If This Is Failure, I Like It

I thought I did worse this quarter, but I ended up trailing the S&P 500 by less than 50 basis points. That meant that I trailed the S&P 500 for the first year in eight by somewhat less than 1%. So goes the streak.

On the bright side, it happened in a period where growth was trouncing value, and large capitalization stocks were trouncing the small.? My investing style is value-oriented, and all-cap, so I will always be smaller than the S&P.? I did better than value indexes, and better than small caps.? Is this examination of factors an excuse?? I don’t know.? The wind was at my back for the last seven years, and it is in my face now.? What I do know is that I’ve had my share of bad decisions, and I will try to rectify them in 2008.? The next reshaping is coming up soon, and I am gathering my tickers and industries.

But winning big and failing small should be good for anyone. With that, I wish you a Happy New Year.? Let’s make some serious money in 2008, DV.

18 thoughts on “If This Is Failure, I Like It

  1. 7 out of 8 years outperforming. That’s awesome!!!, and I wouldn’t sweat 1 year at all. That is an excellent long-term track record.

    You obviously recognized that large-cap and growth beat small-cap and value, and I guess from my perspective as one who factors tactical asset allocation decisions and style considerations heavily I would be thinking hard about if the outperformance cycle of small-cap value ended and last year was just the beginning of large-cap growth outperformance. It might make sense to fish in a different pond so that you’ve got tailwinds in 2008 and not headwinds. Fishing in small-cap value could continue to be a headwind for a number of years like the late 90s.

    I’ve definitely got a large-cap growth/hiqh quality bias going into 2008 and I’ll stick with overweighting energy as well.

  2. Congrats!

    “What’s your benchmark?” is probably among the least-asked questions amongst traders (including “value investor” traders). “Is it appropriate for what I do?” is possibly even less commonly asked. I think most people default to the S&P 500 as a benchmark, with some “acceptable level of under-performance” marking the line below which they are dissatisfied. I also think most people default to a benchmark on the basis of saying to themselves, “this is what I would be in if I wasn’t an active trader” (including self-managed “investors”), you know, the alternative investment theory that metrics like the Sharpe and Sortino are built upon.

    I’m assuming your benchmark is relative to the S&P 500 from this post. Maybe the total return on DSV or EMM would be a more appropriate benchmark in a small-to-mid cap domestic U.S. value style? Or have you thought about setting an absolute return benchmark that is irrespective of what the indices do? Just a couple of thoughts.

  3. Your post once again had me thinking about the issue of benchmarking. It seems to me that the best judge of a personal stock picker such as yourself would be an equal weight index – such as the Value Line Geometric Average. No individual I know manages based on a cap weighted basis.

    While certainly a pain in the you know what, I would venture that the best way to truly asses stock picking would be to compare your returns to that of an equal weighted index for each industry group of each stock you held over the specific holding periods for each position. Otherwise, what is thought of as stock picking prowess could just be mistaken tilting towards industries, cap size or the like. For example, lets say over the past few years I owned a portfolio heavy on oil refiners, agricultural equipment manufacturers, managed care providers, consumer tech and financial exchanges. Effectively, I would have hit most of the major sectors of the market, but my insane outperformance would be due to the industry group or subgroup rather than any stock picking ability. The only way to measure stock picking would be to compare one’s refining position(s) to an equal weight index of that industry subgroup.

    Also, history would suggest that if this is truly a shift in the cycle towards large and growth stocks/sectors, it could last quite some time – over 5 years is typical historically.

  4. James, are you trying to separate someone’s skill at picking stocks from their skill at picking industry groups? Does somebody “not get credit” for being in the right industry at the right time, or for timing the market successfully (if they did)? Does their account care about the “source of their returns?” and whether it’s alpha, beta, or schmayta?

    If someone buys equal dollar amounts of every position in their portfolio, then perhaps an equal-weight index is a better relative benchmark than a cap-weighted index, provided that they’re just as likely to buy anything of any cap size. If they tilt towards small cap, then are there any equal-weight small cap indices? Would they really buy something that had only $25 million in market cap?

