They worship consistency in performance despite the fact that Shahan et al (1986) found out that extraordinary managers, with an exceptional long- term track record, underperformed their relevant index 30-40% of the time their study covered.
The Irrelevance of Short- Term Performance Consistency
Often the periods of underperformance lasted for several consecutive years. Pacific Partners, for example, produced a total return of 22,200% versus 316% for the S&P 500 between 1965 and 1983. Nevertheless, did the fund experience underperformance, and even severe declines, for several consecutive years. Periods of such underperformance would have resulted in the termination of the Partnership by all but the most hard-nosed value investor.
Furthermore, does the example show that concentration on short-term performance and volatility often reduces long- term results. Those who had left Pacific Partners in the first half of the 1970's because of its underperformance paid an extraordinary price. They missed an average return of 31,3% (vs. 13,2% by the S&P 500) between 1976-1983.
Why Most Investors Fail in Value Investing
Most of the outstanding money managers mentioned in Buffet’s “Superinvestor of Graham and Doddsville” underperformed for prolonged periods of time. It is reasonable to assume that none of them panicked during those periods of underperformance. Neither is it likely that they changed their value approach to stock market investing.
Greener fields would attract most other investors after such periods of underperformance. Many money managers labelling themselves as value investors being on a diet start looking at the menu as soon as they underperform their relevant index for a short period of time. Sooner than later they go and start sampling, and eventually deciding that they are not longer on a diet. They will eagerly grab the stocks that are moving. The ones other institutional investors that did well have in their portfolio. It is quite of an irony that investors obsessed with short- term results are even likely to achieve them. But they have to pay a high price. They can only achieve those results at the cost of foregoing superior long-term outcomes.
The Relevance of Style Consistency
The abovementioned is far from saying that consistency does not matter when it comes to value investing. But it is the consistency in the process, and not in short- term results, that is most important. Brown et al. (2009) verified in their study "Staying the Course: The Role of Investment Style Consistency in the Performance of Mutual Funds" that style consistency leads to superior risk adjusted long-term returns.
They tested three specific hypotheses related to the style consistency issue and found out that:
- A negative relationship exists between portfolio style consistency and portfolio turnover.
- A positive relationship between a fund’s style consistency and the future actual and risk-adjusted returns it subsequently produces exists.
- The consistency of a portfolio’s investment style and the persistence of its performance over time represent distinct influences.
Thus, they conclude that: " (...) it appears that the ability for portfolio managers to sustain a preferred degree of consistency to their designated investment styles is a valuable skill."
The Usual Suspects of Underperformance
Two main reasons leading to long- term underperformance stand out. To a lesser extent it is to be found in over-diversification, which induces the dilution of investment ideas and exhausts the resources of a portfolio manager.
More often the underperformance is induced by excessive portfolio turnover rates. High turnover indicates overconfidence and an investment horizon that is too short to allow contrarian value investing strategies to materialize
In addition, short- termism leads to risk-aversion. Perfect examples for the fallacy of short-termism are university endowments. Theoretically they are ideal institutions to develop a truly long- term approach to investing. They could make investment under the assumption of indefinite existence. Nevertheless, do they invest a high percentage of their endowment in bonds and thus, run high opportunity costs of not being invested in equities. They accept below average long-term rates of return on a significant portion of their funds. Such a behaviour is irrational and more than strange. It is only explicable with a high aversion to short-term volatility within those institutions. Such a phenomenon is often described as a Myopic (short-sighted) loss aversion, which is also a major contributor to the phenomenon of closet indexing within big institutions.
Investors who buy into the myth of performance consistency are doomed to fail in value investing. They will often sell in a panic as soon as the next crash makes them realize that stock picker’s that can always outperform the market do not exist. Several studies have shown that value investors with long records of superior returns underperformed their respective indices for extended periods of time.
In order to be successful in value investing over the long haul it is not enough to buy cheap stocks on quantitive and/ or qualitative metrics. As important is to have a burning desire for value investing, a sound process, conviction, persistence, tranquillity, faith and trust. Those Investors will adhere to the consistency that really matters. Namely, consistency in the investment framework, process and style.
It is always weird to see how many of the supposed long- term value investors, as soon as a crash occurs, turn into traders. Investors lacking a sound process, stamina and sticking around till fellow investors recognize the worth of their holdings are bound to fail in value investing.
Value Investing and Behavioral Finance; Presentation by Christopher H. Browne to Columbia Business School; Graham and Dodd Value Investing 2000; November 15, 2000
Keith C. Brown, W.V. Harlow, Hanjiang Zhang; Staying the Course: The Role of Investment Style Consistency in the Performance of Mutual Funds; April 28; 2009
Ernst W. Gronblom; The Case for Focus Investing; Helsinki Capital Partners; December 10, 2009
V. Eugene Shahan; Are Short- Term Performance and Value Investing Mutually Exclusive? The Hare and the Tortoise Revisited, Hermes, Fall 1984
Warren E. Buffett; The Superinvestors of Graham-and-Doddsville