How Do We Beat the Market?

It's been two months since my last post when the coronavirus really became the world's biggest problem. Back then, people were saying life will never be same, the world will hit a recession worse than the great depression, and on and on. To me what people are saying is not necessarily wrong, but it is the peoples tone that I focus on. The media is having a field day with this. Their job is to maximize their views or sell their papers and magazines. They will emphasize the worst news over and over because it gets people's attention and hence sells. After a long period of this blanket coverage, it cloud peoples judgement.

And the key to successful investment is good judgement, even though investment has a huge luck component. When an investor's judgement is clouded they can seriously lose. An investor whose judgement is not affected can win. Or to put it more bluntly, the latter can take advantage of the former. And the latter group consists of the great investors. They are coming out of the woodwork to make some serious money. Among them are Paul Ichan and Bill Ackman. These people made bets against the market, against the coronavirus. And they succeeded not because they were lucky but because they noticed their bets had huge risk/reward ratios and they had the guts to act on it. One can easily google their names and see their recent interviews on Youtube. I found them highly informative and recommend others to watch.

Back in the 50s in Buffett's heyday when Buffett made 30 plus percent every year, his secret was find individual cheap stocks from the Moody's Manual. That was an edge back then because it is hard to read through several thousand pages of three-column text and numbers. And he did it twice! Today that doesn't work, because all such information is digitized. So one can simply use screeners or write their own code to do what Buffett did much faster and for much more stocks. Plus Buffett has already spread the gospel of value investing, so his secret is out. Because of these two factors, I heard many people suggest that the stock market is more efficient today than before.

I vehemently disagree.

Take a look at the following log graph of the S&P 500 (at top). The economy and market grow exponentially, so the trendline should be a straight line. When gods are the only participants in the market I guess the S&P500 should also be a straight line, because gods have perfect information. But since the stock market participants are mortals with limited information, the graph is not smooth. That doesn't mean the market is not efficient.

Next, we can look at two different time periods, one contemporary and one from the past. The second graph show the index over the last 40 years. And the third graph show the index in the period covering the two world wars, including the great depression. If the market is more efficient today than earlier times then it should show in differences between the second and third graph. But looking at graph two and three it isn't clear that one is more volatile than the other. We have had massive peak to trough moves around 1989, 2000 and 2008. Just as we had them in the 1910 panic and the great depression.



So I can argue the market is not any less volatile than earlier years! So the market has been and still is inefficient. But how can we take advantage of this inefficiency. I already stated that stock picking is harder today than in Buffett's early years. Well, the market is inefficiency today simply because all good American companies are expensive.

Take Microsoft for example. In the last 7 years the stock price has gone up by approximately 7x. Meanwhile its earnings has only doubled! Compare this with Tachibana Electech (TSE:8159), in the 7 years that I have held it the stock has gone up 2.5x but its earnings also doubled. And while Microsoft is selling at 30x earnings, Tachibana is selling at 10x earnings. And I know different people will say that this anomaly is justified in different ways. I can guess some of the reasons:

• the investors don't care about earnings and value
• the investors believe in America but don't believe in foreign currencies and foreign economies
• the cheaper company is more likely to be a fraud
• future growth will justify it.

But in my opinion all these arguments do not justify the anomaly, and there are many counter arguments against it. Therefore, in my opinion, these two stocks reflect the current market inefficiency. But they are not the exceptions right now. Many many companies like Microsoft are just as expensive. And in the Japanese market many many smallcap companies are as cheap as Tachibana.

So, following this train of thought, it is natural to wonder how to take advantage. The solution, as with all investing strategies is by arbitrage. But whereas Buffett arbitraged across the different companies in the Moody's manual. I believe successful arbitrage today must be across entire markets and across different periods. For example, in the US, the market has swung between value and growth over long periods. In the 90's it was all tech growth. But the 2000s it was value, and now 2010 is the decade of growth again. Well, you can guess what I am betting on today. I am convinced the coming decade is going to be a roaring decade for value. If there was ever a time to invest in value stocks, it is now! This also means that different sectors of the market are treated very differently at the same time; for example, Japan versus US stocks.

I've come to realize this simple concept slowly over the lifetime of this blog, which is around 8 years. And consequently, I can easily see the reason behind active management's poor performance. After 2009, a lot of people started their own hedge funds. And their returns were phenomenal, even better than the high performance of the market overall. I am convinced these people realized that the way to have a successful fund is to start at a time when stock picking really is useful; i.e. when the market is depressed. That is time arbitrage. But in the last few years when the market is inflated, people who ran funds cannot put their portfolios into a defensive position even if they know the market is inflated. No investor who is paying high fees wants their money in cash. So the investors are implicitly forcing money managers to go headlong into a market that is inflated. So, these money managers oblige by taking more risk, whether they realize it or not. And now, we are seeing and we will see stories of money managers who were swimming naked as the tide comes down. As an example, I saw one manager of a small hedge fund whose equities are down 50% in the first quarter! And seeing the stocks in the portfolio, I think this is going to be a permanent loss. So what is that manager to do? I think the most prudent action is to close up shop, and hope that people will forget and start another fund later.

So, for brevity I will conclude this post here. This post is really the first half of an article regarding my current views, strategies and investments. My next post will follow up with the second half of the article, where I will describe what I have done in the last three months of market turmoil.

In the meantime, stay safe!