    “How did I do versus what I could have done if I just bought ___ and sat on my hands?”

    That’s the question that a “relative benchmarker” is answering, and it probably should be answered based on what they WOULD have bought if they weren’t playing the home game themselves. Other relative benchmarks, aside from the ones already mentioned, could be: a total-market ETF, an international total-market ETF, a mix of different asset class ETFs, or the risk-free return of cash (as in the Sharpe ratio).

    I’m not personally a fan of relative benchmarks. I would rather take an absolute return view based on a longer time horizon and aggressive goals. Hypothetically speaking, making 5% in a year that my relative benchmark lost 5% wouldn’t exactly give me “warm and fuzzies.”

  5. FWIW, I agree with Bill that you cannot separate stock-picking from industry/sector selection in determining manager skill. They are connected in a way that cannot be divorced. I don’t have the links or studies at my fingertips, but studies demonstrate that 70 to 80% of a stock’s performance is tied to sector/industry group.

    In fact, I would argue that for the manager who wants to outperform by a wide margin, they would be better served spending more time developing solid sector/industry themes and less time on bottoms-up fundamental research like tracking quarterly changes in working capital which is probably a less productive use of the limited time resource.

    Look at 2007. Look at the performance of energy and materials versus financials and consumer discretionary and forget any individual stock-picking. There was a ton of alpha to be gained by simpling overweighting the former and underweighting the latter. FWIW, I had substantial energy exposure in 2007 based on my top-down outlook for energy.

    Passively investing in the S&P 500 gives one broad exposure to U.S. stocks and is the most likely alternative for the investor who wants to spend absolutely no time at all researching, rebalancing, etc. IMO, the important thing is to not play “move the goalpost”. If one outperformed the S&P 500 for many years because of a dedicated small-cap value tilt which had a tailwind, then it isn’t right to change the benchmark to a small-cap value index once there are headwinds to make comparisons more favorable. One can always find some index they outperformed which means staying consistent in the comparison is the only right way to do it.

    One component of active management (and something I utilize heavily) is tactical asset allocation where you vary what style and segment tilt you have over time. This is potentially another way to get outperformance over a passive index.

  6. I’ve traditionally selected stocks in a manner similar to David – looking for deep value without regard to capitalization. I’m enough of a swing trader that the Value Line Arithmetic index works well as a benchmark for me. In 2007, I found that there were enough deep value stocks available in favored market areas – energy, materials, agriculture, dry freight, and emerging markets – that it was possible to outperform in value stocks if one was willing to let go of sector/industry diversification. Taking a trading approach to positions helped me to avoid losing money when I ventured into (and then usually out of) oversold value traps in the financial sector.

  7. The nice thing about the S&P 500 is that you can get the total return including dividends quite easily. I’m not sure about getting this value for other indexes.

    It is hard in general to come up with a benchmark that is right. Valueline has been working well since 2000, but was poor in the late 1990’s and the S&P500 trounced it during this period. Perhaps the Wilshire 5000 would be more appropriate, but it tends to correlate quite strongly with the S&P500 and again you have the difficulty in getting the total return including dividends.

  8. Thanks to all for the thoughtful responses – no surprise!

    I was, and probably poorly so, attempting to highlight how ridiculous relative benchmarking is in the industry but also highlight something else. I agree it is difficult to separate a stock from its industry or sub industry group. However, I was trying to raise another point.

    With the explosion in ETF’s and the increasing trading liquidity, would a more effective style be to focus at the industry level? For example, one may look at the gold mining sector and determine that Gold Fields is one of the cheapest stocks in the group and like the sector a lot. Just buying that stock would have been a bad decision over recent past versus the industry.

