Why we’re not celebrating the vindication of our investing principles
Value investors have had a miserable time over the past years. Now that our investing principles are finally being vindicated, you’d expect us to gloat. But Herr Schadenfreude is not a friend of ours.
You can listen to a professional narration of this article below:
A year ago, my family started a new tradition. On the day before one of our birthdays, the five of us (my wife and the kids) go to a sushi restaurant for a special dinner. We celebrate the last day of the pre-birthday person being this age. This single focus of the dinner is on the pre-birthday person. We go around the table and each share what we love about the pre-birthday person, as well as our favorite memory with them. Then, the pre-birthday person does the same for each of us. It's an incredibly touching and intimate dinner that we all look forward to throughout the year!
I think my kids like this pre-birthday dinner better than the official birthday celebration. I know I do for sure. We have a large extended family, so birthday dinners are usually messy and loud, with a lot of small children running around breaking things. The birthday person and the reason why we all got together is often lost in the chaos. This pre-birthday dinner brings the focus to the right place – the celebration of the birthday person.
Mia Sarah just turned 9 and we went for a pre-birthday dinner to a fancy sushi restaurant. The next day, as I was driving Hannah (17) and Mia Sarah to school, Mia Sarah was telling me how much she loved the dinner. I told them that it wasn’t the restaurant that made the dinner special, it was the people at the table. We would have enjoyed it just as much at a hole-in-the-wall sushi restaurant – in fact, that is what we'll do next time.
Nassim Taleb called traditions "the melody of life." I really like that – melody is the bedrock of music; it is what makes music memorable. Traditions add stability; they are the constants; they are something we can latch onto and look forward to in the turbulence of life. I wish for you that you may be able to create more wonderful traditions this year.
Over the next few weeks, I will be sharing excerpts from the winter letter I wrote to IMA clients. In the past, I would sanitize them and turn them into articles. I think the relationship with my readers has evolved to the point that I don’t need to do that.
Herr Schadenfreude Is Not a Friend of Ours
Everybody needs to have his or her why.
Why gives us meaning in life. This is what pulls us forward, what makes us grow as individuals, what gives us purpose in life. It’s the reason we get up in the morning. We usually have multiple whys. For instance, my why as a parent is to raise kids who are good human beings that can thrive in this world. My why as a writer is to help and inspire people. My why as an investor, which perfectly aligns with IMA's why (being CEO and IMA's locomotive is helpful here), is to produce uninterrupted compounding for the IMA Tribe.
For years, the "uninterrupted" part of IMA's why did not matter. The music was blasting loudly, the punch bowl was continuously refilled with the cheap liquor of low interest rates, and everyone was dancing and making money. The less common sense you had, and the richer your imagination was, the more money you made. Sure, risks were everywhere. Everybody knew about them. But for a long time, the more risk you took, the more you easily and quickly became more and more “wealthy”. Profits, cash flows, valuations and margin of safety were not the words that were popular at that party.
And then… interest rates went up, the music stopped, the punch bowl was taken away and, predictably, the speculative bubble burst.
Warren Buffett said: "Over the years, a number of very smart people have learned the hard way that a long stream of impressive numbers multiplied by a single zero always equals zero."
Over the last year, I observed many smart people who had shown incredible, mouthwatering returns for the last 5-10 years, only to have them multiplied by a negative 70-90%. It is difficult to continue compounding one's capital when you are down this much on a portfolio level; at this point, volatility becomes a permanent loss of capital. You might as well multiply them by Buffett’s proverbial zero. This is how compounding gets permanently interrupted. Their portfolios profited from the bubble, and then perished because of the bubble. Of course, most of their clients came to them at the top, chasing high returns.
It is only natural for us to entertain a visit from our German friend Schadenfreude; after all, anyone who was not dancing but rather was concerned about what would happen to their clients' capital when the music stopped looked inadequate – not quite a failure, but not as smart or enlightened as the ones dancing at the party. But now the tables have turned.
Being a value investor became an incredibly lonely and painful place to be over the last five years. If you ran a value investment firm, attracting clients was very difficult. I’ve read about mutual funds closing value investment strategies and consultants removing the “value” boxes from their “value-core-growth” portfolio construction framework.
IMA was a rare exception; we have grown significantly in a shrinking universe. I think this is because we are attracting "misfits" like you, who are drawn by our common sense and are fine with getting rich slowly and not having to worry about the music stopping one day. Or, if you'd like me to go Disney on you, the clock strikes midnight and their shiny carriage turns into a pumpkin.
From the bottom of my heart, thank you for your trust!
Though we achieved very reasonable returns that I am proud of over the last decade, I have to admit that I have personally had unpleasant experiences when prospective clients almost laughed at me when our returns did not measure up to the out-of-this-world returns they received from their "growth" money managers whose portfolios were drowning in bubbly stocks.
I am embarrassed to say that in recent months we did on occasion consort with Herr Schadenfreude, but we quickly sent him away. Deriving pleasure from someone else’s misfortune just doesn’t seem like the right thing to do. Also, for me it’s personal.
I have some value investment friends who have had their investment principles slowly eroded by the seemingly never-popping bubble. You don't lose your principles overnight; it’s a slow, painfully incremental process. (This applies not only to investing but to other parts of life as well.) One compromise led to another, and, God forbid, they produced returns, and did so for quite a long time. Today, these friends are hurting; they are good, smart, even brilliant people. I talk to them all the time and value them as human beings; I treasure their friendships.
Pain destroys any arrogance that has infiltrated our thinking. It occupies our subconscious mind, effectively trapping us in a loop of self-reflection where nothing else matters. It serves as an effective reminder of our mistakes, allowing us to reexamine and refine every aspect of our investment process. It is the best teacher, helping us to ensure that we learn from our mistakes and never make them again. It is an invaluable tool that can help us grow.
Ben Graham, the father of value investing, developed his investing framework after he suffered significant losses during the Great Depression. I’ve benefited tremendously from pain, too – I wrote about my painful travails from 2015 in Soul in the Game, in the chapter called “Pain, Opera, and Investing.”
If I did not have all my investable assets managed by IMA (which is the right thing to do for a money manager), I might have let some of these friends manage my family’s money.
That is just one of many reasons Herr Schadenfreude is not welcome at IMA.
Of course, there are a lot of people who lost their money, whose lives have been ruined by the bubble burst. Unfortunately, a Jeremy Grantham quote comes to mind as I type this: “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.” Most people (not all) who lost their money will learn a lot from this bubble. But society as a whole, especially its future iteration, will learn very little. We’ll have other bubbles, likely with different actors, in our future.
Our why – uninterrupted compounding - is our North Star. This doesn’t mean that we are not going to have down years – volatility is an inescapable part of the stock market journey. But we are going to continue building and improving our all-terrain portfolio. We are prepared to be a responsible adult at future parties filled with drunken teenagers.
You can download a selection of my best articles from 2022 as a beautifully produced PDF in this link.
Schuman Piano Concerto in A Minor
Today I’d like to share with you Piano Concerto in A minor by German composer Robert Schumann (1810–1856). Robert wanted to become a great pianist, and his teacher, Friedrich Wieck, assured him that he could, but a hand injury caused by a concoction created by Wieck that was supposed to stretch Robert’s fingers shattered that dream. Robert married Weick’s daughter Clara, despite Weick’s legal opposition. Clara was Robert’s equal both as a pianist and a composer. (We’ll explore her work in the future.) The premiere of this concerto took place in 1841, with Clara Schumann as the soloist.
Click here to listen.
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to bonus@soulinthegame.net.
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