This document provides six lessons from famous investors like Warren Buffett, Peter Lynch, and John Neff that can help investors beat the market. The lessons are: 1) Be fearful when others are greedy and greedy when others are fearful (Buffett); 2) Focus on long-term investing rather than short-term changes (Lynch); 3) Consider dividends which provide over 40% of stock returns (Neff); 4) Quantitative models are better than human judgment due to emotions (O'Shaughnessy); 5) Consider growth and value factors (Greenblatt); and 6) Diversify across industries and sectors (Neff). Following the wisdom of these investing legends can help investors achieve higher returns.
This document provides six lessons from famous investors like Warren Buffett, Peter Lynch, and John Neff that can help investors beat the market. The lessons are: 1) Be fearful when others are greedy and greedy when others are fearful (Buffett); 2) Focus on long-term investing rather than short-term changes (Lynch); 3) Consider dividends which provide over 40% of stock returns (Neff); 4) Quantitative models are better than human judgment due to emotions (O'Shaughnessy); 5) Consider growth and value factors (Greenblatt); and 6) Diversify across industries and sectors (Neff). Following the wisdom of these investing legends can help investors achieve higher returns.
This document provides six lessons from famous investors like Warren Buffett, Peter Lynch, and John Neff that can help investors beat the market. The lessons are: 1) Be fearful when others are greedy and greedy when others are fearful (Buffett); 2) Focus on long-term investing rather than short-term changes (Lynch); 3) Consider dividends which provide over 40% of stock returns (Neff); 4) Quantitative models are better than human judgment due to emotions (O'Shaughnessy); 5) Consider growth and value factors (Greenblatt); and 6) Diversify across industries and sectors (Neff). Following the wisdom of these investing legends can help investors achieve higher returns.
HOW THE WISDOM OF HI STORY' S BEST INVESTORS CAN HELP YOU BEAT THE MARKET
V A L I D E A C A P I T A L M A N A G E E M E N T , L L C .
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INTRODUCTION
Stocks are going up next month; stocks are going down next month. Buy gold; sell gold; buy tech stocks, sell tech stocks. Emerging markets look good, emerging markets are headed for a fall -- the financial world is filled with all sorts of often-contradictory advice from all sorts of people. And, unfortunately, all too often the people giving the advice have mediocre to poor track records, or, even worse, self-serving agendas.
At Validea Capital, we believe it's thus crucial to listen to those who have had sustained success in the stock market, not those who simply talk the loudest. People like Warren Buffett, Peter Lynch, Joel Greenblatt, John Neff and a select handful of other investing greats -- "The Gurus". These highly successful investors have done what few have -- studies show that as many as 85% of professional fund managers underperform market averages -- and they've been kind enough to share their wisdom over the years. Here are six guru-given lessons that we believe are crucial for investors to remember.
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Warren Buffett The Greatest Guru
"If [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful." -- Letter to Berkshire Hathaway shareholders, 2004
When investors get excited, they can get very excited -- too excited, in fact. Rising stock prices give rise to the idea that stocks are going to go up forever, or at least for a very, very long time, and investors continue to crowd into stocks long after they've surpassed reasonable values. Then one day they awaken to a cold dose of reality, and prices come tumbling back to Earth. (Just think back to the tech stock boom and bust.)
On the other hand, when investors get fearful, they can get very fearful -- too fearful. Plunging stock prices make them think the market will never recover. Things have changed, the pundits inevitably say, and stocks are no longer the best long-term investment vehicle. Investors ditch stocks to the point that they become very undervalued. Then one day they wake to a different dose of reality, one alerting them that they've missed out on huge buying opportunities.
Buffett understood these phenomena -- and capitalized on them by not getting caught up in the short-term, follow-the-crowd mentality. By being greedy when others were fearful throughout his career, he has snatched up good, fundamentally sound stocks that had fallen to bargain prices because of overwrought fears. And by being fearful when others were greedy, he's often avoided the manias that led others to pile into flashy but overpriced, fundamentally flawed stocks -- his refusal to join the tech bandwagon back in the late 1990s is a perfect example.
