Why Investors Succeed

John Mauldin | Thoughts from the Frontline
April 26, 2002

As I leave the country today, headed for Mexico's beaches, I can't help but notice the stock market seems to be stuck in neutral, where it has been since the first of the year. So far, at least, my Muddle Through Market prediction at the beginning of the year seems to be the right one.

There is a considerable body of research that has been done which suggests investors would usually be better off exiting the market sometime in May and coming back in sometime in October. While not 100% accurate, the Summer Doldrums happen often enough to be a useful investment technique.

This year, I wonder what event will happen to make this market prove the rule wrong? I come up with nothing. Just a long, hot summer of sideways to down. It will be a tough market to invest in - unless you become a value investor. And I know a very good writer who can teach us some of the basics of value investing.

I have asked my good friend Lynn Carpenter to write this week's e-letter so I can relax and enjoy my mini-vacation. Lynn is the editor of the highly regarded Fleet Street Letter. She spends her time researching companies, looking for value. And she has done well. Her portfolios were up last year and the year before and are doing well this year. She has given us an excellent presentation which is also a fun read. She also gently gives me a lesson on the underlying psychology of investor mistakes. You might want to save this one and read it again every so often.

But first, a quick note on last week's value recommendation from Tom Donaldson. Some of you wrote and said how can Senior Housing Properties (SNH) pay a dividend that is larger than their earnings?

The answer is that for REITS (Real Estate Investment Trusts) earnings are primarily classified as FFO - Funds generated From Operations. This standard measure for SNH is currently at $1.72 estimated for 2002 vs. dividend payout of $1.24 - coverage is 138%. Note this was just raised and is now a yield of 8.6%! Payout ratio is a conservative 72%. Also remember REITS must payout 90% of what are called operating earnings, so if they want to pay out less they must work to get operating earnings down. This also gives SNH room to raise their dividends over the next few years. When you read Lynn's article below, you will get an idea of how important dividend growth can be. And now, to Lynn.

The Makings of a Good Investor

My pal, John, writes about things I don't know a lot about. That's why I read him. To learn something. And I'm always rewarded. But lately he's been writing about something I am quite familiar with - investor's mistakes. It's a hot topic.

Something new is going on in business schools today. Most of what happens in advanced finance classes would bore anyone without the soul of an actuary. But these days, instead of devising ever-longer formulas about ever-more hypothetical situations, biz schools are getting down to what counts: investor psychology .

John has featured a couple of very good articles on the subject lately, especially his letter called /article.asp?id=mwo032802Why Investors Fail. If you missed it, go back to his /archive.asparchives and look them up. Give them some thought. But today, we'll make the leap from knowing what investors do wrong to take you over the fence to those green pastures where investors do everything right.

I bump up against investor behavior every day from the opposite viewpoint of those who study it. As an investment newsletter writer, my goal isn't to stop people from making mistakes so much as it is to help them do the right thing in the first place. So I've spent a lot of time noticing what my readers do, and figuring out how I can help. And it's become clear to me that good investors and bad investors not only do things differently, they have entirely different attitudes.

How to Hold Your Fork

But the greatest irony in all this focus on investors' mistakes is that much of what makes the list is not so dopey. Focusing on what investors do wrong is not much of a cure. It's like teaching your kids how to hold the fork instead of just telling them that they shouldn't grab it fist on top.

Take "cognitive dissonance." We couldn't live without it. Cognitive dissonance comes about when you know something and later facts challenge that belief. There's a clash. The solution most of us make is to stay with the first theory and reject the later information - or put it in a separate compartment-- so that we can continue doing what we have been doing.

If it weren't for cognitive dissonance and our habit of rejecting later information none of us would ever marry or raise children. The idol of our dreams will have flaws -often huge flaws- that we'll overlook in their case. Babies coo, gurgle, cuddle and smile. Just as in our dreams. But they also throw up their dinner, cry for hours at night when you're sleepy, and their bathroom habits are unspeakable. We love them dearly anyway.

Or take a "refusal to admit mistakes." Well, of course. Any healthy person is a little slow to admit mistakes. On occasion, my husband has pointed out one or two of mine, and I had to agree with him. Eventually. But he had to come up with a good case first.

And do you hang on to losers hoping they'll prove you right? Congratulations on being a fine human being. Humans have a built-in mechanism that warms them to underdogs. It's one of the nicest things about us and the stuff of lovingkindness. Staying with a belief when there's no scientific proof we're right and no gain close at hand is also what enables us to have faith.

In fact, if we stopped doing many of the things that lead to mistakes when investing, we'd be lesser people. That's why I don't think a list of errors will get us far. But you can remain human and still be a good investor. It's a matter of developing habits more than weeding habits.

I've met a lot of talented investors. I've met a lot of people who weren't good investors and turned it around. So, forthwith... what do good investors do?

Good investors know the difference between an investment and a lottery ticket.

