Investing ideas come in many forms:
- Factors like Valuation, Sentiment, Momentum, Size, Neglect…
- New technologies
- New financing methods and security types
- Changes in government policies will have effects, cultural change, or other top-down macro ideas
- New countries to invest in
- Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
- New asset classes or subclasses
- Durable competitive advantage of marketing, technology, cultural, or other corporate practices
Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.
For an example, think of Ben Graham in the early days. He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.
As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.
The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.
Value investing principles, rather than dying there, broadened out to consider other ways that securities could be undervalued, and the analysis process began again.
My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.
Now think of the technologies that led to the dot-com bubble. The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.
My second point is that often the price performance of an investment idea overshoots. Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. It might happen because of expected demand that does not occur, or too much short-term leverage applied to long-term assets.
Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? A new investment factor is discovered:
- it earns great returns on a small amount of assets applied to it.
- More assets get applied, and more people use the factor.
- The factor develops its own price momentum, but few think about it that way
- The factor exceeds the “carrying capacity” that it should have in the market, overshoots, and burns out or crashes.
- It may be downplayed, but it lives on to some degree as an aspect of investing.
On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. On a dollar-weighted basis, the verdict on the factor might not be so hot.
So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? Not very useful. Dollar weighted? Better, but still of limited use, because the discovery era will likely never be repeated.
What should we do then to make decisions about any factor/idea for purposes of future decisions? We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.
It leaves us with a mess, and few firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”
That’s all for now. As always, be careful with your statistics, and use sound business judgment to analyze their validity in the present situation.