In their latest Q1 2021 Market Commentary, Horizon Kinetics have a great section titled – Subjective Considerations and Why Almost No One Uses the Magic Formula. It provides a great illustration of why investors like Sir John Templeton are able to be successful with a simple and patient approach to investing. Here’s an excerpt from the commentary:
The magic formula works. But here’s why it isn’t done; it just brings on a catalog of problems.
− As this strategy begins to succeed over a period of years, the portfolio will become more concentrated and volatile. What if those two stocks are down one year while the market is up? As a fund or portfolio manager, you will be asked to justify why you don’t sell the two ‘losers’ (that’s how it’s pronounced, with a disdainful emphasis on the “L”) why you don’t take action to remediate an obviously poor choice?
− You will be objectively measured to be a bad portfolio manager until such time that you decisively outperform, a date that you know will be many years and many lost bonus opportunities in the future.
− Some clients will expect you to ‘work’ for your return. But in your case, you haven’t made a single trade in 10 years. You will be asked to justify the value you’re adding.
− You will doubt yourself, and want to trade. You will believe that you can add value by selecting another superior stock. BUT, if you recall the smart penny portfolio, only the two ultimately successful stocks in your portfolio can self-identify: they know which ones they are, but you don’t. You will find that it’s the easiest thing in the world to trade; just have to press the “Enter” key. You will miss it terribly. Not so easy to not trade; let’s call it informed inactivity.
− Even as, in future years, your static portfolio begins to match or exceed the benchmark, just as the discipline is beginning to pay off, you will be asked ever more forcefully to ‘trim’, or ‘lock in some profits’ – which would, of course, undermine the strategy.
A Legendary Story About a Magic Formula Investor
We’re hardly the first people to arrive at this conclusion about holding an undervalued investment for as long as it takes to realize its true value. John Templeton, perhaps the greatest contrarian investor of all time, owes his fame to this approach. Ironically, he would have been fired several times over for underperforming the market, had he worked for any creditable investment firm. The Templeton Growth Fund underperformed the S&P 500, cumulatively, for its first 14 years, through 1968. Ask yourself: wouldn’t you have fired him? (But he worked for himself, so only he could fire himself.)
Another irony is that although he managed the Templeton Growth Fund, he was a tried-and-true value investor. He started this fund at the end of 1954. Subsequently, although he only outperformed in about half the years, he ended up with one of the greatest investment records of all time, spanning 37 years to the end of 1991, when he retired. Cumulatively, over the course of those 37 years, the Fund generated a return of 17,862%, which was more than three times that of the S&P 500 return of 5,243%. There might be no one else who ever tripled the return of the S&P 500 over that span of time.
How does one reconcile this? Templeton focused on a couple of big trends, and he stayed with them, and that gave him his edge. One trend is that he was the first outside investor to discover the Japan stock market. He noticed, in the 1950s, that Japanese companies were growing at higher rates, for the most part, than elsewhere in the world, yet had very low P/E ratios, which he found attractive. He stayed with Japan for a very, very long time. He took this approach with his other investments as well.
One way to characterize his almost singularly differing world view is that he would find something interesting, and which he came to know well, and stayed with it. For the preponderance of the market, particularly the index and asset allocation-model investors, every quarter, or certainly every year, they gravitate from the set of investments that were popular that year to those that are popular in the next year.
One reason this is not a very successful strategy is that it implies the manager has to know a great deal about a lot of investments, whereas John Templeton only had to know a great deal about a few investments, and he understood them very well. He simply left them alone and let compounding do the rest.
Compounding, when allowed to work, can be astoundingly powerful. But it takes a long time to work; it can’t be done in fits and starts.
You can read the entire market commentary here:
Horizon Kinetics Q1 2021 Market Commentary
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