The Catch-22 Of Investing

I’ve been digging through the financial commentary archives of The Wall Street Journal and The New York Times to compare the tone of investment commentary in the late 1990s to the financial news in the immediate aftermath of 1987’s Black Monday in which the value of the Dow Jones dropped by 22% in a single day.

It leaves an impression to see how quickly investor attitudes changed in under ten regarding the same exact companies. On October 20th, 1987, few people were talking about the inherent quality of enterprises like Coca-Cola, Colgate-Palmolive, and Johnson & Johnson, which had been paying out annual dividend increases of almost thirty years by that time. And had been reporting steadily growing profits as well. No one cared.

Just about all common sense was abandoned. The initial prints from The Wall Street Journal and The New York Times compared the fall to the oil embargo of 1973 and were pointing out that America was doomed for yet another extension of the 1966-1981 period that saw minimal forward price movement in the equity markets.

FNN, which was the version of CNBC that viewers had at the time, broke out that iconic Dorothea Lange picture of a Depression-era woman holding her lip and rolled reruns of men in bread lines. The unpredictability, rapidity, and depth of Black Monday jolted most American investors, and the press certainly did not help restore rationality–recommending prudence and assuaging concerns does not sell newspapers or improve TV ratings.

That’s not to say you couldn’t find intelligent men in crisis if you kept your eyes peeled. Warren Buffett was penning editorials in Fortune Magazine talking about crises are where the real money is made. But to most people, he was still guy a random Midwestern running an insurance company. His larger-than-life personality did not take shape until his assumption of leadership at Solomon Brothers after the price fixing scandal of a few years later.

PBS viewers had a bit of luck, as the show hosted by Lou Rukeyser counselled long-term thinking and stated that selling in response to share price declines was a guaranteed way to become a mediocre investing by locking in permanent capital losses. The opinions of Rukeyser and his like-minded panelists were quickly discarded as old-foggy thinking.

The most populist way of receiving assurance in 1987 involved following the press accounts of Sam Walton. When Wal-Mart stock fell, reporters rang the Bentonville headquarters to receive a comment from Sam Walton. After being informed that he lost $500 million in a single day, Walton responded, “It’s only paper.” And then he went out bird hunting. He certainly exhibited the most high-profile nonchalance to his personal stock-market declines.

Within ten years, the general trepidation towards the markets was replaced with an unconstrained optimism that showed up in the valuations. The same blue-chip stocks—Coca-Cola, Colgate-Palmolive, and Johnson & Johnson—which people couldn’t get rid of fast enough just ten years previously were suddenly trading at 35-55x earnings.

This change in sentiment is a mental model I keep in my back pocket because it plays out over and over again. In 2011 and 2012, people couldn’t get enough of oil stocks. Now, no one wants to touch them. When financial commenters discuss Church & Dwight—a legitimately excellent business—they say things like, “Time cures all pricing risk.” There is some truth to the fact that super long-term horizons with excellent businesses can compensate for overpayment, but it could take 10+ years to work out Church & Dwight’s 28x earnings valuation before you re-establish the base from which you receive returns that match the business growth (or the stock could instantly fall 20% and re-establish fair value instantly.)

There are a lot of mutually contradictory pieces of financial advice out there. One of the hallmarks of Warren Buffett’s wisdom is that you should not overpay for a stock. But yet, when you listen to his speech at Florida University in 1990, you will hear him mention that some of the best stocks to buy are those “that the numbers tell you not to” because the fact that you want to buy them anymore is an indicator of a superior brand. No one would walk around looking for ways to justify paying 30x normal earnings for J.C. Penney, but plenty of people would do that for Hershey. That tells you something about long-term earnings power.

All of this is a long-winded way of saying: Perceptions quickly change, and we are dealt many incompatible philosophies (often from the same source) as we try and figure it out. The inspiration for this post was a quote I read at Seeking Alpha from a man who said he became a better investor once he became a millionaire. He stated that he only earned 3% annual returns net-of-fees during the 1990s, and added that his performance exceptionally poor given the low valuations of stocks in 1991 and the strong economic growth in the American economy that followed.

When explaining his life story, he mentioned that he grew impatient anytime a stock price didn’t advance for a couple years in a row, and then regularly moved on to the next thing. Throughout the decade, he witnesses the discarded stocks outperform the new ones. Because he had an absurdly high savings rate, he was still able to put aside $820,000 by age 60. He mentioned that once the dividends got high enough, and in light of his past record of poorly timed sell decisions, he just quit selling and started focusing on the dividend income.

His story is useful because: (1) it recognizes that having a high savings rate is more important than just about anything else, (2) he had the self-awareness to acknowledge that his strategy wasn’t working when plenty of others would have no problem mentally putting up a shield of cognitive dissonance, and (3) the switch to a dividend focus enabled him to minimize the taxes, trading fees, and tendency to sell low.

The fact that he was able to become more of a buy-and-hold investor once he became rich illustrated the Catch-22 of investing: Earning superior returns is often the result of being able to buy-and-hold even through dreadfully long periods of underperformance. The people most willing to ride out these storms are probably people who are not in timely need of building wealth. Those who are trying to get rich with some rapidity are more likely to discard stocks that aren’t regularly advancing in price.

Take something like GlaxoSmithKine. It experienced an earnings reset in 2010 when it saw profits fall from $3.38 in 2009 to $0.99 in 2010 as it lost a significant amount of patent exclusivity and was having trouble increasing revenues coming out of the recession because it lowered prices to create market share. The consequence? Between 2003 and 2015, earnings per share did nothing. GlaxoSmithKline made $2.52 per share in 2003, and is expected to make $2.50 per share this year.  That’s a fifth of your investing life with no earnings gain. You got to collect the dividend, and that is it.

A wealthy investor might look at that and think—hey, I’m collecting 6% on my money. I’ll spend this, or if possible, reinvest this and see what happens years down the road. The product brands are strong, healthcare has a strong tailwind as the market revenue for every segment is growing, and eventually GlaxoSmithKline will deliver in accordance with its historical roots. The past decade has been bumpy, but the stock still has a record of delivering 11% annual returns even incorporating an eleven-year period that did nothing but pay out dividends. In the long run, the high dividends reinvested at this low price will be a benefit. That principle has been well established by Jeremy Siegel in his research on tobacco stocks, and the earnings quality of GlaxoSmithKline is high enough to warrant perpetual reinvestment without fear of a Wachovia-type ending.

It would be much harder being a young investor trying to maintain this attitude. When you are trying to turn $50,000 into $1 Million, you might see your college graduate friends raving about Facebook and its perpetual gains (rising from $62 to $81 per share in the past year). People find a way to ignore 80x earnings valuations when the account balance says you’re getting richer every day. Fear-of-missing-out syndrome can kick in while your GlaxoSmithKline stock is languishing.

Long-term investing strategy can play this game on you where the strategy that builds the most wealth over the long haul involves tolerating years of chronic underperformance. Of course, tolerating this is much easier when you don’t need capital gains in the near term to pay tuition bills, mortgage payments, and the other expenses of life. For those early on the road, it would seem the best course of action would be to respect your past self and maintain your holdings in general underperformers (especially if there is a meaningful dividend to reinvest) and focus your energy instead on improving your savings rate and finding new areas of growth possibilities. You won’t go through that period where you see your discarded stocks outperform the new things you find.