Over the last five years, when talking to people (those who aren't regular Fleet Street readers, at least) one problem has become clear... and so has one trait that separates the savvy from the hapless.

By my seat-of-the-pants calculations, it seems as though nine of every 10 people who cornered me to talk about their investing prowess during the late bull market had never invested a dime in stocks in their lives.

They weren't liars. They just didn't realize that the stock market is only a place where you go to do your buying and selling. Being there doesn't make you an investor.

A polite atheist might get down on his knees in church, but that doesn't mean he's praying. Most of the people who came alive in the late, great, bull market were speculators, not investors. The difference is profound. But let's make it easy.

If you go to the garden center and buy a peach tree for your orchard, counting the future bushels of peaches you'll get, knowing the cost of planting and upkeep, and understanding when and where to plant for the best yield, that's investing.

If you buy a peach tree when they're almost gone and stand in the parking lot waiting for a desperate latecomer to rush toward you and make you a higher offer, that's speculating.

An investor doesn't buy stocks to trade them. He buys stocks to harvest the peaches. He buys a piece of a business. The stock certificate is just a symbol and a convenient way to keep track of ownership. If you don't understand what the company does, you're speculating. If you don't know its competitors and their potential -present and future- you're speculating. If you're buying with an eye to making big profits fast and bailing in a matter of months, you're speculating. If you feel the need to do something to your portfolio every week, you are probably speculating. If you are afraid to wait because you might miss out on a stock that's about to "take off" when (a) the FDA approves its newest drug, (b) it's going to get a new contract with Microsoft, (c) you heard rumors that Warren Buffett is buying it, (d) any kind of urgent news... you are speculating. None of this is bad behavior. It just isn't investment behavior. You could do all those things as a speculator and succeed... but only if you realized that it was speculation and acted accordingly.

Good investors don't panic when the market is nutty

If one of my stocks dropped and Morgan Stanley downgraded it to accumulate, you know what I'd do? I'd consider buying more.

Most people should never buy more under those circumstances, but investors can. The reason is simple. Speculators are trading on market opinion. Opinion is a big, big deal in speculation and you'd better pay attention. Speculators who know what they are doing expect to take a lot of losses, and they get out fast when opinion works against them.

Investors can ignore opinion because they start out differently. Before I buy a stock, I have looked at the last five to 10 years of performance, the trends (getting better or worse?), the company's competitors, its industry outlook, its management, its debt levels.... And then, I estimate what the business should be worth 10 years from now. I only buy when I know that I'm getting a good deal compared to that long-term estimate. And when the market suddenly changes the price, I don't look at the market for guidance, I look back at the business. If it's still on track, I ignore the price of the moment. It will all come right eventually. Historically, the market is very efficient; it simply gets a little crazy in the short run.

As Benjamin Graham put it so neatly, "In the short run, the market is a voting machine. In the long run, it's a weighing machine."

Now we come back to those investor mistakes. Are you committing the dread sin of hanging on to losers if you don't sell out as the price falls? Maybe, maybe not.

If you know what the business is worth, you know whether the company is winning or losing. Market prices change daily, businesses don't. Which brings us to when you do sell...

Good investors have an exit strategy

Let's be clear here, good speculators have exit strategies, too. You can't be a good investor or a good speculator without one.

Now here's where knowing whether you are investing or speculating really matters. Buying is easy, selling at the right time is the hard part. One of the strategies that is very popular these days is the trailing stop. Many people set it at 25% and sell if the stock drops that much from its last high.

That is not a sensible strategy for investing. It's for speculating. It's only necessary if you don't know what the company is worth, market opinion guides your strategy, and you are trying to make your money too fast. If you use it thinking it will keep you out of trouble, you are speculating. Only better analysis and higher standards going in will keep you out of trouble as an investor.

I've known people who thought trailing stops meant they could only lose 25% at worst. So they stopped out of one stock, reinvested what was left in another and stopped out again. Then did it again. They weren't down 25%. They lost 58% in three trades.

The week of Sept. 19, as the markets reopened after the World Trade Center bombings, I saw lots of newsletters and investors take huge losses because of their trailing stops. They sold at the worst moment, for the worst reason. Our Fleet Street stocks were down, too. Especially AMR (American Airlines). But by yearend, not only had our portfolios recovered, they had risen to new highs. Even AMR advanced 20% before we sold it.

So, if not trailing stops, what do investors do? How do they know when to exit?

My approach is to sell when a company becomes fully valued or overvalued and the price begins to slide. Or when the business changes for the worse. Some successful value investors sell whenever a stock gets to 90% of their estimate of its long-term (10-year) valuation. Others may sell on a ratio basis, if the price to sales reaches a certain level, for instance. Growth investors may sell when EPS growth rates taper downward. Other investors who watch cash flow, especially those who look for "economic value added" may sell when cash flow growth slows or goes negative. Whatever the exit strategy, it should be tied to the system you used to evaluate the stock in the first place.

