Confidence in the Face of Danger

Be Confident in Process, Humble in Results

November 12, 2009
by Tom Jacobs

CGI Co-Founder and Portfolio Manager Tom Jacobs explains why confidence in your investment process arms you against the great losses that have some and will do so again. 

Did you know that in 2008, the average stock under $100 million market cap lost 75%? Centaur Capital’s Matthew Richey provided this sobering information to attendees at Complete Growth Investor’s Las Vegas Conference last month. No wonder small cap value investors were hurting on paper.
Of course, it’s precisely that drop that makes small cap value the long-term best performing asset class, per research including that in David Swenson’s Unconventional Success.

The argument is a simple one, going like this:

1. The greatest inefficiencies are found in companies about which the least information is available and/or where emotion has wrecked havoc.

2. Because the nature of financial media is to focus on the large—eyeballs interested in Johnson & Johnson, say, versus Premier Exhibitions—inefficiencies are found in smaller and more illiquid stocks.

3. Because market emotion affects the price of smaller, more illiquid stocks more dramatically, they are more volatile, too. As investors pulled their money out of hedge funds in 2008, it killed the prices of smaller, more illiquid stocks far more than large caps.

4. As successful money managers gain assets under management, this restricts their investments to large caps, reinforcing all the reasons that opportunity and volatility are greater in smaller, more illiquid stocks. 

5. As so clearly noted in the 1940 edition of Graham and Dodd’s Security Analysis, most investors should stick to the popular, well-known issues, because while their returns will be mediocre, they won’t be hurt as badly by more dramatic short-term volatility. See #4.

6. All other stocks are the work of the investment analyst, because the analyst understands that market emotion will provide opportunities, massive volatility provides that opportunity and risk most often due to relative smallness and illiquidity, and understanding and evaluating these opportunities require expertise.

What most people want, as my brother honestly said to me recently, is something for nothing. They want the potential returns from, say, small cap value, without the gut-wrenching, knee-shaking, head-spinning volatility. But it’s not possible. It’s so simple, yet no one gets it. Because few get it, a Bernie Madoff can sell riskless 12% returns to those who would buy the snake oil.

The reason that it’s possible to outperform over the long term is precisely because most people can’t handle the truth: Investors must be scared away from a stock enough so that it is priced far below intrinsic value for there to be an opportunity. And you never know where that particular “far below” is. So you may buy with room left on the downside.

The world of cheap advice promises the ability to time buying and selling, so determine this year’s trend, to chase that momentum. But no one knows when the momentum turns, which is does with a vengeance.

The entire world of investing is, for the most part, picking up nickels in front of steamrollers. Grab this growth and get out. Dive for that quick opportunity and escape the doom ahead of you.

But the steamroller, unannounced, comes. The stolid owners of large dividend-paying companies reinvest their dividends and don’t worry. They accept mediocrity for relative safety.

Small cap value investors know that for every percentage point of downside, if they have purchased at enough of a discount to intrinsic value, they will profit on the other end. What none of knows is when.

It’s no wiser than this Buffettism: Be greedy when others are fearful, and fearful when others are greedy. In November, he wrote in The New York Times of his stock greed. Through that period and the spring, we did so at Complete Growth Investor. We did not know the market would rise over 50%. We didn’t care. We knew only that as analysts of value, the odds were in our favor. Other complained, “Oh! If I only had cash!” But everyone always does. We switched out of lesser values into greater ones.

Our investment in ATP Oil & Gas (ATPG) rose over five times since March, giving us a 245% gain on our average basis. We didn’t know it would happen or when, but the odds favored us. Ditto Steak N Shake (SNS), Sears Holdings (SHLD) and more—all priced for the dustbin in March. Anyone can name bargains they wish they had bought then. But most were shaking in their boots, and in the worst case, going to cash. Oops. We didn't know which of our investments would do well, but we knew that with a group of values selected with care, some would, in time. We honored our process and let the market handle the rest.

If you don’t have the time and energy to become confident in your process, you will never succeed because the craziest markets are exactly where confidence is required to ride out the storm and take advantage of the bargains being thrown about. Most investors have it all wrong: they think that it’s the results that count, and they chase this gamble and that gamble. They invest in the sun and hide in the storm, a recipe for poverty.

There are only two paths, and they’ve been the same since Graham and Dodd wrote it in 1940: If you would rather play with your kids, walk the dog, and work hard at what is within your circle of competence at your job, then stick to the popular, well-known issues, and sacrifice returns for relative safety.

If you are passionate, if you can’t help yourself spend your space time with investing, then get to work, study hard, gain confidence in your process—as a value investor, Graham and we would add—and let the results take care of themselves. You can control your process, but not the results. You can control you.

Leave the nickels to others. The steamroller will come. Value investors—even those down 75% last year—over time outwit, outplay and outlast. They are the investing survivors. They measure returns over years, the wisdom known since Keynes and before. All that is required is process and patience, and they are in short supply. Which is precisely why they work.

There is nothing new under the sun. Everyone wants something for nothing, and long-term gain comes only with short-term pain. Be different. Join us. It’s what we do every day and have done for years, and what I’ve done to return 145% versus the S&P 500’s 39% since January 2003. Not a flash in the pan, hyping of short-term results, but seven years of ups and downs and real money gains.

Go with an old guy—me, 53—and our team at CGI. We’re off the beaten path, which is where a smart investor--the investor who knows that returns are measure in years-- wants to be.

Join CGI Growth & Value Focus today with a 30-day money back guarantee. You have everything to gain and nothing to lose!