Key Lessons From The Gurus

In an interview with, Validea CEO John Reese discusses which of his “Guru Strategies” has performed best over the long haul, and some of the key lessons he’s learned in implementing his models, which are based on the approaches of some of history’s greatest investors.

“The models still continue to work” years — and even decades — after being developed, Reese says. “I have actually been keeping track of the portfolios since 2003 based upon the original strategies. Eleven out of 12 models have continued to outperform the S&P 500, some have outperformed the S&P 500 by a factor of five to one.”

Interestingly, one of the top performers has been the Benjamin Graham-inspired model, which is based on the approach Graham laid out more than 60 years ago. By focusing on undervalued stocks with strong financials and fundamentals, the strategy has produced double-digit annualized returns since its 2003 inception, while the broader market has struggled. And fundamentals are what most of Reese’s models key on. “For the most part, the successful investors over a very long period of time have been the people who look at the fundamental values of the company” rather than technicals, he says.

Reese also discusses how using multiple models to assess a stock can enhance returns. And he says that the most common variable used by the gurus he follows is one you might not expect: the debt/equity ratio (or some variation of it). “They sort of consider that poison to a company, and they want to see low or sometimes even no debt to equity,” he explains.

How Many Stocks Is Enough?

How many stocks should an investor own in order to diversify away stock-specific risk? Some interesting data shows that it may be fewer than you think.

The data comes from hedge fund guru Joel Greenblatt’s book, You Can Be A Stock Market Genius, and was highlighted by top value investor Whitney Tilson a few years back (and recently reprinted on The Motley Fool website). According to Greenblatt’s book, the risk-reduction benefits of adding more stocks to your portfolio significantly decreases once you get to about 20 or so stocks. Tilson, citing the data, said that “owning two stocks eliminates 46% of nonmarket risk of just owning one stock.” As you add stocks to the portfolio, that nonmarket risk declines as such:

• Owning four stocks eliminates 72% of the risk

• Owning eight stocks eliminates 81% of the risk

• Owning 16 stocks eliminates 93% of the risk

• Owning 32 stocks eliminates 96% of the risk

• Owning 500 stocks eliminates 99% of the risk

“Generally speaking, my ideal portfolio would have 12-20 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), of which roughly five were 10% positions and rest were 5-9% positions,” Tilson wrote. “Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there’s obviously a big penalty in terms of performance if one’s best ideas are 3-5% positions instead of 7-10% positions.” (Keep in mind that Tilson’s artice was published in 2004, so his approach may have been altered since then.)

Bogle: Think Long Term — Very Long Term

Legendary Vanguard founder Jack Bogle says he’s cautious heading into 2012, and that investors need to take a long-term perspective.

“With the economy, I’m cautious,” Bogle recently told the Associated Press (a tip of the cap to NPR for highlighting the interview). “I don’t expect a boom in consumer spending over the next two or three years. People don’t have the wherewithal to spend a lot more, and in today’s world, they don’t have the confidence. Confidence can change overnight, but wherewithal cannot.”

“If you’re investing in stocks with idea of a one-year outcome, you should not invest,” Bogle adds. “You can lose a lot. If you invest in stocks with a five-year outlook, I would think it is highly debatable if you should do that. You have to think about more than just the probabilities of a market crash. You have to consider the consequences for your savings, and whether you’d be decimated.”

For bond investors, Bogle says that with interest rates and yields so low right now, “you just have to take those for what they are — a lot lower than what they have been historically.”

Bogle also discusses his belief that excessive trading is a big problem for the market, and that policies need to be enacted to tame the amount of speculation in the market. And he talks about his disenchantment with U.S. tax policy, saying that it’s an “absolute absurdity” that “gamblers on Wall Street” often pay less taxes on winning stock picks than American workers pay on their wages.




Grantham’s GMO Not As Gloomy On Stocks As You Think

While Jeremy Grantham’s GMO has been gloomy about the outlook on stocks, the firm’s head of asset allocation says there are also good opportunities in the market right now.

“We think there is money to be made,” Ben Inker tells The Boston Globe. “There’s plenty of stuff to be worried about. [But] there’s actually a fair number of stocks worth owning. For us, that’s exciting.”

Inker tells the Globe that it’s a bad time to own bonds, and say many high-quality stocks are cheap right now. He likes dividend payers and large, stable, profitable firms that do well whether the economy is good or bad, like Coca-Cola. He says “places where people seem to have less hope than more” are places to look for stocks, like Japan and Europe.

While many investors run from stocks in tough times, Inker talked about having a longer-term mindset. “People assume that times will be bad forever,” he said. “And when times are good, people assume they’ll be good forever. And they are overwhelmingly wrong in both assumptions.” He thinks the broader U.S. market is overvalued, but adds that “you should not wait until the market is screamingly cheap before you put any money into it.” Avoiding stocks entirely is a risk, he said, and those who do so could “miss out on perfectly good returns.”



