Today, in reviewing Chapter 3 (or more precisely Zweig’s commentary on Chapter 3) we learn of the perils of extrapolating the past, as Zweig puts it: “...the intelligent investor must never forecast the future by extrapolating the past.”
Commenting on Commentary on Chapter 3
Chapter 3 is all about reviewing historical investment performance. At first the cursory reader may be tempted to skip this chapter as it was titled in a manner that it was an exploration of stock market levels up to 1972, but in judging this chapter solely by its title one would miss the genius of the central lessons inherent in it.
As mentioned above one of the wise lessons in this chapter is what I mentioned above to not forecast the future solely based on the past, however, for me the bigger lesson is simply that what you pay for an investment matters - or succinctly price matters.
Zweig dives into the logic of some of the 1990s prominent investment gurus and the argument that effectively says that if you hold stocks long enough, you eliminate all of the risk, that stocks are a “free lunch” if the investor just has enough time. You may be saying to yourself, but isn't it correct that over a long enough time line history does show stocks in the aggregate have positive returns? And that would be correct, the nuance is that statement isn’t enough to guarantee that you as an investor actually earn those returns. Why? Because over that time horizon some/many companies fail, leading to “survivorship bias” in aggregate returns, meaning that the individual investors' portfolio construction would have had to be able to overcome those losers, or maybe more succinctly, not everyone owned the market portfolio. But all of the aforementioned is just a sidebar to the deeper truth in this chapter which is: “The value of an investment is, and always must be, a function of the price you pay for it.”
So long as profits are finite, the price an investor is willing to pay must also be finite. Reflecting on that for a second, it’s a simple message, for all investments there will be some price at or above which it is simply too high, it is an impossibility the profits will be earned to cover that price. Graham calls it the “rule of opposites” that the more enthusiastic investors are in stocks for the long run, the more likely they are to be proven wrong in the short run. Perhaps this is just saying that the more hopium the market prices into stocks the more likely they are to be disappointed.
Too high of prices should lead an investor to ask at this price how can future returns still be higher? Once everything is ‘priced in’ where can the new optimism come from?
Zweig challenges us to think about future returns with cold calculating logic, not with market punditry and ‘noise’ from gurus. And exactly what is that cold calculating logic of stock returns, well it is 3 factors (Graham seemed to like 3s): 1) real growth (the rise of company earnings), 2) inflationary growth (general rise in prices that companies can pass through ) and 3) speculative growth or decline (the general appetite for investing in stocks). We’re not going to dive into these factors, but I would like to again highlight the fundamental logic that underlies these which I think was perfectly summed up by Warren Buffett in this quote:
"The absolute most that the owners of a business, in aggregate, can get out of it in the end - between now and Judgment Day - is what that business earns over time."
Your investments can’t ‘out-earn’ the economy in aggregate. Does that exclude some companies from earning a disproportionate share of economic output, of course not. Can you or anyone consistently find and buy shares in just those companies at fair prices and then exit them at the right time? Probably also no.
This is where some themes start to converge. Graham defines an element of intelligent investing as aspiring for ‘adequate’ performance. If we use the formula above, one place an investor might find ‘adequate’ performance might simply be what Buffett has called the ‘American tailwind’, simply capturing the real growth of an economy and letting it compound.
Of course betting on an economic tailwind to continue is not necessarily enough, as Zweig reminds us: “The only thing you can be confident about while forecasting future stock returns is that you will probably turn out to be wrong.”
As investors, if we’re trying in some way to put the ‘odds on our side’, then for me this chapter is all about realizing that price matters.
Next post we’ll begin to explore Graham’s views on the topic of ‘Portfolio Construction’.
Until then:
“You’ve got to be careful if you don’t know where you’re going, ‘cause you might not get there.’ - Yogi Berra.
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