This habit takes care of a whole lot of second guessing. In 2000, Office Depot fell nearly 50%, but according to the reasons I'd bought the stock, it was on track. In the next 22 months, it rose 250%. I wasn't even surprised.

What about cognitive dissonance? If you know why you bought an investment, the market price is a "later fact" of no great relevance. You can easily ignore it. (And if you are a speculator, it is relevant, and you can't ignore it.)

Good investors are patient

Hey, I never said it was sexy. Trading is sexy. Speculation is sexy. Investing usually isn't. But good investors take their time getting in and selling out. There are rewards. For one, they only buy at a price that allows strong prospects of winning. This goes for growth and value investors alike. It doesn't go for momentum investors, because they are not investors. They're speculators. Just like "Long Island Tea" isn't really tea. It's booze.

Second, patient investors let gains compound. A new investor -and I can already tell she'll be a good one some day- recently sent me an excited e-mail. She had just gotten her first stock split with TJX Corp. She was already happy with the 20% gains, she'd made so far and wanted to know what the split meant. I pointed out that it meant nothing. Yet. Just twice as many shares, each one now worth half as much.

But the board had increased dividends by 33%. The current yield is still small, but if you look at TJX, a fine and reliable business, you can see that holding it has paid off well. In the past five years, the stock has split three times and dividends have steadily risen. Anyone who bought shares five years ago is now collecting a 15% yield on their original investment, every year, from their dividends alone. That's more than the historic market average, and more than the market is likely to return annually over the next few years. It's reliable. If the bear market deepens, those investors would be wise to hang on to their TJX and collect dividends instead of cashing in and risking putting that money into something that may not pay off.

And patient investors who don't get in a hurry to sell out on bad news don't turn paper losses into real losses. Sit down at your computer some Saturday afternoon. See if you can find a chart for a stock that has gone straight up, never down... one with no crooks, bends or dips in sight. You can't. That stock doesn't exist. You can't climb the slope to the top without stepping into a hole every now and then. Good investors keep their eye on the top.

And, finally, good investors are realists

After one of his especially good years, Warren Buffett met his shareholders in Omaha and said it wasn't much of a performance. That wasn't "Aw Shucks, Warren Bucks" playing coy. He meant it. The market had gone up so much that almost anyone one could have made money that year. He only made a little more money, and the margin wasn't a blowout. Or as Buffett puts it, "when the tide goes out, you can see who's been swimming naked."

Every time I get a letter from someone who wants a sure-fire way to make 100% this year, I cringe. When I hear from someone who merely wants to make 30-40% a year, I get even more nervous. The 100% dreamer is such a gambler he might as well be in Gamblers Anonymous. I can't save him. But the person who expects to make 30-40% as a routine is in a dangerous frame of mind. It sounds reasonable. We've even seen it happen not too long ago.

But it's unrealistic. The best investors in the world have never managed to keep up a record like that for more than a few years (three or four) running. Warren Buffett went from $10,000 to some $43 billion or so averaging just over 20% a year, and he's alone in the world at keeping such a high return for so long with so few disruptions. At one point, he'd outperformed the market for 30 years. No one else has ever done that.

Oh, and the long-term market average is under 12% a year. Just thought you should know.

John made this point recently. If you can be in the top 50% of investors each year for ten years running, at the end of that ten years, you will be in the top 80% of all investors.

And I have to add a footnote. I don't think you should beat the market every year, necessarily. When the S&P was rising 40% a year, and the Nasdaq spiked 100% in 1999, it was a speculative bubble. It was very hard to match that performance without getting into far too risky stocks. Setting your sights lower than crazy might have meant an underperformance in 1999, but it also meant you weren't likely to be one of the 90% losers in 2000-2001.

The real deal is this. You can make a lot in stocks. But you are far more likely to make good money compounding dividends. Over the long run, 60% of market returns have been made on reinvesting and compounding dividends, not on capital gains.

There are lots of other traits that might help. Having what my dad called a "hard head," but what I prefer to think of as a streak of independence, is probably good. You are better off if you never look at an analyst's earnings expectations and make your own estimates, but you can succeed without going that far. Learning to do your own research is helpful, but it's not necessary if you have a good advisor and can decide for yourself whether the information he gives you seems right.

Or, you might just speculate for the fun of it and turn your investment portfolio over to a good money manager. It's not a crime to speculate. It's just terribly risky.

One More Thought

For those of you who would like to read Lynn regularly, I suggest you subscribe to the Fleet Street Letter. It is one of the best value oriented investment letters I know of, and is very reasonably priced for the service. You will get lots of solid value driven investment ideas.(I should note that I also write for FSL from time to time as a guest analyst.)

You can click the link below to subscribe online.

http://www.agora-inc.com/reports/FST/Value

Next week I will be back. I will be in California Monday through Thursday and still have a few openings if you would like to talk about your investment portfolio.

Here's hoping I can hit them as straight as Lynn's advice,

Your relaxing while you are reading analyst,

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