Buffett-Style Tech Picks

Could Warren Buffett be on the lookout for more tech stocks? That’s a question that Validea CEO John Reese examines in a recent article for Canada’s Globe and Mail.

“Not long ago, that question would have seemed foolish. Warren Buffett avoided investing in technology companies, saying that the nature of their businesses did not allow him to determine which tech companies truly had ‘durable competitive advantages’ over their peers,” Reese writes. “But with Mr. Buffett’s company, Berkshire Hathaway, having scooped up more than $10-billion (U.S.) worth of International Business Machines’ stock over the past few months, it’s now a question that begs to be asked.”

Reese uses his Buffett-inspired Guru Strategy — which is based on the approach Buffett used to build his empire — to see if any tech stocks currently appear to have “Buffett-esque” fundamentals. Among those that pass muster: Connecticut-based Amphenol Corp. Reese also takes a look at tech giant Research In Motion, seeing how the Canada-based firm matches up against his Buffett-inspired approach. To read the full article, click here.



Nygren: Don’t Chase Bond Performance; Buy Stocks

Top fund manager Bill Nygren says that the best thing investors can do in 2012 is buy more stocks. “The best idea for 2012 is for investors to increase their equity exposure and decrease bond exposure,” Nygren tells CNBC. “We think stocks are cheap.” He says he thinks it’s a mistake for investors to chase hot bond performance, with many stocks trading at “very, very attractive valuations”. Nygren also says it’s important to think long-term, and not try to time the market in the short term. And he talks about some of his current holdings, like JPMorgan Chase and Intel.

Stattman High on Oil Firms, “Nibbling” at Bank Stocks

Blackrock’s Dennis Stattman, whose Global Allocation Institutional fund has been one of the better performing funds in its class over the past five and ten years, says he’s keying on companies that are based in developed markets but have exposure to the strong growth in emerging markets. Stattman also tells Bloomberg that he takes a longer-term approach to investing and doesn’t try to time the market in the short term. He says he doesn’t think investors should be focusing too much on any one country or any one currency, and adds that he’s overweight energy stocks and has begun “nibbling” at U.S. bank stocks.

Top Manager Getting Less Defensive

Top mid-cap fund manager Jonathan Simon says he’s adding some risk to his portfolio heading into 2012, and is high on some regional banking stocks. Simon tells CNBC that he is particularly concerned with a company’s free cash flow, and how it uses that cash. “They have to have a very disciplined approach to capital allocation — maybe making acquisitions, paying down debt, paying a dividend or a stock buyback,” he says. “That’s the key.” He says he’s cautiously adding some more economically sensitive stocks to his portfolio, and he mentions some that are on his radar right now, including M&T Bank.

Ritholtz on Individual Investors’ Greatest Enemies

Barry Ritholtz of The Big Picture blog and FusionIQ says investors need to know who they are up against when managing their portfolios — and says that to find perhaps the greatest enemy, you don’t have to look far.

Writing a guest piece for John Mauldin’s “Thoughts from the Frontline” newsletter, Ritholtz says the first two main enemies investors face are “Mr. Market” himself (who often stands by impartially as cheap stocks get cheaper or pricey stocks get more overvalued) and other investors (primarily professional investors, who have an array of staff and tools on their side that individual investors don’t have).

The third enemy, however, may be the worst of all: your own brain. “You just assume it knows what it’s doing, works properly, doesn’t make too many mistakes,” Ritholtz writes. “I hate to disabuse you of those lovely notions; but no, sorry, it does not work nearly as well as you assume. At least, not when it comes to investing. The wiring is an historical remnant, hardly functional for modern living. It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of grey matter, they might as well not even bother using their brains at all.”

Ritholtz cites a few examples, one of which involves the “Dunning-Kruger Effect”. The main idea of this tenet is that the worse you are at something, the worse your ability is to evaluate how good you are at it. “As it turns out, the same skill set needed to be an outstanding investor is also necessary to have ‘metacognition’ — the ability to objectively evaluate one’s own abilities,” he writes.

Ritholtz says that and other behavioral shortcomings help lead four out of five investors — mutual fund managers and individuals — to underperform benchmarks year-in and year-out. He says evolution has honed our survival instincts, but that those instincts are the opposite of what is needed to be a good investor — i.e., not following the crowd, not fleeing in the fact of danger, etc. “The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making,” Ritholtz says. “Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated — and that does not help returns. Indeed, our evolutionary ‘flight or fight’ response developed for a reason — it helped keep us alive out on the savannah. But the adrenaline necessary to fight a Cro-Magnon or flee from a sabre-toothed tiger does not help us in the capital markets. Indeed, study after study suggests our own wetware works against us; the emotions that helped keep us alive on the plains now hinder our investment performance.”

But, Ritholtz adds, humans also have the ability overcome these problems. And, he says, individual investors do have some advantages over the pros. Among them: the freedom to invest with longer-term time horizons in mind; the lack of limits on stock and position sizes; and the ability to admit mistakes and correct errors without having to worry about being fired.