7 Traits for Investing Greatness:
#2 Process, not Outcome
#3 Ignore Forecasts & Predictions

Categories Author: Jim O'Shaughnessy, Investing

Active investing is hard. Plus, there’s a strong temptation to join the “masses going Passive” — or else get left behind. Following up on the first part of this article, here are the 2nd and 3rd Traits (of 7 total) that I think are necessary to be a successful long-term Active investor:

#2 — Process, or Outcome?

Successful Active Investors Value Process over Outcome.

“If you can’t describe what you are doing as a process, you don’t know what you’re doing.”

— W. Edwards Deming

The vast majority of investors make investment choices based upon the past performance of a manager or investment strategy. So much so that SEC Rule 156 requires all money managers to include the disclosure that “Past Performance is not Indicative of Future Results.” It’s ubiquitous — and routinely ignored by both managers and their clients. In keeping with human nature, we just can’t help ourselves when confronted with great or lousy recent performance. “What’s the track record?” is probably the question asked most frequently by investors when considering a fund or investment strategy. And, as cautioned in Part 1 of this article, that vast majority of investors are most concerned with how an investment did over the prior 1-year or 3-year period.

Yet successful Active investors go further and ask, “What’s their process in making investment decisions?” Outcomes are important, but it’s much more important to study and understand the underlying process that led to the outcome, be it good or bad. If you only focus on outcomes, you have no idea: Is the process that generated the desirable outcome superior or inferior? This leads to performance chasing and relying far too much on recent outcomes to be of any practical use. Indeed, shorter-term performance can be positively misleading.

Look at a simple and intuitive strategy of buying the 50 stocks with the highest annual sales gains.1 Consider this not in the abstract, but in the context of what actually happened in the previous 5 years:

table

The $10K invested in the strategy grew to $33.5K, doubling the same investment in the S&P 500, which grew to $16.2K. The 3-year return (the metric that almost all investors look at when deciding if they want to invest or not) was even more compelling, with the strategy delivering an average annual return of 32.9%, compared to just 7.4% for the S&P 500.

Also consider that these returns would not appear in a vacuum. If this were a mutual fund, it would probably have a 5-star Morningstar rating, it would likely be featured in business news stories quite favorably, and the long-term “proof” of the prior 5 years would suggest that this intuitive strategy made a great deal of sense and therefore attract a lot of investors.

Here’s the catch — the returns are for the period from 1964 through 1968. This was a time when, much like the late 1990s, speculative stocks soared. Investors without access to the historical results for this investment strategy would not have the perspective that the long-term outlook reveals, and thus might have been tempted to invest in this strategy just before its impending crash and burn.2

Had an investor had access to long-term returns, they would have seen that buying stocks only based on their annual growth of sales was a horrible way to invest — the strategy only returned 3.9% per year between 1964 and 2009! Investing $10K in the 50 stocks from All Stocks with the highest annual sales growth grew to just $57.6K at the end of 2009, whereas the same $10K invested in U.S. T-Bills compounded at 5.6% per year, turning $10K into $121K. In contrast, if the investor had simply put the money in an index such as the S&P 500, the $10K would have earned 9.5% per year, growing to $639K over time. What the investor would have missed during the phase of this strategy’s exciting performance is that “valuation matters” — a lot. Turns out this type of stock is usually very expensive, and very expensive stocks rarely make good on the promise of their sky-high valuations.

Thus, when evaluating an underlying process, it’s important to decide if it makes good sense. The easiest way to do that is to look at how the process has fared over long periods of time. This allows you to better estimate whether the short-term results are due to luck or skill. To do this, we like to look at a strategy’s rolling Base Rates.3

Lest you think this could only be accomplished with quantitative strategies that can be backtested, consider Warren Buffett’s results at Berkshire Hathaway. If you were making a choice about whether to invest in Berkshire stock using short-term results at the end of 1999 as a guide, you probably would have passed them by.4

But if you checked on Buffett’s process, you would find that nothing had changed and that he still adhered to the same stringent criteria he always had, generally seeking for stocks with:

  1. Recognizable brands with a wide moat5
  2. Simple, easy to understand products and services
  3. Consistent, solid earnings over a long time period
  4. Low and manageable debt
  5. Good ROE and other solid ratios

These criteria seem like sensible ways to buy stocks, and Buffett showed no signs of deviating from the strategy — he was (and is) patient and persistent, sticking with a proven strategy even when it isn’t working in the short term. Now take a look at Buffett’s Base Rates (using Berkshire Class A stock) from 1977 through 2016:

Base Rates: Berkshire Class A (BRK.A)table

BRK.A’s Base Rates are very similar to investing in the cheapest 10% of stocks using What Works on Wall Street’s “Value Composite 1”, which ranks stocks on the basis of:

1. Price-to-Book6
2. Price-to-Earnings
3. Price-to-Sales
4. EBITDA-to-Enterprise Value
5. Price-to-Cash Flow


(1964–2009)
table

This process always focuses on the cheapest stocks in the universe and makes a great deal of intuitive sense, backed up by its process and the performance over time.

#3 — No Fortune-Tellers

Successful Active Investors Generally Ignore Forecasts and Predictions.

“I don’t let people do projections for me because I don’t like throwing up on the desk.”