Buffett's "greedy/fearful" mantra isn't just talk. The chart below compares the results of the American Association of Individual Investors Sentiment Survey over the past two-plus decades to the performance of the S&P 500. As you can see, times when investors have become overly bearish, or pessimistic, is often been followed by periods of stellar returns. Other studies show similar results. When it comes to consumer confidence, the story is often the same. A study performed by money manager Kenneth L. Fisher and finance professor Meir Statman, for example, has found that months in which consumer confidence was low tended to be followed by months in which stock returns were high, particularly for small-cap and Nasdaq stocks. 1
While there's never a guarantee that periods of negative consumer or investor sentiment will be followed by market gains, the tendency seems clear: Worried investors often realize that their fears have run away with themselves, and when doomsday scenarios do not, in fact, play out, they breathe a sigh of relief and jump back into stocks. Those who have kept their eye on the long-term ball and snatched up bargains during the downturn, like Buffett, then usually profit handsomely.
1 Statman, Meir and Fisher, Kenneth L., "Consumer Confidence and Stock Returns" (August 2002). Santa Clara University Dept. of Finance Working Paper No. 02-02.
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Peter Lynch The Star GARP Manager
"If ... you decide to invest in stocks directly or with a mutual fund with a one-year horizon or a two-year horizon, that's silly. That's just like betting on red or black at the casino. What the market's going to do in one or two years, you don't know. Time is on your side in the stock market. It's on your side." -- "Betting on the Market", Frontline, PBS television
In the short term, equities can do just about anything. In the fall of 2008, stocks on average tumbled 40% in a span of just two months; then, when things looked ever-so-bleak in March, they surged almost 30% in the best six-week span for the Dow Jones Industrial Average in more than 70 years.
But the great paradox of the stock market is that, while incredibly unpredictable and often quite volatile in the short term, it is remarkably consistent over the long haul. Stocks have averaged 7% real, after-inflation returns for more than two centuries -- from the pre-industrial horse-and-carriage days to the days of jet travel and high-speed Internet. 2 Yes, they've bounced up, down, and all around during parts of that 200-plus year period, but they have always reverted to that 7% figure. The data below, sourced from the Ibbotson: Stocks, Bonds, Bills, and Inflation Yearbook 19262010 , also supports Lynch's contention about time being on your side in the stock market. As you can see, from 1926-2010, the S&P 500 lost money in about 3 out of every 10 calendar years, on average. But over three-year spans, it lost money only about half as often. And when your holding period was 10 years, you'd have had just a 5% chance of losing money, and the market has generated positive returns in all 15 year rolling periods.
2 Siegel, Jeremy. Stocks for the Long Run. McGraw-Hill Professional, 2007
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John Neff The Investors Investor
"Because stock prices nearly always sell on the basis of expected earnings growth rates, shareholders collect the dividend income for free. This advantage adds up year after year because when most investors, or Wall Street, or the media, make price comparisons, they don't include yield A dividend increase is one kind of 'free plus'." -- John Neff on Investing
Every day, the financial news networks and business sections of newspaper are chock full of stock quotes that state how the market and particular stocks are faring: "Microsoft up 5% today"; "The S&P 500 fell 1.2% Tuesday"; "Basic materials stocks surged 4.3% yesterday". But while those price change measurements are often taken as an absolute assessment of a stock's performance, they only tell part of the story -- about 60% of it, to be more precise.
That's because throughout history, dividend payouts have accounted for more than 40% of stock market returns. 3 Over the long haul, investing in good stocks that pay strong dividends can thus make a huge difference. The graph to the right, sourced from Ned David Research, shows various scenarios if one had invested in the S&P 500's dividend growers, payers, non-dividend payers or the market (as defined by an equally weighted S&P 500). As you can see from the data in the chart, dividend growers produced a 9.7% annualized return over 38 years, while the dividend payers produced a 9% annual return. This was superior to the 7.4% annual return of the equally weighted S&P 500, and far above the 1.9% annual return for those stocks that did not pay a dividend at all.
