Playing the Loser's Game

In a 1975 article in the Financial Analysts Journal entitled “The Loser’s Game”, Charles D. Ellis wrote:

Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages.

Ellis concluded that the influx of smart and motivated people into the industry led to money management becoming a “loser’s game” -- a game in which you'd be crazy to compete and one that you should perhaps consider surrendering to (i.e. buy an index fund). Ellis recently reiterated this opinion in a recent article for the Financial Analysts Journal. 

Time to throw in the towel?

It's natural to read these comments and get discouraged about buying individual stocks, but Ellis's 1975 article offers a few excellent tips on how to not play the loser's game. 

1. Be sure you are playing your own game.

The individual investor’s advantage is not in trading. The hedge funds, mutual funds, and professional traders of the world simply have better data, more advanced trading platforms, and more financial incentive to focus on the short-term. The weekend investor doesn’t stand a chance versus this type of firepower, so trading is a game where the odds are stacked against the individual investor.

Staying patient, keeping a long-term mindset, and exploiting your advantages as an individual investor alters the playing field and improves your odds of success.

2. Keep it simple.

The less complicated your investment strategy, the better. As Ellis recommends, "Try to do a few things well." By focusing your efforts on one strategy -- whether it is based on dividends, small caps, deep value, etc -- and consistently sticking with it, you can more effectively tune out distractions and make better decisions. As a result, you'll keep trading costs down and give yourself the best opportunity to realize your return objectives. 

3. Concentrate on your defenses.

Ellis advocates improving your selling strategy because the market’s focus on buying makes it difficult to gain an edge on that side of the equation. It’s a fair point. 

To figure out how we might improve our selling strategy, let's consider the market's selling strategy.

While each investment firm has its own selling strategy, we know that the average mutual fund turnover ratio in recent years implies that, on average, stocks owned by funds have been held for just over one year.

Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots well above your fair value estimate, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.

4. Don’t take it personally.

According to Ellis, the market turned into a loser's game precisely because investors’ "efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem." Resist the temptation to try harder for better returns. In fact, do just the opposite. This doesn’t mean you should pick stocks at random and buy and hold forever. Do your homework, of course, but be deliberate and patient, too. Let the market go through its phases of euphoria and despair and stay your course. Don't try to force returns.

Bottom line

Trying to beat the market in the short-run is a loser’s game if you make it your primary investment objective, so don’t play it. Instead, redefine the game. Establish your own objectives, stick to your strengths, and stay patient and when you look back at your returns five years from now, I think you'll like what you see. If you happen to beat the market, all the better.

For more on the "loser's game", a new multi-part video series by Sensible Investing addresses the topic and has a lined up a number of good interviewees. Here's the trailer.

What do you think? Let me know on Twitter @toddwenning. 

I've updated my Dividend Compass spreadsheet to fix a few bugs. You can download the updated version here. 

What I've been reading this week:

• Profile of hedge fund manager Joel Greenblatt - Barron's
• How The City is overcharging investors - Monevator
• Buying insurance after a disaster strikes - A Wealth of Common Sense
• Time, not timing, is the key to investing success - Washington Post
• Don't let a single event change your investment strategy - NY Times

Stay patient, stay focused. 

Best,

Todd

A version of this post was published on April 14, 2012. It has been updated.

Book Review of The Outsiders

I finally got around to reading William Thorndike's The Outsiders -- a sure classic that I've added to the "must read" section of my recommended books on investing.

Looking through my Kindle copy of the book, I have 70 highlights and bookmarks, so going through all of them here would be a bit onerous to both read and write.

Instead, I want to focus on the core principles of eight CEOs that Thorndike lays out in the introduction.

With a nod to Buffett's Graham and Doddsville, which analyzes a group of investors who consistently beat the market by following the principles of Benjamin Graham and David Dodd, Thorndike calls his group of CEOs "Singletonville" after former former Teledyne CEO Henry Singleton.

While each CEO was dealt different sets of cards, they all played their hands incredibly well by understanding the following principles and putting them into action:

• Capital allocation is a CEO's most important job.
• What counts in the long run is the increase in per share value, not overall growth or size.
• Cash flow, not reported earnings, is what determines long-term value.
• Decentralized organizations release entrepreneurial energy and keep both costs and "rancor" down.
• Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
• Sometimes the best investment opportunity is your own stock.
• With acquisitions, patience is a virtue...as is occasional boldness.

Right away, you'll notice that most CEOs don't embody these principles. In fact, if you invert each principle, you're closer to how most CEOs approach their jobs (with perhaps the exception of the sixth principle).

Even though Buffett's been writing about the importance of management's capital allocation decisions for decades, it's a topic that's been undercovered for much too long.

The reason it has flown under the radar, I believe, is that analyzing management is largely qualitative in nature and doesn't lend itself well to screening tools and Excel spreadsheets.

Measuring management

Indeed, it's generally only after the fact that a CEO's impact can be measured and appreciated. Thorndike writes, for instance, that "You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500)."

The key for investors, of course, is to identify these CEOs before they dramatically outperform the market and their peers.

And here is where understanding the capital allocation processes practiced by the CEOs in Thorndike's book come in handy. If you come across a CEO or management team with an approach that includes some of the principles mentioned above, you might be onto something.

The next step is to read the company's annual reports, understand how executives are incentivized, and reverse engineer management's capital allocation decisions to determine why and how management arrived at its decision to acquire a certain company, divest an asset, or repurchase its stock.

Just because a company may not be led by a member of Singletonville doesn't mean the company isn't worth owning. Elite capital allocators are few and far between; decent-to-good capital allocators, while still rare, are more common. Provided those decent-to-good capital allocators are running a company with durable competitive advantages, that can still be an attractive business to own at the right price.

Finally, the princples outlined by Thorndike in Outsiders can also help you avoid investing behind CEOs that are decidedly poor capital allocators, and ultimately that might be just as important as finding the elite CEOs.

What I've been reading this week

• Capital allocation paper by Michael Mauboussin and Dan Callahan, CFA
• Bonds have taught us a lesson in 2014 -- Monevator
• Investing lessons from a 108-year-old investor -- Telegraph
• A good investing checklist by Richard Beddard
• All-time highs in the market are perfectly normal -- A Wealth of Common Sense

Stay patient, stay focused.

Best,

Todd

@toddwenning on Twitter