Successful Investing Means Living With Discomfort – Montier, Mauboussin

Johnny HopkinsJames Montier, Michael MauboussinLeave a Comment

There is no question that the life of a successful investor can be an uncomfortable and solitary one. Hence the reason why so many investors underperform by picking the ‘good news’ stocks and following the crowd. For some reason we find it easier to accept a mistake if we invest in a ‘good news’ stock than if we lose money in a company that is widely considered to be less desirable, even though the less newsworthy stock may actually provide significant out-performance. It is therefore important to understand how much discomfort you are prepared to accept during your investment life in order to achieve successful out-performance.

One of the best pieces of advice written on dealing with this discomfort can be found in the book – The Manual of Ideas, by John Mihaljevic. Specifically the chapter titled – The Rewards of Psychological Discomfort includes some great quotes from Michael Mauboussin and James Montier on what can be achieved if you can learn to live with this feeling of investing discomfort.

Here’s an excerpt from the book:

On more than one occasion, we have heard investors respond as follows to a deep value investment thesis: “The stock does look deeply undervalued, but I just can’t get comfortable with it.” When pressed on the reasons for passing, many investors point to the uncertainty of the situation, the likelihood of negative news flow, or simply a bad gut feeling. Most investors also find it less rewarding to communicate to their clients that they own a company that has been in the news for the wrong reasons.

Comfort can be expensive in investing. Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations. If discomfort were entirely related to fundamental factors such as a company’s business prospects and intrinsic value, then little reward might exist for accepting discomfort. However, the latter seems to be at least partly due to investors’ psychological makeup. Most of us find it easier to accept a mistake if we can do so in good company. Investing in Enron and losing money may make us feel less bad because many smart people suffered the same fate. However, if we lose money in a company that has been widely panned by analysts and shorted by the smartest hedge fund managers, we may feel especially inadequate.

Consider an investment in a casualty of Apple’s rise to dominance—Research in Motion, Nokia, or Sony. Many analysts predicted the demise of those companies as their share prices declined. If we invested in such a company and lost money, we might feel quite lonely. Similar reasoning may apply to an investment in the much-maligned and heavily shorted for-profit education industry.

Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude. Observes Michael Mauboussin, chief investment strategist of Legg Mason Capital Management and chairman of the Santa Fe Institute: “Buffett’s advice is so good but so hard. The point when there’s a valuation extreme is precisely the point when the emotional pull—in the wrong direction—is strongest.” Adds James Montier, portfolio manager at GMO: “People love extrapolation and forget that cycles exist. The good news is that you get paid for doing uncomfortable things, when stocks are at trough earnings and low multiples their implied return is high, in contrast you don’t get paid for doing things that are comfortable.” John Lambert, investment manager at GAM, seeks to generate ideas in “areas of currently depressed sentiment and hence probable low valuations.”

If we owned nothing but a portfolio of Ben Graham–style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously. We might look at the portfolio and conclude that every investment could be worth zero. After all, we may have a mediocre business run by mediocre management, with assets that could be squandered. Investing in deep value equities therefore requires faith in the law of large numbers —that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.

This conceptually sound view becomes seriously challenged in times of distress. By contrast, an investor in high-quality businesses that are conservatively financed and run by shareholder-friendly managements may fall back on the well-founded belief that no matter how low the stock prices of those companies fall, the businesses will survive the downturn and recover value over time.

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows. In a stressed situation, investors may doubt their investment theses to such an extreme that they disregard the objectively appraised asset values. After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow? Is store real estate really worth anything if the store makes no money and the entire retail industry is struggling? Bill Ackman’s investment case for J.C. Penney made tremendous sense given the assumptions used in his analysis, but fearful investors may tweak the assumptions in such a way that little estimated value remains for the equity holders. This dynamic serves to make the stock prices of companies like J.C. Penney exceedingly volatile, providing an opportunity for investors willing to assume the discomfort of buying when everyone else seems to be selling.

Each of us knows best how much discomfort we are willing to assume in the service of superior investment returns. We should not fool ourselves, either. Investors typically do worst when they enter situations in which they lack staying power, whether due to financial or other reasons. Plenty of money can be made in businesses that make us perfectly comfortable. The drivers of success merely shift—for example, away from a willingness to look foolish by going against the crowd toward an ability to analyze the durability of competitive advantage. Many analogies serve to illustrate this point. In real estate, money can be made both in premium beachfront property and in fixer-upper homes in middle income neighborhoods. The skills and sensibilities of the people profiting in these distinct areas differ markedly.

The people who tend to succeed seem able to match their strengths to the requirements of the opportunities they pursue.

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