Stick to the knitting

Stick to the knitting

We have discussed previously the ingredients required to invest successfully over the very long run. And it is encouraging that the two essential ingredients, the ability to value a business and understanding how the market works -particularly its bipolar nature and tendency to treat temporary events as permanent – can be taught.

But there is one other ingredient that is talked about far less, perhaps because this element is accepted as not being learnable. The ingredient is, I believe, Buffett’s special gift. It is of course temperament.

Many years ago Buffett famously wrote:

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

When markets are volatile and most investors are losing their heads or when high and rising prices are drawing ever increasing numbers of former bears who are throwing in the towel, these are the periods when discipline and fortitude are essential to plant the seeds of the next fortune.

The benefits of the right temperament can be leveraged in any asset class.

Witness, by way of example, the current boom in commercial property on Military Road in the Sydney Suburb of Mosman. Vacancies on the exclusive strip are at their lowest in four years and rents are now reaching $2000 per square metre. According to the Australian Financial review, 40 national and state upmarket brands, including one of my old favourites, Henry Bucks, have set up shop.

In the two years to 2011 however rents had fallen 20 per cent and there were as many as 30 vacant stores. Laura Ashley, Portmans, Saba, Just Jeans and Ella Bache vacated the strip when their leases came up for renewal.

To take advantage of the recovery requires an ability to control emotional urges. One requires patience to take advantage only when commercial real estate is distressed and similarly the discipline to pull the trigger when everyone else is calling the end of the world.

“…to be fearful when others are greedy and to be greedy when others are fearful.”

Another example of the calibre of emotional intelligence required to succeed is Buffett’s own Berkshire Hathaway share price and his response to it.

Many investors look to the current Berkshire share price of $172,089 per share and compare it to the $11.5 Buffett was offered for his stock in 1964, wistfully imagining having purchased a portfolio made up only of stock in the world’s eight largest corporations back in the 1960s.

But very few investors who bought stock back in the 1960s would have had the temperament to hold it through thick and thin.

Berkshire Hathaway has been 58 per cent more volatile than the S&P500 index and only investors who remained disciplined and held their Berkshire shares would have enjoyed the long term performance.

By way of example, over the 20-month period to February 2000 – the peak of the internet bubble – Berkshire shares lost 44 per cent in market value terms, while the market gained 32 per cent.

Think about that for a moment…

Imagine you invested with a fund manager and while the market went up by 32 per cent, your units fell, in market value terms, by 44 per cent! Perhaps giving more life to the example, imagine you invested a million dollars with Montgomery and your $1 million turned into $560,000 while an index fund would have turned your million into $1.32 million. Would you have stuck around?

Not many rating houses in Australia would have continued to give Buffett a high rating after he underperformed by 76 per cent over two years. And very few Australian institutions would have maintained an allocation with Buffett either.

However Warren Buffett did stick with the methodology, preventing emotion from interfering with a disciplined strategy.

Warren Buffett isn’t worth US$53.5 billion because he sold at the first sign of dark clouds on the horizon, because he balked at short term underperformance or because he sold Berkshire shares when he thought they’d gone as high as they were going to for the foreseeable future. No. He has more than tripled the return of the S&P500 since 1976 by simply by being emotionally intelligent. The fact is you can do the same but it isn’t easy – and I’m speaking from experience.

At Montgomery, the last two months have seen both of our funds underperform their respective indices. Should we do the submit and change strategies? Should we jump out of the high quality companies we own and buy the C3 and C4 quality companies that have been rallying the most in the ASX 200 Industrial Index (see Table.1)?

Table 1. Performance of XNJ Constituents

Clearly the answer is no.

What we know is that poor quality companies don’t add economic value over the long run and this is reflected in the less-than-satisfactory increases in intrinsic values over the same period. Most importantly, over the long run prices are determined by intrinsic values and as long as the intrinsic values are higher and rising, and the prospects for the business are bright, the prices should take care of themselves.

Warren Buffett said as recently as October 31 for Fortune Magazine, “Temperament is more important than IQ. You need reasonable intelligence, but you absolutely have to have the right temperament. Otherwise, something will snap you.”

In our view the market is once again in expensive territory with just a small number of large caps showing any margin of safety. Nevertheless, valuing a company is not the same as predicting its direction, and so while the market keeps rallying, we must follow our process and ignore the temptation to swing no matter how loud the calls to do so.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.