lot going for it. You don’t need to rely so much on market timing but instead also benefit from better ongoing diversification. You can make more gradual and measured shifts over time to your overall allocation. You can be more selective in picking only the very best candidates from each of the strategies you employ.
The downsides are the greater complexity and work load this would involve. I would need to learn more about how to successfully invest in value plays for a start! These are often quite idiosyncratic and need detailed research. The best way to trade them may differ from my current approach.
As interesting as it might be, I’m not sure I have the bandwidth to hone multiple strategies while I have a full time job. More importantly, even if I did learn how to invest in value plays well, the complexity of juggling multiple strategies may be detrimental in itself. There is a slippery slope to over-complicating your process, losing discipline and ending up in a mess. Executing one approach well is hard enough.
However, there are some possible short-cuts. There is no shortage of decent ideas from other private investors online. This could help reduce some of the work. I could alternatively delegate value investing to a fund, while I continue to specialise in my current approach. It might be worth doing some research to find a value fund manager I’d be confident in delegating to.
A ‘sprinkle’ of flexibility
To avoid diluting my edge or over- complicating my current strategy, it may be best to just incorporate a little bit more flexibility within my current approach. While there are limits to what this could achieve, every little helps.
While I have been strict in only investing in high quality, I do allow some flexibility already e.g. in how I account for valuation as well as momentum when choosing what to buy. Another thing I could do is aim for broader sector diversification on my watchlist. I have some diversification in geographies, sectors and between faster growing businesses and stalwarts, but I haven’t thought about this as carefully as I could have. I probably have too many IT businesses. Perhaps more higher quality cyclicals could be a good idea.
Another area of flexibility that is relatively straightforward to incorporate into a strategy is the flexibility to hold cash. This essentially allows you to do a bit of market timing. Many private investors I follow online periodically raise cash and a few of them seem to time this pretty well, managing to raise cash on the highs and redeploy when the market has fallen.
However, most investors, including me, don’t time this well. I’ve often raised cash when the markets looked shaky as an insurance against further falls. But this has always come at some cost given the market’s inevitable tendency to bounce back. I think it’s only really of benefit to raise cash when you can be confident of buying back again at significantly lower prices. Given the difficulty in judging the timing of this well, I think this flexibility is best saved for rare circumstances.