Of course, that doesn't mean blindly investing in high- dividend-yield stocks will automatically give you superior returns. But, as Neff points out, using dividend yield as one factor in your stock-selection strategy can supply an added bonus to the capital gains your investments make. And in downturns, the dividend payments you receive can make the price declines a bit easier to take, helping you stick to your long-term strategy.
3 Fonda, Daren and Reshma Kapadia. "Dividend Stocks: Primed for Payouts". SmartMoney, March 2009.
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James O'Shaughnessy The Quintessential Quant
"Models beat human forecasters because they reliably and consistently apply the same criteria time after time. ... They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. People, on the other hand, are far more interesting. We are a bundle of inconsistencies, and although they make us interesting, they play havoc with our ability to invest our money successfully."
-- What Works on Wall Street
Human beings are emotional creatures. Often, our emotions serve us well. Fear, for example, causes us to flee certain dangerous situations, guiding us out of harm's way.
Sometimes, however, our emotions actually lead us into greater danger than that which we are trying to flee. Suppose for a moment that you are walking in the woods and you come upon a menacing-looking bear. Your instincts will probably tell you to run as fast as you can in the opposite direction. But depending on the type of bear, that can be the worst thing to do. Some types of bears are much faster than humans, for one thing, and running from them can also make them think that you are prey. Playing dead or fighting back is often advised in dealing with attacks from certain types of bear.
When it comes to the kind of bears we see in the stock market, our emotions also can lead us astray. When stocks are falling, investors want to run the other way and sell off equities, fearing the declines will swallow up their portfolios forever. But in doing so, they ignore the fact that stocks often move erratically in the short term, and without regard to their true long-term prospects. Investors ditch good stocks -- and they do so at low prices. When they see rising stocks, on the other hand, they often do the opposite, piling into equities with visions of a never-ending profit parade. Not wanting to be left out, they snatch up "hot" stocks that are often overpriced and overhyped.
Those emotion-driven behaviors, of course, go against one of the oldest truisms of stock market logic: buy low, sell high. In reality, investors often allow their emotions to get the best of them and instead buy high and sell low -- that's what O'Shaughnessy understood so well. By relying on proven, quantitative methods that identified strong, bargain-priced stocks, he removed those pesky emotions from the equation, and allowed reason and research to drive his stock decisions.
The research of DALBAR, Inc. (see below) supports O'Shaughnessy's belief that human instincts lead to poor investment decisions. Studying the two- decade period from 1988-2008, DALBAR found that the broader market rose an average of 8.4% annually -- excellent gains. But by studying inflows to and outflows from mutual funds, DALBAR determined that the typical investor gained an average of just 1.9% per year in that period below the inflation rate of ahead 0f 2.9%. Bond investors also did much worse the their comparable index, showing that investors underperform across asset classes.
Why the huge discrepancy between market returns and actual investor returns? "Close examination of investor behavior reveals that many investors wait for markets to rise and then pour cash into mutual funds," DALBAR states. Then, "a selling frenzy begins after a decline." By buying high and selling low, investors thus deprive themselves of the stock market's great long-term benefits.
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David Dreman The Great Contrarian
A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest. People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new. Buy during a panic, dont sell. -- Contrarian Investment Strategies: The Next Generation
In 2008, when Lehman Brothers collapsed and the financial crisis was erupting, most investors headed for the hills. Day after day of crisis-centric headlines and dire warnings from pundits led them to think they'd be foolish to stick with stocks, and downright crazy to buy more. In the first full month after Lehman went bust, investors pulled more than $86 billion out of stock and mixed equity mutual funds, according to Lipper Analytical Services. Funds kept flowing out for several months before hitting another mini-peak in March 2009 -- the same month the bull market began.
