I caught an interesting interview with asset stripper / investor Wilbur Ross the other day.
For the unacceptable face of capitalism, Ross made a pretty good show of it. For a start, he revealed his childhood ambition was to be a creative writer. So was mine!
More importantly, in his telling, Ross’ key move to restructure the US steel industry was on the side of the unions and against ineffectual management. He made billions saving the rust belt from itself.
But I was most struck by a comment he made about investing in bankrupt steel company LTV in 2001, for which he was initially pilloried.
Far from being the crazy risk taker his critics suggested, Ross said:
We’re in the business not so much of being contrarians deliberately, but rather we like to take perceived risk instead of actual risk.
What I mean by that is that you get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.
So what we had done we analysed the bid we made, we paid the money partly for fixed assets, we basically spent $90 million for assets on which LTV had spent $2.5 billion in the prior 5 years, and our assessment of the values was that if worst came to worst we could knock it down and sell it to the Chinese.
Then we also bought accounts receivable and inventory for 50c on the dollar. So between those combination of things, we frankly felt we had no risk.
That’s the sort of value investing approach that made Ben Graham, Walter Schloss, and Warren Buffett their fortunes.
And while telling perceived risk from actual risk is far from the cakewalk that Ross implies, it’s a vital concept to understand – whether to give you faith to invest against the crowd, or for anyone silly enough to indulge in picking stocks.
Risk junkies or sober investors?
Let’s highlight that key quote from Wilbur Ross on risk:
You get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.
The first thing to say is this is a very different concept from the risk of efficient market economists. When they say ‘risk’, they mean what I’d call volatility.
More specifically, according to the efficient market hypothesis, risk, reward and volatility are all part of the same cat’s cradle – you can’t get one without taking on the other.
Remember: most economists don’t believe it’s possible to say one share is cheaper than another. To get higher rewards, you can only blindly put your money into riskier (that is, more volatile) assets.
To which Warren Buffett might reply: Never mind the theory, feel the size of my bank account.
Value investors like Buffett and Ross (or growth investors, or indeed any kind of non-passive trader) believe they can identify situations where they are paying 50p to buy £1 worth of company.
They call this the ‘margin of safety’, and say that it reduces the risks they take – because they are buying more cut-price assets – while increasing the reward – because they can eventually sell those assets for higher prices.
Where do such opportunities come from?
You might ask why anyone would sell a share worth £1 for 50p?
This brings us back to Ross’ concept of perceived risk. A value investor could argue that perceived risk is higher than actual risk because of:
- Oversight – An investor may identify company assets he believes the market has overlooked, allowing him to ascribe a value of say £1 on a 50p share.
- Underrating – The share may be trading correctly on its current prospects, but the market may have overlooked its medium to long-term potential. Think of Buffett’s investment in Coca-Cola, or more recently Burlington Rail.
- Fear – The biggie. When the market is fearful, most share prices are indiscriminately slashed. If you correctly judge that the fear is overdone, picking up bargain shares in a bear market is like hitting three gold bars on a fruit machine.
Don’t try this at home
Sounds easy, doesn’t it? Unfortunately it’s not.
Most people fail to beat the market when they try stock picking. It’s a scientific fact. Review the psychological quirks that can make you think you’re better at it than you really are.
In my view buying more shares when times look bleak and rebalancing your portfolio towards safer investments when everyone is bullish is a bit safer.
That’s the classic Ben Graham approach of varying your stock allocation between 25% to 75% depending on how cheap the market looks, and it’s a good one because you never sell out completely – and so should avoid your dodgy market calls losing you a lot of money.
That’s important, because again most people are bad at such market timing. Private investors tend to put most money into the markets around their highs, and pull out their cash in the lows. And all this churn costs fees and taxes, which is a net loss from private investors to the finance industry.
As ever, you’ll probably be better off just passive investing through the highs and lows of the market.
Hindsight is the best investor
Being a stockpicker as well as a strategic asset allocator, I’m admittedly a fine one to talk. If you too decide to walk this dubious path, then read some behavioral finance to try to get an edge in deciding what’s a perceived risk versus an actual risk.
As Tim has written on his Psy-Fi blog, it’s usually emotion, not the rational judgment of risk, that we should bet against:
Sectors with a buzz about them get rated higher than those with bad vibes. Value investors take note: done properly excess returns can be achieved without real extra risk.
Yet even this isn’t a sure thing. Alan Greenspan famously warned of ‘irrational exuberance’ in the tech stock market in 1996, but it was easy to quadruple your money by riding the bubble in the four years that followed. If you avoid what’s popular too soon, you’ll be risking lower returns.
Ultimately, perceived risk and actual risk are in the eye of the beholder. Only hindsight can be sure which was which.
Comments on this entry are closed.
