We believe that superior risk management is the key to successful value investing. Why? To us, investing is not about having a crystal ball to see the future, because successful prediction is impossible in an uncertain world! Though we can’t control what will happen, we can control the investments that we own when we face that uncertain future. The best value investors understand that there is a difference in the story behind a stock, and the value of the stock itself.
You would have a lot of company if you thought that it was Yogi Berra who gave us the title of today’s research “Prediction is difficult, especially about the future.” But you would be wrong.
This quote is, however, a classic example of a real Yogi Berra quote: “I really didn’t say everything I said.” The prediction quote came from Dr. Nils Bohr, widely considered to be the founder of quantum physics. Dr. Bohr was immensely quotable himself. One of the funniest exchanges Bohr ever had was with another titan of physics, Albert Einstein. Einstein came of age before quantum physics, so he despised its emphasis on how much in the quantum world was unknowable (such as Heisenberg’s uncertainty principle) and hence must rely on probability. Einstein famously told Bohr that “God does not play dice with the universe,” to which Bohr answered, “Don’t tell God what to do with his dice!”
Dr. Bohr with Einstein
Bohr wasn’t trying to be funny with his views on the difficulty of prediction, rather he was simply outlining the bedrock principle of mathematical uncertainty that lay behind quantum physics. As a value investor, I use Dr. Bohr’s quote a lot because it helps explain my investing philosophy.
"The horse is here to stay but the automobile is only a novelty—a fad." - The president of the Michigan Savings Bank advising Henry Ford's lawyer not to invest in the Ford Motor Company in 1903
Perhaps CNBC and other pop culture investing media is to blame for spreading the false narrative that prediction is the basis for success. Don’t blame them, after all - they have 24 hours per day of TV airtime to fill. But to us, this is completely and totally wrong, at least when it comes to value investing. It’s just too easy to be wrong, because prediction is hard – especially about the future. Maybe what it takes to really internalize this lesson is long and painful experience, and the scars from it that I bear, in watching – up close and personal – the repeated prediction failures of the “experts.”
“There’s no chance that the iPhone is going to get any significant market share. No chance.” – Steve Ballmer in 2007, while the CEO of Microsoft
We believe value Investing is NOT Seeing the Future More Clearly. Value Investing IS Better Risk Management.
Did anyone have a stronger claim on a better crystal ball into the future of technology than Steve Ballmer in 2007, as the CEO of Microsoft? Yet the quote above demonstrates that Ballmer whiffed hard on the greatest technology innovation in the last decade. His crystal ball failed him. This doesn’t mean he was stupid. It means that he was human.
You shouldn’t be surprised by this. I certainly am not. In my career, I have interviewed hundreds of CEOs of publicly traded companies. During this time, I have watched CEOs get things wrong all the time – even about their own businesses! While CEOs are certainly better placed than most to see the future of their businesses, the future is unknowable. This sobering realization was a big part of my education as a value investor.
I remember as if it were yesterday, as a young investor learning the ropes at T. Rowe Price, hearing this comment: “The cheaper a stock is, the less you have to get right.” It made me realize that value investing is not about having a clearer crystal ball. Rather, in my view, value investing is about facing an inherently uncertain future with a portfolio of investments that have already been de-risked. Put another way, it is the ownership of great businesses through stocks that are controversial for obvious reasons – and therefore undervalued. This undervaluation creates the favorable balance of risk and reward that can give you the confidence to face an uncertain future. In my opinion, it’s not better prediction that wins in value investing, its better risk management. Dr. Bohr would understand this opinion.
I wanted to write this note to make clear our value investing philosophy. Numerous times in my many meetings with clients over the years I have been asked “What do you think the market or a particular stock will do this year?” I will tell you now, like I told them all then: “I have no idea. That is not my job.”
My job, rather, is to prepare for an uncertain future by owning individual investments that we believe have already been de-risked, that are cheap for reasons that we understand. Most often this cheapness comes at a cost: things are typically cheap for a reason. It could be a terrifying lawsuit, a new competitor, a new product launch, technological change, the loss of a patent; just about anything. Almost always these fears are well-founded and obvious to all – and therefore result in a gloom of discount weighing upon the shares. This is good news for us, as value investors.
Story-driven investors, however, react differently to adversity. Such investors obsess about an unknowable future, throw their hands up in frustration, and - scared of “uncertainty” - exit. But what do these people believe that they know that somehow everyone else doesn’t? I can only assume that they believe that their crystal balls are better. I don’t think the data supports that conclusion. Just ask Steve Ballmer.
Such misguided investors act as if they believe that investing is about owning the best stories that they can find. But let me assure you now, if there is one thing I have learned in two decades of public market investing, it’s that while you may mistakenly think you own the story, what you really own is the stock. You had better understand how that stock is valued. In my experience, the stock has a value that may be completely disconnected from its “story.” That’s when value investors can really shine.
Find a stock that is undervalued relative to the business it represents, where all the terrors of an uncertain future are fully priced into it, and you, my friend, are a value investor. Own a diversified portfolio of such ideas, and you may even be a good one. Because then you don’t have to predict, because you are already prepared for an uncertain future. You just have to be patient.
"There is no danger that Titanic will sink. The boat is unsinkable and nothing but inconvenience will be suffered by the passengers." - Phillip Franklin, White Star Line vice-president, 1912
This is what I have learned in two decades of value investing: the future, you can’t control, but you can control what you own when you face that future.
Make no mistake: there is a simple trade at work here. We believe investors who seek “good stories” give up, leave and sell to value investors willing to assume that risk of uncertainty – for a price. If this price is rewarding enough to satisfy value investors, then they invest and can profit from that investment. The key is to determine the balance of risk and reward through the Dark Arts of valuation, which is a topic too long to be dealt with here. Email me here for one of our many whitepapers on the topic of valuation if you want to learn more.
Of course, value investors know what Dr. Bohr knew, that prediction is difficult, especially about the future. To us, this means that those who blaspheme by worshiping the false gods of “great stories” are facing that same uncertain future as value investors face – without the benefit of the downside protection that comes from better risk management. This seems to us a horribly flawed trade structure. We think clients deserve better.
To us, such “story-based investing” is a failed process that – done repeatedly – subjects investors’ hard-won savings to risk unnecessarily. And that, dear reader, is a crime. Why? Because no one should take a risk for which they are not compensated. Given that we are in the risk-management business, and not the prediction business, we would never pursue such a strategy. This is all part of our valuation-driven philosophy of “winning by not losing.”
So please understand if, when you and I chat, I have no opinion about what the market will do. That, I leave to the “experts.”