Don’t be surprised
I’m reminded of a gentleman who discovers a genie in a bottle. Granted one wish only – apparently even genies have pricing power – the man asks for peace in the Middle East. The genie backs away and says, “That’s way too difficult. Give me something easier.” The man ponders his options and asks the genie instead, to help him pick a good mutual fund. The genie quickly responds, “Let me get to work on the Middle East.”
I’m now entering my fourth professional decade managing money. And one thing I’ve learned is that there’s no shortage of surprises. What should happen, doesn’t always. What could happen comes to pass instead. And sometimes, what can’t happen actually does. Investing, like life, is imminently unpredictable. There are surprises – some good, some bad.
I’ve had great confidence in many of my investments, like when I believed the Hong Kong holding company that I purchased at less than cash value couldn’t lose me money but it did. Thankfully, there were upside surprises as well, like when I invested in a national arts and crafts retailer, hoping to double or triple my money but instead ended up with almost a 15 bagger.
As the Roman philosopher Pliny the Elder noted two thousand years ago, “The only certainty is that nothing is certain.” Or, as that modern-day philosopher Mike Tyson said, “Everyone has a plan ‘til they get punched in the mouth.” I’ve therefore learned not to be too precise, and now operate with a range of expected outcomes. Accepting uncertainty, in turn, has also allowed me to take instruction from those with good ideas. I’ve learned to take chances, recognising that not all of them will succeed.
At FPA, we are disciplined value investors who spend the majority of our time trying to understand what makes a business tick. When we find a good business that might be misperceived and may be ticking a bit faster than the market’s perception, we buy it. We also understand what types of investments are out-of-bounds, i.e. outside our circle of competence.
The bottom line is that I’ve never been terribly comfortable with losing money and I therefore have always sought to protect capital before trying to grow it. When I started my own firm, Crescent Management, in 1990, I explained to people that I’d manage their savings being mindful of the downside - no differently than I managed my own very small portfolio. That was working reasonably well and I thought my ‘go-anywhere’ strategy could translate into a somewhat differentiated mutual fund, which led to the Crescent Fund’s inception in 1993.
It was a good start. My business grew, thanks to decent returns and lower than average risk across both stocks and bonds. But then… You’ve heard of the Sports Illustrated cover curse? You get the cover shot and then you choke. Like Pete Rose shown (below left) on the August 1978 cover[¹], the same week his 44-game hitting streak ended. Or the June 1988 Michael Spinks (below right) cover[²] before his fight with Mike Tyson. Tyson knocked him out and into retirement in just 91 seconds.
Apparently, the curse carries over to other magazines. In February 1998, Money Magazine put a hardly deserving, unproven 34-year old on its cover. With sunglasses and a lack of humility, leaning against a BMW parked on a Beverly Hills street, I was just asking for trouble. Of course, mind-bending underperformance followed. For the next two years, the FPA Crescent Fund was 59% behind the market. I thought I’d never play ball again.
All joking aside, it was frightening and humbling and delivered a large dose of humility. Back then, plenty of other managers were performing well. I told clients that I was protecting their capital against the insanity of the tech/internet bubble. I wasn’t terribly convincing. More than 85% of the fund was redeemed. It was brutal. I have two theories why I had any capital left to manage:
- People felt so bad for me that they wouldn’t redeem – kind, but oddly masochistic; or
- Shareholders forgot they had invested in the fund.
Fortunately, and none too soon, the market woke up to the fact that valuations were indeed nuts. Over the next three years – 2000 to 2002 – the fund outperformed by 84%. For the five years, including the horrible 1998-99 period, Crescent shareholders found themselves ahead of the market by some 44%.
The 38% S&P 500 decline from 2000-02 reinforced my commitment to avoid losing money to the best of my ability. The conviction in my philosophy and process had ultimately paid off. This shows that it’s not helpful to examine a period of only rising or falling stock prices. I’d rather perform well over time, rather than for just a moment in time – preferring market cycles instead of lunar cycles or some other arbitrary metric. Our goal is to perform well over full market cycles and we have thus far.
Playing inside our self-imposed boundaries helps limit the negative surprise factor and also leads to varying risk exposure, i.e. the amount we’ve invested in stocks, bonds and other asset classes. When we find opportunities, we commit capital, increasing our risk exposure. Conversely, when the environment is more barren, cash builds by default and our risk exposure declines. What we won’t do shares equal billing with what we will do.
Just because we may not be invested doesn’t mean we’re sitting around doing nothing. We never stop learning about businesses. School is in session every day but exams tend to come in a cluster, which brings to mind a Bill Parcells quote; “This is what you work all season for. This is why you lift all them weights.” Similar preparation allows us to be ready when the inevitable opportunities present themselves. At that point, we’ll draw down cash to make investments.