A longtime reader emailed me this week wondering if there was some course he could take to become more effective at managing his money. He has accumulated a nice sum over the years and is planning to retire and he wants to manage his portfolio on his own.
I thought about it for a bit, made a few inquiries and the sad truth is that there really is not such a course or class. To succeed at investing, you have to be knowledgeable about a wide range of things and be aware of most of the strategies being used at any given time in the marketplace.
While I prefer the value approach, I am well aware that a lot of people have a very difficult time with the periods of outperformance and the very long holding periods involved in my private-equity-style approach. With this approach, you really do not have to be all that aware of the market day to day or even week to week, but the truth is most people simply can't do it. This is particularly true when you're retired and there are no more dollars coming in the door.
I made a few calls, talked to a few friends and sat down and pondered the concept of a grand unified theory of investing. What I came up with is probably not the end-all, be-all of investment theories, but I do think it gets most of the way to a grand theory. I determined over the years that there are five things that work in the markets. These five things have worked since I started in this business. Four of the five have worked since the very first market was developed, and I suspect they will work until the world ends or the planet goes fully socialist. The fifth has worked for most of my life and should continue working for several decades to come, but may not last forever. For our purpose, however, it works just fine right now, so I will include it.
The first of the five is deep-value, private-equity-style investing. This type of long-term-oriented investing has worked and always will work. Assets have value, and if you can buy them for less than that value, you will turn a profit. The key here is the margin of safety, and over the years I have found that using things like F-scores and Z-scores can help you avoid a lot of value traps and buggy-whip companies. Deep value and margin of safety have worked and will keep working as long as there are markets traded by actual people and not just computers.
I thought about making the second metric part of the value slice, but I really think that for at least the next 20 years or so community banks deserve their own bucket. I won't go on at length as I have done that countless times in the past, but conditions in this sector will drive strong gains for a long time as the industry consolidates.
The next bucket is large-cap quality stocks. I use the gross profits definition of quality as devised by Robert Novy-Marx of the University of Rochester. Using just those stocks over $5 billion of market cap that have gross profits that are a high percentage of total assets beats the market, but Novy-Marx found that when you add a low price to book value to the mix, performance improves. When I studied it, I found that if you swap a low enterprise value to EBIT for price to book, it got even better.
The fourth bucket is for you action junkies. Combining earnings and price momentum not only beats the market, it trades more frequently than the other strategies. The approach that I found works best is to combine earnings growth of 25% over the past year with dual momentum. We take our universe of fast-growing companies and only buy those that are beating the market over the past year and are positive over the past three months. This strategy works great, but the volatility can be stunning at times in both directions.
Our final bucket is the cash-for-a-crash bucket. This has worked for folks like our old friend Mr. Womack, Andy Beal, Hetty Green and Warren Munger and it will work in the future. If a 20-year-old starts investing today, odds are he will see five or more big crashes of 20% or greater in his lifetime. Having cash when the world is on sale is how fortunes are made and it should be a component of the grand theory.
Like Ben Graham before me, I will divide the world into enterprising investors and defensive investors. The enterprising investors should pick one or two strategies that best fit their personality and concentrate entirely on those. I chose deep value and community banks, but if I was a younger man (or single and kidless), I would split the world into momentum and community banks and focus all my efforts on those two strategies.
The defensive investor should split the money among the five strategies and rebalance every two years or so. If we get a crash in the two-year period, then take money from the others to refill the cash bucket at rebalance time. I think this approach will deliver strong absolute and relative returns and allow the defensive investor to sleep better.
That's the Melvin Grand Unified Theory of Investing. While it may not be the final and absolute best solution, I think it's a good one. Tomorrow we will start taking a deeper look at each component.