I have been investing in index funds for many years. The reason is quite simple: indexes beat 80- 90% of the active managers. This is very true! For the average investor (Buffett says, for 99% of investors) who do not enjoy a Sunday afternoon spent sipping good coffee and evaluating individual companies to invest in, index investing is definitely the way to go. Ben Graham also recommended this for the defensive investor (as opposed to the enterprising investor). However, if you’ve read our first newsletter and are now interested enough to read the second one, you might not be the defensive investor type. For now, I want you to imagine this scenario: if you are given $1 million to invest in your hometown, most likely you won’t choose to invest in every single business in the town in small amounts. You know your hometown well enough to know that some businesses are better than others. Most likely you’d ask who the CEO/founder is and to read the financials (and would compare the earnings against the asking price) and would want to know how profitable and how quickly growing the business is. You’d probably seek to at least avoid those unprofitable, debt-ridden, shrinking businesses run by your less than scrupulous former high school classmates. People become very logical and careful when considering an investment in their hometowns, but suddenly lose all perspective when the stock market offers daily prices for all businesses around the world.
That is what happened to me throughout my ETF investment days. I started to question which index is optimal and that led me down the rabbit hole, so to speak. The SPY is a standard one but is only large cap stocks. So you could look at IWM or VT, which cover smaller companies (which tend to have better, though more volatile returns). However, most of the growth and undervaluation right now is international, so you’d want to look at EFA or EEM and rebalance among them and IWM or SPY. However, then you learn that value (and momentum) stocks consistently outperform growth stocks, so you see that RPV or GMOM consistently outperforms and you start to look into small cap and value funds. You start to question when the optimal timing to rebalance is and whether you should tilt towards more undervalued markets. This is the path that led me to Buffett and to want to look beyond just investing in indexes. Indexing has become very popular and that is a great advantage to us as rational, business-like value investors. When over 30% of the stock market is bought and sold without any consideration for underlying, intrinsic value or quality of the companies, it creates great opportunities for those who are able to understand business quality and value.
But you will be surprised by the return that can be generated by utilizing a little bit more information than just the fact above that indexes beat most active managers over time. Take a look at the study findings by gurufocus (a great resource for investors). They divided 2,403 stocks into three categories: undervalued, fair-valued, and overvalued by using a simple indicator PEPG (we actually prefer Discounted Cash Flow valuation, but this valuation is not an exact science, so we look at multiple measurements). PEPG is P/E ratio (Price to Equity) over Past Growth, which is defined as P/E ratio divided by average EBITDA (Earning Before Interest, Taxes, Depreciation, and Amortization) growth rate over the past 5 years. Here, the advantage to using PEPG to measure the valuation of the business, instead of P/E, is that P/E ratio fails to take into account of the “growth” part of the business (they actually get very similar findings from utilizing P/E). Stocks can be roughly considered undervalued if the PEPG ratio is below 1.
We can see that for the top 100 most predictable companies (business has consistent increases in earnings every year), there were 25 undervalued stocks in Jan. 1998. This group of stocks gained about 20% annually if held for 10 years and 8 months. The fair-valued group has an annualized median gain of 12.1%, even the over-valued group has an annualized median gain of 9.5%. For the second 100 most predictable companies, the gain is lower, as expected. The undervalued group has an annualized median gain of 13.8%. The over-valued group has 7.6%. All these numbers are much higher than the 3.1% of the annualized median gain of all 2403 stocks (the index). The S&P 500 gained 2.7% annually over the same period and the SPDR S&P 500 index (SPY) gained 3.08%.
What does this tell us? It tells us the safest way to invest is to buy great businesses at a fair price. We can also see how a little bit more knowledge could get much higher return than investing small amounts in everything/ETFs. In finance departments across business schools and economics departments the prevailing theory is that of the efficient markets hypothesis and the importance of wide diversification. The investment strategy that Buffett and Munger take and that we take does not believe wholeheartedly in these theories. We believe markets are only somewhat efficient and occasionally they’re completely crazy (those are the very best times to be a rational, disciplined investor) and that diversification is good if you’re investing only in indexes. However, if you’re picking individual stocks with discipline and care, then it’s more likely to result in “de-worsification”. It’s very hard to have 50 or 100 good, well-researched ideas in investing (ask any VC investor this). So the average outcome of your 10th through 50th ideas is likely to be a lot worse than the average outcome of your 6 best ideas. It’s a simple notion that the more stocks you invest in, the closer you will get to the average outcome. (The idea of risk management on the other hand probably deserves a separate newsletter in itself.)
Of course I don’t want to make it sound like easy. As Buffett said “it is simple, but it is not easy.” The trick is, as he emphasized “stay invested within your circle of competence”. That is why sometimes it is even more important to know what you do NOT understand than what you do. For example, Buffett is never a big fan of technology companies, and has publicly expressed that he doubted whether “the internet will change how people chew gum (Berkshire Hathaway is the biggest holder of Wrigley’s).” In our next newsletter, we are going to write about “durable competitive advantages”, one of the most important characteristics Buffett looks for in the businesses he wants to invest in.