From a research perspective, the past 12 months have been the most difficult in The Intelligent Investor’s 10-year history. The Growth Portfolio fell 37% in the year to 30 June, the Income Portfolio fell 26%, and the last Buy recommendation to show a positive return was ARB Corporation in August 2006. There have been 15 since, of which three – Timbercorp, RHG and Platinum Asset Management – have more than halved.
That would be concerning in itself, but it’s been all the more frustrating because this bear market was supposed to be fun. We spent an exasperating few years standing on the sidelines refusing to get dragged into the bull market euphoria. We first lamented the lack of bargains way back in September 2003 when Making the case for cash. We made The case for more cash in July 2004 and then sounded a series of increasingly dire warnings: Profits won’t defy gravity forever in May 2005; Easy money signals tough times ahead in April 2006; Rise and fall on RBA’s call in June 2006; Dear Glenn, you have a problem in January 2007; Hangover will follow global binge in June 2007; Expensive lessons from cheap credit in August 2007; Scylla, Charybdis and Bernanke in September 2007; and Strong arms ready to crush weak hands in January 2008.
And on top of the worrying global picture, we warned about particular sectors with articles such as Is your bank going broke? in April 2007, Danger lurks in the banking sector in January 2008, and countless warnings on the listed property sector, such as Property trusts don’t add up from June 2006 and last year’s special report Are your property investments safe as houses?. We rang the warning bell on MFS and ABC Learning and, at 30 June last year, the ratio of sells to buys was five to one. People were leaving The Intelligent Investor because they were sick of the pessimism.
Not our finest hour
Yet here we are somewhere between the start and the end of the bear market we had to have – what was supposed to be our finest hour – and our Growth Portfolio is suffering more than the overall market. How did we get here?
It’s not that we’ve bought a bunch of dud stocks. Despite share price retractions that might make you think otherwise, many of the businesses we’ve recommended are progressing as expected. Albeit hindered by the high Aussie dollar, ARB and Cochlear are working out nicely, Flight Centre has well and truly exceeded expectations and Infomedia is still churning out dividends in the face of a gale force currency headwind.
Even where we think we’ve initially overestimated the value on offer – as with Timbercorp, RHG, Platinum Asset Management, Sigma Pharmaceuticals and Mortgage Choice – the extent of the error is a fraction of the share price fall. No, the problem is that because of our investments in stocks such as these, we’re now passive participants in a market that offers extraordinary value.
Given the excesses and problems we accurately foresaw, it would have been reasonable to expect more patience. Instead, we shot our bolt too early, despite expecting better value to emerge. We thought we’d be able to switch from our original selections into that better value as it emerged – but that clever trick doesn’t work if the value continues to emerge in the stocks you’ve already picked. It has been a salutary experience for everyone and we owe it to ourselves – and to you – to try to take something from it.
As humans we’re all psychologically wired to be poor investors. We’re wired to follow the crowd, to extrapolate the recent past, and to cling to our prior decisions in spite of confuting evidence. These psychological shortcomings are exacerbated for us by the fact that we provide our research to some 9,000 subscribers and face constant pressure to provide buy recommendations.
Over the years we’ve handled these pressures reasonably well, but the main lesson from the past year is that we aren’t immune. The experience itself has taught us a lot (C.S. Lewis called experience ‘that most brutal of teachers’, but ‘you learn’ he said, ‘my God do you learn’) but we’ve also decided to add some extra rigour to the way we reach our stock recommendations.
Senior analyst Gareth Brown recently handed me an article published in The New Yorker in December last year. Centre stage in the story is Peter Provonost, a critical-care specialist at Johns Hopkins Hospital in the US. In 2001, in an attempt to counter line infections at the hospital, he introduced a simple five-step checklist for doctors to follow. As the article explains:
Doctors are supposed to (1) wash their hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. Check, check, check, check, check. These steps are no-brainers; they have been known and taught for years. So it seemed silly to make a checklist just for them. Still, Provonost asked the nurses in his [intensive care unit] to observe the doctors for a month as they put lines into patients, and record how often they completed each step. In more than a third of patients, they skipped at least one.
During the next two years, they calculated that this simple checklist ‘prevented forty-three infections and eight deaths, and saved two million dollars in costs.’ The article goes on to ask, if something so simple can transform intensive care, what else can it do? Well, for one, it can improve the analytical process at The Intelligent Investor.
Redressing the balance
I feel we need to define the process we use for selecting stocks more clearly. So for starters we’ll be instituting a simple, written checklist that forces us to address certain issues that our psychology might otherwise encourage us to gloss over. We’re also going to redress the balance between the time we spend running the business and the time we spend researching stocks – we all feel there’s too much of the former and not enough of the latter – and we need to apportion our time better between genuine searching for opportunities and simply regurgitating news. So you can expect to see more in-depth stock research – especially from Greg and myself.
Finally, I’d like to reiterate the sentiments in Greg’s Confessions from the research desk. I’m proud of the service The Intelligent Investor has provided over the past decade and, while we’ll have our ups and downs, now is certainly not the time to panic and make wholesale changes. The Growth Portfolio has risen 3% in July while the index fell 6%. Given the portfolio of extraordinarily cheap stocks it contains, that’s a trend we expect to continue. So amid all the pessimism, we see reasons for optimism.
It would be wonderful to relive the past 12 months knowing what we know now, but unfortunately life isn’t like that. It is at the times we are most challenged that we learn our most valuable lessons. For the analysts at The Intelligent Investor, now is such a time.
I trust that the lessons we learn now will have a greatly beneficial impact on the performance of our recommendations in coming years, and that we will restore the excellent performance our portfolios have shown in the past.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.