Stay or Leave?

Trying to accurately predict a market correction successfully is virtually impossible. As the legendary former mutual fund manager Peter Lynch said: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.”

In the 92 years since 1926 and up to December 31, 2017, the US S&P500 has produced 24 negative years and 68 positive years. In other words, the S&P500 has been producing positive returns for 74 per cent of the time and negative returns for only 26 per cent of the time. And if we restrict the count of negative years to those episodes of 10 per cent or great declines, they amount to just 13. That’s just 14 per cent of all periods or one in seven years.

More recently – taking a more typical investment horizon – the 38 years since 1980 has seen ‘intra-year’ declines of between 3 per cent and 49 per cent every year. Declines are simply part and parcel of investing and once again, the market has produced a positive return in 29 of those 38 years.

Decreasing the variance of returns

The longer the time frame over which an investment is left alone, the lower the variance of returns. Over a one-year time period, the S&P500 has shown an ability to generate dramatically variable returns, ranging from 54 per cent gains to 43 per cent losses. Extend the time horizon from one year out to three years and the best annualised return produced is 31 per cent while the worst three year period produced a minus 27 per cent annual return. Extend further, out to a decade and the best period produced a 20 per cent annualised return while the worst decade produced a negative 1.4 per cent. Shortly, we’ll talk about value so keep the low returns in mind. Finally, extend the horizon out to 20 years – no reasonable investor in the stock market should have a horizon less than this – and the best annualised return is 11.7 per cent, while the worst is still positive at 3.1 per cent per annum.

None of this is particularly reassuring however because sequencing – the order of the returns – plays a big part in personal experience. Nobody wants to invest just before ‘the big one’ and perhaps that’s why investors are so keen to predict a crash accurately. A big fall early can really set you back. But worse, investors tend to find buying and selling (bad behaviour) much easier than buying and holding (good behaviour).

Consequently, the discomfort following a correction causes investors to exit the market, subsequently hampering the decision to reenter, and thereby missing the subsequent and equally inevitable recoveries.

If predicting crashes, which occur over many months is difficult, if not impossible, imagine how challenging it is to miss the very best handful of days?

Turning again the S&P500 data, missing just a few choice days over the past two-and-a-half decades results in materially detrimental reductions in returns.

Ten thousand dollars invested in the S&P500 on January 1, 1992 and reinvested annually, with all dividends, through to December 31, 2017 grew to $108,700 – an annual compounded return of 9.6 per cent. But missing just the ten best days resulted in the $10,000 growing to just $54,200. This is one of the reasons that professional investors implore others to invest for the long term and use the aphorism that time in the market is more important than ‘timing’ the market.

Over a long period of time, the volatility of the market washes out, and investors are more likely to see a positive end-result.

Two caveats

We’ve demonstrated that ‘time in’ the market is clearly important but let me first remind you that if you are investing for the long-term, you must stick to ‘quality.’ By quality, I mean quite simply, in companies that have the ability to generate high returns on their incremental equity.

‘Time in’ the market is clearly important but let me first remind you that if you are investing for the long-term, you must stick to ‘quality.’

By quality, I mean quite simply, in companies that have the ability to generate high returns on their incremental equity. A company that is regularly and sustainably able to retain a large portion of its annual profits, and reinvest those retained profits at high rates of return, will generate very pleasing results for shareholders over the long run.

By contrast, the longer the period of time one remains invested in mediocre companies, or those market indices dominated by mediocre companies, the worse the returns will be. A mediocre company is simply a company that must raise capital or retain profits to stay in business even as the returns generated are in the low single digits.

Buying low quality businesses late in a market cycle does not reliably create value; investors making a lot of money then become less focused on risks.

Looking at real returns

Let’s take the S&P500 between 1927 and 2007 and look at rolling ten year returns[1] as well as the P/E ratio at the commencement of each ten-year period. What do we see?

Back in May this year one of our global analysts, Daniel Wu, looked at precisely this data and discovered that over 10-year investment horizons, the initial price you pay has a material impact on your annualised real return.

The very highest returning decades were those where the commencing P/E for the S&P500 was less than 10 times and the very lowest returning decades occurred when the commencing P/E for the S&P500 was above 27 times (note today’s CAPE Shiller P/E is over 30 times).

