Novel Investor

Compounding investing wisdom...

The Downside of Chasing Huge Wins

by Jon

Most people know John Maynard Keynes the economist. Not many know Keynes the investor. The track record of his personal accounts and the King’s College Chest Fund show he was a decent, though risk-averse, investor.

One thing stands out when you compare the two records. He consistently used margin loans in his personal accounts. I wanted to take a deeper dive into the impact margin loans had on his results.

For those not aware, a margin loan is borrowed money used to buy securities in an attempt to juice returns. The results can be exceptional if things go right or horrendous when things go wrong.

When you borrow money against an asset, and the value of the asset falls, bad things can happen. The main reason is due to minimum margin requirements. Lenders don’t like to lose money any more than we do, so minimum margin requirements help safeguard lenders from losses.

But it doesn’t protect you from losses. In fact, the minimums do the opposite whenever it’s triggered. Because you’re hit with a margin call. Continue Reading…

A 90-Year-Old’s Tale of Compounding

by Jon

Warren Buffett turned 90 last weekend and many tributes have come out since highlighting his track record. Why wouldn’t they? It’s the best long term track record ever.

It starts with the 31.6% annual return during his partnership days from 1957 to an almost perfectly timed closure in 1968.

He followed that up with a stint at Berkshire Hathaway. Since he took control in 1965, its stock has achieved a 20% annual return…so far.

The chart below shows what a $10,000 investment in Berkshire in 1965 looks like. Continue Reading…

Follow the Earnings

by Jon

Growth stocks were in vogue by the end of 1972. The five most popular companies had a market cap of $100 billion on earnings of $2.2 billion.

$100 billion is nothing by today’s standards, but those five companies — IBM, Minnesota Mining (3M), American Home Products, Xerox, and Eastman Kodak — accounted for 15% of the total market cap of every company listed on the NYSE. They had an average P/E of around 40. The general view was their growth made them “safe.”

Therein lies a problem. Equating high multiples with “growth” is a common mistake made by investors. But making the leap from “growth” to safety compounds the error.

The skill is in separating growing companies from high multiple stocks that are rising in price. Because one meets certain characteristics that drive earnings growth over time. The other has only to do with price action. Continue Reading…

The Popularity Contest in Mega Caps

by Jon

The popularity contest is alive and well in the stock market. The S&P 500 is at all-time highs, up 9.2% year to date. That’s total return, by the way. If that seems surprising in any way, you’re not alone.

On the surface, one might conclude that we’re in a raging bull market. The enthusiasm, the speculation, the day trading…all the ingredients are there.

A more nuanced answer is that there’s a bull market in a handful of names hiding a bear market in many more.

The largest companies in the S&P are performing exceptionally better than the rest. So much so, that it’s having an outsized impact on the index. The numbers are mindboggling really. Continue Reading…

Peter Bernstein: Lessons from Long Run Market Returns

by Jon

Long term stock market performance can be deceptively misleading. It can often lead to costly assumptions by investors.

The first issue is that no one ever experiences the long run. That is unless you began investing in 1871 or 1926 or whatever year is the currently accepted start of “reliable data.”

Next is the vast difference in the industry breakdown of markets today versus the past. Railroads and banks dominated markets in the late 1800s/early 1900s. How relevant are those returns to today? Industries like technology and healthcare didn’t exist a century ago. The rest was a sliver of the overall market.

Then there’s the problem with averages. The long-run average return smooths out and hides the extreme experiences investors face in the short term. The nature of markets is far less certain than its long-run average return projects. Surprises abound.

Finally, how long is long enough for long-run data to be reliably useful? For instance, there’s been nine (or is it ten now?) bull markets since 1926. What kind of conclusions can we draw from a sample size of nine? That bull markets come in all shapes and sizes seems to be the best conclusion so far.

Peter Bernstein came to similar conclusions in 1974 after auditing a century of stock market performance. However, he didn’t write off long term performance entirely. He shared a few lessons that should help when making assumptions about the future. Continue Reading…

How Much is “Likely” and Other Issues with Probabilities

by Jon

In most games of chance, the odds are easily figured out. You can calculate the odds in advance for coin flips, dice throws (craps, backgammon), or a spin of the roulette wheel because each has a fixed set of outcomes.

Now take a game like the stock market. Calculating odds gets trickier because it adds complexity and uncertainty. The outcomes are no longer fixed and the number of variables to consider grows exponentially.

Unfortunately, human nature makes this worse. It turns out, we’re terrible at estimating probabilities. Our biases get in the way.

Our troubles begin with availability. A simple rule of thumb tells us to put higher odds on something that happens more often. Unless we have trouble remembering how often that something really happens.

The availability bias screws with how we estimate probabilities. When we weigh the probability of an event happening, our estimate is based on how easily we remember a similar event and how often we remember it happening. Unfortunately, how easily we recall something has more to do with recency, vividness, and personal involvement. Continue Reading…

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