Math, History and Psychology - Part 3
Smead Capital Management
By Bill Smead
July 12, 2012
Dear Fellow Investors:
Over
the years, we have heard Charlie Munger state that Psychology is the
most underrated and underutilized of the major academic disciplines in
business and investing. Andy Grove backed this up in a Fortune magazine
interview by telling about the best business advice he had ever
received. His City College of New York professor told him, “When
everybody knows that something is so, it means nobody knows
nothin’.” At Smead Capital Management (SCM), we like to say that
successful investing is the defeat of human nature. This missive will
dig into the academic discipline of psychology and speak to using it to
invest successfully.
Why
is psychology an underrated and under-utilized discipline in business?
We believe there are four reasons. First, it is counter-intuitive.
Psychology
requires you to toss out logic and rationality. When there are either
seemingly unsolvable economic or business problems, psychology demands
at the extreme that you bet against the obvious. When a never ending
stream of good news causes logical and rational
experts to predict more of the same, you must “circle the wagons” (John
Kenneth Galbraith-A Short History of Financial Euphoria). Currently,
the US stock market suffers from what Randall Forsyth at Barron’s calls
“rational despair”. It is an unhealthy pessimism
in the same way that ‘irrational exuberance” was a destructive
optimism. These are psychological phenomena.
Second,
psychology never got the best scholars or professors. In the late
1970’s, psychology was considered an easy class and a default major for
those on rehab from economics or math or history or chemistry.
Psychology has been considered somewhat of a “voodoo” discipline. It
helps us explain things, but can it really solve anyone’s problems.
Psychology is the unwanted step-child of higher academics.
Third,
psychology kills the ability of intelligence to equate to successful
investing. A PhD in Economics or Math and a librarian are likely to know
math and history better than anyone you know. However, the math you
need to be a successful investor is learned by the end of the seventh
grade, in our opinion. If you are comfortable doing percentages and have
the ability to understand crowd psychology, you
can be a wealth creator in the US stock market. Over-educated people
have a tendency to over think situations. Ben Graham said that as soon
as the complex math gets thrown into the situation, you know that
trouble is brewing. Here is how he said it in 1958:
“Mathematics
is ordinarily considered as producing precise, dependable results. But
in the stock market, the more elaborate and obtuse the mathematics,
the more uncertain and speculative the conclusions we draw there from.
Whenever calculus is brought in, or higher algebra, you can take it as a
warning signal that the operator is trying to substitute theory for
experience.”
Just
ask the folks at Long-Term Capital Management or analyze the investment
returns of all the money being run today based on
macroeconomic/mathematical
genius in mutual funds, ETFs and hedge funds. Is the average
institutional investor getting what they are paying for? Is there any
chance the category is going to do well when it reaches down into the
retail investment world? It is one of the psychological
signs that we look for.
Lastly,
psychology is hard to measure. At SCM, we look at sentiment polls,
insider buying, media coverage, asset allocation, anecdotal evidence and
just about anything else which confirms that the crowd has moved to one
side of a market. Reading the psychology is mostly learned by
participating in the markets and through years of experience. The
primary benefit of experience is having been in similar
situations before. Professional golfers talk about dealing with the
psychology of being the leader on Sunday in a pro golf tourney.
Professional investors measure psychology in the same way. It is a gut
feel and a learned discipline.
Andy
Grove’s thought points out that psychology in business is most valuable
at extremes. At SCM, we operate under the assumption that if 80% of
the participants in a market are bullish or bearish, the exact opposite
of their opinion is the right bet. A few examples would be helpful.
Everyone knew by 1999 that the internet was “going to change our life”
and that you must own companies which would benefit
from that huge secular trend. They couldn’t have been more wrong. The
sentiment polls showed historically high levels of bullishness among
individual and institutional investors. A Paine Webber/Gallup poll of
their clients with less than five years experience
showed that they expected 22.6% compounded returns over the next ten
years. They got two 40% bear market declines and a lost decade in the
stock market.
A Bespoke website poll at the bottom of the stock market on March 9th of 2009 showed that 89% of those polled felt that the US stock market
was headed lower and 59% felt that it would bottom at or below 5000 on
the Dow. It was trading at 6480 at the time. One year ago, the Barron’s
“Big Money Poll” showed that 73% of those polled were bearish on US
Treasury Bonds and only 5% were bullish. The
tiny minority was the big winner over one year. At the risk of being
repetitive, psychology is very useful at extremes.
This
same psychology is useful in the shares of individual common stocks. We
have a rule at SCM. Whatever we own that gets questioned, objected to
or made fun of by those we come in contact with, is likely to
outperform in the following three years. In 2008, we got a regular diet
of criticism for owning Starbucks (SBUX). Every day, someone would call
us and say, “Nobody is going to want to pay $4 for
a cup of coffee” or “those guys will never get their mojo back”.
We’ve
received the most questions recently on Bank of America (BAC) and
Gannett (GCI). Quite a contrast, since Warren Buffett seems to be buying
up every community newspaper in the country and pumped $5 billion into
Bank of America preferred stock with warrants to buy the common
attached. We have been questioned for avoiding energy, basic material
and heavy industrial shares in light of the secular
crowd belief in the “global synchronized trade”. China’s secular trend
smells, feels and acts like the internet bubble to us, so we have to sit
it out.
In
summary, we at SCM believe that the academic disciplines of Math,
History and Psychology are important to undergirding the investment
discipline
of those who seek to create wealth in common stock investing. All three
in concert is our preference and don’t forget to pay psychology its
proper respect.
Best Wishes,
William Smead
The
information contained in this missive represents SCM's opinions, and
should not be construed as personalized
or individualized investment advice. Past performance is no guarantee
of future results. All of the securities identified and described in
this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in this missive and do not represent all of the securities
purchased or recommended for our clients. It should not be assumed that
investing in these securities was or will be profitable. A list of all
recommendations made by Smead Capital Management
within the past twelve month period is available upon request.
(c) Smead Capital Management