That’s solid advice. However I’m not sure I agree with:
“If you avoid what’s popular too soon, you’ll be risking lower returns.”
If it’s too soon, it won’t be popular in the sense you’ve described. If you are aware that it is popular (because everyone is talking about it), it is too late. I read academic paper that actually proved it, and if I recall where I read it, I’ll come back and post the source.
Hi TI
I’ve been scribbling some inane blurb about risk for a future post, but it’ll probably have to go in the bin now as you’ve just covered all the points I was going to and far better than my English ‘O’ level grade C will allow. Damn. Anyway, good article, I like Ross as he’s another down to Earth billionaire type that some of us would like to emulate.
And +1 for the “stockpicker as well as a strategic asset allocator” club, us fence sitters will rule the world yet.
.-= UK Value Investor on: French Connection saves the day =-.
Ross is a fascinating guy. I’ve been lucky enough to interview him a few times in the past, several of those for a 2003 BusinessWeek cover story. Everyone focuses on his winning bets, which have been huge, but he’s made mistakes too (his Telecom stakes in the US never seemed to do that well, for ex.) and that’s where a lot of his price discipline pays off. He never looses all that much.
For me his single most remarkable characteristic is an ability to master minute details about a vast number of companies and industries, and then spin all that data up to one broad read of what’s most important.
His success is a real argument for research. He and his staff exhaustively research the industries they’re focused on, and when he buys in he’s often making the best of his very deep knowledge of bankruptcy laws to do so at rock bottom prices.
I agree that what looks like audacious risk taking is more often smart pricing based on enormous knowledge.
Hi TI
Great post as usual. I’m no longer comfortable with the efficient market hypothesis as I’ve now read enough books and seen enough data to believe that the market becomes over or under valued, is far from efficient and this can be spotted in advance. Of course, picking up on one of your points, I can’t say what the market will do today meaning I don’t trade it as it can remain irrational much longer than I can remain solvent.
That said though I’m with you and UKVI with my strategic asset allocation but with some tactical asset allocation spice instead. No individual stock picking for me.
.-= RetirementInvestingToday on: Interest rates at 0 haven’t worked- QE hasn’t worked- will QE Lite – S&P 500 cyclically adjusted PE PE10 or CAPE – August 2010 Update =-.
Computers and modern day data analysis are disproving the “efficient market hypothesis” every day. I believe market timing is possible.
@Gabriela – Well, once we’ve decided to go our own way on trying to beat the market, it’s going to be a matter of personal choice and judgment, and academic papers aren’t going to be of great use since the ‘one academic paper to rule them all’ still says it’s impossible, and the aggregate performance of managed fund managers – who are paid millions and have incentives to outperform yet still lag simple trackers – would seem to agree for most.
Besides the tech market, another example would be house prices here in the UK. I saw a bubble here in 2003/4, yet prices even after the slump have only returned to 2006/7 levels. I’d have been better riding the wave in this instance.
Other times will be different, but every time you lose +ve returns you have to make them up elsewhere to avoid lagging the market, as you will appreciate.
Cheers for stopping by! 🙂
@UKVI – You’re too kind. Let’s hope we don’t a sharp stab in the unmentionables from our fence sitting. 😉
@Nanette – Thanks for stopping by, and I envy your opportunities to meet and talk to Ross. The super-rich are fascinating, both in how different they are (see F. Scott Fitzgerald!) and in how mundanely the same. But I’ve only really spend substantial time with multi-millionaires, never billionaires, so I can’t comment on the latter.
You’re surely right to flag up his knowledge of law as a key factor. I’ve even heard it said that the reason Microsoft was so successful has roots in its unusual appreciation and application of law (partly via Gates’ father) as for its tech smarts. Law defines the rules of the game, yet many players (myself included) are ignorant of much of its nuances.
@RIT – It’s a fascinating subject, with endless caveats and but what ifs. I know for a fact my portfolio is higher because of non-passive steps I’ve taken over the past few years, but I don’t yet know if it was luck or judgment and I’m not sure I’d be certain even after 50 years.
I definitely do not believe that most people for whatever reason (and it may not be ‘smartness’ – I’ve seen plenty of very clever active investors do as badly as the punt on my daughter’s name variety) will profit by trying to trade shares or even time markets.
This leads to the tension within this blog, where I do one thing but urge another. I may be lucky enough to get a relentlessly passive-orientated friend to write a few posts in the next few weeks (and perhaps beyond) which will hopefully redress this a little.
The most important part of this post is the header: “Don’t Try This At Home.” There are thousands of professional investors out there whose firms spend all day, every day trying to do what Ross does, and most of them can’t come close. For a nonprofessional, the odds are stacked heavily against you.
While the markets may not be completely efficient, they are efficient enough that part-time investors are normally better off sticking with indexing.