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Ten Lessons (Not?) Learnt

James Montier
Asset Allocation
 Lesson I: Markets aren’t efficient

A long litany of bad ideas:

CAPM
Alpha and Beta
Black and Scholes
Risk management
Mark-to market
M&M dividend and capital structure irrelevance
Shareholder Value
Regulatory regime

Most insidious aspects of EMH are the advice on

sources of outperformance
Inside information (illegal in most places)
If you can see the future better than everyone else
Also tells us that opportunities will be fleeting

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 -3
-2
-1
0
1
2
3
4
5
6

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1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
Economist forecast

1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Not a drop of evidence that we can forecast anything at all

2007
2008
Actual result

2009
Forecast error over time: US and European markets 2001-2006, %

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Analyst expected returns (via target prices) and actual returns (US, %)

50
Analysts’ forecast
40 Actual outturn
30

20

10

-10

-20

-30

-40

-50
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

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 Lesson II: Relative Performance is a dangerous game

Homo Ovinus

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 Institutional investors vs. US market (weight difference)

-1

-2

-3
Growth

Low Momo

Low issue
High Momo
Large

Value

High issue
Accruals

Accruals
Small

High

Low
Source: Lewellen (2009)

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 Many active managers aren’t even trying!

Lewellen concludes:
“Quite simply, institutions overall seem to do little more than hold the market
portfolio. Their aggregate portfolio almost perfectly mimics the value-weighted
index... Institutions overall take essentially no bet on any of the most important
stock characteristics known to predict returns, like B/M, momentum, or accruals.
The implication is that, to the extent that institutions’ holdings deviate from the
market portfolio, they seem to bet primarily on idiosyncratic returns – bets that
aren’t particularly successful. Another implication is that institutions, in aggregate,
don’t exploit anomalies in the way they should.”

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 Why not? Career and Business risk (Homo Ovinus rides again)

Cohen et al ‘Best Ideas’ Cohen et al conclude

20
“The poor overall performance of
mutual fund managers… is not due to a lack
18
of stock-picking ability, but rather to
16 institutional factors that encourage them to
14 overdiversify.”
12

10

0
B e s t Id e a s M a rk e t

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 Performance around hiring and firing decisions (%)

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 Lesson III: This time is never different

3.5

2.5

1.5

0.5
1 12 23 34 45 56 67 78 89 100 111 122
Months

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 Mill/Minsky/Kindleberger framework for bubbles

Displacement

Credit Creation

Euphoria

Critical Stage/Financial Distress

Revulsion

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 Why don’t we see bubbles?

Black Swans Predictable Surprise

– Unpredictable – At least some where aware of the
– Massive Impact problem
– Ex-post rationalization – The problem gets worse over time
– Eventually explodes into crisis

Five impediments to recognising predictable surprises:

(i) Over-optimism
(ii) The illusion of control
(iii) Self-serving bias
(iv) Myopia
(v) Inattentional blindness

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 Lesson IV: Valuation Matters (in the long run)

Source: GMO

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 Buy when it’s cheap: if not then, when?

Buying at 10x G&D PE

Date of Purchase % decline from purchase to market trough Months to market trough Months before mkt return to purchase level

1917.09 -16 3 18
1931.10 -53 8 21
1942.03 -4 1 3
1982.03 -1 4 6
Average -19 4 12

US market 1881-2008
Subsequent Average Return Worst Subsequent Return % of times subsequent return positive

1 Yr 2 Yr 3 Yr 5 Yr 10 Yr 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr

13 21 34 41 67 101 -24 -26 -18 -11 -38 80 92 91 94 92

10 26 37 43 80 93 -24 -11 -72 3 -38 82 92 90 100 95
9 34 41 52 93 82 -16 15 5 18 8 83 100 100 100 100
5 134 112 126 243 87 131 102 125 242 85 100 100 100 100 100

Source: GMO

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 0
10
20
30
40
50
60

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1881
1885

1890
1894
1899

1903
1908
1913
1917

1922
1926
1931
1936

1940
1945
1949
Graham and Dodd PE (S&P500)

1954

1958
1963
1968

1972
1977
1981
1986

1991
1995
2000
2004
Source: GMO

2009
 Bottom up valuation: What would Ben think?
% of stocks passing BG conditions
25

Now Mar-09 Nov-08

20

15

10

0
UK Europe US Japan Asia

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 Lesson V: Wait for the “fat pitch”

600

500

400

300

200

100

0
1 2 3 4 5 6 7 8 9 10 11 12
Source: Plottt et al

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 ADHD and stock holding periods
10

1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: NYSE

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 Lesson VI: Sentiment matters

12

10
Low Sentiment
High Sentiment

0
Low PE High PE

Source: GMO

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 Exploiting sentiment (US 1962-2000)

2
When sentiment is low: Buy young, volatile, unprofitable firms
When sentiment is high: Buy old, stable, profitable firms Sentiment Low
1.5
Sentiment High

0.5

-0.5

-1

-1.5
Age (old vs young) Volatility (high vs low) Profitability (high vs low)

Source: Baker and Wurgler

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 Sentiment suggests need for caution
55

50

45

40

35

30

25

20

15
96 97 98 99 00 01 02 03 04 05 06 07 08 09

ADVISORS SENTIMENT BEARISH

Source: DATASTREAM
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 Lesson VII: Leverage can’t turn a bad investment good

• Leverage can’t turn a bad investment good, but it can turn a

good one bad

• Limits staying power

• Can turn a temporary impairment (i.e. price volatility) into a

permanent impairment of capital

• Beware of financial innovation…often just leverage in a thinly

veiled disguise

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 Lesson VIII: Beware of over-quantification

Ben Graham:
“Mathematics is ordinarily considered as producing precise and dependable results; but in the
stock market the more elaborate and abstruse the mathematics the more uncertain and
speculative are the conclusions we draw there from…Whenever calculus is brought in, or
higher algebra, you could take it as a warning that the operator was trying to substitute theory
for experience, and usually also to give to speculation the deceptive guise of investment.”

Keynes:
“With a free hand to choose coefficients and time lag, one can, with enough industry, always
cook a formula to fit moderately well a limited range of past facts.
I think it all hocus - but everyone else is greatly impressed, it seems, by such a mess of
unintelligible figures.”

Munger:
“It seems like higher mathematics with false precision should help you, but it doesn’t. They teach
that in business schools because, well, they’ve got to do something!”

There are no points for elegance in the real world.

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 Risk isn’t a number

Risk isn’t volatility, it is the permanent impairment of capital

Volatility creates the opportunity.

Keynes again:
“It is largely fluctuations which throw up the bargains and the uncertainty due to
fluctuations which prevents other people from taking advantage of them.”

Think about risk as a trinity:

Valuation risk
Business risk
Financing risk

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Lesson IX: There is no substitute for skepticism

Santayana:
“Skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or
to the first comer: there is nobility in preserving it coolly and proudly.”

We are in the rejection game.

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 Lesson X: Benefits of cheap insurance

Insurance is often disliked in investing, because of the nature of the cash flows, but
that often makes it cheap!

Examples:
Inflation insurance
Moral hazard/market melt up insurance

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 Long-term volatility
75

65

55

45

35

25

15

5
28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

Source: SG, Bloomberg

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 Lessons (not) learnt

I. Markets aren’t efficient

II. Relative performance is a fool’s game
III. This time is never different
IV. Valuation matters
V. Wait for the fat pitch
VI. Sentiment matters
VII. Leverage can’t make a bad investment good
VIII. Beware of over-quantification
IX. There is no substitute for skepticism
X. Don’t underestimate the use of cheap insurance

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