— Charlie Munger

“I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be.”

— Warren Buffett

You can’t turn on business TV or read all the various business news outlets, or even talk with other investors, without being bombarded by short-term and long-term forecasts and predictions. Against all the evidence, forecasts and predictions about what might happen in the future are intuitively attractive to us, since we are desperate to have a narrative about how the future might unfold. As I mentioned above, we tend to extrapolate well into the future with what has happened recently, which almost never works. We’ll explore the results of this in a minute, but for now, consider that since we literally hear or read so many forecasts about markets, stocks, commodity prices, et cetera that to follow up on the efficacy of each would be a full-time job. Lucky for us, others have done this job for us, and the results are grim.7

In his book Contrarian Investment Strategies: The Psychological Edge, money manager and author David Dreman looked at the accuracy of analysts’ and economists’ earnings growth estimates for the S&P 500 between 1988 and 2006. Dreman found that the average annual percentage error was 81% for analysts and 53% for economists! In other words, you might as well have bet on a monkey flipping coins (as mentioned in my Feb. 2017 MoneyLife Radio interview).

People tend to take recent events and forecast similar returns into the future. Dreman nicely captures the results by looking at large international conferences of institutional investors where hundreds of delegates were polled about what stocks they thought would do well in the next year. Starting in 1968 and continuing through 1999, Dreman found that the stocks mentioned as “favorites and expected to perform well” tended to significantly underperform the market. In many instances, the selected stocks ended up in the stock market’s rogue’s gallery. As an example, the top pick in 1999 was Enron, and we all know what happened there: one of the largest bankruptcies in corporate history.8

To avoid seeming like a cherry-picker, Dreman looked at 52 surveys of how the favorite stocks of large numbers of professional investors fared between 1929 and 1980, with 18 studies including 5 or more stocks that experts picked as their favorites. The results? The 18 portfolios underperformed the market on 16 occasions. As Dreman dryly notes: “This meant, in effect, that when a client received professional advice about those stocks, they would underperform the market almost 9 times out of 10.”

If you need more recent evidence, Nazim Khan’s 2012 “Financial Forecasts Gone Wrong” reveals even more famously wrong forecasts.9 As well, the results of an August 2000 Fortune Magazine article “10 Stocks to Last The Decade: A few trends that will likely shape the next 10 years. Here’s a buy-and-forget portfolio to capitalize on them” provides even more proof.10 The results? As of 12/31/2016, those 10 stocks11 were down 27%, versus the S&P 500’s 116% gain.

Finally, many studies have shown that this pattern is common to almost all forecasts — in virtually every other industry where professionals make predictions and forecasts, whether forecasting stock prices, or the number of patients needing medical treatment, or the accuracy of college admissions offices trying to pick who to admit — in virtually every other industry where professionals make predictions and forecasts.12


Go to Part 3


  1. Also see “Short-Term Luck Versus Long-Term Skill” (jimoshaughnessy.tumblr.com/post/137235375474/short-term-luck-versus-long-term-skill).
  2. As the data from What Works on Wall Street makes plain, over the very long term, this is a horrible strategy that returns less than U.S. T-bills over the long term! See “The Less You Pay, the More You Earn” (jimoshaughnessy.tumblr.com/post/92760346789/the-less-you-pay-the-more-you-earn).
  3. Base Rates create a “movie” as opposed to a “snapshot” of how strategies perform in a variety of market environments. For more, see “Base Rates are Boring (And REALLY Effective)” (http://jimoshaughnessy.tumblr.com/post/94558957584/base-rates-are-boring-and-really-effective)
  4. Indeed, your decision would have been reinforced by the news stories circulating that Buffett’s simple process no longer worked in the tech-dominated “new normal” for the stock market. That’s because, over the previous 3 years, Berkshire underperformed the S&P 500 by 7.6% per year, and 3.8% per year over the previous 5 years.
  5. Wide moat: A competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit. (investopedia.com/terms/w/wide-economic-moat.asp)
  6. Full disclosure: OSAM does not use P/B (price-to-book) in any of our strategies. For more background, see “Price-to-Book’s Growing Blind Spot” (osamlibrary.com).
  7. In a post at his website TheInvestorsFieldGuide.com, my son and fellow OSAM Portfolio Manager, Patrick O’Shaughnessy, highlighted a study that showed that “The CXO Advisory group gathered 6,582 (investment) predictions from 68 different investing gurus made between 1998 and 2012, and tracked the results of those predictions. There were some very well-known names in the sample, but the average guru accuracy was just 47% — worse than a coin toss! Of the 68 gurus, 42 had accuracy scores below 50%.”
  8. Brilliantly profiled in Bethany McLean & Peter Elkind’s 2013 The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron.
  9. See morningstar.in/posts/12556/financial-forecasts-gone-wrong.aspx
  10. See archive.fortune.com/magazines/fortune/fortune_archive/2000/08/14/285599/index.htm
  11. Now only 8 stocks — Nortel and Enron went bankrupt.
  12. For more on this, check out “The Unreliable Experts: Getting in the Way of Outstanding Performance” (jimoshaughnessy.tumblr.com/post/127484251129/the-unreliable-experts-getting-in-the-way-of).