    A stock picker would argue that they can gain and edge and value individual companies, and in certain areas like distress I agree. However, for “regular” investing I thought it would be interesting to see someone like David do a true analysis of stock picking talent vs simply being in the right industry or sub group. In my mind, the increased risk at the company level is not worth the relatively small incremental return premium above the “right” industry or group – again excluding more advance capital structure investing like distressed or reorg where people like Marty Whitman turn nickels into dollars.

  9. By the way – I forgot one last point. Personally, I benchmark to absolute returns and that is how we talk to clients. For example, for most people we talk about targeting inflation plus 3-5%. Of course the challenge there is using an accurate inflation figure! With the pre-1990’s cpi running in the high single digits, that sets a pretty high hurdle rate!

  10. Brent, the Yahoo Finace version of Value Line Arithmetic, ^VAY, is adjusted for dividends and splits. They probably offer the same calcs for other indices.

  11. The Yahoo!Finance adjusted column does !NOT! take into account dividends for indices. The best choice for the S&P 500 is the StandardandPoors dot com website for long-running total returns, and the tracking ETFs for Yahoo!Finance data. The ETFs !ARE! properly adjusted for splits and divvies, which is why I suggested using them for relative benchmarks.

    I think the “what would I have bought if I wasn’t active” is the best index solution for those seeking a relative benchmark. If that’s Value Line Arithmetic for one person, then that’s it – if it’s SPY for another, VTI for another, DSV or EMM, etc.

    For those that prefer an absolute return benchmark, a compounding target above projected increase in cost of living may be appropriate, but I’d watch the language! “Inflation” is a monetary phenomenon, a cause of increased prices, not increased price per se. Perhaps a long-term average or projection plus some percent.

    Another choice for absolute return benchmark may be [cost of living today as percent of equity] + [projected increase rate in cost of living] + [desired compounding]. Think about someone living off of their trading (“investments”), and you’ll see what I mean.

  12. For most items, ETFs and stocks, mutual funds, the splits and dividends adjusted column works just fine. However, for stock indices, like S&P 500 and ^VAY, it doesn’t work.

    Verify for yourself. Click historical prices, download the data, and compare the close vs. adjusted closes from 10 years ago for the indices versus their ETFs.

    I think their retaining the adjusted column when it isn’t adjusted is a bug in their data.

  13. Happy New Year David

    You know, Fama & French showed that Value beats Growth. I think they were using P/B to discern between the two styles. There is an interesting paper in the current CFA Financial Analysts Journal discussing this if you have access to one. The citation is; The Anatomy of Value and Growth Stock Returns; Fama & French; FAJ Vol63, Number 6, page 44.

  14. Hi David

    I should add acouple of comments to # 14 above. There is more attrition (lack of survivorship) in the growth stocks. I can’t cite the article for this. If you define Value as P/B though value is a growth stock that has stopped growing. If you use Buffet’s intrinsic value then you come up with a different universe.

    The second drag on growth that is much larger now than in the past is the “naked shorting” that is taking place. If you look at the “failed to deliver” list at the SEC there are many more growth stocks on it than value.

    Louie

  15. Bill, that’s kind of bizarre in the sense that if they are calculating splits and dividends correctly for the individual constituents, the adjusted daily return for the indices would just be the sum of the appropriate weighting factors (equal for the ^VAY and cap weighted for the S&P) times the adjusted daily returns. So if they really get it wrong, it’s a simple matter of using the wrong variable in some piece of code when the right the right one must be equally available in the same database.

  16. Bizarre, maybe, but a bug nonetheless. Perhaps they get their data from a provider that would charge too much for a total return series on an index? After all, Yahoo is passing it along as a loss leader. Regardless, for total return I would use the div adj return on an ETF or an index fund, or got to the S&P website, or RFE and pay for the series.

    I do think the proper relative benchmark for a stock index is the total return, so the S&P 500 was more like 5.5% than 3.5% in 2007, and I would count dividends and transactions expense in my returns. Taxes are different for everybody based on other items, so I do pretax returns or, if I ever try to add in taxes, assume the maximum.

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