Today, we know that investors who shunned stocks amid the crisis missed out on one of the best buying opportunities of their lifetimes. And that's nothing new. In his book Contrarian Investment Strategies: The Next Generation, David Dreman looked at how stocks responded after "11 major postwar crises", which included the Berlin blockade, Korean War, Kennedy assassination, Gulf of Tonkin crisis, 19791980 oil crisis, and 1990 Persian Gulf War. He showed how, one year after all but one (the Berlin Blockade, when the market dropped), the market was up between 22.9% and 43.6%, except for a 7.2% rise after the Gulf of Tonkin crisis. The average gain was 25.8%. Two years after the crisis, the average gain was 37.5%. It's worth noting that following the September 11, 2001 terrorist attacks, which occurred after Dreman wrote Contrarian Investment Strategies, it took just one month for the S&P 500 to climb back to pre-September 11 levels.
Of course, buying during a crisis is no small task. Every bone in your body tells you to head for the hills. But, as Dreman notes, humans are prone to overreaction when times are tough, leading them to punish stocks far too much during crises -- leaving a myriad of bargains for strong-stomached investors to scoop up. The financial crisis of 2008 once again showed that to be the case.
The chart below illustrates just how resilient the stock market has been in rebounding from a myriad of crises over parts of three different centuries. From extremely long events that impacted the economy for extended periods of time (like the Vietnam War) to shorter but deeper economic shocks (like the Great Depression), the U.S. economy has rebounded after each crisis, and the market has gone on to new highs, leaving many investors who decided to bail during the crises wishing they had stayed the course.
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Benjamin Graham The Granddaddy of the Gurus
"Investment is most intelligent when it is most businesslike." -- The Intelligent Investor
Were my holdings up or down this week? What is the broader market doing today? Is volume high? Low? When did a stock hit a 52-week high? Too often, investors spend a lot of time and effort worrying about such short-term numbers. In doing so, they miss what's truly important: the strength of a company's business. To Benjamin Graham, that's what really mattered.
Unlike most investors, Graham didnt approach stock purchases as though he were buying pieces of paper that would hopefully rise quickly in value so they could be sold for a profit. Instead, he approached stock buys as though he were buying the company itselfall its profits, all its debts, all its assets, all its revenue streams. So while technical analysts and chartists use a variety of complex measures to assess a stocks past price patterns and predict its future movements, only two simple factors are important to Graham and his followersthe real value of a company and how that relates to what youre paying for its stock. Graham knew that in the short-term, stocks are unpredictable, but in the long run, a stocks price tends to move with and reflect the real value of its business.
This mindset rubbed off on his most famous pupil, Warren Buffett, who studied under Graham at Columbia University. "Focus on the future productivity of the asset you are considering," Buffett wrote in a March 2014 Fortune column. "If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. ... If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. ... And the fact that a given asset has appreciated in the recent past is never a reason to buy it."
Remember, the underlying value of a business rarely changes anywhere near as dramatically as its stock price. That means short-term declines in stock prices should be looked at as opportunities to buy into strong businesses on the cheap -- not reasons to sell.
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Timeless Lessons
You don't need to reinvent the wheel to succeed in the stock market. In fact, those who try to do so by using newfangled investment schemes or flavor-of-the-month strategies often fail miserably. That's because the core tenets of good investing -- focus on good businesses with cheap shares, stay disciplined, and keep emotion at bay -- don't change. That's what the Gurus knew, and it's how you too can succeed in stocks over the long haul.
John P. Reese is founder and CEO of Validea Capital Management and portfolio manager for the Omega America and International Equity funds. He is also the author of The Guru Investor: How to Beat the Market Using History's Best Investment Strategies. John is considered an expert on the strategies of Wall Streets greatest investors and is a graduate of MIT and Harvard Business School
For further information on Validea Capital Management and our portfolio offerings, or to download our full 10-year performance track record, visit our website at http://www.valideacapital.com/gurus
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Disclaimer: Validea Capital Management, LLC. is a registered investment advisor under the Investment Advisors' Act of 1940. The names of individual investors appearing on this website are for identification purposes of his methodology only, as derived by Validea Capital from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this document personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and trade names appearing in this document are the property of their respective owners, and are likewise used for identification purposes only. All graphs and performance figures mentioned in this document are for illustrative purposes only and not indicative of any investment that has been or could be made. Investing in the stock market involves risk, including the risk of principal loss. Information in this report is in no way intended as personalized investment advice and should not be interpreted as such.