This is an excerpt of the summer letter I wrote to IMA clients.
Today the stock market is in a bubble; this is not a secret to most market participants. Most investors are ignoring it and just infatuated with the ride. They are playing Fool’s Gambit – waiting for a greater fool to buy their overvalued stock from them. And why not, greater fools have been showing up in droves for years. Low interest rates inflated the prices of all assets forcing everyone to take greater and greater risks.
Then there is pure, unadulterated greed. This market bubble is filled with this “get rich fast” attitude and the fear of missing out; all bubbles are. This time the market has been further deformed by social media, which seems like an enormous amplifier and arguably prolonger of that behavior, bringing what seems an endless supply of incremental buyers (bigger fools).
Companies like GameStop make Tesla’s valuation look rational (Tesla’s valuation is anything but rational, as I wrote before, it discounts a temporal wormhole into the future). But at least Tesla is a company of the future. GameStop is a struggling retailer of video games where the future – digital downloads – make its business model obsolete one download at a time. As of this writing it is valued at $17 billion dollars.
Initially GameStop’s ascent may have started as financial nihilism by “have nots” trying to blow up the haves (“greedy hedge funds”) that were short the stocks. Short sellers left GameStop stock months ago.
Today GameStop’s stock is completely divorced from the underlying business it is supposed to represent. If the company never files another financial report shareholders won’t notice or care. It is just a meme, a speculative gambling instrument used by one fool in search of an even greater fool. Though it may seem that the supply is endless, at some point you are going to run out of fools. You just don’t know when.
Today the market is filled with people who want to get rich fast. You cannot use logic and reason with a person who wants to get rich fast. The allure of winning a stock market lottery overnight is too strong.
This speculative behavior doesn’t stop with main street.
As a professional money manager if you don’t play the fool’s gambit then you are taking career risk. God forbid, you dare to hold cash or don’t buy stocks that you believe are overvalued, but which are going up today and may even go up tomorrow, but could also collapse when the music stops.
Not playing this game is a non-decision decision for us. It is an easy choice because clients entrusted us with their life savings, all the money they are ever going to make. After you look them in the eyes and understand the gravity of what you are doing, playing fool’s gambit stops being a choice. As you look through your portfolio, you’ll clearly see that we don’t play fool’s gambit. This is why we are blessed with the clients we have and are very diligent in not accepting clients whose approach is antithetical to our investment principles.
Market Timer’s Gambit
Rational people not drunk on greed, who are fine with getting rich slowly, may want to avoid this market altogether. They may play Market Timer’s Gambit. Their argument (on the surface) is very logical. It goes like this: “I am going to stay on the sidelines for now and will go in after the market dips”.
We are very sympathetic to this view. However, there are two problems with this strategy. First, market irrationality can last a long time. And second, though it sounds good in theory, in practice it is very difficult to execute.
Here is an example: Let’s say you went 100% in cash waiting for the market to correct.
You waited for a long time and then the market declines 10%. You feel slightly vindicated, but the market really just settled to where it was a few months ago.
You have a decision to make: Get in or wait? You are of course prudent, and the market is declining, so you decide to wait.
The market is down another 10%. You feel a bit more vindicated. Now you feel rewarded for your patience and for the last few years of return you’ve missed out on.
But your gut tells you if the market declined 20% and it can go down lower. You wait.
You were right. The market declines another 10%. Economic news is ugly. The market decline may send the economy into a recession. Or the economy is already in a recession.
Now you are worried. You decide to wait.
The market declines another 10%. This cash now feels so dear you don’t want to part with it. You feel like you’ve got this figured out. You tell yourself you’ll invest when the news gets better.
The news is not getting better. But a strange thing happens. The market has a few strong days. Commentators call them a dead cat bounce, expecting further declines. These few strong days are followed by a few more. Suddenly the market has retraced the last 20% of the decline. You feel bad that you didn’t invest two weeks ago (at the now “obvious”) bottom.
I can continue but I won’t. You get the point.
Once you are completely out, it is incredibly difficult psychologically to make a binary decision to dive back into the market. I’ve met quite a few people that have stayed out of the market since 2000 and are still waiting for their chance to get in. Just imagine the psychological rollercoaster they went through and the returns they left on the table.
Even if you got the market timing right once, putting it into a repeatable process is impossible. In addition to getting the timing of the economy right, you have to time the stock market response to the economy. I know many people who timed the market successfully once; I don’t know any who’ve done it twice.
One Stock at a Time
Investing in the stock market doesn’t need to reside in the binary extremes of Fool’s Gambit and Market Timer’s Gambit. There is a different game available: One Stock at a Time. That is the game we play.
Even in this insanely overvalued market not all stocks are overvalued and in search of a greater fool. Armed with patience, a long-term time horizon and our time-tested value investing process, we patiently look for high quality companies, run by great management, that are significantly undervalued (i.e., have a margin of safety). This process is not fast and furious and won’t get you rich quickly. It requires a lot of mundane work and turning over a lot of rocks. We read company financial filings, talk to management, competitors, build our own financial models, debate these investments among ourselves and with our global network of investors.
We only need 20 to 30 stocks – there are tens of thousands of stocks globally. When we cannot find enough stocks that meet our stringent investment criteria our cash balances go up and then they’ll decline as we find new stocks. We don’t time the market; we value individual stocks, buy when they are cheap and sell when they are dear.
Let’s just sum it up. The market today is a $1 bill trading for somewhere close to $2 or more. Many stocks in the market today are $1 changing hands for $4, $6, $20. But we don’t own the market; instead we have humbly assembled a portfolio of $0.30 to $0.60 dollars. One stock at a time.