The data clearly reinforces the observation that the higher the price you pay, the lower your returns.

When the investment horizon was extended from rolling ten-year windows to rolling twenty year periods, the first observation reinforced our earlier findings – there were no negative periods. But even over twenty years, initial overpayment will, more likely than not, be detrimental to your investment returns.

With the exception of one twenty-year period, all periods that produced an annualised real return of less than 3 per cent occurred when the P/E ratio at the commencement of the period was above 15. More importantly, all twenty-year periods that produced an annualised real return of more than 12 per cent occurred when the commencing P/E was less than 10 times earnings.

Our study confirmed that when market prices are elevated as they are today, investors ought to pay a little more attention to protecting the downside and worry less about extracting the very last ounce of returns, even when a “buy-and-hold” for the “long term” commitment is made.

Some might conclude that the above suggests there merit in timing the market. There clearly isn’t because it is too hard to get right consistently. Instead there is merit, even over long periods of time, in ‘pricing’ the market and adding to one’s investments when prices are attractive.

As a very successful investor once told me: ‘Roger you’ll get rich buying and selling, but you’ll get wealthy buying and owning, buying and owning, buying and owning.’ He stressed the absence of the word ‘selling.’

Stay invested!

So far we have established that investing in quality for the long run simply works. We have also learned that you’ll probably do better, and boost returns, by adding to your investments when prices are cheap.

Now it’s time to put the nail in the coffin for those trying to time markets.

A few years ago Fidelity Investments, one of the world’s largest fund managers with over US$2 trillion in client assets, concluded an internal study to determine which type of clients tend to achieve the best investment returns.

The study reviewed client accounts from 2003 through to 2013. Fidelity discovered that the very best performing accounts were held by investors that were dead! In second place were investors that had forgotten they had accounts at Fidelity!

Clearly neither group had the ability to time their entries and exits.

Finally, is there any data that shows timing detracts from returns? Happily, there is plenty.

Learning from the past

DALBAR is a leading research firm who for 21 years have been researching investor behaviour through their annual Quantitative Analysis of Investor Behaviour study, measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds over both short and long-term time frames.

Their conclusion is that investors who try to time the market, invariably get it “badly” wrong, baling out under stress during downturns and piling in when market strength makes them optimistic.

Over the very long term, while it has been shown that equities provide the highest return for investors, most investors are not reaping the full benefit of these returns.

Since 2001 the average equity fund investor has earned returns far lower than the funds they invest in. This can only be attributed to their buying and selling behaviour. DALBAR’s research revealed that the problem is not the returns of the funds. The reported stated, “Analysis of the underperformance shows that investor behaviour is the number one cause” and “An investor’s goal is to maximise capital appreciation while minimising capital depreciation. The average mutual fund investor has simply not accomplished either goal.”

Elsewhere, Peter Lynch, the legendary manager of the Magellan Fund at Fidelity between 1977 and 1990, and who returned more than 29 per cent on average per annum, calculated that the average investor in his fund didn’t perform nearly as well.

By Lynch’s numbers, the average investor in his fund made just 7 per cent. Even worse, it was also reported that Fidelity’s own analysis showed the average investor in Lynch’s fund actually lost money! How so? Whenever Lynch would have a setback or underperform the market over short time periods, investors would redeem – or sell low. On the flip side of the coin, the times when Lynch was riding high and outperforming the market were the same times investors were allocating the most money to his fund – buying high and missing the upside from his relative lows.

Conclusion

Recently, we have been asked how investors should interpret the various commentary about the state and pricing of the US stock market. The answer is that we simply don’t know if or when a correction will occur.

What we do know is that the very best companies, when purchased at a rational price, will produce extraordinary returns for investors over the long run.

If you can add to that strategy whenever prices are low – buying stocks the way you buy groceries – your returns will be even better.

For that reason The Montgomery Fund, The Montgomery [Private] Fund and the Montgomery Global Fund, are all holding some cash to take advantage of attractively priced opportunities as they arise. And as professional long-term investors seeking quality, we won’t be afraid to do so.

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